Description

Prosafe Production owns and operates eight FPSOs (Floating Production Storage and Offloading vessels) on long term contracts, particularly in areas such as Brazil, West Africa, and Australia.  They also own one VLCC (Very Large Crude Carrier) which is currently laid up and may be converted to an FPSO if/when a new contract is awarded.

We've approached the Prosafe valuation with a DCF, given the long term nature of their contracts and cash flow.  We have used a 10% discount rate on the cash flow available to equity holders after all interest and debt principal repayments, and arrive at a value of 18 NOK, a 20% premium to the 15 NOK price today.  It's important to note that this 18 NOK valuation is simply the value of their existing long term contracts and does not assign any value to future growth or project awards.  In addition, it does not assign any residual value post contract expiration, arguably a conservative approach given there is always scrap value.  Given the outlook for the FPSO market which I discuss below, there is meaningful upside from growth as well in terms of new business awards.

Prosafe's contracts provide for a consistent amount of annual EBITDA per unit, in other words, the revenue escalates with increasing operating costs, which are predominantly crew costs.  In addition, each unit requires approximately $1m of annual maintenance capex.  Based on Prosafe's contracts, we expect $250m of EBITDA declining to approximately $200m of EBITDA over the next 5 years.  Their contract coverage on some ships runs through 2018, with option extensions through 2024.  For more details, they have a nice chart on their website on contract expirations.

The cost to build an FPSO is extremely variable. For example, it can be as little as $250-$300m or up to $2 billion, depending on the size, mooring system, and whether it will be placed in a harsh environment.  Prosafe targets an unlevered after tax minimum 12% IRR when signing up these contracts depending upon execution risk, counterparty risk, and the length of the contract.  In most cases, they've achieved a 13-15% IRR unlevered.  Given the long term nature of these contracts, Prosafe has been able to obtain 80% debt financing on these projects, thus making the levered IRR in the 20-30% range. 

Typically, a contract is signed for 6-8 years with extension options for an additional 6-8 years thereafter.  EBITDA rates are usually 10-15% lower during the option period.  Historically, most contracts have taken the extension option post the initial contract, even staying well past the option period as the wells were still producing.

The company has expressed a desire to pay down debt initially with free cash flow, targeting net debt 3-3.5x EBITDA.  Once achieved, capital will be allocated between growth and paying dividends, which may begin as soon as 2011. 

Macro Outlook

FPSO demand is driven by oil field development, normally in waters deeper than 300m, where a separate production hub is needed.  With built in storage capacity, FPSOs reduce dependency on existing infrastructure.  In addition, since requirements are very field specific, units are typically constructed towards long term life-of-field contracts (i.e. 6-20 years).

The long term picture for the FPSO market is a positive one.  Demand for oil is likely to continue to grow, and with oil prices stabilizing at a higher level, an increasing number of drilling projects should develop.  At the same time, existing oil fields are seeing output declines and most of the easily accessible reserves have already been discovered.  Future production is likely to stem from more remote and challenging areas such as deep water with limited infrastructure, where the FPSO concept has a competitive advantage.

New FPSO awards and tender activity picked up in Q4 2009 after being nonexistent from August 2008 through the first 9 months of 2009, and the street expects to see 10-15 new awards in 2010.  There are currently 134 FPSOs in operation worldwide, including 13 units sitting idle today.  Over the next 5 years, 44 units are scheduled to come off contract and 9 units have been ordered speculatively.  Thus by 2014, the available supply would theoretically be about 66 units.  For the same period, industry specialist Petrodata has identified 96 tenders/queries on the demand side, creating a nice potential supply/demand imbalance.  Moreover, this supply/demand picture may underestimate the need for new units given that historically only 20% of new contracts have been redeployments.

Given the long term growth trend in deepwater field development with floating production as the preferred solution, and that FPSO stocks have not participated in the oil services rally, we find this to be a very attractive space. 

Additional Info

In March 2010, Prosafe announced a Letter of Intent (LOI) to sell its turret and swivel technology to National Oilwell (NOV) for USD $165m plus 10% of sale revenues over the next 7 years.  To date, this technology has only been used on the company's internal projects, we therefore had not been assigning any value to this business and the net asset value of the company should increase by the full amount of the sale.  The proceeds strengthen the balance sheet and put Prosafe in a better position to explore growth opportunities in the FPSO space or begin paying a dividend.  The deal is expected to close in Q2 2010.

The turret/swivel technology which is being sold enables mooring of FPSOs in both shallow and deep water.  Prosafe's competitors, namely BWO, SBM, Modec and Bluewater, all have proprietary mooring systems.  A 7 year supply agreement with NOV should give Prosafe continued access to the equipment at competitive terms.  Cost for a full mooring system is typically in the USD $50-100m range, thus if NOV is successful at penetrating the market, Prosafe's 10% share of external revenues over the next 7 years provides some upside.

In the recent past, Prosafe stock took a major hit as the company was pressured by capex overruns on several of its FPSO newbuilds.  However, the latest unit was delivered in late 2009, and the company has no further capex requirements other than regular maintenance capex on its existing FPSOs. 

Today, the company still trades at a discount to the present value of its long term contracted cash flows and net asset values.

Catalyst

BW Offshore Ltd (BWO.NO) owns 30% of Prosafe and has a spoken strategy of consolidating the space.  It is possible that BWO makes a bid to acquire the rest of the company, particularly if valuations stay where they are with BWO trading at a premium to contracted cash flow and Prosafe at a discount.

Otherwise, we expect the stock to move as the company continues to pay down debt and begin paying a dividend in 2011.  New contract awards are another catalyst for price appreciation.