Songa Offshore: A Fallen Angel With The Potential To Deliver Enormous Returns
Songa Offshore (SGAZF.PK) is a Norwegian-Cypriot offshore drilling contractor that was founded in January of 2005 with the purchase of two semisubmersible drilling rigs, Mata Redonda and La Muralla. The company renamed these two rigs to Songa Venus and Songa Mercur, respectively, shortly after acquiring them. The company expanded quickly after purchasing these two rigs, buying the Stena Dee (renamed theSonga Dee) in March 2006, the Deepsea Trym in January 2007, theDeepsea Delta in the second quarter of 2008, the Deepsea Driller(renamed the Songa Eclipse) in 2011, and a few other rigs and interests in rigs over the years which have been bought and sold. Today, the company has five offshore drilling rigs in operation with four more under construction. The Songa Eclipse is not included in this count due to its pending sale to Seadrill Ltd. (SDRL). The sale of the Songa Eclipsesquarely positioned Songa Offshore as a midwater drilling contractor with the potential to become one of the leading such contractors on the Norwegian Continental Shelf. The company was listed on the Oslo Børs in January 2006 and it also trades on the pink sheets in the U.S.
Income and Cash Flow Analysis
Songa Offshore reported its third quarter results on November 26. At first glance, these results appear to leave a lot to be desired. But that is not the case. In fact, the apparent weakness of these results could be hiding an opportunity for brave investors. Here is the company's income statement from the most recent quarter, along with the results from previous quarters:
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Source: Songa Offshore
As this income statement shows, Songa Offshore reported a loss in the third quarter. The cause of this loss was an "impairment loss on asset held for sale" of $116.77 million. This impairment loss is a one-time loss caused by the sale of the Songa Eclipse to Seadrill, which will be discussed later. If this impairment loss is excluded from the results, then the company's results are much more in line with the preceding quarter. Excluding the impairment loss caused by the sale of the Songa Eclipsewould bring the company's net income up to $8.379 million. This is slightly lower in the second quarter, but this is more than explained by the lower revenues during the quarter. The slight decrease in revenue quarter over quarter is also not a problem as it is explainable by maintenance and operational activities common to this industry.
Songa's results from the second and third quarters of 2012 do show a considerable decline in profitability compared to the third quarter of 2011. This declining profitability occurred even in the face of rising revenues and cannot be explained solely by the impairment loss due to the sale of the Songa Eclipse. The lower profits can be explained by higher costs, particularly depreciation and amortization. The higher depreciation is due to Songa Offshore's rig fleet, which was larger in the third quarter of 2012 compared to the third quarter of 2011. Naturally, a greater number of rigs will lead to higher depreciation and amortization since more rigs are being depreciated. It is important to keep in mind that depreciation and amortization is a non-cash expense and, as such, does not affect the money that the company actually brings in. Another major contributor to the decline in profits is an increase in operating expenses. The increase in operational expenses was caused entirely by the Songa Eclipse, as shown here:
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Source: Songa Offshore
As with most offshore drilling companies, Songa Offshore's operational expenses are entirely attributable to the costs of operating the rigs in its fleet. The reason why Songa Eclipse saw such a sharp increase in the year over year operating expenses is because the rig began operating in the fourth quarter of 2011. The Songa Eclipse was in the shipyard being built and undergoing seatrials until the middle of the third quarter of 2011 when the rig began mobilizing. As a result, there were very limited operating expenses incurred by the rig in the year ago quarter because the rig was not operating!
The increase in depreciation and amortization and operating expenses were not entirely covered by revenue increases. This was due to upgrades being performed on two rigs: Songa Delta and Songa Trym. TheSonga Delta was in the CCB shipyard receiving upgrades and other work that is intended to extend the rig's useful life. The rig left the shipyard in November and immediately thereafter successfully passed its Class-required incline and client acceptance tests. Songa Delta mobilized to its assignment location on November 14. Songa Trym, meanwhile, is expected to remain in the shipyard until the middle of December. TheSonga Trym is also receiving upgrades and life-span enhancements. Songa Offshore elected to perform a Special Periodic Survey at the sametime, as that minimizes the amount of time that the rig spends in a shipyard over its useful life. This is a good move because it maximizes the amount of time that the rig will be operating and earning money as opposed to being in a shipyard and not earning money. These two rigs will begin generating revenue once again for Songa Offshore once they arrive at their respective assignment locations and start operating. Songa Delta will most likely begin operating either at the very end of the fourth quarter or the early part of the first quarter of 2013. Songa Trym will most likely be about a month later. Both rigs will experience a full quarter of operations by the second quarter of 2013 and this will prove positive for Songa's revenues and earnings.
Despite the negative impacts that these two rigs have had on Songa's revenues and the profitability decline that Songa has suffered, the company's cash flows are vastly improved over the prior year quarter.
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Source: Songa Offshore
As the statement of cash flows shows, Songa Offshore's operating cash flow climbed to $310,516,000 in the most recent quarter, up from $124,124,000 in the year ago quarter. This represents a 150% increase in operating cash flow in a year. Songa Offshore's free cash also showed marked improvement year over year, although it was negative in both years. A negative free cash is normal during the early years of an offshore drilling company due to the enormous costs of building up its fleet. To get an idea of these costs, consider that a shallow water jack-up rig costs approximately $200 million to build and an ultra-deepwater offshore drilling rig costs approximately $600 million to build. This negative free cash flow should turn positive as the company's rigs are completed and begin operating. Songa Offshore's free cash flow, calculated as operating cash flow minus capital expenditures, was -$279,465,000 in the third quarter of 2012. This represents a substantial improvement from the -$552,711,000 that the company reported in the third quarter of 2011.
Growth Prospects
Songa Offshore is well positioned for growth going forward. As mentioned earlier, Songa Offshore has four new rigs under construction. There is no risk that the company will be unable to contract out these rigs. In fact, all four of these rigs have already secured contracts with Norway's Statoil (STO) and the rigs will begin working on these contracts as soon as they are delivered. However, it will take a few years for Songa Offshore to realize the growth from these new rigs due to the time that it takes to construct them. Here is the construction and delivery schedule for these new rigs:
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Source: Songa Offshore
The potential that these four rigs have to grow Songa Offshore's cash flows should not be understated. The contracts that these rigs have secured have an average dayrate of $430,000. This works out to approximately $1.72 million per day of new revenue or approximately $156,520,000 of new revenue per quarter on average. This is enough to more than double the company's revenue, based on the results from recent quarters. However, it is unlikely that Songa Offshore will actually generate revenue at this level as things such as routine maintenance will drop revenue below the theoretical maximum potential calculated above. However, Songa Offshore has historically been very good at keeping these sorts of interruptions to a minimum and so the company typically achieves more than 90% of its theoretical maximum potential revenue.
Songa Offshore Achieved Revenue Efficiency Quarter over Quarter
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Source: Songa Offshore
This chart shows Songa Offshore's quarterly revenue efficiency, which measures the percentage of contract revenue earned compared to theoretical maximum potential revenue. Followers of the industry will likely notice that the above numbers are some of the best in the industry and indeed they are. If we assume that Songa achieves a 94% revenue efficiency with its new rigs (which is not unreasonable) then that would represent $147,128,800 of new revenue. This is still enough to double the company's revenue.
From an investment perspective, revenues are not as important as earnings and cash flows. The Songa Dee, which is the most similar rig to these newbuilds in Songa Offshore's fleet, costs the company approximately $170,000 per day to operate. If we assume that the new rigs will each cost approximately the same on average to operate, then we can calculate that the new rigs will produce approximately $260,000 each per day of profits. This works out to $23.7 million per rig per quarter, or approximately $94.6 million per quarter from all four rigs. As this analysis excludes things such as the large amount of "Payables Received" on the cash flow statement, it should be easy to see the outsized positive impact that this will have on the company's cash flows and EBITDA.
Valuation Analysis
At the time of writing, Songa Offshore has a market capitalization of $278 million. This market capitalization is, for reasons that will be discussed later, substantially lower than where it stood at the beginning of the year. Using this, we can calculate the company's total enterprise value (TEV). At the time of writing, Songa Offshore's TEV stood at $1.18 billion. This is substantially less than it would cost to build a company like Songa Offshore from scratch. According to Keppel Corp., one of the premier builders of offshore drilling rigs, it costs approximately $550 million to build one harsh-environment midwater rig. Thus, to construct the eight rigs in Songa Offshore's fleet, it would cost approximately $4.4 billion. I have excluded the ninth rig in Songa Offshore's fleet (the Songa Eclipse) because it has been sold to Seadrill and thus would not be necessary to replace were someone to attempt to build the company from scratch. This does not include the time needed to construct these rigs (approximately three years in the best case scenario) nor does it include the costs incurred to secure drilling contracts for the rigs. So, Songa Offshore certainly looks undervalued based on its current market cap and enterprise value.
Songa Offshore had a negative EPS over the trailing twelve month period due to the aforementioned writedown incurred due to the sale of theSonga Eclipse offshore drilling rig. As a result, examining the P/E is going to be rife with errors because of this. However, we can take a look at the P/E ratio excluding the loss due to the sale of this rig to determine valuation based on this metric. The company's trailing twelve month EPS is -$0.23 if the sale of the rig is included in the EPS calculation. The writedown due to the sale of the Songa Eclipse was $116,770,000 or approximately $0.58 per share. Thus, the company's trailing twelve month EPS excluding the writedown is $0.35. This gives Songa Offshore a P/E ratio of 3.91 at the current market price. This is an incredibly low P/E considering the company's growth potential.
Songa Offshore's free cash flow is negative due to the enormous expenses that Songa Offshore has had to incur due to the upgrades onSonga Trym and Songa Delta as well as the construction of its four new rigs. As a result, comparing the stock price to free cash flow will deliver misleading conclusions. The company's TTM operating cash flow is $454,923,000 or $2.24 per share. This gives the company a P/OCF of 0.61.
Songa Offshore is cheap based on all metrics. The stock could easily return triple digits should the company begin to be valued at a level where the enterprise value is equal to the cost to replace the company's fleet or if the P/E ratio rises to levels on par with its peers.
Investment Opportunity and Risks
Despite all of this growth potential, Songa Offshore has lost 63.57% of its value this year. This could create an opportunity for intrepid investors. The primary reason for this year's stock price plunge was financial troubles at Songa Offshore. One reason for this is that the costs that the company incurred for its aforementioned rig upgrades weresignificantly above budget. Although a portion of these costs were covered by Statoil, Songa Offshore was still struggling under these costs throughout the year. These upgrade projects are now largely completed and so the costs related to these projects should no longer plague the company.
The company's debt load could present another potential risk. Songa Offshore owes a total of $1.4 billion in bank loans, bond debt, and credit facilities related to its four rigs under construction. This gives the company a net debt to equity ratio of 1.03. The company expects to reduce this significantly in the fourth quarter to $1.09 billion.
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Source: Songa Offshore
This debt remains perhaps the biggest risk to the company's future. Although Songa Offshore has made all required payments on this debt, the company is in breach of the covenants attached to the bonds. The company breached the covenants by failing to maintain the required debt to EBITDA ratio. Songa has obtained waivers for this violation. However, none of the company's debt (except for the shipyard facilities) matures before 2015. By this time, Songa Offshore will have its four new rigs in operation. The additional money and profits that these rigs will generate will greatly improve the company's ability to support and pay down this debt.
Songa Offshore is a fairly high-risk play. However, it appears that the worst is behind the company. The company has the potential to deliver very large profits to investors as long as it can indeed handle this debt load, especially when the weakness in the stock price this year is considered.
By Power Hedge
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