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
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:
These 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 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.
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:
Given 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.
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.
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.
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?
No position in Awilco Drilling, but thinking about it…