Fred. Olsen Energy: The Ugly Duckling

Company: Fred. Olsen Energy ASA (FOE: OSEBX)

Written: January 2017

Authors position: Long since Jan 2016

Weighted Average PPS: ~15NOK

Fleet-Status-FOE


Overview of Investment Thesis

  • FOE qualifies as one of the most hated company in Norway, creating a unique contrarian investment opportunity.
  • The company’s credit expansion has been significantly more conservative compared to its peers, contributing to a solid debt profile.
  • FOE’s cost efficiency in regards to operational cost and Capex makes the company competitive at depressed dayrates.
  • Earlier recovery of the mid-water segment is expected to materialize as compared to the ultra-deepwater.
  • Trading around 20 NOK, FOE is cheap as soap and investors can be rewarded with ~13x return if the segment turns around.
  • Investing in FOE violates Warren Buffets famous motto; Rule No.1: Never lose money. Rule No.2: Never forget rule No.1; but FOE’s significant discount to its intrinsic value provides enough upside to justify the high probability of bankrupcy and/or restructuring.
  • As the future return of FOE is very binary in its nature (bankruptcy or jackpot) buying long term call options can provide preposterous upside.
  • Don’t invest money you can’t afford to lose in an “all-or-nothing trade”, FOE remains in need to retrieve new contracts

FOE is an Oslo based drilling contractor with a track-record spanning on more than 4 decades. The Fred Olsen family started its ship owning business in mid 1800s and the offshore industry involvement in 1967.  The company’s main geographic focus is set at Norway and the UK, while the company also has operations in other offshore regions. The fleet of nine units includes three UDW/DW assets, four mid-water semis, one tender support vessel and one accommodation unit.

Backlog

*The table displays FOE’s backlog up until the end of 2017. The full fleet status is available above in excel.

Borgny retired in 3Q16 and Borgland, Byford and Borgsten became idle in Sep/Oct. Given early 1Q17 expiry for Bideford and Blackford, FOE will be down to one rig (Bolette) in operations for the remaining of 2017. Bolette is contracted to 3Q18 supporting EBITDA with approximately $25M per quarter.

FOE’s backlog is now the shortest it has been (~$390M as of 3Q16) in more than a decade, down from more than $5bn at its peak. Subsequently, FOE has become one of the most disliked stocks in Norway, with analyst continuously cutting their price target (1 NOK is the lowest I’v seen). A large focus, and rightfully so, has been put on FOE’s diminishing backlog and its old fleet. Analyst black and white view has, however, created an herd mentality centering around FOE as their ugly duckling.

 

The diagrams show my own forecasted CFO numbers and the consensus EBITDA (based on ~6 different analysts). The two diagrams are presented in $M. As EBITDA is roughly a proxy for CFO, we can compare my estimates to the consensus.

Ownership structure

The Fred Olsen family is known for its conservative way of handling business. Leading up to the oil crash, the normal behaviour of the offshore drillers where to use excessive leverage to build as many new rigs as possible. This market behaviour was very much rewarded up until the crash. Comparing the two contrasting companies FOE and SDRL to each other shows a clear difference in behaviour leading up to the oil crisis.

FOE issued zero equity and $294M net debt between 2009 and 2014, while SDRL issued $794M in equity and $6959M in net debt. FOE bought Bolette (Gusto, 12K) which was finished in 2014, and was preparing to buy Bollsta (Aker H-3, Semi Submersiable) which was later canceled. Under the same period SDRL bought around ~30 new builds and has around 14 additional ones that are under construction today. As FOE has been significantly more conservative with their credit exposure compared to their peers, their balance sheet is one of the cleanest in the offshore drilling segment.

Balance Sheet

Resting on the backlog of Bolette alone, the logical question arises how long FOE can survive without significantly diluting the capital stock. As of 3Q16 non-current liabilities is at $988M. Calculating non-current liabilities ($988M) +/- Net working assets ($386M) – 4Q16 CFO(~$100M) gives FOE ~$500M in debt left for the end of 2016. The remaining $500M in debt will be somewhat problematic to pay of as 2017 CFO is estimated to be around $100M.

Let’s take a closer look at when the debt matures. The debt maturity in 2016 is not a problem as FOE currently has a solid cash position of $391M following settlement of the claim with Hyundai Heavy Industries in regards to the Bollsta new-build. The $200M of debt maturing in 2018 should not be a problem as well, as FOE can use the CFO generated from 4Q16, 17 and 2018 to pay it down. The $500M debt left ($300M 2019, $200M 2020+) will as discussed before be problematic. If the market has not turned by 2019, FOE might need to issue equity and/or restructure its debt.

To issue equity to cover the $300M that matures in 2019 will be somewhat problematic as well because of FOE’s low stock price. Assuming no debt is rolled over, FOE would be require to issue 120M shares to reach $300M (assuming $2.5 issuance price). FOE currently has 66M shares outstanding, and by issuing 120M, the bull scenario return would be reduced from ~13x to ~5x. Keep in mind that this assumes that no debt will be rolled over, which is highly unlikely in my opinion.

Covenant Breach

It has been circulating rumors that FOE is expected to breach its financial covenants in 2017, which I don’t agree with. I also consider this to be irrelevant as the covenants will most likely be renegotiated. I estimate that FOE will comply with their covenants for 2017, and will as earliest breach them in the beginning of 2018. FOE has already started a discussion regarding covenant waivers and amendments to their original credit facility agreement. Link:

The financial covenants are as follows.

• Net debt/EBITDA < 4.5x

• Interest coverage > 2.5x

• Minimum > USD 30M

The Leverage Ratio and the Interest Coverage Ratio shall be calculated on a trailing four-quarter basis. This means that we will still have the benefit from high EBITDA in 2016 when calculating our covenant for the quarters in 2017. 2017 Q4 will be the first quarter when we have no benefit from 2016 quarters (which have high EBITDA) in our covenant calculation.

I estimate net debt to be around $500M in the start of 2018. Assuming $500M in net debt, FOE needs to be below ~$111M in trailing EBITDA to breach the leverage ratio. Therefore, I estimate that FOE won’t breach the leverage ratio in 2017, while 2018 might be problematic. I estimate interest expense to be ~$40M in the start of 2018. To breach the interest coverage ratio FOE needs to be below ~$100M in trailing EBITDA, which again will not be broken before 2018.

Pipeline

FOE’s exposure to the mid water segment is an important advantage as the segment has limited new-build overhang and the most aged asset base. Following a period of major upgrades/CRS of six rigs (during 2013-2015), I see very low capex requirements in 2017-2018. Combining this with FOE’s low debt burden and conservative business practices should let the company to break-even at significantly lower dayrates than its competitors.

In regards to retreiving new contracts, Statoil (STL: OSEBX) is a key customer for FOE. As part of STL’s cost-cutting effort, the company has either suspended or cancelled as many of its existing contracts as possible. The company had earlier locked in rigs on contracts at relatively high dayrates and suffered when the commodity prices crashed, resulting in a slump in drilling activity. In recent times, STL has delivered very strong results, indicating its on track to balance the overcapacity in its portfolio.

The picture shows the backlog of STL’s fleet in the Norwegian continental shelf. Songa’s four Cat-D, COSL Promoter and Deepsea Atlantic are the only rigs with long-term contracts at this moment.

The picture shows the quantity of STL floater fleet in the Norwegian continental shelf. We can clearly see that STL is in a process to reduce its NCS rig fleet. However, it’s highly likely that STL’s long term rig demand is higher than the 6 floaters currently contracted for 3q17 and beyond. As STL is withdrawing from its shale operations in North America to focus more on the NCS, I expect FOE to be able to snag at least on long term contract in the mid/short term. As FOE’s fleet has such a low number of units, one or two contracts will work as a very bullish catalyst for the stock.

Valuation

For 2015 FOE produced around $600M in CFO. Assuming no further dilution (66M shares outstanding), there is no question FOE is worth at least NOK 280/share under “normal” conditions when the backlog is supported (~NOK 290/share at its peak). That would imply a 13x return in an extreme bull scenario (assuming bought at NOK 20/share). That kind of return is only available because investors fear for FOE never getting their backlog back. However, I believe that FOE’s current risk-reward profile is seriously skewed to the positive side. I’v shown that I don’t expect FOE to participate in any significant equity dilution until the end of 2018. I’v also shown that I believe FOE has a noticeably higher probability of retrieving one or several new contracts than what the consensus is expecting. The First lesson of Wall Street is to exploit mass-market psychology of acting in a contrarian fashion. Buying offshore drillers in the current environment might be the toughest investment there is. And that’s why its probably the best investment as well.


EDIT 30 Jan 2017

Here is a graph illustrating the negative sentiment. The green bars represent analysts who recommend buy, the lightbrown hold, and the red sell.

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