As Benjamin Graham once wrote, there are no bad assets, just bad prices. This statement describes what value investing is all about: As long as a company is cheap enough it is worth buying.
The big question value investors always have to ask is this: Is the company cheap enough? Sometimes the answer to this question is not apparent.
The offshore drilling sector is a prime example. As the price of oil has collapsed over the past two years, offshore drillers have been walloped by falling demand for their services. With the use of shale oil exploding, the cost of extracting shale oil has plunged; in comparison to deepwater drilling, it’s now much easier for oil companies to drill for oil onshore than spend billions on potential offshore projects only for the well to come to nothing.
Huge losses
Earnings have collapsed at the largest drillers since 2014, and as a result, massive losses have been forced on shareholders. Specifically, shares in Rowan Companies (RDC, Financial) have plunged 68%, Ensco (ESV, Financial) is down 89%, Transocean (RIG, Financial) has fallen 82%, Seadrill (SDLP) is insolvent and down 99%, and Atwood (ATW, Financial) has slumped 81%.
Rowan has produced the best returns because it has the most conservative management. Unlike Seadrill, which borrowed heavily against future cash flows to fund the expansion of its fleet before the oil downturn, Rowan limited its development program to four new expensive ultra deepwater drillships funded with a small amount of debt but a lot of cash. At the end of the first quarter, the company reported cash and cash equivalents of $1.2 billion and net debt of $2.6 billion, which is not the best balance sheet to have to go into a prolonged cyclical downturn, but it is better than many of the other drillers.
The question is, do Rowan and any of the company’s peers now offer value after the declines in the value of their shares over the past two years? This is a topic I’ve reviewed several times in the past because the long lifespan of oil rigs makes them a durable asset and buying these long-term durable assets at an appealing price could yield impressive long-term results if and when the market returns to growth. Still, as Graham wrote, it’s not the asset that matters, it’s the price. Are the drillers cheap enough yet?
Cheap enough?
Answering this question requires an estimation of asset values. How much are the assets on these drillers’ balance sheets actually worth? This question is not easy to answer because there is little in the way of an active market for old/relatively new drillships and oil rigs.
It’s estimated that the secondhand price for drillships acquired at the peak of the market for $650 million go for around $65 million today. Such a deeply discounted price presents a problem for valuation. In fact, this price may not be low enough as there are so many drillships out of work (all but one of Rowan’s four new rigs are out of work and the last contract rolls off in August 2018) customers can effectively name their price when it comes to signing new contracts.
Trying to work out the value of the rig asset based on future cash flows then is nearly virtually impossible. What’s more, even if we take (arguably an artificially high figure) the $65 million price tag for drilling units and superimpose that onto existing balance sheets we find that companies like Rowan have negative shareholder equity as there’s been no such re-evaluation by managements. Another example, Transocean, may seem cheap with a market capitalization of only $3.3 billion but between year-end 2015 and the first quarter of this year, the value of the company’s assets as reported on its balance sheet has remained stable at around $27 billion. It’s difficult to see how this figure accurately represents the actual value of the company’s assets when another data point suggests similar assets have lost 90% of their value.
Overall, until it’s possible to value the equipment on drillers' balance sheets accurately, it’s going to be impossible to tell whether these stocks offer value. One thing that is clear is that advances in technology and cost deflation for oil service companies has dramatically depressed the income they can generate from their assets, and it’s very unlikely industry profitability will ever return to historic highs. Therefore, the assets need to be revalued to reflect the different environment. Even though the drillers have lost most of their equity value since 2014, there could be further declines to come as writedowns pile up and the sector settles into the new normal.
Disclosure: The author owns no share mentioned.
