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Oil Driller Capitalizes On Brazil's New Deepwater Bonanza

THE BUZZ The world knows Brazil for many things, but one claim to fame the country has been struggling to capture is "energy giant.

In the mid-2000s, massive oil and gas reserves were discovered in Brazil's Atlantic waters, leading to a major push by the state-controlled oil giant Petroleo Brasileiro (PBR), better known as Petrobras, to obtain new platforms and field services to exploit the bonanza.

One beneficiary has been QGOG, an arm of the Queiroz Galvao conglomerate formed to provide drilling services in Brazil (where it still operates, despite its Luxembourg address). Its revenue has grown fourfold since 2009 as it's brought new deepwater rigs online, and it's become one of the top 10 oil drillers in the world.

But as Bloomberg recently reported, for many Brazilians the oil boom is yesterday's bubble. The Brazilian stock market hasn't seen an energy IPO in two years, after several new issues priced high that collapsed in the aftermarket thanks to project delays and disappointing output. Petrobras itself is rattling near the bottom of its industry group with a Composite Rating of 8.

Still, analysts expect things will turn around for Petrobras this year with profit growth of 42%. American investors might see this as a good time to dive in.

"QGOG should be bought on the IPO based on expected growth from Petrobras," wrote IPO Desktop chief Francis Gaskins in his report. "It seems unlikely that competitors could break into the Petrobras/QGOG relationship.

THE COMPANY QGOG, an acronym for Queiroz Galvao Oleo e Gas, got going in 1979 when Petrobras invited some local companies to start up oil and gas operations. The company started up two onshore rigs in 1981 and eventually added seven more.

QGOG started moving offshore in the 1990s, and in 2006, it won bids to operate three deepwater rigs for Petrobras. It now operates a total of eight offshore rigs, and also owns a 20% interest in a floating production storage and offloading (FPSO) unit called Capixaba.

Much more is in the works. Expansion has focused on the ultra-deepwater zone, deeper than 7,000 feet, where QGOG has a 15% interest in three more rigs under construction that should start up between 2016 and 2019. It will fully own another drillship that will navigate the greatest water depth of them all, 12,000 feet, set to be delivered in January 2015. It's also has three more FPSOs in the works, expected to launch between this May and September 2014.

QGOG derives its revenue from charter and service day-rates obtained through contracts that generally run five to seven years after a rig is delivered and longer for FPSOs.

RISKS/CHALLENGES Although Petrobras' state monopoly was broken in 1995, it still provides more than 90% of QGOG's revenue. The company has been seeking to diversify geographically, but, says in the prospectus, "there are only a limited number of potential customers that are available to replace Petrobras.

Financing all this new construction has been very expensive, and QGOG is more than $3 billion in debt. Moreover, none of the IPO proceeds will go to pay it off, but will instead finance even more projects. QGOG is depending on its future production to enable it to pay its creditors.

The energy industry is highly cyclical, and though its stocks have been rallying this year, most industry groups in oil and gas are currently ranked low to middling in IBD's Industry Group Rankings.

QGOG's long-term contracts lock in the day rates, so if its costs rise, it will feel the margin pressure.

As we all know from the Deepwater Horizon disaster, ultra-deepwater drilling involves new technologies and carries substantial risks.

THE RESULTS Thanks to some new projects coming online, net operating revenue in the first nine months of last year jumped 38.7% over the prior-year period to $575.9 million. Profit was 66 cents a share, vs. a year-earlier loss of 12 cents.

USE OF PROCEEDS The company expects to raise about $518 million from the offering of 27.5 million shares, or $597 million if the underwriters exercise their options in full. It plans to split the proceeds about evenly between capital expenditures on existing projects and on new projects.

THE MANAGEMENT Leduvy de Pina Gouvea Filho Chief executive officer Joined in 2009 after holding executive positions at San Antonio International, Schlumberger (SLB) and BG Group. Previously, he spent 17 years at Petrobras. He holds an engineering degree from the Universidade Federal do Rio Grande do Sul and a postgraduate degree in petroleum engineering from the Petrobras Training Center.

Guilherme Robeiro Vieira Lima Chief financial officer Joined the company in 1996 and attained his current position in 2004. Previously, he worked at UNAP, Montreal Engenharia and Sotreq. He holds an MBA in finance from Instituto Brasileiro de Mercado de Capitais, and an MBA in petroleum from Coppe/UFR.

Rodrigo Ribeiro Chief drilling operations officer Joined in 2000 and obtained his current position in July. Previously, he worked for Odebrecht Oleo e Gas. He holds a mechanical engineering degree from Universidade Santa Ursula, a post graduate degree in petroleum engineering from Fundacao Educacional Luiz Reid / Gold Black and a safety engineering degree from Faculdade Salesiana Maria Auxiliadora.

QGOG Constellation SA Luxembourg 352-20-20-2401 qgog.com.br Lead underwriters: JPMorgan, BofA Merrill Lynch, Itau BBA, Credit Suisse and Bradesco BBI Offering price: $19-$21 Expected date: week of Feb. 4 Ticker: QGOG