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Third Avenue Value Fund 1Q18: Offshore Oil Services, BMW, Ocean Rig UDW

Offshore Oil Services

  • One of the very few industries globally that is currently undergoing a recession, let alone one of historic severity. Fewer still are industries for which there is an extremely high probability that the current recession is cyclical rather than secular
  • Sentiment may have been a more influential factor as the price of a barrel of oil bottomed in early 2016 at levels that would render most of the world’s oil production uneconomic
  • Sentiment was also impacted by the fact that oil’s price decline happened to coincide with that of a number of industrial commodities, which caused many to speculate that oil demand may be part of the problem, not just supply
  • This concern faded quickly as global oil demand has continued to rise consistently and strongly
  • Naturally, given the low oil price environment, spending enormous amounts of money to find new resources or develop existing resources has not been high on the list of priorities for oil and gas producers
  • The service providers are the tip of the whip, so to speak, where the amplitude of the business cycle is most magnified
  • As compared to most onshore oil and gas projects, offshore projects tend to require extremely large and sophisticated pieces of equipment, such as drilling rigs, and yet more equipment, such as OSVs to service those rigs
  • In short, the offshore oil and gas industry is incredibly capital-intensive. Service providers who own and operate the required equipment, sometimes spending as much as $700 million to build a single drillship, often require the use of large amounts of debt to fund that capex
  • By combining cyclicality and debt-funded capital intensity, the offshore services industry is a recipe for occasional financial distress. However, the corollary is that it is also a recipe for creating unusually attractive special-situation investments at distressed prices
  • We are convinced that the world absolutely needs the 25% of global oil supply that is currently produced offshore and if spending on offshore projects doesn’t increase in the relatively near future, the world will cease to enjoy that supply
  • In reality, there are growing signs that the recovery in spending has already begun in earnest
  • We are also convinced that the securities prices of some offshore oil service companies reflect enormous discounts to the replacement value of the assets
  • The real trick is to undertake this activity in a manner that does not subject us to the financial leverage normally associated with these companies
  • We identified the opportunity to purchase two companies in the offshore oil service industry which recently emerged from bankruptcy sporting net cash balance sheets and a third in a newly formed company which has been entirely funded with equity for the sole purpose of purchasing a specific class of drilling rigs from distressed sellers at large discounts to replacement value

Ocean Rig UDW, Inc

  • Ocean Rig was one of the many companies that succumbed to the financial distress brought on by the acute offshore oil services recession
  • Company was financially restructured in a bankruptcy process which concluded in 2017. Ocean Rig emerged from bankruptcy with virtually all of its debt having been converted into equity, which is why it is today a net cash company
  • Ocean Rig is an owner of modern semi-submersibles and drillships, the type of assets used in deep-water drilling. These rigs are among the most costly to build
  • We are confident that the price we have paid for shares of Ocean Rig represents a small fraction of the replacement cost of these assets
  • It is true that deep-water assets, like semi-submersibles and drillships, may benefit from a recovery at a somewhat later stage than jack-ups, but we believe that eventually dryrates for each type of asset must return to levels that provide a respectable return on the hundreds of millions of dollars it costs to build them
  • Absent that age-old economic law returning to the drilling industry, the industry will not build new rigs, as has been the case for the past four years, and the industry will continue shrinking as assets are retired and scrapped
  • That process would lead to a smaller supply of rigs, a better supply and demand balance and a likely return to dryrates that provide a respectable return on investment
  • Our math suggests that at dryrates anywhere close to normal, Ocean Rig’s operating performance would justify a share price significantly above today’s price, possibly multiples of the current price

BMW

  • Forces of change impacting the automotive industry have been headline news for several years. There is electrification revolution, autonomous driving, ride-sharing, diesel emissions cheating scandals, tightening and then easing of EPA regulations, concerns about the sustainability of Chinese economic growth, slowing US passenger vehicle volume sales and deteriorating subprime auto loan credit statistics in the US, to name a few
  • We are far more attracted to the luxury automotive space than the mass-market. Luxury auto manufacturers operate in a global oligopoly dominated by Daimler, Volkswagen, and BMW
  • The industry is generally less competitive than mass-market, tends to produce higher operating profit margins and is historically less cyclical than mass market, a trait that is counterintuitive to many people but real nonetheless
  • These characteristics have enabled some of the automotive industry’s best returns on capital, which, in turn, leads to several of the industry’s best balance sheets
  • Constant funding of R&D in furthering engine technology, materials technology, efficient manufacturing and now electrification is extremely expensive
  • To the extent that an auto manufacturing business is only modestly profitable and/or must use resources to service debt, it is an incredible challenge to spend sufficiently to keep pace with leading engineering
  • Strength of credit rating is a competitive advantage to the many auto manufacturers with captive finance units. BMW today has among the industry’s highest profit margins and is arguably the industry’s most robustly capitalized with approximately EUR 20 billion of net cash
  • BMW also happens to already be among the world’s leading producers of electric vehicles
  • We expect that BMW will likely continue to enjoy a favored position as the world of auto manufacturing evolves
  • BMW is trading at perplexingly low multiples. Fund’s cost of BMW shares amounts to roughly 7x earnings, approximately 1x tangible book value and a nearly 10% FCF yield

Third Avenue Value Fund 1Q18 Letter

Image Source: Silversands

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