Rowan Companies’ >10% Bonds Are Great For Income-Oriented Investors
Rowan Companies ‘ >10% Bonds Are Great For Income-Oriented Investors
Rowan Companies (NYSE:RDC) is one of the only offshore drillers with a properly financed balance sheet, notable backlog, and low-cost rig fleet. This will enable it to survive the current cyclical downturn. However, there is the real probability of near-term downside, which will pressurize equity valuations. A more conservative approach to an investment lies in RDC’s high-yield bonds.
Pre-2015, RDC specialized primarily in high spec jack-ups. However, in 2015, RDC invested in four ultra-deepwater drillships. Besides the drillships, RDC has a fleet of 31 mobile high spec jack-ups. On a geographic basis, the company has operations in the Gulf, UK, Norwegian sectors of the North Sea, the Middle East, and Finland. With a primary focus on jack-ups, diverse geographic operations and a notable backlog, the company is well-positioned to survive the downturn.
Why the Bonds
An investor looking to buy equity in RDC should be forewarned. There are a significant number of industry signs that suggest RDC’s valuation will get cheaper. Contract run-offs, future impairments, an oversupplied market and a decreasing backlog make RDC’s equity a value trap in the near term. In my opinion, there is more probability of the equity getting cheaper in the near term than what most bulls would want (capital appreciation).
There are four main reasons why investors should avoid the equity in the near term: future impairments, an influx of new builds, rolled-off contracts, and potentially terminated contracts.
There will be future impairments.
One of the biggest reasons why investors should consider RDC’s bonds over the equity is to protect themselves from future non-cash impairments. Yes, impairments are non-cash and really only affect GAAP earnings. However, decent sized impairments will influence future downside. Remember, the company had $566M and $330M in asset impairments in 2014 and 2013, respectively. Furthermore, with 10 jack-ups that were built pre-1998, these rigs have real potential to get stacked, scraped and written off.
The worldwide jack-up market consists of 596 jack-ups (all currently marketed). Furthermore, there are 125 more jack-ups that are under construction or sitting in shipyards. Given the fact that 88% of RDC’s fleet consists of jack-ups, there is a huge potential for the company to scrap and sell its older units. Moreover, with the supply and demand disequilibrium getting future contracts will be challenging, to say the least. This will influence the company to take sub-par dayrates and/or stack, scrap and sell a good portion of its fleet. From an investment standpoint, this will push the equity to lower valuations.
Rolled off contracts.
An additional headwind for equity investors is the rolling off of contracts in 2016. In 2016, RDC will have nine jack-ups coming off contract. Thus far, none of these ships have a contract after they roll off. If these units do not get contracts RDC will be forced to stack them, taking further impairment charges. Also, if there aren’t any re-contracted rigs there will be further pressure on their already shrinking backlog of $3.6B.
Potential for terminated contracts.
In a worst-case scenario, RDC’s customers might decide to terminate their contracts early. If this happens, RDC may or may not get an early termination fee. For valuation purposes, all investors should discount any potential termination fees to zero, due to arbitration. If any contract is terminated early, RDC will most likely have to stack the terminated rig. Further asset impairments will transpire from the termination.
Forget the Equity – Buy the Bonds
Right now there are two debentures on RDC’s balance sheet that look interesting. For investors looking to minimize risk, the bond maturing in 2017 would make the most sense.
This issue is trading near par, yet investors can still lock in a solid 6.9% yield. Due to the company’s solid backlog through 2017, this bond is near low-risk territory. The enterprising investor might want to have patience with this issue, given the fact they may be able to get in at a better price. The bond I am more attracted to is the one maturing in 2019. This bond has a current yield of 10.746%.
Source: Finra 2019
Source: Finra 2019
Source: Finra 2019
This issue has a much nicer yield coupled with a steeper discount from par. However, there is more risk attached to this issue given the fact that it matures in 2019. Though, by 2019, the offshore industry might be back in a cyclical upswing, lowering the forward non-systematic risk. As with the last issue, enterprising investors might want to wait for a better entry point, locking in a better yield. My price target for this bond is $80-$85.
The bonds make more sense than the equity because they will pay the investor in the form of a dividend while he or she waits for maturity. Furthermore, RDC has plenty of liquidity going forward, which will minimize the chance of a default (decent cash position, and untapped revolver and future backlog). Also, in the event of a default or a total business restructuring, the bonds will hold up much better than the equity (I believe that the chance of a default/restructuring is slim).
The recent reverse in the price of oil helped push the majority of offshore driller stocks upward, along with their bonds. I am not a commodity expert by any means, but there are a lot of signs that suggest that there could be more downside going forward (disequilibrium in supply and demand). Furthermore, the wild volatility of crude oil will cause RDC’s bond prices to fluctuate in value going forward (I would be very surprised if this did not happen).
Given the inherent volatility of energy prices, investors interested in RDC’s bonds should be patient. There will most likely be another day when investors can pick up a solid bond for a significant discount, locking in a very attractive yield. Patience is key to this game. The patient investor wins in the end.
Some retail investors might think that RDC would make a good acquisition target. However, there are clauses against the company getting taken over in their contractual obligation agreements. A thesis should not be based on a takeover by any means.
The company also has a $209M unfunded pension liability. The plan is to contribute $22M in 2016 to this liability. Furthermore, there is potential for higher funding obligations if rates or pension asset values decline. Additionally, a 1% decrease in the discount rate assumed by the company will increase the liability by $94M.
Salvage values on jack-ups have decreased from 20% to 10% in 2014 (of historical cost). Moreover, with a decent sized amount of jack-ups that are built before 1998, salvaging these assets could be lost hope.
The company capitalized its drillship new builds (finished in 2015). Capitalizing expenditures will artificially inflate profitability metrics, operating cash flow and increase PP&E in the short run. In the medium to long term, these metrics will have pressure from an increase in depreciation. Also, if one of the drillships has a contract terminated, investors should expect a decent sized asset impairment.
If you have been reading my articles about the offshore energy sector, then you should know that I am bearish on the sector for the near term. In the long run, I believe that the sector will recover, but only after further bankruptcies transpire. Investors interested in the sector due to the undervaluations should reconsider the equity, given the fact that this is a minefield of value traps.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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