Awilco drilling is seemingly every small cap value investor’s favorite North Sea driller; you’ll find it written up wherever value guys hang out. Its high dividend is its primary attraction and the dividends sustainability, its primary question mark.
Usually high yields usually scream trouble to me, and I can identify several scenarios where Awilco’s dividend could be challenged, but I believe Awilco also holds a sustainable niche. I purchased it last year before the first dividend was paid and while it’s not the “load up the truck” buy of last year, it’s still attractive.
This post is my one year update. I wrote it to help me freshen up my valuation. Your constructive criticisms will help me refine my analysis, so have at it, but please note I am using a yield based analysis to ballpark the value of the company. In the links to other sources at the bottom of this article, you can find a more traditional cash flow model if that’s your preference.
History of Awilco
Awilco Drilling PLC is a UK based drilling contractor. It owns and operates the two refurbished and enhanced mid-water semi-submersible drilling units, WilPhoenix and WilHunter, each rated to operate in 1200 and 1500 feet of water respectively. In 2009, Transocean wanted to merge with GlobalSantaFe, but the combination would have created a total monopoly in the North Sea. To obtain UK approval, Transocean was required to sell off two ships to another operator. Transocean needed a buyer quickly, the Awilhelmsen group fit the bill, and thus began the current incarnation of Awilco Drilling.
For those like me, who hadn’t heard of the Awilhelmsen group before, it is a private Norwegian company with interests in shipping, oil field services, real estate and financial investments. They owns 48.7% of Awilco Drilling and are the controlling investor. Awilco’s market cap is approximately 645 million with 125 million in 5 year debt. The stock was listed publically in 2011 on the Oslo Axess exchange as AWDR:NO and is also available on the pink sheets as AWLCF. Not surprisingly, liquidity is significantly better on the Axess market than the pink sheets.
The WilPhoenix and the WilHunter rigs were almost 30 years old when they were purchased from Transocean in December 2009. Upon receipt, Awilco’s first action was to take the old rigs to dry dock and invest another 97 million to upgrade the rigs, enhance their capabilities and extend their life another 20 years. The upgrades improved the rigs highly desirability and reliability. They have been under continual contract since released from the shipyard in 2011.
In January 2013 the company announced it would begin paying out all its available cash over a $40 million reserve as dividends. Until then, the company was aggressively paying down debt. The first dividend payment began at $1/quarter in May 2013 and was raised to $1.10/quarter this past November.
On a $21.50 stock, a $4.40 per year dividend is a yield of 20.4%. Pretty good, eh? Well yes, but there are some gotchas. For starters, the rigs only have 18 years of fatigue life left in them. This means (a) we only get the dividends for 18 years and then nothing, and (b) part of our dividend is really the depreciation of our rigs as they covert from productive equipment today to scrap in 18 years. We should consider this portion of the dividend as a return of capital and definitely not earnings.
To model the depreciation in value, we can divide the share price of $21.50 by 18 years of remaining life or $1.20/year. Now the value of the rig probably only declines as a straight-line if you’re an accountant. In reality, the decline in the rigs useful value would be more back end weighted, but I’m being intentionally conservative. With this assumption, the $4.40 actual dividend, less this $1.20 adjustment equals a $3.20 normalized dividend. At our $21.50 share price, we get a normalized yield of 14.9%.
But we still have some adjustments to make. We need to account for scheduled and unplanned maintenance. For instance, one ship is due to dry dock for two months in 2016. While the cost of the maintenance is already accounted in the cash the company keeps in reserve for maintenance; there is no reserve for the loss of revenue while the rig is in dry dock. So if both rigs are out of action two months every five years for scheduled maintenance and we have another two months of unplanned downtime per rig every five years as well, we need to reduce the normalized yield by 4/60 or 6.6%. This takes us down to a normalized yield of 13.9%.
While 14% is not as eye catching as 20%, it’s still a pretty impressive number in a low interest world. For comparison, Awilco’s 5 year bonds yields 7%. If a normalized 12% would seem reasonable for a small cap with good management, then a little more capital appreciation would seem possible as well. With a 16% bump in price to $25/share, Awilco would trade for a 12% normalized yield while still paying out $4.40 per share in dividends.
Currently, day rates in the North Sea are benefiting from a tight market.
Can this last? Normally, I would advocate for a quick revision to the mean, but Awilco is a little different situation that many rig operators.
Awilco management thinks day rates will soften in 2015 and firm back up in 2016. The following two charts from their March presentation show the status of North Sea rig utilization and contracts.
But aren’t day rates are notoriously volatile and what about all those new super rigs being built?
Yes, rates are volatile, but only where there is an active, changing market. For me, this is where the investment gets very interesting and Awilco picks up a little bit of a moat.
The North Sea is a mature oil province that was drilled up in the 1970’s and 80s. In its day its wells drilling in 1000 feet of water were considered deep, but that was 20 years ago. Now, no one considers the North Sea to be deep water anymore. So while plenty of new rigs are being built, all of them are being built for much deeper water (5000-10,000 feet) where operators will pay much higher rates.
No one is building brand new rigs for the old mature fields and no one can afford to pay deep water rates for routine work in the North Sea. But the old mature fields aren’t dead just yet; there is still remedial work to be done and spot opportunities to apply new technology. If nothing else, the current rigs in the North Sea could stay busy plugging and abandoning the old wells for years to come.
What keeps competition from moving in and lowering day rates?
While rigs can be moved across the ocean from one basin to another that takes months during which time the rig is not earning money. Furthermore, not just any rig can be certified for North Sea operations, so there is a regulatory hurdle to be overcome to operate in the UK during which time the rig would also be sitting around not earning any money. Finally, but not insignificantly, the old rigs made for the North Sea were designed for the North Sea and deal with its notorious weather and rough seas better as well, but no one is building brand new, old rigs anymore.
The most likely competition would be someone doing what Awilco did. Buy an old rig take it off the market for a year and retrofit it. To make the economics work best, it would help to have a forced seller like Awilco had with Transocean. It could happen, but it will not happen overnight.
The company’s current contracts are with strong counter-parties, so we’re covered through 2016, but long term this is probably the most significant risk.
Key Indicators to watch:
Day rates for Awilco’s drill semi-submersibles – Any changes on the contracts?
Day rates for North Sea drillers – Is anybody bring new rigs into the market?
Any significant change in the price of oil? – Obviously a long-term significant price drop would impact the day rates.
Rig accident – Every 10 years there is a catastrophic offshore drilling accident resulting in a huge fire, spill, destruction of the rig, and a tragic loss of life. However, every year 600-700 offshore rigs across the globe operate safely without incident and news coverage. Yes, a tragedy could strike Awilco, but this needs to be weighted as a 1 in 500 type event or even a 1 in 100 probability and can be accounted for by reducing the value of your investment by 1 per cent.
Unfavorable acquisition – Currently, Awilco is a cash generating dividend paying machine. What happens if Awilco purchases another rig or makes another large acquisition? Will this dry up the dividends? Perhaps, but let’s don’t forget that the Wilhelmsen’s made a pretty good deal when they bought the two rigs from Transocean a few years ago. Maybe should want them to make another good acquisition and make us even more money. This risk is probably a wash. They do seem like intelligent operators.
Extended drop in oil prices – Some North Sea work is mandatory for regulatory reasons and needs to be performed regardless of the current oil price, but the majority of well work is done for purely economic reasons which would obviously suffer with a 30% drop in oil prices. Of course, a rise in oil prices is always possible too. Shave a little more off fair value for this risk if you want, but wait until Mr. Putin is finished annexing the Ukraine first.
Regulatory Risk – There’s been chatter of a change in UK taxes, but nothing firm.
Other good sources of information:
To learn more about AWILCO, check out these links:
Company Presentation March 2014
Tim Eriksen’s Value Investing Congress Notes
Disclaimer: I own AWLCF and AWDR:NO