Offshore Drillers: Normalize It
SECTOR REVIEW
Insight Offshore (June MODU): Introducing
Normalized Earnings Framework
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The rules have changed. Between 2005 and 2012, we estimate the industry
will add 118 net jackups (i.e., capacity additions less retirements) and 113 net
floaters to the global offshore drilling, resulting in 30% and 54% increases to
global jackup and floater fleets. Given significant capacity adds and secular
declines on the U.S. GOM shelf, we believe pricing power (i.e., dayrates) in a
recovery scenario will be muted notwithstanding higher oil prices. In the jackup
market, we also fear the conclusion of several LNG ‘mega’ projects between
now and 2011 could negatively impact rig demand, further handcuffing the
potential pricing power of drilling contractors in an economic recovery.
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If pricing power is limited, we believe the stocks could trade less on fullcycle
earnings power. Despite the cyclical nature of the spending cycle,
drilling stocks have historically traded more like growth stocks, with the group
trading at premium valuations to the market for most of the period since the
1970s. We believe premium valuations have stemmed from the tremendous
operating leverage for the drillers through the dual utilization and dayrate levers.
As a result, OFS investors have historically focused on the full-cycle (i.e., peak)
earnings power of the companies in a spending recovery scenario. Given our
expectation that pricing power will be diminished, we believe a normalized
earnings framework is more logical and a superior approach for stock selection.
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Let’s be normal offshore. We are introducing a normalized earnings
framework for the drillers, extending the analysis introduced by Brad Handler for
OFS in March. With investors largely looking through earnings challenges in the
next 12 to 18 months on anticipation of a spending recovery, we wanted to (1)
determine if valuations on a normalized basis supported further upside in the
shares, and (2) gauge valuations on a relative basis. We calibrated our
normalized earnings on a rig-by-rig basis using a normalized return on
replacement cost methodology.
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Replacement cost approach. Given the asset-intensive nature of the industry,
we believe the earnings power of oilfield assets in a tight market is determined
by their replacement cost and the returns (dayrates) necessary to justify adding
new capacity. As a result of capacity additions and the sharp reduction in
commodity prices, we are setting our normalized earnings for the drillers based
on the long-term average return on replacement cost of 8.5%, but have made
adjustments to anticipated future returns for commodity assets such as mat
jackups and shallow water semis given industry capacity additions.