Description

Summary

Offshore oil exploration and development is a long-running trend within the energy industry that has been reinforced by a number of developments over the last several years.  The first of these are technological advances that have enabled and reduced the risk of offshore exploration, especially in the deepwater.  For example, many deepwater prospects are located beneath a very thick layer of salt.  (In the Gulf of Mexico, these regions are referred to as “sub-salt.”  In other regions, they are called “pre-salt,” referring to the sequence in which the geological strata were deposited.)  These salt layers had historically obfuscated seismic waves since the salt is soft and absorbs acoustic energy.  It is also shaped unevenly which further distorts the signal.  New seismic techniques such as Wide Azimuth, however, have overcome these challenges, improving the image of the subsurface and reducing the associated exploration risk.  This is very significant since these wells can cost $50-100MM which makes the exploration risk particularly ominous.  Other advances include newer generations of floating drilling rigs that are capable of drilling in deeper water depths and drilling more quickly, which also reduces costs.

A second trend encouraging deepwater development has been a shrinking opportunity set for the major oil companies.  Many years ago, national oil companies (NOC’s) needed to partner with the majors in order to access the majors’ expertise and capital.  Today, however, much of this know-how resides among the service companies such as Slumberger, and high oil prices have eliminated the NOC’s need for the majors’ capital.  In addition, as oil prices rose dramatically over the last decade, NOC’s sometimes forced the majors to renegotiate the terms of their joint ventures.  Consequently, deepwater exploration has become one of the remaining attractive investment areas for the majors. 

While the industry has enjoyed considerable success uncovering large new deepwater reserves, these are very expensive areas in which to operate with the total costs in some cases exceeding $1MM per day.  Drilling a deepwater well is essentially a highly specialized construction project that is performed from a floating platform in up to 10,000 feet of water depth.  The platform or drillship is “dynamically positioned” by thrusters that counteract the influence of wind, waves and currents in order to keep the rig stationary above the well on the seabed.  Due to space constraints on the rig, supplies and personnel must be delivered and removed on a just-in-time basis.  These include items such as drill bits, drill pipe, drilling fluids, diesel fuel, casing pipe, tubing pipe, and other specialized components that are consumed during the drilling process.  During the project, specialized services are also required such as Measurement While Drilling (steering the bit on the fly), Logging While Drilling (taking measurements from directly behind the bit, also on the fly), wireline logging (taking more measurements), cementing and fracturing.  The service companies who perform these tasks charge a high standby rate for making their staff wait if the rig is not ready for them when they arrive.  Lastly, rig-based personnel typically work in shifts (i.e. 30 days on, 30 days off) and must be shuttled to and from the rigs by helicopter or boat.  As you can imagine, this is a very expensive and logistically complex operation with many decisions and adjustments that need to be made throughout the process.  Consequently, effective communication and coordination between the rig and all of these other parties is absolutely critical to the efficient and safe drilling of the well.  

Other factors are further contributing to the growing demand for remote communications between the rig and shore-based personnel.  As alluded to above, effective coordination is directly related to project profitability which has motivated the drillers, operators, and service companies to expand their use of data sharing wherever possible.  For example, the drillers collect data about the rigs’ various systems (i.e. drilling systems, engines, pumps, HVAC, etc.) and transmit them back to their home offices where engineers can monitor the rig remotely.  Data collection on the rig is also increasing among operators who collect data from MWD, LWD, and wireline logs and transmit this data back to experts onshore whose input is needed in the decision making as the well is being drilled.  Importantly, these rigs are dispersed around the globe, and yet they need the input and direction from a finite set of engineers and scientists at the drillers’ and operators’ offices.  Allowing these onshore experts to monitor multiple rigs simultaneously from their offices instead of having to travel to the rig itself dramatically improves productivity and decision-making times.  Lastly, it is important to understand that the industry’s supply of these experts has been constrained.  Weak oil prices through the mid-1980’s and 1990’s lead to ongoing rounds of layoffs which traumatized that generation of engineers and strongly discouraged young people from entering the industry.  Consequently, the industry was already thinning from a labor perspective, and this has become even more so as drilling activity has increased.  A smaller driver of bandwidth use offshore is beginning to come from the rig staff during their off hours.  Much of a typical rig is staffed by young men in their 20’s, and the current generation of those individuals is conditioned to having constant access to the internet.  Consequently, drillers are considering improving their Wi-Fi access in order to reduce staff attrition.

Industry Structure of Remote Communication Providers

Because drillers and oil companies usually operate globally, they prefer to work with communications providers that have global infrastructures and can follow the rigs around the world.  RigNet is one of only two remote communication providers to the offshore energy industry that can provide this global coverage, and they have roughly 30% marketshare.  Harris CapRock is the other, with roughly 35% marketshare.  CapRock was originally an independent remote communications provider that served the energy, maritime, and government markets, but it was acquired by Harris in 2010.  Harris then acquired Slumberger Global Connectivity Services (Slumberger GCS) in 2011 and combined it with CapRock.  It remains to be seen how this new entity will perform in the marketplace, but I find the potential for disruption and neglect to be very attractive conceptually.  For example, CapRock and Slumberger GCS were similarly sized businesses, with separate networks, and these will need to be merged together which is a complex undertaking.  In addition, Slumberger GCS was tightly integrated into its parent, and this will have to be untangled.  A third dimension is Harris’ involvement, which was presumably the impetus behind senior management departures at both CapRock and its group in 2011.  It also remains to be seen how closely CapRock will focus on the oil and gas market under Harris.  Harris was presumably attracted to CapRock’s government business, and a 2011 Harris investor presentation showed that “Energy and Maritime” was by far the smallest addressable market within Harris’ Integrated Network Solutions segment which itself accounts for roughly 37% of Harris’ revenue but only 9% of Harris’ segment profits.  RNET also faces a small competitor called Stratos which is a subsidiary of Inmarsat, though Stratos’ primary asset is a microwave network in the Gulf of Mexico.  The rest of the market is served by regional providers and the NOC’s themselves who insource this function because their government mandates encourage them to create jobs.  PEMEX and Petrobras, for example, have their own internal communications departments, though Petrobras is starting to open up to outside vendors because their expansion plans are outpacing the capabilities of their IT department. 

RNET enjoys a number of competitive advantages, though it is unclear how effective these will be in stealing marketshare from Harris CapRock over time.  RNET was founded in 2000 with a vision of creating a “clean sheet” IP-based network to provide “fully managed remote communications.”  They essentially allow drillers’ IT departments to outsource their communications needs which allows those departments to focus on other areas and operate with less staff.  Furthermore, this is an function that lends itself to outsourcing as it requires specialized expertise and problem solving abilities.  RNET has gone to market with a “pull marketing” approach that facilitates a collaborative relationship with customers.  For example, their user meetings allow customers to influence RNET’s R&D spending to ensure that RNET develops and structures its solutions in ways that are most helpful.  RNET is also an asset-light company that has primarily focused on owning the networking equipment on the rig, which can be thought of as “the last mile.”  (CapRock, by contrast, owns more of the network, such as teleports, and Slumberger CGS even manufactured some of their own equipment.)  One of the reasons that RNET insists on owning the networking equipment on the rig is that they are committed to being a solutions provider as opposed to being merely a bandwidth reseller or a repair company.  In addition, owning and managing Layer 3 of the IP network allows RNET to see every device on the network remotely.  This is essential for being able to quickly diagnose and remedy problems.  In some cases, problems can be fixed with a few button clicks, but if a technician needs to be deployed, he will go into the situation with a much better understanding of what he needs to take with him and repair on the rig. 

Customers overwhelmingly value reliability and service repair time when considering a communications provider.  This is because communications represents less than 1% of the cost of operating a rig, but can create enormous disruptions when it fails, and this is inevitable since the equipment operates in a harsh environment.  Customers also value having a standard solution that works around the globe, having a solution that is compliant with local regulations, and having a competitive price, but those three factors pale in comparison to the importance of reliability and service response time.  RNET believes that its network gives it an advantage in this area and that its competitors use older methodologies such as Frame Relay and ATM which prevent them from managing their networks as effectively.  RNET’s responsiveness is also partly a function of a very proactive and customer-centric culture that stems from its staffs’ backgrounds in oil and gas.

Interestingly, despite being more asset light than its peers, RNET generates much higher margins.  As part of its acquisitions of CapRock and Slumberger GCS, Harris provided adjusted EBITDA guidance for those two acquisitions.  Based on these figures, those two businesses carried considerably lower EBITDA margins than RigNet in 2010:

*This figure is for the twelve months ending 6/30/11.

Furthermore, because RNET is asset-light, it has items in its operating costs that Slumberger GCS and CapRock report as D&A.  Consequently, the margin disparity is even greater at the operating profit line.  There are a number of factors that account for RNET’s higher margins.  The first is RNET’s focus on upstream oil and gas customers as these are the most demanding and profitable customers.  The EBITDA margin associated with drillers, for example, are roughly 60%, whereas the EBITDA margin for general maritime customers is in the 40% range.  In addition to focusing on the most profitable vertical market, RNET also appears to operate leaner and smarter than its competitors.  For example, CapRock operates out of a large teleport in south Houston that can be easily seen from the freeway.  RigNet, by contrast, operates out of a suite within a modest midrise office building in what is know locally as the “energy corridor.”  RNET’s reception area is a nicely appointed, though it is a small room that not staffed, and visitors are met by a telephone and a company directory.  Besides having a thrifty culture, I expect that the relative age of RNET’s infrastructure has conveyed cost advantages as well.  Lastly, RNET’s margins have benefitted from focusing on new rigs that are more likely to require a “secondary tenant” which is very profitable work.

Unit Economics

RNET enters into three to five year contracts with drillers under which RNET installs the communications equipment on the rig and then provides the associated services.  The driller is referred to as the “primary tenant” that will use this infrastructure, and this contract structure ensures that RNET will earn a compensatory return on the capital that they spend outfitting the rig.  RNET, however, chooses to build out this infrastructure so that it is almost ready to serve the operator and service companies as well.  This stands in contrast to CapRock who historically only installed the drillers’ infrastructure, and who continues to take this approach on the majority of its deployments.  RNET’s management, however, is very focused on securing as many secondary tenants as possible which is why they install the “gold plated solution” up front and then work with the drillers to know who the operators are likely to be and try to add them as secondary tenants.  Beyond the driller and operator, service companies can be added as tertiary tenants for little incremental cost, and Wi-Fi connections can be provided for the crew as well.  In the past, service companies have not been major bandwidth consumers because they are on the rigs for relatively short amounts of time.  They also tended to borrow the operators’ connections or bring pop-up satellite dishes.  There are some indications, however, that the service companies are beginning to want their own dedicated connections, and RNET entered into its second global purchasing contract with a major global service firm in 3Q11. 

During its roadshow, RNET provided some figures about the economics of a typical contract which I have used to estimate the associated EBITDA and ROI’s:

Assuming: 1)the contract is for five years, 2) the equipment has a five year useful life with zero salvage value, and 3) a 40% tax rate, these contracts generate the following ROI’s:

There are three caveats to these figures.  The first is that these figures are based on an “illustrative example,” and the results of individual contracts likely vary by driller, operator and geography.  Both Floating and Jack-Up rigs in the North Sea, for example, consume 90-95% more bandwidth than their counterparts in the Gulf of Mexico, in part because video conferencing is more common in the North Sea.  The second caveat is that some of the capital expenditures listed for the primary tenant are really being spent to prepare for the secondary and tertiary tenants; RNET is ultimately spending more than $25,000 to equip a floating rig for the secondary tenant.  The third caveat is that RNET only secures a secondary tenant about 50% of the time.  Nonetheless, I don’t know of any other business that will allow you to earn a mid-20% baseline return and then earn an +800% return on incremental capital. 

RNET depreciates its equipment over five years, though the equipment has little technical obsolescence, and they have some equipment from 2001 that is still running today.  It is more common, however, for customers to damage equipment or opt for upgrades, both of which result in equipment being replaced before the end of its useful life.  Management has indicated that 90% of their current capital expenditures are “success based,” meaning that they are tied to a new contract and the up-front capital expenditures described above.  This is very significant from a valuation standpoint because it means that once the industry’s newbuild cycle is completed, RNET’s capital expenditures will step-down dramatically, and the company will begin gushing FCF. 

US Land Segment

While most of this discussion concerns RNET’s offshore business, RNET also has a small US Land segment that provides communications to land rigs in the US.  This business is more competitive since the barriers to entry are lower, and it is also more volatile since it tracks the US land rig count.  This division represents roughly 18% of total revenue, 13% of total EBITDA, and 13% of total operating income.  RNET also supports international land rigs, though those results are included in its “Eastern Hemisphere” segment whose results are primarily driven by offshore rigs.

Growth

Growth over the next several years should come from three primary avenues.  The first is the rig newbuild cycle.  From 2012-2014, 67 floating rigs and 77 jack up rigs are expected to hit the water.  Another leg of orders began recently, and this is expected to lead to roughly 34 additional floating rigs that I’d expect to enter service in the 2015-2016 period.  RNET expects to maintain its 30% marketshare of these new rigs.  There is also the prospect that RNET could gain another 19 floaters and 7 jack up rigs over the next couple of years if Ensco chooses to move their acquired Pride rigs off of CapRock’s network and onto RNET’s.  I believe this is highly likely as Ensco was RNET’s launch customer and is reportedly happy with their work.  In addition, Ensco prefers the sole-provider model. 

The second growth driver is more bandwidth and services being consumed per rig.  Management, for example, believes that secondary tenant penetration could rise from its 50% level today up to 70-75% in the future as the upcoming set of newbuilds should include more secondary tenants and RNET is becoming more effective at securing such clients. 

The third growth driver is adding other remote sites within energy such as the other types of service vessels and offshore production sites such as FPSO’s.  These second and third growth drivers displayed their significance in the first nine months of 2011 as RNET’s offshore revenues grew nearly 9% Yr./Yr. despite their offshore rig count declining modestly.  (Some of this revenue growth came from a mix shift towards floaters.)

Valuation

Because we are about to enter a period of rapid expansion in the offshore rig fleet, I have forecast revenue growth to be strong through 2014 and then decelerate meaningfully after that, though the newbuild cycle could possibly be extended.  I developed conservative and aggressive scenarios.  In the conservative scenario, I assumed that revenue grows at an 8% CAGR from 2011 through 2014 and a 6% CAGR from 2014 to 2016.  My aggressive scenario assumes that revenue grows at a nearly 12% CAGR from 2011 through 2014 and then at a 6% CAGR from 2014 to 2016.  The primary difference between these scenarios is that the conservative one assumes that Pride’s rigs stay with CapRock, whereas the aggressive scenario assumes that Ensco converts these rigs to RNET, which I believe is the most likely outcome.  I also assumed that margins would improve modestly since RNET’s incremental margins are significantly higher than their reported margins.  Below are the highlights of my model:

*Includes RNET’s current $1.95 / share net cash position.

**From $17.44.

I believe that both of these scenarios are conservative, in part because I assigned soggy multiples.  Using 2012 results, RNET is currently trading at an EV / EBITDA of 6.9x, but the Offshore Support Vessel companies are trading over 8.0x, and those companies are basically offshore truckers.  (The OSV’s ferry supplies to the rigs and also tow the rigs to new locations.)  In addition, I believe I have been conservative with respect to RNET’s margin expansion and the potential impact of converting Pride’s fleet.

As mentioned before, 90% of RNET’s capital expenditures are tied to new contracts, so when they eventually stop adding new rigs, their capital requirements will collapse.  If you assumed that the newbuild cycle will end abruptly in 2016, this would put RNET’s 2016 FCF in the range of $2.25 to $2.65 in my two scenarios.

Risks

Because offshore oil and gas customers place such a high value on reliability, the market is essentially closed to new entrants.  MTN Satellite Communications is a company that provides remote communications to cruise ships, and they have attempted to enter the oil and gas vertical five times without success.  Furthermore, even within oil and gas, it is relatively difficult for rigs to change providers because doing so is disruptive.  A few years ago, Transocean entered into a global contract with CapRock, but RNET is still serving some Transocean rigs because it has been too difficult to bring those rigs in to be converted.

I believe the largest risk is that RNET could lose rigs to Harris CapRock either vicariously or through industry consolidation.  For example, in 2010, Noble acquired Frontier who had three rigs with CapRock and three rigs with RNET.  Noble is one of RNET’s largest customers and converted Frontier’s three CapRock rigs to RNET.  Ensco’s acquisition of Pride could lead to a favorable outcome as well.  But some potential consolidations could be adverse to RNET. 

Another risk is that RNET squanders its capital on a foolish or overpriced acquisition.  The remote communications space has been consolidating, and one of the reasons that RNET went public was to provide the capital to participate in this.  They have also said that they would consider stepping out into another vertical market such as general maritime and doing so would require an acquisition.  After meeting with management, however, I came to recognize that they are running the business shrewdly, and they seem much less likely to make a poor acquisition than I had originally feared.  Mark Slaughter (RNET’s CEO) admitted that the oil and gas vertical represents the “peak of the mountain” in terms of EBITDA margins, but he believes that they can still expand down the mountain judiciously since some of the other verticals have EBITDA margins

Catalyst