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Rally Impending for This Offshore Drilling Stock

- By Faisal Humayun

Investment overview

As sentiments have improved toward the offshore drilling industry, there have been stocks that have surged significantly.

I see a good investment opportunity in these stocks, including Rowan Companies (RDC). In the last 12 months, the stock has gained 11.6% and has seen a meaningful rally since September 2016.


Considering the company's fundamentals, fiscal 2016 results and outlook for fiscal 2017, I believe Rowan Companies is undervalued and would make an interesting investment.

I must mention at the onset, however, that I advise limited exposure to offshore drilling stocks even if they are trading at attractive valuations. The industry is likely to see gradual recovery and exposure to these stocks should be considered.

Strong balance sheet

When Rowan Companies reported fourth-quarter 2016 numbers recently, the first thing I analyzed was the company's balance sheet strength, which remains robust. This is one of the critical factors in remaining bullish on the stock.

The company had cash and equivalents of $1,255 million as of December 2016 as compared to $485 million in December 2015. This suggests the company, over the last 12 months, has been able to conserve cash with the order backlog providing robust operating cash flow and had minimal capital expenditure commitments.

With current debt repayment of $127 million, I see no concerns from a debt refinancing or repayment perspective. I do believe the company is well positioned to pay additional debt in 2017.

Overall, with debt to capitalization of just 34% as of fiscal 2016, Rowan Companies is well positioned not only to emerge strong from the crisis, but also for opportunistic acquisitions of assets when there is more clarity on sustained industry recovery.

Cash flows will remain healthy

As of Feb. 14, Rowan Companies has an order backlog of $900 million. Considering the same EBITDA margin as 2016 and the same EBITDA cash conversion ratio, Rowan Companies is likely to report operating cash flow in the range of $500 to $600 million for 2017 on a conservative basis.

These estimates are conservative as they do not incorporate any potential order backlog additions for 2017. As industry conditions improve, I do expect the backlog to swell. Even with $600 in operating cash flow, Rowan Companies is likely to report positive free cash flow as it has no speculative new rigs for delivery. It expects fiscal 2017 capital expenditures of $105 to $115 million. Even at a conservative operating cash flow of $550 million, the company is likely to report free cash flow in excess of $400 million.

This will ensure the company pays short-term debt maturities through internal cash flows instead of debt refinancing. The financial flexibility will also allow Rowan Companies to further reduce debt.

The company's order backlog is slim at $430 million for fiscal 2018. I will see this as a concern if the offshore industry fails to show meaningful signs of recovery in the second half of 2017. In the near term, however, I believe stock sentiments will be dictated by a strong balance sheet and oil potentially moving higher after consolidation at current levels.

Partnership with Saudi Aramco

The company's partnership with Saudi Aramco is another critical reason to be bullish on the stock for the long term. I believe the partnership is likely to be a game changer as it is in the world's largest market for jack-ups. As oil trends higher, Saudi Aramco is positioned to benefit.

While the initial contract is for five jack-ups from Rowan Companies and two from Saudi Aramco, this ensures firm cash flow in the near term and the beginning of a bigger association in the long term. The new company plans to order up to 20 rigs to be delivered over 10 years, beginning as early as 2021, to meet offshore drilling demand.

If oil prices surprise on the upside, I believe this might come sooner. The bottom line, however, is Rowan Companies has found a strong partner that will help improve the backlog in the years to come.

Conclusion

Rowan Companies has a quality fleet with 19 high-specification jack-ups. The company's ultra-deepwater drillships are among the best in the industry. As industry sentiments improve, the market potential for the company's rigs remains bright.

Further, the company's backlog will ensure Rowan Companies ends fiscal 2017 with strong fundamentals, even if it is meaningfully lower compared to 2016. One of the biggest positives for Rowan Companies is that it has no speculative new rig deliveries, which will allow it to conserve cash.

Overall, the stock is worth considering at current levels, but I do advise limited exposure to the sector until oil witnesses further upside and sustains above $60 per barrel.

Disclosure: No position in the stock.

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This article first appeared on GuruFocus.