Valaris

Moat: 3/5

Understandability: 4/5

Balance Sheet Health: 2/5

Valaris Limited is a global offshore contract drilling company, providing services to the oil and gas industry, with a focus on ultra-deepwater and harsh environment operations.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview:

Valaris operates a diverse fleet of drilling rigs across various geographies. The company’s operations are primarily focused on providing offshore contract drilling services to international oil and gas companies. Their fleet includes drillships, jackups, and semi-submersible rigs, catering to different water depths and operating environments.

Revenue Distribution: Valaris’s revenue is heavily dependent on contract drilling services. They provide these services on a day-rate basis, where they charge their customers a daily rate for the use of their drilling rigs. This is influenced by utilization rates and day rates that they are able to negotiate with their customers. Revenue is distributed among regions, but a large portion is from the Americas.

  • Floters 36%
  • Jackups 43%
  • ARO 17%
  • Others 4%

Industry Trends: The offshore drilling industry is highly cyclical, primarily driven by fluctuations in oil and gas prices. Increased exploration and development activity driven by higher prices leads to greater demand for drilling rigs, pushing utilization and day rates higher. Conversely, during periods of low prices, demand contracts, leading to lower utilization and day rates, along with possible contract terminations. The industry has also seen a push for more efficient and environmentally friendly operations. This is also a highly capital-intensive industry, requiring large upfront investments in equipment. Consolidation has been occurring over the years. Additionally, a global push for decreased fossil fuels could materially harm future demand for new drilling.

Margins: As an industry, the margins are determined by the difference between day rates received and operating costs, and that can be highly volatile, as shown by several historical crashes. The EBITDA margins in Valaris’s last quarter were very high at 40% (59% before a major legal payment that was recorded), but they are highly dependent on revenue and utilization rates. There are indications that margins could decline sharply once current contracts rollover at lower rates.

  • Floters - 16.5%
  • Jackups - 41.5%
  • ARO 26.5%
  • Other - 4.7%

Competitive Landscape: The offshore drilling industry is intensely competitive, with many large players vying for contracts. Competition is based on factors like rig capabilities, operational efficiency, safety records, reputation, and price. Competition affects all of the companies in the industry as it’s very hard for any company to have a differentiated product. Valaris has a large modern fleet and strong operational track record, but faces competition from newer, better-equipped rigs, and lower-cost providers.

What Makes Valaris Different: Valaris is one of the largest offshore drilling companies in the world, with operations across numerous regions and a modern fleet. It has a strong track record with some of the most advanced rigs available and has been investing heavily in upgrades and modifications. It has also been diversifying its operations, including new energy and other technologies, to address changes in the market.

  • A focus on high-spec, harsh-environment, and ultra-deepwater drilling assets
  • A history of operating and managing a broad range of rig assets.
  • Has taken actions to reduce long-term costs.
  • Has shown strong operational uptime as well as a focus on safety

Moat Analysis: Valaris’s moat is categorized as narrow due to its unique position in the deepwater and harsh environment market, along with its well-diversified, high-spec, and modern fleet of drilling rigs. They have made large investments in new technology. These factors contribute to a moderate level of competitive advantage, but they aren’t really difficult to replicate over time. This translates to better-than-average returns over time, but it is not long-lasting or certain due to the highly cyclical nature of the industry and its inherent competition.

  • Intangible Assets: While the company has some brand recognition as a large and reputable drilling contractor, it’s not a strong driver of demand.
  • Switching Costs: The switching costs for their customers aren’t significant, because large customers contract on a project by project basis. Some may have long-term contracts, but these can be terminated and re-negotiated. Therefore this isn’t a reliable part of their moat.
  • Network Effects: No real network effects are in play for their business.
  • Cost Advantages: While the company benefits somewhat from economies of scale, it’s not so much to be considered a major moat component.

Moat Rating: 3 / 5 Given that this is a highly cyclical industry with very high competition, and with their current business not being that differentiated and thus not sustainable, the company only has a narrow moat that may provide it with average returns if they continue to do what they have been doing. This is highly dependent on management’s ability to operate well and maintain its large fleet.

Legitimate Risks That Could Harm the Moat and Business Resilience:

  • Oil and Gas Price Volatility: The biggest risk factor is the volatility of crude oil and natural gas prices. A sharp drop in prices would have a significantly negative impact on demand for drilling services, leading to lower utilization rates, day rates, and revenues.
  • Industry Cyclicality: The oil and gas industry is cyclical, and periods of overinvestment, followed by declines can lead to large asset write-downs and losses.
  • Overbuilding and Competition: Overbuilding of the fleet due to market competition can lead to overcapacity in the market. That leads to lower day rates and therefore reduces the company’s profitability and returns.
  • Technological Disruption: The industry may also be disrupted by rapid technology changes. This could render older drilling equipment obsolete and reduce their demand.
  • Regulatory Risk: Increased environmental regulations or a shift towards renewable energy could also affect demand and increase costs.
  • Geopolitical Risk: Operations are located across the globe which exposes it to political instability and conflicts in certain regions, disrupting operations and impacting revenues.
  • Customer Concentration: a significant portion of revenues come from a few customers.
  • Operational Risks: The company has many moving parts and a lot of dangerous high-intensity environments where it operates, increasing risks in a variety of issues.
  • Transition to Renewable Energy: The global transition from fossil fuels to alternative sources could reduce the long-term viability and demand of offshore drilling.

Resilience: Valaris is a large, well-known company with a lot of experience. They have significant relationships in their respective markets. However, because they have such high reliance on external factors, it’s hard to deem the company as being very resilient. In times of strong demand and high prices, the company may have positive earnings, however, all external factors seem to be trending towards lower profitability.

Financials:

Recent Financial Performance: In 2023, Valaris saw a significant turnaround. The company reported profits, driven by better day rates and higher utilization of its drilling rigs. Contract drilling revenues for the full year 2023 were $1,421.1 million, a substantial increase compared with $1,070.5 million in 2022. Also, the company generated Net income of $964.4 million in 2023. The improved performance is mainly attributable to higher revenues and reduced restructuring costs that were booked in 2022, which was a big contributor to the net loss of $456 million.

  • Revenue: The revenue consists mainly of the day rate that is received by the drilling fleet with ARO services and offshore drilling being the main source of revenue. The highest revenues are derived from jackups rigs at around 43%.
  • Profitability: They had a huge net profit for 2023, mostly from an improvement in their financial operations. The EBITDA margin was at an impressive 40.1%, though they are dependent on volatile day rates.
  • Capital Expenditures: In 2022, CapEx totaled $643.2 million, and in 2023, it was $1,141.8 million. This means that they have made significant investments in their fleet.
  • Free Cash Flow: FCF was $184.4 million in 2023.

Financial Analysis of Most Recent Quarter (30th September 2024):

  • The operating revenue from the Floaters, Jackups, and ARO segments were pretty level with the previous quarter. But there was a large increase in operating revenue from ‘Other’ operations from $5.9 million to $37.5 million.
  • Operating expenses were largely consistent across the different sectors with the largest changes related to Reconciling items. These have increased the total expense from $27.6 million to $131.1 million.
  • The company recorded a net loss of $42.6 million for the quarter. Most of these losses are due to non-recurring items.
    • The company’s earnings for the quarter were hampered by the recognition of the loss related to the ARO.

Understandability: 4 / 5 Valaris’ business model is relatively easy to comprehend: they are a contract drilling company that leases out drilling rigs to oil and gas companies. However, understanding the cyclicality of the industry and the specific factors that influence day rates and utilization does add some complexity. Additionally, the company also operates in different parts of the world, in complicated environments, which makes understanding their financials and risks more difficult. Overall, a somewhat complicated industry with fairly easy to understand operations.

Balance Sheet Health: 2 / 5

  • Debt: The company has a highly leveraged capital structure with high long-term debt of 2.2 Billion.
  • Debt service: It is hard to tell if the company can cover its future debt due to the volatile revenues and day rates of their operations. But for 2023 they have a great free cash flow, allowing them to service debt.
  • Cash: Current cash of around $400 Million, but the company has $1.2 billion in working capital, showing its ability to repay short-term obligations.
  • Equity: Equity of $1.7 billion in 2023. Overall, the company’s balance sheet is not in the best shape, with a high debt load and a low cash position. It is extremely important for them to achieve profitability. This is in large part due to them exiting bankruptcy and all the restructuring that came with that, as well as the capital-intensive nature of the industry.

Recent Concerns / Controversies and Management’s Response

  • Bankruptcy: Valaris recently emerged from bankruptcy in April 2021. In this restructuring, a lot of debt was extinguished and they had to renegotiate several contracts. This is in large part why the company had an impressive 2023. This also came at a cost of shareholder dilution.

  • Contract Termination: The company has faced some contract termination issues in the last year, most notably with VALARIS DS-11. They are actively pursuing a new contract. However, these terminations have contributed to volatility in revenues.

  • Rising Costs: While they are profitable now, the company is facing rising costs in personnel and supply chain. It is important that they can maintain their margins over a long-term timeframe.

Management Commentary:

  • Management is focused on returning capital to shareholders, but no such program has been initiated.
  • The company is seeing an increase in contract duration, indicating some stabilization in the demand for offshore drilling. However, a lack of pricing power from the company is worrisome.
  • The main focus is now on debt management and they expect to maintain their cash and liquidity positions, while still meeting all financial obligations.

Overall, they seem to be confident in their performance, and are seeking to take advantage of their size and operational expertise. They are also looking to consolidate contracts that were renegotiated during the 2021 and 2022 bankruptcy.