Editor’s Note: This article was first published on Ideas from HFI Research on March 18.
By: Jon Costello
Valaris Ltd. (VAL) is a Bermuda-domiciled offshore contract drilling company. I’ve followed the name for the past few years but never invested due to the industry's vulnerability to fickle day rates and its brutal cyclical downturns.
However, my interest was recently piqued when VAL shares fell into the low $30s. I began buying after realizing that macro trends within the industry favor a continuation of its upcycle and that a cash flow inflection could generate multi-bagger returns from current prices.
Based on conservative assumptions over the next few years, I believe VAL shares remain extremely undervalued. They’re one of my favorite ways to play higher oil prices and navigate range-bound or potentially sideways oil price action over the next 18 to 24 months.
Valaris Emerges from Bankruptcy
VAL is the successor to Ensco Rowan, which was formed through Ensco’s acquisition of Atwood Oceanics in 2017 for $839 million and then its acquisition of Rowan in 2018 for $2.4 billion. Ensco Rowan entered bankruptcy in August 2020.
At the time of the bankruptcy, the company listed $12.9 billion of assets and $7.3 billion of long-term debt. In bankruptcy, it reduced long-term debt by $6.5 billion. Its existing credit facility and unsecured notes were converted to equity.
The company also secured a $520 million capital injection and $550 million of new 8.25% Senior Secured Notes that mature on April 30, 2028. Interest on the Notes can be paid in kind at 12% for the life of the note. Old shareholders received warrants issued on 5.6 million new VAL shares. The warrants expire in April 2028 and have a $131.25 strike price.
Reorganization and fresh-start accounting adjustments made in the bankruptcy process—which occurred amid depressed asset values during the Covid downturn—reduced the company’s reported asset value by $9.1 billion. VAL emerged with an asset value of $2.6 billion. It exited bankruptcy in May 2021 through an IPO of 75 million shares that began trading at around $22 per share, giving it a $1.65 billion market cap.
Since the IPO, share repurchases have reduced VAL’s diluted share count to 72.9 million. With shares trading around $38, the company has a market cap of $2.8 billion. Its $700 million in net long-term debt results in an enterprise value of $3.5 billion.
The Bull Case: It’s All About the Cash Flow Inflection
The bull case for all offshore drillers rests on the cash flow inflection that occurs during an industry upcycle.
Over the course of an entire cycle, offshore drilling is a lousy business. During downturns, lower oil prices reduce capex budgets among the oil majors and national oil companies that serve as the drillers’ primary customers. Lower capex, in turn, reduces the demand for offshore drilling rigs. As demand for rigs falls, the day rates by which rig prices are set decline. Since rig contracts run anywhere from a few months to multiple years, sustained low day rates reduce the earning power of a given rig fleet over time. Margins come under pressure, and offshore drillers operate at a loss for years at a stretch.
Adding to the industry’s woes during a downturn, uncontracted rigs must be maintained. These rigs are either “warm stacked,” or kept ready for redeployment, or “cold stacked,” in which they’re essentially mothballed at minimal expense. Warm stacking and cold stacking are costly. For instance, when VAL exited bankruptcy, its 18 cold-stacked rigs cost the company $60 million a year—just to maintain assets that generate no revenue. When market conditions improve, reactivation costs for cold-stacked drillships can run into the tens of millions of dollars.
These cyclical downturns have been a recurring feature of the modern offshore industry since it embraced capital-intensive deepwater drilling in the 1980s. The combination of declining day rates on a company’s existing fleet plus the increasing expenses associated with warm stacking and cold stacking idle rigs risks sends cash flow plunging. The deep cash flow losses bring about a large-scale industry purging that forces many operators into bankruptcy.
The most recent downturn was particularly brutal. Among the major global offshore drillers, only Transocean (RIG) avoided bankruptcy.
The opportunity in VAL’s stock stems from the cash flow inflection that occurs as negative operating leverage experienced in a downturn transitions to positive operating leverage in an upturn. This transition turbocharges cash flow growth. Prices rise, and what used to be a drag on corporate cash flow becomes a contributor.
This cash flow inflection is yet to come for both VAL and the offshore drilling industry. At the moment, the trend of improving day rates appears to have been delayed for a few quarters, not longer.
Equally important for investors, the offshore drilling industry’s economics have undergone a structural improvement. During the last downturn from 2014 to 2020, time was the offshore drilling investor’s enemy. Going forward, however, time will increasingly become the investor’s friend.