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Margin of Safety 101

Valuation is an imprecise art and the future ain’t always what it used to be. This is why the adherence to the concept of a margin of safety separates value investors from others, who may come across as less concerned about loss.

Assumed capable of absorbing unfortunate developments, margins of safety take different shapes, for instance when fast-growing compounders sell for ridiculous multiples of their prudently-assessed earning power or, on other occasions, when strategic assets sell for a fraction of their reproduction value – a common pattern within industries undergoing deep distress.

In this latter category, Rowan Companies – already discussed in Maximum Pessimism: Opportunities in Oil & Gas – provides a case in point.

To set the stage, long-term prospects in offshore drilling are bright, for it supplies a quarter of global oil and gas production and sports attractive economics: NPV-wise, massive reservoirs and low marginal costs offer sound investment alternatives to majors focused on securing uninterrupted distributions to their shareholders.

The downside, of course, lies in the significant capital outlay and lasting commitment required, whereas it is easier to pull the plug onshore, and adjust expenditures to get to the desired levels of activity – an appreciable feature during volatile times.

But depleting reserves must be replaced and shale production has yet to prove a game changer. Light oil is not the type generally wanted by refiners while the rise in interest rates looms as an ill wind that blows no good: once financing tightens up, investors may not remain as keen as before to bankroll unprofitable ventures.

In effect, shale producers such as those drilling in the Permian basin routinely boast about their ability to break even at $40 a barrel, yet they often omit to compute hefty development costs in their communications – which, for the most part, and to their credit, are designed to reassure bondholders.

Should we trust their dreadful financial records, it seems that Art Berman was on the mark when he dubbed the shale mania a “retirement party.” In that respect, offshore drilling is everything but dead, although it may take some time to overcome a series of legitimate concerns.

Back to Rowan and the margin of safety concept. The company hasn’t been spared by the downturn and freeze in development spending that ensued, but it safeguarded its fortress balance sheet – by far the best industry-wide – and managed to lose only negligible amounts of cash.

The basic premise is simple: if a business generates satisfactory returns on capital over the full cycle – that is, in offshore drilling, over fifteen to twenty years – its market value shall at least match its reproduction value, for the latter typically amounts to what a new entrant would have to invest in order to earn similar returns.

As at last September, Rowan’s assets were:

1. Four seventh-generation drillships, which replacement cost amounts to roughly $2 billion. A 50% discount could do no harm – better safe than sorry – so we counted them for $1 billion.

2. Seven ultra-harsh environment jack-ups, which replacement cost flirts with $3 billion: once applied the 50% discount, an adjusted private market value of $1.5 billion seemed safe.

3. Three harsh environment jack-ups: replacement cost of $540 million, same 50% discount treatment, assigned value of $270 million.

4. Six conventional (“modern benign”) jack-ups: replacement cost of $960 million, assigned value of $480 million.

5. Three older jack-ups, gracefully counted for zero.

6. A $90 million dividend from ARO Drilling – the Rowan’s joint-venture with Saudi Aramco – imminently payable.

7. A $301 million investment in the same ARO Drilling via $270 in long-term notes and $31 million in ordinary shares.

8. $1.1 billion in working capital, all in excess cash.

9. $490 million in backlog, counted for zero.

The sum of these parts gave a total asset value of $4.7 billion, from which $2.7 billion in long-term debt were subtracted to get an adjusted net value of $2 billion – round numbers always sound better – or $15 per share once divided by the 127 million units outstanding.

At a price of $11 per share as of September 2017, in addition of a superb opportunity to ride the recovery – should it occur someday – and notwithstanding the risks, an investment thus offered an appreciable margin of safety.

The big news, however, broke out in October when it was announced that Rowan will merge with Ensco in a deal that valued the former at $20 a share – a price deemed highly unsatisfactory by yours truly and several fellow shareholders.

Unable to assess the prospects of the combined and now highly leveraged enterprise, we decided to sell out and pocket a lovely short-term gain. All in all, here was a discarded cigar butt that had one excellent puff remaining in it.

(No position.)

This brings us to discuss another long-time favorite of mine among battered drillers: the Tisch family-controlled Diamond Offshore.

Prepared for apocalypse, the company stands out among its peers for its remarkable financial standing, with $1.2 billion in liquidity – for $200 million in short-term liabilities – a premier portfolio of drilling equipment carried at $5 billion after agressive depreciations, years of backlog, and $2 billion in intelligently structured long-term debt, of which $1.25 billion mature between 2039 and 2043.

Given the cyclical nature of the business, its earning power should be appraised over the full cycle – from 2000 till today – rather than by extrapolating results of a particular year, as the market did in 2018 with a share at $10, or in 2008 as it traded at $140, or fifteen times peak earnings.

Averaged over the last eighteen years, earnings per share amounts to $2.8 and return on equity holds well above 12%. Once put in perspective with the current share price of $10, it appears that the company is selling for four times its average earning power and less than half its book value ($25 per share) despite an adequate history of returns.

Capital allocation has been supremely shrewd, for management returned boatloads of cash in prosperous years and opted to selectively upgrade its fleet, whereas reckless peers leveraged their balance sheets to the hilt in order to build new rigs.

Of course, nothing guarantees that offshore drillers will someday resume with their former earning power – investing in cyclical, capital-intensive businesses goes beyond calmly waiting for a reversion to the mean. Diamond’s fleet, for instance, is much smaller in 2018 (17 drilling units) than over the last decade (45 units), but it has been upgraded to a point where it now commands daily rates four to five times higher.

Following the recent sell-off, the market manifested its intense displeasure with a turnaround that has yet to occur. Placid investors focused on fundamentals may be keen to profit from this outburst of exasperation, and hop in as maximum pessimism strikes again.

Many shall be restored that are now fallen, it is said, and many shall fall that are now in honor.

(No position, but may reacquire shares in the upcoming days.)

Sticking to the topic, but jumping from one business to another for the sake of transparency: I have received several comments – some friendly, some less so – about a short note on TripAdvisor which, to my regret, was apparently perceived as vitriolic.

To be clear, I have nothing but admiration for the management and their phenomenal entrepreneurial story. What I stressed back then was the somewhat misleading nature of the company’s financial communications, as well as a valuation that seemed to entail zero margin of safety.

Notwithstanding this call for caution, one can indeed come up with a model wherein the base of users gets monetized to a greater degree – provided that the strategic initiatives work – and envision the TripAdvisor platform as a magnificent money machine in the making. I’ve done my own to assess the vast potential and yes, there’s a decent likehood of this fortunate outcome to happen.

It is just a different ball game, perhaps more speculative, in which I personally feel like a one-legged man in an ass-kicking contest.

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