RIGNET INC RNET
February 09, 2011 - 9:55pm EST by
jdr907
2011 2012
Price: 14.86 EPS $0.23 $0.63
Shares Out. (in M): 17 P/E 65.0x 23.0x
Market Cap (in $M): 252 P/FCF NA 20.0x
Net Debt (in $M): -37 EBIT 15 18
TEV ($): 215 TEV/EBIT 15.0x 10.0x

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Description

Rignet presents an undervalued and overlooked opportunity to invest in the niche market providing voice, data and managed services to offshore oil and gas rigs.  This market is benefitting from a growing deepwater drilling fleet, high commodity prices, increasing real time monitoring, communication and data requirements at offshore drilling rigs as well as an increased regulatory environment brought about after the Macondo spill.

Rignet is the #2 player in this market,  providing its outsourced IT services over a global IP/MPLS network.  The company has 375 customers in over 800 physical locations in 30 countries around the world, operating within 3 segments - Eastern Hemisphere, Western Hemisphere and US Land.   RNET effectively acts as a system integrator, piecing together broadband capabilities, satellite capacity, teleports and fiber into an MPLS/IP network connecting clients corporate offices to their remote oil and gas assets.  The market has consolidated into an effective duopoly, with Harris Corporation acquiring the #2 and #3 players; Caprock in May 2009 for $525 mm or 9.7x EBITDA, and Schlumberger GCS in November, 2010 for 8.5x EBITDA.  Rignet went public on December 14th, 2010.

Competitive Landscape

RNET services roughly 31% of global offshore rigs, while market leader CapRock (sub of Harris Corp.) has roughly 40%.  The distant third player is Stratos Broadband, a subsidiary of Inmarsat with ~3% market share.  The balance of the market is either done in-house, at the national level or by small regional players.   CapRock, has over $600 million in revenue, and targets its services beyond the offshore oil and gas industry.  While Rignet has taken an 'asset light' approach to the business, leasing assets on an on demand basis, CapRock is facilities based, owning teleports to communicate with its global network.  Stratos Broadband, similarly offers broadband equipment and services to a much broader market than just the oil and gas sector.

Rignet is differentiated within the industry by a) being the only pure play targeting the oil and gas sector thus allowing more customization and understanding of the target client needs b) has deep relationships with Drillers as well as E&P Operators - exclusive relationships with Noble & Ensco, 2 of the 4 largest drillers c) Offering a truly outsourced IT service, as opposed to just a broadband pipe d) superior customer service and e) a managed service portfolio that is unmatched within the industry.  Rignet was founded in 2000 and has grown the business all organically to its current size.  While Caprock can operate with lower operating costs by owning assets, it obviously is a more capital intensive business, and does not allow the flexibility of adapting to new technology quickly.   On top of these operational differentiators, Rignet has shown faster growth as well as displaying industry leading EBITDA margins, despite its 'asset light' business model.

 

RigNet

GCS

Stratos

CapRock/GCS

CapRock

'09 EBITDA %

35.9%

27.5%

19.5%

19.2%

15.0%

 The higher EBITDA margin is primarily a result of its suite of managed services as well as its exclusive focus on the oil and gas sector, which has shown minimal pricing competition.  CapRock's focus has historically been on maximizing its fixed investment in its owned and operated teleports by selling as much bandwidth as possible, and not focusing on value added services.  They have typically priced at a lower level and have not offered a full suite of products.  RigNet has taken an asset light approach, leasing teleports globally as well as satellite capacity from FSS operators such as SES, Intelsat, Eutelsat as well as fiber and microwave when required.  They have been able to price at a premium level by selling more packaged solutions, and in turn acting as an outsourced IT office for remote locations.  The product suite consists of broadband voice, data, internet access, on rig communication, video conferencing, secure networks as well as managed services.  Due to the existing pricing dynamic as well as the duopolistic nature of the market, I think the risk that Harris becomes increasingly promotional is limited, as customers have demonstrated a willingness to pay a premium for the IT based approach that Rignet offers. 

Business Model

Rignet gets paid on a per rig 'day rate' or ARPU with customer agreements that range from one to five years.  The drillers are the first tenant targeted by RNET, and sign contracts ranging from from 3 to 5 years.  RNET will invest roughly $400k in capex per offshore deepwater rig and $175k / shallow water jackup rig which typically includes a satellite dish as well as fiber and necessary wiring within the rig.  The company will generate annual revenue of roughly $300k / year for deepwater and $100k / year for shallow water through the term of the contract with 5% annual escalators.   The second tenant on the rig, the operator, will require significantly less capex, only about $25k, but will pay a premium day rate and generate almost $500k / year for deepwater assets, for an average contract length of 1-3 years. 

 The company is broken into three segments - Eastern Hemisphere, Western Hemisphere & US Land.  Both the offshore segments have low volatility with oil and gas prices, while the US land segment (~12% of revenues) is highly correlated with commodity prices.  The Eastern Hemisphere, representing 66% of revenues and with Gross margins of 61% has benefitted from oil discoveries in West Africa, North Sea, Middle East and South East Asia among other areas.  The company has a larger geographic presence in the East, has more deep water assets deployed and a greater concentration of second tenants per rig leading to higher gross margins than the rest of the business.  The Western Hemisphere, about 21% of revenues, is primarily made up of the Gulf of Mexico and offshore Brazil, which is currently seeing significant investment.  Brazil historically was closed to outside parties, but by the end of Q1, Rignet will be serving 11 rigs in deepwater off Brazil of the 27 currently deployed in the region.  Additionally, Petrobras historically has used its own telecom network, but due to the expanding growth, their IT department has not kept up with the growth plans, and has shifted to using the Drillers communications network, thus giving Rignet an indirect additional tenant per rig to target.  Growth in the West will be more robust than the East in the next few years, and should accelerate once permitting in the Gulf of Mexico resumes.  Margins, currently at 41%, should continue to expand and eventually reach comparable levels as the Western hemisphere as it gains scale, and increases tenancy/rig.  US Land is significantly more cyclical, and highly correlated with gas prices, as it is less expensive for an operator to deploy a land rig when commodity prices are high, and pull them out when prices have dropped.  The amount of deployed US land rigs hit an all time high in June 2009 at about 1700 with average day rates of $125 / day to Rignet.  After rig counts fell off a cliff in 2009, US land revenue dropped 59% in 2009.  Rig counts have since rebounded to levels around 1,500, however day rates are still at least 25-30% lower than their peak, and margins are yet to rebound fully.  Within the offshore piece of the business, drillships and semisubmersibles in deepwater generate up to 3x higher day rates than jackups in shallow water.  The overall telecom costs in both shallow and deep water amount to little over 0.2% of the total day rate that an operator would pay to lease a rig.   For example, a Deepwater rig may cost up to $400k / day, with telecom costs representing only $800-$1,500. 

 Barriers to entry into this market remain high, as entrenched incumbents like Rignet and Caprock have deep relationships within the oil and gas industry.  Rig owners want to have standardized networks across all of their deployed rigs, so a new entrant going rig by rig would be hard pressed to displace an existing network.  On top of that, capex deployed in the field creates a financial barrier as well.  Overbuilding on an offshore rig remains difficult due to tight quarters and lack of space for multiple satellite dishes.  Lastly, the long term contracts that the Drillers sign (3-5 yrs) on a rig by rig basis, make market share gains difficult to come by.   After the initial term of a contract, renewal rates are 96%.  Management commented they have had new entrants try to come in several times, only to retreat after failing to gain any scale. 

Revenue & Margin Drivers

Given the highly recurring nature and long visibility of the business, 2011 analyst estimates, guided by the company are essentially accounted for by existing business, new builds coming online in 2011 and new contract wins that have already been signed or are being negotiated.  Potential upside to current 2011 numbers and what will drive 2012 revenue and margin expansion are discussed below.   

Increasing Deepwater Rig Count

An important part of this story, is the rapid industry wide growth of the deep water drilling fleet.

Rig Deliveries

2011

2012

2013

Total

Deepwater Floaters

34

15

14

73

   % Increase

13%

6%

5%

28%

Jackups

22

18

9

49

   % Increase

5%

4%

2%

11%

Scheduled deliveries of Floaters will grow the existing deepwater fleet by 28% over the next 3 years from a base of 260, while the jackup fleet will increase by 11% from 465 currently.  The company stated during the roadshow that its contracted share of rigs being delivered in 2011/2012 is greater than their existing rig market share of 31%.   While RNETs current mix of jackups / floaters is roughly 65%/35%, the company expects this will rapidly move closer to 50/50 over the coming years.   This has important implications for average day rates, as mentioned above the 3x greater amount of revenue generated from a deepwater rig.

Market Share Shifts of Existing Rigs

Consolidation within the drilling industry has created market share opportunities for Rignet.  In 2010, Noble, RNETs largest customer, acquired Frontier Drilling.  Rignet serves all of Noble's rigs, except for 2.  When Noble acquired Frontier, Rignet had 3 of 6 Frontier floaters already under contract.  Noble made the immediate decision to cancel its contract with Caprock on the other 3 floaters, and install Rignet on those rigs. 

On Monday, Ensco announced it was acquiring Pride in a $7+ billion acquisition.  Rignet serves all of Ensco's rigs, including those currently being built in the shipyard.  Rignet does not serve any of Pride's rigs currently, most are maintained by Caprock.  The contract with Ensco does not require them to convert the rigs to Caprock, however it is probable that this will be done over time, which could present significant upside from current estimates.  After speaking with management, they remain very positive on the potential of this opportunity, and believe Ensco sees it as 'logical' to consolidate to one network over time.  Management does not expect the same immediate cancellation of current Caprock deals like what happened in the Noble/Frontier deal, however it is possible over time that Ensco will migrate all rigs to RNET services.  Ensco was the first customer of RNET in 2000, is the 2nd largest customer at about 7% of revenues, and the company is currently in negotiations with them to add additional value added services to the existing contracts.  Without consolidation of telecom contracts, Ensco would have to run duplicative networks, minimizing potential synergies of the acquisition. 

Aside from the addition of rigs that this would bring, it would substantially shift RNET's contracted fleet to more deepwater rigs.  Pride currently has 24 rigs, 19 floaters and 7 jackups, with an additional 2 drillships under construction due in 2011 and 2013.  It would be reasonable to expect that the low hanging fruit would be the ships under construction currently, and that if this did take place, a gradual transfer of the balance to Rignet as contracts run their course over the next 1-5 years.  The geographic mix of where Pride's rigs are, directly overlap with RNET's network - 9 in Brazil, 5 in the Gulf, 5 in West Africa, 2 in the North Sea, and 1 in India & the Mediterranean. 

Management was confident enough to say that this was the most positive M&A in the space possible for RNET.  In addition, this essentially takes off the table risk that Transocean or a larger player would acquire Ensco. 

Incremental tenant per rig

Rignet currently has about 1.5 tenants / rig - with a total of 3 tenants typically working on an operating rig at any given time - driller (Ensco), operator (BP) and service company (Halliburton).  Over the next few years, the average number of tenants / rig should rise to between 1.7 to 2.0x, as the company signs additional operators, and their deployed fleet shifts further towards deepwater from jackups which carry longer contract lengths.  The tenant that influences this important statistic the most is the Rig Operator, and if they are a viable customer.  A) Rigs do not always have an active operator on them B) If the operator is a National Oil Companies (NOCs), they may not use a third party for telecom services.  B) 10-15% of the time, the operator chooses to overbuild Rignet with a competitor, typically Caprock C) Getting the service customer (3rd tenant) is more difficult, and has shorter contract lengths.  Servicers are typically only on the rig between 10-40% of the time, and when they are out there, they may subscribe to RNET services, or conversely have a pop up satellite dish if the rig is stable for limited communication needs or pirate phone/bandwidth services from the existing tenants.

Most of the capex in the business is success based, with maintenance capex at only 2-3% of revenues.  The incremental IRR on a new contract with one tenant on a deepwater rig are compelling, assuming an average 4 year contract length (typically 3-5 yrs), with zero salvage value and no contract renewals - 4 year IRRs are roughly 28%. 

IRR of 1st Tenant - Driller   Year 0 1 2 3 4
Initial Capex      $   (400,000)        
Annual Revenue                    -    $    350,000  $    367,500  $    385,875  $    405,169
Expenses @ 60.0% Contribution Margin                -         (140,000)       (147,000)       (154,350)       (162,068)
Total Cash Flows      $   (400,000)  $    210,000  $    220,500  $    231,525  $    243,101
IRR assuming 0 salvage value @ Various Discount Rates        
28.8%   10.0% ($400,000)        190,909        182,231        173,948        166,041
27.6%   11.0% ($400,000)        189,189        178,963        169,289        160,138
26.5%   12.0% ($400,000)        187,500        175,781        164,795        154,495

When a second tenant is added, the IRRs get very interesting.  The incremental IRR on signing the Operator as the second tenant are north of 1000%.  Additional capex needed is only about $25k, while they charge a premium to the operator- typically $500k / year, over a shorter contract length - typically 1-3 years. 

Analyzing the current 1.5x tenants per rig, the all-in unit IRR per deep water rig is around 55%.

Add 2nd Tenant - E&P Operator  Year 0 1 2 3 4
Initial Capex            (25,000)        
Annual Revenue              500,000  $    525,000    
Expenses @ 70.0% Contribution Margin         (150,000)       (157,500)    
Incremental Cash Flows            (25,000)        350,000        367,500    
               
Total Cash Flows      $   (425,000)  $    560,000  $    588,000  $    231,525  $    243,101
               
IRR assuming 0 salvage value @ Various Discount Rates @ 50.0% E&P tenants per rig - 1.5x  
58.2%   10.0% ($425,000)        350,000        334,091        173,948        166,041
56.8%   11.0% ($425,000)        346,847        328,098        169,289        160,138
55.4%   12.0% ($425,000)        343,750        322,266        164,795        154,495
               
Incremental IRR of additional tenant          
1261.9%   10.0% ($25,000)        318,182        303,719                -                  -  
1249.7%   11.0% ($25,000)        315,315        298,271                -                  -  
1237.6%   12.0% ($25,000)        312,500        292,969                -                  -  
 

Increasing Day Rates

Oil & gas rigs and their related remote offices are being operated like corporate branch offices, driving increasingly sophisticated technologies, especially as exploration moves into deeper waters, and following the Macondo disaster.   One of the differentiating characteristics competitively for RNET is the full suite of managed services which it provides.  The company charges its customers a flat day rate based on core network and data services + value added services.  The day rate obviously increases as more services are taken.  Some of these include real-time data management enabling transmission of geotechnical and petrpophysical data generated in remote locations to central offices.  The company offers systems that manage and distribute data collected from drilling instrumentation, measurements, cementing, weather etc.  RNET also offers Wide Area Network optimization which runs the VSAT network like an intranet, improving speeds by 100x.  An increasingly in demand service is remote video services - allowing videoconferencing with home offices as well as real time video of monitoring equipment.  Lastly, the rigs are wired for personnel access to wifi & internet access.   Management believes that video may be the key driver in the near term to drive increased day rates across its fleet.

The company has been aggressively selling these types of services, and is seeing increasing day rates paid to them by their customers.  In addition, one of the fallouts of the Macondo oil spill is the regulatory requirements for better real time data collection and transmission.  Ensco finds it feasible that broadband data collection and transmission per rig in the gulf will more than double in the next few years as a heightened regulatory environment is put into place.  As a test case, the North Sea, which has significantly more rigid regulatory requirements, has on average 2x greater bandwidth needs than rigs in the gulf. 

Additional Upside Potential

The company commented during the roadshow of 2 large RFPs coming down the pipeline, which could present significant growth opportunities.  Baker Hughes is currently in the third round of its RFP process to streamline its telecom needs, but seems like it will go to a global provider like AT&T or Orange, who would then subcontract the offshore component to a company such as RNET.  RNET believes that its current business with Baker is secure, and some upside potential exists, but nothing game changing.  Similarly, Halliburton has also started an RFP process to consolidate its global communications networks on rigs - the total contract value could be around $20 million / year.  This RFP is in the early stage, with proposals due in 30 days.  Halliburton similar to Baker are currently using multiple vendors , making roaming around various networks more difficult and expensive. 

Market Adjacencies

Deutsche Bank estimates that the global upstream energy communications market for addressable drilling rigs (onshore & offshore) is $600 million, with Rignet currently addressing 17% of it.  Beyond the structural growth described above, the company believes that it can enter adjacent markets that require similar if not identical expertise.  The company has already started exploring international land drilling - which is a more stable industry than the US offshore, b/c it is mainly tied to oil drilling and tends to have longer term contracts.  A similar adjacent market is offshore production platforms.  This comes with a different set of requirements; ie: more permanent infrastructure, less bandwidth intensive, lower margin and more fragmented.  The last market they have discussed, although realize is hypercompetitive is energy maritime vessels.  These additional markets would almost double the addressable market that Rignet serves.  I believe the company will try to attack these adjacencies in a prudent way, possibly through M&A, but remain disciplined with regards to expected returns and appropriate valuation. 

Board of Directors

The company recently replaced its VC backed board with a strong telecom board slate.  Among those joining the board are Kevin O'Hara, a co-founder of LVLT and former president of MFS Global which was sold to Worldcom in 1996, Keith Olson, former CEO of Switch & Data which was sold to Equinix and Brent Whittington, the current COO of Windstream.

Margin Expansion

The company will continue to drive margins higher, as managed service revenue drops to the bottom line with contribution margins in excess of 70%.  In addition, overall higher ARPU driven by larger % of deepwater assets, greater bandwidth intensity, rebound in US land and the Gulf of Mexico as well as further leveraging SG&A spend will continue to enhance EBITDA margins, and free cash flow.   I am modeling for the company to expand EBITDA margins from the 31% level, after taking a $4 million hit for public company costs ($2.5 mm non recurring), as well as seeing margins drop in the Western hemisphere primarily as a result of the drilling halt resulting from the Macondo spill.  Management is targeting margins of 35% in 2012, still below peak levels.  Additionally, the company expects nominal 7-11% structural growth, and excluding any impact from ARPU expansion, market share shifts or moves into adjacent markets. 

Rignet Model             CAGR
    2008 2009 2010 2011 2012 2008-2012 2010-2012
                 
Eastern    $          54.6  $         60.9  $      61.1  $      65.7  $      69.6 6% 7%
Western                 12.2             11.2          19.4          22.1          29.3 24% 23%
US Land                23.0               9.9          12.3          14.2          15.6 -9% 13%
Total Revenues    $          89.9  $         80.9  $      92.8  $    102.0  $    114.5 6% 11%
% Growth     -10% 15% 10% 12%    
                 
Gross Profit                
Eastern    $          30.9  $         37.7  $      37.4  $      41.3  $      44.6 10% 9%
Western                   6.6               6.4            7.9            9.9          15.7 24% 41%
US Land                14.0               4.7            5.7            7.0            8.1 -13% 19%
Gross Profit    $          50.6  $         45.8  $      50.7  $      57.2  $      65.9 7% 14%
Gross Margin   56.3% 56.6% 54.6% 56.1% 57.5%    
                 
EBITDA    $          26.7  $         27.2  $      26.9  $      31.6  $      39.0 10% 20%
% Margin   30% 34% 29% 31% 34%    
% Growth     2% -1% 18% 23%    
                 
Net Income                10.3            (16.7)         (10.0)          10.8          15.8    
EPS         $0.63 $0.93    
                 
Normalized EPS (excluding non-recurring) $0.30 $0.21 $0.23 $0.63 $0.93 33% 101%
                 
Free Cash Flow                
Adjusted EBITDA                30.3             29.2          28.9          32.6          40.1    
Less:  Net Interest Expense                 (2.5)              (5.1)           (1.6)           (0.9)           (0.1)    
Less:  Capex                 (8.7)            (10.2)         (12.7)         (13.5)         (14.0)    
Less:  Cash Taxes                 (5.9)              (5.5)           (7.7)           (6.5)           (9.5)    
FCF                13.2               8.4            6.9          11.8          16.5 6% 55%
      -36.4% -17.6% 70.4% 40.6%    
                 
Eastern as a % of Revenues   60.7% 75.3% 65.8% 64.4% 60.8%    
Western  as a % of Revenues   13.6% 13.9% 20.9% 21.7% 25.6%    
US Land as a % of Revenues   25.6% 12.2% 13.3% 13.9% 13.6%    
    100.0% 100.0% 100.0% 100.0% 100.0%    
                 
Eastern Growth     11.6% 0.3% 7.5% 6.0%    
Western  Growth     -8.2% 72.9% 14.0% 32.5%    
US Land Growth     -57.3% 24.9% 15.4% 10.0%    
Total Revenues Growth     -9.9% 14.7% 9.9% 12.3%    
                 
GM                
Eastern   56.6% 61.9% 61.2% 62.9% 64.1%    
Western    54.2% 57.2% 40.7% 44.9% 53.5%    
US Land   60.9% 47.2% 46.3% 49.5% 51.8%    
GM   57.4% 59.0% 55.0% 56.1% 57.5%    
                 
 

Valuation

Rignet's IPO priced at $12 in December, below its projected IPO range of $14-$16.  The pricing seemed to have been impacted by a few things including lack of liquidity, the timing in late December, the amount of work necessary to understand both the E&P and telecom aspects of the business, as well as interest from a large Boston mutual fund who was price sensitive.  While liquidity remains limited, RNET does present an attractive opportunity that would otherwise be overlooked because of its market cap, and positioning within a confluence of industries. 

The stock currently trades at 6.8x 2011 EBITDA and 5.5x 2012 EBITDA, with a 2012 FCF yield of 7.3%.  This company presents a long term opportunity to make north of a 50% return on your investment, valuing the company at a discount to the M&A which recently took place in the space.  Caprock was sold for almost 9.7x EBITDA, and GCS for 8.5x.  Valuing RNET at 8x EBITDA gets you to $22, or 48% higher than current levels.  Several catalysts listed above may ultimately make my estimates conservative.   For example, if in fact Ensco does close on its acquisition of Pride and transition the telcom services over to Rignet over a 5 year period, a DCF of the potential cash flows of just the 21 deep water rigs of Pride is worth over $4 / share.  

Another valuation benchmark to look at within the telcom sector are the CLECs, which trade in a range anywhere from 5-9x EBITDA.  Given the limited competitive intensity in this market, combined with the compelling IRRs on a per unit basis, a premium multiple is warranted relative to the US based CLECs.  

Stock Price Implied at Various Multiples of 2012 EV/EBITDA    
           
  7.0x 7.5x 8.0x 8.5x 9.0x
Base Case $19.70 $20.88 $22.07 $23.25 $24.44
% Upside 32.6% 40.5% 48.5% 56.5% 64.4%
Upside Case $20.73 $21.99 $23.25 $24.50 $25.76
% Upside 39.5% 48.0% 56.4% 64.9% 73.4%
           

Risks

Regulatory

Macondo - While the company did not see a significant impact from the Macondo disaster, there remains the potential for a prolonged period of uncertainty.  While rigs sit idle or 'warmstacked', the company will continue to get paid by the Rig owner, however lacking additional tenants will provide a headwind to increasing ARPU.  While the ban on drilling has been lifted, the Obama administration still hasn't allowed the permitting process to move forward, so visibility into what the environment will look like and when is difficult to see.

Consolidation

If one of the company's large clients were acquired by another company that is a customer of Caprock, there could be risk numbers.  Noble and Ensco make up 18% of revenues, while the remaining 8 of the top 10 make up another 20% of revenues.

Irrational Pricing Pressure from Harris

It is possible, not necessarily rational that Harris, after acquiring the two large competitors of RIgnet, could try to drive market share growth but significantly cutting pricing.  This probably wouldn't give them the best return on their investment, and seems unlikely in my mind.

Overpriced Acquisition

The company could make a large acquisition in an adjacent market that has lower barriers to entry, and destroy shareholder value. 

Lack of Liquidity

The stock trades lightly, only about 60k shares per day and has a 7 million share float.  The 180 day lockup of 8.8 million shares expires in June, and I expect the VCs will look to sell shares.    

Catalyst

- Ensco / Pride acquisition closes in Q2, and Ensco converts Pride rigs to Rignet telecom infrastructure
- Drilling resumes in the Gulf of Mexico, with new regulatory requirements including heavy real time monitoring and data needs
- Successful entry into market adjacencies such as Int'l land, Oil & gas platforms
- Evenutal takeout candidate - company remains subscale and presents an attractive M&A target
- Successfully gain share by winning part or all of the Halliburton RFP and increasing revenue from Baker Hughes through their process
- Management proving out the business model to a combination of oil/gas and telecom analysts
- Continued shift to a deepwater fleet from shallow water
- Growth in rig counts among Ensco, Noble and other key customers
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    Description

    Rignet presents an undervalued and overlooked opportunity to invest in the niche market providing voice, data and managed services to offshore oil and gas rigs.  This market is benefitting from a growing deepwater drilling fleet, high commodity prices, increasing real time monitoring, communication and data requirements at offshore drilling rigs as well as an increased regulatory environment brought about after the Macondo spill.

    Rignet is the #2 player in this market,  providing its outsourced IT services over a global IP/MPLS network.  The company has 375 customers in over 800 physical locations in 30 countries around the world, operating within 3 segments - Eastern Hemisphere, Western Hemisphere and US Land.   RNET effectively acts as a system integrator, piecing together broadband capabilities, satellite capacity, teleports and fiber into an MPLS/IP network connecting clients corporate offices to their remote oil and gas assets.  The market has consolidated into an effective duopoly, with Harris Corporation acquiring the #2 and #3 players; Caprock in May 2009 for $525 mm or 9.7x EBITDA, and Schlumberger GCS in November, 2010 for 8.5x EBITDA.  Rignet went public on December 14th, 2010.

    Competitive Landscape

    RNET services roughly 31% of global offshore rigs, while market leader CapRock (sub of Harris Corp.) has roughly 40%.  The distant third player is Stratos Broadband, a subsidiary of Inmarsat with ~3% market share.  The balance of the market is either done in-house, at the national level or by small regional players.   CapRock, has over $600 million in revenue, and targets its services beyond the offshore oil and gas industry.  While Rignet has taken an 'asset light' approach to the business, leasing assets on an on demand basis, CapRock is facilities based, owning teleports to communicate with its global network.  Stratos Broadband, similarly offers broadband equipment and services to a much broader market than just the oil and gas sector.

    Rignet is differentiated within the industry by a) being the only pure play targeting the oil and gas sector thus allowing more customization and understanding of the target client needs b) has deep relationships with Drillers as well as E&P Operators - exclusive relationships with Noble & Ensco, 2 of the 4 largest drillers c) Offering a truly outsourced IT service, as opposed to just a broadband pipe d) superior customer service and e) a managed service portfolio that is unmatched within the industry.  Rignet was founded in 2000 and has grown the business all organically to its current size.  While Caprock can operate with lower operating costs by owning assets, it obviously is a more capital intensive business, and does not allow the flexibility of adapting to new technology quickly.   On top of these operational differentiators, Rignet has shown faster growth as well as displaying industry leading EBITDA margins, despite its 'asset light' business model.

     

    RigNet

    GCS

    Stratos

    CapRock/GCS

    CapRock

    '09 EBITDA %

    35.9%

    27.5%

    19.5%

    19.2%

    15.0%

     The higher EBITDA margin is primarily a result of its suite of managed services as well as its exclusive focus on the oil and gas sector, which has shown minimal pricing competition.  CapRock's focus has historically been on maximizing its fixed investment in its owned and operated teleports by selling as much bandwidth as possible, and not focusing on value added services.  They have typically priced at a lower level and have not offered a full suite of products.  RigNet has taken an asset light approach, leasing teleports globally as well as satellite capacity from FSS operators such as SES, Intelsat, Eutelsat as well as fiber and microwave when required.  They have been able to price at a premium level by selling more packaged solutions, and in turn acting as an outsourced IT office for remote locations.  The product suite consists of broadband voice, data, internet access, on rig communication, video conferencing, secure networks as well as managed services.  Due to the existing pricing dynamic as well as the duopolistic nature of the market, I think the risk that Harris becomes increasingly promotional is limited, as customers have demonstrated a willingness to pay a premium for the IT based approach that Rignet offers. 

    Business Model

    Rignet gets paid on a per rig 'day rate' or ARPU with customer agreements that range from one to five years.  The drillers are the first tenant targeted by RNET, and sign contracts ranging from from 3 to 5 years.  RNET will invest roughly $400k in capex per offshore deepwater rig and $175k / shallow water jackup rig which typically includes a satellite dish as well as fiber and necessary wiring within the rig.  The company will generate annual revenue of roughly $300k / year for deepwater and $100k / year for shallow water through the term of the contract with 5% annual escalators.   The second tenant on the rig, the operator, will require significantly less capex, only about $25k, but will pay a premium day rate and generate almost $500k / year for deepwater assets, for an average contract length of 1-3 years. 

     The company is broken into three segments - Eastern Hemisphere, Western Hemisphere & US Land.  Both the offshore segments have low volatility with oil and gas prices, while the US land segment (~12% of revenues) is highly correlated with commodity prices.  The Eastern Hemisphere, representing 66% of revenues and with Gross margins of 61% has benefitted from oil discoveries in West Africa, North Sea, Middle East and South East Asia among other areas.  The company has a larger geographic presence in the East, has more deep water assets deployed and a greater concentration of second tenants per rig leading to higher gross margins than the rest of the business.  The Western Hemisphere, about 21% of revenues, is primarily made up of the Gulf of Mexico and offshore Brazil, which is currently seeing significant investment.  Brazil historically was closed to outside parties, but by the end of Q1, Rignet will be serving 11 rigs in deepwater off Brazil of the 27 currently deployed in the region.  Additionally, Petrobras historically has used its own telecom network, but due to the expanding growth, their IT department has not kept up with the growth plans, and has shifted to using the Drillers communications network, thus giving Rignet an indirect additional tenant per rig to target.  Growth in the West will be more robust than the East in the next few years, and should accelerate once permitting in the Gulf of Mexico resumes.  Margins, currently at 41%, should continue to expand and eventually reach comparable levels as the Western hemisphere as it gains scale, and increases tenancy/rig.  US Land is significantly more cyclical, and highly correlated with gas prices, as it is less expensive for an operator to deploy a land rig when commodity prices are high, and pull them out when prices have dropped.  The amount of deployed US land rigs hit an all time high in June 2009 at about 1700 with average day rates of $125 / day to Rignet.  After rig counts fell off a cliff in 2009, US land revenue dropped 59% in 2009.  Rig counts have since rebounded to levels around 1,500, however day rates are still at least 25-30% lower than their peak, and margins are yet to rebound fully.  Within the offshore piece of the business, drillships and semisubmersibles in deepwater generate up to 3x higher day rates than jackups in shallow water.  The overall telecom costs in both shallow and deep water amount to little over 0.2% of the total day rate that an operator would pay to lease a rig.   For example, a Deepwater rig may cost up to $400k / day, with telecom costs representing only $800-$1,500. 

     Barriers to entry into this market remain high, as entrenched incumbents like Rignet and Caprock have deep relationships within the oil and gas industry.  Rig owners want to have standardized networks across all of their deployed rigs, so a new entrant going rig by rig would be hard pressed to displace an existing network.  On top of that, capex deployed in the field creates a financial barrier as well.  Overbuilding on an offshore rig remains difficult due to tight quarters and lack of space for multiple satellite dishes.  Lastly, the long term contracts that the Drillers sign (3-5 yrs) on a rig by rig basis, make market share gains difficult to come by.   After the initial term of a contract, renewal rates are 96%.  Management commented they have had new entrants try to come in several times, only to retreat after failing to gain any scale. 

    Revenue & Margin Drivers

    Given the highly recurring nature and long visibility of the business, 2011 analyst estimates, guided by the company are essentially accounted for by existing business, new builds coming online in 2011 and new contract wins that have already been signed or are being negotiated.  Potential upside to current 2011 numbers and what will drive 2012 revenue and margin expansion are discussed below.   

    Increasing Deepwater Rig Count

    An important part of this story, is the rapid industry wide growth of the deep water drilling fleet.

    Rig Deliveries

    2011

    2012

    2013

    Total

    Deepwater Floaters

    34

    15

    14

    73

       % Increase

    13%

    6%

    5%

    28%

    Jackups

    22

    18

    9

    49

       % Increase

    5%

    4%

    2%

    11%

    Scheduled deliveries of Floaters will grow the existing deepwater fleet by 28% over the next 3 years from a base of 260, while the jackup fleet will increase by 11% from 465 currently.  The company stated during the roadshow that its contracted share of rigs being delivered in 2011/2012 is greater than their existing rig market share of 31%.   While RNETs current mix of jackups / floaters is roughly 65%/35%, the company expects this will rapidly move closer to 50/50 over the coming years.   This has important implications for average day rates, as mentioned above the 3x greater amount of revenue generated from a deepwater rig.

    Market Share Shifts of Existing Rigs

    Consolidation within the drilling industry has created market share opportunities for Rignet.  In 2010, Noble, RNETs largest customer, acquired Frontier Drilling.  Rignet serves all of Noble's rigs, except for 2.  When Noble acquired Frontier, Rignet had 3 of 6 Frontier floaters already under contract.  Noble made the immediate decision to cancel its contract with Caprock on the other 3 floaters, and install Rignet on those rigs. 

    On Monday, Ensco announced it was acquiring Pride in a $7+ billion acquisition.  Rignet serves all of Ensco's rigs, including those currently being built in the shipyard.  Rignet does not serve any of Pride's rigs currently, most are maintained by Caprock.  The contract with Ensco does not require them to convert the rigs to Caprock, however it is probable that this will be done over time, which could present significant upside from current estimates.  After speaking with management, they remain very positive on the potential of this opportunity, and believe Ensco sees it as 'logical' to consolidate to one network over time.  Management does not expect the same immediate cancellation of current Caprock deals like what happened in the Noble/Frontier deal, however it is possible over time that Ensco will migrate all rigs to RNET services.  Ensco was the first customer of RNET in 2000, is the 2nd largest customer at about 7% of revenues, and the company is currently in negotiations with them to add additional value added services to the existing contracts.  Without consolidation of telecom contracts, Ensco would have to run duplicative networks, minimizing potential synergies of the acquisition. 

    Aside from the addition of rigs that this would bring, it would substantially shift RNET's contracted fleet to more deepwater rigs.  Pride currently has 24 rigs, 19 floaters and 7 jackups, with an additional 2 drillships under construction due in 2011 and 2013.  It would be reasonable to expect that the low hanging fruit would be the ships under construction currently, and that if this did take place, a gradual transfer of the balance to Rignet as contracts run their course over the next 1-5 years.  The geographic mix of where Pride's rigs are, directly overlap with RNET's network - 9 in Brazil, 5 in the Gulf, 5 in West Africa, 2 in the North Sea, and 1 in India & the Mediterranean. 

    Management was confident enough to say that this was the most positive M&A in the space possible for RNET.  In addition, this essentially takes off the table risk that Transocean or a larger player would acquire Ensco. 

    Incremental tenant per rig

    Rignet currently has about 1.5 tenants / rig - with a total of 3 tenants typically working on an operating rig at any given time - driller (Ensco), operator (BP) and service company (Halliburton).  Over the next few years, the average number of tenants / rig should rise to between 1.7 to 2.0x, as the company signs additional operators, and their deployed fleet shifts further towards deepwater from jackups which carry longer contract lengths.  The tenant that influences this important statistic the most is the Rig Operator, and if they are a viable customer.  A) Rigs do not always have an active operator on them B) If the operator is a National Oil Companies (NOCs), they may not use a third party for telecom services.  B) 10-15% of the time, the operator chooses to overbuild Rignet with a competitor, typically Caprock C) Getting the service customer (3rd tenant) is more difficult, and has shorter contract lengths.  Servicers are typically only on the rig between 10-40% of the time, and when they are out there, they may subscribe to RNET services, or conversely have a pop up satellite dish if the rig is stable for limited communication needs or pirate phone/bandwidth services from the existing tenants.

    Most of the capex in the business is success based, with maintenance capex at only 2-3% of revenues.  The incremental IRR on a new contract with one tenant on a deepwater rig are compelling, assuming an average 4 year contract length (typically 3-5 yrs), with zero salvage value and no contract renewals - 4 year IRRs are roughly 28%. 

    IRR of 1st Tenant - Driller   Year 0 1 2 3 4
    Initial Capex      $   (400,000)        
    Annual Revenue                    -    $    350,000  $    367,500  $    385,875  $    405,169
    Expenses @ 60.0% Contribution Margin                -         (140,000)       (147,000)       (154,350)       (162,068)
    Total Cash Flows      $   (400,000)  $    210,000  $    220,500  $    231,525  $    243,101
    IRR assuming 0 salvage value @ Various Discount Rates        
    28.8%   10.0% ($400,000)        190,909        182,231        173,948        166,041
    27.6%   11.0% ($400,000)        189,189        178,963        169,289        160,138
    26.5%   12.0% ($400,000)        187,500        175,781        164,795        154,495

    When a second tenant is added, the IRRs get very interesting.  The incremental IRR on signing the Operator as the second tenant are north of 1000%.  Additional capex needed is only about $25k, while they charge a premium to the operator- typically $500k / year, over a shorter contract length - typically 1-3 years. 

    Analyzing the current 1.5x tenants per rig, the all-in unit IRR per deep water rig is around 55%.

    Add 2nd Tenant - E&P Operator  Year 0 1 2 3 4
    Initial Capex            (25,000)        
    Annual Revenue              500,000  $    525,000    
    Expenses @ 70.0% Contribution Margin         (150,000)       (157,500)    
    Incremental Cash Flows            (25,000)        350,000        367,500    
                   
    Total Cash Flows      $   (425,000)  $    560,000  $    588,000  $    231,525  $    243,101
                   
    IRR assuming 0 salvage value @ Various Discount Rates @ 50.0% E&P tenants per rig - 1.5x  
    58.2%   10.0% ($425,000)        350,000        334,091        173,948        166,041
    56.8%   11.0% ($425,000)        346,847        328,098        169,289        160,138
    55.4%   12.0% ($425,000)        343,750        322,266        164,795        154,495
                   
    Incremental IRR of additional tenant          
    1261.9%   10.0% ($25,000)        318,182        303,719                -                  -  
    1249.7%   11.0% ($25,000)        315,315        298,271                -                  -  
    1237.6%   12.0% ($25,000)        312,500        292,969                -                  -  
     

    Increasing Day Rates

    Oil & gas rigs and their related remote offices are being operated like corporate branch offices, driving increasingly sophisticated technologies, especially as exploration moves into deeper waters, and following the Macondo disaster.   One of the differentiating characteristics competitively for RNET is the full suite of managed services which it provides.  The company charges its customers a flat day rate based on core network and data services + value added services.  The day rate obviously increases as more services are taken.  Some of these include real-time data management enabling transmission of geotechnical and petrpophysical data generated in remote locations to central offices.  The company offers systems that manage and distribute data collected from drilling instrumentation, measurements, cementing, weather etc.  RNET also offers Wide Area Network optimization which runs the VSAT network like an intranet, improving speeds by 100x.  An increasingly in demand service is remote video services - allowing videoconferencing with home offices as well as real time video of monitoring equipment.  Lastly, the rigs are wired for personnel access to wifi & internet access.   Management believes that video may be the key driver in the near term to drive increased day rates across its fleet.

    The company has been aggressively selling these types of services, and is seeing increasing day rates paid to them by their customers.  In addition, one of the fallouts of the Macondo oil spill is the regulatory requirements for better real time data collection and transmission.  Ensco finds it feasible that broadband data collection and transmission per rig in the gulf will more than double in the next few years as a heightened regulatory environment is put into place.  As a test case, the North Sea, which has significantly more rigid regulatory requirements, has on average 2x greater bandwidth needs than rigs in the gulf. 

    Additional Upside Potential

    The company commented during the roadshow of 2 large RFPs coming down the pipeline, which could present significant growth opportunities.  Baker Hughes is currently in the third round of its RFP process to streamline its telecom needs, but seems like it will go to a global provider like AT&T or Orange, who would then subcontract the offshore component to a company such as RNET.  RNET believes that its current business with Baker is secure, and some upside potential exists, but nothing game changing.  Similarly, Halliburton has also started an RFP process to consolidate its global communications networks on rigs - the total contract value could be around $20 million / year.  This RFP is in the early stage, with proposals due in 30 days.  Halliburton similar to Baker are currently using multiple vendors , making roaming around various networks more difficult and expensive. 

    Market Adjacencies

    Deutsche Bank estimates that the global upstream energy communications market for addressable drilling rigs (onshore & offshore) is $600 million, with Rignet currently addressing 17% of it.  Beyond the structural growth described above, the company believes that it can enter adjacent markets that require similar if not identical expertise.  The company has already started exploring international land drilling - which is a more stable industry than the US offshore, b/c it is mainly tied to oil drilling and tends to have longer term contracts.  A similar adjacent market is offshore production platforms.  This comes with a different set of requirements; ie: more permanent infrastructure, less bandwidth intensive, lower margin and more fragmented.  The last market they have discussed, although realize is hypercompetitive is energy maritime vessels.  These additional markets would almost double the addressable market that Rignet serves.  I believe the company will try to attack these adjacencies in a prudent way, possibly through M&A, but remain disciplined with regards to expected returns and appropriate valuation. 

    Board of Directors

    The company recently replaced its VC backed board with a strong telecom board slate.  Among those joining the board are Kevin O'Hara, a co-founder of LVLT and former president of MFS Global which was sold to Worldcom in 1996, Keith Olson, former CEO of Switch & Data which was sold to Equinix and Brent Whittington, the current COO of Windstream.

    Margin Expansion

    The company will continue to drive margins higher, as managed service revenue drops to the bottom line with contribution margins in excess of 70%.  In addition, overall higher ARPU driven by larger % of deepwater assets, greater bandwidth intensity, rebound in US land and the Gulf of Mexico as well as further leveraging SG&A spend will continue to enhance EBITDA margins, and free cash flow.   I am modeling for the company to expand EBITDA margins from the 31% level, after taking a $4 million hit for public company costs ($2.5 mm non recurring), as well as seeing margins drop in the Western hemisphere primarily as a result of the drilling halt resulting from the Macondo spill.  Management is targeting margins of 35% in 2012, still below peak levels.  Additionally, the company expects nominal 7-11% structural growth, and excluding any impact from ARPU expansion, market share shifts or moves into adjacent markets. 

    Rignet Model             CAGR
        2008 2009 2010 2011 2012 2008-2012 2010-2012
                     
    Eastern    $          54.6  $         60.9  $      61.1  $      65.7  $      69.6 6% 7%
    Western                 12.2             11.2          19.4          22.1          29.3 24% 23%
    US Land                23.0               9.9          12.3          14.2          15.6 -9% 13%
    Total Revenues    $          89.9  $         80.9  $      92.8  $    102.0  $    114.5 6% 11%
    % Growth     -10% 15% 10% 12%    
                     
    Gross Profit                
    Eastern    $          30.9  $         37.7  $      37.4  $      41.3  $      44.6 10% 9%
    Western                   6.6               6.4            7.9            9.9          15.7 24% 41%
    US Land                14.0               4.7            5.7            7.0            8.1 -13% 19%
    Gross Profit    $          50.6  $         45.8  $      50.7  $      57.2  $      65.9 7% 14%
    Gross Margin   56.3% 56.6% 54.6% 56.1% 57.5%    
                     
    EBITDA    $          26.7  $         27.2  $      26.9  $      31.6  $      39.0 10% 20%
    % Margin   30% 34% 29% 31% 34%    
    % Growth     2% -1% 18% 23%    
                     
    Net Income                10.3            (16.7)         (10.0)          10.8          15.8    
    EPS         $0.63 $0.93    
                     
    Normalized EPS (excluding non-recurring) $0.30 $0.21 $0.23 $0.63 $0.93 33% 101%
                     
    Free Cash Flow                
    Adjusted EBITDA                30.3             29.2          28.9          32.6          40.1    
    Less:  Net Interest Expense                 (2.5)              (5.1)           (1.6)           (0.9)           (0.1)    
    Less:  Capex                 (8.7)            (10.2)         (12.7)         (13.5)         (14.0)    
    Less:  Cash Taxes                 (5.9)              (5.5)           (7.7)           (6.5)           (9.5)    
    FCF                13.2               8.4            6.9          11.8          16.5 6% 55%
          -36.4% -17.6% 70.4% 40.6%    
                     
    Eastern as a % of Revenues   60.7% 75.3% 65.8% 64.4% 60.8%    
    Western  as a % of Revenues   13.6% 13.9% 20.9% 21.7% 25.6%    
    US Land as a % of Revenues   25.6% 12.2% 13.3% 13.9% 13.6%    
        100.0% 100.0% 100.0% 100.0% 100.0%    
                     
    Eastern Growth     11.6% 0.3% 7.5% 6.0%    
    Western  Growth     -8.2% 72.9% 14.0% 32.5%    
    US Land Growth     -57.3% 24.9% 15.4% 10.0%    
    Total Revenues Growth     -9.9% 14.7% 9.9% 12.3%    
                     
    GM                
    Eastern   56.6% 61.9% 61.2% 62.9% 64.1%    
    Western    54.2% 57.2% 40.7% 44.9% 53.5%    
    US Land   60.9% 47.2% 46.3% 49.5% 51.8%    
    GM   57.4% 59.0% 55.0% 56.1% 57.5%    
                     
     

    Valuation

    Rignet's IPO priced at $12 in December, below its projected IPO range of $14-$16.  The pricing seemed to have been impacted by a few things including lack of liquidity, the timing in late December, the amount of work necessary to understand both the E&P and telecom aspects of the business, as well as interest from a large Boston mutual fund who was price sensitive.  While liquidity remains limited, RNET does present an attractive opportunity that would otherwise be overlooked because of its market cap, and positioning within a confluence of industries. 

    The stock currently trades at 6.8x 2011 EBITDA and 5.5x 2012 EBITDA, with a 2012 FCF yield of 7.3%.  This company presents a long term opportunity to make north of a 50% return on your investment, valuing the company at a discount to the M&A which recently took place in the space.  Caprock was sold for almost 9.7x EBITDA, and GCS for 8.5x.  Valuing RNET at 8x EBITDA gets you to $22, or 48% higher than current levels.  Several catalysts listed above may ultimately make my estimates conservative.   For example, if in fact Ensco does close on its acquisition of Pride and transition the telcom services over to Rignet over a 5 year period, a DCF of the potential cash flows of just the 21 deep water rigs of Pride is worth over $4 / share.  

    Another valuation benchmark to look at within the telcom sector are the CLECs, which trade in a range anywhere from 5-9x EBITDA.  Given the limited competitive intensity in this market, combined with the compelling IRRs on a per unit basis, a premium multiple is warranted relative to the US based CLECs.  

    Stock Price Implied at Various Multiples of 2012 EV/EBITDA    
               
      7.0x 7.5x 8.0x 8.5x 9.0x
    Base Case $19.70 $20.88 $22.07 $23.25 $24.44
    % Upside 32.6% 40.5% 48.5% 56.5% 64.4%
    Upside Case $20.73 $21.99 $23.25 $24.50 $25.76
    % Upside 39.5% 48.0% 56.4% 64.9% 73.4%
               

    Risks

    Regulatory

    Macondo - While the company did not see a significant impact from the Macondo disaster, there remains the potential for a prolonged period of uncertainty.  While rigs sit idle or 'warmstacked', the company will continue to get paid by the Rig owner, however lacking additional tenants will provide a headwind to increasing ARPU.  While the ban on drilling has been lifted, the Obama administration still hasn't allowed the permitting process to move forward, so visibility into what the environment will look like and when is difficult to see.

    Consolidation

    If one of the company's large clients were acquired by another company that is a customer of Caprock, there could be risk numbers.  Noble and Ensco make up 18% of revenues, while the remaining 8 of the top 10 make up another 20% of revenues.

    Irrational Pricing Pressure from Harris

    It is possible, not necessarily rational that Harris, after acquiring the two large competitors of RIgnet, could try to drive market share growth but significantly cutting pricing.  This probably wouldn't give them the best return on their investment, and seems unlikely in my mind.

    Overpriced Acquisition

    The company could make a large acquisition in an adjacent market that has lower barriers to entry, and destroy shareholder value. 

    Lack of Liquidity

    The stock trades lightly, only about 60k shares per day and has a 7 million share float.  The 180 day lockup of 8.8 million shares expires in June, and I expect the VCs will look to sell shares.    

    Catalyst

    - Ensco / Pride acquisition closes in Q2, and Ensco converts Pride rigs to Rignet telecom infrastructure
    - Drilling resumes in the Gulf of Mexico, with new regulatory requirements including heavy real time monitoring and data needs
    - Successful entry into market adjacencies such as Int'l land, Oil & gas platforms
    - Evenutal takeout candidate - company remains subscale and presents an attractive M&A target
    - Successfully gain share by winning part or all of the Halliburton RFP and increasing revenue from Baker Hughes through their process
    - Management proving out the business model to a combination of oil/gas and telecom analysts
    - Continued shift to a deepwater fleet from shallow water
    - Growth in rig counts among Ensco, Noble and other key customers
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