Are Offshore Drillers a Value Trap?

Diamond Offshore, Transocean, and Seadrill look cheap, but for how much longer?

Jun 1, 2014 at 4:46PM

The offshore drilling sector has not had a good year. Year to date, Transocean (NYSE:RIG) is down 16%, Diamond Offshore (NYSE:DO) is down 11%, and Seadrill (NYSE:SDRL) is down 13% as Wall Street analysts continue to speculate that the industry is heading toward a two-year slowdown.

Unfortunately, yet more warnings over the sector's outlook have recently emerged; this time, they came in the form of a caution. Wall Street believes that some investors who are looking at taking a position in one of the offshore drillers as a value play due to their low valuation may be stumbling into a value trap.

Looks too good to be true
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 ratio of 0.9, while 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. These analysts believe that downward revisions to earnings could send valuations higher over the next few quarters. 

Overall, Barclays believes that there is a 30% downside to current EPS forecasts after factoring in items such as lower-than-expected day rates. With this being the case, analysts believe that after taking into account the worst-case scenario, Diamond could be trading at forward P/E's of 26.2, Transocean at a ratio of 12.9, and Seadrill at a ratio of 9.1 times.

Barclays bear
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. It also reiterated the fact that companies with high levels of leverage were going to suffer the most, claiming that Seadrill's shares could collapse by as much as 52% if forecasts proved accurate.

Only time will tell if Barclays' forecasts will come true. As of yet, there has been no such decline.

Net asset values could fall
Unfortunately, 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 since if a stock is trading below its net asset value per share then it is considered to be undervalued. Wall Street believes that underlying net asset values of drillers could decline from their present levels, similar to the way net asset values were written down by 16% following the financial crisis and then by 8% after the Macondo disaster.

Foolish summary
In conclusion, Barclays' view on the offshore drilling industry may prove to be more pessimistic than it should be. However, the bank's analysts raise some valid points. If day rates and utilization rates within the offshore drilling industry continue to fall, earnings are going to fall and this will result in a re-rating of offshore drillers' valuations.

If earnings fall, valuations will rise. Drilling companies that once looked cheap will then look expensive -- a classic value trap.

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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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