Description

Northern Ocean: An asymmetric levered-equity play on deepwater drilling

Northern Ocean (“NOL”) is a simple entity, owning just two high-spec harsh environment (“HE”) semi-submersible rigs, Deepsea Bollsta and Deepsea Mira. These are some of the highest quality HE semi-submersible rigs globally, built as recently as 2018 and 2019, and have the capacity to drill in the most demanding markets in the world such as Norway, the Barents Sea and Namibia. The yard cost of the two rigs is $1.5b ($900m for Deepsea Bollsta, $650m for Deepsea Mira) while NOL’s enterprise value at NOK 7.0/share is $622m (Appendix 1).

NOL is part of Norwegian billionaire John Fredriksen’s complex web of entities that constitute his shipping empire. Among the various holdings, NOL is probably the entity that receives the least amount of attention; even among offshore drilling investors, it’s seldom mentioned. It is a “stranded” piece of equity: Northern Ocean was not meant to exist in the first place. Originally part of Northern Drilling (“NODL”), itself an odd security that was intended to be consolidated into Seadrill, but the event of which never materialized due to the sector downturn in 2014-2015 and Seadrill’s rapid decline with it, NOL was finally spun-off from NODL in 2020 to ‘unlock’ the value of NODL’s HE assets. So far, NOL has never been ascribed much value for its rigs by the public market. 

Recently, Fredriksen put a bid out for NOL after he breached 40% ownership following a private placement and was thus required to make an offer for the remaining shares under Norwegian securities law. Fredriksen was required by law to pay at least NOK 7 for each remaining share as this represented the highest consideration that he paid for shares in NOL in the last 6 months. He did precisely this on July 10th. The shamelessly low price (~$300m EV/rig and significantly below where NOL shares have traded in the last 1-3 years) virtually ensures that Fredriksen will not get enough shares to squeeze out remaining shareholders. And in fact, KWC, after being tasked to produce a fairness opinion on the transaction, came out with a statement against the offering, saying that it does not represent a fair offer. 

These shareholder-unfriendly moves help explain why NOL’s share price declined by 34% year-to-date. The risk of future dilution at the expense of common shareholders is there but we are getting increasingly compensated for it. The private placement, while dilutive, is also where the opportunity lies today. Post to the private placement, NOL is now better capitalized and will have fully funded Deepsea Bollsta’s upcoming 5-year SPS, positioning itself as to receive longer-term contracts in 2025 and beyond. A large overhang at NOL has been the absence of long-term contracts and the resulting uncertainty of cash flows in 2025 and 2026, but with the market for HE semi-submersible rigs continuing to tighten and operators now being able to be more certain of NOL’s working capital conditions and rig availability in the coming 18 months, the chances of landing more long-term contracts has increased. In addition, as time goes on, the Namibia market (where NOL’s rigs operate) will move increasingly from ST exploration wells to LT work but now we’re talking a few years out in the process. A more stable outlook would do wonders to the valuation: NOL’s rigs are valued at a 50% discount (EV-basis) to the recently transacted private asset Transocean Norge, which has contracts in place till 2028, and a 33% discount to Odfjell Drilling's $450m implied EV/rig, where contracts are put in place on the majority of the fleet till 2026.  

The leverage profile at NOL ($100m equity per rig) creates a distinct multiplier effect to any reduction in the discount. If, say, Northern Ocean’s assets were valued equally to that of Transocean Norge ($637m) and we then applied a 20% haircut to reflect corporate costs and a ‘Fredriksen’ discount, the equity upside from NOK 7.0/share is 206%.

To state the obvious, to believe that there is any equity value in NOL one needs to subscribe to the idea that the deepwater rig market is in the early stages of a multi-year recovery. RIG certainly believes so itself, as signaled by its purchase of Transocean Norge. In addition, consolidation has started to pick up pace, with Diamond Offshore having agreed to be acquired by Noble Corporation and Total acquiring the majority of one of Vantage’s assets (75/25 JV) to secure rig supply in coming years. In an industry-recovery scenario, NOL will prosper. I see these industry developments as likely but will refrain from rehashing the thesis here as it has been discussed many times on VIC (I refer instead to posts and discussion boards on Valaris, Seadrill, Deep Value Driller, Vantage Drilling, etc). Happy to answer questions in the comments on industry thesis.

Summary of Recent Corporate Events: 

On 19 June 2024, Northern Ocean did a private placement of 90m shares at a price of NOK 7 per share. Hemen (Fredriksen-controlled) was allocated 43m shares, bringing its total to 114m, or 38% of shares outstanding. The largest outside shareholder, Hayfin Capital, was allocated 19m shares, bringing their total to 65m shares (21% stake). They previously owned 25% of the company. Notably, there was significant insider participation, with 3 board members and 3 managers on the executive team also allocated shares. The private placement was dilutive but ostentatiously needed to fund Deepsea Bollsta’s upcoming 5-year SPS and for working capital needs. The placement did allow NOL to renew its upcoming maturities, with a group of banks providing a $300 million loan facility (replacing the old $390 million loan facility). The Bank Facility will have no amortization the first 12 months, and $30 million p.a. thereafter. Final maturity is in June 2026. Sterna Finance (Fredriksen-controlled) will also provide a loan facility of $215 million and NOL will have the option to convert its cash interest into PIK, against a pre-agreed premium, if it so desires.

All shareholders did not get the opportunity to participate in the private placement, with only 86.6% of shareholders being offered to subscribe to their respective pro rata shareholdings. Because of this, there’s expected to be a subsequent offering for the remaining 13% shareholders in the coming weeks/months. I’m not including the additional offering in my model because of its small size but note that this will change the math slightly post the event.

Simultaneous with the private placement, Sterna exercised its right to convert $15 million from a financing facility into 30m shares in NOL, at a price of $0.50 per share (5.51 NOK as of 08/05/2024). Sterna thus got a 10% stake in NOL, which it quickly sold/delivered to Hemen as the entities are both under the ownership of Fredriksen. Since his two vehicles, Hemen and Sterna, on a consolidated basis now owned 48% of the company, he was required to make a bid for the rest of the shares, according to the Norwegian Securities Trading Act (Section 6-6).

Fredriksen will likely not get to take over Northern Ocean with the present ‘forced’ bid, as NOL’s other large shareholders are not expected to tender their shares. According to Norwegian law, Fredriksen’s offer would have to include all the company's shares. This is an important point when considering the insider participation in the recent private placement. Why would insiders make a substantial investment in the stock if they knew that it would be acquired at a ridiculously low price like NOK 7 per share? Also, why would Hayfin agree to invest in the private placement just to redeem their position at the same price a month later? Hayfin is an experienced rig investor acutely aware of the value of harsh-environmental semi-submersibles, as they sold their 2/3rds interest in Transocean Norge to Transocean just last month. 

Earnings Power of the Assets

Deepsea Mira is currently on contract with TotalEnergies in Namibia (managed by Odfjell Drilling) until early Q4 2024 but an option is available to extend the contract till year-end. Just about 18 months ago, Deepsea Bollsta left the Norwegian market to join its sister rig in the Orange Basin in Namibia, where a multitude of offshore oil discoveries have recently been taking place. The rig will be undergoing its 5-year SPS in Q3 2024 and later commence a 63-day contract with Chevron (managed by Odfjell Drilling) in Q4 2024.

In 2023, NOL earned $167m in dayrate revenue, or $303k per day, and $53m in gross rig income (day rate revenue - daily rig expenses), a rate of $96k/d if we assume that Deepsea Bollsta worked 365 days of the year and Deepsea Mira commenced its contract on June 28th as per NOL’s press release. The dayrates on contracts announced since have been higher: Deepsea Mira’s 180-day contract extension was done at a $378-417k/d and Deepsea Bollsta’s 63-day contract with Chevron looks to have added $36-48m in backlog revenue. The dayrate on this contract is a little confusing.

Dayrate on Bollsta's New Contract

• Announcement on June 26th of Bollsta’s contract with Chevron, estimated total backlog of $80-95m

• 64 days expired on Mira's existing contract extension (Apr 23rd to June 26th) * 378-417k/day = 24-27m of existing backlog consumed

• 44-47m of revenue backlog remaining on Mira’s contract

• Total backlog (80-95m) – Mira’s backlog (44-47m) = Bollsta's backlog (36-48m)

However, the estimated backlog on Bollsta using this method results in a dayrate of $571-762k on the 63-day contract, so we must conclude that the revenue backlog includes either mobilization or other hidden fees (parts of SPS? Standby fees?) because the dayrate is simply too high. 

NOL should generate higher gross income rates in the future as its dayrates increase faster than costs. There’s inherent large operating leverage to dayrates: Northern Ocean had a 32% rig margin in 2023 and in Q1 2024, when both rigs were working under new contracts, the rig margin had increased to 40%. A sustainable rig income rate should be $150k per day. As one data point, Deep Value Driller, owner of a single 7th generation drillship and listed on the Norwegian stock exchange, is earning $150k/d on a bare-boat charter with Saipem. With a $150k day margin, NOL generates $110m of gross rig income per annum across its two rigs. This comfortably covers its interest payments ($53m) and administrative expenses ($7m) and leaves shareholders with $50m in pre-tax earnings. At NOK 7.0 per share, this equates to 4.0x pre-tax earnings. Should Northern Ocean get LT contracts in the $500k dayrate range, the earnings multiple will be even lower. However, in the event that such contracts are put in place, I would expect that the company gets sold to one of the larger drilling rig players. Valaris is an interesting candidate to speculate on as a buyer, since Fredriksen already owns 7% of the company through Famatown Finance. 

Valuation:

The enterprise value of NOL is $622m, or $311m per rig. The combined yard cost for the two rigs is $1.5b (Appendix 2) and comparable assets are trading in the public markets, or were recently transacted, at $450-500 million per rig. If NOL came to trade at book value, the company’s equity value would be over $1b, or NOK 41 per share (480% upside). Let's not even mention the fact that to replace NOL's assets today, the cost would be closer to $2b and require several years of waiting for a build spot at the shipyards...

The most relevant comparable asset is the one previously discussed: Hayfin's sale in Transocean Norge to Transocean for a consideration of $425m (total implied rig value: $637m). Ironically, the rig was originally ordered by Seadrill (yes, yet again under the control of John Fredriksen) and was later acquired by Hayfin and Transocean in 2018 from a Singaporean shipyard for $500m after Seadrill could no longer honor its commitments. I believe the most likely outcome here to be one where NOL trades at some discount to Transocean Norge’s fair value mark as there is always a risk that Fredriksen will orchestrate more corporate actions that are not in the interest of minority shareholders. Even after taking this into consideration, the upside in NOL’s shares look significant; a price of NOK 20-30 per share remains below what was paid for Norge, or a 186-329% upside from NOK 7 per share.

I do not expect Fredriksen to try to take over NOL, but if he would try, there exists a vast cliff between the current price and what he would be needing to pay. For example, at just NOK 10 per share (43% above the current NOK 7 price), where NOL traded for most of the year and close to the previous private placement in 2023, a take-over would still only imply $350 million per rig. It’s hard to see how that deal gets done. It would require a share price above NOK 20 (186% above current) to land at an implied rig value of $500m. At $500m per rig, the IRR on the deal should be in the high-teens range. In short, Fredriksen could offer far above NOK 7 per share while still getting a very good deal. I’m not confident that he will try though. Interestingly, Fredriksen’s sprawling empire has been simplifying: his stake Seadrill was wiped out after its second bankruptcy proceeding, NODL was delisted from the Norwegian stock exchange in May 2024 and considering NOL’s odd position as a levered, sub-scale operator within a recovering rig industry, NOL is unlikely to remain a publicly listed company for much longer.

To summarize why the opportunity exists, NOL shareholders are currently (i) staring down the barrel of uncertainty on future cash flows, (ii) have reasons to be worried about the actions of its majority owner and (iii) these issues are exacerbated by already substantial leverage. At the same time, however, the company just increased its runway with the cash infusion from the private placement, is facing tailwinds in Namibia and the HE semi-submersible industry globally, and there are buyers out there who would definitely be interested in acquiring NOL’s assets above their current trading price.

Appendix 1:

Appendix 2:

Catalyst

• Long-term contracts on Deepsea Bollsta and Deepsea Mira
• Contract announcements to fill 2025 white space
• Attempted take-over by Fredriksen or a bid from a third-party

Risks:

• No contracts in place for 2025, working capital issues if not resolved
• Controlling shareholder diluting minority shareholders