Are Offshore Drillers a Value Trap?

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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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 01, 2014, at 6:32 PM, MarioCarbone wrote:

    This nosense about value trap is based on idea of one individual analyst that didn't explain why he believed that prices in this industry will HAVE TO go down 30%.

    With such aproach every industry is value trap. Can you imagine if you predict that tomorow banking commisions go on half. We should close all the banks because will go to bankrupcy. And clever analysts would lose job. Finally :)

    If we speak seriously tha prices for offshore drillers would go down if industry won't be competitive against onshore drillers. But is is competitive because prices that form the cost to get oil offshore in deep sea are still at least 10% lower of the average onshore drilling. So the primary projects will be still on sea and with competitive market as it is, the prices are already around optimal level.

  • Report this Comment On June 01, 2014, at 7:34 PM, awallejr wrote:

    Rupert do you just parrot whatever Barclays says? You have been doing this now for like your last 5 "Articles" involving SDRL. To be blunt you really are starting to look foolish. Come up with something original at least.

  • Report this Comment On June 02, 2014, at 7:17 AM, jcnme wrote:

    Sdrl just signed a 5 yr deal with total for an average of 600000 a day. If that's a falling rate then count me in.

  • Report this Comment On June 02, 2014, at 12:10 PM, spokanimal wrote:

    You are mis-using the term, "value trap".

    A value trap involves a stock that has dropped quickly and substantially from highs, in anticipation that something bad might happen, but before it actually OCCURS, leading many to believe it is unjustified, and exposed to the strong possibility that the fears will be realized.

    With Transocean, and other drillers, dayrates have ALREADY dropped and uncontracted rigs have ALREADY turned up, following the decline in the sector stocks after last year's dayrate peaks.

    The "value trap" was during the decline in anticipation of what is occurring now.

    Now... it's just pure value in the trough of the industry downturn, and contrarians are the ones picking at the bones of these stocks.

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