2023-10-16 21:18:03 ET
Summary
- Noble Corporation's shares have risen by about 50% over the past year, reflecting the recovery in the offshore drilling sector.
- The company reported solid financial results, with adjusted EPS of $0.38 and $104 million of free cash flow generated during the quarter.
- Noble has a strong backlog of contracts and is well-positioned to benefit from the increasing demand for offshore rigs, particularly in deep and ultradeep waters.
Shares of Noble Corporation ( NE ) have been a tremendous performer over the past year, rising by about 50%. The offshore drilling sector faced carnage from the 2014-2020 period as oil prices crashed several times, creating a glut of debt-financed rigs. However, there is a saying that “past gluts create future shortages” because gluts cause investment in capacity to fall. That is what has happened in the offshore sector to a tremendous degree. While shares of NE are pricing much of this in, there could be further upside if oil prices stay around current levels.
In the company’s second quarter , it earned $0.38 in adjusted EPS. This was below last year’s $0.40, though its acquisition of Maersk Drilling impacts comparability. Contract revenue rose sequentially from $575 million to $606 million. EBITDA was $188 million up sequentially from $138 million, thanks to a strong 29% margin. With these results, Noble generated $104 million of free cash flow during the quarter.
There is strong demand for offshore rigs, particularly in deep and ultradeep waters relative to the available supply. Accordingly, NE has 90% utilization for its marketed floaters (used for deeper, more complex projects). Its jack-up fleet is less utilized at 62%, though floaters earn day rates about 2.5x as high, making them a more important driver of earnings.
This divergence in utilization is driven somewhat by geography. Industry-wide, West Africa is the major hot spot and has 100% utilization, while Gulf of Mexico is 96%. The North Sea is lagging, and this is where many of its jack-ups have been positioned. If North Sea demand does not rise, Noble has noted these jacks-ups can be re-deployed into stronger regions to generate revenue.
Given these solid results, Noble reiterated its guidance for full year EBITDA of about $775 million on about $2.45 billion revenue. In my view, this should lead to free cash flow of about $350 million, normalizing for any working capital movements. NE is returning this to investors with $165 million in repurchase over the past year. Subsequent to Q2, Noble launched a $0.30 quarterly dividend, speaking to its confidence in the sustainability of its cash flow.
Its backlog plays a significant role in this confidence. As of August 2 nd , Noble has a $5 billion backlog. Offshore rigs are contracted out for long periods of time, particularly floaters, given the fact deepwater projects are long-cycle, and both the producer and rig-owner need visibility on costs and availability. Jack-ups, which are more mobile and can operate in shallower waters, tend to recontract over shorter time periods. Its existing backlog is already at about 66% of its Q2 revenue run-rate, likely enough to keep it free cash flow breakeven absent a single new contract.
Noble Corp
Of course, it is signing up new contracts. Last quarter, it added $750 million to its backlog, 1.25x its contract revenue, pointing to solid contracting activity where demand continues to outstrip its supply. The backlog is also well-priced with a $405k floater day rate and $180k for jack-ups on average though I see upside from here. There are also just 12 tier 1 ultra-deepwater ships left in inventory, so if companies want to keep drilling and exploring at their current pace, they will need to re-up existing contracts.
In practice, producers plan not to just sustain offshore activity, but to increase it. According to Schlumberger (SLB), the 2022-2025 period should see $200 billion invested in deepwater—up 90% from 2016-2019 levels. This is supported by what companies have announced. For instance, Guyana is a tremendous growth market with Exxon Mobil ( XOM ), a key Noble partner, proposing yet another project worth over $12 billion that will run through much of this decade. In Brazil, there are plans to spend $200 billion on infrastructure with increased exploration activity by Petrobras ( PBR ) a major contributor, which will further add to PBR’s demand for rigs.
This comes against a backdrop where Russia and Saudi Arabia have announced they are extended their oil production cuts through year-end. The Israeli-Gaz conflict also reminds investors that much of the world’s oil supply comes from a geographically fragile region. Plus, oil demand is still rising, with the International Energy Agency forecasting a ~5% rise by the end of 2028.
This all points to increased demand for offshore rigs. Critically, there is simply no new supply on the horizon to meet them. Also, it would take about three years to build a new rig. This is why there is no inventory—in 2020, we were in the grips of the pandemic, no one was going to build more deepwater vessels. This means inventory is essentially locked in until 2027. Plus given construction costs, NE says it would need a 10-year contract at $650k to justify the capital investment. That is still well above current market levels. As such, the floater population remains well below the 2011-2014 level, keeping prices up.
When I look at the offshore rig market, I actually see similarities to the US housing market. In articles on companies like KB Home (KBH),I spoke how a lack of building in the 2010s caused us to have a shortage of housing, which is why prices have risen so much and have held high despite the rise in mortgage rates. Something similar has happened in the offshore market, which was decimated first by prices plunging in 2015-2016, and then again in 2020. Management teams are deeply scarred by that experience and unwilling to do speculative newbuilds. This is likely to keep supply persistently tight.
Noble is no exception to this; it was one of several drillers to file for bankruptcy in 2020. That process though means this new Noble is a fundamentally stronger entity. A decade ago, this company carried debt of over $5 billion, almost all of which was wiped out. Today, it carries just $330 million of net debt for a leverage ratio of 0.5x. Its balance sheet is pristine. Not only is it not debt-financing new construction, it is not even equity-financing new construction, instead returning free cash flow to investors.
Importantly, Noble is also well positioned in the industry as it is the #1 drilling partner for some of the largest oil majors, including Exxon Mobil (XOM), Shell, and TotalEnergies. As noted above, XOM is aggressively growing its presence in Guyana while Shell recently dropped its plan to let oil production fall over time, given ongoing demand growth. It has also signed new contracts with Petrobras; in fact South America saw more activity in H1 2023 than all of 2022.
The offshore market is fundamentally changed. We have shifted from having drillers bet on rising demand by building new ships. Instead, they are deeply scarred by the collapse they have seen, which is keeping inventory extremely tight. Just as we have seen in housing, in the face of rising demand, I expect this means prices will rise, likely eventually having to near the $650k level required to support fleet growth.
Over time, if Noble can recontract at the $575 level, cutting the spread below replacement cost in half, free cash flow would rise by about $360-390 million, and this assumes no benefit from re-deploying its jack-up fleet. This would more than double the company’s free cash flow, though even if market conditions reached that point tomorrow, it would likely take about 3 years to see NE hit the $700 million free cash flow level, given its backlog is largely priced already. Still, this positions Noble for significant annual free cash flow growth for several years.
Risks
Because it takes several years to build ships, a sudden increase in supply is not a near-term risk for Noble, or even a medium-term one. I do believe the industry has learnt its lesson about overbuilding. Still over the longer term, if we were to see newbuild construction begin to take place, that could eventually lead to over-supply. For now, with no newbuild activity, that risk is unlikely to hit the market for at least 3-5 years.
Rather, the primary risk would be a drop in oil prices back to $60 or lower, which makes the economics of offshore production more challenged. Importantly, with its backlog and low debt levels, NE is much better positioned for this risk in the past and can weather such a storm, though buybacks would stop. With 2/3 of its revenue contracted next year, NE would be more exposed to an oil price drop in 2025 than one in the next 12 months. Recessions tend to reduce oil demand and would be a risk. However, given rising demand for oil and already announced plans to drill offshore by major explorers like Exxon, I view this risk as low, absent a significant recession and am assuming oil stays in the $75-100 area, where offshore economics work. Still, if you are bearish on oil, I would not invest in Noble Corp, as that will be an environment less conducive to offshore exploration and production.
Over the very long-term, rising renewables production may lead to lower crude oil demand, but this is an issue still many years with oil demand still rising. I would note that if the West stopped sanctioning Russian oil, allowing those exports to return to normal, the need for drilling elsewhere would decline, and this would likely reduce offshore rates. That seems unlikely anytime soon with the Ukraine war still raging.
For Noble specifically, the key will be continuing to contract its vessels as their current contracts mature; given strong market utilizations, this should not be difficult, so long as the oil price environment remains similar. The company spends about $350 million/year to refurbish its rigs and extend their useful life. In an inflationary environment, these costs can rise, which could reduce free cash flow. That said, this inflation would also likely make it more expensive to build new rigs, which would help to further limit supply and likely lead to higher rig prices over time. Overall, I view risks as manageable
Valuation
With a $7 billion market cap, Noble is trading with a 5% free cash flow yield, which for an industry that has historically been quite cyclical (though as I have argued, management reaction functions have changed meaningfully) feels full. For comparison, equipment rental companies, like United Rentals ( URI ) have a 7+% free cash flow yield, though they do not have the growth potential, given there is not a lack of equipment like is rigs. Using the 575k recontacting scenario, you can see how free cash flow accelerates as it recontracts ships below. Using a 10% discount rate and assuming its multiple contracts to result in an 8% FCF yield, this analysis provides a fair value of $54, about 12% higher than current levels.
With jack-up re-deployment and share repurchases below its fair value price, this estimate is likely to be conservative if the gradual recontacting towards $575k occurs. If one kept a constant 5% free cash flow yield, fair value would be $80. However, I think this current 20x FCF multiple is pricing in the growth that is likely coming and as that occurs, we will see multiples contract. I used a slightly higher FCF yield than URI trades at to be conservative.
I expect NE to earn about $2.25 over the next 12 months for a 21.3x P/E. At my $700 million free cash flow target, Noble will be earnings about $4.85-5.00 share in 3 years, translating to about 30% annual earnings growth rate the next three year, for a PEG (price/earnings to earnings growth rate) of about 0.7x. With a PEG below 1, NE is well positioned to grow into its multiple, particularly as it can return essentially all of its free cash flow to investors via dividends and buybacks given its very strong balance sheet.
Conclusion
This analysis shows that even after a strong run, NE has further upside. Even without getting to newbuild breakevens, seeing jack-up improvement, or being able to sustain an expanded multiple, NE’s strong free cash flow trajectory can support a higher share price. Over the next year as we see NE able to recontract at higher rates and drive cash flow higher, I expect to see shares continue to rise. I am targeting a share price of $55-60, as I expect NE to be able to outperform some of these conservative metrics I laid out. I would be buyer here.
For further details see:
Noble Corporation Can Rise Further As Offshore Rig Capacity Remains Scarce