Noble Corp has been in business since its founding in 1939. It has historically been equipped with a management team very focused on its employees’ lives & safety. The corporate DNA suggested by the history of the firm is a favorable one; it showed compassion for its workers, boasted the highest safety rating in the entire industry, and tried to maintain all of its operations very conservatively, only taking on debt in extreme circumstances. The annual reports were riddled with stories of various workers who had been helped out by the management team. They also possess one of the highest returns on invested capital over the last 5-10 years, averaging out at around 30-35%. In addition, they have employees who receive higher compensation as a percentage of revenues than the industry average. Management will be there to steer the company through hard times and therefore this quick review of them should not be overlooked. A good management team focused on conservatism can often breed superior results. This was a good first step in the right direction.
Now I’ll move on to their income statement. They sported the highest gross, operating, and net margins in the entire industry, which resulted from strategic deployment of their fleet across the globe. These margins are not one-year occurrences, but rather the standard set by them over the last 5 years or so.
Gross margin: 68%
Operating margin: 54%
Net margin: 45%
Noble has the highest margins because of two things: being the lowest cost driller and paying lower taxes. Noble became the low-cost driller based on the global deployment of their fleet. The waters they drill in receive some of the highest margins on the globe, thus driving their profits much higher than competitors. The low taxes stemmed from Noble’s switch of incorporation from the U.S. to the Cayman Islands. The U.S. taxes would not allow for Noble to remain as globally competitive, so they moved to incorporate elsewhere and now their only taxes are determined by the jurisdiction of where they drill. In 2008, they again switched over to Switzerland because of the Obama Administration’s talk of taxing companies like Noble who had moved offshore and tried to create a tax shelter. Switzerland is considered a safer tax regime than the Cayman Islands, so this is why Noble moved a second time. I’m sure changing the country of incorporation created a lot of paperwork for management and a few headaches in setting up new headquarters, but this showed me the lengths to which the managers were concerned about creating shareholder value. Their trailing 12 months effective tax rate was only 15%, as compared to near 40% for the U.S. I will speak later about why this low-cost nature of Noble is extremely important for shareholders.
I spoke at the beginning of Noble being extremely financially conservative. Take a look for yourself:
Values in millions
- $1,480 current assets ($1,300 in cash & receivables)
- $6,634 Property & Equipment
- Liabilities & Equity
- $433 current liabilities
- $751 long-term debt
- Total liabilities: $1,608
- Total equity: $6,788
- Total Assets: $8,396
The equity ownership in the $8.4 billion of assets is $6.8 billion, giving them a debt to equity ratio of .23. This is by far the most conservative balance sheet you will find within offshore drilling, mainly due to the constant need for capital within the industry. Their long-term debt comprises only 8.9% of their overall assets and amounts to half of their annual free cash flow. In other words, all of their long-term debt can be paid off in 2 quarters of operations. They could also cover their entire liabilities with just cash & accounts receivable. This is a great sign that I see as a zero possibility for bankruptcy. Don’t ignore this fact; the possibility for failure is always a major one to consider. In addition to a stellar balance sheet, which had a 10+ year history of similar debt loads and conservatism, the management only built new rigs when there was a customer willing to contract in advance. Many competitors decided to go the other route and “build on speculation”, which is building a rig without a contract ahead of time. This then has them hoping that they will be able to contract once the rigs leave the shipyards. Rigs are very expensive to maintain and this “building on speculation” strategy is considered very risky. Noble had always built after securing a contract so that there was no gambling on the industry’s outlook for the future- if industry conditions worsened, they still had their contract in place. This corporate culture and ability to resist the urge growing too quickly is what has driven this company’s success for a long time.
These rigs that they purchase run anywhere from $75 million to $500 million a piece. Purchasing these rigs leads to a high amount of debt within the industry, so this is why I looked for a company with a very conservative balance sheet. I am no engineer, but I do understand the financials behind these rigs and they can often return in excess of 15-25% in the first year of operation; this leads to high returns on invested capital, which is great for creating future shareholder wealth. The problem is, these rigs need to be constantly maintained and, every once in awhile, major upgrades need to take place to allow them to remain competitive. So, in addition to buying new rigs, current rigs also must be considered in analyzing the amount of shareholder value created over time. The best way to analyze the funding needs in maintaining rigs and the cash generated from operations is the cash flow statement. Here is a segment of this from the 2009 Annual Report:
(Cash is in thousands)
As you can see, the cash from operating activities is $2.1 billion, and is basically their earnings before the expenses related to maintaining their rigs. The two entries listed as “other capital expenditures” and “maintenance capital expenditures” are only split into two categories because the “other” section is considered to be for major upgrade projects and therefore not to be considered as an ongoing expense every year for the future. I will lump both of the “other” and “major maintenance” expenditures into one I will call “capex” (capital expenditures). These expenditures are necessary in maintaining a competitive global fleet and therefore can be seen as being as necessary expenses to continue operations. If you subtract capex from operating activities, you will come up with the company’s free cash flow for the year. For 2009, this figure is about $1.5 billion. Then you will notice that there is a figure of about $700 million dedicated to new construction, which signifies money spent to build new rigs for the future. As I stated earlier, the returns on investing in new rigs can come in at about 15-25% annually. So, about $1.5 billion in new shareholder value was created in 2009 and roughly half of it was invested into a high-return area, which will then create more value for the future. The other half of the $1.5 billion is paid out in special dividends, used to repurchase stock, and lower the debt even further. As Charlie Munger once said, “The difference between a good business and a bad business is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time.” As seen here at Noble, rather than having to worry about their debt and short-term funding for next year, the only decision-making needed is how to best return value to shareholders, whether through dividends or share repurchases. One thing I would like to caution about in analyzing this data is that you will notice a growth trend from 2007-2009. This has continued on since the first year’s annual report I have available to me, 2000, and is easy to follow, however I would advise against basing your decisions on following growth. I look to pay a good price for current earning power, not what might come in the future if they grow faster. Being conservative is key, especially in a capital-intensive industry like offshore drilling.
If you followed my cash flow analysis, you know that $1.5 billion of shareholder value was created in 2009, and if you check the current stock price, the company is being valued at $7.5 billion. This leads to an initial rate of return based on free cash flows of 20%. A statistic to keep in mind: the long-term rate of return in the stock market over the last 150+ years is about 7-8%, so an initial return of 20% is great. The company is still growing and will be well-positioned to deliver you higher returns than this into the future.
I may seem somewhat optimistic and aggressive about the company’s future, however there is something I have not yet explained, and that is the company’s backlog. This is a list of the contracts that extend beyond 2010 and totals about $8 billion in revenues for the next few years.
As you can see, the contracts negotiated for 2010 would provide $2.8 billion in revenues and only came from 54% of the available days for the fleet, meaning that 46% of the days are still not contracted and not projected on the backlog. The typical deployment of these rigs fell anywhere from 80-90% during a given year, so if you do some calculations, you can get a rough estimate on revenues and earnings. It could easily come in at higher than $4 billion this year. This should all be taken with a grain of salt, but is still useful in conservatively projecting the future revenues for a few years. Also, Noble has 3 new deepwater rigs coming in the next year or so that will add about $500 million in annualized revenues over the next two years. Considering the company has $3.1 billion in 2009 revenues, $500 million is no small increase. These are all very favorable statistics to consider in valuing this company.
A few more metrics you should be made aware of:
Listed above is basically a Du Pont model without the multiplication between the individual numbers. Return on equity (ROE) is one of the most important metrics on a company to determine how much return you are making on your equity ownership in a business, and without going into the algebra, can be broken up to determine where the ROE comes from. Leverage and return on assets together determines the ROE, so the more efficient the company is in generating income and the more leverage the company has, the higher the ROE. The return on assets is much more important than leverage, because any company can have a highly leveraged balance sheet, but very few have high returns on assets. Noble is one of those rare companies. A high return on assets figure stems from either being low-cost in the industry or having great asset efficiency. To determine which one it is, return on assets can be broken down into net margin and asset turnover. In terms of Noble, their net margin tells the whole story. Very few companies have high net margins the way Noble does, and their asset turnover ratio is normal. The high net margins mean that the low-cost nature of this company is driving the return on equity and allowing for long-term growth in shareholder value. For those of you unfamiliar with the Du Pont model, I have a report on it posted in my “Articles” section on this blog.
I hope I have convinced you that this is a great business, delivering awesome returns of shareholder value, with great management, displaying conservatism and trading at a great price. The only issue left to speak about is the Gulf of Mexico oil spill. Noble currently has 6 semisubmersible rigs in the Gulf and would stand to lose 26% of their revenues from these no longer generating earnings. They have 62 rigs in total, but the semisubmersibles generate much more revenue than some of the other types of rigs. This can be a cause for concern if they lose ¼ of their earning power with the 6-month drilling moratorium. Noble’s contracts are structured in such a way that if this moratorium continues, contract dayrates slowly ratchet down from 100% dayrates to 80%, to 50%, and so on as time elapses. The increments vary per contract and this is not public information. Eventually, these will get down to covering daily costs, and in some cases, will go down to zero. One thing that must be made clear, though, is that the rigs are completely mobile. They are not obligated by law to stay within the Gulf, and if necessary, I’m sure the Noble management will deploy these rigs in other regions. Noble must shoulder the cost of moving these rigs, but they could eventually find available contracts elsewhere. I have read every article on the Gulf since April 20, and from what I can see, the Obama administration is still deciding how to act. Originally, a complete ban on drilling was enacted, and now they have shifted into allowing the shallow water drilling because of a public outcry about the loss of jobs. A statistic to keep in mind that may help assuage your fears for the future: there have been more than 50,000 wells drilled in the Gulf of Mexico since 1947. This is the first time a spill has been this devastating, but there is no telling how the government will ultimately react to this. Perhaps they will enact a full-fledged ban on drilling indefinitely, but considering the jobs lost, this seems unlikely. The only long-term effects I can see happening are higher costs to adhere to whatever regulations are put in place and higher insurance premiums paid to insure the rigs. I am nowhere near certain about the future in the Gulf.
But do you want to know what my thoughts are? I don’t care what the administration does about the ban. If anything, the ban is a bad thing in the short term and a great thing long term. At least for Noble, that is. Think about the debt loads I described earlier that exist because of the capital-intensive nature of the industry. If this ban stays in place, or is extended further, Noble is in the best possible position. Many of the drilling companies have built on speculation and the new rigs will be introduced into very turbulent times. As the companies struggle to find contracts, the debt payments will come. They must find some way to cover their short-term obligations, so either they add more long-term debt, dilute their shares, or sell rigs to other drilling companies. Noble believes there will be many opportunities to snag rigs off the open market at favorable prices from struggling firms in the future. Although Noble is not the largest company in the industry, they have the most flexibility and financial strength to take on some more rigs because of their conservative balance sheet. I would compare them to Berkshire Hathaway during the 2008 crash when approached by many failing firms who asked to be saved. Berkshire ended up investing $5 billion in Goldman Sachs on extremely favorable terms that has since cost Goldman billions. The lesson here is having cash when others need it can create many favorable situations during rough times. Hopefully Noble will have that opportunity in the near future.
In terms of why the stock is offered at such a great price, it is a classic example of a one-time, fixable short-term problem that, once resolved, will allow Noble to perform well in the future. There is much uncertainty in the industry right now about deepwater drilling, but it is a sin to mistake uncertainty with risk. The only risk is losing ¼ of their earning power. Wall Street hates uncertainty and sells as if it was the same thing as downside risk, but it is not whatsoever. This presents a great opportunity if you can assess the situation rationally and calculate your chances of success. I do not see much risk in investing in the most conservatively financed company in the industry, even when stressed with this drilling moratorium. Noble does have a higher exposure the Gulf than many other companies in terms of percentage of revenues, but they have the financial flexibility to do whatever it takes to emerge a winner. Once this BP spill blows over and everyone realizes the power of Noble’s business, the stock price will correct itself.
For full disclosure, I have placed half of my portfolio in this company. My conservative valuation on the business today is about $12-15 billion, and is currently trading at around $7.5 billion. In other words, it is trading at $30/share and is worth something like $45-$55/share. These numbers have come from analyzing the earning power of this business and where it would be priced if the industry weren’t under government scrutiny. This large gap between price and value leaves a very large margin of safety for any investor to feel secure in.
So, in review, Noble has:
- Highest margins in the industry across the board
- A great management team with high returns on invested capital over the last 5 years
- Most conservative balance sheet available, leaving much room for flexibility and error
- A diversified fleet in the types of rigs it owns to allow for pricing changes in dayrates for different rig types
- Returns on assets, equity, etc… are phenomenal
Lastly, remember that I have related their price to a percent yield on your initial investment. It is based entirely on current earning power and could be much higher if the company continues to grow. My time horizon on this investment is either until the price becomes more rational quickly, leading to a price correction in excess of 60-70%, or a 2-3 year holding period. Along the way, the company should constantly be reevaluated based on its business fundamentals, not its stock price. We have chosen an industry that is currently under the watchful eyes of the American public and the U.S. Government. It is unrealistic to think that the stock price will move nowhere and then suddenly double one morning. So please, remember, you are buying this stock because it is out of favor. It may not be at a bottom in terms of its price; I do not attempt to predict where market prices are going, only where businesses may end up financially. Because this stock is out of favor, the price very well may fall even more. If it does, don’t think of it as losing money, think of it as a T-shirt that went to clearance after you bought it on sale. If you have the money and the willpower, I’d recommend you buy more stock if it falls sharply and the reason for the drop in share price is unrelated to business fundamentals. And PLEASE, resist the urge to check the stock price every day. The business isn’t going anywhere. Do you need a daily price on your house to tell you that you made a good purchase?
Click here for the pdf: Drilling For Wealth
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