Description

Highly asymmetric upside/downside. Extremely hard to envision permanent impairment of capital. Market mistakenly views the company as an offshore play. Company is ignored in the tanker trade. 254% upside. 

Standard Drilling is a holding company that is primarily known for its interest in Supply Platform Vessels (SPVs). These vessels are used to supply offshore drilling rigs but it actually has a significant interest in a VLCC since early 20’. 

I realize the company is quite small but many people are taking a basket approach to tankers anyway. That should make it a little bit easier to include a less liquid small-cap.

Background

Highly experienced Norwegian investor Oystein Spetalen is a key driver behind the company and one of the architects behind its inception and strategy. SAGA tankers ASA owns 18% of the company. Spetalen owns 64% of SAGA tankers. Ferncliffe is also one of his vehicles.

The offshore market has been a disaster and that explains why the previous two excellent write-ups (original from 2017 and one a VIC winner) did not yield the desired outcome. End of 19’, start of 20’ it looked like offshore was turning the corner before COVID killed any hopes of a fast recovery. SDSD has been left for dead once again and is -50% year-to-date. Down 46% from the last VIC write-up and 51% from the original one in 2017. 

Why would it be any different this time?

The company traded its vessels for profit to acquire a stake in a VLCC with prescient timing and that’s a very hot market with tremendous momentum and record type earnings. I currently don't know what's being discussed on VIC but I think the tanker thesis was originally laid out by Hkup here, if I'm not mistaken, and I expect there is a lively discussion on developments going on in that thread. Possibly there have been other tanker pitches. The stock can get caught up in both sentiment as well as a very strong current of shipping earnings. The market does not (yet) see aware of this exposure. 

The previous write-ups on SDSD go in more depth regarding the offshore industry and are highly recommended. In this addition I'm focusing on 1) the VLCC stake 2) updated valuation 3) showing the market is disregarding the significant tanker exposure

Context / Market outlook

The recent broader market rally puzzles me. Because of my absence, sick for a few weeks and in the current situation without daycare quite overwhelmed by increased responsibility, I’m not sure how most/many of you are looking at the market.

It seems to me that this situation is so bad we can’t avoid a severe global contraction. Some  markets reflect that reality but some do not at all. I think it is a fantastic environment to find things that will survive a severe contraction. Initially I think the U.S. dollar is a decent place to hangout for the initial deflationary shock. Afterwards we may see inflation depending on the number of courses the FED and congress decide to serve during their ultimate orgy.

Standard Drilling seems like a perfect investment for this environment. It cannot be killed no matter how severe the recession ends up. It is operating cash flow positive and expected to be free cash flow positive. It is exposed to the strongest bull market you can find. The company has a significant cash hoard that does well during a deflationary shock. If we turn to inflation shipping (with high fixed costs) and prices that can be adjusted quickly should do well under those circumstances. 

SDSD has skilled shareholder friendly management, with high insider ownership, that understands downturns and is actually able to take advantage. Not too mention insiders are buying shares. 

The industry last really peaked in 07’ and a lot of vessels were ordered at that time and they arrived in the years after destroying the supply/demand equation. Fleet growth has been slowing down across the board:

Order volume for newbuilts is very low. It takes a VLCC at least 18 months to get to market:

Orders could remain low for a while because there’s a deluge of environmental regulation:

Ships typically needs to be in service for 25 years. It is historically exceedingly difficult to earn a good return if your ships turn obsolete within several years. It is not completely clear what the future of shipping is going to be to meet environmental standards. It can be advantageous to own ships that fit well into the “new-world” standard. I think that’s why shipping companies have been conservative. I don’t expect the orderbook to explode given that we are in the middle of this pandemic. 

Specific for the offshore  industry rig count had been increasing but with where oil futures are at we can forget about further growth:

The industry does seem to move towards some rationalizing. Tidewater CEO Quintin Keen plans to shrink global market share. He also said some interesting things about Tidewater’s reputation as a solid operator being a competitive advantage:

we've had our customers pay a significant amount of upfront for modifications that they desire as well as mobilization fees.

And starting to get more money upfront is a way of changing the business pricing model and my hope is we will continue to see that. I see that customers are willing to do that with a company like Tidewater, because we have the balance sheet and we don't have the existential risk that a lot of companies do have. So as a result, they're willing to spend $2 million to $3 million with Tidewater upfront on a project, because they know that we're going to be here longer term. And so -- so that part of the pricing model is beginning to get pushed a bit, but it will take a higher degree of consolidation and a larger focus. There are certain areas around the world that are already combining vessel forces. And so, you'll see this in areas -- we can see it in Denmark and some other areas, where they are corralling the vessel companies and trying to force a more efficient use of vessel traffic and I see that increasing in focus as we go through the next five years to 10 years. And so my sense is that the evolution of the industry will in fact take some time.

Although much smaller SDSD should benefit from that same dynamic.

What does the upside look like?

Earnings in shippping are highly volatile:

 I don’t think normalized earnings is a great way to value this company. The profitability is to a great extent derived from the outlier months or years. 

I don’t think asset value is a great way to value it either. Assset value is an excellent way to assess the downside but asset prices understandably don’t follow earnings as they go parabolic. 

Imho one of the more productive ways to think about the attractiveness of this bet (at least to the upside) is to add up the asset value and add up to that a one-time value for expected windfall earnings in the short term. 

I’ve largely followed Avalon’s valuation model, in the 18' write-up, because it was laid  out very clear and gives a good overview of the company. The table below lists all of the company’s indirectly owned assets. The purchase price indicates what SD paid for the vessel in the secondary market. New build costs indicate what  it would cost to order a brand new vessel. Age of the vessel speaks for itself. New build parity is a figure arrived at by mechanically depreciating the new build costs:

In the next table I’ve outlined three scenarios. I’m a bit embarrassed to present a distressed scenario with 152% upside. I’ll outline how I got there so you can adjust it as you like. 

Scenario A: Under the distressed scenario I’ve valued the assets by the valuation they are put on the balance sheet per end of 19’. That value is based on the two different fair value assessments. Both are then subjected to a discount rate. Distressed value discount rate is in the range of 44% to 50% and 24% to 29% based on the size of the respective vessels. I’ve discounted the VLCC by 29% as it isn’t included in the most recent balance sheet.  

Scenario B: In the purchase valuation scenario I’ve listed the assets for purchase value. Most of them were acquired at deeply distressed prices but admittedly they have also depreciated which counterbalances that. The valuation I personally like best is to take the purchase valuation and give some credit for the superb 2020 earnings season which would result in ~245% upside to fair value. 

Scenario C: The new build parity valuation has been focused on in the previous write-up as it is the industry standard. I think it is currently a bit optimistic because the outlook for the industry is now quite bleak. 

In all scenarios I’ve added an option to consider bonus earnings. Bonus earnings are based on the windfall earnings the VLC is set to generate in 20’. I estimate the vessel yielded something like $115k/day in the first third of the year. That should result in $10 million of earnings. Rest of the year I’m assuming it yields $75k/day million over the rest of the year (after costs) which is about $20 million. I get to that number by assuming a $60k average day rate for the remainder of the year. Assuming a $15k premium for an ECO tanker.  The tanker earnings are split and 1/3rd goes to SDSD. Ultimately, operating cash flowing to SDSD could be in the $10 million neighbourhood. Please note that this $10 mil could be a lot less or more depending on how spot rates develop and how lucky/unlucky the operator gets. 

As of 31 December 2018, the Company has issued 576 026 424 ordinary shares. Considering the speculative upside fair value for A, B and C would be respectively $0.21,  $0.26 or $0.30 per share. 

What does the downside look like?

Half the market cap consists of cash. Near the end of the year there can be ¾ ths of the market cap in cash. There is no debt. 

The large size vessels are partly contracted early 2020:

The mid-size vessels to a lesser extent:

Rates for PSV’s were increasing end of 19’ and start of 20’:

The average cash break-even for SDSD on the large PSV vessels is about $7k per day. The mid size breaks even at $6.7k per day. There’s about $500 in overhead costs per vessel per day. 

Last reported rates were slightly above break-even. Last year the company turned a profit. This is about 2/3s of longer term historical averages.

SDSD is positioned to have one of the lowest breakeven rates compared to peers, all cost included. It also has a rock solid balance sheet. Currently that’s an advantage because operators don’t like to deal with deadbeat operators that possibly neglect maintenance resulting in safety and/or reliability issues. 

Insiders are buying. So far in 2020, Martin Nes (Chairman) bought a million shares:

NewsWeb

Former CEO Espen Lundaas bought a million shares 

https://newsweb.oslobors.no/message/498801

Chairman Martin Nes bought another 2 million shares  

NewsWeb

Former CEO Espen Lundaas bought another 2 million shares

NewsWeb

Why is the market overlooking an excellent risk/reward?

• This is just a $40 million market cap company at this point. 
• Main listing is in Oslo. 
• Considered an investment company. No dividend. 
• It is one of many holdings of the billionaire Chairman
• The share price has gone nowhere in years. 
• Energy is one of the most out-of-favor industries. 
• Within energy the offshore industry is the worst of the worst. 
• Offshore is left for dead. 
• Bankruptcies are a common reality. 
• The name of the company implies offshore drilling. 
• The VLCC is owned through a JV. 
• Likely very few people know about the tanker interest. 

The stock price has been sliding to nowhere and is down ~50% year-to-date. The Van Eck Oil Services ETF is down 51% year-to-date. Very comparable offshore companies like Tidewater is down 60%.  

Tanker stocks (DHT, FRO, EURN) are trading in a very different way:

At the start of the year all tankers were trading down as many investors were uncertain how COVID-19 would play out for tankers. China demand for energy was down a lot etc. About three weeks ago the market started to wake up to the contango/storage situation and tankers started rallying enthusiastically. 

SDSD did absolutely nothing but stay dead.

You could argue it only owns 1/3rd  of a tanker. 

That’s true but on a relative basis it isn’t so different from the pure play tanker/VLCC companies. I’ve put together two very simple charts. The first shows these companies transportation or storage capacity in barrels of oil vs the market cap. The second shows transportation or storage capacity in barrels of oil vs enterprise value. 

SDSD’s transportation capacity compared to its market cap is quite low. 

SDSD’s transportation capacity vs its enterprise value is the highest. That’s because the other companies are employing massive amounts of debt. 

If you are 100% sure about the direction of the tanker trade you are not getting the most direct  leverage out of SDSD. However, it is by far the safest play. 

All of this is just based purely on the tanker exposure which is actually the side-show at this company. 

If you completely write off all the PSV vessels and just value this by the stake in the VLCC and the ~$20 in cash on the balance sheet it is still trading at a 20% discount to book value. 

Catalysts

SDSD could get sold as industry consolidation into regional power blocks seems a wise strategy

A future large dividend, as has been paid in the past, would unlock value

A large share buyback program would be even better 

Just the VLCC can earn 25% operating cash flow yield for 2020. Big earnings get noticed. 

Executives are actively selling and buying vessels. A sale of a large number of PSV’s and converting them to cash would likely be noticed by the market. 

If they continue to invest in VLCC’s at some point the company will no longer be valued as an offshore driller but a shipping company. VLCC pure plays are valued above book value. The average for oil service companies is 0.5x book value.

Catalyst

• Consolidation
• Special dividend
• Buyback initiation
• VLCC cash flow surging in
• Sale of PSV's
• Convert to VLCC play