One sector of the market that has looked consistently cheap for the last five years is the offshore oil and gas drilling industry.
At the time of writing, the biggest companies in this sector trade at a price-book value of around 0.4 or less, even though the price of oil and drilling activity has recovered modestly over the past two years.
The three most significant players in this market are Transocean Ltd. (RIG, Financial), Rowan Companies PLC (RDC, Financial) and Diamond Offshore Drilling Inc. (DO, Financial). Of these three, Rowan and Transocean trade at book value of around 0.35 while Diamond is trading at a price-book ratio of 0.4. None of these businesses are expected to report a net profit during the next two years, so from a valuation perspective, it is only really possible to value them based on net asset value.
From a valuation perspective, how reliable are these net asset values? Are they trustworthy enough for investors to rely on them when calculating the margin of safety between intrinsic value and the current stock price?
What's the real value?
In all three cases, the most valuable assets of each company are their drilling fleets. The value of each drilling asset depends on various factors, such as age, ability, scrappage value and, ultimately, demand.
Because it is going to be challenging to provide a complete evaluation assessment of each asset, I'm going to give a rough estimate of what I think the assets are worth looking at past market trends. For example, we know that at the beginning of this decade, brand new sixth-generation drillships were costing customers more than $600,000. According to recent sales, the price in the secondary market is now around half that.
Straight away, if we look at Rowan's balance sheet, it becomes clear the value of the assets on this company's balance sheet might not be worth what it believes they are. Even though it has taken some write-downs in recent years, the value of assets on the balance sheet has actually increased since 2012 from around $6.2 billion to $6.9 billion. Transocean seems to have adopted a more conservative method of accounting. It has written down the value of its drilling assets by nearly $5 billion since 2012. Diamond's fixed assets have stayed relatively unchanged over the past six years.
Growing market
I admit, this is an exceptionally inaccurate way of measuring the underlying asset values of these companies, but it does immediately show what I am looking for -- the fact that if liquated today, these companies would not be worth their published book values.
That being said, the outlook for these companies is much brighter than it has been for several years. Offshore spending is expected to increase 4% to 5% in 2019 and even outgrow onshore investment. Oil majors will spend $208 billion on offshore drilling and other oilfield services this year. Barring a sudden decline in the price of oil, the deepwater industry could grow as much as 25% over the next three years according to the most optimistic forecasts.
In this market, the combined Ensco PLC (ESV, Financial) and Rowan Companies should be able to achieve substantial growth with its new-found scale, but looking at Ensco's balance sheet, this is another company that seems to be overstating the value of its drilling fleet in the current environment.
The company's total value of fixed assets over the past several years has remained constant, though the number of shares and issue has increased, cutting book value per share by 60% since 2012.
Not cheap enough
This analysis isn't perfect, but it does give a broad overview of the state of the industry at the moment.
Considering all of the above, if I had to pick one of these companies to invest in, I would go for Transocean. Ensco and Rowan have the potential to create a drilling behemoth, but at this point, we don't know how the two companies will act when combined.
Meanwhile, Diamond looks expensive. If we assume the company's book value per share is actually 50% less than the current published value, the stock is trading around book value today. Applying the same logic to the book value of Transocean implies a possible margin of safety of around 20% to 30%.
That kind of margin of safety might be attractive for value investors. However, as I have tried to make it clear, it is almost impossible to try and establish the actual underlying value of each company's assets because there are so many moving parts.
With that being the case, I personally believe the industry is uninvestable.
Disclosure: The author owns no stocks mentioned.
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