Noble Corporation: Business Analysis & Valuation

Business Overview:
Noble Corporation is a contract oil and natural gas drilling company. Its fleet consists of 62 mobile offshore drilling units (excluding additions from the recent Frontier Drilling acquisition). Shown below is the latest status of its fleet: Noble Corp has a long history of navigating well through difficult industry conditions and delivering good returns on capital and operating margins.  Also, compared to its competitors, Transocean (RIG), Ensco (ESV), Diamond Offshore (DO), Rowan Companies (RDC), Pride International (PDE), and Atwood Oceanics (ATW), Noble is among the top performers based on the metrics below:

Business Analysis:
Operating revenue for Noble and other contract drilling companies depends on drilling activity by exploration and production (E&P) companies which in turn depends on the outlook for oil prices. In the last three years, crude oil prices have gone through a wild ride causing drilling activity to peak and then to fall off very rapidly. The industry uses two metrics to evaluate the key drivers for revenue:
(i) Average Day Rates:

(ii) Average Utilization:

Jackups Segment:
Day rates have been coming down as drilling activity has slowed. Also, during the peak of the cycle, contract drillers around the world ordered a record number of new Jackups. These are also known in the industry as “being built on speculation”. These newbuilds are expected to flood the market starting 2010. Most of these newbuilds are uncontracted and thus are expected to put tremendous pressure on day rates for the resetting Jackup contracts for Noble Corp as well as its competitors. Shown below is the data for Jackup Market (Data from RigZone’s 2010 Jackup Market Outlook):

Jackup day rates for Noble Corp were lower in 2010 H1 than for the industry going into 2010. This trend wasn’t specific to Noble Corp, but was evident for all other competitors too – mostly because of the oversupply conditions in this market.

There are factors other than supply/demand that determine “day rate” for a specific rig in a contract. To name a few, factors such as age of the specific rig, high spec capabilities, the contractor’s track record, operator needs and relationships, and specific rig’s maintenance and performance records also play some role in the pricing equation. Although the average age of Noble’s fleet is 27 years old, it has “rebuilt” (made substantial improvements to) a majority of them. The average age of its Jackup fleet taking this into consideration is 13 years. Ensco has the youngest Jackup fleet (in the same sense) in the industry with an average age of 9 years. We can compare metrics for Ensco’s Jackup fleet to that of Noble to get a sense of the difference (there isn’t much):

The other factor that helps demand a premium in day rates in normal market conditions (roughly balanced demand/supply) is high spec capability.

With the overhang in supply in the current market conditions, it might be an exaggeration to say that the older and lower spec rigs in the industry will be completely marginalized, but it is likely that these units will face more day rate pressure than the high spec, newer units. Amidst fierce competition for work, owners of higher spec units have the option to step down and compete for contracts with the lower spec rigs, potentially forcing some lower spec rigs to keep day rates repressed to stay active. A potentially mitigating factor to note here is that newly built rig owners, especially unestablished rig owners building rigs on speculative basis, have higher day rate hurdles due to financing costs in order to earn acceptable margins.Later in the valuation section, I will use the economics described above to roughly measure its impact on Noble’s Jackup fleet. 

Before we move on to examining the other segment for Noble, let’s look at the current contract status for its Jackup fleet

As you can see, most of the contracts expiring in 2010 are in the Mexico region. In fact, all the rigs in the Mexico region are currently contracted to Pemex, Mexico’s state owned petroleum company. In a difficult market like today, it is concerning that these rigs could be out of work for some time. Also, to add to these difficulties, Pemex originally submitted a tender with age restrictions that would have ruled out Noble Corp’s Jackup fleet. However, very few bidders showed up, causing Pemex to lift this restriction. Subsequently, Pemex also submitted its proposal to the finance ministry to up its budget by 54%. As per Noble, in its Q2 call, Pemex may be in the market for another 21 rigs in Feb 2011 because of this budget increase. This news improves prospects for Noble’s expiring contracts in this region lifting some of the near-term concerns relating its expiring contracts.

Semisubmersible segment:
Day rates for the semisubmersible segment have gone up, despite the fall of oil price from its peak. Also, its utilization has stayed in the 90% + range. This trend is not specific to Noble Corp, but is evident industry wide indicating tighter supply. However, since the Deepwater Horizon accident, not only is the short-run outlook for deepwater drilling in the Gulf of Mexico is grim, but the long-term global impact is yet to be fully understood. This uncertainty in my opinion is what creates the opportunity to invest in Noble Corp. Let’s examine Noble Corp semisubmersible fleet:

As you can see from above, only one operator (Anadarko) has terminated contract so far based on force majeure. This termination is currently in dispute, and revenue recognition is being deferred in the current financial reports. Also, as part of the Frontier acquisition, Shell agreed to support Noble during the Gulf moratorium.  The agreement let Shell suspend the rig contracts of any rig operating or anticipate to operate in the Gulf during the moratorium, if needed. In exchange, Noble will continue to earn a reduced day rate that will cover its operating costs and allow the rig to be quickly returned to duty. The term of the contract will be extended at original contract day rate to reflect any suspension period. This reduces to a large extent the uncertainty of force majeure for its rigs operating in the Gulf.

Now that BP has capped its oil well, the possibility of extending the moratorium beyond Nov 2010 is much smaller. One of the most likely outcomes is stricter regulations. As an example, drilling contractors may be required to upgrade their fleet to meet with new minimum standards for blowout preventers. The older rigs may need to be redesigned to make space for such blowout preventers rendering them to undergo costly upgrades or possibly make them obsolete. Such a requirement would be a boon to contractors that have a younger fleet, thus creating a competitive advantage for them. In the last quarterly call, the CEO of Noble Corp commented that the cost of upgrading its fleet to meet these requirements are very manageable – “on a per rig basis, we are talking millions not tens of millions of dollars”.

The other possible outcome is a permanent shutdown of deepwater drilling in the Gulf. In such a case, Noble and other contractors in the US GOM would be looking for work elsewhere for its semisubmersibles. Such a scenario will cause the economics of day rates for the Semisubmersibles to be very similar to those in the Jackup segment.  Note that offshore US GOM accounts for 30% of US produced crude oil (Source: EIA special report US GOM fact sheet). As per 2006 MMS Estimated Oil and Gas Reserves in US GOM report, most of the remaining proven reserves are in water depth >1500' (considered as deepwater). Also, offshore drilling activity provides major employment for the surrounding states. Given all the above factors and that the BP oil well is now capped, this draconian outcome seems unlikely. Although difficult to quantify, it seems less than 10% probability for such an outcome.

Frontier Acquisition:
Noble recently bought Frontier Drilling. It was a cash transaction for $2.16B. Noble financed the transaction with a combination of cash on hand, and new long-term debt. Noble estimates total debt to go up to $3 billion (currently at $751 million) and the debt/capital ratio to go up to 28% (currently at 10%). Management thinks it can pay off debt in 3 years if it wants to, and the increase in leverage is very manageable. Earnings and cash flow are expected to be accretive starting 2011.

As per analyst estimates at Morningstar®, the acquisition was done at Frontier’s fleet replacement cost and 5x EBITDA. Frontier was facing debt covenant violations in light of potential loss of earnings from the US GOM force majeure termination of one of its rigs. Noble took advantage of Frontier's distress, by using its strong balance sheet to make this acquisition.

As part of the transaction, Noble has added three dynamically positioned drillships, two conventionally moored drillships, one deepwater semisubmersible rig, and one dynamically position FPSO vessel. All of these are already under contract. Also, Noble netted $2 billion in backlog (which is great given that it only paid $2.16 billion). Since Frontier’s 95% of this backlog is with Shell, it agreed to various agreements for Noble’s existing fleet. In addition to the agreements related to its contracts in US GOM described in an earlier section, Noble signed a 10 year contract with Shell for the Globetrotter, which is due to be delivered in the second half of 2011. As per the contract, day rate for the first five years will be $410,000. During the later five years, day rates will adjust based on market rates for such rigs every six months. Shell also agreed to similar terms for a second ultra-semisubmersible rig to be delivered in 2013.

The combined impact of the Frontier acquisition and the agreements with Shell increases Noble’s backlog to $12.9 billion from $6.9 billion previously, second only to Transocean's backlog. While much of the backlog is scheduled in the second half of the decade, the increase is substantial. Another point to note is that Shell prefers to form a relationship with an established player like Noble at higher day rates rather than a marginalized player with newer rigs and lower day rates. Also, it shows that Shell was willing to commit to deepwater for another decade even as the oil spill accident was playing out.

Valuation:
 

We estimate the earnings power of Noble Corp (excluding accretion to earnings due to the Frontier acquisition) using a worst-case (10% chance), mid-cycle (80%), and peak-cycle (10%) scenario. The details of this estimation are shown in appendix.

Noble traded at a PE ratio of 12-14x in 2006-07. Then, with the onset of the global recession, PE ratio was compressed to 4x. Oil prices recovered but uncertainty remained due to the BP Deepwater Horizon accident, Noble traded at 6x. In the longer-run, Noble ought to trade at 8-12x to reflect the growth characteristics of  deepwater drilling. Shown below is a sensitivity matrix for Noble’s stock price.

In the worst case, the downside risk is 36% from the current price (32.6$ on Aug 13, 2010). In the most likely outcome, the upside is 70% (mid-cycle scenario with a PE ratio of 10x). Note that the above is estimated without taking into account the Frontier acquisition.

Appendix: Noble Corp’s Earnings Power Estimate 

Assumptions used for the estimate:
 

Given the above assumptions, we can estimate the average day rates and utilization for the four segments:

The above give us revenue estimate for each segment under the various scenarios. To estimate earnings power, we need to estimate operating margin for the three scenarios. For peak-cycle, use the highest margin that Noble has achieved in 2007-2009. For mid-cycle, use the average of 2006-2009. For worst-case, use the average of last 10 years. The operating margin in this case is much lower than the mid-cycle scenario, but it models Noble’s costs going up dramatically.

Disclosure: The author has a long position in NE. This is not a recommendation to buy or sell any security. This article is for information purposes only.

Value Investors: The “Cockroaches” of Finance

Why I am talking about cockroaches on a finance blog? I hate cockroaches. They are top in my list of disgusting and obnoxious insects. Despite that, they are the topic of the discussion today because they have admirable risk-management skills, as noted by Richard Bookstaber in his book “A Demon of Our Own Design.”

Cockroaches are ancient insects that have existed very successfully, relatively unchanged, for at least 250 million years. This means that they have inhabited earth 100 times longer than humans and predated the dinosaurs by about 15 million years. They have survived through many unforeseeable changes – extinction of dinosaurs, ice age and other catastrophic climactic changes, and changing predators that have come and gone over the course of its lifetime.

Richard Bookstaber points out that “Its not only remarkable that the cockroach has survived so long, but it has done so with a very basic and somewhat suboptimal mechanism. Its defense mechanism is limited to moving away from slight puffs of air, puffs that might signal an approaching predator. It ignores a wide set of information about the environment – visual and olfactory cues, for example – that one would think an optimal risk management system would take into account. The rule that cockroach obeys is so simple that it depends on its giant fiber nervous system; it is a reaction that does not need to be filtered through the brain, but rather goes directly from the sensory hairs that detect the puff of air to the thoracic ganglia controlling its leg motion.”

He further contrasts the extremely coarse risk management structure of the cockroach with that of the furu, a once-dominant fish in Lake Victoria in the middle of Africa. “The furu is a good example of how a specialized creature can be defeated by unanticipated environmental changes. Lake Victoria is the world’s second largest freshwater lake, size of Ireland, in east-central Africa. Even though it is huge, it is relatively shallow with an irregular coastline  of countless inlets and swampy bays. Living in protected isolation in this vast and varied habitat, the small perch like furu specialized to a remarkable degree, diversifying from a single species over the relatively brief 12000-year life of the lake to at least 300 species, ranging in size from 4 to 12 inches. There are furu that survive as scavengers living off of the organic waste of the lake bottom; algae scrapers that feed off of shoreline rocks; snail crushers that have developed long teeth to pull the snail out before it can fully retract into its protective shell; larvae eaters that sift insect larvae out through mouthfuls of mud; prawn eaters that inhabit the deeper waters where the prawns live; and “child eaters” that eat the newly hatched child of other furu just after they are released from their mother’s mouth, or in some cases by first ramming the mother to dislodge the eggs from her mouth.

For the biologist, the furu of Lake Victoria rival the finches that Darwin studied in the Galapagos Islands. In the summer of 1954, the lure of the lake to the naturalist changed forever by the actions of a Kenyan game fisheries officer with a bucketful of Nile perch.

Unlike the diminutive furu, the Nile perch can weigh upwards of 100 pounds. In the mid 1950s, the fish was introduced to other African lakes with spectacular results: Commercial fish production rose tenfold in just a few years. But these other lakes contained species of fish that had time to adapt to the Nile perch or had habitats where the Nile perch did not tend to go. Neither of these conditions turned out to be the case in Lake Victoria.

In the two decades following the initial stocking of Nile perch in Lake Victoria, naturalists who were following the furu found that they were increasing pulling Nile perch out of their nets. Soon the only place they came across the furu was in the stomachs of the predatory Nile perch. It seems the furu did not know what hit them. Defenseless and apparently clueless to the voracious predator that had been unleashed in their midst, they were rapidly becoming extinct. But their impending extinction was not the result of natural selection based on fitness in the usual sense; they were diverse and suited for almost every conceivable element of the Lake Victoria ecology.There was, however, one component of behavior where this was not so, a component that had not mattered at all in the thousands of years they had inhabited the lake but that made all the difference once the Nile perch was introduced. With the exception of a few of the insect- and snail-eating species, the furu at some point in their life cycle move out of the littoral areas and head for the open waters. Because it is such a large fish, the Nile perch tends to stay in deeper waters, so the furu fish that stay near the shoreline, inlets, and rocks might go their whole lives without running into one. For Lake Victoria, that represents a lot of secure real estate. But the furu had never had any evolutionary need to distinguish between the shallow coastline and the deeper waters. This did not represent a failure of fitness or an inability to adapt to its environment. Its path towards extinction was just a result of the dumb luck that someone had introduced an alien species into its waters.

The cockroach and the furu are two of the many examples in biology that illustrate the benefits of coarse behavior and the perils of fine-tuned behavior in reacting to a broad range of natural uncertainty. The coarse response, although suboptimal for any one environment, is more than satisfactory for a wide range of unforeseeable ones. In contrast, an animal that has well-defined and unvarying niche may follow a specialized rule that depends critically on that animal’s narrow perception of the world. If the world continues on as the animal perceives it – with the same predators,food sources, and landscape – the animal will survive. If the world changes in ways beyond the animal’s experience, the animal will die off. Precision and focus in addressing the known comes at the cost of reduced ability to address the unknown.”

To carry Bookstaber’s biological case study into the capital markets, value investors are the “cockroaches” of the investment world. They eschew leverage, invest only when the price is cheap in securities that have sufficient collateral. Just like the cockroach, their behavior is coarse and suboptimal, especially in rising markets. But, these cockroaches can and will survive through many catastrophic changes.

The furu, on the other hand, is akin to to today’s highly leveraged investor seeking to eradicate risk by fine tuning portfolio using complex math that only a PhD can understand. With risk so theoretically constrained, the “furu” of the investment world use leverage to exploit small market inefficiencies. But, their approach is similar to “picking up dimes in front of steamrollers." Just like the furu, their extinction is assured when an alien predator comes fast and furious in their lake !

Shown above is the rise and fall of the hedge fund Long Term Capital Management (LTCM) from 1994 to 1998.

Portfolio Update: Semi-Annual Report August 31, 2010

In Feb 2010, I liquidated all my holdings since the market had moved up dramatically and the margin-of-safety for the securities in my portfolio then had narrowed. I now intend to track the performance of my portfolio (since Feb 2010) and make it public on a semi-annual basis. However, this performance is not audited (not because I don't want to, but the costs don't justify at this point). Also, leaving such a paper trail is useful to objectively evaluate oneself on a 3-5 year basis. If I don't track it in writing and make it public, there are good chances that I will either not remember the years of poor performance or selectively choose to forget about it. How many things you thought about 3-5 years ago do you remember today in vivid details? To keep this process as honest as possible, I do not have any other trading accounts outside of the one I am tracking. However, I do invest all my family's and my retirement funds (up to the limit allowed as per tax laws) yearly in mutual funds. I am not yet confident of my investing skills to risk my future retirement.

Do note that this is not meant to be viewed as solicitation of any kind. I am not an investment advisor, and do not have any legal authority to advice you or manage your money.  You should seek a professional investment adviser that can guide you based on your risk profile and goals. As usual, this report is not meant to be used as a recommendation to buy or sell any security.

This report is for the period Feb 1, 2010 (inception) to Aug 30, 2010. Here are the top 10 holdings in the portfolio, holdings by sector and performance history:

I have written extensively on a few of the above holdings: Ensco, Viterra, and Edenred. The investment thesis for each of these holdings at the time of the writing in the past continues to hold true.

[Section added on Sept 2, 2010] Winthrop Realty and Leucadia contributed positively to the portfolio with 18.96% and 6.91% respectively. The stocks in the energy sector - Exxon Mobil, Ensco PLC, and Noble Corp - contributed negatively to the portfolio's performance with -2.5%, -3.07% and -5.85% respectively. Accor and Viterra were marginally in the positive category contributing 1.48% and 2.55%. 20% of the portfolio is in cash and it is yielding close to zero. This is very typical of what I expect from the portfolio going forward. A few names that are working out and a few that need time for Mr. Market to catch up on. Also, with 20% cash, it gives the portfolio a chance to be ready to take advantage of any disruptions in the market to add to existing positions at a lower cost or initiate positions in one of the ideas on "deck" (research completed but not met purchase price target).

The investment philosophy for investing in a security is that of buying at a large discount from my evaluation of its intrinsic value and holding it until most of that value can be realized. This is what 'buy-and-hold' investing really means. People often mistake 'buy-and-hold' to mean holding the stock forever which often translates to holding the stock even when it is grossly overvalued. The only time I will sell a security that is cheap is to buy another security that is even cheaper i.e has a better risk/reward characteristic than the current holding or if I realize that the original reason for the investment no longer holds true. Usually, when I buy the security, its near-term outlook is dire at best - there is a good reason why these stocks are cheap. As it applies to the portfolio today, the holdings are cheap because the market at large is worried about unemployment, deflation, uncertainty about deepwater drilling due to the recent BP oil spill, decreased demand in grains around the world, weather uncertainty etc. However, all these factors are already discounted in the price of the holdings and then some. Having said that, I think that the market will take a few years to realize the intrinsic value of the portfolio holdings. I am willing to be patient. This is why value investors get paid - its really a form of arbitrage. Besides, doing so also helps keep the portfolio turnover low, and the tax bill smaller.

Another characteristic of the portfolio is that of being concentrated. Currently, I hold seven stocks invested in three sectors. My portfolio would fail miserably if an asset allocator looked at it. However, there are a few reasons for doing so. I still have a day job that I like and try to put my best in which leaves me limited time to perform high quality in-depth research. It is physically impossible to do so and have more than 10 securities in the portfolio. Studies have shown that a portfolio needs no more than 10-15 securities to get most of the benefits of diversification. If you have 100 stocks in your portfolio (or your mutual funds has that many stocks) then its really just going to mimic the market. In such a case, you are better off just owning an index fund. The downside to having such a high concentrated portfolio is that a single mistake can cause a big dent. I try to minimize this risk by buying stocks that are selling at a discount of 40-50% relative to its intrinsic value, that have very low levels of debt, do not require continuous access to capital markets, and are not reliant on the mercy of rating agencies (lesson I learnt from the mistakes of the investors in AIG during the crisis).

Even though the portfolio has held up well (+5.45% vs -5.85% for S&P500), there are chances that it may under perform the market in the short run. I have no way of predicting what the market will do in the next six months. However, on a long-run, given the portfolio holdings today, I feel pretty good about it. I do not have a target performance goal (because that may cause one to take unnecessary risks without having adequate payoff), I expect the portfolio to return north of 15-20% for each of these holdings.

My next report will be on March 1, 2011.