A 'first look' at Valaris
In yesterday's e-mail, I shared the presentation I gave at last week's Value Investing Seminar in Italy.
Today, I'd like to share highlights from a presentation by Daniel Bols of Somnium Capital Fund, who gave a compelling breakdown of Valaris (VAL), one of the largest offshore contract oil-drilling-service companies in the world.
But first, a bit of history...
Valaris filed for bankruptcy in August 2020, a victim of the pandemic with more than $6 billion of net debt. It emerged from bankruptcy at the end of April 2021 with a net cash position, and the stock quadrupled from around $20 to $80, where it remained until a year ago. Since then, it has fallen to close yesterday at $48.91:
This write-up on the Value Investors Club forum shortly after the company emerged from bankruptcy captures what a great buy the stock was back then. (You need to register for free as a guest to read the full post and the 112 comments.) Excerpt:
... if you can buy steel at a dime on the replacement cost at a time when supply will keep shrinking, yet demand is likely increasing and you can do it with a net cash balance sheet and positive cash flow, you're likely to do somewhere between satisfactorily to outstanding. I wish I had a view on the price of oil, steel or future offshore rates. I have no crystal ball. I'm an old-fashioned value guy who likes buying sad companies that just came out of bankruptcy with a view that offshore which has supplied roughly a third of our globe's oil will need to reinvest to keep its market share. Meanwhile, should offshore demand recover, human greed will overcome the inevitable drama along the way and while the guy with the best balance sheet (VAL) will not have the most torque, it will also have the least downside should this thesis take another year or three to play out.
The thesis today hasn't changed much – though because the share price has doubled, a 10-cent dollar has now become a 20-cent dollar, as Bols argues in this three-page write-up he gave me permission to share. Excerpt:
Valaris... currently trades 20 cents on the dollar relative to its replacement asset value. Valaris is on track to grow free cash flow ["FCF"] from ~$70 million in 2024 to around $0.7 billion by 2027, when FCF margins reach 18% of its current EV [enterprise value]. Post-2027, if the industry returns to normalization of offshore day rates in a structurally undersupplied rig market, FCF could double again...
The estimated replacement cost of its fleet exceeds $20 billion. The company's drillships alone would cost [$10 billion] to build. Yet, Valaris trades at an EV of just $4.0 billion. This is not only because the offshore sector carries the stigma of bankruptcy and [environmental, social, and governance] divestment, or the shales crowding out all other investments over the past decade. It is also that Valaris still has a significant part of its fleet under legacy contracts.
Bols argues that the pullback in the stock in the past year "offers a new investment window" because:
The market is pricing the stock as if the cycle is over, whereas in our view its mid-cycle is just getting started. There is compelling market data showing that the offshore rig market is merely undergoing a cyclical pause, not a structural decline. Rig utilization rates remain high (88-92%), indicating tight supply even during this lull. Analyst consensus – from firms like Evercore ISI, Westwood, and Clarkson's – is clear that incremental floating rig demand is set to materialize [in] late 2026 and accelerate through 2027-2028...
Bols continues:
Valaris is not a bet on higher oil prices, but the rerating of already negotiated day rates for a part of its fleet. Analysing its fleet status report shows that contracted day rates in 2027 for new ships are expected to reach $500,000. By the end of 2026, the majority of the active fleet will be working under contracts that better reflect prevailing market economics. In other words: the business you're seeing today isn't the business you're buying for 2026-2027.
I checked in with Bols a few days ago and he sent me this update:
Valaris just announced a $760 million contract win for two drillships, DS-16 and DS-18. The former, in particular, is significant proof of the free cash flow inflection underway that I mentioned in my presentation; with a doubling of day rates.
Companies like Valaris react often to the short term oil price fluctuations, which does not make sense as offshore investment decisions are made very long term. It is surprising that the market reaction is subdued. The FCF inflection is clearly ongoing. Investors have time to buy in.
I would also note that another investor I respect a lot, Mohnish Pabrai of Pabrai Funds, likes and owns Valaris as well, as he discussed in a recent interview (starting at 28:49).
I think Bols and Pabrai make a good case for VAL, so I pulled some historical financials, starting in this case with the balance sheet. In the chart below, you can see that the company was saddled with a high level of net debt, which was then extinguished during bankruptcy. This resulted in a net cash position, which has slowly crept up to $721 million of net debt today:
Then I looked at the company's cash from operations, capital expenditures ("capex"), and FCF over the past 20 years:
During the boom years from 2012 to 2015, Valaris followed the rest of the oil and gas industry in massively overbuilding. This led to a huge crash, negative FCF every year since 2017, and, eventually, bankruptcy.
But the trend in the past five quarters has been positive – at precisely the same time as the stock has fallen – as you can see in this quarterly chart over the past six years:
Lastly, let's look at valuation. As of yesterday, the stock has a $3.3 billion market cap and $4 billion EV. With analysts' consensus estimate of $4.37 per share this year and the stock closing yesterday at $48.91, it trades at 11.2 times current-year earnings, which doesn't appear cheap...
But keep in mind that you can't value cyclical stocks the same way as steady growth companies. In fact, they're generally most overvalued when their price-to-earnings (P/E) ratios are the lowest – because earnings are at a cyclical peak – and, conversely, are the cheapest when their P/E ratios are the highest (or negative).
As with almost all companies, you have to value them based on where you think earnings will be in one to five years. If Bols is right that Valaris' FCF will soar 10-fold from $70 million to $700 million (or anything close to that), then the stock will likely be a multibagger.
My team and I are analyzing this closely, and if we decide to recommend it in Stansberry's Investment Advisory, those subscribers will be the first to know. If you aren't already subscribed, you can learn how by clicking here.
Best regards,
Whitney
P.S. I welcome your feedback – send me an e-mail by clicking here.