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Disclosures & Disclaimer

This report must be read with the disclosures and the analyst certifications in

the Disclosure appendix, and with the Disclaimer, which forms part of it.

Issuer of report: HSBC Securities and Capital

Markets (India) Private Limited

View HSBC Global Research at:

https://www.research.hsbc.com

THIS CONTENT MAY NOT BE DISTRIBUTED TO THE PEOPLE'S REPUBLIC OF CHINA (THE "PRC")

(EXCLUDING SPECIAL ADMINISTRATIVE REGIONS OF HONG KONG AND MACAO)



We see value in the sector despite a slow recovery in

offshore markets; stocks trading at undemanding valuations



Our proprietary ‘Rig Market Value’ shows ca. 50% upside

across the sector; read across for SPM and MAERSKB



We adjust target prices and estimates to reflect our utilisation

outlook; maintain Buy on RIG, NE and DO

In this report, we discuss why we think current share prices offer deep value opportunities

in this subsector, and are not a value trap. Our analysis suggests that market concerns

over liquidity with the offshore drillers are overdone, with cash needs largely under control

into the early 2020s; we estimate around USD3bn is needed over 2019e-2021e against

total available liquidity of almost USD7bn. We also see sector consolidation as a

continuing theme, and one that supports our rig market value (RMV) calculations.

Context: Despite a drawn-out offshore recovery, we think the fall in the drillers’ share

prices over recent months presents an attractive opportunity. The drillers are at multi-year

lows on price/book metrics, and although the sector is likely to be loss-making until the

early 2020s, we see good value in the stocks (backed by our proprietary rig market value

calculations). Our target prices are on average 50% higher than current market prices.

What’s changed in this report: We adjust our forecasts to reflect Q4 2018 results, new

guidance, recent contract announcements, and our own lower utilization assumptions for

2020e/2021e. On average for our coverage, we lower our forecast EBITDA by 24% for

2019e and 11% for 2020e. We lower our RMV estimates by c13% on average.

Investment view: We see attractive asset-based value across the sector. Our preferred

play is Transocean (RIG) – the market leader with significant exposure to resurgent harsh

environment drilling. Our other Buy-rated names are Diamond (DO) and Noble (NE).

Read-across: Among other Buy-rated companies with offshore drilling exposure, we like

MAERSKB, which announced in August 2018 that it is planning to separately list its drilling

business in 1H 2019 (our RMV sees this fleet worth USD5.2bn), and also SPM, supported

by restructuring and the potential for portfolio change (we estimate SPM’s offshore rig fleet

is worth USD1.5bn).

Key investment ratings and valuations

Company

Ticker

Curr.

Current

Price

Market

Cap (USDm)

New Rating

New TP

Upside/

Downside

___ EV/EBITDA (x) ____

______ PB (x) _______

Old Rating

Old TP

2019e

2020e

2019e

2020e

Transocean

RIG US

USD

8.73

3,975

Buy

14.60

13.30

52.4%

11.9

11.1

0.4

Diamond

DO US

USD

10.29

1,414

Buy

17.20

13.70

33.1%

16.2

18.3

0.4

0.5

Noble

NE US

USD

3.15

777

Buy

6.10

5.30

68.3%

16.4

11.0

0.2

Note: Current prices as of close 19 February 2019. Source: Bloomberg, HSBC estimates

25 February 2019

Abhishek Kumar*

Analyst

HSBC Securities and Capital Markets (India) Private

Limited

abhishek.kumar@hsbc.co.in

+91 80 4555 2753

Tarek Soliman*, CFA

Analyst

HSBC Bank plc

tarek.soliman@hsbc.com

+44 20 3268 5528

David Phillips*

Head of Equity Research, Developed Europe

HSBC Bank plc

david.1.phillips@hsbc.com

+44 20 7991 7558

Edward Stanford*

Analyst, Transportation

HSBC Bank plc

edward.stanford@hsbc.com

+44 20 7992 4207

Thomas C. Hilboldt*, CFA

Head of Resources & Energy Research, Asia Pacific

The Hongkong and Shanghai Banking Corporation Limited

thomaschilboldt@hsbc.com.hk

+852 2822 2922

Anshak Singhal*

Associate

Bangalore

* Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is

not registered/ qualified pursuant to FINRA regulations

Global Oilfield Services

Equities

ENERGY EQUIPMENT &

SERVICES

GLOBAL

Offshore Drilling: Deep value in deepwater

Equities

●

ENERGY EQUIPMENT & SERVICES

25 February 2019

With offshore drillers trading at multi-year lows on price-to-book ratios, it is almost inevitable to

look at these stocks from a valuation point of view. The question is whether these stocks are

offering deep value with potential for significant upside on rerating or they are a value trap even

at these mouth-watering levels.

We have tried to answer this question in this report with discussion on both the sides of the

argument. We conclude that risk/reward is in favour of the offshore drilling companies after a

share price drop of more than 50% in the last quarter of 2018.

Our preferred name is Transocean, which is the market leader with a strong presence in the

harsh environment market - one segment of which has rebounded strongly through 2018. It is

also fairly well placed from a liquidity point of view. Other Buy rated stocks in the sector are

Diamond Offshore and Noble Corp, and we see read-across for MAERSKB and SPM.

Offshore drilling – The good



Undemanding valuation well supported by our proprietary replacement value matrix

Offshore drillers are trading at their multi-year lows price to book value metric despite

having impaired almost USD14bn in last four years.

Our proprietary vessel-based Rig Market Value (RMV) metric shows upside of c52% on

average for the offshore drillers we cover. Our RMV numbers are also supported by recent

market transactions.

The current share price of Transocean is implying an almost 20-25% reduction in rig market

value assumptions. The same metric suggests c20% reduction in rig market value

assumptions for Diamond and c15% for Noble Corp.

Among the drillers we prefer Transocean for its exposure to the harsh environment and 7th

generation UDW (ultra-deepwater) market, which are among the stronger segments within the

offshore drilling market; Diamond and Noble are other Buy rated stocks in the sub-sector.

Deep value, or a value trap?



Stocks trading at multi-year low multiples; we see value despite an

expected slow recovery in the market



Our proprietary rig market value (RMV) metric suggests share price

upside of c50% on average across this sub-sector;



RIG is our preferred play in the sector, rated Buy; other Buy rated

stocks are DO and NE, read-across for MAERSKB and SPM

Undemanding valuation and

RMV metric shows upside of

c52%

Equities

●

ENERGY EQUIPMENT & SERVICES

25 February 2019

Offshore Drillers − Rig market value vs current market price as at 19 February 2019

Rig Market Value (RMV)

RMV per share

Current market price (CMP)

Difference between RMV and CMP

RIG

13.1

8.7

51%

14.9

10.3

45%

5.1

3.2

59%

Source: HSBC estimates, Refinitiv Datastream

HSBC’s Rig Market Value (RMV) is our proprietary tool which estimates the current market

value of a rig fleet taking into account asset specifications, the value of attached drilling

contracts and recent rig sale transactions. This approach has been useful as an additional

method of estimating the current fair value of the offshore drillers, and in particular, acting as a

potential valuation ceiling for the companies.

Our RMV estimates current ‘steel’ value, taking into account a rig’s age, water depth

capability, current status (i.e. stacked or not) and current contractual position (for which we

estimate a NPV). With near-term earnings estimates in a loss-making position, we believe a

more appropriate way to look at such asset-heavy companies is on an asset-by-asset

valuation basis rather than looking at near-term EPS or EV/EBITDA-based metrics.



A consolidating industry- The offshore drilling industry has gone through a lot of consolidation

over the last 12-24 months; Transocean has been at the forefront of this. It bought Songa

Offshore and then Ocean Rig in 2018. More recently Ensco and Rowan are merging in a share-

swap deal. We do expect further consolidation in the industry as some of the smaller players are

struggling hard to survive and some are already going through bankruptcy proceedings.

The benefits of consolidation in the industry are manifold: firstly it helps bring rationalization

in the industry with asset retirements; secondly a consolidating industry with fewer players

will instill a disciplined approach with fewer rigs chasing a particular job. This means bids

would be more rational, leading to an eventual rise in the day-rates, and thirdly this will

bring down the operating expenses and make the companies more competitive.



Refinancing needs do not pose near term challenges - One of the main concerns of the

market around these drilling companies is their ability to fund their operations during the

stress period (which is not likely to improve for another couple of years). Our analysis of the

drillers’ debt profile shows that most of the near term financing needs have been taken care

of by the companies in the last 2-3 years and the refinancing needs appear only in 2023/24.

Though the drillers won’t be free cash flow positive in the next 2-3 years on our estimates, we

think they won’t have any significant financing needs in the near term and the cash on the balance

sheet and the revolvers should be able to take care of that. We estimate liquidity needs of offshore

drillers around USD3bn between 2019e-2021e against total liquidity availability of USD6.7bn.

Offshore drillers- Price to Book chart- 1 year forward

Source: Refinitiv Datastream

Consolidation likely to

continue as a theme in

foreseeable future

Near term risk from

refinancing is low

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

Jan-14 Jun-14 Nov-14 Apr-15 Sep-15 Feb-16 Jul-16 Dec-16 May-17 Oct-17 Mar-18 Aug-18 Jan-19

RIG DO NE

Equities

●

ENERGY EQUIPMENT & SERVICES

25 February 2019



Potential for earnings recovery in a recovering market is substantial - Given the costs

of running a rig have seen significant deflation, and oversupply in the value chain indicates

only limited increases in the medium term, any upside in day-rate will directly help the

bottom line of the driller. This means the potential for earnings growth is substantial when

the tide turns in favour of the drillers. This situation can arise if we see a significant pick up

in demand or additional retirement/scrapping which is quite possible.

Just as an example, in 2018, in a span of 9 months, day-rates for the harsh environment

category of rigs increased from 150-200K per day to 275-300K per day as the market

became tight due to incremental demand coming from the North Sea. Even on our

estimates of day-rates growth, which we consider to be conservative, we see a 136%

increase in forecasted EBITDA numbers over 2019e to 2025e period for the three drillers.



No threat of new supply- We see little threat of additional supply coming into the market in

the near future other than the rigs which are already under construction at yards. In fact we

think a significant proportion of these rigs under construction won’t be actually completed

and will ultimately be scrapped. Also, current cost of a second-hand rig is much less than

the cost of a new-build.

As an example the recent deal between Ocean Rig and Transocean happened at a value of

USD270-280m for a 7

-generation rig which is much lower than the cost of a new-build, which

is around USD500m. Operators are likely to prefer buying rigs at discounted prices rather than

going for any new-build. Besides, we also think that operators will find it very difficult to find

financing for a new-build despite very liberal terms of payments from yards (10% upfront, 90%

on delivery) and current day-rates are not supportive for a decent payback.



The offshore market will continue to exist - We have seen in the last 2-4 years that offshore

project break-evens have declined and projects are now viable well below USD50/barrel from a

level of USD60/barrel a few years ago. Besides, time to first oil is also decreasing, leading to a

better return profile for offshore projects. Though offshore projects still cannot compete with US

tight oil in terms of payback period, the returns are increasingly attractive. This leads us to

believe that there will always be demand for offshore oil and that means rig demand will not go

away. In fact, most of the consultants in the oil industry are already talking about a significant

increase in offshore FIDs in 2019 given the returns have become very attractive.



Operators’ cash flow at high levels- Operator cash flow is at the levels seen in 2014 when oil

prices were above USD100/barrel. Focus from operators is clearly on shareholder returns but

we are seeing instances of rising capex in 2019. Exxon has guided for capex in the range of

USD28-30bn (up from USD26bn in 2018) while Total has increased its capex from USD12.5bn

in 2018 to USD14-14.5bn this year (+15% yoy). This has positive implications for offshore

capex, which we expect to rise in 2019 from last year’s levels. For more details refer to Global

integrated oils 4Q results: more of what we need to see dated 13

February 2019.

Offshore drilling – And the bad



Acute oversupply and low utilization- Overall the rig market is going through a period of

acute oversupply with close to 41% of semis, 46% of drillships and 36% of the jackup fleet

actively looking for work. The situation is even worse if we add the currently-under-construction

rig fleet to this tally. We expect this situation to gradually improve but a significant jump in

utilization is highly unlikely in the near future. This is likely to put a cap on the day-rates as

competition for any new job will be intense. However, there are some bright spots, such as the

harsh environment market, where the demand/supply situation is more balanced.

Potential for earnings

upgrade is substantial in

case of day-rate pick up

We don’t see new supply

coming in the medium term

There is a space for offshore

market despite threats from

shale

Operators’ cash flows at high

levels and we expect

increase in capex

Oversupply and low

utilization remain the key

risks

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