There have been a few offshore drilling companies written up in VIC lately which I find interesting.  Noble is another offshore driller which is poised to grow free cash flow substantially in 2 years and has a few near term catalysts.

DESCRIPTION: 

Noble drilling is a leading offshore drilling contractor for the oil and gas industry.  Noble performs contract drilling services with a fleet of 79 offshore drilling rigs.  It performs these services worldwide including the Middle East, U.S. Gulf of Mexico, Brazil, Asia, India, North Sea and West Africa.

THESIS:

Noble Drilling stock has significant appreciation potential, as the company has begun publicizing their consideration of a tax-free spinout of shallow water jackup and midwater floater assets.  The Board of Directors is still studying the structure of the spinout, but appears to favor a high-payout C Corp as opposed to an MLP.  Management has begun publicly discussing the possibility with investors and analysts in the last month, leading to increasing awareness. 

This idea plays into the increasing trend for companies to restructure themselves into income vehicles, and also represents a management team agreeing to listen to shareholder demands for higher payouts of cash flow. 

Upside potential at 10 X 2015 EPS is $55 per share.

CATALYSTS:

Management recently began discussing ways to divest the company of older, shallow water jackup rigs and certain mid-water floaters in a “tax-efficient” manner.  Market participants have been clamoring for an MLP structure, but management and the Board seem intent on a tax free spinoff of a C-Corp.  Doing so requires a ruling from the IRS certifying the tax-free status of the spinout, a process which could take six months or more. 

In addition to the potential spinout, the company continues to build and contract new drilling rigs, with 5 Ultra-deep water drillships and 6 heavy duty jackups set to come on stream over the next two years.  These rigs will add substantially to earnings power as they are introduced, and are largely responsible for the earnings growth shown above. 

As the rig building program subsides, the company will start to generate meaningful levels of free cash flow which would be available to buy back stock or pay to shareholders, starting in 2015.  Recent contracts on high spec jackups have been for longer term and higher rates.  Ultra-deepwater rigs like the ones being built by NE have been getting 4-5 year contracts at dayrates ranging from $525,000 to $625,000 per day, with the higher rates occurring in more expensive operating environments.

RISKS:

As with most energy stocks, NE is highly sensitive to the price of oil.  Developments in shale drilling, horizontal drilling, and fracture stimulation have led to rapid growth in oil production in the Onshore US.  The Jones Act prevents large scale exports of crude oil, though limited exceptions have recently been granted.  It is possible that US production grows so fast that it overwhelms domestic demand, causing at least the domestic oil price to decline. 

Post-Macondo, the operating environment offshore has become more difficult, causing higher operating costs, increasing downtime and lower earnings estimates across the offshore drilling industry.  To cite just one example, blow out preventers must now be brought to the surface periodically for testing.  Drilling contractors have taken steps to mitigate these factors, such as adding redundant equipment, changing contract terms, etc. 

While we believe we are at or near the end of downward earnings revisions for this reason, we can’t be sure of that.  Whether we are at the end of these revisions or not, we believe that the aforementioned change in corporate structure is more important to the stock in the near term.  New rigs may be delayed in delivery or commercial availability – we assume this will be the case.

VALUE CREATION:          

Management has indicated the Board is considering a spinout, but has not provided details as to which rigs will be included.  We therefore can’t know for certain how much cash flow they will generate, how much debt will be placed on the new company, etc.  The numbers below illustrate one possibility in order to test our thesis. 

Spinco Potential Valuation:

# of Rigs spun off in new entity                 30

EBITDA generated by those rigs, 2014     $750 MM

Minus: G&A for new company                   $  60 MM

Minus: Interest expense              ($1 BB * 6%)       $  60 MM

Minus:  Cash Taxes (10% -- Swiss HQ)     $  30 MM

Minus:  Capex                                                   $120 MM ($4 MM per rig)

Distributable CF – Spinout                            $480 MM

Potential Distributions                                   $400 MM

Likely worst case yield                                   10%

Likely low end equity valuation:                                $4 BB

By taking older assets and converting them into a yielding security, the company can potentially create a spinout stock which trades at a similar or higher valuation to the parent.   Capex is lower on Spinco because most of the large capex spend shown above is for new rigs.  Deepwater rigs cost about $650 MM each, and jackups are about $150 MM each for the type they are building.  This subsidiary won’t be building rigs, so won’t have the associated capex.  The Spinco is assumed to carry $1 BB of debt, making the above valuation equal to almost 7 X EBITDA. 

Remainco Potential Valuation:

EBITDA from remaining rigs                         $2.0 BB

Potential EBITDA muliple                              7.0 X **

Potential EV, Remaining company            14.0 BB

Combined Potential Valuation:

Combined EV (Spinco plus Remainco)     $19.0 BB

Minus Debt (add 1 BB for newbuilds)      $  6.0 BB

Combined Equity Value                                 $13.0 BB

Number of shares                                           253 MM

Combined value per share:                         $51.38

The parent company will have only high specification, modern assets.  Similar companies with high-quality assets have been shown to trade at a premium in the marketplace (**SDRL 9.1 X 2014 EBITDA, PACD 7.7 X 2014 EBITDA), especially if they demonstrate a willingness to distribute cash to shareholders.

CONCLUSION:

The potential spinoff represents a catalyst for revaluation of the stock.  In addition, industry and regulatory pressures which have caused estimates to decline have stopped getting worse.  The addition of 11 new rigs over the next two years, most of which have contracts, should allow for rising earnings estimates.  The combination of these factors makes the risk-reward for buying NE attractive at current levels.