Awilco Drilling (AWDR.OL): cheap with a catalyst redux?

Awilco Drilling PLC is a recently formed company that owns two semi submersible drilling rigs. The rigs were bought from Transocean in the beginning of 2010 that, following a merger, was under obligation to reduce its exposure to UK waters. The two rigs, the WilPhoenix and the WilHunter, have been upgraded in 2011, and after a bit of a slow start in 2012 the company is now set to generate a significant amount of free cash flow that it intends to pay out to shareholders. The author of this write-up at the OTC Adventures blog sees a possible yield of more than 20%, and that sounded cheap enough that it got my attention. As usual some quick stats before diving deeper:

Last price (May 10, 2013): 82.75 NOK
Shares outstanding: 30,031,500
Market Cap: NOK 2.49B ($428.7M)
Free float: 51.27% ($219.8M)
P/B (mrq): 2.4x
P/E (ttm): 11.0x
EV/EBITDA (ttm): 7.35x

Backlog

Based on these metrics the company doesn’t look very cheap, but we can make a decent estimate of the future profitability based on the current contract backlog. The WilHunter is on contract until 15 November 2015 while the WilPhoenix is on contract until early May 2014. The day rates that Awilco Drilling will receive are therefore already locked in. From the latest company presentation:

Awilco Drilling backlog April 2013These rates are quite high thanks to tight supply in the UK drilling market, and if everything goes smoothly Awilco Drilling should generate a lot of cash. I have created an estimate for 2013 based on the above backlog assuming that other items such as operating expenses and depreciation stay at levels consistent with previous year. Note that the interest expense is slowly going down because the company is paying down approximately $16.5 million in debt this year.

Awilco Drilling estimated 2013 results

Awilco Drilling pays almost no taxes because the rigs are owned by subsidiaries located in sunny Malta. The effective tax rate might even go down in the future because the UK corporate tax rate is being lowered the next few years from 28% to 20%, and the taxes that they do pay are mostly UK taxes. Last year the company paid just 6.4%.

The possible income of roughly $116 million in 2013 would translate to a significant amount of free cash flow. Last year capex spending was $5 million while depreciation was $17.5 million. This means that free cash flow could approximately be $129 million while free cash flow to equity (after paying down $16.5 million in debt) could be ~$112.5 million. This represents a yield of roughly 25%!

Do I expect that they company will achieve this? No, because this is more-or-less a best case scenario. On average we should expect some bad stuff and operating expenses are probably going up compared to 2012. But with a possible 25% yield you have room for some unfavorable events and still arrive at a >20% FCFE yield. But a significantly worse results is certainly also possible. The company owns just two rigs, and serious problems at one of them could have a very big impact. There is a lot of idiosyncratic risk.

Dividend prospects

The second big positive is that Awilco Drilling is planning to return basically all free cash flow to investors, after maintaining a $35 million cash buffer. This intention is communicated crystal clear in  the financial reports and the various presentations. See for example the latest presentation:

Awilco Drilling divided prospectsGiven how much cash flow the company could generate the next few years it isn’t hard to see how the initiation of a big dividend could be a catalyst for the shares to reprice higher. Since the company already had $17 million on the balance sheet at the end of 2012 it should be right on track to start quarterly dividend payments in the second quarter of 2013.

Valuation

So we will get probably get a high yield with limited risk the next couple of years because high rates have been locked in, but is this enough reason to pay more than two times book value for a company that is active in a commodity industry? The question is of course how well book value reflects the economic value of the two rigs build in ’82 and ’83. The rigs were sold by Transocean for $195 million in January 2010 in what was arguably not the best economic climate. Transocean booked a loss of $15 million on the transaction while it already had recognized a $279 million impairment loss on the two rigs in 2009 when oil went below $40/barrel. In other words: a couple of years ago the book value of the two vessels – before being upgraded in 2011 for almost $100 million – was around $500 million. Add that Transocean was forced to sell because of antitrust concerns and it seems plausible that Awilco Drilling got a good deal.

This doesn’t bring us really closer to a valuation, and fact is that a narrow value estimate is going to be a though task because it depends on volatile day rates multiple years in the future. The UK market is almost sold out until 2015, but what will happen with the rates after that? It’s highly uncertain, but even if rates would plummet you would have some downside protection since you will get a large part of your investment back the next couple of years while the company is simultaneously deleveraging. If rates stay around the current level, or go up, an investment in Awilco Drilling should work out very well as long there is no negative tail event (think Deepwater Horizon, Piper Alpha etc).

While you would get a good return in that scenario I think investors should also demand a high expected return. You get the idiosyncratic tailrisk that everybody thinks about when see a burning oil platform on the news with Awilco Drilling, and you can diversify that away, but there is also a lot of market risk, and I think that’s a lot bigger and more important. The profitability of oil drilling is strongly correlated with oil prices and thus the strength of the economy, and there is a lot of operating leverage involved in owning a drilling rig. Throw a bit of financial leverage in the mix and it should be clear that equity investors should demand a healthy return! The average value investor isn’t a big fan of CAPM, and for a good reasons, but seeing that Transocean trades with a beta slightly above 2 should say something about the market risk.

I’ve played around with a few valuation approaches and what makes most sense to me is to assume that earnings will be high the next three years, and that the risk in achieving these earnings is moderate so that the expected cash flows for the next three years can be discounted at a reasonable average rate such as 10%. Current day rates are probably the best starting point for a prediction of future day rates, but since this is a lot riskier a significantly higher discount rate is appropriate. If I would use a 10% discount rate for the first three years and a 20% discount rate for the years after that I get an approximate value of ~$600 million dollar and more than half of that NPV comes from the first three years. Lower discount rates can obviously increase the value a lot, but I doubt how appropriate that is given the amount of risk involved after the first few years.

Insiders

Awilco Drilling PLC is owned for 48.73% by Awilhelmsen AS, a privately owned investment company. Sigurd E. Thorvildsen is the Group CEO and also Chairman of Awilco Drilling PLC. The COO of Awilhelmsen AS is also a non-executive director. So while the CEO of Awilco Drilling PLC doesn’t have a stake in the company (besides a few options) shareholders are well represented on the board. I prefer to see a CEO that owns a significant stake in the company, but this is also a decent structure.

Conclusion

The near term cash flows of Alwilco Drilling and the intention of the company to return that money to shareholders through dividends sound very attractive, and especially in today’s yield starved world I can imagine that the initiation of a healthy dividend can act as a catalyst to propel the stock higher. But I’m not willing to buying stocks hoping on a greater fool to sell them to in the future, I have to be comfortable with the underlying intrinsic value. And while I do think that Awilco Drilling is cheap, I’m not that sure that it is a huge bargain. It’s a very risky asset and it should deliver a relative high yield as a compensation for those risks. I haven’t yet completely made up my mind, but at the moment I’m inclined to pass on this stock. What do you think? How much is it worth?

Disclosure

No position in Awilco Drilling, but thinking about it…

21 thoughts on “Awilco Drilling (AWDR.OL): cheap with a catalyst redux?

  1. Deep Value

    Well to figure out if the company is cheap just take the historical day rates in the region and figure out the discounted cash flow. The recent upgrades to the rigs will probably give them 5-7 years of useful life on the low end… all the way up to 20 years to what they have listed on their annual reports.

    The big plus for the company is the low leverage of the balance sheet. Only 98 million in debt with cash flows of 100+ million. Basically this is a great play if you are bullish on the price of oil. Personally I don’t oil is going to crash and I’m willing to take the risk on oil prices. What we really need is for the company to secure a nice 3-7 year contract on one of their rigs to create the value…. in the mean time I’ll collect the dividends.

    I already modeled out the cash flows on historical pricing and the price I come up with is $25. With the low cost structure of the company they can add on more rigs and this can easily become a growth story.

    Reply
    1. Alpha Vulture Post author

      But what are the right historical day rates? The results of 2012 were obtained with historical dayrates, and dayrates were 50K/day a decade ago. They are currently at an all-time high @ 400K/day, so what should be the base case?

      Reply
      1. Deep Value

        The whole offshore industry has been in a bull market for the last 10 years. What’s really interesting is even with this surplus profits in the industry the supply side of the rigs haven’t caught up with demand yet. This tells me one cannot simply buy a rig and expect to land a contract. Skilled workers are in short supply and you got the industry leaders like Seadrill stating the markets are going to tighten further in 2015-2016. This doesn’t make it true, but John Fredriksen didn’t become a billionaire without knowing his industry well.

        The day rates tend to be volatile over time, but I think we’ll be safe to assume day rates of $250k as a worst case. Of course we got the next 2 years baked in at current rates with the potential to have a giant windfall when they are back on the market. I think a lot of the downside is baked into the current price. Investors will get most of their capital back within the next few years and you literally pay for nothing for what happens after. Think of it as an annuity with a call option on a growing business.

        What it comes down to is if you aren’t bullish on the industry then this becomes very difficult to value.

        Reply
  2. Zimbo

    > The WilHunter is on contract until 15 November 2015 while the WilPhoenix is on contract
    > until early May 2014

    WilPhoenix is one of the only rigs available in the region in 2014. It will probably be contracted soon throught end 2015/early 2016. Current contract rate for WilPhoenix is 315k$/d. I would expect the new contract to fetch close to 400k$/d as there will be only two additional midwater rigs entering UK North Sea in 2013 and 2014.

    For me this is a special situation, which I am planning to exit with in a year or two as I expect the stock to double during that time. This is what you call the Greater Fool-scenario.

    Waiting for the greater fool may generally be riskier than buying cheap and waiting for the market to correct the pricing error as the greater fool may never appear.

    But is DCF analysis any better in this situation? You discount the income for 2013-2015 by 10% and then 20% after that. I feel that the result you get with these estimates is inaccurate at best. Better DCF would result from calculating residual value of the rigs and estimating contract values after 2015, but that is difficult to do as well and will yield an inaccurate figure.

    Awilco looks to be making in FCF close to its current mcap during next three years (2013 111k$, 2014/15 148k$ = 407 m$. The terminal value is for free.

    I have no idea what oil prices will be in 2016, but the day rates were lowest at 2009-2010 when they hit 250k$/d. Awilco would still make 70m$ FCF at this level. The rigs are old, but may well last another 10-15 years. There is a decent terminal value.

    As the DCF is hard to do and contracts are fixed (almost) at high rates for three years making rise in price likely, the greater fool strategy is not a bad idea here.

    Reply
    1. Alpha Vulture Post author

      I’m the first to admit that a DCF analysis is wildly inaccurate since the future is so unknown here, but it’s better than nothing. At least it recognizes the opportunity cost of getting paid back a significant amount of our investment the next three years, and it attempts to incorporate the high risk & uncertainty of the terminal value.

      But given that I calculated an IV that’s ~50% higher than the current market cap, and that the majority of the IV comes from the first couple of years I certainly understand your viewpoint, and as already said: I haven’t yet made up my mind, it’s tempting…

      Reply
  3. Arvosijoittaja

    An approach, where you try to discount Awilco’s free cash flow until end of time, makes no sense. A proper way to calculate DCF that way, would be to model different scenarios after the contract expiration. This would very likely lead to a range of possible fair values, which is so wide that you can’t invest based on that.

    The approach, where you take an arbitrary discount rate of 10% and then move to another arbitrary discount rate of 20% is, well, just arbitrary.

    You could of course guess that the oil rig supply at north sea after 2015 remains tight, but if you don’t have data to support that, then it is just a guess.

    Awilco’s near future (until 2015) can be estimated very accurately and the rest is very unclear. The logical conclusion is to see, if there is a long case, if you limit your analysis to the time until 2015. The greater fool in me says that if the company hikes the dividend to 20+% range, which looks likely, then it is very likely that the stock price doubles. It is perfectly possible to calculate the opportunity cost and the value of the following opportunity:

    – 60% probability: the share price doubles in two years. You exit with 100+% profit.
    – 40% probability: the share price drops -40%, because mgmt did not hike dividend/some other problem. You exit within 6 months.

    Now, you hard-earned cash is tied at max 2 years and you’re well out of the stock, when the contracts expire. All that time, you have an option not to sell, if they manage to extend the contracts with good conditions.

    Alternately, you could calculate DCF until end of 2015 and add the liquidation value. With your 10% discount rate, the 25% FCF is already worth 62% of MCap until end of 2015.

    Reply
    1. Alpha Vulture Post author

      The 10% discount rate is what I use for average risky equity investments: call it opportunity cost or required return. I think it’s fair to say that the cash flows after 2015 are significantly more risky than average, and doubling the discount rate is a bit arbitrary, but it should be a move in the right direction. Big brother Transocean has a 2.0x beta and Diamond Offshore a 1.4x beta. Both are more diversified than Awilco Drilling, so less risky. Transocean has a bit higher debt/equity ratio than Awilco drilling, while Diamond Offshore has no debt. So i’d say that thinking that Awilco Drilling is twice as risky as an ‘average’ company is a reasonable starting point. With a risk free rate of basically zero you would need a return that’s twice that of an ‘average company’ to compensate for this risk.

      If you do this you see that the terminal value of Awilco Drilling isn’t that high compared with the cash flows from the first three years: that’s basically 50% of the current value. And because of the relative high discount rate you are also not projecting cash flows until the end of time. The cash flows after 10-15 years add almost zero value, and that matches nicely with the expected lifetime of the rigs. The valuation also isn’t extremely sensitive to a change in discount rates for the period after three years. Lowering the discount rate from 20% to 15% for the 3+ year period increases value from 600M to 700M in my model.

      Now, you hard-earned cash is tied at max 2 years and you’re well out of the stock, when the contracts expire. All that time, you have an option not to sell, if they manage to extend the contracts with good conditions.

      Shouldn’t you give the market a little bit credit, and assume that stock will go down if they don’t have extended the contracts at that time on good conditions?

      Reply
  4. Thomas Braziel

    Thanks for the post. Definitely an interesting idea. There is another play like this.. I’ll post the name when I remember it. Would be interesting to compare and contrast.

    I like Zimbo’s comment and think it’s a great way to think about it: “Awilco looks to be making in FCF close to its current mcap during next three years (2013 111k$, 2014/15 148k$ = 407 m$. The terminal value is for free.”

    So the idea would be to just look at contracted cash flows. To get to Zimbo’s numbers of course you have assume the 2rd rig signs a contract for 400K a day for 18 months or so. Everybody know a broker or oil man in the UK who could verify this?

    Best, Thomas

    Reply
    1. Alpha Vulture Post author

      I don’t, but think it’s a reasonable estimate. If you check the latest company presentation you can see that in 2014 there isn’t a lot of potential supply available besides rig #2.

      Reply
  5. Arvosijoittaja

    >Shouldn’t you give the market a little bit credit, and assume that stock will go down if they don’t have >extended the contracts at that time on good conditions?

    Agreed. Awilco’s management will have to decide what they want to do with the free cash flow after the Q2 earnings. The earnings call will be held in Aug/Sep time frame. Waiting two years for the catalyst is too long time, should be 6-9 months from now. My initial model allocated max -40% loss, if the catalyst fails. That should be big enough.

    >If you do this you see that the terminal value of Awilco Drilling isn’t that high compared with the cash >flows from the first three years: that’s basically 50% of the current value. And because of the relative >high discount rate you are also not projecting cash flows until the end of time. The cash flows after 10->15 years add almost zero value, and that matches nicely with the expected lifetime of the rigs.

    The terminal value is still the basis for investing or not investing here. With 10% discount rate, the NPV of the free cash flows until end of 2015 is only 62% of the current MCap.

    I agree that the FCF from later years has progressively smaller impact on the result. Still this leaves 7-12 years, which have to be based on a wild guess. Additionally, it is not clear how long the remaining life-time of the rigs is.

    It seems we have quite a different approach here. I am comfortable with a short-term bet that the dividend will have a huge impact on the share price. I wouldn’t be comfortable with a bet based on a valuation requiring a long-term forecast, since Awilco’s future after 2015 is very unclear.

    Reply
    1. Alpha Vulture Post author

      Yes, seems we have a slightly different approach. Most important for me is being reasonable sure that I can buy at a significant discount to intrinsic value (unfortunately very hard to estimate), not the possibility of potentially selling to a greater fool in the near future (I certainly see how that could work out favorable though!).

      Reply
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  7. DTEJD1997

    Hey all:

    Good to see some seasoned investors getting interested in and taking a position in this company.

    I have two comments to add:

    The life expectancy of these rigs depends on daily rates a few years from now. If they are good, that will support maintenance & retrofits. As long as rates stay strong, these rigs are probably going to be in service.

    I’ve heard somewhere that there are 60 year old rigs in the Gulf of Mexico…Not to suggest that these rigs will last 60 years, but if rates are strong, they should have plenty of life left in them.

    As to the strength of rates, the next couple of years are tied up pretty tight.

    Aft that if oil stays high, I think day rates will too. I think that the newest rigs will be sent to drill off of Brazil in the ultra-deepwater fields. Older rigs that Awilco has will be working secondary or tertiary fields.

    Nobody knows what oil prices will be 2-3 years from now, but I think there is AT LEAST a 50% that they are at today’s rates or higher. This company is also a hedge against a decline in the USD. If oil is $120/barrel, these rigs are going to have a lot of value and a lot of life left.

    We’ll see…

    Reply
  8. DTEJD1997

    Hey all:

    Looks like things are progressing well here. Awilco has letter of intent to lease one of the rigs at rates of about $400k a day until 2017 with an option to extend till 2019.

    Oil prices have actually gone UP.

    Earnings will be reported soon here. We’ll see if they continue the dividend. My thought is that they will.

    If Awilco leases these rigs for the next 4-6 years at day rates of $400k, this company is still dramatically undervalued.

    We will see.

    Reply
  9. Steven

    Hi Alpha Vulture,
    Was wondering what you think of the price decline in the last month and if you think its a buy at these levels?

    Reply

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