Noble: A Smart Drill Bet
Noble (NE; recent price, $73) is a contract drilling company that owns and operates a fleet of 63 mobile offshore drilling rigs used in the exploration and development drilling efforts of oil and gas producers.
We think Noble is well positioned to benefit from a secular trend towards drilling in international waters with technologically advanced drilling equipment. We believe that Noble will outperform its offshore drilling peers, given the company's strong position as a provider of premium rig assets, its focus on international drilling, and its enviable historical financial track record relative to its peers.
Noble's stock—despite deserving, in our opinion, a premium valuation to peers—currently trades at or below peer levels, and also appears undervalued based on our net asset value model. The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).
Much of the world's crude oil and natural gas is trapped within layers of rock buried beneath the ocean floor. Offshore drilling rigs are the physical assets used to construct wells, and are typically contracted out to oil and gas producers for a prescribed period of time, at a prescribed day rate (e.g., $100,000 per day).
In shallow waters (typically up to 450 feet in water depth, although the drilling depth beneath the seabed can easily be 20,000 feet or more), a jackup is generally employed. Jackup rigs are mobile, self-elevating drilling platforms equipped with legs that can be secured to the ocean floor for support.
In deeper waters, where a jackup cannot be used because of the water depths involved, a semisubmersible or a drillship may be used. A semisubmersible is a floating platform that can be partly submerged in water; its position is maintained either by fixed mooring anchors, or by a dynamic positioning (DP) system. Drillships are ships that have a drilling platform built into the ship, are self-propelled, and are typically equipped with a DP system.
Rising Demand for Premium Rigs
In the past several years, high demand for offshore rigs has pushed up industry day rates to previously unheard-of levels, such as nearly $190,000 for a 250- to 300-foot independent leg cantilevered jackup in West Africa in January, 2007 (vs. about $58,000 in January, 2005). While day rates have recently declined in the U.S. Gulf of Mexico (after several years of strong growth), international regions have continued to show strength. Operators continue to sign multiyear contracts for offshore rigs in international regions at attractive day rates, and have coaxed a number of drillers to mobilize rigs out of the Gulf of Mexico for better opportunities elsewhere.
As new drilling opportunities increasingly arise in more technically challenging drilling conditions, we expect that premium rigs (rated at 300 feet of water depth or greater) increasingly will be in demand.
Noble's 63 rigs consist of 44 jackup rigs (three of which are currently under construction), 13 semisubmersible rigs, 3 drillships, and 3 submersibles. In addition, Noble offers engineering and consulting services to its customers.
Big in Foreign Markets
The company operates about 85% of its fleet in a variety of foreign markets. Contract drilling operations generated the lion's share of revenues in 2006 (92%). As of January, 2007, excluding the three jackups under construction, Noble had 51 of its 60 active rigs (85%) located outside of the U.S. Gulf of Mexico, and therefore, we think, is relatively well insulated from potential hurricane-related damage. The leading international regions were the Middle East (14 rigs), Mexico (10 rigs), the North Sea (3 rigs), West Africa (8 rigs), and Brazil (5 rigs). India and the Far East accounted for the remaining five international rigs.
The company continues to rebuild and retool its fleet, with 24 of the 63 rigs either newly built or upgraded since 2002. Including the three newbuilds under construction, Noble will have 30 of its 44 jackups rated at 300-foot water depth or greater.
In addition to contract drilling, Noble provides a variety of technologically advanced drilling-related services for its customers, including drilling-related software programs, project management, and labor services.
Risks in Mexico?
With its international exposure, we view Noble as well insulated from the recent weakness in jackup day rates in the U.S. Gulf of Mexico, and well positioned to benefit from rising day rates elsewhere. While operating expenses are on the rise industrywide, we note that Noble expects to have 25% fewer days in shipyard in 2007 than in 2006, which, if realized, could be an advantage relative to peers. Overall, we see significant operating margin expansion in 2007 and further expansion in 2008.
While Noble has historically had an orientation toward foreign drilling markets, its decision in recent years to exit the U.S. Gulf of Mexico jackup market appears to have been well timed, given the recent malaise in jackup day rates in this region. Average day rates for 300-foot, independent leg cantilevered jackups (the workhorse of the premium jackup fleet), which recently fetched as much as $150,000 per day in March, 2006, have dropped to $90,000 per day as of January, 2007, based on data from ODS-Petrodata. While this is still well above corresponding day rates between 2002 and 2004 (when such rigs attracted less than $50,000 per day), it still pales in comparison to corresponding day rates in other markets, such as West Africa ($189,000 per day) and Southeast Asia ($207,000 per day).
Ten of Noble's 41 active jackups are now located in Mexican waters, where day rates appear relatively stronger, and are benefiting from an increase in spending by Pemex, Mexico's nationalized oil company, as it attempts to ramp up future production growth. Recently, Noble recontracted six of the 10 jackups with Pemex at approximately $170,000 per day apiece, vs. prior contracts of about $65,000 per day. While Noble may bear some risk in the future from having a high concentration its assets with a single customer, at present we believe this concentration is yielding attractive day rates.
Sunny Earnings Picture
We think Noble has excellent earnings visibility in the near term, with 95% of available operating days in 2007 already committed by contract. Prospects for coming years are still strong with 75% booked in 2008, and 35% in 2009. We believe that floaters and premium jackups in international waters will continue to attract strong day rates, as we see high demand persisting, and likely to continue to outpace available rig supply, despite newbuild arrivals. As a result, we believe current leverage to uncommitted days in 2008 and 2009 is favorable for the company.
For 2007, we expect Noble's fleet of jackup rigs to generate an average day rate of about $117,000, with 96% utilization. For 2008, we expect average jackup day rates to rise to about $142,000, also with 96% utilization. The company's drillships are expected to generate an average day rate of $122,000 in 2007, and $164,000 in 2008, but should rise sharply in 2009 to about the $340,000 mark as older long-term contracts finally expire. Utilization for drillships is projected at 100% in 2007, and 99% in 2008. Noble's fleet of semisubmersibles is projected to generate an average day rate of about $260,000 per day in 2007, and $302,000 per day in 2008 (with utilization at about 99% in both years).
Overall, we see total revenue growth of 45% in 2007, and 29% in 2008. We project earnings per share of $9.29 in 2007, and a 37% advance in 2008 to $12.73, compared to reported EPS of $5.33 in 2006.
Performance Merits a Premium
Our net asset value (NAV) estimation of about $94 per share is derived by calculating operating income projections for each rig in the company's fleet, based on current and projected day rates, estimated operating expenses, and estimated rig utilizations, over 10 years.
We then incorporate company-wide projections of effective tax rates, net capital spending, and changes in noncash working capital, to derive an estimate of free cash flows, plus a terminal value, the latter representing expected cash flows beyond 10 years as the company retools its fleet. The resulting free cash flows are then discounted by the estimated weighted average cost of capital for the company.
Relative to the peer group of eight offshore drillers, between 1996 and 2005 (excludes 2006 results, since not all such results are yet available for all peers), the company ranks first in net profit margin, second in return on assets, and second in return on equity. Given Noble's strong track record of financial performance, we believe that it merits a premium to its peer group of eight other offshore drillers.
Currently at a 5.6 times multiple to our estimated 2007 earnings before interest, taxation, depreciation, and amortization. Noble is trading on par with the peer group. Using a 7.0 times multiple yields a value of $95 per share. On a price-to-operating cash flow basis, the stock trades at a 6.8 times multiple, about 7% below the 7.3 times peer group average. Using a 9 times multiple on projected 2007 operating cash flows yields a value of $98 per share. Blending these relative valuation metrics with our NAV model, we arrive at our 12-month target price of $96 per share.
Assessing the Vulnerabilities
We believe that Noble's corporate-governance practices are generally sound. Independent outside directors represent eight of the 10 seats on the company's board, and board members are slated for reelection annually. The audit and compensation committees are composed solely of such outside directors. All outside directors have a sizable equity component to their compensation, in the form of restricted stock, which vest over three years. However, we note that the chief executive also fulfills the functions of the president and the chief operating officer, and that the current chairman of the board is slated to retire on Apr. 30, 2007.
Risks to our recommendation and target price, in our view, include significant declines in capital spending by oil and gas producers on new drilling activity, delivery slippage of newbuild rigs under construction by Noble, and faster-than-expected arrivals of other newbuild rigs. Other risks include higher-than-expected downtime for the company's rig fleet, an increase in labor and equipment cost inflation, lower-than-expected day rates for drilling rigs, and a downturn in demand by Pemex.