Description

Songa Offshore (“Songa”) is a Norway-listed company which operates four “mid-water” offshore drilling rigs and one drill ship in each of Australia, the North Sea, and Western Africa. Songa has a total enterprise value (“TEV”) of $2.1 billion and is expected to generate 2009 revenue and EBITDA of $643 million and $442 million, respectively. We believe Songa has over 100% upside because: (i) Songa is likely to start paying 100% of earnings as a structured ordinary dividend which will re-value Songa on dividend yield (current stock price at ~18% yield on 2009 dividend), (ii) operating risk is declining as the company secures high-priced contracts, and (iii) Songa is guided by an exceptional management team and anchor investor with a track record of returning cash to shareholders.

• Robust Mid-water Offshore Market: The table below shows historical and projected supply of rigs in three segments of the offshore drilling market. Jackup and deep-water supply is projected to increase by 62% and 29%, respectively, from 2006 to 2009. Supply of mid-water rigs, Songa’s segment, will remain flat. Meanwhile, ODS-Petrodata estimates mid-water demand will outstrip supply by 15 rigs in June 2008.

From the demand perspective, the backlog for mid-water rigs has increased significantly in recent years. In January 2005, the average mid-water rig was booked for approximately 200 days. By January 2006, this had increased to 400 days, and by August 2007, the backlog was 600 days. The tight market has resulted in drastic day rate increases. In 2006 mid-water day rates ranged from $200,000 to $250,000. In late 2007, rates rose to a range of $350,000 to $435,000 and were at the upper end of that range in tight markets like the North Sea and Australia. With newbuild costs up 25% since 2005, limited rig building capacity, and customers’ use of a $40 per barrel oil price assumption in their project approval process, we believe mid-water drilling will remain robust for the next few years.

• Below Market Contracts: Songa was founded by Arne Blystad, a Norwegian investor, who initially recruited managers from Transocean and Frontline to acquire, refurbish, and operate mid-water rigs ahead of an anticipated tightening in the market. Between April 2005 and May 2006, Songa acquired and signed initial contracts for the Venus, Mercur, Saturn and Dee rigs. Trym was acquired in December 2006. Relevant data on the rigs is shown below.

Songa has contracts (including options) [1] on its rigs for 98%, 45%, and 20% of 2008, 2009, and 2010, respectively. Initially, management aggressively sought contracts in 2009 and 2010 but was hindered by launch delays of one to eight months on three rigs. The silver lining is that mid-water day rates have continued to increase (approximately 80% since the beginning of 2006). Having achieved utilization rates in the mid-90% range on its recently launched rigs, the company is poised to sign contracts for 2009 and 2010 at higher rates relative to 2008. The previous table shows significant day rate improvements for all rigs in 2009. With operating leverage, the higher day rates in 2009 translate into an 80% and 100% increase in EBITDA and free cash flow, respectively.

• Rational Management focused on Return of Capital: Management is typically a significant risk in any offshore driller investment. Most managers overspend on “gold-plated” newbuild projects, maintain low contract coverage so as to retain a “call option” on further increases in day rates, and retain too much cash. Songa is unique because Arne Blystad, who owns 22% of the company, and the management team, which owns 7%, have a track record of rational capital allocation. Blystad is a reputable Norwegian investor with success in a number of shipping-related sectors, including chemical tankers, dry bulkers and crude tankers. Tom Jebsen, Songa’s CFO, was previously the CFO of Frontline, a Norwegian shipping company that pioneered large ordinary dividend payouts for shipping companies. The team has already demonstrated its financial acumen with Songa by: (i) acquiring assets cheaply ahead of a significant tightening in the mid-water segment, (ii) circumventing a restriction on share repurchases under the bond indenture by executing total return swaps on 5 million shares (8% of the float) when the stock was trading poorly, (iii) redeeming a bond to give the company financial flexibility to pay ordinary dividends, and (iv) re-domiciling the company from Norway to Cyprus to lower the tax rate and facilitate quarterly dividends. We believe management is poised to return significant capital in 2008. We are especially pleased because management’s recent actions suggest they are focused on returning cash via ordinary dividends as opposed to share repurchases or special dividends, maximizing value for shareholders.

• Yield-Based Valuation: Songa currently trades at 5.4x 2009 P/E and a 22% 2009 free cash yield. This compares with multiples of 9x P/E for comparable companies in the United States and Norway, implying a 40% discount. Songa’s current discount is primarily due to investor impatience with the delayed launch of rigs and relatively low contract coverage in 2009 and 2010. The following table shows our financial projections.

Songa could achieve 2009 and 2010 contract coverage of 80% and 60%, respectively, as contracts are signed for Venus, Trym, and Mercur. Based on $442 million of EBITDA in 2009, the company will be levered at only 1.1x net debt to EBITDA. Assuming the company pays out 100% of net income (less than 85% of free cash flow) as an ordinary dividend, the market could value the company at a yield of 8% to 10%. While there are no direct yield-based comparables in the offshore drilling sector[2], we believe these yield assumptions are reasonable relative to yields in the shipping industry which are approximately of 10% despite the fact that the “Dry Bulk Index” of day rates has increased 3x since January 2006 (tanker rates have been stable over the same period). High cash dividends clearly enhance valuations, resulting in 10x EBITDA multiples for highly cyclical businesses. Relative to shipping, we believe 8% to 10% yields for Songa are reasonable[3]. These yields imply a price of NOK 142 to NOK 177 assuming a 2009 ordinary dividend of NOK 14.17.

Catalyst