Long: Awilco Drilling PLC (AWDR NO)

Note: Values in write-up are converted using 5.7 USD/NOK exchange rate.

Full PDF write up can be found at: https://www.box.com/s/6hdv8nn9lg4zxfm37aja

Summary

Awilco Drilling (AWDR NO or AWLCF in the “grey market”) is an incredibly attractive opportunity to get long a stock before a generous dividend policy re-rates the shares higher. During the second half of 2014, Awilco will be generating sufficient cash flow to support an annual dividend of approximately $150mm v. the company's current equity market capitalization of ~$440mm, resulting in a yield of ~30%+ on today's market cap. While hard to precisely determine where the equity price may ultimately settle as the introduction of yield can often lead to premium valuations based upon more traditional valuation metrics like EV/EBITDA or P/E, a guess says that the yield could conservatively settle in the high-teens % (let's call it 17% for arguments sake), resulting in a share price of ~150 NOK, or over 90% upside from current levels. Price appreciation through the end of 2014, coupled with an estimated ~$200 mm paid in dividends in 2013 and 2014 would yield a total return of almost 150% over the next 24 months.

Details

Awilco Drilling PLC (AWDR NO) is UK-domiciled company that was formed in 2009 to acquire two midwater semi-submersible drilling rigs from Transocean as a result of anti-trust concerns related to the Global SantaFe merger. Both of the rigs are currently operating under term contract in the UK sector of the North Sea at an average dayrate of approximately $315k/d. The WllPhoenix (previously the Arctic II) is a 1982 vintage semi-submersible rated for 1,200 feet of water and was upgraded in 2011. The WilHunter (previously the GSF Arctic IV) is a 1983 semi-submersible rated for 1,500 feet of water and was also upgraded in 2011.

With only two assets and no newbuild projects on horizon, the company appears to be running to maximize cash flow, consistent with the statement from the Q4 2012 report:

“The Company’s intention is to pay a regular dividend in support of its main objective to maximise returns to shareholders. A dividend payment on a quarterly basis is expected to commence during the first half of 2013. All of the company’s free cash flow is intended to be distributed subject to establishing a robust cash buffer to support operational working capital requirements and planned capital expenditure. In the case of attractive growth opportunities the company will endeavor to maintain a meaningful dividend distribution.”

The UK sector of the North Sea market for floating rigs is currently extremely tight and recent dayrates have reflected this trend. There is no availability for 2013 and limited availability of rig time in 2014, which has driven leading edge rates for midwater semi-submersible rigs rig to $400k/d - $425k/d. Awilco recently extended the WilHunter with Hess through November 2015 for plugging and abandonment work at $385k/d (which, when adjusted for $10-$15k/d in lower operating costs in fact is equivalent to $395-$400k/d), Transocean just extended a contract on the Sedco 714 (almost the exact same specs as the two Awilco rigs) for an additional 18 months beginning in April 2014 for $435k/d. The WilPhoenix will have an opportunity to reprice in mid-to-late 2014 from its current contract rate of $315k/d.

So what does this all mean financially? The company is extremely simple to model. Revenues are modeled simply as dayrate x % utilization. Their operating costs are $85k/d per rig. SG&A is roughly $3mm per quarter, interest expense is around $12mm per year, depreciation is $18mm and total capex in 2013 is estimated to be $15mm (maintenance levels). Tax rate appears to be around 10%. The company has generally been able to achieve operational uptime on its rigs greater than 95%, but for modeling purposes, we'll be more conservative and assume 93%.

The company currently has 30.2mm FD shares outstanding and around $98mm of net debt, yielding a current enterprise value of ~$540mm.

A simple model is included below (only visible in the PDF write-up), which highlights the most likely earnings scenarios for 2013 and how the company is positioned exiting 2014.

One valid concern as it relates to Awilco would be that these assets are old and their remaining useful life is unclear. In general, I would say it's difficult to determine exactly the remaining life of these assets. They weren't "rebuilt" in 2011, more like "refurbished." All an offshore rig really is is a bunch of steel and components. If you maintain the asset well and replace the components, these assets have already shown they can last 40 years or more. There are still jackup rigs in the Gulf of Mexico operating that were built in the 1950's and 1960's (admittedly not many). My best guess is these can work another 15-20 years, but the longer they work, the more refurbishments will be required.

Another concern might be that the assets are earning an unsustainable rate of return currently and that when they reprice after their contracted period there is significant risk of reversion to the mean. I'll concede that these assets are over-earning at current leading edge rates. To replace an asset like this brand new would likely cost $400-450mm. The interesting point is that these rigs are relatively low specification floating rigs and no one would ever build one like these again. A brand new, state of the art ultra-deepwater rig costs around $650mm and takes around 2.5 years to construct. At current dayrates of $400k/d and operating costs of $85k/d, each one of Awilco's rigs are capable of generating $80mm-ish in free cash flow, which would imply an after tax cash on cash return of approximately 20% (assuming $400mm replacement cost). My best guess as to the FMV value of each rig in current condition would be ~$250mm, which would yield around 30% on that basis. Brand new drillships are being contracted for around $575-$600k /d, which yields around around $150mm of annual EBITDA (roughly $135 of free cash flow) or roughly a low 20% after tax unlevered return.

Offsetting this is the fact that there is some ability to lock in rates under term contracts, as with all offshore rigs. The WilHunter was recently locked up through November 2015 at a rate of $385k/d (which is equivalent to $400k/d when accounting for a lower operating coat for the particular type of work this rig will be doing). The WilPhoenix is well positioned with some of the only 2014 availability in the region and I would expect this rig to be contracted through early 2016 at a rate of $400k/d within the next few months. We see no real pricing risk until beginning of 2016. For this type of asset, it's unusual to see term of more than 2 years. I would characterize the cash flows as basically locked in through 2015.

I think it's fair to look back to the trough of the market to see where dayrates for these assets troughed out. $250-$260k/d is about as bad as it got in 2009-2010, while dayrates were $315k/d in 2011 when Awilco finished refurbishing these assets. At $250k/d, assuming 95% utilization, each rig can still generate around $55mm of gross margin per year, but corp FCF is reduced to ~$70mm or so after deducting G&A, interest, and maintenance capex. The cash in cash return relative to replacement value in this case would be less than 10%. Of course, if the market is bad enough, the assets could stack out all together, like any oilfield business.

These assets are most definitely mobile between geographic regions, but the stringent safety requirements and customer specifications in the North Sea make it more difficult for midwater rigs to migrate into this market. To being in a rig from Brazil or West Africa (which we view as the only realistic sources of supply), it would take more than $100mm in incremental capex in some cases and $30mm or so to mobilize the asset to the region. I believe there will be a few rigs that could come back (in fact, Diamond Offshore is already doing so), but that they will only do so on the back of 2-3 year contracts that will justify the incremental capital investment. In fact, despite the strength in this market, some operators in other markets are electing to cold stack / scrap midwater rigs because they are too old and dilapidated to justify investing additional capital. In order for rigs to leave the UK market, it would likely take a doomsday scenario for the floating rig space.

In terms of supply / demand factors, this is never something easy to pin down for offshore drilling assets. Supply is fairly visible as there is a global database of every rig, it's current contracted status, dayrate etc. There are 70 or so UDW rigs under construction today, but almost all of these rigs will go to markets that demand the leading edge technologies like West and East Africa, Norway, Brazil, and the Gulf of Mexico. The UK North Sea is a mature market where you don't need capability to still in 10,000 feet of water and you don't need the shiniest new equipment to get the job done. Most of the work being done today is development and remediation of existing oil fields. Demand is driven by oil prices and, quite honestly, other than the tightness if availability in 2014 and high dayrates, I don't know how to predict future demand in this region. I would say, however, that at $115 Brent, pretty much every project is economic. And the UK North Sea is filled with marginal investments.

I haven't run a full DCF on the company, but what I would probably do is assume a terminal value for each rig at the end of 2016 and liquidate the company then. But if you get $150mm of dividends per year for next three years and liquidate company at $200mm per rig total undiscounted cash flow to equity would be like $750mm (before tax) on a $450mkt cap today.

While you can't value the company on yield alone, it does do a lot to determine equity prices in the short run. I hate unsustainable yield hogs (money shufflers) with the most fiery passion of my belly, but this is simply just milking these assets for what they are worth. I would also point to a company like Diamond Offshore's valuation and yield. If you strip out the few newer assets they have, the quality is similar or worse than Awilco's and they trade at a 5% dividend yield and 12x eps. Clearly this is a smaller cap, but I feel confident in saying that the current equity value is fully supported by the contracted (or soon to be contracted rigs) and you're getting the terminal value for free.

Investment Risks

1. Awilco only has two assets. If one of them is damaged or has extensive unpaid downtime, this could have a major impact on the company's ability to execute its strategy.

2. Awilco's assets are old. How much longer can 30 year old offshore drilling assets last? Unclear, but they are still running well and are clearly in high demand.

3. High dayrates in the North Sea could attract additional capacity. Two additional midwater semis will be entering the UK North Sea during 2013 and 2014, which could have an adverse impact on pricing / utilization for the existing assets. Mitigating this risk somewhat is a strict regulatory regime in the UK as it relates to rigs..

4. The company decides to execute M&A and pay either a lesser dividend or no dividend at all.

Catalysts

1. Given the tightness of the UK semi market, it is reasonable to expect Awilco's remaining 2014 availability on the WilPhoenix to be contracted and extended well into 2015.

2. Dividend should be initiated by the end of 2Q2013. The company would like to build another $20mm of cash or so on the balance sheet as a working capital / capex buffer before paying out cash, so it might take a couple of quarters to ramp up to the full dividend level.

1. Given the tightness of the UK semi market, it is reasonable to expect Awilco's remaining 2014 availability on the WilPhoenix to be contracted and extended well into 2015.

2. Dividend should be initiated by the end of 2Q2013. The company would like to build another $20mm of cash or so on the balance sheet as a working capital / capex buffer before paying out cash, so it might take a couple of quarters to ramp up to the full dividend level.