Description

Songa Offshore ASA – (SONG NO – NOK 48.00/US$ 7.10)

• Songa Offshore is a new company, founded in early 2005 by Arne Blystad and Gunnar Hvammen, set up to take advantage of the extreme tightness in the offshore rig market.
• Songa has assembled a fleet of 2 Semi-submersible rigs (a 3rd generation unit and a 2nd generation unit), a 3rd generation drillship, and a 20% interest in a 3rd generation semi currently working in the North Sea.
• Therefore Songa is perfectly positioned to take advantage of the currently very strong, and rising, market for rigs, as it looks to fix it 2 contract free semis and its drillship, while the Deep Sea Bergen will benefit over time as its contracts roll over at higher rates
• Based on current assumptions, Songa is trading at an EV/Ebitda of 3.5x for 2007, and 2.4x for 2008, making it the cheapest drilling stock we are aware of.
• Songa is currently listed in the Norwegian OTC market, and trades an average 522k shares per day, or $3.5mln per day. Songa is seeking a full listing on the Oslo Stock Exchange and should be listed by January 2006.


Company Background

Songa Offshore is a new company, founded in early 2005 by Arne Blystad and Gunnar Hvammen, set up to take advantage of the extreme tightness in the offshore rig market
Songa purchased 2 semi-submersible rigs in June of 2005 from IPC in Mexico. The 3rd generation Songa Mercur, built in 1990 with a rated water depth of 1,500ft and the 2nd generation Songa Venus, built in 1974 and upgraded in 2005 to a rated water depth of 1,500ft. Both rigs are currently being upgraded in Galveston.

Subsequently, Songa purchased a 20% interest in the Deep Sea Bergen, a 3rd generation Semi, currently working for BP in the North Sea. Finally, in September, Songa purchased the “cold stacked” drillship Golmar Robert Bauer, now re-named Songa Saturn.

Management

In terms of management, Songa has hired Bob Scott as CEO. Bob Scott was the former COO at Transocean (RIG). Bob retired earlier this year after over 20 years working at RIG, but was immediately heavily recruited by Transocean’s competitors. As the compensation being offered rose, Bob finally agreed to join Songa as he felt that Songa was too small to be considered “competition” to his old employer and was well positioned to take advantage of the rising market. Since joining, Bob has hired a team of 6 other senior managers and over 30 operations people. Having Bob, with his experience and contacts is a clear competitive advantage for Songa, and a big risk mitigator for investors considering investing in an offshore rig start-up. The biggest hurdles these start-up companies face are staffing and credibility. With Bob, Songa is able to hire top industry people, and thereby gain immediate credibility within the industry and, more importantly, with potential customers.

The Market

The market for offshore rigs has been on a tear over the last 12 months. Not only has the market continued to rise consistently over time, but it seems that the pace of the acceleration in rates has been gaining momentum. Equally as important, with the tightness in rigs and the fear E&P companies have that they will be left without a rig to drill the prospects they have worked so hard to acquire, E&P companies have been willing to book rigs further out in time, and for longer contract periods. Therefore, currently many operators are booking rigs at record rates for 3+ year contracts starting in 2008. The longer this continues, the bigger and longer the guaranteed cash flows will be for rig companies. It is amazing to be in a situation where in a cyclical industry, ever longer term contracts are being fixed, starting further out in the future and at record and rising rates.

Rates have risen dramatically over the last 12 months. Rates for 2nd generation semis have risen from $55k per day to $250k per day currently. Rates for 3rd generation semis have risen from $55k per day to $300k over the same time period. Given that operating costs are mostly fixed, these increased rates flow straight to the bottom line.

Currently, over 20% of the floater market is booked beyond the end of 2008. 45% of the fleet is booked through until the end of 2007, and 85% is booked through to the end of 2006. Clearly, anybody with a rig available in the near term is in a great position to take advantage of this tight market, and can not only exact high rates, but also longer term contracts to go along with those rates.

Strategy

Songa’s strategy is to get the Venus and Mercur out of the Galveston yard working on shorter term contracts (6 to 12 months) as soon as possible. The idea is to start generating cash flow and to get the rigs closer to the markets where they will ultimately work. Concurrently, Songa’s management is focusing on fixing the rigs out for longer term contracts (3 years) starting at the end of these initial contracts. In addition to longer term contracts, Songa is working with potential customers to determine what upgrades should be completed before the rigs start on their new longer term contracts. Naturally, once upgraded, these rigs can command higher rates than their current shorter term contracts.

Venus:
Signed a 1 year contract contract at $205k, commencing July 1, 2006. The contract has 2 6 month options attached to it, at a rate of $225k.

The rig should mobilize out of Galveston and towards the area of operation (expected to be Australia) any time now. Mobilization costs as well as further minor upgrades totaling $15mln are being paid by the client.
After its initial contract, the Venus will likely be upgraded to 3,000ft rated water depth, at which point it will be able to command rates between $225k and $300k.

Mercur:
Expected to sign a “get out of the yard” LOI within the next month. Songa expects to achieve a rate above $275k per day. I expect this rig to start working by Q3 2006

Then, similarly to the Venus, the Mercur will be upgraded, probably to 5,000ft rated water depth and contracted out for a longer term contract (3 years)

Saturn:
Currently at a yard in Turkey where it is being upgraded. Songa plans to add a 3rd mud pump, increase living quarters, increase variable deck load etc for a total cost of $60mln.
The rated water depth will be 3,000ft and therefore the drillship will be able to command a rate of between $250k and $350k per day. Songa expects to sign an LOI for the Saturn during Q1 at a rate above $275k

I expect this vessel to be ready for operation by Q4 2006. The Saturn will immediately be put out on a longer term (2 to 3 year contract).

Deep Sea Bergen (20% owned)
Currently working on the Norwegian shelf for a 1.5 year contract at a day rate of $145k per day. In Mid 2007 this rigs rate should jump to the $280k per day level.

Valuation

FD shares outstanding: 76.5mln
Price: NOK 48 (US$ 7.10)
Market Cap: US$ 543mln
Net Debt: US$130 mln
EV: 673mln
EV/Ebitda 06: 7.9x
EV/Ebitda 07: 3.5x
EV/Ebitda 08: 2.4x

Given the rate assumptions mentioned above, and $50k per rig per day operating costs ($80k for the Deep Sea Bergen), as well as $1mln per quarter of SG&A, Songa will generate Ebitda of $85mln, $193mln and $280mln in 2006, 2007 and 2008 respectively.

What is remarkable about Songa, is that within the next 3 months, these cash flows for the next 3 years will be determined with certainty as the long term contracts are negotiated.

By year end 2007, even assuming the Mercur is upgraded to 5,000ft rated water depth for a capital cost of $70mln, Songa will have net debt of only $60mln. By year end 2008, Songa will have net cash of $144mln, or $1.88 per share.
In 2008, Songa’s will generate free cash flow of $204mln, and the company would therefore be trading at 2.6x free cash flow.

Founders and insiders own over 35% of the shares of Songa, so I believe it is highly likely that Songa will quickly implement a dividend policy whereby all excess cash flows are distributed to shareholders.

Catalyst

+ Will announce Contracts for the Mercur and Saturn rigs next quarter
+ Will be listed on the Oslo Stock Exchange in January
+ Once contracts have been signed, Songa will likely announce a dividend payout policy whereby it will look to payout all excess cash flows.