Northern Offshore - Market Fails to Notice Upcoming Rise In Earnings, Free Cash Flow

My most popular series of posts by far have been those on Awilco Drilling. Awilco has been a solid investment, providing a total return of over 70% since I first wrote about the company last May. Despite these results, the company still trades at a dividend yield of close to 22% and an EV/EBITDA of 4.1, and I believe the shares still have a lot of room to run. Today's post is about a similar high-yielding company in the same industry. This company is reminiscent of Awilco a year ago, when the market had yet to price in the coming increases in earnings and cash flow from new contracts.

Northern Offshore owns a collection of marine drilling assets, including two jackup rigs, a semisubmersible rig, a drillship and a floating production unit. Northern is domiciled in Bermuda with its executive offices in Houston, and trades on the Oslo exchange as "NOF." (There is also a US ADR, NFSHF, though trading volume is thin.) Northern's assets are leased to drillers and explorers in the North Sea, Asia and soon, Africa.

Compared to Awilco's stellar management team, Northern has not always enjoyed the same leadership quality. Struggling with an unmanageable debt load, the company underwent a reorganization in 2005 that included a share issuance and a brand new board of directors. Unfortunately, the new team made a massive and debt-financed $455 million acquisition in 2007. The acquisition was poorly-timed, and in 2010 the jackup rigs the company acquired were written down by $205 million. Despite the unfortunate transaction, Northern managed to stay current on its debt and eventually paid down the balance. Today, the company has a net cash position.

Let's take a look at Northern's active operating assets. Like Awilco, these assets are hardly new, yet they still have a reasonable lifespan and will produce a great deal of cash flow over that life.

Northern Producer

Northern Producer is the company's floating production facility, currently operating in the North Sea. Northern Producer was originally contracted as a semisubmersible drilling rig in 1977 and converted to a floating production facility in 1991. Northern Producer is contracted to EnQuest for the life of the oil field, and earns revenues based on production levels. In 2013, Northern Producer earned tariffs on an average of 18,103 barrels per day and earned just over $40 million in revenues.

Energy Driller

Energy Driller is Northern's semisubmersible drilling rig, originally constructed in 1977. The rig has undergone substantial upgrades, most recently in 2012. Energy Driller in contracted to ONGC off India's west coast at a dayrate of around $210,000 until April 2015. Energy Driller has historically operated off of Southeast Asia and Brazil. In 2013, Energy Driller earned revenues of just under $58 million.

Energy Endeavor and Energy Enhancer

Energy Endeavor and Energy Enhancer are Northern's harsh environment jackup rigs, currently operating off of the Netherlands and Denmark by Wintershall and Maersk, respectively. Endeavor is contracted until November 2014 at a dayrate of around $160,000. Wintershall has an option to extend the contract by six months. Enhancer is contracted until July 2015 at a dayrate of around $140,000. Maersk has a one-year option to extend the contract at a higher rate. Both Endeavor and Enhancer were constructed in 1982. In 2013, Northern's jackup rigs brought in revenues of nearly $77 million.

Northern has two new jackup rigs on order to be delivered in 2016. More on these a bit later on.

In 2013, Northern Offshore's active assets earned $174.9 million revenues, and produced $50.4 million in EBITDA and net income of $11.3 million. Free cash flow was $30.2 million, which the company devoted entirely to paying dividends. Based on its current market capitalization of $238.6 million, Northern's valuation seems attractive.

One could see the EV/EBITDA multiple of 4.5 and the double-digit free cash flow yield and conclude that Northern is cheap, but that would be some very lazy analysis. After all, drilling companies face some unique challenges. Drilling companies must engage in significant capital expenditures, lest their assets become too old or degraded to have any economic value. Drilling companies are also subject to fluctuations in dayrates, and risk revenue declines once contracts end. For those reasons, buying drilling companies purely on backward-looking EBITDA or free cash flow yield can be a losing proposition.

However, at some point, the free cash yield becomes high enough or the EBITDA multiple low enough to adequately compensate for these factors and then some. This is likely to be the case for Northern Offshore in 2014. Remember how I described Northern's active operating assets and their revenues? I used the term because Northern has another very significant asset, one that sat idle for all of 2013.

Energy Searcher is Northern's drillship, used in exploration activities. The ship completed a contract earlier than expected off Vietnam in 2012, and was sent to Singapore for maintenance after. Northern Offshore marketed the ship for the entirety of 2013, but could not find a taker. Finally, Northern has signed a contract with Camac Energy for use off Africa's west coast, and at a handsome rate: nearly $100 million per year, with an option for an additional year. The ship is currently on its way to its new market, where it will begin operations in mid-2014. The revenues from this contract should add handsomely to Northern's EBITDA and free cash flow.

Before I proceed to evaluate the impact of Energy Searcher's contract, a few caveats. First, Energy Searcher is an OLD vessel. Rigzone.com and other shipping info sites list the date of construction as 1982, but some other sources indicate that Energy Searcher was originally built in Sweden in 1958 and converted to a drillship in 1982. Apparently, the original engine is still going strong, but anyone wishing to model out Northern's results should probably not assume a long remaining life for Energy Searcher. Second, Northern's troubles marketing Energy Searcher are not new. The ship also sat idle for much of 2011. Finally, Energy Searcher's new employer, Camac Energy, is hardly a prime operator. Camac is a highly speculative prospector that recently required a capital injection from a South African pension fund to continue its operations. Should Camac run into further trouble, its ability to perform on the Energy Searcher contract could be in doubt.

Assuming all goes well, Energy Searcher will provide a serious boost to Northern's operating results. In previous years, drilling and production costs have ranged from 40.7% of revenues all the way to 71.1% of revenues.

Conservatively assuming that drilling and production expenses eat up 70% of Energy Searchers's revenues, Energy Searcher will contribute an additional $30 million or so to Northern's EBITDA and free cash flow once the contract kicks in. The chart below compares Northern's actual 2013 results with pro forma results including Energy Searcher's revenues. The projection ignores increased revenues from a higher dayrate for Energy Enhancer and assumes general and administrative costs remain steady.

Once Energy Searcher is again in operation, Northern's EBITDA and EBIT will likely jump significantly. Free cash flow will likely rise by a similar amount, though some working capital investment may blunt the effect slightly. Regardless, 2.8x pro forma EBITDA and 4.7x pro forma EBIT is flat out cheap, even for a company that faces distinct risks.

Complicating the matter is Northern Offshore's order for two high specification jackup rigs, currently being built in China for delivery in 2016. Northern Offshore will require financing for the total cost of just under $180 million. Northern Offshore will have a few financing options available, including a bond issue, a sale-leaseback arrangement with a company like Ship Finance or Ocean Yield, or selling off its existing assets. Whether the new jackup rigs will be a profitable investment is another question, and one that is difficult to determine two years in advance. Much depends on the direction of oil prices and jackup dayrates in the interim.

Despite these risks, I contend that the market has failed to adequately price in Northern Offshore's upcoming EBITDA and free cash flow boosts. Once the market notices the absurd EV/EBITDA multiple and the 20%+ free cash flow yield that the Energy Searcher contract could bring, shares could appreciate, much like Awilco's did once its rigs were fully contracted and operating. In the interim, shareholders will be well-compensated by Northern Offshore's 14% dividend yield.

Alluvial Capital Managment, LLC does not hold shares of Northern Offshore for client accounts. Alluvial does hold shares of Awilco Drilling for client accounts.

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Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.