Noble Corp. (NE) is an offshore drilling contractor with a high specification fleet of 20 floating rigs and 15 jackup rigs (post Paragon spin-off described below) and a newbuild rig order book consisting of one ultra-deepwater drillship and two jackups.  Noble, along with the entire offshore drilling space, is out of favor due to cyclical concerns about oversupply in offshore rigs.  Our view is that the stock prices of offshore drillers represent a compelling risk reward scenario.  We chose to write up Noble, but also like Ensco (ESV), Rowan (RDC) and Hercules Offshore (HERO), the latter being a much more speculative trade.  Noble was written up by frankie3 in April of last year at a similar price, adjusting for the Paragon spinoff.  In his write-up he predicted many of the things that make us excited about the story today and highlighted the spinoff of its older shallow and midwater rigs as a potential catalyst.  That spinoff occurred earlier this month, and we agree that it was a significant catalyst for the company.  Our thesis here is that increasing free cash flow, large capital returns to shareholders and substantial contract coverage will put a floor on the stock not very far from the current trading price.  We collect a 5.5% dividend yield while we wait on a rerating or a turn in the cycle.  When the cycle turns, we see 50-75% base case upside.

Capital Structure

Noble had an average diluted share count of 254 million shares in the second quarter of 2014.  Reported cash was $141 million and long-term debt was $6 billion.  Post the Paragon spinoff earlier this month, Noble received $1.7 billion of proceeds from Paragon’s debt offering.  Noble has no obligation for Paragon’s debt.  These proceeds were used to repay Noble’s outstanding commercial paper.  Pro forma net debt totals $4.2 billion, or approximately 2.2x consensus 2015 EBITDA.  Noble has $350 million in debt maturities in 2015 at $300 million in 2016.  Pro forma book value is approximately $30 per share.    

Supply/Demand Backdrop

The most recent deepwater newbuild cycle began in late 2010 at which point there were approximately 80 modern high spec floating rigs operating globally.  Since then, 35 have been delivered and the fleet has maintained a high degree of utilization and attractive margins, encouraging further new construction.  According to IHS Petrodata, the current floater market is already in a state of oversupply.  This oversupply will likely get worse with 46 units to be delivered before the end of 2015.  On the existing base of 325 floaters around the world, this is a growth rate of 14%. IHS projects that the floater market may be oversupplied by as many as 89 units, or 24% of the projected supply at year end 2015 if you assume flat demand.  While Noble describes jackup supply and demand as stable and tight in some markets, the jackup market may follow the floater market into a state of overcapacity.  Global supply of operating jackups is expected to grow by 85 units to 616 units, or 16% of the current supply of 531 jackups.  Contracted jackups only total 457 rigs.  This amount of supply growth with little to no chance of a commensurate growth in demand means that dayrates for floaters and jackups will likely decline.  If current dayrates are higher than next year’s rates, then the drillers are over-earning today.  One could make the argument that the stocks look cheap on current run rate earnings, but hanging a thesis on the current valuation is almost certainly buying into a value trap.

That’s the bear and consensus case, and in our view the case that is priced into the stocks.  Where could that case be wrong or have some upside?  On Noble’s second quarter conference call, CEO Dave Williams highlighted that they are already seeing some signs of an eventual market turn. 

“And is there a reason for optimism?  We believe the answer is yes.  We believe that a gradual build in client demand will become evident as we progress through the next 12 months and customers proceed with a new list of project priorities. We have in fact already begun to see the first signs of this gradual build.  Rigs have begun to secure work and we are experiencing the early stages of demand recovery.” 

Beyond 2015, Noble has identified only ten uncontracted newbuilds that will enter the market (other than rigs destined for Brazil).  Of those ten, construction on five is yet to be confirmed.  On the demand side, Noble highlighted 42 years of new rig work in West Africa that appears to be moving forward after many delays.  Also, Mexico is likely to significantly grow its offshore rig count in the coming years as it opens up to outside operators in an attempt to reverse its production declines.  Earlier this week, the Mexican government announced that foreign oil companies would be allowed to bid on 80% of the country’s prospective resources.

Investors seem to be focusing only on the new rigs that will enter the market and may be turning a blind eye to the rigs that will exit.  Ensco provided great color on its Q2 call on how attrition of old rigs would likely occur in both the floater and jackup markets:

“The presence of uncontracted new builds deliveries has created supply pressure which we believe will result in an increasing number of older jackups and floaters being retired. Based on the population of the competitive independent cantilever jackup fleet, we estimate that currently there are more than 50 jackups that our 35 years of age or older.  And that this age group will nearly triple in the next three years to approximately 150 jackups or 28% of the global jackup fleet. Upon reaching 35 years of age, each of these rigs will be required to complete a regulatory survey in order to meet classification requirements, and significant capital expenditures may be required to keep these rigs certified especially for jackups that have not been well maintained over their useful lives.  These capital expenditures may prove cost prohibitive for many of these rigs, and we believe that these surveys could serve as a catalyst for jackup retirements.  While the numbers I just gave you are for jackups that are at least 35 years of age, if we look at actual rig retirements over the past three years the average age of the 36 jackups taken out of the global supply is 32 years. The global fleet of competitive floaters may experience a similar phenomenon as approximately 60 floaters or 20% of global fleet are at least 35 years of age. With customers preferences for newer rigs that provide drilling efficiencies, with less capable floaters challenged to find contracts in the current environment, many of these floaters may face extended periods of time without work.  Drillers may look to reduce costs on older assets by stacking these rigs, and reactivation costs for floaters, depending on the condition of the rig and the length of time the rig has been stacked may prove too costly and force these rigs into retirement.”

Clearly, Ensco believes that even its older rigs need to exit the market.  In its second quarter earnings release, Ensco announced that it would sell five non-core rigs, which were mostly older assets that would struggle to compete in the current environment.  While scrapping is always an option, older rigs can have other applications such as floating production facilities.  We expect that other drillers will follow suit in retiring, scrapping and selling older rigs.  Fleet age is an important investment consideration when looking at the drillers.  In this competitive environment, the newest, most capable rigs will likely see some dayrate deterioration.  Some older, less efficient rigs will likely get no work at all.  Couple high operating costs with significant maintenance and regulatory capex, and these older assets become real liabilities.  We view this attrition as a counterbalance to new rigs entering the market, though likely of lesser significance.

We also see upside to the bearish consensus view related to the pace and number of newbuild jackups that actually get delivered.  Estimates vary from company to company, but as many as half of the jackups on order are speculative orders, meaning that the buyer is purely financial and/or has no current rigs operating.  For the vast majority of customers, these rigs have little to no value since they don’t meet their technical specifications and aren’t run by a proven contractor.  Similarly, rig contractors have their own newbuild programs that they probably regret today and won’t be interested in buying additional rigs that don’t meet their standardized specifications unless they are deeply discounted.  Many of the rigs may never make it to market or will get pushed far to the right of their original delivery date.

How the Market Eventually Clears

Absent a significant, long-lasting decline in oil prices, we think that the over-supply in both the floater and jackup markets will generally play out as follows.  We preface this by saying that nothing ever plays out exactly as expected, and characterizing the global drilling market as one is not accurate given each region has its own unique dynamic and supply/demand drivers.  However, we think a general discussion is helpful to illustrate the forces at work and how market participants are likely to respond in our view.  First, dayrates will continue to decline in response to a growing glut of rigs, perhaps to cash breakeven cost, a figure that varies widely depending on the rig, the project and the region.  Rig contractors have a big incentive to keep rigs working at the expense of margin when the alternatives are to idle it, warm stack it, cold stack it, sell it or scrap it.  Each has a declining level of expense; none involves revenue.  If the rig contractor believes it has a good chance of getting work for the rig in the very short-term, it will idle the rig and keep it fully staffed.  For modern dynamically positioned floaters, this also involves burning a lot of fuel that the customer typically pays for.  Warm stacking basically means the rig runs on a skeleton crew but otherwise remains fully operational.  There are still large operating costs, but the benefit is the rig can go back to work without significant capital expenditures.  Once it is cold stacked and the crew is gone, the rig requires tens of millions of dollars of reactivation capital to get it in operational condition again.  Many rigs that are cold stacked will never work again.  If there are buyers for an idle or stacked rig, a sale is a great option for monetization.  In this environment, however, buyers are unlikely to emerge for anything but the best equipment except at distressed prices.  Scrapping has the benefit of eliminating the operating costs and collecting a few million dollars for materials, but obviously is the option of last resort.   

Compounding the situation is the fact that rig demand is highly inelastic.  Offshore prospects, especially in deepwater, take years to generate, the timeline for which often gets extended, but rarely gets pulled forward.  For this reason, we suspect that the decline to cash breakeven and the stacking of rigs en masse might occur quickly and soon.  Older, less capable rigs won’t find work at any price.  They will get stacked first and will likely be permanently retired.  If prior cycles are an analogy, higher spec modern rigs will continue to work at a very high utilization albeit at lower day rates.  For example, in the last downturn during the financial crisis, the highest quality rigs never really stopped working and maintained utilization above 90%.  As new rigs enter the market, they will continue to push inferior rigs into retirement, which will be the primary clearing mechanism.  Theoretically, retirement of rigs that have reached the end of their useful life could more than offset new rigs entering the market. 

Demand will remain fairly constant.  Schlumberger expects global offshore drilling expenditures to grow at a mid to high single digit pace for the next several years.  As the newbuild order pipeline runs off, dayrates will bottom and then begin to rise.  Since the newbuild queue will be virtually empty, rates will once more move upward as a new cycle begins.  Again, the timeframe for the cycle turn is uncertain and in large part depends on how quickly contractors concede that their older rigs need to be stacked.  The faster and more severe the downturn, the quicker the market clears, and ultimately the better it is for the drillers.  If other contractors take Ensco’s proactive approach, we could reach a supply/demand balance before Noble and the other drillers lose the majority of their contract coverage.  Noble is already talking about evidence of a recovery, but we have a less sanguine view.                           

Paragon Spinoff

Last week the company completed the spinoff of its older rigs into a new publicly-traded company called Paragon Offshore (PGN).  Noble received $1.7 billion in the transaction, which was used to reduce debt.  Shareholders received shares in a new company with a market cap of $1.1 billion on its first day of trading, though that market cap has declined to under $800 million since then.  Paragon looks decently cheap, and will likely establish a dividend shortly.  However, as mentioned above, older rigs will struggle in this environment, and we don’t think that the valuations for older fleets like Transocean, Diamond and Paragon are cheap enough to take that risk.  Manny wrote a compelling short piece on RIG in May.  We agree with his views and think there is a good chance RIG will cut its dividend absent some sort of financial engineering that brings in significant non-dilutive capital.    

Prior to the Paragon spinoff, Noble would have an average fleet age of 27 years when the final rig in its newbuild program is delivered in 2016.  Post-spin the fleet average age drops to just 13 years.  This fleet includes five old jackups with an average age of 36 years that are working in Saudi Arabia.  These were kept for “strategic reasons” (read: “we did not want to spin off a relationship with one of the largest NOCs in the world”).  If you exclude the five Saudi rigs, the average age drops to under ten years.  We think this young, high spec fleet will maintain a high utilization, even in a severe downturn.

Valuation

We are not calling the bottom on the cycle or the stock prices.  Indeed, we see additional downside as leading edge floater dayrates move lower for at least the next twelve months.  Though as Joe Rosenberg, chief strategist at Loews Corporation said, “You can have cheap equity prices or good news, but you can’t have both at the same time.”  Loews happens to own a controlling interest in Diamond Offshore.  Our comments are more focused on the price and the favorable risk/reward scenario that they present.  The ensuing decline in day rates has been widely forecasted, took up most of the Q&A time on the drillers’ last quarterly conference call, and is largely priced into the stocks.  For instance, a basket of the largest drillers is down approximately 20% YTD and has generated slightly negative total returns over the last three years despite oil prices that have been very favorable for offshore drilling.  Our basket consists of equally weighted positions in DO, ESV, NE, RDC, RIG and SDRL.  Offshore drilling stocks have completely decoupled from other energy stocks as well.  The Energy Select Sector ETF (XLE) is up 9.7% YTD and up 51.7% over the last three years.  Noble has not traded at this low of a price to book multiple since the early 90s (we estimate a 10% discount to book post spin, see p. 28 of Noble’s 6/24 presentation:

 http://phx.corporate-ir.net/phoenix.zhtml?c=98046&p=irol-presentations). 

While many drillers will likely need to impair older rigs as dayrates decline, similar to what Ensco did last quarter, the remaining Noble rigs are much newer and are unlikely to be significantly impaired.  In addition, Noble is trading at the lower end of its historical valuation range on EV/EBITDA and P/E despite a newer fleet that arguably deserves a higher multiple.  However, EPS and EBITDA multiples are less relevant going into a downturn and consensus numbers likely still have some downside, especially in 2016 as Noble loses the significant contract coverage it will enjoy this year and next.  Post the Paragon spinoff, Noble has a contract backlog of $11.1 billion.  For 2014, Noble has 75% and 86% of its available operating days contracted for floaters and jackups, respectively.  For 2015, those numbers drop to 67% and 53%, respectively.  Even with a lower contract coverage percentage, contracted revenue from backlog is projected to grow in 2015 due to a full year contribution from new rigs.  Interestingly, we think EBITDA may be relatively flat as contracted newbuild rigs added to the fleet offset rigs going off contract or resigning at lower rates.  This will largely depend on how successful Noble is at keeping its rigs rolling off contract working at acceptable dayrates.  Backlog will remain in decline until the market turns.  But, as Noble stated on the last conference call, “backlogs are now serving their true purpose: to provide financial stability in the near term and greater future visibility.”    

Oil services stocks often bottom prior to the trough in earnings.  We suspect this cycle will be no different.   One difference in this cycle though is that drillers pay large dividends and the stocks have a healthy yield.  We think Noble’s dividend has room to grow even before the cycle turns.  The nice carry we get paid to wait supports some floor in the stock.  We don’t know exactly what that floor might be, but we doubt it is much below the current price. 

One of the other exciting aspects of this situation is the growth in free cash flow that Noble should begin to enjoy soon.  Since 2007, the company has spent $11 billion on new rigs as compared to the current enterprise value of $12.7 billion.  We can debate about the wisdom of this hefty spend.  Arguably, the spend has been an overhang on the stock for several years, and clearly Noble and its peers ordered too many rigs.  Regardless of whether it should have been spent, we expect capex to drop significantly in the near future and the company to generate free cash flow beginning in the fourth quarter of this year.  Remaining capex on the three final newbuilds totals $1.1 billion, the bulk of which will be spent this year.  No rigs are expected to be delivered in 2015, and the final jackup will be delivered in 2016.  With the newbuild program all but complete by the end of this year, capital expenditures should drop from $2 billion this year to $850 million next year, of which only $200 - $250 million is maintenance capex. The company has been clear that they do not plan to build any more rigs and will not pursue acquisitions at current market prices.  Using Noble’s guidance for expenses, tax and maintenance/upgrade capex remaining this year, we get to a free cash flow multiple of approximately 6x.  To be clear, this does not include any of the newbuild spend as we are trying to arrive at what the business looks like after the newbuild program is completed.            

To recap, we chose to write-up Noble primarily because of its discount to book and the fact that it will become free cash flow positive prior to Ensco, whom we view to be the top operator in the space.  The industry cycle may not turn for more than a year.  In the meantime we collect a 5.5% dividend, which is likely to grow.  If the valuation does not change by early next year, we think that management will direct its growing free cash flow to a share repurchase program.  We see limited downside from the current price, though buying today will almost certainly show short-term losses as negative sentiment driven by declining dayrates pushes stocks lower for one more leg down.  However, for those readers with a longer-term view, we think NE will generate significant returns over the next two to three years.  In the conservative scenario that the stock trades back to book value and we collect one dividend over the next year, this would equate to a total return of 15%.  At that valuation we would continue to view the shares as extremely undervalued.  In the upside scenario where the cycle turns meaningfully positive, we see upside to 2-3x book, making Noble a multi-bagger from the current price.  In prior peaks, the stock has traded above 3x book.  For those interested in a pair trade, we think shorting old fleets like RIG and even PGN will continue to work.    

Risks

Prolonged period of declining dayrates

Decline in oil prices below a level that encourages offshore drilling

Management teams that continue to build rigs despite visibility to over supply

2016 consensus numbers move lower with dayrates

Backlog concentration – Shell represents 52%

Manageable debt load becomes a problem in a prolonged downturn

Increased dividend

Share buyback

Free cash flow generation

Evidence of bottoming dayrates and cycle turn

Successful roll of expiring contracts