These Offshore Drillers Could Be Set for Further Pain

Analysts believe that Transocean, Seadrill, and Diamond Offshore could be in for further declines.

May 28, 2014 at 12:03PM

The offshore drilling sector has not had a good year. Year to date, Transocean's (NYSE:RIG) shares have fallen 16%, Diamond Offshore (NYSE:DO) has fallen 11%, and Seadrill (NYSE:SDRL) is down 13%. These declines are a result of speculation that the offshore drilling industry is about to enter a two-year slowdown.

Unfortunately, yet more speculation has recently emerged. This time, though, it is in the form of a warning to value investors. The speculation states that these investors could be falling into a value trap by taking a position in one of the heavily sold-off drillers.

Looking cheap
At current levels, the offshore drillers look cheap. Diamond Offshore, for example, currently trades at a 2015 P/E of 9.8 and price-to-book ratio of 1.5. Transocean trades at a forward earnings multiple of 8.1 and a price-to-book of 0.9. Seadrill trades at a forward P/E of 7.9 and a price-to-book of 2.2.

While these valuations appear attractive at first glance, analysts at Barclays see numerous headwinds going forward. This could result in earnings forecasts heading for another round of downgrades, leaving the above drillers looking expensive instead of cheap at current levels. 

Barclays believes that there is a 30% downside to current earnings-per-share forecasts for the next few years after factoring in items such as lower-than-expected day rates and lower fleet utilization rates. With this being the case, analysts believe that after taking into account the worst-case scenario (in this case, a 30% slump in earnings), Diamond could be trading at forward P/E for 2015 of 26.2 times, Transocean at a ratio of 12.9 times, and Seadrill at a ratio of 9.1 times. These forecasts are not so harsh on Seadrill, but they make Diamond look expensive right now. Transocean, on the other hand, appears appropriately priced. 

This is not the first time that Barclays has issued such a dismal forecast on the industry's outlook. Back in January, the bank issued a research note stating that drillship day rates could fall as much as 16% over the next few quarters. As a result, the company downgraded 2015 earnings forecasts by as much as 40% for some companies.

The bank also reiterated the fact that companies with high leverage were going to suffer the most. These forecasts took aim at Seadrill specifically, and claimed that the company's shares could collapse a further 52% if the forecasts proved accurate.

Only time will tell if Barclays' forecasts will come true. As of yet there have been no such declines.

Net asset values could fall
Unfortuanly, Wall Street analysts have another warning for value investors. Analysts believe that as day rates deteriorate, net asset values of offshore assets are going to decline.

Net asset values are usually used by value investors to establish a base case for investment. If a company's stock is trading below its net asset value per share, it is considered undervalued. Wall Street believes that underlying net asset values of drillers could decline from their present levels, similar to the way that net asset values were written down by 16% following the financial crisis and then 8% after the Macondo disaster.

With this in mind, it could be the case that the price-to-book values of Transocean, Diamond, and Seadrill are all pushed higher as the value of assets decline and debt remains constant. 

Foolish summary
There continues to be much speculation about the state of the offshore drilling industry. These forecasts from Barclays add yet more confusion to the industry's outlook. Still, these views are interesting to note. They also seem to correspond with many other analysts who are calling for a drop in offshore drilling profits over the next few years. Investors need to be cautious.

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Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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