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GlobalSantaFe's Platform for Growth

By Stewart Glickman Standard & Poor's Equity Research thinks that fundamentals for the offshore oil and gas drilling industry are positive, given a scarcity of rig supply and rising rig demand (see BW Online, 12/7/05, "The STARS Align for Oil Drillers"), and believes this should benefit GlobalSantaFe (GSF

; recent price, $49.68). We also think that the company has a strong balance sheet, with long-term debt-to-equity of about 12%.

We view the shares as attractively valued, based on our expectations for increased offshore rig demand and rising day rates (the sum paid to a drilling contractor for each 24 hours of operation under contract) in a number of the company's key operating regions. GlobalSantaFe carries Standard & Poor's highest investment recommendation of 5-STARS, or strong buy.

GlobalSantaFe was formed in November, 2001, through the merger of Global Marine and Santa Fe International. The company's fleet comprises 59 rigs, including 45 jack-ups (mobile offshore drilling rigs), 11 semisubmersibles (floating offshore drilling units whose pontoons and columns, when flooded, cause the unit to submerge to a predetermined depth), and three drillships. Within the jack-up fleet, 31 of the 45 rigs are rated at water depths of 300 feet or greater, representing one of the largest such "premium" jack-up fleets in the industry.

GEOGRAPHICAL BALANCE. The company also provides turnkey drilling management services through a subsidiary, Applied Drilling Technology, which generated about 27% of total revenues in the first nine months of 2005, but only about 8% of segment operating income. In addition, GlobalSantaFe operates an oil and gas exploration business, which generated 2.3% and 6.5% of total revenues and segment operating income, respectively, in the first nine months of 2005. The vast majority of the company's fortunes, however, are dictated by its contract drilling segment.

Geographically, GlobalSantaFe's rigs are nicely balanced across five major regions: the U.S. Gulf of Mexico (where the company operates 14 rigs), West Africa (12), Northwest Europe (10), Southeast Asia (7), and the Mediterranean (6). The remaining 10 rigs are allocated to the Middle East, South America, Central America, and Canada.

Whereas only about 25% of GlobalSantaFe's jack-up operating days are still uncommitted for 2006, the company's entire fleet has about 75% of available operating days uncommitted for 2007, including about 75% for its nine midwater semisubmersible rigs.

IMMINENT RIG SHORTAGE. With natural gas prices remaining at historically high levels, and with currently producing wells experiencing accelerating decline rates, we think demand for drilling units is likely to increase. Based on data from Global Insight, we project natural gas prices to average $9.34 per million British thermal units in 2006, more than double the $4.27 per million Btu averaged in 2001, the last cycle peak for the industry.

We see looming shortages of jack-up rigs by mid-2006 in a number of key drilling regions around the globe, including the U.S. Gulf of Mexico, Northwest Europe, Southeast Asia, the Middle East, and West Africa. In our view, GlobalSantaFe -- with 35 of its 45 jack-ups balanced across these five regions -- should benefit from such a shortage, should it occur, due to upward pressure on day rates.

A rig shortage, in our opinion, is already close at hand. Based on data from research outfit ODS-Petrodata, the number of jack-up rigs in the global fleet that are either working or actively marketed (the "effective" fleet) has barely budged since 2002, up a mere three rigs to 331. Jack-up demand, however, has increased markedly: The effective utilization for the global jack-up fleet rose to 97.6% at the end of November, 2005, vs. 82.3% in January, 2002.

Not surprisingly, jack-up day rates have skyrocketed since 2002. The benchmark 300-foot independent-leg cantilevered jack-up in the U.S. Gulf of Mexico, for example, averaged more than $97,000 per day in November, 2005, more than quadruple the average of about $21,000 per day in January, 2002. In Southeast Asia, day rates for 250- to 300-foot jack-ups have risen to about $106,000 from $61,000 over that same time span, and jack-up day rates are up about 35% to 40% in Northwest Europe and West Africa.

LOSS OF RIGS. Because rigs can be mobilized from region to region, supply changes in one region can influence day rates in other regions. As a result, the devastation of Hurricanes Katrina and Rita in the Gulf of Mexico rippled through the global fleet. In total, 11 mobile drilling units in the Gulf were severely damaged by the storms -- either sunk, to be declared constructive total losses, or requiring extensive shipyard time for repairs.

Although the order book for new rigs is growing -- currently sitting at 58 rigs, of which 43 are jack-ups -- we anticipate that the impact of the new arrivals will be fairly modest, for three reasons. First, the new jack-ups have delivery dates stretching from 2006 through 2009, with about 10 to arrive in 2006.

Second, many of these new jack-ups are still not yet on contract (i.e., built on speculation). Unless and until the rigs are sold to a contract driller that intends to operate them, the new rigs could sit unutilized.

Third, the sizable loss of rigs from the two Gulf hurricanes implies that the 2006 inflow, even if all of them became operational, would only just about restore the size of the pre-Katrina fleet. To put these additions in context, an extra 43 jack-ups represents about 11% of the worldwide fleet of 385 jack-ups.

DAMAGE ASSESSMENTS. GlobalSantaFe's Gulf of Mexico fleet did not go undamaged by Katrina and Rita. Indeed, during Katrina, the company suffered damages to three of its semisubmersible rigs: the GSF Arctic I, the GSF Development Driller I, and the GSF Development Driller II. The Arctic I resumed operations in late November, while the Development Driller II started operating in mid-November. The Development Driller I is now expected to begin operating in May, 2006.

Whereas Katrina damaged the company's semisubmersibles, Rita affected jack-ups, damaging three such rigs in the fleet: the GSF High Island II, the GSF High Island III, and the GSF Adriatic VII. The High Island II shifted during the storm, causing damage to its legs. At present, company management expects the rig to be out of service until mid-March, 2006.

Damage assessments on the other two jack-ups are still ongoing. It's possible that, upon completion of these assessments, either or both the High Island III and the Adriatic VII could be declared constructive total losses, in which case the company would be entitled to receive their respective insured values of $55 million and $70 million, well above book values of $1.2 million and $1.4 million.

EPS EXPECTATIONS. We believe that GlobalSantaFe has high earnings quality. Based on our proprietary Standard & Poor's Core Earnings methodology, we see 2005 S&P Core EPS of $1.44, an 8.7% divergence from our operating EPS estimate of $1.58. Of the 14-cent divergence between estimates, approximately 10 cents is due to estimated stock-option expensing, 2 cents due to gains on asset sales, and 2 cents due to an adjustment for pension gains.

Starting in 2006, however, options are to be expensed under accounting standard SFAS 123R. Therefore, we estimate S&P Core EPS of $4.25 -- only a 2-cent, or 0.4%, divergence from estimated operating EPS of $4.27, due to an adjustment for pension gains.

Given rising day rates, we think GlobalSantaFe should be able to contract out its uncommitted jack-up days in 2006 at healthy premiums to previously contracted levels. We see total revenues of about $3.16 billion next year, up 39% from the $2.28 billion we estimate for 2005, with the contract drilling segment generating about 95% of the incremental revenue growth.

Although cost inflation does appear to be rising, we think day rate gains will far outpace cost increases, and envision significant operating-margin expansion in 2006. As a result, we see operating EPS of $4.27 in 2006, more than double the projected $1.58 in 2005. For 2007, we see total revenues of $3.73 billion, up 18%, and with further margin expansion, we see operating EPS of $6.04.

INDUSTRY-LEADING DIVIDEND. On a relative valuation basis, we think GlobalSantaFe shares should trade at a modest premium to the company's peers, given the high percentage of premium assets in the fleet. Recently, however, the shares were trading at 7.8 times estimated 2006 earnings before interest, taxes, depreciation, and amortization (EBITDA), below peers' 8.5 times multiple, and at 9.8 times estimated 2006 operating cash flow, below peers' 11.3 times multiple.

For an intrinsic valuation of the company, we utilize a net asset valuation, in which we project day rates, utilization, and margins for each rig in the fleet over a period of 10 years, and assume terminal growth of 3% per year, discounted at a weighted average cost of capital of 8.9%. After subtracting the value of long-term debt, and adding back cash and marketable securities, we estimate a net asset value of $60 per share.

We use known day rates and utilization through 2007 where contract data are available; estimate such day rates and utilization where rig days are currently uncommitted; and assume deceleration of current day rates to historical average day rates by 2014. Our net asset valuation excludes any potential cash flow to be generated from the GSF High Island III and Adriatic VII, given the possibility that either or both of these rigs could be declared constructive total losses.

Based on an assumed 10 times multiple on 2006 EBITDA, and 11.5 times on 2006 cash flow, blended with our net asset valuation of $60 per share, our 12-month target price is $60, representing about 21% upside to the recent price of $49.68. Combined with an industry-leading dividend yield of 1.8%, we believe the shares are attractive.

RISKY BUSINESS. We find GlobalSantaFe's corporate governance practices to be largely sound. The company's board of directors is majority-controlled by independent directors; the office of chief executive is separate from that of chairman; and the audit committee is entirely composed of independent directors. We view as a negative, however, the company's practice of a staggered board, in which approximately one-third of board members are nominated each year for reelection for three-year terms.

Risks to our recommendation and target price include lower-than-expected drilling activity in North America, West Africa, Northwest Europe, and Southeast Asia; lower oil and natural gas prices; longer-than-expected delays in repair work for hurricane-related damage; faster-than-expected arrival of newly built rigs to the global fleet, particularly jack-ups; and greater-than-expected costs on turnkey drilling projects.

Analyst Glickman follows shares of oil and gas drillers for Standard & Poor's Equity Research Services

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