One Small Driller With a Big Upside
Norman is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Industry Overview
Contract drillers are considered part of the upstream Exploration & Production (E&P) segment within the Oil & Gas industry. They can be differentiated a variety of ways including by their domestic vs. international operations, rig types and depth capabilities, and whether the driller is onshore or offshore. For offshore contractors, rigs can be deployed to a number of regions including Australia, Southeast Asia, W. Africa, S. America, and the Gulf of Mexico. The industry is highly dependent on crude oil prices and driven largely by Brent crude rather than West Texas Intermediate (WTI) given the international nature of their operations. Some non-GAAP industry metrics useful for analysis include day-rates, utilization, and backlog.
The customers of contract drillers tend to be the larger integrated and diversified oil companies. The value add a contract driller provides is that they bear the risk of making large CapEx outlays for the rigs that can be upwards of $700M for an ultra-deepwater semisubmersible. Because of the large CapEx outlays, many firms within the industry do not pay dividends. Plant, Property, and Equipment (PP&E) can comprise up to 80% of the total assets on the balance sheet.
Contracts generally have a set time frame and a day rate specified. Oftentimes they will have cost escalation provisions and sometimes foreign exchange provisions as well. The customer generally provides indemnification with respect to pollution or contamination for the driller and as well pays for the mobilization cost of getting the rig to the drill site, albeit at a lower day rate. Some contracts have an option for cancellation by the customer with partial compensation for loss of contract.
The industry trend recently has been toward high-specification rigs and ultra-deepwater rigs which command the highest day rates, upwards of $600,000/day in some contracts. As a result, this favorable revenue mix will help to bolster average day rates. Additionally Brent crude has been trending upwards since late June 2012.
Brent Crude Oil Spot Price data by YCharts
Business Overview
Atwood Oceanics (NYSE: ATW) is a relatively small offshore contract driller with 9 rigs under contract, 4 under construction, and two inactive rigs that are not actively marketed (cold-stacked). Atwood’s fleet size is 1% of the total worldwide fleet of 797 rigs. Atwood files fleet status reports with the SEC via the 8-K form at the beginning of every month. Average day rates for Atwood have been trending upwards and were reported at $301,000 on the Q3-2012 earnings call. Atwood does not pay a dividend and is in fact prohibited from doing so based upon its debt covenants unless approval is obtained from the lender.
Recent CapEx outlays have reduced their cash on the balance sheet to $78M. Comparatively, they started the fiscal year with $295M cash on hand. Any future CapEx will require additional financing via debt or equity issuance. Historically CapEx has been financed by a mixture of cash on hand, cash flow from operations (CFFO), and their revolver. Management guidance projects debt of $800M on the balance sheet at end of fiscal year.
One decision management makes is whether to reduce CapEx outlays to let cash accumulate again on the balance sheet so they can build rigs in the future without relying as heavily on cash flows from financing. Or instead issue more debt so they can expand their fleet more expediently to go after the ultra-deep market and other market opportunities. The issuance of more debt would alter the capital structure of the firm and increase the debt-to-total assets ratio which is today 30%. In Atwood’s most recent 8-K filing dated 8/28/2012, they increased their revolver by $200M to $1.3B, pledging two jackup rigs as collateral. Below is a CapEx/Depreciation schedule based upon the Q3-2011 10-Q and I padded annual CapEx estimates with $70M of annual maintenance.
Investment Merits
There are a number of investment merits for Atwood. They have had a culture of operational efficiency as evidenced by their high utilization rates. They have a robust backlog of orders, and the industry trends are pointing to increasing demand in the ultra-deepwater segment which is where Atwood has made its CapEx investments.
Investment Risks
The three main investment risks are a decline in Brent crude pricing, high customer concentration, and an accident like a blowout occurring.
Decline in Brent Crude pricing
There exists a positive correlation between Brent crude prices and the share price of ATW stock. Any decline in Brent crude prices will have a negative impact on ATW share price.
Customer Concentration
Nearly 74% of Atwood’s revenue comes from 3 customers with Chevron (NYSE: CVX) being the largest. Thus Atwood’s revenue is largely dependent upon their ability to maintain the relationships with their existing customers and sign new contracts or renew/extend existing ones. Failure to do so will reduce utilization thus reducing average day rates, and ultimately total revenue.
Accident
Following the BP (NYSE: BP) and Transocean’s (NYSE: RIG) Macondo incident in the Gulf of Mexico, any major accident or blowout can pose a number of potential issues including shutdown, legal risks, and regulatory risk. Also the ability to obtain drilling permits from regulatory agencies like the Bureau of Safety and Environmental Enforcement (BSEE) or Bureau of Ocean Energy Management (BOEM) may be also reduced. A Blowout Preventer (BOP) is designed to prevent this from occurring. Atwood currently maintains a single BOP on its rigs, but both the new ultra-deepwater rigs under construction, Atwood Achiever and Atwood Advantage can handle 2 BOPs.
Valuation
I relied primarily upon comparables analysis for valuation. Using a universe of 6 competitors as comps, namely Seadrill (NYSE: SDRL), ENSCO, Noble, Diamond, Rowan, and Transocean a target price can be reached of $51.47 to $56.50 per share representing a 14.3% to 25.0% upside to today’s market price of $45.04/share. I also project them to report annual EPS of $3.88 on net income of $255.2M vs. the consensus estimate of $3.90. For assumptions, I used sales growth rates of 17.2%, 30.3%, 12%, 11%, and 9% for fiscal years 2012, 2013, 2014, 2015, and 2016, respectively. Other assumptions include a gross margin of 54%, SG&A of 7% of sales, and an effective tax rate of 14% for 2012 based upon management guidance. I expect their margins for 2012 to be very similar as a percent of sales as they were in 2007.
Catalysts
New contract(s) secured
If any of the actively marketed rigs under construction get contracted, that will serve as a catalyst. Additionally if any of the cold-stacked rigs are sold for a non-recurring gain or are re-activated and contracted, that would serve as a catalyst as well and cause the stock price to move. Bear in mind that the reactivation cost of a cold-stacked rig such as Southern Cross can be up to $15M, which Atwood would want to recoup in the initial contract.
Oil prices spike
If there’s an oil price shock that causes Brent crude to spike, that will be a significant catalyst for Atwood and encourage more E&P activity.
Share Repurchase
A share repurchase agreement would be a significant catalyst. It would signal that management believes Atwood is undervalued by the market. Atwood currently has no Treasury Stock on the balance sheet. Given the CapEx intensive nature of the business, a share repurchase program seems remote.
Ymwg owns shares of ATW. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
