The broad energy sector has witnessed massive carnage, and the offshore drilling sector has been among the worst hit. Just to put things into perspective, Seadrill (SDRL, Financial) has declined by 70%, Ocean Rig (ORIG, Financial) has declined by 82%, and Pacific Drilling (PACD, Financial) has declined by 81%.
After such deep corrections, it is natural that investors will be wary of considering exposure to the sector, and I agree with the opinion that the offshore drilling sector will witness difficult times through 2016. However, when sentiments are so bearish, there are always some excellent long-term investment opportunities, and smart investors gradually accumulate stocks in industries where sentiments are as bearish as possible.
With this view in mind, here is my offshore drilling stock pick for 2016. I don’t expect the stock to surge in 2016, but the worst might be over, and the offshore driller is worth accumulating at current levels.
Rowan Companies (RDC, Financial) is my offshore drilling sector stock pick for 2016, and I am bullish on the stock at current levels. Rowan Companies' stock has declined by 27.5%, and this is an excellent performance compared to its peers. Even if other names are considered, Ensco (ESV, Financial) has declined by 50%, Transocean (RIG, Financial) has declined by 33%, and Diamond Offshore (DO, Financial) has declined by 43%. There are strong fundamental factors supporting the stock.
Strong balance sheet
As of September, Rowan Companies had $2.8 billion in long-term debt and $290 million in cash and equivalents. This implies net debt to capitalization of 37% and provides Rowan Companies with strong financial flexibility in times of challenging industry conditions. It is not surprising to see Rowan Companies commanding investment grade rating of BBB-/Baa3.
From a liquidity perspective, Rowan Companies has $290 million in cash and $1.5 billion in undrawn revolving credit facility. Liquidity position of nearly $1.8 billion provides a strong cash buffer in addition to the company generating strong free cash flows.
Rowan Companies has only $400 million in debt maturity through 2017, and this implies no debt refinancing concerns in the near term. Overall, the company’s balance sheet position and liquidity are robust and likely to remain vigorous through 2016.
Robust order backlog
As of September, Rowan Companies had $4.1 billion in total order backlog. This provides strong revenue visibility even in challenging times.
For 2016, the company’s order backlog is nearly $2.0 billion, and this will ensure strong EBITDA and cash flow generation. For the first nine months of 2015, Rowan Companies reported $1.6 billion in revenue and $658 million in operating cash flow. Considering the same revenue-to-cash-flow conversion metrics, investors can expect approximately $800 million in operating cash flow for 2016.
Even for 2017, the company’s order backlog is around $1.1 billion, and I expect that to improve through 2016. The key point here is that the company’s revenue and cash flow is likely to remain decent even in challenging times, and this will help Rowan Companies deleverage in the next 12 to 24 months.
No new builds
Besides leveraging impacting credit metrics for offshore companies, one of the biggest challenges faced by offshore drillers is the new rig pipeline for the next two to three years. In particular, Seadrill has a significant new rig pipeline, and it is likely to translate into further leveraging instead of debt reduction.
For Rowan Companies, the biggest advantage is that the company has no new rig deliveries. Therefore, with $800 million operating cash flow likely in 2016, the company’s focus will be on increasing the cash buffer or reducing debt.
In other words, even if industry conditions remain challenging through 2016, Rowan Companies is likely to end the year with fundamentals better than 2015. It would be another point of discussion if industry sentiments remain weak through 2017, but that is too early to predict and for the next 12 months, Rowan Companies will maintain its investment grade rating with ease.
Conclusion
Considering all these positive factors coupled with the fact that the company has a significant number of high-specification rigs, Rowan Companies is worth considering at current levels. The stock can remain sideways or trend only marginally higher in 2016, but these valuations will be hard to get once industry recovery commences.
It makes sense to consider gradual exposure to a quality stock trading at TTM EV/EBITDA of 4.6. Rowan Companies will be the best-performing offshore drilling stock in 2016 and among the best-performing companies in the long term.
Disclosure: No positions in the stock
