Description

We are recommending a short of Tidewater Marine (TDW) due to high valuation and our expectation of an imminent cyclical downturn in the OSV (offshore supply vessel) market over the next 6-12 months.  The offshore supply vessel (OSV) market is facing an onslaught of new ships being delivered over the next two years as high industry returns encouraged high order rates of new vessels.  It is our expectation that supply pressure from new vessels will cause a decline in utilization and day rates by the second half of 2007 leading to significant earnings downgrades in the future.

 

 

Company Description:

 Tidewater is an OSV operator in the Gulf of Mexico, Europe, West Africa, Australia and the Middle East. Offshore supply vessels typically run crews, materials and supplies to shallow and deep water rigs. Tidewater’s fleet consists of approximately 34 deepwater OSVs, 255 supply vessels, 88 utility boats, 57 tugs and 8 other. Of these 442 boats 257 have an average age of 24 years and account for 56% of the company’s profits. This fleet is among the oldest in the world and many of the boats will need to be replaced in the next few years to maintain current operations.

 

 

Numbers

Price: 51.92

Market Cap: $2.92 B

Enterprise Value: $2.96 B

Price to Book- 1.72x

Dividend Yield- 1.2%

EV/07EBITDA (Street) - 5.9x

EV/07EBITDA (Our) – 8.3x

P/E 07 (Street) - 8.8x

P/E 07 (Our) - 14.9x

 

 

Industry background:

Over the past few years, new exploration for oil and natural gas have caused a spike in OSV rates as utilization on existing rigs increased and a number of new rigs were placed into operation.  Additionally, demand in the Gulf of Mexico has been particularly strong due to repair work in the aftermath of Katrina.  Leading edge day rates have risen in the Gulf from historical levels of 5,000 USD to over 13,000 USD as of late November 2006 and utilization has almost doubled from 50% to 85%. Concurrently, strong demand and stagnant supply in the international market has forced up rates from $8,000 to $12,000 USD per day. This has occurred as operating costs have remained relatively flat ($2,800 to $3,300 per day). Most vessels currently operate on spot contracts within the Gulf and on six month to one year contracts within the international market.

 

 

Thesis:

We believe that OSV day rates should start to collapse during 1H07 and earnings downgrades should materialize as the market comes to the realization that supply will exceed demand for OSVs in a relatively short timeframe. Most of the street is positive on the sector/stock and have normalized these peak margins for the next couple of years.  We believe that as supply comes to market, current un-stainable margins will decline.  It is our belief that nothing has changed fundamentality in the industry to warrant a sustained margin shift as OSVs are relatively commoditized vessels and easy to produce in the shipbuilding world.

Although much of our thesis is a sector call, we also like the micro short story for TDW.  Competitors, such as Bourbon (GBB FP), may look more expensive in terms of multiple yet their fleets are much younger.  One of the big advantages of newer boats is that fuel efficiency is much higher (fuel costs are borne by the company leasing the OSV, not the owner).  Beyond overall industry day rates declining, we think there will be a further divergence in the rates charged on newer versus older vessels.  Tidewater’s aged fleet will ultimately suffer the most in the coming downturn. 

 

 

Fleet Replacement:

Unlike many of its competitors, Tidewater’s management has decided to delay the replacement of its aging fleet (current order book stands at 25 new vessels). New orders at shipyards are taking anywhere from 12 to 18 months for delivery given the enormous size of the current backlog from other operators. Tidewater seems to have put itself in a precarious situation as many of it boats may need to be stacked or scrapped over the next few years and many of its competitors have spent the necessary Capex dollars to remain competitive in the current market.

 

 

Supply and Demand:

            As with many other commodity businesses, spikes of profitability inevitably attract more supply and competition. The current situation in the OSV market is no different. Consultants estimate that the 2 year order book worldwide is between 450 and 500 new boats on a worldwide fleet of around 3,500 boats.

Demand created from new jack ups and platforms should range between 140 and 160 new boats per year for the next few years. This calculation is based on the number of new rigs (23 to 25) and the combination of fixed (33 to 35) and floating platforms (36-38) being placed into the international and domestic market over next year. It takes approximately two medium sized supply vessels to service a rig or floating platform and one to service a fixed platform.  These are approximate numbers and newer vessels are more efficient (i.e. bigger, faster, etc.) meaning that these numbers may be conservative.  We believe that demand is one of the least understood components by the market and is often not quantified properly by the sell-side.

 

Here are the unit economics of supplying a new OSV to the market under current conditions:

 

Unit Economics
Appox. Cost of  a new OSV	6,000,000
Debt (50%)	3,000,000
Cost of Debt	8%
Interest Cost	240,000
Return on Capital Calculation
GOM			International
Day Rates	12000		Day Rates	8300
All in Cost of Operation	3200		All in Cost of Operation	3100
Operating Profit Day	8800		Operating Profit Day	5200
Utilization	80%		Utilization	80%
Days a Year	365		Days a Year	365
EBT Per Boat	2,569,600		EBT Per Boat	1,518,400
Tax Rate	35%		Tax Rate	22%
NI	1,670,240		NI	1,184,352
ROI	28%		ROI	20%
Return on Equity Calculation
GOM			International
EBT Per Boat	2,329,600		EBT Per Boat	1,278,400
Tax Rate	35%		Tax Rate	22%
NI	1,514,240		NI	997,152
ROE	50%		ROE	33%

 

As you can see the economics of currently supplying one of these commoditized boats to the market is extremely attractive. Under our assumptions ROI over time should bottom closer to 8-10% in such a commodity business.

 

 

TDW Historical EBITDA Margins (Cyclical Business):

Peaks (97, 01) - 45% and 40% respectively

Troughs (93, 00, 04) - 22%, 17%, 22% respectively

Current margin- 45%

Normalized margin between 26% and 32%

 

Risks:

• Significant damage to GOM infrastructure caused by hurricanes such as Katrina (possible but unlikely)
• Supply is slower to enter the market than expected due to shipyard bottlenecks
• Short term sentiment risk from large oil spikes as the market even though rig utilization is extremely high (on the other hand, if oil prices happen to fall, utilization could plummet, followed by OSV day rates)

 

Conclusion:

Over the next two years we expect rates and utilization to be driven back to historical levels as supply begins to apply significant downward pressure on OSV operators. In the Gulf of Mexico rates have already begun to moderate as demand from hurricane repair work has finished up.  Operators with a significant portion of their fleet in aging craft will have to stack ships or offer significant discounts to leading edge rates, which should also be falling, in order to maintain operation. As this happens utilization and day rates will fall and margins should compress to normalized levels (historical EBITDA margins has been around 30%) from the current 42-45% EBITDA margins. Given Tidewater’s aging fleet, lack of new capacity and limited ability to replace scrapped boats in the near term the company should struggle with any cyclical downturn in OSV dayrates.

 

Valuation:

Based on our assumptions, we believe normalized earnings is somewhere around $2.50/share.  If we apply a 12x earnings multiple (we think this is appropriate for a cyclical business such as this) on our normalized number, then we come up with a fair value of around $30/share (about 40% downside from the current stock price).  Furthermore, we believe that the risk for potential upside in the stock is limited. It is tough to argue that rates will continue to rise given the enormous wave of supply that is set to come out in the next couple of years. If rates only flatten (instead of fall as we predicted) one would be buying a stock at a 10.5 times earnings multiple with no growth potential and a company facing a huge Capex cycle spend over the next 4 years to replace its scrapped/stacked supply fleet.

Catalyst

• Supply will begin outstrip demand sometime in 1H07 and leading edge day rates, which are transparent to the market, should begin to fall
• Older vessels are forced to offer a significant discount to declining market rates as incremental supply enters the market
• Demand slackens further in the Gulf as work caused by the 2005 hurricanes finishes up and rigs move into international waters
• Tidewater is forced to spend a large amount of its declining cash flow to fund the purchase of a new fleet that will not make delivery until at least the end of 2008