Description

Prosafe owns 11 of the world's 18 heavy-duty, harsh environment offshore hotels ("floatels").  Each floatel is a massive, semi-submersible floating structure housing 400 to 800 workers.   The floatels are rented for anywhere from a few months to 3 years by offshore E&P operators like Total, Statoil, Pemex, BP, and ConocoPhillips to build (20%), maintain (70%), and de-commission (10%) oil production platforms in deeper or harsh waters.  Prosafe's rigs are mainly used in the North Sea (UK and Norway) and Mexico, with Brazil emerging as a new market.  Prosafe split off its FPSO business (Prosafe Production) prior to the financial crisis (May 2008) to become a pure-play, oligopolistic floatel operator. 

Several near-term events may lift Prosafe's valuation:

1) Forward contracts are accelerating from an all-time low in summer 2010 to above-average levels in summer 2011. Valuation is highly correlated with forward bookings of the fleet, as investors reward certainty of earnings and a tightening market. Between 2000 and 2010, the average utilization of the fleet (number of days booked) for the following year, measured at the end of summer, was 68%. In late summer 2010, Prosafe's fleet was only 47% booked in 2011 so the stock traded at only 6.6x P/E. This is similar to summer 2003, when utilization dipped to a below-average 57% and the stock traded at 6.6x P/E. Fast-forward to late summer 2004, utilization shot up to an above-average 79%, causing a re-rating to 12x P/E. Between 2003 and 2005, Prosafe stock returned 260% (vs. 130% for the OIH). We are in a similar up-cycle now, as projects deferred due to $40 oil in 2009 are resumed. The company has already announced 6 contracts in the last 4 months. Prosafe's utilization in 2012 is now 58%, and we expect it will jump to at least 70% between now and August when the company announces Q2 results. The table below shows Prosafe's historical valuation versus forward utilization (measured at August/September each year) for the past 10 years.  When forward utilization rises above 67%, the stock trades between 10x and 15x P/E. 

Year                            Fwd. Utilization                                           Fwd. P/E
2000                                        60%                                                     9.3x
2001                                        78                                                        7.3
2002                                        57                                                        7.5
2003                                        57                                                        6.6
2004                                        79                                                        11.8
2005                                        87                                                        11.3    
2006                                        81                                                        15.9
2007                                        67                                                        15.8
2008                                        67                                                        9.6
2009                                        70                                                        3.5
2010                                        47                                                        6.6                                                                              

 2) The dividend payout is likely to rise from 50% to 75% this year.  Leverage has declined from 3.7x after the split-off in May 2008, to 2x at December 2010.  On an August 2010 earnings call, management said: "The reduced leverage is, of course, increasing our financial flexibility going forward that will give us better room in terms of either returning more capital to shareholders or investments."  Since this statement, leverage has dropped further and will be only 1.7x at June 2011 at less than 5% interest rates.  Management and the Board of Prosafe have a track record of returning cash to shareholders when risk in the business declines (i.e. greater contract backlog).  Between 2001 and 2008, Prosafe stock returned 650% versus 150% for the OIH and 27% for the S&P.  Of this 650% return, 180% came from cash dividends.  In 2007, Prosafe had a 75% payout ratio on the back of a rising contract backlog.  Because Prosafe had higher leverage after the split with Prosafe Production, the board reduced the payout to 40%-50% in 2008 and the credit facility has limited Prosafe's payout to 50%.  But this can likely be amended or refinanced in the current market (confirmed in our conversations with banks in Norway).  If we capitalize a 75% payout or 75 cent dividend at a 6-7% dividend yield, it implies the stock could be worth US$11 to US$12.5.  

3) Renewed Growth:  Prosafe's massive historical returns are due to both dividends and growth.  We estimate the components of Prosafe's 650% total return between 2001 and 2008 as follows.  300% was from organic earnings growth due to rising floatel demand (floatels doubled from 9 to 18 units in the past 10 years) and utilization (generally north of 85%) leading to higher dayrates.   170% was from opportunistic acquisitions (Prosafe grew its floatel fleet from 7 to 11 units).  180% was from cash dividends.  Prosafe's current low leverage enables it consider not only a higher dividend, but also growth via acquisition or new builds: 

a. Consolidation: Prosafe's acquisition track record is very good.  In 2000 Prosafe acquired Regalia for $97 million.  This rig currently generates EBITDA of $57 million.  In 2006, Prosafe acquired Consafe's 3 floatels by issuing richly valued stock at 15x P/E for a seemingly full price of 14x P/E.  Two years later, Prosafe doubled its dayrates on its Mexican fleet because it was not competing with Consafe for the business.  Prosafe may have an opportunity to acquire Oslo-listed Floatel International.  Floatel International operates two new units in Norway and Brazil on 3 and 5-year contracts, respectively.  Floatel is 30% owned by Keppel Fels, the yard which built the rigs.  Keppel is not likely interested in long-term ownership of the vessels (it doesn't want to compete with potential customers).  An acquisition of Floatel would lower the average age of Prosafe's fleet, and would give Prosafe control of over 70% of this niche segment.  Given the scattered nature of assets, we believe Prosafe would not face anti-trust hurdles.

b. New build:  Prosafe may build new rigs to serve customer demand, particularly with Petrobras in Brazil.  In 2010, Petrobras contracted 2 floatels on 3 to 5 year contracts for the first time.  The scale of offshore activities in Brazil is such that the real demand may be significantly higher yet there are no new floatels being constructed today.  In the drilling market, recent newbuild deals have had contracted, unlevered payback periods of 5-6 years.  With 50% to 80% leverage, the equity returns implied by these deals are between 20% and 40%.  If Prosafe were to build a new floatel for $300 million and finance it with 65% debt, it would imply an equity IRR of 30% assuming a 5-year unlevered, contracted payback.  In other words, a $100 million equity investment would grow to $350 million in 5 years ($1.10 per share in incremental value).  Such returns could re-ignite the stock because they are not only high, but generated with low risk (fully contracted with investment grade E&P customer).   

From a down-side perspective, we like Prosafe for several reasons:

1) Maintained earnings through a 50-year flood.  Oil service companies are cyclical, so we were surprised by how resilient Prosafe's earnings were through the downturn.  Below, we compare Prosafe's EBITDA for the past 4 years with some oil service companies, and even some hotel operators.  Prosafe's EBITDA was flat, while peers' EBITDA declined between 12% and 37%.  Prosafe has demonstrated the power of its dominant market position.  When utilization dipped from 85% in 2009 to 75% in 2010, Prosafe maintained its earnings by raising prices.  This is in stark contrast to oil service comparables which suffered price declines of 30% to 50%.   

2) Low valuation.  Prosafe is considered a "boring" oil service company.  For most Norwegian research analysts, it is the 15^th or 16^th name they cover.  Having spoken to most of them, their understanding of the company is often stale.  The recent "action" in oil services has been in drillers like ESV and equipment manufacturers like NOV.  Prosafe has lagged the OIH by 15% this year.  Its shareholder base is dominated by pension funds and mutual funds in Norway, and it has low foreign and hedge fund ownership.  Other than 2009 when Prosafe traded as low as 3.5x P/E, its lowest valuation was 2 years after the 2001 recession, when it traded at 6.6x P/E, and again 2 years after the 2008 recession when it also traded at 6.6x P/E.  Downside should be relatively low because Prosafe is not far above its 10-year low valuation. 

3) Low leverage.  Prosafe's low cost of debt (current borrowing rate is Libor plus 75 bps), 5% tax rate (domiciled in Cyprus), and capex at 10% of revenue result in high cash conversion.  This, combined with resilient earnings, have helped the company reduce leverage to 2x through the downturn. 

4) Aligned Board and Management.  An empire building mentality usually results in late-cycle acquisitions with cash and debt.  This is one of the ways to get killed in oil services.  Prosafe management been aligned with shareholders over the past 10 years.  The company opportunistically acquired 3% of outstanding shares in 2009, when most companies were frozen.  Our conversations with management indicate that they are thinking prudently about capital allocation. 

So what are the main investment risks?

1) Capex. The average age of Prosafe's floatels is 25 years. After the Macondo incident, there has been a lot of focus on old vs. new equipment and in the drilling sector there is a valuation bifurcation between newbuild operators (e.g. Seadrill) and older equipment operators (e.g. Noble). The difference here is that customers don't have a choice to go to newer equipment. Floatel International built 2 new floatels which are contracted for 3 to 5 years. Our diligence (we spoke with rig yards and former employees of floatel companies) suggests that Prosafe's rigs are well-maintained and can last up to 50 years (per the Keppel CFO). Prosafe operates 4 floatels in the North Sea which has the most stringent requirements for equipment (especially in the Norway sector). This is where Prosafe has greater capex risk. But one of these three vessels (Regalia) already went through a $190 million refurbishment in 2008 and another (Caledonia) is going through a previously scheduled $100 million upgrade in 2012. A third rig, the Bristolia, just signed a 2-year contract outside the North Sea region (described below). We understand that the remaining Norwegian floatel (Scandinavia) is in good shape.

2) Mexico concentration.  6 of Prosafe's 11 floatels work for Pemex.  However, these rigs have been working in Mexico for the past 11 years, and Pemex recently lost one rig (Jupiter) so it has become more dependent on Prosafe.  In fact, Pemex renewed contracts on the Jasminia and Hibernia by 572 days and 219 days, respectively, on April 26, 2011.  Pemex also signed a new 2-year contract for the Bristolia on April 26.  Given Pemex's publicly stated need to halt the steep decline in production at Cantarell field, Pemex will likely need Prosafe's rigs for many years, and this risk is unlikely to surface within the time frame of our investment in Prosafe. 

3) New supply.  Unlike other oil service sub-sectors, there is no new supply of floatels.  However, as has been the case for the past 10 years, we expect that new floatels will be added as the market tightens and utilization rates increase.  For example, in 2006 Consafe added 3 floatels to the market, but this was after Prosafe's forward utilization had gone from 57% to 87%, and Prosafe stock had returned 260%.  It takes 2 to 3 years to build a new floatel.  A conversion of an old mid-water rig may take 18 months to 2 years, but current midwater day-rates are higher than current floatel dayrates, so we are unlikely to see such conversions. 

Catalyst