Description

North Atlantic Drilling

It is not often one can find a company with best in class management, great assets, great visibility of cash flows and very favorable fundamentals, trading at an extremely compelling valuation (double digit dividend yield anyone?), plus a series of catalysts that should re-rate the stock.   Yet, North Atlantic Drilling fits the mold – this is a company with over $500M of EBITDA and a dividend yield of 11%.

Best in class management: North Atlantic Drilling (NADL) was established in February 2011.  It was spun out from Seadrill (SDRL), one of the premier rig operators in the world, who currently owns 74% of NADL and also provides its management team.  The objective was to highlight the value of Seadrill’s harsh environment fleet with a focus in the North Atlantic, specifically the Norwegian region.  NADL benefits from being part of the Seadrill organization, known for its aggressive contract negotiation skills as well as the ability to leverage its dominant position when ordering from shipyards, both in terms of prices and delivery slots. 

I would also point out that aside from its operational skills, management, led by its controlling shareholder (and billionaire) John Fredriksen, has been extremely shareholder friendly, with a history of continuous dividend increases, special dividends as well as other shareholder-friendly financial engineering actions.

Great assets: NADL’s fleet consists of five harsh environment semi-submersibles (including a newbuild scheduled for 1Q15 delivery and one unit owned by Seadrill, under management by NADL; these do not include an option to acquire a second semi-submersible from Seadrill for 2014 delivery at accrued cost), one harsh environment drill ship, and 3 harsh environment jack-up rigs.  Aside from a 1986 semi and a 1993 jack-up, the fleet is fairly modern (’00 or later).  Interestingly, last week the company announced that it extended the contract for its 1986 semi-submersible West Alpha, the oldest rig in the fleet, for another 2 years with Exxon Mobil starting 3Q14, at a contract value for the additional two years of $410M, or an implied value of around $561K/day (which compared to some analysts’ assumption of $450K/day). 

Great visibility of cash flows: order backlog stood at $3.2B as of mid-June.  Importantly, except for the West Navigator drillship, contracted until mid-2014, the rest of the fleet is all contracted into at least 2015. Also, one should note that the various contracts are staggered in terms of maturities. 

Great fundamentals: the case for high spec rigs has been well documented, given substantial offshore discoveries in Brazil ultra-deep water as well as West Africa.  Combined with high oil prices (Brent has averaged around $110 over the past year as well as YTD), it is no news that oil companies have been aggressively trying to explore the new regions to replace quickly declining reserves.   What is different in the NADL story is that given the harsh environment these rigs operate in (for instance, very cold temperatures), they must meet very strict guidelines in order to be allowed to work in these northern regions, and essentially have to be designed and built to those specifications.  What this means is that while rigs in other parts of the world are fungible – that is, while a rig operating in Brazil can be moved to Africa or to other regions and back, they cannot be placed in the Norwegian Continental Shelf (NCS) -although the opposite can happen.  This implies that the market which NADL operates in is essentially a protected market.  In a scenario where demand were to falter for instance, rig operators would try to move their assets around the world to ensure utilization, which would pressure day rates in general, but certainly less so within the NCS area.  In fact, during the recession in ’08-’09, day rates in Norway were the most resilient of all, with floaters and jack-ups remaining fully utilized.

In addition, the supply-demand picture is fairly favorable in the region where NADL operates: 2011 saw great exploration success in the NCS, with major discoveries in the Barents Sea and in the southern region.  Total oil and gas discoveries in Norway totaled 3,225 mmboe in 2011 alone – which compares to a total of 2,601 mmboe between 1986 and 2010. Thus, significant ramp up of drilling activity is expected for those new discoveries.    

In general, arctic areas (which include the North Sea, the Norwegian Sea, the Barents Sea, Arctic Russia, Greenland, and Northwestern Canada) are deemed to be the next frontier and are estimated to hold 23% of global oil and gas reserves, which bodes well to NADL, given its ruggedized, harsh environment, high spec fleet. 

Furthermore, on the supply side, there are too many old rigs operating in Norway – I estimate that about half the existing fleet has an average age older than 24 years.

Growth opportunities: The Company has repeatedly mentioned its intention to increase its fleet size, and I believe they want to get to at least 10 units, which would make it the largest operator in Norway.  Aside from the recently ordered newbuild, NADL has an option to buy another semi-submersible from Seadrill at accrued cost, as mentioned.  Also, I would not rule out acquisitions of other companies/assets in the space.

With growth in the fleet, NADL’s intention is to also further boost the dividend payout.  In fact, when discussing the various day rate scenarios for its recently ordered newbuild (West Rigel), it illustrates the potential increase in dividend based on those various day rates.  Recently, Seadrill highlighted its 3-yr contract for West Leo at $625K/day as a good datapoint of where the market is today.  At such a rate, the EV/EBITDA multiple for the newbuild would be close to 4.5x, and it would provide a potential dividend increase of almost 8c/share.  That would be 44% incremental to the current payout of 18c/share, resulting in a dividend yield of over 15% at the current stock price.

So, given the attractive profile described above, why is NADL sporting a double digit dividend yield?  In my opinion, that is in great part attributed to its lack of liquidity.  First, Seadrill owns 74% of NADL, resulting in a small free float. Second, NADL has been trading in the Norwegian OTC, where average volume is under 1M shares per day (on a stock with dollar price under $2).

Enter one of the catalysts: the company has publicly declared its intention to list on the NYSE during the second half of 2012.  The hope is that should improve liquidity and open up the story to a wider audience of investors.

Other catalysts: Aside from listing in the US, there are a few potential catalysts on the fundamental side, all discussed before  – a contract announced for the newbuild, the exercise of the option with Seadrill for another newbuild, and potential increase in dividends.

Valuation: NADL’s EV is around $4B (debt includes $1.875B of bank debt, at L+2%, $500M 7.75% bond held by SDRL, and $200M revolving facility at L+3%, also provided by SDRL).  At a consensus ’12 EBITDA of $557M, that implies a multiple of slightly over 7x EBITDA.  While that is roughly in line with peers (note that SDRL, which has never looked particularly cheap on an EBITDA basis - except in ’08, sports a multiple of over 10x), I would maintain that the EV/EBITDA metric does not paint the full story, partly because it penalizes the balance sheet for payments towards the newbuild, which has yet to contribute to EBITDA.  Also, comparables can be misleading as certain companies with lower multiples have a significantly older fleet , and will likely need to order new units (and see increase in debt levels and/or drain in cash) or else risk seeing EBITDA deteriorate as older units become less desirable and eventually need to be scrapped.

Both SDRL and NADL see dividends as a key measure in rewarding shareholders, so I think dividend yield is a good metric to value the Company.  In a time where Treasuries offer paltry yields, at what kind of yield should a Company with growth and good visibility in cash flows trade?  Take your pick, but note that NADL exhibits the highest yield in the group, with better visibility and assets than most.  Notable comps  include: Diamond Offshore at under 6%, Transocean at 0% (discontinued due to Macondo), Fred Olsen (significantly ageing fleet) at 9%, Songa Offshore at 0%, Seadrill at ~8.5%, Rowan at 0%, Ocean Rig at 0%, Pacific Drilling at 0%, and last but not least, the S&P at just shy of 2%.

At the average yield of only companies with positive yields within the set of companies NADL considers its peer group (7.8%), we get an upside of 40% on the stock, not including a double digit dividend yield (including all the companies, several of which pay no dividends, the stock would be more than a double).

At a SDRL dividend yield, the upside on the stock is 30%, again before the dividend yield.

Note this assumes no further increase in dividends, which I believe are likely to occur down the road (especially if past actions are indicative: the quarterly dividend payout was 3.5c/share last September, then raised to 4c in December, and now stands at 4.5c). Giving some credit for incremental dividends coming from the newbuild: assume 2c incremental dividend (based on a day rate of $450K/day, which I believe is extremely conservative) and applying a 9% yield (still highest among peer group), we would still get a price appreciation in the high 30% range, with no benefit from the dividend yield.  

 Risk: There are some obvious risks here, such as:

- lack of liquidity (hopefully will improve with NYSE listing, and worst case scenario, one just gets to clip coupons at double digit yields),

-price of oil (while I think current levels of Brent are still more than supportive of day rates, I recognize that they can hurt names like this in terms of sentiment; note recent contracts including the extension of West Alpha, have been at very favorable day rates), and even

-a potential rise in interest rates (which could make dividend paying stocks less attractive on a relative basis – but given the magnitude in the rate differential, I am not too concerned in the near term).  However, let me discuss another issue than can be perceived as a risk: the fact that the company is not de facto independent, given Seadrill’s controlling stake. 

Even though it is a standalone company with its own board, let’s not kid ourselves – this is an extension of Seadrill, starting with the fact that they share management.  So there is the risk that there could be conflicts of interest between the controlling shareholder and minorities.

However, thus far, Seadrill has acted extremely favorably towards NADL:

• NADL did a private placement in late March with the purpose of securing the order for the newbuild (at very favorable terms).  Seadrill agreed to backstop the full $300M, with a minimum of half the amount.  Besides also extending a $200M revolving facility (at L+3%), Seadrill capped a potential tax liability that was an overhang to the NADL story – there is an ongoing tax dispute with the Norwegian authorities related to treatment of certain assets in terms of domicile for tax planning (which SDRL/NADL strongly intend to defend), which could cost the company up to $263M. In conjunction with the deal, SDRL has said it will assume 100% of the liability above $63M. 
• After NADL secured the newbuild West Rigel at attractive terms, SDRL entered a similar agreement for the exact same asset and gave NADL an option to acquire the rig from SDRL at cost.  My interpretation is that SDRL knew that NADL would not have the capacity to order a second rig on spec (that is, without a contract), but given the attractive terms, used its own balance sheet and placed the order anyway and once NADL has secured a contract for West Rigel, it will then be able to acquire the rig from SDRL (perhaps in conjunction with the listing in NY?). 

Catalyst