Rowan Companies Has Made a Big Mistake

Rowan Companies (RDC) has lagged the S&P 500 significantly during the past decade or so, and investors have every right to question the company's poor performance.

I believe that Rowan's strong balance sheet is to blame for this underperformance. Now, normally a strong balance sheet would be a good thing. However, it is often thought that a company holding back too much cash is under-investing and not achieving the best returns for its shareholders. This would appear to be the case with Rowan.

At the end of the company's third fiscal quarter, Rowan had cash and equivalents on its balance sheet of around $1 billion, total debt of $2 billion, and a net-debt-to-equity ratio of 0.2; Rowan's current ratio was nearly 6 for the same period. If we compare these metrics to peers such as Seadrill (SDRL) and Ensco (VAL), it would appear that Rowan's balance sheet is stronger than the industry average. It also implies that the company could be under-investing. It is fairly standard for companies within the oil and gas drilling sector to have a high level of debt. Seadrill and Ensco have net-debt-to-equity ratios of 1.6 times and 0.4 times respectively, and current ratios of 0.7 and 1.4 respectively.

What's more, a quick glance at the earnings-per-share growth of the three companies reveals how beneficial this additional borrowing has been.

Source: Finviz.com.

Ensco has not been borrowing as heavily as Seadrill, but the company has borrowed more than Rowan. The effect of this can be seen in the company's five-year EPS growth. In addition, we can also see that Rowan's saving of cash has seriously affected its EPS; a lack of investment has resulted in falling earnings.

Holding cash on deposit in this current low interest rate environment is silly. Rowan would be able to achieve a better return from investing in new drilling units.

The sector leader knows best
Seadrill, the world's largest offshore driller by market capitalization, understands how to invest properly. As of July this year, Seadrill had 22 new units under construction including nine drillships, two harsh environment semi-submersibles, and 11 high-specification jack-ups. In addition, the company has fixed priced options for two additional UDW units. 

While 261 new drilling units have entered the offshore drilling market since 2005, the utilization rate of these drilling units has been a consistent 100%. Investors could be concerned with Seadrill's rising level of debt, although personally I do not believe that this is a problem yet so long as rig utilization remains high.

While the company's net-debt-to-equity level may be nearing 200%, the company's net-debt-to-asset level as of the third quarter was closer to 55%. This is a more manageable and realistic figure considering that debt is usually tied to assets.

Lacking dividends
Rowan's cash-saving antics also mean that the company is not paying out a dividend to its investors. What's more, peers such as Transocean, Seadrill, and Ensco all offer dividend yields close to or above the 5% level. This is yet another area in which the company lags its peers.

Ensco in particular offers investors a 5.1% dividend yield, which is well covered by its cash flows. For the nine months ending September, the company generated $1.4 billion in cash from operations; it then paid out $350 million in dividends. I should point out that capital expenditures during this period totaled $1.3 billion, but the shortfall was not an issue considering Ensco's low level of gearing (debt.)

Foolish summary
Overall, it would appear that Rowan's strong balance sheet is in fact holding the company back. While Rowan is saving, Seadrill is spending heavily and this is paying off for the company and its investors. You only need to look at Seadrill's impressive EPS growth during the past five years and the company's current 9% dividend yield to see that it is achieving a much better return for its shareholders than Rowan.