This blog article presents an investment view of Atwood Oceanics Inc., from an equity and credit perspective, based on ValueAdd’s proprietary financial model. This model helps portfolio managers/research analysts generate multiple investment ideas across the capital structure (equity and credit/debt), thus enhancing their probability to outperform the market. This article was first published on Seeking Alpha on September 6, 2016.
Summary of Atwood Analysis
- The oil and gas drilling services industry is under acute pressure due to low crude oil prices, sluggish demand, and an excess supply of rigs.
- Drillers are facing contracting backlogs, difficulty locking in new contracts, and declining utilization and day rates.
- Atwood is no exception, with contracted days falling from 61% for 2H FY 2016 to 23%, and 10% over the next two fiscal years.
- Liquidity is key, and, I believe – despite the uncertainty in revenue flow – that ATW can comfortably service its obligatory payments and capital expenditure plan.
- A fundamental valuation indicates a further downside for equity. I believe that yields on the senior note will tighten and will offer an opportunity for bond holders.
Atwood Oceanics (NYSE:ATW) is an offshore driller that currently operates 10 rigs; two more rigs will join the fleet by September 2017. ATW and other offshore drillers have been hit hard by the bleak outlook on their E&P spends, as well as an oversupply of rigs.
We feel that it is time to short the common stock and go long the 6.5% senior unsecured note 2020 (senior note) for upside from current levels.
Why Short the Equity?
Although the conventional valuation indicators could show a sharp undervaluation (FY 2016E P/E of 2.82x, free cash flow/share of 0.65x, book value of equity per share of $48.91), as per our valuation model the stock could offer gains if you go short at current levels over a span of three to six months.
Atwood fundamentals reflect industry woes, whereas the relatively poor backlog and utilization justify the equity’s undervaluation. The oil and gas services industry is suffering from three major problems: an oversupply of new rigs, lower crude oil prices, and a continuous drop in demand. Declining revenue backlog and utilization, on top of plummeting day-rates, are likely to impact industry performance in the near future. Noble Corp (NYSE:NE), Diamond Offshore Drilling (NYSE:DO), and Transocean (NYSE:RIG) show a similar trend in their latest filings. It’s a buyer’s market, where customers are renegotiating the contracted prices and causing pressure to mount on day-rates.
In addition, because of a recent change in the company’s dividend policy, no dividend income is expected. Why would anyone buy or hold an equity when it doesn’t offer any income or capital gains?
Atwood equity stock still appears to be overvalued, and has under-performed against its S&P Small-Cap Index Benchmark (SML Index), as you can see below:
Atwood Equity Performance Vs. S&P Small-Cap Index
Why Go Long the Senior Note?
For investors seeking a steady income, the senior note will offer a fixed return of 6.5% and the company will have enough liquidity to pay interest until maturity. In addition, it also offers a possibility for capital gains. The senior note is trading at near-distressed levels, and we don’t see any distressed situation for at least the next three years. Improving liquidity, attractive leverage and coverage ratios, no near-term maturities, and relaxed covenant terms will eventually lead to tightening spreads and a narrowing of the gap in yield to maturity (YTM), as compared with the Energy Sector High Yield Index (BUHYEN Index) by the end of FY 2016 or early FY 2017 (after the next call date).
The addition of any new contracts will be a bonus for both senior note and stock holders in the coming three to six months. It’s unlikely that the company will call the senior note fully on the next call date (February 2017), as it is already trading well below par. Even if it does, new note buyers will enjoy a huge upside at current price level of ~78.3%. That’s assuming that it is called at 103.250%, as per the call schedule in the 424B2 filing of March 7, 2013. We feel as if the negative news is already priced into the senior note.
Atwood Senior Note YTM Vs. Bloomberg HY Energy Index
Extremely Low Probability of Ratings Downgrade
On April 18, 2016, Standard & Poor’s downgraded Atwood from BB to B+ with a negative outlook, expecting a weak debt leverage — especially the funds from operation (FFO) to debt ratio in 2017 and 2018. According to Standard & Poor’s, a further downgrade is not ruled out if the FFO to debt ratio remains below 12% for a sustained period without any signs of improvement. The company’s senior unsecured debt was also downgraded by Standard & Poor’s, which indicated an average 40% recovery in case of default.
Regardless, because of the following factors, we believe that Atwood will be able to maintain a fair FFO to debt ratio for FY 2016E and beyond, and might not face another downgrade:
- ATW’s focus on debt repurchase of its senior note ($159.3 million during nine months June 2016) will keep debt levels under control.
- Its liquidity position is strong, with $624 million last 12 months (LTM) Aug. 19, 2016, for further debt repurchases.
- Assuming no new contract additions, 2016E and 2017E revenue could decline by 28% and 57%, respectively. Assuming flat growth thereafter, the company could still maintain an FFO to debt ratio of about 13%, indicating a no/low rating downgrade risk.
- Any new contracts might boost margins due to ATW’s high quality rigs and cost efficiency.
- An extension of repayment on the revolving credit facility payment to 2019 (from May 2018) and covenant amendments will ease the pressure on liquidity.
The credit stats show a healthy trend, with net leverage at 1.76x and interest coverage at 10.96x (LTM June 2016). Despite the announced reduction in commitment of revolver credit facility from $1.395 billion to $1.12 billion from May 2018 to May 2019, liquidity seems to be strong. No maturity is expected until 2019.
Relatively Speaking, ATW Is a Better Bet on Strong Credit Fundamentals
As per the latest ATW 10-Q (June 2016) the utilization will decline from 61% in the H2 2016 to 10% by 2018. ATW’s utilization rates and operating margins had remained steadily above its peers until FY 2015. Both backlog and utilization are the lowest among its peers thereafter, which justify its equity undervaluation. ATW beats its peers with strong margins. The three-year average profitability seems to be strong, with the adjusted EBITDA margin at roughly 50%, the EBIT margin at roughly 35.8%, and the net income margin at roughly 27.1%. This is largely due to ATW’s superior quality rigs and efficient operating cost management. Yet its future earnings outlook is marred by a lack of contracts on operational rigs. Of the 10 rigs currently in operation, three are idled and four will roll off contract by the end of 2016.
However, ATW ranks high on credit fundamentals. In relation to its peers, it has the highest EBITDA margin at 57.8%, the lowest net leverage at 1.76x, and the highest coverage at 10.96x. ATW actually outperforms Transocean, its largest peer. The highest interest coverage indicates a strong potential for continuous interest payments for the senior note as well as the credit facility.
Source: ValueAdd Research ATW credit model
What Are the Risks Involved in Going Long on the Senior Note?
Personally, I would watch the successful refinancing of the revolving credit facility mature on May 6, 2019, ahead of the senior note. In the worst-case scenario — if ATW files for bankruptcy and decides to sell all of its assets — the recovery of the senior note would still be 100% (please see the recovery valuation below). This means that there is virtually no downside for bond holders, assuming a smooth bankruptcy process.
Recovery Valuation of Senior Note
Source: ValueAdd Research ATW credit model; bond price from Bloomberg as of Aug. 29, 2016. (Detailed FV calculation of drilling asset within PPE is available upon request.)
Atwood also holds a higher customer concentration risk than its peers. ATW’s top three customers — Shell (NYSE:RDS.A), Kosmos Energy (NYSE:KOS) and Noble Energy (NYSE:NBL)– accounted for 60%+ of LTM June 2016 revenues (see the chart below). Note that my analysis assumes no liquidity shocks.
Three Customers Account for 60%+ of 2016 Revenue
Source: ValueAdd Research ATW credit model
To summarize, the current equity undervaluation of ATW is elusive. It rightly prices its poor business fundamentals (i.e., shrinking revenue backlog, declining utilization and plummeting dayrates). In addition, it’s no longer a dividend play. Hence, I expect further underperformance from the equity, so it makes perfect sense to short the equity.
On the other hand, credit fundamentals look relatively less risky vs. its equity as well as its peers. The 6.5% coupon offers a steady income through maturity, as well as a potential for upside. I don’t expect any further rating downgrades on the back of strong credit fundamentals, recent measures to improve liquidity, no immediate maturity until 2019, and downside on the FFO to debt ratio of around 13%. In the worst-case scenario of bankruptcy, the senior note offers 100% recovery assuming a deeply discounted asset valuation. Thus, going long the senior note is fully justified.
Thank you for your time!
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Disclaimer: The views expressed in this article are my personal views/ opinions based on my equity and credit analysis and should not be construed as investment recommendations. Readers are requested to use your own judgement before you make your investment decisions. ValueAdd or myself will not be responsible for any gains/losses arise from your investment decisions.
Disclosure: I/we have no positions in ATW. This ValueAdd blog article was originally published on Seeking Alpha, however it is suitably edited.
Author: Girish Bhise
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