August 31, 2009

Spin-off Idea: Cardinal Health

By end of business today Cardinal health, CAH, will spin-off its medical care division, Carefusion, CFN, and it will focus on drug distribution. The spin off is very interesting midst all the talk of health-care reform because whenever there is uncertainty it pays to go long.

The market is very hot for the CFN spin off. Although CFN accounts for only a small portion of CAH's revenue, maybe less than 7%, it makes third of its profit. The business is very high margin and its potential for growth is solid. The independent company will be able to focus on new products and free to allocate capital to R&D. But it is fully valued when the when issued shares trade at $19. I figure its value is around $20-$23.

What is interesting is the parent company. The market is betting against it. Short volume has increased significantly over the last month or so. Wagers against health-care shares rose more than 7 percent, the most of 10 groups, to 890.3 million as President Barack Obama proposed an industry overhaul. Shorts thesis is earnings will come be under pressure due to health-care reforms. May be it is true. But CAH margins will stay intact and it will be part of the solution.

Once the spin off is complete, CAH is no more than a logistics provider to drug makers. It provides supply chain services to them and have no R&D commitments. Drugs like goods funnel in and through its distribution network reaches customers. So if health-care reforms lead to reduced costs of drugs, CAH's input costs and revenue will come down in tandem. Its margins will not be affected. Sure the absolute level of revenue and earnings will decline but the company value will be still intact.

I am liking going long CAH rather than CFN, it gives better odds.

August 19, 2009

Value Idea: Pride's Spin off

Forced Sellers:
I think this will be dumped by investors because they will want Pride high margin business in the deep water drilling and not the shallow-water low margin and limited growth business. But the $64,000 question is are they forced sellers due to non economic reasons or are they justified in their actions?

Industry Fundamentals:
lower utilization rates and pressure on daily rates. Oil finds moving to deeper waters, which seahawk fleet is not capable of operating under. Their biggest customer are requiring more depth capable rigs, which prices them out of more business.

The disparity between the US Gulf of Mexico Shelf and deepwater rig markets continues to widen. Earlier this year, the jackup market reached its lowest level in 33 years, according to ODS-Petrodata figures, and slid downward from that point. Drilling contractors continued their exodus from the Gulf whenever possible, moving jackups to more lucrative areas. Despite a slowdown in some jackup markets, eight rigs will have mobilized from the Gulf by the end of July. As far as the deepwater Gulf, most people consider it a growth market. As many as 17 new-build deepwater rigs are scheduled to enter the region by the end of 2010. More deepwater rigs could mobilize there for a few wells, then mobilize back to other markets during this period. As a result the utilization rates have been coming down steadily over the last few quarters.
Rig TypeCurrentMonth Ago6 Months Ago1 Year Ago
Drill Barge90.0% (9/10)90.0% (9/10)90.0% (9/10)90.0% (9/10)
Drillship90.5% (38/42)92.7% (38/41)79.5% (31/39)78.4% (29/37)
Jackup74.9% (275/367)74.9% (274/366)82.5% (296/359)91.0% (312/343)
Semisub80.2% (134/167)82.5% (137/166)82.7% (134/162)83.9% (130/155)
Submersible50.0% (1/2)50.0% (1/2)100.0% (2/2)100.0% (2/2)
Tender80.8% (21/26)76.9% (20/26)92.3% (24/26)88.5% (23/26)

Natural gas prices are weak and depressed. There is plenty of supply and surplus inventory to keep the pressure on prices for awhile. I do not want to try to forecast or predict the direction of natural gas because what if my baseline forecast did not materialize. Natural Gas prices are called the "widow maker" for a reason, they are very hard to call.

Overcapacity in the sector. There are several deliveries to take place for shallow water rigs. During the past several years, the supply of available jackup and semisubmersible rigs has been unable to meet the increasing demand of oil and gas companies on a global basis. As a result of this global supply and demand imbalance, various industry participants ordered the construction of over 180 new jackup and semisubmersible rigs, over 60 of which were delivered during the last three years. Approximately 60 additional jackup and semisubmersible rigs are scheduled for delivery in 2009.

The new rig deliveries scheduled for 2009 include over 30 jackup rigs, the majority of which are not contracted for work upon delivery from the shipyard. These new drilling rigs will increase supply and likely reduce utilization and day rates as rigs are absorbed into the active fleet, especially in light of the recent decline in oil and natural gas prices and jackup rig demand. However, the current supply of jackup rigs is limited and it is time consuming to move offshore rigs between markets. Accordingly, as demand changes in a particular market, the supply of rigs may not adjust quickly. Utilization and day rates in specific markets could fluctuate significantly while utilization and day rates in other markets may be relatively unaffected. Additionally, several rig construction cancellations have been recently announced and the tightening credit market has created substantial uncertainty as to whether construction of other rigs will be completed.

Ok, you would say that weak industry fundamentals are cyclical and should adjust. Then seahawk would give you great risk/ reward proposition, assuming its price will fall to below liquidation value of its assets, which more likely it will. In this case company fundamentals has to be flawless to get me interested.

Company Fundamentals:

  • Potential of fines regarding bribery charges and accounting irregularities, however there is limit to the fines paid to $1 million, any excess pride will take care of it.
  • Mexico Oil company account for 60% of SeaHawk gross revenue. One customer dominate their business. This was not a problem when the company was a division of Pride but on a stand alone basis is very risky.
  • accounting is a bit aggressive:
    • changes to depreciation expenses by extending the useful lives of rigs, which means a boost to their earnings as depreciation expense get smaller. This annoys me to no end when companies change their depreciation policies or assumptions. It makes comparisons difficult and obviously management motives to boost earnings by hook or trick.
    • already there is investigation for accounting irregularities by pride into Seahawk division.
  • no debt and clean balance sheet, which a very good in this environment.
  • SeaHawk Jackup rigs are shallow in the 200-250 feet range which does not work in the current industry dynamics. Their biggest customer are requesting deeper and deeper rigs, which prices Seahawk out.
  • very capital intensive business. in order to expand more capex need to spent to buy new rigs. most free cash flow will go to acquisition of new PPE.
  • most of its rigs are idle they have 40% utilization rate.
  • most rigs are old so it may require some capex going further
  • no unique competitive advantage that is very apparent that will distinguish their operations from others.

SeaHawk's president and CEO was CEO of Hercules offshore, similar business to seahawk. He left the company in June 2008 and the company took a big impairment expenses due to large acquisition done on his watch, $2.3 Billion in cash and stock. As a result of the acquisition, Hero balance sheet is over leveraged and impairment charges mounted when the turn in the economy came.

Investment returns over his tenure were not overly outstanding.

ROE11.35%19.13% 38.98% 11.35% (73.37%)

He spent $660.1 million in capex, not including the merger deal, cumulative over the 2004-2008, and generated $618.9 millions in cash from operations during the same period. During the same period cumulative earning were partly at $291.2 million, and if you include 2008 results it would be a significant loss.

Management Compensation Plan

This is a bright spot, somewhat, as the good chunk of compensation is in form of equity. I say somewhat because not all long term incentive compensation is equity. The better alternative is to have 100% of their long term compensation in restricted stock. From their filing:
The beginning value of the initial equity award is $4,800,000 for Mr. Stilley, $1,000,000 for Mr. Manz, $690,000 for Mr. Cestero and $575,000 for Mr. German. ....50% of the equity compensation will be in the form of restricted stock.
Competitive Position
The company is second lowest cost operators in the GOM region. Hero operates better cost structure than Seahawk. According to my analysis the operating the costs per available day is

BusinessNotesOE per avail Day
Seahawkonly GOM locations$49,634
Hercules Off shorevery similar business to Hawk but diversified geographically~$28,000
Ensco International Incorporatedshallow water but more specialized assets/ fleet. their GOM fleet water depth is 250-400 ft $50,175
Rowan Companiesshallow water but more specialized assets/ fleet water depth 250-500
DOdeep water rigs- not very applicable

Nobeldeep water rigs- not very applicable~$63,000
RIGdeep water rigs- not very applicable (55 standard jackups with depth from 250-400)

There are so many strikes against the spin off and not too many positives even if valuation are ridiculously cheap, which I did not need to perform. This is a leveraged play on the prices of natural gas, which is very hard to call: will it stay depressed or take off? Weak sector fundamentals and potential liability and fines all are external to the company and can be manageable by good management team. However, I have my doubts about the new CEO hi track record in Hero is not encouraging. If there is any contrarian play on this name, I do not see it. I will pass on this spin off.

August 11, 2009

Spin-off Idea: Pride International

Not a lot of spin offs came to the market lately. But I think that is about to change as companies will reorganize themselves and cut businesses that no one want to buy. There is two opportunities right now: Pride International Spin off of Seahawk Drilling and CableVision spin off of the Madison Square Garden business. I will introduce the Pride spin off and talk some other time about Cablevision.

Pride International (PDE) is spinning off its Gulf of Mexico operations to shareholders. Pride International is an offshore drilling company that leases rigs and vessels to producers. The company recently made strategic effort to focus on deep water and other high-specification drilling solutions. As a result the decision to spin-off its shallow water business. Jack-up revenues has been declining in over the last few quarters. Management thinks this GOM drilling is slow growth business and that's why they want to divest out of it.

The shallow water business or the leasing of jack-up rigs is concentrated in the Gulf of Mexico (GOM) only with no other international operations. The shallow waters of the GOM is a mature region that oil production has peaked some time ago. companies are moving deeper and deeper for new finds. Pride management is justified in dumping this low growth business to focus on the deep water. However, the questions is can an independent Seahawk make earnings grow on their own without the constraints of Pride management of investing in deep water segment?

The offshore and land drillers have been trading at very low valuation. The sector PE is around 10. some notable high margin and specialized businesses like DO, RIG and NE are selling at PE between 5-9. These businesses have very specialized field and very much have solid backlogs, unlike Seahawk, for years to come so the valuation seems puzzling?

The service companies are leveraged play on the price of oil and gas, particularly natural gas in the Gulf of Mexico. Currently Natural gas is at very low pricing levels that make some field uneconomical to operate. Most will making a call on the price of gas to invest in these GOM drillers. I want to avoid making such a call. I am not in the forecasting business but in the investing business.

This is an interesting proposition. The spin off will be completely debt free with management that is properly incentivized with restricted equity and options but the company operate in poor sector until Natural gas increase in value. The price of the commodity does not concern me a lot at the moment and will play a secondary factor in the decision making. I will look for more important things on the company level:
  • management compensation plan
  • management track record and prior accomplishments
  • accounting practices and policies
  • valuation once it is traded
  • competitive position in the industry
  • what are my risks
  • Will there be forced sellers?

Not every spin off is an automatic investment; the economics of the company must make sense as well. I will work on my analysis to see if this is worth establishing a position in.