I think Prosafe in an interesting contrarian investment candidate at the moment due to the following qualities:

• It is the leading player in a niche industry with roughly 50% market share
• The company’s business, while it can be capital intensive, produces nearly 60% cash operating margins (45% margins when including D&A) and significant free cash flow on a maintenance basis.
• The business has been very stable and predictable for many years, despite significant volatility in the oil and gas industry that it serves.
• The company has historically produced ROE’s in the low 30% range at 80% utilization, and 45% or better with utilization rates above 85%.
• The stock today trades at what appears to be a discount to replacement value.
• The company recently increased its dividend and currently pays a yield of 9.2%.

Of course, I used the description “contrarian” for a reason, as this price would appear to reflect near universal pessimism about the longer-term future of the company’s business, which to me seems a little bit overdone.  Also, Prosafe was written up in April 2011 on VIC, and that piece has some interesting background on Prosafe that I recommend interested readers take a look at. With that introduction, here are some details about the business.

Prosafe is the world’s leading owner and operator of semi-submersible accommodation rigs (also known as “floating hotels” or “floatels”) with ownership of 11 of the world’s 22 units.  Prosafe was formed by a merger of Procon (itself a spin-off from Transocean) and Safe Offshore in 1997.  In May 2008 Prosafe spun off its Offshort Support Services business in order to become a pure-play accommodation rig business. Prosafe is a Norwegian company but is domiciled in Cyprus, which has been in the news lately for negative reasons but which also offers 10% corporate tax rates. 

Floatels are positioned alongside oil production platforms and connect to them by gangways so that oil workers can access the platform. Prosafe’s units can accommodate anywhere from 306-812 people, depending on the size of the rig, and offer catering facilities, storage, offices, medical services, and other amenities.  PRS’s units are most used in harsh environments, such that the majority of the demand is in the North Sea, deep offshore Gulf of Mexico, and more recently, offshore Brazil.

Unlike offshore drilling rigs, floatels are typically used later in the oil production process, after the exploration phase has been completed.  The typical use is for hook up and commissioning of wells after production has been established, and then used on an as-needed basis for maintenance and production work on producing wells and infrastructure, which usually occurs several years after a given platform begins production. Finally, they are also used for de-commissioning projects for mature wells. Importantly, these activities tend to be relatively stable and predictable, and less dependent upon near-term oil prices, than is the case for offshore drilling rigs. As a result, Prosafe’s floatel business hasn’t been nearly as volatile as offshore drillers and other E&P related service businesses.  Proof of this can be seen in Prosafe’s financial history, which shows very consistent financial performance right through the 2007-2010 energy price volatility.  This is because in declining oil and gas pricing environments, oil companies tend to cut back on new exploration but not current production or maintenance. Floatels are typically booked well in advance, often 1-2 years, which provides reasonable visibility into future business performance.  

Prosafe’s current fleet includes six dynamically positioned rigs and five anchored rigs, with four new units on order for delivery, with two ultra-harsh weather rated rigs coming in late 2014/ early 2015, and then another two (high end but not Norway-rated) scheduled for delivery in 2016.  With a dominant position in the harsh-weather, high end segment of the business Prosafe enjoys very strong returns on its rigs due to the specialty niche and high barriers to entry.  New high end rigs cost $350 million, such that not many companies have access to the capital markets necessary to finance such a purchase. Rigs have useful lives of about 30-45 years, but can be extended and modernized with a major renovation every 20 years or so.  One recent example is Prosafe’s own rig Safe Caledonia, which was recently renovated to extend the useful life by 20 years for an investment of $125M.  Such are the economics of well-done renovations that, assuming an 80% utilization rate, a 60% cash operating margin, and $235K daily rate, this particular floatel should have a cash-on-cash payback period for the renovation of about 3 years. Caledonia has already gotten some excellent new charters in the UK North Sea coming off its renovation work. As noted above, competition has historically been rather limited in this business.  Prosafe has ordered two ultra-high end new-build rigs scheduled for delivery at the end of 2014 or early 2015. The first new-build on order is the Safe Boreas, expected to be delivered at the end of 2014, and the second is the Safe Zephyrus, which is expected by early 2015. These new units will be the largest and most advanced floatels in the world, rated for harsh conditions, and boasting both a dynamic positioning system as well as 12-point mooring capability for maximum flexibility. Each will accommodate up to 450 people.  Prosafe has also ordered two additional units that are state-of-the-art but not the highest tier harsh weather-rated, scheduled for delivery in 2016, with each costing in excess of $200M. It appears that these will be utilized for customers in areas other than Norway.

The table below shows the list of floatels in the Prosafe North Sea fleet, including the two new additions scheduled for delivery in late 2014 / early 2015.   The North Sea environment requires the highest harsh-weather ratings and features, and Prosafe is well positioned as all four of its existing rigs have been fairly recently refurbished.  The Safe Bristolia was converted and refurbished in 2006, the Regalia received a 20-year life extension in 2009, the Caledonia was renovated in 2013, and the Safe Scandinavia is undergoing a 20-year extension and refurbishment project now and will be back in operation in Q2 2014.

Safe Bristolia               Built 1983, converted in 2006, upgraded 2008; 587 beds

Regalia                         Built 1985, upgraded 2003, refurbished 2009; 306 beds

Safe Caledonia                        Built 1982, upgraded 2004, refurbished 2012; 454 beds

Safe Scandinavia         Built 1984, upgraded in 2003 and 2005; refurbished 2014; 583 beds

Safe Boreas                 to be delivered late-2014; 450 beds

Safe Zephyrus             to be delivered early 2015; 450 beds

Prosafe provides updated rig bookings on its website on a frequent basis. The visibility is good with regards to all four active North Sea units. The Calidonia is booked out to late 2015 with three different projects at day rates from $235K to $250K. The Regalia will start a project at the end of February 2014 with Statoil, and then is scheduled to begin a 450-day project in the UK with Talisman in August 2014 that will take that rig out to early 2016. Both of these projects are booked at $300K / day.  The Bristolia is working two back-to-back UK projects on contracts that begin in April 2014 and that should run to year-end 2015 run out to mid-2015 at $295K - $297K per day. The Scandinavia will come out of the yard after its 20-year refurbishment and begin working in April 2014 for a nine-month contract with Statoil at $270K per day and then has a gap before beginning a 6-month contract in the summer of 2016 at a $343K day rate. 

The two new-build harsh weather rated rigs have signed initial contracts.  The Boreas will be delivered in late 2014 and will begin work in Norway on a 6 month contract with five 2-month options in April 2015 at $338K per day. The Zephyrus, which will be delivered in late 2014 or early 2015 and will be ready for operations in the summer of 2015.  It has a contract that begins in early 2016 for nine months with options out to 2019 at a $300K per day rate; I would expect that Prosafe will find a project for it for the year or so gap after delivery but prior to the mid-2016 contract.

As far as the rigs outside of the North Sea, PRS has five rigs working the Gulf of Mexico for PEMEX (via Cotemar Group).  These rigs are provided on a bareboat basis under which Prosafe leases the rigs but does not provide crew and pays none of the operating expenses. As such, the day rates are much lower than the rest of the fleet at roughly $42K-80K per day, depending on the rig, but this is effectively all operating profit. These rigs are the Safe Hibernia, Safe Britannia, Safe Regency, Safe Lancia, , and Jasminia.  Another rig, the Safe Concordia, works in Brazil, and one rig is in Southeast Asia. Below are the rigs outside of the North Sea.

Safe Hibernia               Built 1977, upgraded 1991, 94, & 2006; 632 beds

Safe Brittania               Built 1980, upgraded 1987 & 2003; 812 beds

Safe Regency               Built 1982, upgraded 2003 & 2008; 780 beds

Safe Astoria                 Built 1983, converted 2005, upgraded 2012; 349 beds

Safe Lancia                  Built 1984, upgraded 2003

Jasminia                       Built 1982, upgraded 2003; 605 beds

Safe Concordia                        Built 2005, 461 beds

The Hibernia is booked to March 2014, the Brittania to December 2014, the Regency through December 2017, the Lancia through December 2016, and the Jasminia through December 2015. The Concordia is booked to Petrobras through June 2017 at $163K per day; this contract is in foreign currency but the contract is inflation adjusted (yearly) and currency adjusted (monthly).  Prosafe has one rig working in Southeast Asia, that being the Astoria.  This rig is expected to finish up its current job in Indonesia in early 2014 and be mobilized to the Philippines, where it will begin an 11 month job with a one-month option for Shell at $200K per day in June 2014.

Prosafe has historically been able to generate 60% cash operating margins and 40-45% operating profit (after D&A) at utilization rates in the 80% range for its fleet.  Simple back-of-the-envelope math shows that Prosafe should be able to earn better than 40% cash-on-cash on its two new-build rigs, using an assumed total cost of $350M, of which $100M is Prosafe’s equity investment and the remainder is financed with long-term debt at fairly low rates.  At 80% utilization and $300K day rates, and assuming low initial maintenance costs, each new rig should be able to do approximately $88M million in annual revenue.  My guess is that cash operating profits would be 60% or $52M and that there would be roughly $40M in free cash flow taking into account $12M or so in interest expense. Taxes would be very low, given the accounting D&A and the 10% corporate tax rate in Cyprus, such that fully taxed cash flow might be $38 million.  On its $100M in equity, that’s a high-30% annualized ROE.  Just for reference, Prosafe reported an ROE for 2013 of 32% and 48% in 2012 for its existing business.  Prosafe’s new-build arrivals will also virtually guarantees higher revenue, operating income and dividends over the years 2015-2016, assuming the rest of the fleet reaches historical utilization rates.

It seems that Prosafe stock has followed the offshore drilling sector to recent lows, but I believe that the company’s business model has some significant advantages relative to offshore drillers.  First of all, there has been huge numbers of new ultra-deepwater drilling rigs entering the market or on order, and accommodation rigs tend to lag the utilization of offshore drilling. Prosafe, on the other hand, has roughly 50% market share in its industry and therefore is the best positioned to win new business given that it has more rigs and higher quality rigs. Second, unlike drillers, Prosafe has no liability or risk related to any kind of offshore drilling accident, as exemplified by the BP Macondo well disaster. If anything, if there is a problem at an offshore production site, Prosafe may benefit by providing accommodation rigs for longer-term maintenance and repair. Also, as noted before, drilling activity tends to be curtailed when commodity prices fall or capital becomes scarce, whereas production is almost never curtailed in those circumstances. While the offshore drilling industry is becoming more exposed to offshore Brazil, Prosafe has a big part of its fleet deployed in the North Sea, where there is old infrastructure that will need maintenance work in the UK and where there has been some considerable exploration and early production activities at newer fields offshore Norway, which tells me that there will be demand.  Prosafe’s harsh weather rated rigs have a great advantage here.  Prosafe has only one rig working in Brazil.

There are two major risks I see to an investment in Prosafe.  One is overbuilding in the industry, which might reduce day-rates and utilization.  There has been a recent spate of new-build orders that is unusual for an industry that hadn’t seen many new-builds in many years.  There are five new higher end rigs due to come on to the market in the next three years, of which two will belong to Prosafe and two are ordered by competitor Floatel, which will double Floatel’s rig fleet to four. The global fleet, which was estimated at 21 as of mid-2013, is expected to expand to 24 as of year-end 2014, 30 by year-end 2015, and 32 by year-end 2016.  Prosafe will have 15 of those units at year-end 2016.  Prosafe management has stated that part of this is a catch-up for the last decade or so, when the industry basically didn’t add much new capacity.  Also, the huge number of new high-spec, deepwater and ultra-deep water drilling rigs acts as something of a leading indicator for accommodation rigs. According to a recent SeaDrill presentation, there are 75 rigs working in the North Sea, and offshore exploration is moving in the direction of harsher environments and greater depths. The UK North Sea infrastructure is apparently aging and needs repair and upkeep, and also there have been several new discoveries in the North Sea that will eventually need commissioning and hookup. This should be a very strong leading indicator for future accommodation rig demand.  Prosafe’s competitive advantages are that it has the largest fleet, the most efficient cost structure due to economies of scale, and enjoys the industry’s lowest financing costs. The company also has the longest track record of operations, which should be worth something to its customers when comparing rig providers / operators.  So while I concede that this is a concern and I don’t want to understate it, I think today’s stock price very adequately discounts a lot of the risk of new units coming on to the market and whether day rates and / or utilization will dramatically decline after 2016 due to overbuilding. Also, investors are collecting a 9% plus yield while they wait, so a lot of cash will be returned to shareholders between now and then.  Prosafe announced that its year-end 2013 backlog was $1.7B (including options) which is by far the highest level in the company’s history.

While the spot price of oil doesn’t tend to affect Prosafe’s business much, if oil and gas prices should decline for a very long period of time, or if there was an event that reversed the industry trend toward deep-water drilling, the long-term outlook could be significantly reduced.  This appears to be more of an out-year risk, since things look very healthy in the accommodation rig market for now.  Again, it’s hard to make long term predictions, but recent discoveries seem to bode well for future rig demand.

Let me mention a couple of other minor risk factors. I mentioned the Cyprus domicile at the beginning of this report, but it appears that the recent Cyprus banking crisis won’t affect Prosafe much as the company had less than $1M US on deposit in one bank on the island. Finally, there is some FX risk related to the fact that Prosafe stock is priced in NOK; this is largely offset by the fact that most of the business is done in USD globally and Prosafe reports all of its financial results in USD. The fact that the stock is priced in NOK may introduce some short term FX for investors, but longer term it should all come out in the wash given the business deals in USD.

Given that PRS is a Norwegian company, it is not easy for me to get a sense about the management team, except that like other publicly traded Oslo companies, PRS doesn’t pay its CEO like a rock star.  But I think the major capital allocation decisions I’ve seen the team at PRS make have look like very good ones.  The decision to spin off the oilfield services decision in May 2008 was done right at the top of the oil and gas market. As an interesting aside, Prosafe actually acquired 22% of competitor Floatel in a deal in July 2011, only to sell the interest literally two months later when Floatel merged with another entity for a gain of $10.5 million on a $65M investment. Not a bad IRR for a two-month investment!  They seem to handle their fleet well, with the recent renovations of the Safe Caledonia and Safe Scandinavia allowing them to book those rigs for extended North Sea jobs at excellent rates.  Of course, the new build rigs are the biggest decision and we won’t know how that will turn out, but given that the rigs are already getting orders it is unlikely the returns on that capital won’t be decent.  Prosafe changed its dividend policy in 2012 to pay out roughly 75% of the annual net profits, and moved to a quarterly distribution.  The dividend is indicated to be 64 cents annually paid at 16 cents per quarter.  Assuming that this is a sustainable pay-out, the dividend yield is currently 9.3% at the current price of $6.90 US. 

As far as valuation, the market cap is currently about $1.6 billion, and the EV is $2.2 billion.  For the 2013 full year, Prosafe reported revenue of $523.5M, with operating profit of 46% of sales, or $245 million. Excluding D&A, cash operating profit was roughly 58.5%. Operating cash flow was $265M for the full year.  Cap-ex net of asset sales was $208M, such that FCF was about $58M.  Assuming maintenance cap-ex of roughly $60M per year, I estimate MFCF is probably over $200M.  At the EV of $2.2 billion, you get ownership of the current 11 rigs (average EV/rig of $200M).  I expect FCF in 2014 to be roughly flat given the large spend on the new-builds, so net debt will increase some during 2014 as the company pays out $140M in dividends. 

It is important to note that Prosafe has already put down $250 million for its various new builds, such that this represents hidden value embedded in Prosafe’s stock price.  Obviously, this cash has been spent but the assets that will generate a return on that cash won’t be here for another year or so, but as my example earlier shows, they should be very accretive to cash flow and dividends. The last concern I have is the debt ratio, in that I don’t expect Prosafe to generate a lot of FCF in the next two years due to the spending on the new builds.  I expect net debt to increase by roughly $250M between now and the end of 2015 due to the impact of dividends and very modest FCF. However, Prosafe has recently been able to tap the debt markets for both long-term and low cost debt, and I think that while the leverage will go a bit higher than I personally like to see, it won’t be pushed into the danger zone any time soon.  Nevertheless, even if things get really tight, the company could easily adjust the dividend downward to build up the ratio, though of course the market would likely punish the stock in the short term in such a scenario.  Still, this wouldn’t cause shareholder dilution or impair the intrinsic value in any way.  

As far as timing, I do expect a weak Q1 for Prosafe as the Safe Scandinavia will be in the yard for its 20-year life extension, and the Safe Bristolia will be moving from its contract that expired in late December to its next scheduled contract that starts in April. Also, the Regalia will be mobilizing to its new contract that starts at the end of February, so will only be earning full day-rates for a month.  These are the three highest-earning rigs for Prosafe, and they will only get a combined one month of full day rate from them in Q1. However, after Q1 the rest of 2014 looks pretty strong, with all the rigs booked out except for the Safe Hibernia (contract in the Gulf of Mexico ends in March).  It looks like utilization might very well be in the 90s for the year from Q2-Q4, and most of the rates are pretty good. I suspect that the likelihood of a weak Q1 is weighing on the stock here, but it seems pretty clear that this is just an accident of the booking schedule combined with Prosafe’s decision to renovate the Scandinavia during this period.  However, following Q1 there should be a period of strong performance given the record backlog. 

My best guess for a reasonable outcome here would be for the market to get a bit less negative on the longer term story for demand for accomodation rigs, and eventually settles for a yield of 7.5% from Prosafe.  This would push the stock price to $8.50, which would be 25% higher from here.  If this took two years, the total return would be 40% or so due to dividends.