Levered Technology, Unlevered Drillers

My colleague Byron King wrote to you about the allure of private equity in his recent two-part series, “Energy and Private Equity.” He describes how quite a few companies are weary of the mounting costs of listing their shares on public exchanges — Wall Street’s short-term focus being among the worst.

As Byron points out, the advantages of “going private” are numerous and growing. I want to expand on Byron’s ideas by contrasting the capital structure of two well-known companies — cell phone maker Motorola and offshore driller GlobalSantaFe — and why private equity and merger activity is likely to continue bidding up drillers.

Most private equity deals seek to optimize the target company’s capital structure, or the appropriate mix of debt and equity claims.

Debt holders have a priority claim on the company’s assets, while equity holders have a residual claim. If things go wrong, debt holders are first in line at bankruptcy court, but their exposure to the good times is basically limited to a fixed stream of payments. Equity holders are left with nothing if the company a) goes bankrupt and b) there’s nothing left after creditors liquidate what’s left of the assets in an attempt to recoup as much of their principal as possible. But equity holders enjoy all the extra cash flow when business is booming.

When used appropriately, debt, or “leverage,” can greatly enhance shareholder returns. Private equity, aka “leveraged buyout,” funds generally look for businesses with solid competitive positions that consistently generate cash. Private equity deals are heating up into a craze because the supply of cheap credit appears to have no limit (until all of a sudden, everyone discovers that there is, in fact, a limit).

Private equity funds first pool together their capital. Then they leverage their buying power by layering debt on top of their capital. This allows them to buy much larger businesses — and streams of future cash flow — than they otherwise could buy outright with their limited funds. Returning to the concept of capital structure, the debt holders get paid a fixed 5-6% per year and the equity holders have a claim on the rest, whether it ends up being a total loss or a stream of cash that’s even larger than they anticipated.

Motorola’s Levering Shareholders’ Exposure to Creative Destruction

Motorola’s recent disappointments have been numerous. A glut of cell phones is building in the supply chain and the fallout is not going to be pretty. Wireless carriers are giving them away with minimal contract commitments. The title of this article on Bloomberg yesterday says it all: “Motorola’s Zander ‘Running Out of Scapegoats’ as Profit Fades”:

“Earnings and revenue this year will be ‘substantially’ below its forecasts because of plunging mobile phone prices, Schaumburg, Ill.-based Motorola said yesterday. Zander, who already is cutting 3,500 jobs, said the company will overhaul marketing and product design to make its prices competitive without sacrificing earnings.

“The world’s second biggest maker of mobile phones also named a new president and detailed a plan to step up its share buyback program amid a proxy fight with shareholder Carl Icahn.

“Instead of sparking optimism, the news set off criticism of Zander’s choice for the promotion and a product plan that investors said didn’t show enough concern for bigger rival Nokia Oyj’s recent advances in the market.”

Bloomberg then describes Motorola’s big management shake-up in the wake of this ugly news:

“Motorola’s choice for its new president and chief operating officer, Greg Brown, who runs the networks and enterprise unit that sells networking devices to companies and government agencies, also drew fire.

“‘There’s not a single senior Motorola executive that had more predictions go wrong,’ said Albert Lin, an analyst at American Technology Research in San Francisco, of Brown. He rates the shares ‘neutral’ and said he doesn’t own them.

“Motorola also said Chief Financial Officer David Devonshire will retire. Director Thomas Meredith will be acting CFO.

“Motorola expects a loss of 7-9 cents a share, its first loss since 2004, on revenue of $9.2-9.3 billion this quarter. Motorola didn’t provide new full-year figures.

“‘I never would have thought that they would go into a money-losing situation,’ Lin said.”

Lin “never would have thought that they would go into a money-losing situation.” This statement is puzzling because it’s not that hard to imagine a situation where Motorola goes into the red. Short product cycles and high R&D spending requirements can combine to produce red ink very quickly when business sours.

In recent months, Motorola shareholders had gotten excited about the leveraged recapitalization efforts of Carl Icahn. Mr. Icahn has been branded with the title “corporate raider,” yet his tactics have a record of creating value for shareholders when management and the board of directors slack off on this responsibility.

The recent cell phone boom left Motorola with plenty of excess cash that Icahn believes it doesn’t need. Since Motorola’s business doesn’t entail managing a multibillion-dollar bond portfolio, Icahn is pressuring the company to disburse all excess cash to shareholders through share buybacks (allowing for enough of a cash cushion to fund operations through the rapidly approaching down cycle).

Here’s a suggestion to Mr. Icahn: Why not consider targeting one of the many cheap offshore drillers? Most have already booked up their rigs for a few years under long-term contracts at very attractive dayrates. These contracts provide very visible cash flows, so perhaps a recapitalization is in order?

You have a business for which the underlying assets are increasing in value, not deflating. State-of-the-art drilling equipment has not yet succumbed to the global deflationary pressures we see in businesses like cell phone and chip manufacturing. Cell phone manufacturing capacity is overbuilt yet still receives more and more capital investment worldwide — good for consumers, bad for producers. But offshore drillers emerged out of a 20-year recession just a few years ago.

Furthermore, while earnings visibility is very low at most technology companies, several offshore drillers know the next few years of earnings with a fair degree of confidence. To top it off, they’ll have very valuable rig fleets at the end of the high-visibility period. Who knows what the cell phone industry will look like?

Technology businesses are not considered as “capital intensive” as drillers, but in my view, the ever-present challenge of technology obsolescence more than offsets this. Carl Icahn’s efforts may pay off for shareholders in 2007, but they will magnify, or leverage, the shrinking shareholder base (shrinking due to share buybacks) to the downside of technology’s creative destruction.

Examining the Effects of GlobalSantaFe’s Cash Flow on Its Balance Sheet

When you buy a stock, you are essentially buying a claim on the company’s assets and the cash that those assets generate when they are put to productive use. If you look at the assets on a balance sheet from the bottom up, you see that the least liquid assets are toward the bottom and the most liquid assets are closer to the top. Management’s top job is to extract as much value out of these assets as possible, gradually converting them to cash over long periods of time:

Using this “back-of-the-envelope” model, I forecast what the trends in GSF’s cash flow and balance sheet will look like in the future. These financials are certainly easier to project than Motorola’s. This model has the following conservative assumptions: revenues peak in 2008 and slowly decline, net profit margins peak at 35% in 2007 and slowly decline, and annual capital requirements (working capital and capital expenditures) remain in the range of 17-22% of revenue:

The key estimate this model provides, highlighted in yellow, is “free cash flow,” which is defined as net cash from operations minus capital expenditures.

A more accurate measure of free cash flow is net cash from operations minus maintenance capital expenditures. Free cash flow is a measure of the cash available to fund dividends, share buybacks, and growth projects after accounting for the spending necessary to maintain the existing business.

My model estimates a free cash flow peak of $1.6 billion in 2008, followed by a slow decline. But I’m confident that free cash flow will be higher than this because the estimate highlighted in yellow includes capital expenditures high enough to fund an expansion of GSF’s rig fleet, which will in turn add to GSF’s future cash flows. I’m assuming that all excess cash is returned to shareholders via stock buybacks. This produces the compelling returns I outline in the bottom row of the table. These share buybacks can be accelerated if more debt is issued (a “recapitalization”).

Here’s the key point I want to make about GSF and all the other contract drillers: Free cash flows will be so high that most of them must buy back hefty amounts of stock, raise dividends, or expand their rigs fleet quickly to avoid having too much cash pile up on their balance sheets. This is a nice problem for any company to have, but it puts them right in the cross hairs of private equity funds, aggressive peer acquirers, and activist investors like Carl Icahn.

Spreadsheets Must Pay Attention to the Outside World

Free cash flow models are only as good as the assumptions on which they are based. So investors must remember to test a model’s assumptions when they see one. The “micro” analysis of projecting financial statements into the future cannot be separated from the “macro” analysis vital to these projections. The assumptions underlying my GlobalSantaFe model would have to be thrown out the window if, in fact, a huge glut of oil supply were about to come on the market and stay there for a few years.

But my research over the past few months indicates that the odds of this occurring are very low. Peak Oil has already occurred in many areas of the world including the U.S., the British and Norwegian sectors of the North Sea, and now Mexico.

What happens in every country after passing peak production? Demand for drilling skyrockets. The North Sea has been a very active offshore drilling market in recent years, and there’s no sign of a slowdown.

GlobalSantaFe maintains an indicator of industry health called the SCORE (Summary of Current Offshore Rig Economics). It compares the profitability of offshore rig dayrates with the profitability of dayrates during the 1981 peak of the offshore drilling cycle. When the SCORE index is at 100, dayrates equal “the sum of daily cash operating costs plus approximately $700 per day per million dollars invested.” (Source: GlobalSantaFe):

Approaching this in a simpler way — the profit generated by a typical offshore rig when the SCORE is 100 means that its owner is recouping his capital outlay in just four years. In the 130s, you can imagine how quickly rig owners like GSF are “monetizing” their rig fleets.

As for oil demand, it’s important to remember that higher prices are more likely to slow demand growth, rather than reverse it. Global oil demand hasn’t contracted on a year-over-year basis since the early 1980s. John Segner, portfolio manager of the AIM Energy Fund, puts these numbers into context in a recent Barron’s interview:

“China is still using only 6.5 million barrels of oil per day. We are using 20 million barrels per day here in the United States. China is 25% of the world population. The Chinese are getting off bicycles. They want air conditioning. They are getting housing. If China slows, it would just be a bump in the road. Oil-demand growth could slow down, but the chance of it going below 86 million barrels [per day], say, next year? I just don’t see that happening. And I don’t see a lot of capacity growth. Supply-demand is still going to be tight.

“Energy [investments are] going to do very well. The multiples have been contracting for the better part of 12 months. And we are toward the end of that correction more than we are at the beginning of it.”

Drilling Rigs Will Inflate Faster Than Houses

Amid the rumors of a $100 billion private equity bid for Home Depot, I find it surprising that there has been little private equity interest in exploration and production (E&P) or oil field service companies.

Perhaps financial engineering could unlock some value for Home Depot shareholders, but there is only so much you can do with a large retailing business model. Plus, the company is still exposed to the housing bubble’s hangover. It’s impossible to quantify just how much “spec” building and home equity refinancing money found its way into Home Depot cash registers over the past three years.

HD’s price-to-earnings ratio when business is firing on all cylinders is a lot lower than when it’s not — especially when you think about the effect of spreading lower sales across a high fixed cost structure (big box stores) and the financial burden of holding slower-turning inventory.

Home Depot may be a good buyout someday, but I think potential buyers can get a better price at some point over the next two years.

Think about the “leveraged” income strategy employed by most landlords. Assume that a landlord purchases an apartment building with a 10% down payment and a 90% mortgage. If rents provide enough income to offset mortgage interest and maintenance, the landlord is left in a position where his equity goes up and down by a factor of 10-to-1 with each fluctuation in the value of the apartment building.

Leveraged exposure to a long-term real estate bull market is how most real estate moguls have made their billions. If an opportunity comes along to borrow money at a low fixed interest rate and buy a cheap asset that is both inflating in value and throwing off income, it’s hard to lose.

Why not consider contract drilling businesses?

I’d bet that a fleet of drilling rigs will inflate in value at a faster pace than physical buildings over the next 10 years. I’d also bet that quite a few savvy investors recognize this and we’ll see more mergers, acquisitions, and private equity transactions as the energy bull market continues to roll on.

Good investing,
Dan Amoss, CFA

March 27, 2007