Investment overview
One of the biggest casualties in the energy crisis is the offshore drilling sector, with several companies struggling with leverage concerns and others remaining weak due to lack of contracts and declining day rates.
After a challenging fiscal 2016 in terms of business and stock performance, offshore drilling stocks have slumped in 2017 as well. Rowan Companies PLC (RDC, Financial) has declined 42% year to date. Seadrill Ltd. (SDRL, Financial) has slumped 89% year to date and Diamond Offshore Drilling Inc. (DO, Financial) and Ensco PLC (ESV, Financial) have declined 35% and 44%.
While I will mainly focus on Rowan Companies fundamentals and outlook, the conclusions drawn can be applied to my general view of the sector.
Why Rowan Companies?
Among offshore drilling stocks, Rowan Companies is one the few players that can still come out of the crisis with relatively strong fundamentals. The following factors make the company interesting from a fundamental perspective.
Seadrill has been one of the worst performers in the industry. One of the key factors that resulted in the company's downfall was its leverage and excessive speculative new rig orders. In contrast, Rowan Companies has a well managed balance sheet and there are no speculative new rigs lined up for delivery.
In challenging times, the top priority is to deleverage and conserve cash. While Diamond Offshore has also done well on that front, I like Rowan Companies considering it currently has a robust cash buffer of $1.2 billion. In addition, the company has managed to reduce debt by $740 million since fourth-quarter 2015 while issuing $500 million in unsecured debt that is not due before 2025.
Therefore, positive factors related to the company’s balance sheet are the key reason to pick Rowan Companies over other offshore drilling stocks. Further, a deep correction of 40% in 2017 makes the stock worth investigating for further value.
The key positives
The first bullish factor for Rowan Companies is its cash buffer of $1.2 billion. With no new rig capital expenditure, the company can use the cash for further deleveraging, opportunistic acquisitions or for investing in ARO Drilling.
The second bullish factor is the company's joint venture with Saudi Aramco. The deal is for the ownership and operation of jack-up drilling rigs in Saudi Arabia. With the company planning 20 rigs over the next 10 years, this can potentially be a fruitful long-term association for Rowan Companies. The deal, however, will not have a significant impact on cash flows in the next 12 to 18 months.
The third important point is Rowan Companies has a quality fleet. The company has the largest fleet of high-specification jack-ups in the industry and four ultra-deepwater drill ships, adding to the attractiveness of its assets. When the industry recovers, Rowan Companies will be well positioned to garner contracts as it will be supported by a strong balance sheet.Â
The key concerns
The biggest concern is the timing of the industry's recovery. In 2016, there were reports of early signs of recovery for the offshore industry in the second half of fiscal 2017. At this point, however, that seems unlikely.
Oil has been in a narrow range and even if it trades at $50 to $55 per barrel, I do not see strong recovery for the offshore industry. While Rowan Companies has strong fundamentals, a declining order backlog can be a concern in fiscal 2018.
Rowan's order backlog for the remainder of fiscal 2017 is currently $670 million. This will ensure ample free cash flow considering the company expects capital expenditures of $125 to $130 million for the year.
The company’s order book for fiscal 2018, however, is slim at $440 million. I see this as a concern if oil remains sideways to marginally higher. While Rowan Companies expects recovery in the industry to commence at the beginning of 2018, I am skeptical.
It is also important to note new rig contracts will have lower day rates and the EBITDA margin will shrink in the coming quarters. Therefore, for cash flows to remain healthy, the backlog needs to swell, which will be difficult for the next 12 to 18 months.
Conclusion
My broad view of the offshore industry was relatively positive at the beginning of fiscal 2017, but market conditions indicate more pain for offshore drillers in the foreseeable future.
While Rowan Companies is well placed fundamentally, I would advise investors to wait for early signs of recovery in the offshore industry before considering any exposure to the stock. I believe the same holds true for other offshore drillers as well.
Disclosure: No positions in the stocks discussed.
