Times are hard for value investors. The bull market that has been in place since the financial crisis is the second longest-running bull market in history and such an extended period of rising asset prices has made it tough to find any value investments. There are still sectors that offer value, but they are not the most attractive. The offshore drilling sector is one such example.
All offshore drillers currently trade below their per-share book value, which makes the industry look attractive at first glance. However, as with every potential value investment, investors need to consider whether or not the value of these companies will ever recover or if they are just value traps.
Value Play or Value Trap?
The problem with the offshore drilling sector is it is almost impossible to calculate a correct value of the assets on drillers’ balance sheets. There have already been two high-profile drillship sales this year that have come in far below expectations. State-of-the-art drillship, the Deepsea Metro II, was sold for a mere $210 million at the end of March, compared to its 2011 price tag of $860 million. Then at the end of April, Ocean Rig (ORIG, Financial) stepped in to buy the sixth generation ultra-deepwater (UDW) drillship Cerrado for only $65 million. According to Seadrill Ltd. (SDRL, Financial) CEO Per Wullf, even $65 million was still "probably too much" for a rig that has not worked for a year.
Rigzone reports comments from Alex Brooks, an analyst at Canaccord Genuity Group Inc. (TSX:CF, Financial) who speculates that sixth generation UDW drillships like the unit Ocean Rig acquired last year, "are worth about $50 million, or possibly nothing at all, if they haven't been working recently."
Some drillers have already announced hefty asset write-downs, but these have tended to be older rigs that cannot find work in the current environment. Drillships and rigs that are currently working have not been revalued for the most part, but it is only going to be a matter of time before the value of these assets will need to be recalculated. At the peak of the market high, spec drillships were receiving market rates of $650,000 a day, now rates have dropped as low as $220,000 a day. You don’t need to be a CFA charter holder to realize that a 66% decrease in the earnings power of an asset reduces its value significantly. Because some drillships are still on contracts signed in the peak times, lower rates have not fully flowed through to the industry, leaving offshore drillers vulnerable to a contract expiration and write down cliff during the next few years – this makes the group almost impossible to value.
Where’s the Margin of Safety?
An essential part of value investing is the margin of safety principle. If you buy a stock at a deep enough discount to its intrinsic value, you limit downside risk and maximize the potential upside.
The problem with the offshore drillers is that it is impossible to calculate an exact intrinsic value with the value of offshore rigs falling almost every day. Therefore, if it is impossible to calculate a per-share intrinsic value, it is impossible to buy with an appropriate margin of safety.
Take Seadrill for example. The company’s second-quarter earnings report states that the total value of the group’s drilling unit fleet of 68 rigs is $16.1 billion, which gives an average book cost of just under $240 million per unit. On top of the drilling fleet, the company has $7 billion in other assets, $8 billion in long-term debt and $2.5 billion in short-term debt for a total shareholder equity value of $10.3 billion, or $19 .65 per share. However, in the worst case, if Seadrill were to sell all of its drilling units today into the market, based on recent transactions the group may not receive more than $60 million to $70 million on average per unit. (This is a rough estimation and does not take into account the age and specification of every single one of Seadrill’s drilling units). So, assuming the company receives $65 million per unit, the value of the company’s drilling assets will fall to $4.5 billion. The value of other assets takes the net asset value to $11.5 billion, but $10.5 billion in debt reduces shareholder equity to just $1 billion, other liabilities at the end of the second quarter totaled approximately $2 billion. All in all then, based on the rate Seadrill would get for its drilling units if the company sold them into the market today, the company’s equity is worth $-1 billion.
Seadrill is an extreme example, but it is an example nonetheless. Other offshore drillers such as Transocean (RIG, Financial), Ensco (ESV, Financial), Diamond Offshore (DO, Financial) and Atwood Oceanics (ATW, Financial) are all subject to the same issues with valuation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Start a free 7-day trial of Premium Membership to GuruFocus.
