Atwood Oceanics (ATW, Financial) is a global offshore drilling contractor based in Houston. It is engaged in the business of leasing its rigs to oil companies, who then drill the oil out of the ground. Atwood has a fleet of 13 modern rigs, employed in a wide range of areas around the world. Recently Atwood’s stock has been hammered due to the tailspin of oil prices and the general uncertainty related to the oil market. This might present a good opportunity for value-oriented investors.
The industry in which Atwood operates, is dominated by risks the individual company has no control over, such as oil prices. However, what Atwood has done, as opposed to its competitors, is to lock in long-term contracts when the oil price was high. Therefore it can benefit from a stable source of income, even as the oil price hits daily lows, and the competition struggles. Furthermore, it has a wide range of clients, which means it has mitigated the risk of relying too heavily on one customer.
In addition, management has recently renegotiated a contract-extension of one year, in exchange for slightly lower day rates on one of its rigs, providing the company with more certainty over its income in the coming years.
Financials
Over the last 12 months, Atwood has a net income of $394 million, on revenue of $1.356 bllion, which is 15% higher than the $341 million on $1.174 billion it made at the same time last year.
When looking at the company’s financials it is clear that it has one of the most solid operations in the business. Apart from its locking in of profits, it is also signified by its 32% operating margin, which is not only way above the industry average of 17%, but also best in the business.
Furthermore the company earns a return on its invested capital of 10.5%, which serves to further underscore the operational strength of Atwood Oceanics.
Its debt/capitalization is set to average at 35% through 2018; combined with its revolving debt facility of $500 million, this gives it plenty of financial flexibility to weather the current storm on the oil market.
As an extra kicker, it pays a dividend of $1 per year at a yield of close to 6%.
In short then, we are talking about a financially sound, growing company, which has a management with a proven track record at the helm and pays a nice dividend. So then, it’s probably selling at a premium, right?
Wrong.
Valuation
The company is selling at a huge discount to intrinsic value. Specifically it is selling at a price to tangible book – i.e. after subtracting goodwill and intangible assets – of just 0.4. This represents a potential upside of 150% if the stock just converges to a P/B of 1. As I was discussing above, this is an operationally efficient company, which for all intents and purposes should trade at a premium to book, but it doesn’t.
In order to determine how much growth the market is factoring in, over the coming years, I employ a reverse DCF. If the company proceeds as a going concern for another five years, and then subsequently enters the terminal growth stage the annual growth in earnings is expected to be at around -20%, when employing a (highly conservative) discount rate of 11%. One can play around with the numbers in order to change the assumptions, but the overall conclusion remains the same. This company sells far below intrinsic value, regardless if one looks at the valuation in relation to the assets, or the earnings of the company.
Second-level thinking
In order to make sure I’ve got my thesis right, and don’t catch the proverbial falling knife, I employ what Howard Marks(Trades,Portfolio) terms second-level thinking. In other words, I need to be certain that I haven’t overlooked any crucial factors in analyzing the company, and that means asking myself questions such as:
- What is the range of future possible outcomes?
- Why does the market think this company is unattractive, and is it right?
- What will happen to the stock if the market is right?
- What is the probability that I’m right?
- What will happen to the stock if I’m right?
It is impossible to correctly predict the range of future possible outcomes, but according to OPEC, one of the most likely scenarios include a stabilization of the oil market, and a slightly increasing oil price as the demand for oil stabilizes above the current level. Another possibility is that the oil market goes through a continued slump, and oil prices continue to fall and stabilize below the current level of around $50 per barrel, and supply continuing to outrun demand. This is another likely scenario but not as likely as the first. The third scenario I’ll include is that the fall in the oil price signals the coming of a global recession, with demand for oil nosediving, and thus the price falling below $20 per barrel and staying that low for an extended period of time. This is the least likely scenario of the three, and I assign a likelihood to the three outcomes of 65%, 25% and 10%.
As was evident from the reverse DCF I ran above, it is clear that the market is pricing this stock – and the whole drilling sector in general – as if it is expecting a long, protracted slump in oil prices, in the range of $20 to $30 per barrel, a scenario I find highly unlikely. Furthermore, the volatility of the oil price has increased significantly in the last six months, signaling a high degree of uncertainty. And if there is something the market hates more than anything else, it is uncertainty. So with both these factors priced in to the stock already, it is highly unlikely that the stock will continue to fall if the market’s prediction is right because the worst type of doomsday scenario is already priced in.
My prediction can be summed up to the following: “I don’t believe the oil price will fall to the range of $20 to $30 per barrel, and stay there for an extended period.”
I feel fairly confident about this prediction, and as such attribute an 80% probability to its correctness. If I am right about this prediction, then it should only be a matter of time before the price of the stock of Atwood Oceanics converges to the intrinsic value of the company, which I think is at least $2.5 billion, or $39 per share. This represents an upside of 45%, if I am right about my thesis. If I am not right, I don’t stand to lose much as the worst-case scenario is already priced in to the stock.
Recommendation
There is a very wide margin of safety here, meaning I am well insulated against errors in calculation, or overlooking of crucial factors, which means that if I buy this stock, I can continue to sleep well at night.
To me, this is as classic a Dhando-play as they come: “Heads I win, tails I don’t lose much” I highly recommend buying this stock.
