Automodular Corp – Special situation investment: 25% expected return

Summary

• Special situation uncorrelated with market fluctuation.
• 25-30% upside in 9-12 months via a liquidation scenario.
• Further potential upside in GM litigation.

THESIS

Automodular Corporation (OTCPK:AMZKF) shares are worth C$2.71-$2.86. Market price is $2.15 CAN, a 24.5-30.7% margin of safety to intrinsic value.

(in thousands)

Intrinsic value: $53,690
Market Cap: $41,660
Workout return: $12,030
Return after 15% Canadian Tax: $10,226 (24.5%)

Automodular Corp’s special workout situation offers a chance to earn 25% in one year. The risk-reward scenario is compelling with limited downside and some upside optionality in excess of the 25% expected return. This workout investment is decoupled from equity market fluctuations because value realization depends on the company winding down within the next 9-12 months.

SHORT BACKGROUND

Automodular Corp, based in Canada, is a sequencer and sub-assembler of components installed in vehicles. AM has a contract with Ford (F) ending on December 23, 2014. After that, it will have no further revenue streams and will be in position to disburse to shareholders all remaining assets post liabilities. The company management is shareholder friendly and acts consistently with stated goals of maximizing shareholder value. As of 2013, 22% of shares were held by insiders. A longer discussion of company’s history is irrelevant to this analysis because it will not be a going concern involving future cash flow analysis. Comp valuations are also irrelevant because this is a standalone workout situation.

MARKET DYNAMICS

After GM went through bankruptcy proceedings in 2009, it was able to reduce labor costs from $16B to $5B annually and established a breakeven profitability level at a seasonally adjusted annual rate (SAAR) around 10 million vehicles. The US is currently on pace for SAAR of 16.2 million vehicles. To make GM profitable, unions were forced to take large pay cuts with GM shedding legacy healthcare and pension obligations while instituting competitive Tier I and Tier II price structures on its hourly and salaried workers. GM brought down labor costs to be almost in line with foreign manufacturers such as Toyota, Nissan, and Volkswagen. As the United Auto Workers union (UAW) lost some negotiation leverage with GM because of the bankruptcy, Ford was able to press the union for concessions as well. Consequently, this led GM and Ford to insource many sub assembly functions because they became cost competitive with outsourced firms like Automodular. Unsurprisingly, Ford decided to shift sub-assembly tasks in-house and Automodular was left with no work beyond 2014.

Considering the long lead time (over 12 months) for procuring new business in supply chain contracts involving sub-assembly and sequencing, and the fact that AM doesn’t have any contracts lined up, the most likely scenario is liquidation and return of shareholder assets in excess of liabilities. We are in May 2014 with eight months left until the end of Ford’s contract. Automodular will hold a special meeting on May 8th with a request for voter approval of a $19m equity capital reduction plan. The funds will be reallocated from the capital account into its contributed surplus account maintained for its common shares. Effectively, this is the way the management is starting to wind down the company while considering the tax implications of any funds distribution or share reduction.

VALUATION

Intrinsic value of the Automodular Corp workout incorporates four parts expanded below: adjusted assets, liabilities, new cash in 2014, and finally,valuation. I will not be applying a discount rate to this workout investment because it is going to be resolved in the next 9-12 months and a portion of my fund is set aside for workout situations to diversify from the vagaries of market fluctuations.

Adjusted assets with conservative multiples based on Benjamin Graham’s “Security Analysis” and liabilities can be seen on the balance sheet in table 1.

1. Adjusted assets with appropriate multiples upon liquidation.

a. Net operating losses of $8.2M applicable on profitable operations in the US are off balance sheet and will be completely written off under the assumption the company will not be able to utilize these NOLs.

2. Liabilities will need to be subtracted from adjusted assets to determine true book value.

a. $4.5m of operating lease commitments ranging 1-5 years out are assumed to be cancellable with a minimal 3-month penalty fee (based on my conversation with CEO Christopher Nutt, and company’s annual report). Current $3m of operating leases will be covered by operating expenses.

b. Pension plan securities will most likely convert into an annuity, causing excess costs of $500-$750k based on current discount rates according to Mr. Nutt, but this number is still undetermined.

TABLE 1

Assets					adjusted value	multiple
	cash		35,902		$ 35,902	1
trade and receivables			15,032		$ 12,026	0.8
prepaid expenses			1,719		$ 1,375	0.8
current assets				52,653
deferred income taxes			1088
investment
plant and equipment			4,426		$ 443	0.1
other assets			198
total assets				58,365	$ 49,745
Liabilities
payables & accrued liab			5,738
provisions			8942
income tax payable
current liabilities				14,680
deferred income taxes
provisions (more than 1 yr)			534
other liabilities
total liabilities				15,214	$ 15,214	1
shareholder equity				43,151	$ 34,531	liquidation

I am assuming that ~$3m of trade and receivables will not be realized at the end of the year due to some market disruption or non-payment. This is very conservative because the company may well receive the full amount and the disclosure in AM’s 2013 Annual Report indicates that trade and receivables are carried at fair value. I also wrote down plant and equipment to $443k, effectively realizing pennies on the dollar of original investment. This reduction is consistent with the depreciation schedule. Carrying value of PP&E assets on the balance sheet was aggressively written down by the management to reflect fair value and $33.5m has been depreciated to date. According to Christopher Nutt (CEO), supplier equipment is plentiful in Ontario and Automodular’s PP&E may not be worth much during wind down.

Note that provisions total about $9.5m on the balance sheet and any incremental costs relating to additional expenses running the plant during the contract extension from June to Dec 2014 will be covered by Ford. Technically, if provisions increase beyond $9.5m, every incremental dollar spent will also be allocated to the trade and receivables asset to compensate for that cost increase and the book value should be unaffected.

3. Change in cash position at the end of 2014 resulting from remaining operations.

a. Change in cash adds back dividends to reflect the projected cash generated in 2014, assuming the company keeps the same dividend payout from 2013. The company has not indicated a change in dividends so I’m keeping this number at status quo.

b. Change in cash adds back share repurchases similar to the level of 2013.

2014 Pro forma change in cash position reflects Operating Cash Flows (OCF) minus cash used in investing activities. New cash is not factored into the historical balance sheet numbers taken from the end of 2013. The key takeaway is the assumption that the change in cash will be accretive to shareholders either by flowing directly to the cash on the balance sheet (~$11m), dividends (~$6.7m), or share repurchases (~$1.5m), totaling ~$19m as in 2013. Any iteration of the above cash allocation in 2014 is acceptable as long as the cash generated by operating activities is similar to last year. Automodular is not projected to spend cash on investing activities because the company is not incurring CAPEX this year in anticipation of the wind down. Additionally, the change in cash should be consistent with last year’s production of ~$19m when we add back share repurchases and dividends because the scale/scope of work has not been significantly diminished. The salaried employees and hourly union employees benefit from staying until the end of the contract because they will receive a substantial severance bonus. This bonus is reflected in incremental costs paid by Ford and partly in current provisions of $9.5m. Provisions are a non-cash item that was capitalized (put on the balance sheet) in 2013 and include all exit costs associated with the wind down.

4. VALUATION factors in the adjusted assets, liabilities, change in cash positionat the end of the contract, and the 15% Canadian tax paid on foreign dividend distribution in excess of Paid-up Capital (PUC). A corporation can return PUC to shareholders tax free because it is treated as return of capital instead of dividends. Anything in excess of PUC will be treated as a dividend and will be taxed at 15%. So in the numbers below, I am estimating that the arbitrage amount will be taxed at 15% to arrive at the expected return number.

TABLE 2

CAN DOLLARS	Change in CF
	2014E	2013		2012
Financing activities
div paid	$ 6,712	$ 6,712		$ 8,880
shr repurch	$ 1,506	$ 1,506		$ 348
chng in cash	$ 10,941	$ 10,941		$ 10,185
total
new cash	$ 19,159	$ 19,159		$ 19,413
add:	VALUATION
liquidation val	$ 34,531
intrinsic value	$ 53,690
market cap	$ 41,660
arbitrage amt	$ 12,030
Canadian tax	15%
Expected return	$ 10,226
MOS %	24.5%
US DOLLARS	0.91	(exch rate USD to CAD)
2014 tot CF	$ 17,435
liquidation val	$ 31,424
intrinsic value	$ 48,858
AMZKF mkt cap	$ 37,911
arb amt	$ 10,948
Canadian tax	15%
Expected return	$ 9,306
MOS %	24.5%

Upside optionality

GM LITIGATION – the story is fascinating because Inteva (another supplier) won the business to sub-assemble Chevy Camaro parts from Automodular when General Motors (GM) put it up for bidding in 2010. Inteva, a non-union shop, was going to use a temp agency to fill jobs at $10-$12 per hour. AM, a unionized company, lost the business because it couldn’t compete on costs. The unions in Ontario got wind of what happened and were understandably upset. Inteva ended up hiring the same people that worked for AM, paying similar rates that AM would have paid. Automodular is taking Inteva and GM to court based on improper contract termination by GM and inducement of breach of contract by Inteva. AM is asking for a $25m restitution payout. AM’s contract was active during the first quarter of ’09 and in force until September ’10 when it was severed by GM. GM exited bankruptcy on July 10, 2009, and went public on November 18, 2010. I think AM will have a tough time extracting payment from GM in court because of the cloudy bankruptcy period and the potential New GM protection from Old GM. Perhaps Automodular may receive something in mediation due later this year because the contract was effective during the GM bankruptcy transition and the case isn’t clear cut on either side. If the case goes to court, the process will be dragged out for another year or two, undoubtedly increasing legal fees for all parties concerned. I give this upside optionality a value of $0, but it may be worth something if there is a mediation agreement or a court settlement.

Risks

– The overarching theme of Automodular CEO’s management style is enhancing shareholder value. The CEO stated that if the company does not procure a revenue stream within a reasonable amount of time, it will not sit idly in an attempt to find an inferior business to buy if the best course of action is to return cash to the shareholders. Considering the long lead time to generate a new supply contract, liquidation is the most likely scenario at this point. Obviously, if liquidation doesn’t take place because the company diversifies and buys another business instead of acquiring a new supply contract(s), then a discounted cash flow analysis would apply and the company valuation would increase appropriately. Liquidation is the floor scenario because management will only buy a business with higher intrinsic value than the wind down. However, an unwise acquisition is always a risk.

– Wind down may take longer than the projected time frame 9-12 months out from 5/1/14.

– The pension benefit plan may cost more than the projected $500-$750k to convert to an annuity. Given the current interest rate environment, annuities are more expensive than in higher interest rate times. The past CEO and his wife have a projected horizon of ~25 years.
– Salaried and hourly employees may leave prior to contract expiration at the end of the year and hinder operations causing a reduction in incoming cash this year.

Notes regarding the Defined Pension Benefit Plan

The Defined Pension Benefit Plan for the prior CEO calls for a total obligation of about $4.9m while the assets are $2.9m and liabilities are $2.8m for a total asset on the balance sheet of about $100k. When the company winds down, it will have to sell the securities that are generating payments for the pension and will need to purchase an annuity. That cost will fall between $2.9 and $4.9m and Christopher Nutt thinks it can be around $500-$750k in additional expenses; not material enough to factor in the analysis above.

Catalysts

– Share capital distribution should follow shortly after the Ford contract expiration in Dec 2014, when the company has no further revenue streams.

– $19m capital reduction plan up for vote on May 8th is a strong sign of management’s direction of thought toward winding down the company and returning the funds to the shareholders, consistent with the paid-up capital rules defined in the Canadian Tax Act. This step is orchestrated in line with prudent capital allocation and the desire to reduce taxes during the payout.

– An additional $3m should be released as part of trade/receivables fair value that I reduced to arrive at a really conservative number. If the $3m is released, expected return rises to 30.7% in less than 12 months assuming that change in cash is similar to 2013 and 2012. If the $3m is released and we stay with the target return rate of 25%, then the $3m can provide some cushion for the change in cash or some unexpected charges.

Summary

In this difficult sideways market, investment opportunities offering the most upside are going to include catalysts, dividends, and workout scenarios such as the wind down of Automodular Corporation. If the liquidation does not take place and the company continues as a going concern, it will do so because it received a new supply contract and valuation will be adjusted upwards because of the incremental cash flows. If the company buys another business, it will carry intrinsic value in excess of the wind down scenario. However, given the $19m capital reduction plan and the non-existent CAPEX, Automodular is heading towards a business wind down. Meanwhile, the stock pays a substantial dividend of over 10%. AM sports intrinsic value of $2.71-$2.86 CAN (if we take a multiple of .8 – 1.0 on trade receivables). That’s a margin of safety and expected return of 24.5%-30.7% on the current $2.15 CAN price within 9-12 months.

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JOE’S JEANS – Small Cap Valuation

Investment Thesis: Joe’s Jeans (114m cap on 6/7/2013) may want to model itself after 7forallmankind and True religion (TR), which were bought out by VF Corp and a private equity firm for $773m and $826m respectively. The problem is, the competition affected the upscale denim margins after people noticed the upstarts. Specifically, True Religion had the ability to mint coin in its growth stages, Joe’s, still considered in the growth stage – can not. Buying at half the current price is appealing, but as is, expecting outstanding growth in intrinsic value is for the romantics. Unfortunately, as one of my professors in business school used to say “this is fin-ance, not rom-ance”.

Joe’s Jeans Company depends on sales to wholesale and retail markets. Wholesale market carries significantly more volume than retail sell-through but at lower margins. Company owned retail store sales bring more awareness to the brand, carry potentially more profitability, but also more risk due to operational expenses and inventory management requirements.  The management is focusing on international expansion with an eye for 30% of sales coming from overseas (currently 5%).   Japan is a large potential market, just like it was for True Religion, but Joe’s will need to sign up good agents/distributors in that territory. Europe is also interesting if Joe’s is to follow True Religion’s trajectory (TR). TR has substantial penetration in Germany.

Fastest growing segment of operations is men’s jeans wear. However, I don’t know if there is a cap on this growth considering intense competition from denim makers and limited shelf space in retail outlets.  Joe Dahan controls 17% of shares; he is the chief creative designer. He also received a recent payout above $9m with a non-compete clause until 2016. Seven for All Mankind was partially created by Jeremy Dahan who also formed Citizens of Humanity. Jeremy is not related to Joe, but his interest in two companies demonstrates that Joe may leave Joe’s and start another firm when his non-compete expires.  Overall, executive directors own 25% of the company and have a vested interest in the success of the firm.

Joe’s doesn’t hold a competitive market position in denim, fighting for retail shelf space and maintaining it requires reduction in margins and I’m afraid the high time for premium denim has passed as more competitors entered the market. Though Joe’s management claims their core customer is a very loyal 32 year old female making $140,000 per year and owns 7 pairs of jeans, I think these women are style conscious and would be easily swayed to another brand if it was trending. The exclusive “Else” brand in Macy’s at a $68 price point for young girls is probably not a very profitable endeavor for Joe’s considering it would have to generate substantial volume to reap net benefits compared to higher price point offerings.

Joe’s competitive position is guided by pricing, R&D, product identity and brand awareness. Basically, this means they have no competitive advantage with the wholesale channel. I believe that’s partly why they are wisely building out their own retail store chain.

Sources of working capital include cash from operations, sales of AR at 85% of face value to a factor (CIT), and advances against inventory (50% of face value). Selling AR at 15% discount has a negative impact on the bottom line but assures liquidity as a going concern, and helps with working capital needs.  Note that corporate and other expenses line item includes advertising and general expenses associated with running the operation, including professional fees.  I am not confident if these are all indirect expenses because the proportion of corporate spending to overall sales seems high (16.5m to total 119m revenues).  This has the effect of seemingly increasing margins.

Valuation:

Out of the three valuation models, (sum of parts, DCF projection, and Comps) the DCF and comparable models are applicable. DCF on owner’s earnings is a good metric of intrinsic value.  Currently, the company’s $6m in FCF growing at 10% yields a $1.68 valuation (68 million shares), buying it around $.80c makes sense.  I took 10% growth prospects based on increase in same store sales from the reports.
Comp valuation: Joe’s is worth $110m based on EBITDA multiple of 9x.

Question is: do we value the company on ebitda or sales multiples? If sales, Joez is undervalued based on current price of $116m in the market, sales $119 * 1.8 (TR’s multiple) = 214.2m. If, however, we look at ebitda multiple, its’ value is in line with current market price and it is worth $110m via 9x EBITDA. Joe’s margins are lower than TR across the board, including annual sales growth rates almost half those of True Religion (chart below). Ebitda margin of 10% is really low compared to 20% of TR, same with OI and NI. Additionally, Joe’s can’t grow as fast as TR due to much lower working capital (36.8m) when compared to TR at the same growth stage 5 years ago ($113m in 2008).

TR bal sheet highlights
Assets	$        407
Working Capital	$        259
Equity	$   333.00
no intangibles
JOEZ bal sheet highlights
Assets	$     86.00
Tangible Assets	$     58.20
Working Capital	$     36.80
Equity	$     71.70

TRUE RELIGION BUYOUT
Purchase price		$826	margin	multiple x
sales		$467		1.8	x
gross		$300	64%	2.8	x
EBITDA		$91	20%	9.0	x
OI		$78.12	17%	10.6	x
NI		$      46.02	10%	17.9	x
JOEZ purchase price if based on EBITDA multiple of TR
COMP VALUATION		$110	margin	multiple x
sales		$119		0.9	x
gross		$56	47%	1.9	x
EBITDA		$12	10%	9.0	x
OI		$10.72	9%	10.2	x
NI		$5.57	5%	19.7	x
joe currently sells at		$116	so it’s slightly overvalued

2005							2012
103	139	173	270	311	364	420	467
yoy%	35%	24%	56%	15%	17%	15%	11%	25%	CAGR
Note: True religion didn’t have any intangibles on the balance sheet
		2007					2012
		62.77	69.17	80.12	98.18	95.42	119
			10%	16%	23%	-3%	25%	14%	CAGR
Note: Joe’s has 27.8m of intangibles associated with purchase price goodwill of Joe’s denim brand.

Bottom line:

In my opinion, the company is fairly valued in the market with both the DCF approach and the comparable transaction analysis and there are no catalysts for clear valuation growth. Buy at $.80 for a ~50% margin of safety. Sum of Parts valuation doesn’t apply.

exhibit 1 – JOEZ annual results and how they compare to True Religion.

Annual Results		year 1	year 2	year 3	year 4	year 5
Joez Jeans (start ’08)		$       69.2	$       80.1	$       98.2	$        95.4	$     119.0
	yoy		16%	23%	-3%	25%
True Religion (start ’04)		27.7	102.6	139.0	173.0	270.0
	yoy		271%	36%	24%	56%
Earnings from Operations (afer cogs, sg&a, and depreciation)
Joez Jeans (start ’08)		6.12	8.52	6.02	-0.57	10.72
True Religion (start ’04)		6.8	34.0	40.1	47.1	68.9
Net income
Joez Jeans (start ’08)		4.9	24.52	2.6	-1.37	5.57
True Religion (start ’04)		4.23	19.51	24.44	27.85	44.37
Working Capital
Joez Jeans (start ’08)		15.2	26.1	27.7	27.4	36.8
True Religion (start ’04)		7.0	30.3	58.8	72.8	113.1
Total Assets
Joez Jeans (start ’08)		57.7	79.6	81.5	80.2	86.0
True Religion (start ’04)		13.4	44.2	79.8	113.3	166.5
Stockholder Equity
Joez Jeans (start ’08)		36.1	61.5	64.9	64.8	71.7
True Religion (start ’04)		7.6	31.6	64.2	95.3	142.3
	JOE’s Jeans	2011	2012
revenue wholesale		77.0	95.0
revenue retail		18.5	23.0
	gross profit wholesale	31	40
	gross profit retail	12.0	16.0
	Operating income wholesale	18.0	26.0
	operating margin wholesale	23%	27%
	Operating income retail	(0.7)	1.5
operating margin retail		-4%	7%
	corporate and other expenses	(17.8)	(16.5)
	total operating income	(0.5)	11.0

European Union & banks are married at the hip

European Union & Banks

The banks act as natural intermediaries facilitating the flow of funds in open economies of the Euro zone. Some countries like Belgium have a structural surplus and are thus net exporters and some countries like Netherlands have a deficit, and their banks are net importers. The open market economy in the Euro zone is structured to increase the free flow of funds and credit, efficiently balancing out monetary supply and demand across the union. In principle, this mechanism should prevent net exporters from developing bubbles and net importers from enduring credit crunch periods.[1] Banks like Santander are necessary for the open market economy to function in the Euro Zone. They are effectively too big to fail in the current environment.

The banks are spinning their wheels but they are essential to the Zone

The ECB instituted 2 3-year liquidity operations performed at the end of 2011 for the total amount of over $1.3 trillion. The goal of this action by a lender of last resort was to ensure that the euro banking sector avoided a credit crunch[2]. As a result, the majority of those funds were used on the inter-bank market, with a small minority passed on to the retail sector. Total loans in the European Union equaled $31.85 trillion and in Euro Zone $24.05 trillion. Total assets in EU were $60.3 trillion and in the zone $43.68 trillion. Governments and non-financial corporations are clear net borrowers in the EU-27, while other financial institutions and Insurance Corporations and Pension Funds are net lenders. Households and other Monetary Financial Institutions are about equal on borrowing and lending.[3] Banks preferred to deposit excess liquid funds at other banks’ accounts instead of lending them out in the real economy. Part of this behavior can be attributed to tighter capital requirements, economic turmoil in Europe, and excessive credit risk assessment with low net interest margin, which averaged anywhere between 2-3% for most banks in 2012.

On June 28-29, 2012 European leaders gathered to discuss the possibility of a European Banking Union with a single European Deposit Guarantee Scheme (somewhat like the FDIC insurance), single supervisory authority, and single Crisis Management Framework. The authority power was given to the ECB and the supervisor will be phased in during 2013.

EU-27 generated $277 trillion in non-cash transactions in 2011. Bank account debits, credit card payments, and wire transfers constitute the largest three types of transactions with wire transfers representing 89% of value. A credit crunch in the Euro Economy would have dire consequences for businesses.

Small and Medium Enterprises (SMEs) drive economic growth – 99% of companies in the EU are SMEs. During the economic crisis the demand for products softened, lengthening payment terms from the customers and eroding working capital. This prevented SMEs from making capital investments and forced a slowdown in finance demand, damping growth prospects. 75% of corporate funding in the EU is obtained from the banks, as opposed to 30% in the US; therefore the EU has a bank based capital model. Therefore, larger European banks must survive to avoid systemic collapse. Santander is the largest Euro Zone bank and if it fails, economic consequences will be dire.

There is strong political commitment to the European project. It’s in nobody’s interest to break up. Decision process is slow but countries will do what it takes to keep the project on track. Economic adjustments are now underway. Spain has some of the lowest unit labor costs in the Eurozone, helping its competitiveness:
– Fiscal adjustment (taxes and gov’t spending)
– Competitiveness adjustment
– Demand expansion in Central Europe
– Monetary support (money supply through variety of tools including interest rates, discount window, open market operations, signaling, QE, currency pegs, and reserve requirements)

Spain has the following issues that are being addressed:
1. Loss of competitiveness (almost as competitive per unit of labor as Germany)
2. Current account deficit (improving and will be a surplus in 2013/14)
3. High fiscal deficit
4. Structural rigidities.
5. Need to clean up the banking system’s balance sheet (doing so now, like with Bankia)

Political reforms in Europe include a banking union which will have a single supervisory mechanism with a single deposit guarantee fund. This will cut the link between sovereign risk and banking risk. This is good for Santander because it will put an additional degree of separation between Spain and the bank. Nonetheless, the key for SAN’s success is based on diversification, cost control, liquidity management, and risk monitoring. For Santander, emerging markets will offer significant opportunities in the next decades. The bank is very well positioned in Latin America. Brazil along with Mexico should be in the top 10 economies by 2030 with a combined GDP of 18.8 trillion (12.2t Brazil).

What about bailouts

What causes a bailout? There are two main components to a bailout – governments and the banks. If a government’s sovereign bonds are considered junk, with a very high yield and a possible risk of default, the government may drag down the banks of that country because the banks sold the bonds, requiring a bailout. The banks on the other hand, can also get themselves in trouble through their operations in the residential mortgage space, commercial loans, and other bad transactions causing write-downs and insolvency which require a bailout.

For this purpose, a banking union may be a positive political stabilizer. Santander executives agree. It would be needed for bailout funds, deposit insurance, and euro-wide supervision and it would decouple the governments from the banks. The responsibility for the bailouts would fall on the euro zone as a whole.  However, the debt-sharing potential may be a turnoff for the wealthier countries because it will effectively subsidize the weaker nations. Sovereignty is considered fair and mitigating it is unlikely, considering the various cultural and language differences. The union isn’t similar to the United States of America where people have a common denominator in the language and loyalty to one flag.

Maybe dropping the Euro is the answer

So the question stands, wouldn’t it be easier to just abandon the single currency? Probably not, the political and fiscal union should be maintained somewhere between a fully independent/individual country base in Europe and a completely integrated United States of Europe. Sovereignty and nationalism matter, and people will not give up their identity for the full political and fiscal union. The answer to a successful union lies in the middle and must contain the following:
1) flexible markets with commerce flowing freely across borders,
2) adequate lender-of-last-resort mechanisms for solvent lenders and countries
3) creditors of insolvent banks and governments have to be forced to take haircuts to level out upside with downside.

What happens when one or two large European countries are in deep trouble? How can Spain and Italy be firewalled? The ECB can print money and provide it to Spain and Italy (in form of bond buying), driving down their borrowing costs. Another possibility is increasing the funds available to the zone’s bailout fund headed by Draghi (again ECB would provide the money), but it’s essentially the same thing – the fund is the middle man in the transaction. A third idea is to have the strong countries make direct interest subsidies to the weaker ones in return for reform programs. Sure, Germany’s and other strong countries’ citizens may be appalled at the rescue, siting that Southerners’ demise shouldn’t be an anchor around their own necks. Furthermore, inflation would eventually pick up if money supply is increased, but isn’t it much better for Spain and Italy to weather the storm and become productive European players that would purchase goods from Germany and others? The Euro countries are all in the same boat and the least prudent course of action would be for the healthy passengers to puncture a hole in the boat to teach the sick ones a lesson.

The Greek exit example, it can’t be good

Let’s explore the scenario of a European nation like Greece leaving the Euro. What would happen? First, there are 17 zone members and another 10 countries in the union who use their own currency. If Greece was to think about leaving the Euro, it’d have to discuss it with all the members and probably in its own parliament – a process likely to take months[4]. Of course the reason for leaving would be to devalue its currency and make the economy more competitive. This would mean that people invested in the banks would undoubtedly attempt to withdraw their funds in fear of significant wealth erosion. A stampede would ensue, and since the banks are highly leveraged institutions, potentially only one Euro for every thirty owed could actually be withdrawn (depending on capital ratio). If the people were to leave the money in the bank, they would wake up to a potential purchasing power loss of 50% upon conversion of euros to Drachmas.

If Greece left the Euro, it would decimate its own economy. By switching to the drachma, it will print money and re-price all goods on the market, including unit labor costs to become more in-line with the supply and demand equation. The oscillation, or more likely, a total cliff dive in the currency would not cease until a balance point is discovered. Inflation may balloon out of control and political unrest over undercapitalized banks with high unemployment would consume the country leading to poverty and flagrant crime rate. That would be prime ground for an unconventional government to claim power, and that would not benefit the population.  Greece could then do one of 3 things – allow the banks to collapse, call on Euro partners for help, and limit withdrawals. It can’t allow banks to fail – that would be Armageddon. Euro partners would only help if Greece stayed in the zone and the ECB could let Greece central bank to provide liquidity with Athens on the hook for any losses. Greece could limit withdrawals, but that would cripple the economy because it would ration capital for all businesses and credit – the lifeblood of all enterprises – would slow down to a trickle (Cyprus anyone?).

On the positive note, tourism may pick up thanks to half priced offerings and the economy may rebuild out of the ashes, more competitive than ever. But how would the government finance itself to get there, and what about inflation? Its’ current debt is 183% of GDP and if it devalues drachma it’d go to 366% of GDP. It has a current budget deficit, bringing in less than it spends, even before interest payments. If it defaulted across the board – it’d become a pariah state. It’d have to negotiate an orderly default with the IMF forgiving some but not all debts. It could get some hard currency in return to manage the transition with the promise of reform.

The contagion resulting from the Greek default and Euro exit would cause the savers in Spain, Ireland, Portugal, Italy and other weak countries to run at their banks, take the Euros and put them in stronger places like Germany and Denmark. ECB would have to authorize an unlimited printing spree to subdue the panic. The solution to the madness would have to come from the ECB – uncompromised liquidity as a lender of last resort to countries committed to the zone, orderly exit for specific countries that want to leave the Euro (though so far no one left), and rationing access to savings during that transition (like in Cyprus).

How can the Euro survive?

1. Insolvent entities, government or banks, should have their debts restructured. Creditors will take a hit immediately, but it will stem systemic crisis. In Greece, the bailout took too long and eventually the creditors were spared losses but the IMF and the governments will be left holding the bag when the defaults on debts do occur. About 74% of 274 billion Euro Greek debt is with those entities. Taxpayers will pay. If the restructuring occurred earlier, some banks would have holes in the balance sheets that would need to be filled by further bailouts, but the hits could be absorbed.

Insolvent banks shouldn’t be bailed out. Creditors should take the losses before taxpayers.

1. Liquidity backstops for banks and governments that are solvent. For banks, it’s the ECB, for governments it’s the European Stability Mechanism – bailout fund of the zone. It could potentially borrow from the ECB.

An example here is bank Santander, where most of the Spanish banks took a bailout from the ECB and Santander took 35 Billion Euros. The bank was and is solvent, and returned over 20 Billion so far.

1. Flexibility in the labor markets is necessary.

In conclusion, I think that the European Union and the EURO will survive the current economic recession. Draghi signaled that the ECB will do everything to make that happen. People of different races and languages can coexist in a union if their well-being is tied closely together – as is the case in the Euro Zone. The underlying differences will cause friction, no doubt, but Europe is safer when it’s together. The European banking system will be essential in helping to overcome the prolonged downturn, and Santander is an integral part of the group. It will rise when the sunny days return. In the meantime, the bank’s geographic diversification will serve it well in weathering the storm.

---

[1] Ebf-fbe ff2012.pdf

[2] EBF-FBE.eu statistics 2012 – http://www.ebf-fbe.eu/uploads/FF2012.pdf

[3] European Banking Federation

[4] Eurogeddon – Reuters Breakingviews source

Santander Bank – a little scuttlebutt & different point of view

BANK SANTANDER (Spring 2013)

Santander is safer than you may think.
Here’s an unconventional way of looking at 9 major banks and their earnings in the past 10 years. Based on the following table, Santander seems to be one of the most punished large banks in the world. From 2003-2012, the bank had combined net income of almost $82 billion yet it is currently selling at $72.76 billion. Essentially, the market is saying that Santander’s earning power is not close to the largest US banks or HSBC, whose premiums range from 46% to 154%. In the meantime, Mr. Market tells us SAN deserves an 11% discount on the total net earnings of the last 10 years.

table 1:

I know this is an unorthodox approach to valuation but stay with me. If I saved $100,000 (after taxes) each year from 2003 to 2012, I would have accumulated $1,000,000 in my bank account – let’s not worry about dividends for the argument’s sake. Most banks pay various dividends and I’m trying to compare banks and their premiums. If I then decided to withdraw the full amount to pay for a house, can the bank tell me that my million is only worth $890,000 (-11%) and therefore that’s the amount I can withdraw now? Maybe the bank thinks that the extra $110,000 should stay in the account as a safety net for the upcoming decade where I’m expected to be a net drain on the checking account.

I realize that the market provides feedback in real time and the fundamentals could have deteriorated rapidly for Santander, eroding its business model. Historically, the company may have been excellent, but now it could be a dud. We can imply from Mr. Market’s valuation that Europe and Spain in particular are expected to be a drag on Santander’s ability to generate a decent profit in the next decade. And that 55% of revenues derived from emerging markets (table 2), 13% from UK, and 10% from USA are not sustainable, at least not without higher operating costs or non-performing loan increases.

Table2: SAN operation REGIONS:
Emerging	55%
South America	38%
Mexico	12%
Asia
India
Other	5%
Developed	45%
USA	10%
Spain/Portugal	16%
UK	13%
Italy
Rest of Europe	6%

The average market price premium to 10yr net income of the 9 banks in table 1 is 49%, led by the four large American banks (BAC, C, JPM, WFC) & HSBC, which does 50% of its business in Asia. If Santander was valued at this average 49% premium, it would be worth ~$122b – a 67.58% upside to the current price of ~$72.76B. It’s not all roses however, Santander’s SCRIP dividend – essentially a stock dividend, is dilutive to the shareholders and offers no real value because it’s not paid from retained earnings, but rather is a rights issue to convert to newly minted shares created out of thin air.

market cap	current	avg prem	potential	upside
Santander	$72,760	49%	$      121,931	67.58%

Note that I’m not convinced by Morningstar’s assessment of fair value for Santander because it doesn’t get to the bottom of earnings. It weighs book value ($10 per share) by 3 different multiples: 1.3 – 50% of base case without a crisis, .65 – a 20% probability of a downside scenario with some write-downs, and .5 – 30% case of deeper sovereign debt crisis requiring equity dilution. That model yields a $9 ADR price, a 28% premium to $7 current price.

I am more interested in the profit level of the company over the next 10 years and some questions need to be answered to project earnings potential of Santander in that time period.

1)      Is the Euro going to exist as a currency?

2)      Will Spain be able to recover and grow from what seems to be a perpetual recession? And can Santander decouple its’ brand from Spain if the answer is negative?

3)      Can Europe as a whole grow at an acceptable rate (UK specifically)?

4)      How, if at all, will the banks be restricted and regulated in the future to prevent financial systemic pandemics in the European Union?

5)      Will Brazil & Mexico be able to grow in the next 10 years without increasing risk of non- performing loans?

6)      How can the US contribute to SAN bottom line?

I will split this paper into 2 parts. The 1^st part will cover basic banking and some Santander facts (not much math). The 2^nd part will focus on the macroeconomic environment in Santander’s geographical operations, addressing the questions above.

PART i
Overview of Banking

Banks perform the necessary role of maturity transformation by gathering short term deposits with immediate liquidity for the lender/customer and lending out long term loans with potentially fixed rates to reduce uncertainty for the borrower. The banks then hedge the risks by using various financial market products and transferring this risk to investors.

Banking can be boiled down to interest risk and credit risk management. Interest risk depends on short term vs. long term interest rate imbalances and the yield curve changes, while credit risk measures the ability of borrowers to repay loans. Banks can make money in three ways:

1. income from net interest margin (banks borrow money through bond offerings and deposits, then loan it out. The spread is the conventional income. Banks use leverage to loan out anywhere from $10 to $30 for every $1 in equity.)
2. income from service and banking fees (such as trading transactions, underwriting, investment management fees, bank account fees, credit card transactions, insurance operation, etc.)
3. expenseefficiencies from operations and non-performing loans. Cost to income ratio demonstrates a bank’s operational efficiency, which leads to higher profits. It’s defined as operating expenses/ operating income. Anything under 50% is considered outstanding in the industry as most players fluctuate between 60-80%.

2012	SAN	BBVA	HSBC	LYG	BCS (barklays)	BNPQY (Paribas)	CS	JPM	Citi	BAC
cost/income (efficieny)	46.10%	48.10%	63%	100%	65.80%	64.60%	84.20%	62.00%	65.00%	57.70%

To start, gross income is derived from net interest income (interest income- interest expense) and non-interest income, the first two underlined items above. Then operating expenses such as SG&A and depreciation are deducted leading to net operating income. After that any non-performing loan expenses (NPLs) are subtracted, along with taxes and other expenses arriving at net profits. The two main areas of expenditure are operating expenses and NPL provisions. If a bank is going to be profitable, it must have effective cost-controls and lending practices. A strong brand value enhances the bank’s earning power by signaling confidence to customers, leading to increased deposits.

SANTANDER is the third largest bank in the world in terms of pre-provision profit – 23.56 billion euros (2012). In 2012 the bank’s net earnings were 2.2b euros, 59% lower than in 2011. The bank earns 88% of revenue from Retail banking – traditional loans and services provided to the general public. This means that Santander is less difficult to understand than a bank like Lloyds with its insurance operations and operational complexity. Santander’s profitability depends on interest risk and credit risk analyses, coupled with operational efficiency.

Santander’s Spain risk
A large part of the 59% net profit decrease in 2012 was due to the increased provision of EUR 6.14B for Spanish real estate exposure. According to SAN’s annual report, this provision completes the coverage of all real estate in Spain – the bank reduced real estate exposure net of provisions to EUR 12.5 billion. It sold 33,500 properties belonging to the Santander group. Volume of foreclosed properties decreased by 8% during the year and by 2014, SAN can expect to sell most of the property portfolio. Exposure to property in Spain represents 1.7% of total loan portfolio. This is a manageable risk.

A note about Non Performing Loans (NPL)
According to the International Monetary Fund (IMF), 2011 median non-performing loans (NPLs) were at 6% in EU-27 countries. NPLs before the 2008 crisis in the US were averaging .83%. During the Asian Crisis in late 90’s, the Asian banks had ratios above 12% and European countries had ratios above 8% during that time. SANTANDER’s 2012 NPL ratios in Europe (excluding UK) are consistent with the average ~6%, but Spain is among the worst performers at 9.65%. UK is 2.05% and Latin America is 5.42%. USA weighs in at 2.29% for the total SAN group average of 4.54%. Roughly, if a bank can keep NPLs between 2-4% with prudent operating expense management, it should be able to make a decent profit.

Overall
According to Emilio Botin, the bank has a comfortable debt maturity structure and in 2012 it issued EUR 31 billion in debt worldwide and another EUR 9 billion in Spain. SAN returned EUR 24 billion of liquidity to ECB. The company maintains the strategy goal of publicly listed subsidiary banks worldwide. It publicly placed 25% of Santander Mexico in 2012. The overall goal is to gain market share in loans and deposits. The loan to deposit ratio was 113% in 2012, and 117% in 2011. In 2011 the ratio was around 115% for the EU-27 banks, demonstrating a reduction of lending versus deposit funds in the real economy from 2004 ratio of 127%.

Santander consolidated Banesto and Banif under Santander flag. Strategically, the brand is stronger together rather than a wealthy client option vs. the basic operating branches.  The bank has 14,400 branches and more than 100 million customers worldwide. The branch network is the largest in the world.

Costs

Cost-to-income ratio was 46.1% in 2012. The company assigned more than EUR 61 billion in provisions in last 4 years and core capital increased by 25 billion. Santander’s ROE is cyclically depressed in the past few years at around 9% from 20% in good years. The trend will shift toward 15% in the next few years based on the decreased provisions, margin expansion, and market share gains in emerging markets/mature markets.

The brand value of Santander cannot be underestimated. Banking is a confidence enterprise and in economically distressed regions, a brand name is necessary for a feeling a safe haven. In Spain, Santander is gaining market share from competitors as more people shift deposits to the bank.

 

Risks

–          A drop in the Euro directly affects Santander’s underlying fair value without touching any of its fundamentals.

–           Spanish economic corrosion may have a contagion effect on the Euro and the company. Deteriorating confidence may drive customers to withdraw deposits which will force loan reduction to temper risk.

–          SCRIP issues are not real dividends. A SCRIP issue is a stock dividend with a right to sell the share on the open market and receive cash. It increases the number of shares outstanding without increasing the value of the company, effectively diluting existing shares with no net effect on total company equity. This scrip dividend accomplishes several goals for Santander. First, it placates income investors and shareholders since they “feel” wealthier. And second, it boosts perception of a significant dividend yield, and it doesn’t use net earnings for the payout (like regular cash dividends). Thru inertia, 80% of the shareholders received stock dividends, reducing EPS and diluting equity with no benefit until share price appreciation. 20% of the shareholders curtailed their ownership of the company by choosing to sell scrip shares on the market and receiving cash. The company will pay a .60 euro dividend in 2013. Its’ total shareholder remuneration in 2012 was 6.086 billion euros, 4b more than profit.

End of part 1.

Disclosure: I’m long on Santander at $7.00

Part 2 to come: Is Europe, specifically Spain, killing Santander?

Noble Corp. Valuation Report from my Stanford GSB alphanomics team.

	Spring 2012
	Alphanomics Final Project Denis Teplyakov, Pratik Budhdev, Juan Carlos Toro, Mike Kelley, Mark Williams, Alec Mazo

[Noble Corporation]

Valuation Report

Final Group Project – Detailed Analysis of Noble Corporation (Oil Driller)

Recent Statistics

Recent Price			$29
PE Ratio	27.23
Div Yield	1.7%
EPS 2011		$1.46
EPS 2012 est		$2.76
EPS 2013 est		$4.33
Price/Book				1.00

RECOMMENDATION: BUY
Noble intrinsic value is $49.60 (41% margin of safety to recent price)

As a result of the new-build/repositioning program, Noble’s management projects peak revenues when   all units are online at $7.4B by 2015 in contrast to $3B in 2011.[1] With a 5 year 35% net profit margin average, Noble will make $2.59 billion net (compared to $370m in 2011). Even if the net profit margins are lowered and the peak revenues aren’t realized, a substantial margin of safety is present in this investment. We will elaborate on our valuation approaches after macro, industry and company analyses.

Macroeconomic Analysis

Our interest in the energy sector stems from the belief that the growth in the developing countries will drive long-term fundamentals representing increased demand for energy related products. We feel that the economic downturn has negatively affected the energy industry and that the industry has not yet recovered.  Consequently, our thesis dictates that the energy sector holds promising upside from an investment (long) perspective.

Noble Corp. (Noble) falls in the Oil & Gas Drilling and Exploration industry sub-sector of the Energy sector. The contract drilling rig industry is estimated to have a total of 117,000 jobs in 2012 and anticipate over 11,000 new jobs will be created due to growth in offshore driller demand. Jackups host up to 161 workers per rig and floaters host up to 228 workers per rig. Combined average direct employment is 189 workers per rig. [2]

This portion of the energy sector tracks closely with the very cyclical (as well as seasonal) crude oil price. Hence, we examined numerous macroeconomic influences on the prices of crude oil. The various factors affecting the oil prices (and therefore subsequent oil and gas drilling and exploration industry) can be categorized as the following: health of the world financial markets, geopolitical externalities, supply-side shocks, and Acts of God.

Financial Markets

Very few industries escaped the grip of the Great Recession – the energy sector was no exception. Oil prices have seen dramatic shifts over the past five years [Exhibit 1]. Since the sub segments of the energy industry track oil prices, it has been a difficult time for this capital-intensive industry.  Although the prices have continued to be erratic, the general trend has been upward. Consequently, Noble and its peers have been investing in preparation for the anticipated demand [Exhibit 2].

Geopolitical Externalities

World-wide conflicts and civil unrest continue have provided idiosyncratic shocks to the energy market for decades resulting in wide swings in pricing [Exhibit 3][3]. The oil exploration and drilling industry is particularly sensitive to the middle band of crude oil pricing. As oil prices decline in this very cyclic industry, investment in exploration follow suit. Likewise, as oil prices exceed perceptive limits, investment is again squelched due to externalities imposed by governments such as tariffs and subsidies for alternative energy sources.

Supply-Side Shocks

The BP oil disaster in the Gulf of Mexico (and the subsequent moratorium on drilling in the gulf) is a stark reminder of the risk associated with this industry. Noble filed the first lawsuit (breach of contract against Marathon Oil) after the BP disaster. This lawsuit was settled out of court one week ago – terms of the settlement have not been disclosed.

In contrast, discoveries of new oil and gas fields[4] and mechanisms for extracting oil and gas from previously unknown sources provide positive (and negative) shocks to the economics of Noble’s business – sub salt fields and fracking, respectively.

Acts of God

Despite the worldwide inclination to move away from fossil fuels, events such as the earthquake, tsunami and subsequent nuclear disaster in Japan have redirected worldwide emphasis back to traditional fossil fuel energy sources.

Industry Analysis

“The first part of any oil and gas field operations is a lease sale by the controlling government.”[5] Once a lease sale has been negotiated, a survey operator is brought in to find the best drilling prospect areas. After that, floating rigs, jackups, drillships, or semi-submersibles are brought in to start drilling test wells. These units require servicing due to their constant use and support vessels often arrive on location before positioning of the rigs. Since macroeconomic factors and oil prices influence the amount of exploratory drilling and rig contracting, this industry is very cyclical. The decision process and physical activity of rig positioning to start/stop develops over a few months with a pipeline of contract visibility of a few years. Oil companies are reluctant to renege on contractual commitments because they are often tied to stiff penalty payments. Therefore, a good way to analyze the industry direction includes questions around stability of oil prices, rig utilization trends, and capacity expansion. Offshore rigs in use are projected to grow by 10% from 2011. All other factors being equal, as long as capacity doesn’t expand by more than 10%, day rates should increase as a result of supply and demand. There are 560 rigs under contract in 2012.  Supporting reference material can be found in the Appendices.

Oil prices fluctuated from $140 per barrel (WTI) in 2008 to $40 per barrel in the same year, and have moved between $70 and $115 per barrel in the last three and a half years, currently trading at $86. If the trend persists and oil prices stay around $100 per barrel, we can assume that offshore drilling utilization will be high. Global offshore rigs under contract have been growing steadily (graph above). Offshore oil has more plentiful reserves and is usually easier/cheaper to process and refine than on-shore product (though recent controversial developments in fracking show that oil in Bakken Shale can be produced at $10/bbl).[6]

Worldwide Offshore Rig Utilization is improving. Drillships and Semisubmersibles are enjoying around 88% utilization compared to Jackups 82%.[7]

Month	Drillships			Jackups			Semisubs
May 2012	69	78	88.5%	311	379	82.1%	162	185	87.6%
April 2012	66	78	84.6%	305	377	80.9%	162	185	87.6%
March 2012	61	76	80.3%	303	378	80.2%	161	185	87.0%
February 2012	58	74	78.4%	303	377	80.4%	154	182	84.6%
January 2012	57	74	77.0%	307	376	81.6%	155	181	85.6%
December 2011	59	72	81.9%	313	377	83.0%	156	180	86.7%

Offshore industry capacity is expanding and rig replacement rates do not compensate for additional units. Advanced shallow water drilling activity in addition to deep-water drilling is expected to rise. As a result, more sophisticated units are entering the market. There are approximately 93 offshore rigs (52 jackups and 41 floaters) under construction to be delivered between July 2012 and January 2018. There are also options on additional 50 rigs (40% floaters and 60% jackups). Total supply could increase by 150 rigs in the next 5 years. It looks like demand is closely correlated with supply where capacity expansion is expected to grow by 54 rigs in 2012, 26 rigs in 2013 and may even out at 25 per year until 2016.

There are three water depth drilling segments: Midwater (1,000 – 3,400 feet), Deepwater (4,600 – 7,500 feet) and Ultra-deepwater (above 7,500 feet).

Jackups
The Jackup drilling industry can be evaluated by marketed utilization and total supply of the rigs [Exhibit 4]. The industry identifies two age types of jackups, those built before year 2000 and those after 2000. Jackups operate in shallow water environments (under 500 feet). Unsurprisingly, utilization and day rates are higher for newer rigs in harsher environments; therefore the drilling contractors often find themselves building new units in addition to rebuilding old units. The drilling rig industry is capital intensive and depreciation is a substantial line item on the income statements. New jackups have 94% market utilization and supply grew from 40 units in 2008 to 130 in 2012. Old rigs total supply dropped from 370 in ’08 to 340 in ’12 with 89% utilization. This trend demonstrates drilling industry growth, new rig preference, and old unit replacement [Exhibit 5]. Old units are often cold-stacked at shipyards, transferred to independent operators who may convert them to sleeping or storage units, or sold as scrap metal.

Semisubmersibles
Semi-submersible rigs are rated by generation from 1 – 6, with 6 being the latest models that command premium day-rates above $500k. On average, a rig supports 184 jobs. Generation 2 rigs built in late 70’s are either cold-stacked or working at low day-rates (around $200k). Generation 4 rigs command day-rates between $270k and $410k depending on harshness of their environment. Generation and location of the rigs explain the day-rate discrepancies between many drillers. Seadrill commands the most modern fleet with Generation 6 rigs (and a few 5s). Noble rig generation average score is 4. In addition to geography and price, political environment also plays a role in what kind of equipment is deployed in the area. For example Gulf of Mexico operators prefer the highest spec, generation 6 rigs due to the political pressure arising from the 2010 accident.

Drillships

Costing around $600 million per unit, drillships are some of the most substantial investments in the offshore drilling market. However, these units command the highest day-rates and often work in ultra-deepwater, harsh environments. As recently as 2010, the overall order mix was 65 drillships and 17 semisubmersibles [Exhibit 6]. E&P companies display a preference toward these units even at a higher day-rate expense.

Company Analysis

Noble is a well-diversified contract driller with client demand ranging from Major Oil companies (19%) and NOCs (27%), to Independent companies (54%). Noble drills 89% exploration wells and 11% development wells. Noble has an immaculate safety record, which could be used to leverage client acquisition in the increasingly complex offshore well environment. The company elaborates on its core fleet strategy where premium, modern and versatile rigs are in demand. It plans to subtract any non-core assets.

Market Overview
Saudi Arabia & Qatar constitute Noble’s largest market – 15 Noble jackup rigs are working in that area. Mexico has 12 Noble rigs. The Gulf of Mexico has 6 semi subs, 3 drill ships and 2 submersibles in the area. The company is focused on the high-grade market with only the best equipment working in the field. Africa is a key market for Noble newbuilds and a great area for expansion once the barriers of entry are overcome. The costs of operation in Africa are high. Noble is also well-positioned for the North Sea exploration where it is the largest jackup player and price leader in the standard segment.

Management Thoughts & General Projections

Noble’s management team believes that the current fundamental backdrop allows for long-term visibility and opportunities for premium units including floaters and jackups. Therefore the company is going through a transformation by changing its capital structure and investing in new-build assets, looking to shed older ones.

Noble will soon add $1B in revenues with the current slate of newbuilds – 6 new jackups and 5 new drillships (fully realized starting 2014) [Exhibit 7]. Jackups will command $230k day rates that will add $60m per year at 72% utilization (from 2011), $67m at 80% (from 2010/2009) utilization, and $75.5m at 90% utilization.[8] That’s $402m annual added revenues if we take 6 jackups operating at $230k day-rates and 80% utilization. Drillships currently command $410 day-rates and therefore can bring in $108m, $119m, or $135m at utilizations of 72%, 80%, or 90%. Taking the average 80% utilization we assume that Noble will receive another $539m annual revenue stream from 5 new drillships. To summarize: a new drillship can add from $108m-$135m per year + 15% performance bonus. A new Jackup (JU-3000N type, 6 ordered) can contribute $60m-$75.5m per year + 15% performance bonus.[9]

	Drillship
Time to build	36 Months
Cost	$650,000,000
Assumed day-rate	$550,000
Cost per day	$175,000
EBITDA per day	$375,000
Annual EBITDA	$130,031,250
Assume utilization	95% (new units)

Noble management is more optimistic than our team on some revenue projections. They believe that utilization for newbuilds will be 95% and that day-rates will be between $500k and $600k for 3 new drillships, and between $180 and $250k for 5 new jackups. Of course this assumption is taken into account on un-contracted units and is additive to the current $837m revenue stream from 5 recently built and operating ships and 1 jackup.[10] The management also projects a peak day-rate revenue case when all units are online – $7.4B in total annual revenues, as opposed to $3B in 2011.

Noble spends an average of $3m per rig every year for maintenance.[11] Some concerns arise from increased COGS over the years (from 32% to 55% 2008-2012). This may be a result of increased safety procedures and regulatory oversight. The submersible rigs could control premium rates of above $300k per day (over $100m each in revenues per year but are currently not working). These units should go back to work sometime in the future.

The company is open to selling older jack-ups (built in 1980’s). These jackups, when retrofitted, can command rates of about $80-90k per day and can bring in $20-$35m per year. That said, most oil companies prefer to lease newer builds and many drilling contractors are expanding their capacity with newbuilds in the pipeline. Noble has 5 drill-ships and 6 jackups in the build pipeline to be delivered from 2012-2014. Therefore the older jack-ups may be difficult to sell.

Actions Noble has taken so far:
– Strategy evaluation with fleet divestiture options
– Alliance with Shell
Noble has 10 units with Shell. That’s 15% out of 68 operating units.

Debt Strategy
Noble is an asset-based company that is dependent on the quality/age of its operating units. It changed the capital structure strategy after BP’s & Transocean’s Gulf of Mexico disaster when the prices for newbuilds and distressed drilling contractors dropped substantially. The management saw an opportunity to build new rigs and upgrade its current fleet by acquiring “Frontier” drilling rigs at a deep discount to intrinsic value. The company didn’t carry more than $750m in debt prior to 2010[12], and therefore was in prime position to take advantage of the downturn resulting from the spill. It increased its borrowing capacity under the revolving debt facility. The average borrowing cost is 5.06% for the total debt of $4.3B and the senior note maturities are evenly spread across time.[13]

The company expects to allocate substantial capital expenditures to new rigs before 2014, after which it is aiming to reduce its debt/total capital ratio to 33%. The current ratio is 35%, off the 10% low in 2009. While Noble has mostly operated with minimal leverage, 35% debt/total capital is within industry norms. Since 2011, Noble increased its debt to $4.3B but for comparison sake we show 2011 numbers for 5 competitors. As demonstrated below, Noble’s debt/market cap ratio is normal in the industry.

as of mar/2011	NE	DO	RIG	SDRL	ESV
Gross debt	3168	1496	11241	9591	4577
net debt/mkt cap	27%	5%	34%	57%	31%

Noble Corporation SWOT Analysis[14]

Strengths:

Large Fleet:

Noble Corp. has the world’s third-largest offshore drilling fleet, with 79 offshore rigs, including 11 newbuilds located across the world. The company drilling fleet is composed of the following types of units: semisubmersibles, drillships, jackups and submersibles. Such strong fleet enables the company to renew its existing contracts and also obtain new contracts. Several of Noble’s peers have better fleets based on average age, water depth and hook-load, but Noble new build program and planned divestitures should slowly improve its overall fleet profile through 2014 (in 2014 over 40% of the company’s floating fleet will be less than 10 years old and will provide its customers with some of the most modern and capable units in the industry).

 

Diversified Presence

The Company operates mainly in the US Gulf Coast, the Middle East and the North Sea regions as well as Brazil, Mexico, Gulf of Mexico, West Africa and India. Noble has approximately 87% of its fleet deployed in international markets, and a majority of revenue generated from its international operations. Also, in 2011, the Company successfully moved into several new offshore regions as a way to diversify its operations geographically. For example, recently Noble opened an office in Anchorage, Alaska to support its client with their planned Arctic drilling program. Thus, the diversified presence of the company offers it a competitive advantage over the non-diversified peers.

Weaknesses:

Major Dependence on Key Customers

The company substantially depends on key customers. Noble derives significant amount of revenue from several customers, which include Shell, Petrobras, and Pemex. Those companies represented approximately 63%, 20% and 5% respectively, of Noble’s backlog at the end of 2011 and revenues from Shell, Petrobras and Pemex accounted for approximately 24%, 18% and 15% of total operating revenue for 2011. This concentration of customers’ increases the risks associated with any possible termination or nonperformance of contracts. If any of these customers were to terminate or fail to perform their obligations under their contracts and the company was not able to find other customers for the affected drilling units promptly, financial condition and results of operations could be materially adversely affected. One of the ways Noble mitigated this weakness in creating a joint venture with Shell on some of the new builds – aligning incentives for both parties.

Poor Financial Performance

Noble exhibited weak financial performance during the fiscal year ended 2011. In 2011, the company reported revenues $2.616 B., as compared to $2.730 B. in 2010 (decrease 4.2%) and $3.542 B in 2009 (decrease 26%). The company’s compound annual growth rate for revenue was 7.52% during 2006-2010. This was below the Energy Equipment & Services sector average of 23.24%. The company’s underperformance could be attributed to a weak competitive position, inferior products and services offering, or lack of innovative products and services. In addition, its net profit also declined to $364 million during the fiscal year 2011, a decrease of 53% from 2010. The company’s return on equity, assets and capital employed reduced significantly to 4.7% (11%-2010), 2.4% (5.8%-2010), and 2.6% (6.5%-2010) respectively. This indicates that the company is generating low returns for its shareholders. Additionally, the company’s free cash flow is at risk given that Noble currently has eight newbuilds under construction.

Opportunities

Enhancing of the Fleet

In 2011, Noble continued its strategy to add rigs with the latest technology, equipment, and capabilities. The company-completed construction on the Noble Dave Beard and the Noble Jim Day, dynamically positioned ultra-deepwater semisubmersibles. Also Noble announced that it would construct two high-specification heavy-duty, harsh environment jack-up rigs, both of which are scheduled to be delivered during 2013. Also, in January 2011 the company signed a contract for the construction of two additional new-build drillships at Hyundai Heavy Industry (HHI), increasing the number of floating drilling units in its fleet to 26. This fleet enhancement enables the company to increase its customer base and provides growth opportunities.

Strategic Acquisition of Frontier Holdings Limited

In 2010, Noble, completed the acquisition of FDR Holdings Limited (Frontier). Frontier is an independent drilling company and the acquisition enabled Noble to increase its fleet size from 62 to 69 units, with the addition of three dynamically positioned drillships), two conventionally moored drillships, including one which is Arctic-class, and a conventionally moored deepwater semisubmersible drilling rig. Besides, this acquisition enables the company to own and operate a dynamically positioned floating production, storage, offloading vessel (FPSO). Thus, the acquisition of the Frontier strategically expanded and enhanced Noble’s global fleet. Frontier’s acquisition strengthened the company’s capabilities and broadened its global footprint, doubled backlog, and positioned the company to deliver even greater value both to shareholders and customers.

Improving E&P Investments

Noble stands to benefit from the growth in E&P expenditure as it is engaged in providing oilfield services to the upstream energy companies. Investment in upstream oil and gas sector is expected to go up in 2012-2013. In addition, new oil and gas developments will focus on new well sources in the near future. Capital expenditures by oil and gas companies grew by 15% in 2011.

Threats

Stricter Regulation for Deep Offshore Drilling

The US Gulf of Mexico oil spill is expected to have a major impact on the future oil and gas policy of the US. In May 2010, the US government unveiled new legislation to the federal government to collect significant damages from the companies responsible for oil spills. The bill includes raising the tax that companies pay for producing oil in the US by 1%. The legislation would change the cap on damages the government can collect from the oil companies from its current level of $75m to about $10 billion. The spill is expected to lead to stricter environmental rules and standards for deep water offshore drilling. In addition to hurting the future prospects for drilling in Alaska, the spill has also caused some worries for a large number of planned projects in the GOM. The leak will make regulations stricter for the other projects in the GOM and may ultimately lead to an increase in the overall cost of the projects.

Foreign Currency Risks

Noble has operations in approximately 16 countries, which make its vulnerable to risks associated with foreign exchange. Its functional currency is principally the US Dollar. The company incurs a portion of expenses in local currencies, outside the US. Thus the asset values, earnings and cash flow are influenced by the fluctuating foreign exchange rates in relation to the US dollar. Fluctuations in currency would negatively impact the overall financial health of the company. For example, North Sea and Brazil operations have a significant amount of their cash operating expenses payable in local currencies. To limit the potential risk of currency fluctuations, the company typically maintains short-term forward contracts settling monthly. The forward contract settlements in 2012 represent approximately 23 percent of these forecasted local currency requirements.

US Energy Policy

The US energy policy highlights a considerable shift from the fossil fuel driven economy to an economy fuelled by renewable energy. The key measures include elimination of tax breaks such as the intangible drilling and development costs, percentage depletion and manufacturing deduction. By 2019, these measures will increase the expenses of US oil and gas companies to approximately $31 billion, according to some analysts.

Oversupply of Rigs

During periods of inflated commodity prices, the offshore drilling industry increased the rig supply by ordering new units. This could result in a future supply/demand imbalance, particularly for jackups.

Demand fluctuation

Demand for the company’s drilling services generally depends on a variety of economic and political factors, including worldwide demand for oil and gas, oil and gas production levels, commodity prices, and the policies of various governments regarding exploration and development of their oil and gas reserves. Demand for the company’s services is also a function of the worldwide supply of mobile offshore drilling units.

Noble Corporation Porter’s Five Forces Analysis[15]

Threat of new entrants (Low)

The presence of powerful players in the industry acts as a significant barrier to entry and the need for substantial initial investment to set up facilities such as drilling rigs also reduces the threat of new entrants. The industry players are also subject to various regulations, covering taxation, energy and the environment; compliance with these is restrictive to entry into the sector. Regulations increase the costs attributable to sector players and act as a further barrier to entry. The oil drilling industry requires highly specialized workers to operate the machinery.  Since the equipment is so expensive and the labor is costly, any newcomers to the industry would have to be well capitalized. Overall, there is low threat posed by new entrants to market.

Threat of substitute products or services (Low)

At present, there are no direct substitutes for drilling especially where substantial depths must be reached. To access natural gas and oil resources located under the ocean, use of drilling rigs is necessary. When demand for oil is high, oil companies may find it economical to exploit oil shales, which require strip-mining techniques rather than conventional drilling. Currently, the majority of the world’s energy production takes place with the use of non-renewable sources (oil, gas and coal). However, in order to fight climate change, it is widely accepted that it will be necessary to shift to renewable energy sources, and oil companies may begin to diversify into these areas, reducing their demand for drilling services. The threat from substitutes in this market is considered to be low.

 

Bargaining power of buyers (Moderate)

The balance of power is shifting toward buyers. The Buyers in this industry include global energy firms, national petroleum companies and independent operators. In general, such corporations are large, and this affords them greater bargaining power within the market.

Since oil is a commodity, the buyers can go with the company that will drill for the lowest contracted day rate.  However, there are only a limited number of drillers with the capability to drill at extreme depths, so the buyers have to go with one of them. Also, while there are a significant number of oil companies looking for contract drillers, most contract-drilling firms attempt to maintain long-term relationships with their customers in order keep contract backlog high and avoid costly downtime.  This gives the customers a moderate degree of bargaining power when setting day rates. Brand loyalty is not of significant meaning within this sector and buyers are prone to switch to providers with the better offer. However, to assure timely supplies, contracts may be held, boosting the switching costs for buyers. Overall buyer power is moderate; it ebbs and flows, getting stronger when a large number of drill rigs are available and weaker when the supply of rigs is constrained.

 

Bargaining power of suppliers (Weak)

Suppliers to the offshore drilling industry include oil field services companies.  These companies provide participants with supplies and expertise during drilling operations.  Also, suppliers to the market are quite varied and depend on the specific structure of the equipment. Where offshore units are considered, food and general supplies are also necessary to facilitate staff operations on such rigs. The rig builders have more bargaining power when the price of oil is high and there is increased drilling activity, and thus increased demand for drilling platforms.  When the price of oil is low, there is not a lot of demand for rigs, so the builders have little power. Overall, supplier power is considered to be weak.

 

Intensity of competitive rivalry (High)

Although the contract offshore drilling offers some variation in the services and equipment on offer, there is essentially little to distinguish between the overall services offered by players. Substantial fixed costs and the high exit barriers, created by the need for sector-specific equipment. Therefore, companies want to stay in the industry. Rivalry is further increased by the current steep decline in the sector. Overall, there is a strong degree of rivalry among players.

Competitors

Diamond Offshore

According to Morningstar, DO has one of the least competitive fleets because of the current asset manager like business management structure. The company didn’t look too far ahead and refused to spend money on expensive newbuilds in 2010. It has since acquired a few rigs from distressed sellers and ordered three more new builds. DO has 41 rigs and has been slow to upgrade the older fleet due to fear of low capital returns.[16] The company uses debt to build rigs, and may be limited by its balance sheet strength when considering new purchases. Diamond has been paying out special dividends when wiser use of those funds could have been on capital expenditures in the current offshore market uptick.
Management is squeezing every last drop of value from the ancient fleet and was able to lock in long-term contracts for most of its rigs (until 2016). However, beyond 2016, newer rigs will likely out compete DO for new high value contracts and Diamond will face severe problems with profitability. DO is selling at 1.8 P/tan B. Perhaps the lack of future investor wealth creation is the reason that DO is valued at 5.2 EV/EBITDA ratio (the lowest of its peers).

Transocean
Transocean is the dominant player in the offshore contract drilling industry, controlling 18% of existing global fleet and 26% of the deepwater rigs. It has 54 deepwater rigs and 33 jackups under contract. Transocean’s industry reputation has not been good: In 2008 and 2009, surveys ranked Transocean as last among deep-water drillers for “job quality” and as next to last in “overall satisfaction.”[17] In addition to the 2010 Macondo disaster, Transocean suffered another setback in late 2011 with a large spill in Brazil. Brazil is suing Chevron and Transocean for $11 billion. The company wrote off goodwill by almost $5.23 billion in 4^th quarter of 2011 reducing its intangible asset ratio from 22% to 9% (it still has $3.1b in goodwill on the balance sheet). This write-down is probably admission that the company overpaid for GlobalSantaFe in 2007, buying it for $18 billion. Transocean also had a 9%+ stock equity dilution in Dec, 2011, offering 29.9 million shares at $40.50/share.

Ensco
ESV bought out Pride International for $7.2 billion in cash and shares. This move allowed Ensco to diversify from exposure to US Gulf of Mexico and it now becomes a deep-water focused company. ESV has 49 jackups, 27 floaters, 3 managed rigs and 1 barge, totaling 76 units. Like Noble, Ensco’s strategy is geared toward the ultra-deepwater and premium jackups segments. The company divested non-core assets over the last several years. In 2012, the company is expected to spend $1.83 billion in Capex with $1.2 billion attributed to newbuilds.[18] ESV is selling at 1.3 P/ tan Book and may be an interesting investment opportunity along with Noble.

Seadrill
Seadrill has an unusual tendency to pay out a large portion of its earnings to shareholders, maybe because the founder, John Fredriksen, holds 1/3 of the company’s stock. The management is very aggressive and the company is leveraged more than its peers, which may cause problems in a cyclical industry downturn. It has interests in associated companies that often drive quarterly results (like in 4Q11 – 482M loss). Additionally, Seadrill is involved in derivative contracts (3Q11 330m loss). Seadrill holds interest in 4 smaller companies (oil & drilling) and operates tender rigs which are not part of other companies’ portfolios. The company has newest rigs in the industry and the market places extra value on these assets with a 3 p/b ratio, compared to Noble’s 1.3. 3 time book value is probably overvalued for capital-intensive, low-moat companies that don’t have the benefit of brands and trademarks (like Pepsi).

Financial Analysis & Valuation

Noble Corp Projections:

Financial Ratios Valuation – Current Year

Gross income % – NE has the 3^rd lowest gross margin (7.1% below average of comparables) in the comparables group.  This could be a result of the age of the fleet; older equipment has lower day-rates than newer equipment.  NE’s current effort to renew the fleet should have a positive impact on the gross margin.

Net income % – NE’s net income margin is 7.1% above industry average.  The industry NI% is negatively affected by large negative NI% for Transocean and Hercules Offshore.  NE’s net income margin is ranked 7/12 among all companies in the comparables.

ROTC/ROE/ROA – NE is approximately at the mean based on profitability measures compared to industry comps.

DSO/DPO – NE’s collection of receivables is 2.3 days faster than comparables’ average and settlement of payables is 5.0 days longer than comparables’ average.  This indicates that NE is managing working capital effectively.

 

Trading Multiples Valuation Method

The trading multiples indicate a range from $21.10 to $33.70.  Nobles P/E Multiple indicates a share price approximately aligned with current share values.  EV/SALES ratio of 4.52x appears slightly high compared to the peer average of 3.57x.  Similarly, EV/EBITDA of 10.81x is also slightly high compared to peer average of 8.52.  Obviously, this valuation method is highly influenced by the performance of the overall sector. In comparison to previous cycles, the majority of the exploration and drilling industry companies appear to be undervalued at this time.

Graham Formula Valuation

The company lends itself to an asset based Benjamin Graham valuation. Graham model yields a $69.69 intrinsic value. Current margin of safety is 56% if the company can grow its EPS at 10%. We would prefer a 66% MOS where Noble would need to drop to $23.69 for a safe buy, but at current price $30.59 it is a compelling case as well.

–

DCF of Owner’s Earnings and Free Cash Flow

According to a discounted cash flow model with a discount rate of 9.5%, we believe Noble Corporation can be valued at $13.31 billion. This is equivalent to $52.73 per share, 71% higher than the current price.

RIM Valuation

Rim valuation points to an intrinsic value of $55.45 (current price is $30.59) with an 12.6% long term growth rate projected by analysts on Yahoo finance. Discount rate used is 9.50% and is consistent with the industry. ROE projection is 13%, much lower than the actual 5 year average of 19.2%.

Revenue Projections

 

Revenues by unit type:

Globally, players are building capacity even without contracts and so is Noble. This would create a glut in the market putting a downward pressure on the day rates going forward if worldwide demand softens.

• Semi-Submersibles: We expect the utilization levels to improve and reach 95% levels in these three years with the potential increase in Shell and Petrobras’s off take. We expect day rates to improve in 2012, 2013 and 2014 driven the by strong backlog to be filled by Noble and subsequent pricing power with increased utilization levels. We expect the semis to fetch over $ 600k per day rates at the higher end in these 3 years.

 

• Drill Ships: With the increasing demand across the globe and improving oil price scenario, we expect drill ships to command higher day rates for new builds (over $500K) leading to increase in average day rates. We also believe that new builds will be put to work quickly given the contracts in place and expect average utilization to increase to 92% in 2015.

• Jack Ups: Substantially all jack ups are internationally located in places such as West Africa, Korea, Mexico, UK, Saudi Arabia, and India. The international commodity jackup market is improving modestly after a sustained period of malaise. However, dayrate upside will likely be challenged by an onslaught of coming newbuilds (84 deliveries over the coming three years, 3/4th of which are un-contracted). These premium and high-spec jackup deliveries coupled with contract roll- offs may force some standard jackups to work down-market. In turn, the premium and high-specification jackup market continues to tighten and new dayrates are being set. We have assumed that utilization will increase (penetrate) from 79% to 95% in 4 years (2015) with a gradual increase in day rates driven by world demand.

Operating Costs / COGS

The addition of 5 drill ships and 6 jackups to the fleet will result in an increase of operating costs. As observed in previous cycle upswings, we expect the drilling industry to experience higher demand and shortage of high quality personnel for the next three years. This environment will probably drive operating costs higher since there will be a need for hiring, retaining and training personnel.  We expect the increase on costs to peak at 62% of revenues in 2013 from a current 58.9%, scaling down again until reaching current levels in 2015. From 2015 onwards Capital Expenditures should drop considerably since there are no planned additions to the fleet. The forecast of operating costs is consistent with the construction and delivery schedule of new drill ships and jackups already in the pipeline.

The following is our operating cost forecast (in $ millions)

	Dec 31, 2012	Dec 31, 2013	Dec 31, 2014	Dec 31, 2015
Operating expenses	2,045	2,532	2,845	3,280

 

Selling, general and administrative expenses

Overall selling, general and administrative expenses have been stable and consistent throughout the years and we do not expect them to change significantly as percentage of revenues, staying at 3% of revenues for at least the next four years. The following is the forecasted SG&A (in $ million):

	Dec 31, 2012	Dec 31, 2013	Dec 31, 2014	Dec 31, 2015
SG & A expenses	115	135	160	184

Valuation

We have used the following approaches to arrive at price per share for the company and assigned weights to the value per share arrived in each of these methods

• 5 year Residual Income Method: 25% weight
• Discounted Cash Flow Valuation Method: 50% weight
• Comparable companies Valuation Method: 15% weight
• Average Analyst 1 year target: 10% weight (given the lowest weight as we believe sell side analysts are biased in their view to some extent)

Recommended Share Price: $49.60 (Upside of 62% from current price)

Premium / Discount to current price:

 

Further Discussion

Beneish Model demonstrates that Noble is a safe company except for an alarming 2011 (based on manipulators having a score greater than -2.22).

The table below demonstrates that there is not much short pressure on Noble and that institutional investors comprise over 90% of the holding. Perhaps the short ratio of 2.40 tells us that not many people believe the stock is overpriced.

Share Statistics
Average Volume (3 month)3:	3,572,550
Average Volume (10 day)3:	5,232,100
Shares Outstanding5:	252.39M
Float:	250.91M
% Held by Insiders1:	0.54%
% Held by Institutions1:	91.90%
Shares Short (as of May 15, 2012)3:	8.32M
Short Ratio (as of May 15, 2012)3:	2.40
Shares Short (prior month)3:	8.28M

 

 

 

 

Exhibits

Exhibit 1 – 30 years – WTI Crude oil spot price (blue) vs. Noble Corp stock price (yellow)

 

Exhibit:  2 – Comparison of Oil Exploration and Drilling Peers to Light Sweet Crude Index

Exhibit 3: Externalities Affecting World Oil Pricing

Exhibit 4: Worldwide Supply and Marketed Utilization

Rig Supply and utilization for various types by age.

Exhibit 5 – Jackup Construction in the Market

Exhibit 6 – Ultra Deep Fixture Rate Trends (Noble presentation)

Significant growth rate trends for Ultra Deep Water units.

Exhibit 7 – Affect of New fleet to Noble’s Revenues and New Revenue Stream From New Builds.

 

 

Appendices

Appendix A: Rigs

 A few examples of offshore rigs, drilling and production platforms. Left to right: onshore platform; fixed platform; jackup rig; semi-submersible; drill ship; tension leg platform.[19]

 

 

Noble Drillship and Noble Semi-Submersible

Noble Jackup

 

Appendix B: Relevant Descriptions (http://rigzone.com/data/rig_statusdescriptions.asp)

Offshore Rig Status Descriptions

Drilling

Drilling status simply means that a rig is performing drilling operations at an offshore site. These units are either under contract by an operator or owner operated.

Workover

Workover status means that a rig is performing workover or well servicing operations at an offshore site. These units are either under contract by an operator or owner operated.

Accommodation

A rig working in accommodation mode is essentially acting as an offshore hotel. A rig can be deployed in a variety of situations at offshore sites to house personnel or supplies.

Older or marginal rigs engage in accommodation services more frequently than higher spec units as this type of work generates lower day-rates than drilling and workover activities. In periods characterized by reduced levels of drilling demand, some higher spec units may operate in this capacity in order to remain active.

Production

Production status means that a rig is performing production operations at an offshore site. These units are either under contract by an operator or owner operated.

Cold Stacked

In short, to cold stack a rig is similar to “shuttering” an industrial plant – workers are let go, the hatches are battened down and the rig is completely shut down. Cold stacking a rig involves reducing the crew to either zero or just a few key individuals and “storing” the rig in a harbor, shipyard or designated area offshore. Typically, steps are taken to protect the rig including installing dehumidifiers and applying protective coatings to fight corrosion, installing monitoring systems that communicate rig status information to locations onshore and filling engines with protective fluids. Although the duration of cold stacking can vary depending on many factors, rigs that are cold stacked are typically out of service for a significant period of time and are generally not considered to be part of marketable supply.

Costs are generally reduced to minimum levels, although rig owners likely will still have to pay harbor fees, insurance premiums and other miscellaneous expenses. Before returning a cold stacked rig to service, drilling contractors must hire a crew and some level of investment is usually required. The investment may come in the form of a survey, completing deferred maintenance or refurbishment.

Drilling contractors typically cold stack a rig in a cost cutting effort when they do not believe they will find work for the unit at a day-rate above cash breakeven for an extended period of time. Often, this activity is a result of a cyclical downturn in demand for a given rig type. Unit specific issues, like a significant investment requirement for a marginal rig to continue operations, can also drive the decision to cold stack a rig.

Ready Stacked

Ready stacked status means that a rig is idle but operational and is also referenced in the industry as warm stacked. A ready stacked rig typically retains most of its crew and can deploy quickly if an operator requires its services. In a ready stacked state, normal maintenance operations similar to those performed when the rig is active are continued by the crew so that the rig remains work ready.

Daily operating costs for a ready stacked unit remain close to the levels incurred when the rig is actively working. Thus, a rig is kept in a ready stacked state when its owner anticipates that the rig will be able to return to work shortly – either due to having a commitment in hand or the owner’s perception that work will be secured relatively quickly. Ready stacked rigs are actively marketed and considered part of marketable supply.

Under Construction

Rigs classified as under construction are in various stages of the rig building process. Referred to in the industry as “newbuilds”, these rigs have yet to be completed.

Newbuilds may be built on a speculative basis without a firm commitment for work or built to fulfill a specific requirement from an operator. If the rig is being constructed to fulfill a specific requirement from an operator, the owner may receive a firm commitment for the rig in advance of delivery or placement of the construction order.

Enroute

Enroute status means that a rig is in the process of mobilizing from one location to another. Either through their own means or with the assistance of oceangoing vessels, rigs travel between locations in a particular offshore field or between regions across the globe.

Although there is no clear rule, the operator may pay mobilization fees to the rig owner, particularly when rig availability is limited, to compensate the owner for the cost incurred to move the rig. Rigs may be enroute with or without a commitment from an operator.

Waiting on Location

Waiting on location status means that a rig is in standby mode. This status can result from a variety of factors including delays in operator plans; a problem at an offshore site; bad weather; or preparation to mobilize or drill.

Inspection

Inspection status means that a rig is either in the shipyard undergoing a survey or inspection or is undergoing an inspection in the field.

Out of service time can vary depending on the scale of the survey or inspection, and the rig may or may not be actively marketed or contracted during this time.

Modification

Modification status means that a rig is undergoing maintenance, repairs or upgrades which can be performed on location or in a shipyard.

Out of service time can vary widely depending on the work being done, and the rig may or may not be actively marketed or contracted during this time.

 

 

Appendix C: Rig Types

Floating Rigs

Rig Type	Rigs Working	Total Rig Fleet	Average Day Rate
Drillship < 4000′ WD	8 rigs	8 rigs	$235,000
Drillship 4000’+ WD	59 rigs	74 rigs	$459,000
Semisub < 1500′ WD	9 rigs	15 rigs	$249,000
Semisub 1500’+ WD	61 rigs	92 rigs	$296,000
Semisub 4000’+ WD	91 rigs	109 rigs	$403,000

Jackup Rigs

Rig Type	Rigs Working	Total Rig Fleet	Average Day Rate
Jackup	1 rigs	1 rigs	$125,000
Jackup IC < 250′ WD	35 rigs	54 rigs	$74,000
Jackup IC 250′ WD	40 rigs	62 rigs	$77,000
Jackup IC 300′ WD	88 rigs	132 rigs	$86,000
Jackup IC 300’+ WD	131 rigs	155 rigs	$149,000
Jackup IS < 250′ WD	6 rigs	9 rigs	—
Jackup IS 250′ WD	7 rigs	9 rigs	$75,000
Jackup IS 300′ WD	3 rigs	5 rigs	$60,000
Jackup IS 300’+ WD	1 rigs	3 rigs	$70,000
Jackup MC < 200′ WD	4 rigs	11 rigs	$36,000
Jackup MC 200’+ WD	12 rigs	23 rigs	$67,000
Jackup MS < 200′ WD	2 rigs	3 rigs	—
Jackup MS 200’+ WD	7 rigs	15 rigs	$48,000

Other Offshore Rigs

Rig Type	Rigs Working	Total Rig Fleet	Average Day Rate
Drill Barge < 150′ WD	20 rigs	39 rigs	—
Drill Barge 150’+ WD	6 rigs	9 rigs	—
Inland Barge	29 rigs	76 rigs	$56,000
Platform Rig	141 rigs	251 rigs	$43,000
Submersible	0 rigs	5 rigs	—
Tender	24 rigs	33 rigs	$128,000

 

---

[1] 95% utilization is assumed (new-builds carry higher utilizations than older units > 72-84%)

[2] http://rigzone.com/news/article.asp?a_id=117265

[3] http://www.wtrg.com/prices.htm

[4] http://oilprice.com/Energy/Crude-Oil/Massive-Oil-Field-Discovery-In_The-North-Sea.html

[5] http://seekingalpha.com/article/625081-ship-tracking-indicates-offshore-opportunities

[6] http://seekingalpha.com/article/620021-transocean-has-a-major-accounting-problem-and-many-others

[7] Rigzone market research

[8] Noble Fleet-Status report calculation

[9] DO & ENSCO Fleet-Status report analysis

[10] Noble 2012 analyst day presentation

[11] May 08,2012 Morningstar Report

[12] 2010 Noble Financials

[13] FactSet data on Noble

[14]  Noble Corporation 2011 Annual Report, Noble Corporation Company Analysis and Buy Report November 2010, GlobalData Noble Corporation – Financial and Strategic Analysis Review December 2011

[15] Ensco PLC Campany Analysis and Sell Report December 2010, Noble Corporation Buy Report November 2010

[16] Morning Star report on DO, 5/23/2012

[17] http://en.wikipedia.org/wiki/Transocean

[18] S&P, June 2, 2012 report on ESV

[19] http://www.boemre.gov/tarprojectcategories/structur.htm (Bureau of ocean management, regulation & enforcement.

Investment Ideas – published in the Stanford GSB Reporter

-by Alec Mazo
In the last edition of GSB Reporter I provided a quick value investment thesis for two companies: Cummins and Baidu. This time I want to build on those companies to demonstrate two more ideas that could begin to diversify a value portfolio if purchased at the right price: GE and Boeing.
1. GE (GE) – US economy barometer & dividend appreciation potential
Sloan – Mike Kelly Mile Kelley started his career with GE in 2000 as a commercial credit analyst for GE Commercial Finance in Chicago. He later completed GE’s prestigious Corporate Audit Staff program as a manager, served as a finance manager with the Oil & Gas division in Florence, Italy and most recently was in the Corporate Business Development team in Fairfield, CT working in Global M&A and corporate strategy.

I think GE ($204B cap) can be considered a barometer of the American economy even though 50% of GE’s revenues are generated outside of the United States. GE is a well-diversified industrial global conglomerate. GE positions itself to be the best performer in all of its industries and it enjoys a wide economic moat because of its resources and expertise in each field. I will omit the numerous business segments GE represents, but this information is easily available online. In a tough economic environment, the company can have several underperforming business segments, yet still manage to produce decent profits.
Financially, GE delivered around 10% avg net income over the last 10 years. GE’s ROE since 2001-2008 has been hovering around 18% but has dipped since 2008 to around 10% due to the recession and GE Capital troubles. ROE in GE’s case is magnified as a result of leverage, its’ long term debt and other liabilities are approximately $400B while its equity is $125B. However, considering the sizable $465B current asset position vs $203B current liabilities, liquidity is not an issue. DCF with 8% annual owner’s earnings growth, 12% discount rate, and 3% terminal growth rate yields intrinsic value of $26.26 based on $11.8B owner’s earnings (Net Income + Depr – CAPEX + special charges). The margin of safety is 27% to the current $19.39 share price.
GE has increased the dividend payout from $6.3B to $12.4B in the period from 2001-2008, and then scaled back to $6B in 2011. It is a reasonable assumption that when the macro economy stabilizes, GE will drive the dividend to its’ normalized levels which would represent 8-10% yield based on current price (currently 3.51% dividend). GE is a good company to own for income investors looking for exposure to the US and global economy.
2. Boeing (BA) – aerospace
Sloan – Alex Zakroff leads the Global Navigation Services (GNS) organization for Jeppesen, an information services company and wholly-owned Boeing subsidiary whose core products include the provision of navigation information to aviation and maritime customers worldwide.  As Vice President, Alex holds overall responsibility for operational execution supporting Jeppesen’s core navigation products, as well as for leadership and staff development, process improvement and executive communication.
The company operates in two segments: commercial and defense. The first long-awaited and delayed 787 Dreamliners were finally delivered to Nippon Air last quarter. The company delivers between 480-490 commercial airplanes every year, with revenue projections of $68B and operating margins 8-10%. Boeing and Airbus still effectively operate as a duopoly of airplane manufacturing, providing them with economic moats based on their relationships with key customers. However, this customer supply chain will have more options as Bombardier, Mitsubishi, United Aircraft, and COMAC enter the market. The US defense segment spending related to Boeing’s expertise will likely drop as a result of defense spending cuts and Lockheed’s F-35 contract. As a result, defense related revenues will deteriorate from the current 50% of total revenues.
Air travel has consistently grown at 1.5x GDP and developed countries will continue to replace old planes with newer, more efficient models. Operating economics incentivize upgrades, though airlines often use planes for over 25 years. Boeing estimates global demand of 33,500 commercial units in the next 20 years, totaling over $4 trillion. As long as Boeing continues with innovation and reliable customer service, it should be able to maintain a competitive moat against new entrants. Boeing production plans include increasing 737s from current 31.5 to 38 units per month by 2013, 777s from current 5 to 8 per month by 2013, 787s from 2 to 10 units per month by 2013. Margins will not improve immediately with increased production due to 787 delays.
Boeing’s total backlog is $332B, or 5 times annual sales. However, in 2008 the company experienced a year with negative equity partly as a result of the macro economic conditions and partly because of the write downs due to production delays. The company operates in a highly capital intensive business; it is highly leveraged and any operating miscues could be costly. Net profit margins between 5-6% could be considered a good year. Boeing’s EPS numbers in the last 10 years have been wildly inconsistent, fluctuating between $.61 and $5.28, the troughs becoming apparent during and shortly after recession periods. However, I think we can safely assume that Boeing will not go out of business soon considering that the United States government signals the high quality of the firm when the President uses a 747 and government officials fly on 737s. Boeing’s fair value of $78.31 is close to the current price of $75.72, assuming a 4.8% owner’s earnings growth rate, 9% discount and 3% terminal growth. The margin of safety is 6%. Its’ backlog gives investors some visibility for years to come and market price fluctuations could prove attractive entry points if the price could drop to a 30-40% margin of safety.

Portfolio Construction – published in the Stanford GSB Reporter

Portfolio Construction
by Alec Mazo
After spending some time brainstorming various topics of interest relating the Sloan class to the GSB, I knew that I could highlight any one of my classmates and tell their unique stories in this column. But I decided to go a different route. As it turns out, 21 public companies are represented by senior management in our class. If accurately picked with an appropriate equity investments mix, some of these companies would diversify risk and offer good potential for growth in this uncertain macro economy. Here are two highlighted companies from the Sloan class and the investment valuation rationale behind them. I use discount cash flows based on owner’s earnings, a term pioneered by Warren Buffett (Net Income + Depreciation – CAPEX + special charges).
1. Cummins (CMI) – Global reach diversification
Sloan – Beau Lintereur joined the company in 1998 and since worked in the Power Generation Division in the US, China, and most recently India where he was the VP of the Power Generation Division.
Cummins is a $17B cap company that makes engines, engine components, and power generators. Company products can be seen in trucks, heavy machinery, rural farms, and power plants. Cummins has a global distribution business that manages sales and services around the world. The company global footprint includes strong positions in the emerging markets, especially China, India, Brazil, and Russia. 60% of its revenues are generated outside North America. India is responsible for 10% of revenues and China for over 20%. Cummins is making increasing investments in Africa.
At the right price, the firm is a safe investment with a sizable competitive moat consisting of brand name, technological know-how, and entrenched world distribution system. Cummins enjoyed a 10 year 8.3% annual revenue growth and a 10 year 20% annual book value growth. The company is profitable, with average ROE above 20% since 2004. Relating 20% ROE to 14.6% ROA reveals that Cummins isn’t leveraged, its’ debt/equity ratio is 14% ($665m debt), and current assets less total liabilities yield $1B. If we assume that Cummins maintains 8.3% revenue growth for the next 10 years and proportionately increases its’ owner’s earnings, the firm’s intrinsic value is $124.31 with a 9% hurdle rate. The margin of safety is 30% based on $87.30 Dec. 16 selling price.  
2. Baidu – Growth, Chinese internet
Sloan – Dan Guo is a founding member, Senior Director of Engineering and Product at Baidu.com
Baidu ($40B cap) is a Chinese internet search company with control over 70% of the Chinese search market. Its major revenue comes from paid-for-performance services (P4P), the online marketing services based on users’ search queries and customers’ relevant advertisements. China is one of the fastest growing markets in the world and advertisers will continue to invest in search related expenses, so P4P market should grow at double digit rates in the next few years. The overall growth potential for Baidu is attractive; it only serves 300,000 customers with the potential to involve 40,000,000 small/medium registered businesses in China.
In addition to paid search, Baidu is using its position as an online traffic hub to attract younger users with music and online communities. It further looks to develop in mobile search, localized e-commerce, travel, and online video by utilizing its search operation as a beach head for expansion. Competitive environment is tense with Alibaba, Sohu, and Tencent looking to take share away from Baidu. One of the keys for Baidu’s successful expansion to other verticals is increasing its penetration rate in search while fending off competition.
In my opinion, Baidu is currently selling at a premium. Baidu’s phenomenal revenue growth from 2003-2011 ($4.9m-$1.55B) lends itself to optimistic projections and investors think that a 30 P/E ratio is within norms for this kind of investment. Value investors would have trouble justifying an investment in a company selling at anything over 20 P/E for extended periods of time because the long-term market average P/E is 16. Baidu’s current P/E is 44, meaning that an investor would need 44 years to recover his investment using Buffett’s look through earnings (investor’s stock ownership % and it’s corresponding eps). So the story is growth, if the company grows at double or triple rate of a good 15 P/E company, then the market price would be closer to value, but at 26.2 price to tangible book value ratio, the investment community is very optimistic . Given China’s economic characteristics and Baidu’s penetration rate, huge growth is achievable but also risky, considering that an economic slowdown causing advertiser pullback may substantially alter investor projections and the market will adjust the company’s valuation. There is no safety margin for this type of event.
However, Baidu has a strong balance sheet with solvency ratios of .31 total debt/equity, and 3.44 current ratio. It also shows great profitability numbers, 27% ROE & 21% ROA from (’05-’10), and the company boasts a 45% net income margin in 2011. Fair value is $99.37 based on owner’s earnings (453m) with a 47.8% 10 year annual growth rate, 3% terminal rate and 15% hurdle. The company is selling at $115.56. Given current valuation, investors assume phenomenal growth of 48% a year which is difficult to sustain consistently over the next 10 years.