Trading at a discount despite premium assets, a large backlog, and high growth expectations
The company currently trades for 6.9 times 2015 consensus EBITDA and $685 million per rig, which is a premium to its peers, but these have older and more commoditized fleets, lower growth prospects, and less contract coverage. The only true comparable is Pacific Drilling (PACD) because it operates solely new UDW (ultra-deepwater) assets and it’s also expected to grow its EBITDA by 2.5 times before 2016. This company trades at a 10% premium to ORIG. Also, ORIG is valued at 90% of tangible book value (or TBV), while its industry currently and historically has traded for 1.3x TBV (see the following table).
Using peer metrics, the implied value per share of ORIG is $25 to $30, translating to 20% to 40%+ upside (see the following table).
Closing the valuation gap through dividends and MLP formation
The Board recently approved the company’s first dividend for $25 million, which will be paid from cash flow in 1Q14. This will equate to a 4% yield and should grow significantly over time considering the excess cash flow ORIG will have once its entire fleet is complete. In addition and as part of this effort, the company will form an MLP that will go public in 2Q14. The plan is to likely sell a minority interest in its four rigs built in 2011 to this MLP entity. Over time, I’d expect ORIG to drop down its five assets being completed between now and 2015. Seadrill Partners (SDLP) is the only offshore driller structured as an MLP, and it currently trades for $1,350 million per rig.
Assuming that a 40% interest in nine of ORIG’s rigs are sold to the MLP (3.6 rigs), that each of those is valued for $1,350 million, and that the retained interest of rigs held at ORIG (7.4 rigs) is appraised at $750 million per asset, then the implied share price is above $40 or twice today’s price. SDLP’s parent, Seadrill Ltd (SDRL), trades at an 8% dividend yield. I’m forecasting ORIG to generate $470 million of excess FCF after debt amortization once its rigs are complete. Applying SDLR’s 8% dividend yield to $470 million would result in a $45 share price.
The Market Realist Take
In July, we pointed out on MarketRealist.com, in Why non-traditional master limited partnerships are growing, that MLPs have historically been associated with midstream energy. However, the MLP structure has been growing in popularity among other companies that don’t resemble the traditional midstream energy footprint but that still classify as MLPs under the current tax code. A possible impact of this extension could also be that for some non-traditional MLP names with more volatile cash flows operating with an MLP structure, distributions may fall far below expectations or possibly to zero given the increased downside risk.
MLPs have a reputation for stable and growing cash flows, and the increase in MLP structure use to cover assets that have more volatile cash flows might mar the asset class’s reputation. Industry experts believe that due to the risks associated with these non-traditional MLPs—including their short history, lower reliability of income stream, and higher sensitivity to underlying commodity prices—these entities tend to offer increasing yields as compensation. But MLPs have attracted investor interest in the recent past due to high yields, and this might improve their share price valuations, apart from providing capital appreciation.