Description

Thesis

SEVAN Marine (SEVAN.NO, Kr62.25/shr) designs, builds, owns, and operates cylinder-shaped floating vessels used to provide offshore oil/energy services.  The company was founded in 2001 based on its unique cylinder-shaped vessel design and is building a fleet of primarily deepwater FPSO vessels as well as a Floating Driller.  An FPSO is a floating production, storage and offloading vessel that serves as a conduit between an offshore oil field and the tankers that transport the product to market.  SEVAN has designed additional applications for its technology and is working to open up brand new markets by securing contracts for a Floating LNG (liquefied natural gas) vessel and a Floating GTW (gas-to-wire power plant) vessel in the near future.  SEVAN is a compelling investment opportunity as the company has come up with a superior solution for a secular growth industry, is leveraging its technology and expertise into new markets, has more than 100% upside over a one-year time horizon, and offers reasonable downside protection based on existing/near-term contracts (see DCF valuation below).

The superior solution is SEVAN’s patented cylinder design that is cheaper to build and operate and has superior motion characteristics when compared to the traditional ship-shaped floating vessels that are offered by the rest of the industry.  These advantages should drive robust market share and attractive return on invested capital for the foreseeable future.  The secular growth story is driven by several factors, including 1) declining production curves of mature onshore and shallow-water oil reserves that continue to make deepwater oil the primary solution for maintaining and growing world oil production; 2) accelerating interest in Floating LNG to satisfy global energy shortages and arbitrage regional natural gas prices; and 3) the option value of leveraging SEVAN’s technology solution into other floating vessel concepts.

Capitalization:  Kr62.25/shr, 185mm shares, $2.3b market cap, $570mm net debt, $15mm ADV.

Please forgive the limited discussion of valuation in this thesis introduction as the best way to value SEVAN, given that the company is in the growth phase of its economic life cycle, is through discounted cash flow analysis as detailed below.

Fleet Profile

SEVAN is in the nascent stage of growth with one FPSO in operation (as of 4Q07), one FPSO expected on-line in 1Q08, two FPSOs under construction with contracts, two FPSOs under construction on spec, and one driller under construction with contract.  Customers include Petrobras, Venture Production, and Oilexco.  Vessels cost $200-500 million, depending on size and topside specifications, and take approximately two years to build.  Due to its superior motion characteristics, SEVAN typically targets harsh weather or motion-sensitive opportunities for which both barriers-to-entry and economic returns are higher.  Of SEVAN’s five contracts, three are in the North Sea, one is off the coast of Brazil, and the driller is slotted for the Gulf of Mexico.  SEVAN’s average contract length is seven years plus options, which are typically exercised per industry experience, resulting in long-term stability and visibility to earnings.

SEVAN’s Cylinder Technology

We see SEVAN’s patented cylinder vessel design as a game changing technology.  The building of offshore oil production equipment is very capital intensive and SEVAN’s cylinder shape and innovative design give it a 30-40% construction cost advantage to traditional ship-shaped FPSOs.  This advantage comes from the need for less steel and piping per unit volume as well as lower engineering costs and shorter construction time due to more uniform modular assembly.  A traditional ship shape is designed to move as efficiently as possible through water, but an FPSO is not designed with the intent of sailing as it is fixed to a given field for multi-year periods.  The ship-shaped FPSOs that SEVAN competes with therefore require a complex and costly turret system that allows the ship to swivel and point itself into winds, waves, and currents.  Because SEVAN engineered its hull to be as stable as possible in the water and the cylinder shape has natural symmetry, the SEVAN FPSO can be moored to the ocean floor, providing stability in a far simpler and less costly manner.  Relative to ship-shaped FPSOs, the cost to operate the vessel is approximately 10% lower and the superior motion characteristics allow for higher uptime and more efficient processing of oil, especially during times of severe weather.

SEVAN recently participated in a joint industry program with several oil companies to study the SEVAN unit’s ability to stay connected in 10,000 year hurricane/cyclone conditions.  This study was funded by the oil companies (potential customers) and Australian super-regional Woodside even published an article in an internal company magazine extolling the potential benefits of SEVAN’s design.  Here are some excerpts from the Woodside article:

“At present… Woodside… FPSO’s disconnect the turret and sail away in a cyclone.  This is a time-consuming operation that is also costly in terms of lost production and probably unacceptable for integrated gas projects that require very high availability… The [SEVAN] model performed surprisingly well as it rode waves created to the maximum capabilities of the test tank without pitching or rolling as a ship shape would.”

The FPSO industry historically achieves new vessel IRRs of 10-15%.  The construction and operating cost advantages for SEVAN can justify ROIC that is 600 basis points better than other harsh weather competitors.  Another 250 basis points of ROIC outperformance can be justified assuming vessel uptime is improved by 5% and SEVAN shares 50% of the efficiencies.  This is because any barrel of oil that is not produced today gets pushed to the end of the 10-20 year field life.  Based on management guidance and our competitive analysis, we believe that new contracts will generate IRRs in the 15-20% range.  Given SEVAN’s estimated 8.0% WACC, each new contract signing is highly accretive to valuation.

We spent significant time vetting SEVAN’s cost advantage and found that it could be verified in both harsh and benign water.  While SEVAN has captured the three most recent North Sea (harsh water) FPSO awards, the four prior harsh water awards each have construction cost 30% or higher than a comparable-sized SEVAN vessel.  Even in benign waters, construction costs on recent contracts where a ship-shaped FPSO requires a turret and swivel are at least 15% above SEVAN.  In both harsh and benign waters, we are confident that SEVAN has a significant construction cost advantage relative to competitors.  However, SEVAN logically focuses its efforts on harsh waters and motion-sensitive applications where its competitive advantage is wider.

Market Share

Due to its superior technology, SEVAN has managed to capture approximately 15% market share of new FPSO contract awards, since signing its first contract with Petrobras in early 2005, and one driller contract despite having an unproven concept.  The company has also captured each of the last three North Sea (harsh weather) contracts, on which it is more focused.  Now with the delivery of FPSO Piranema in 4Q07, SEVAN has proven its ability to execute and the design is proving its superior motion characteristic in real-life conditions.  Petrobras, in fact, commented positively about SEVAN in a Feb 22, 2008 Upstream article noting that “so far our measurements of stability have recorded a performance that has been far superior to that shown in our tank simulations.”  This proving of the concept has resulted in increased interest from E&P customers, including historically conservative majors, and should further strengthen SEVAN’s market share, ROIC, and contract terms while reducing its cost of capital.  In fact, SEVAN seems to be quite confident in its market position as management has guided to three new contracts, including one new concept (Floating LNG or Floating GTW), by the end of 2Q08.  SEVAN is obviously in later-stage discussions with multiple parties and any such contract announcements will clearly be catalysts for the stock as long-term prospects become increasingly visible. 

Secular Growth

Most large oil fields have been found and are in a state of decline, resulting in an increasing trend to offshore, deepwater fields.  Building infrastructure to these fields is increasingly expensive or not physically possible, leading to the use of FPSOs in favor of more fixed platform and pipeline solutions.  In addition to having cost and timing advantages, FPSOs can be easily moved at the end of a field’s production life, thereby reducing risk and providing better amortization of capital costs.  These trends have resulted in the worldwide FPSO fleet growing from 23 in 1995 to 145 in 2007, or a 16% CAGR, and should continue to drive ~10% CAGR for the foreseeable future according to International Maritime Associates.  While the market is aware that demand for FPSOs is very strong for the next few years, our analysis suggests that long-term demand for oil FPSOs is approximately 20 new vessels per year, with 75% of those being leased from SEVAN or its competitors.  Recent oil and gas discoveries by Petrobras and others in the Santos Basin off Brazil suggest that this new region alone could ultimately require 50-100 large FPSOs to reach full production.  We believe that SEVAN can capture two FPSO contracts per year based on historical market share and perhaps more given recent de-risking of the company’s cylinder concept.

The deepwater trend should also enable SEVAN to capture additional floating driller contracts over time.  Management has suggested that with an additional driller contract SEVAN may spin off the business to better take advantage of robust demand for floating drillers.  As a separate entity, the drilling business will be able to expand balance sheet capacity and dedicate management resources to more aggressively pursue new contracts.  We believe that the driller business can reasonably capture one contract per year as an independent entity.

In seeming confirmation of the option value in both deepwater energy solutions and SEVAN’s technology in particular, the energy industry’s interest in Floating LNG has expanded dramatically over the last six months.  We believe the industry and SEVAN itself will announce a firm Floating LNG contract by year-end at the latest.  Floating LNG in this context refers to the building of floating vessels that contain gas processing and liquefaction equipment on the topside and cryogenic storage in the hull.  Floating LNG is a new concept with as yet no liquefaction vessels in operation worldwide.  The concept will capitalize on the world’s current bottleneck in gas liquefaction capacity which is needed to satisfy regional energy shortages and arbitrage the price differential between regional trapped gas and developed markets.  LNG regasification and transportation capacity have outstripped onshore liquefaction capacity due to labor shortages, cost inflation, and political uncertainty causing significant project delays.  The resulting supply chain bottleneck has turned the industry toward the offshore liquefaction, or Floating LNG, solution.  Floating LNG, while still in evaluation stage, is likely to have shorter lead-times, more manageable infrastructure requirements, and competitive unit economics when compared to onshore projects.  And again, the ability to move vessels over time reduces risk and provides better amortization of capital costs.  Evaluation of Floating LNG has also accelerated due to tougher environmental requirements regarding gas flaring, which wastes increasingly valuable energy and releases green-house gasses.  Infield, an independent oil and gas industry research firm, has identified as many as 2,000 offshore gas fields that the industry may target over time.  SEVAN’s unique cylinder design and its superior motion characteristics are particularly well-suited for Floating LNG due to the importance of minimizing LNG sloshing.  We believe that SEVAN can capture one Floating LNG contract per year and perhaps more as the concept proves out.

Consensus

The sell-side is generally positive on SEVAN with six BUYS, four HOLDS, and one SELL.  However, we believe the sell-side is being conservative in its underwriting of future vessels for SEVAN, with the most bullish analysts projecting that SEVAN ultimately builds its fleet to 17 vessels.  And while the market seems to accept that a downside scenario for SEVAN might be a fleet of 7-9 vessels, we believe such a scenario is excessively conservative given the secular tailwinds and replacement requirements.  While it is understandable that the market might be cautious when underwriting growth for an emerging company and concept, we also feel it is narrow-minded not to pay attention to the facts.  SEVAN has both captured significant FPSO market share and cracked into the driller market over the last three years despite not having a proven concept in either market.  The cylinder concept is now proven and receiving high marks from its customer and management is confident on signing three new contracts by 2Q08.  The secular growth story for deepwater solutions continues to be strengthened by the recent Santos Basin discoveries.  And new markets such as Floating LNG and Floating GTW are fast approaching on the horizon.  While it may require a new corporate structure that divides the various vessel applications, we believe that in aggregate SEVAN could deliver four or more vessels per year on a long-term basis, representing tremendous organic growth for a stock that is currently pricing in only 12 vessels.

Valuation Scenarios

SEVAN has realistic upside of more than 100% over a one-year time horizon and reasonable downside of 10% based on existing/near-term contracts.  While this section will outline a few valuation scenarios, SEVAN is a stock that will require more independent diligence to verify cash flows and appreciate the valuation impact as new vessels join the fleet over time.  All scenarios assume a 8.0% WACC based on 4.50% risk-free rate, 2.50% debt spread (although long-term financing recently arranged at L+150), 10.0% tax rate, 5.00% equity premium, 1.0 asset beta (long-term contracts offset other risks), and 50/50 debt/equity.  This WACC imputes to a 9.5x EBITDA multiple on a completed vessel, which is quite reasonable given the low tax rate and modest maintenance capital requirements.

Downside:  SEVAN launches two vessels per year for the next five years for a total of ten vessels (including the five contracts already signed).  Achieved IRR on new contracts is 15%.  Present value price target at year-end 2008 is approximately Kr55 per share, or 10% downside.  We find it highly unlikely that SEVAN will ultimately be limited to ten vessels.  

Midcase:  SEVAN launches two vessels per year for the next five years (including the five contracts already signed) and two vessels per year for the following five years, taking total fleet to 20 vessels.  Achieved IRR on new contracts is 15%.  Present value price target at year-end 2008 is approximately Kr100 per share, or 60% upside.

Upside:  SEVAN launches two vessels per year for the next five years (including the five contracts already signed) and three vessels per year starting year five on an ongoing basis (for 20 years).  Achieved IRR on new contracts is 15%.  Present value price target at year-end 2008 is approximately Kr200 per share, or more than 200% upside.  While consensus might find this extended build program aggressive, our research suggests that SEVAN is particularly well positioned to capitalize on secular deepwater trends for multiple floating applications that will last not just for the next five years that are published in a sell-side research note, but rather for the next several decades.  While it may be unlikely for SEVAN to see Kr200/shr by year-end, justifiable upside of this magnitude suggests that SEVAN is a stock that can generate substantial annual gains over a multi-year holding period.

Catalyst