Sevan Drilling (SEVDR NO) is a Norwegian operator of ultra deepwater drilling rigs (Sevan Driller currently operating, Sevan Brasil online H1 12, and 2 more ordered for 2013/14). The company is currently undervalued due to misplaced investor concerns about the impact of the potential bankruptcy of its former parent Sevan Marine (SEVAN whose share price has decline 90+% since SEVDR started shopping its IPO in April) and the potential overhang of the uncertainty surrounding SEVAN's remaining 28.5% stake in SEVDR. Once this uncertainty clears (end of Sept 2011 deadline for current restructuring deal) SEVDR should be rerated to valuations closer to those of its UDW peers which could lead to 100%+ upside for SEVDR in its current form and a potential 4x+ return with the successful addition of the 2 newly ordered rigs.
NOTE- OPERATING CURRENCY IS USD DESPITE SHARE PRICE IN NOK
Sevan Drilling has 337mln shares for a market cap of $ 284mln at NOK 4.50 and 5.35 NOK/USD. At 3/31, SEVDR had $ 7mln of cash. Since quarter end, SEVDR has completed an equity offering, paid a down payment on 2 new rigs, refinanced its outstanding debt and started payments on its Sevan Brasil rig which is due to come onstream in H1 12. The net of all these manuevers is that pro-forma cash is ~$ 120mln. Current debt is $ 714mln and SEVDR owes $343mln for the upcoming completion of Sevan Brasil for a total adjusted debt of $ 1,057mln or net debt of $ 937mln. SEVDR also has $ 210mln of rig downpayments which I have removed from the EV as they are saleable assets and are not included in the calculation of 2013 EBITDA. As a result of this, SEVDR's adjusted EV is $ 1.0bln.
SEVAN may be able to successfully restructure (currently in negotiations on debt/equity swap with bondholders), but even if the company goes bankrupt, the impact on SEVDR should not be material. After the IPO, the companies are independent entities with largely separate financing structures (other than technical cross default risk- see below). SEVDR is fully financed for its current rigs with its own debt facilities in place and has strong contracts with blue-chip customer Petrobras who is expected to be the major driver of UDW demand over the next decade (Petrobras is expected to spend $120bln on exploration and production over the next 5 years). According to management, the bankruptcy of SEVAN would have no impact on the Petrobras contracts.
Once the Sevan Marine overhang is lifted, then SEVDR can be judged more on its ongoing performance. With its first 2 rigs, SEVDR looks to be able to generate ~175mln of 2013 EBITDA. If SEVDR trades at 8x this normalized EBITDA then it could trade at NOK 11 which would be equivalent to $700mln per rig. Closest UDW comp Aker Drilling trades at 9x 2013 EBITDA and $900mln per rig.
Sevan Drilling also has an option on strengthening demand in ultra deepwater drilling with 2 new rigs coming online in 2013-4. Assuming similar economics to the current contracts, 2015 EBITDA could double to $350mln with upside from potentially higher UDW dayrates. At 8x EBITDA and assuming 1.4bln of 2015 net debt, the company would have a per share valuation of ~NOK 22 per share which is also ~$700mln per rig. Obviously, higher UDW dayrates or higher rig valuations could lead to further upside.
It is also important to note that 9 insiders purchased $1.3mln of stock at the offering price of NOK 8 per share and 6 insiders have since bought $300k of stock in the open market at an average price just over NOK 6.
In a negative scenario, the value of SEVDR's rigs provide some downside protection because of the current supply tightness to get newbuild UDW rigs before 2014 at the earliest. Because of this 2+ year lead time to build new rigs, existing rigs have a fair amount of value. If a company wanted to buy a replica of a new Sevan rig today, it would cost them $525mln (cost of SEVDR newbuilds for 2014) and they would not be able to get the rig for 2+ years. If we use a discount rate of 5%, then Sevan Driller would be worth ~$580mln and Sevan Brasil would be worth ~$550mln (since it comes online in 2012) based on this 2 year waiting period.
Another way to think about rig values in a distressed scenario is by analyzing UDW rig transactions. The only real distressed transaction we have in the UDW space is Diamond buying 2 Petromena rigs out of bankruptcy in 2009 for $1,050mln (950mln cost + 50mln in additional capex per rig). This transaction would imply a per rig value of $525mln for a distressed UDW rig. Given the strengthened UDW environment since 2009 and attractive attributes of the Sevan rigs, I believe this transaction presents a solid floor for distressed rig valuations.
Based on these distressed rig values, the cash on the balance sheet and the milestone payments (at 75c on the dollar) and Sevan Drilling appears to be worth roughly NOK 4.50 in a liquidation. Due to the shortage of rigs noted above as well as the Petrobras contracts, I believe there would be plenty of bidders for the SEVDR rigs.
Overhang Risk- Sevan Marine is currently in discussions with its bondholders to attempt to restructure. If they are unable to reach an agreement by September 2011, Sevan Marine will likely liquidate. Sevan Marine's stake in Sevan Drilling has been used to secure the company's most recent short-term financing so a liquidation could lead to Sevan Marine's SEVDR shares being distributed to Sevan Marine bondholders who would likely not be natural holders. While they are locked up until May 2012, their eventual disposal could be an overhang on the shares.
Cross Default- A legacy of the IPO is that Sevan Drilling has cross default provisions with Sevan Marine. Thus, if Sevan Marine defaults, Sevan Drilling's banks could, in theory, also place Sevan Drilling into default. Sevan Drilling is in negotiations with its bondholders to remove the cross default provision. "expect(s) to have approval from the lenders to remove the cross default provisions" (7/4 pr). Management believes that the cross default is highly unlikely as the banks lack an incentive to force a cross default as their loans are well secured by the SEVDR rigs. On 7/4 SEVDR issued the following statement: "We are making good progress in discussions with our banks over removal of cross default provisions towards Sevan Marine. We expect to have approval from the lenders to remove the cross default provisions toward Sevan Marine."
Small Cap Driller Risks- SEVDR is a small UDW driller which is a risky business. Operational/unforeseen problems would have a larger than normal impact here due to their small size. Single customer is a risk although somewhat mitigated by the size of Petrobras.
Conclusion
Overall, at NOK 4.50, I believe SEVDR represents an excellent risk-reward due to the SEVAN bankruptcy overhang with relatively near-term catalysts (Q2 SEVDR results in August, SEVAN restructuring by Sept 2011) to unlock that value.