Lodbrok Publishes Letter to Valaris’ Board of Directors
LONDON–(BUSINESS WIRE)–Lodbrok Capital LLP, in its capacity as a top five investor in Valaris plc (“Valaris”), recently sent the letter included below to Valaris’ board and issued the following comment today:
“Lodbrok Capital LLP is highly supportive of Valaris, its management, and its directors. Since our recent letter, the company has continued to demonstrate strong shareholder focus by amending its bond indenture, and we think the new flexibility provides attractive opportunities to proactively unlock shareholder values during the current market volatility.”
Letter set out below:
Valaris plc (“Valaris”)
5847 San Felipe
Suite 3300
Houston, TX 77057
Attn: The Directors
7 July 2022
Dear directors,
Certain funds and accounts managed or advised by Lodbrok Capital LLP (“Lodbrok”) hold an exposure corresponding to 6.3% of the shares in Valaris, through a combination of 4.7% of directly held shares and call exposures on a further 1.6% of underlying shares, as well as more than 7% of the 2028 Valaris notes. Lodbrok has been invested in Valaris continuously since our inception in 2017, and we served on the investor committee in the recent financial restructuring, during which we injected new capital into the business.
In our view, the offshore drilling sector is poised for continued strong recovery after years of rig supply contraction and underinvestment in the industry. We believe Valaris is uniquely positioned among offshore drillers with the lowest asset valuations, the highest operating leverage, and balance sheet flexibility that allows for a best-in-class capital return policy. Based on our calculations, Valaris trades at c. $115m per drillship, or 1.3x EV/EBITDA at the rig level based on the clean dayrate in the recently announced contract for the DS-17. This corresponds to c. 15% of our estimated replacement cost in a market potentially facing shortage of rigs. Furthermore, we estimate an upside of more than 160% to the current share price based on recent asset transactions.
We are highly supportive of the company, the management, and the directors. Valaris has achieved a lot in its first year following the restructuring, having successfully reactivated several idle assets, installed a strong management team, and closed some of the valuation gap to its competitors. At the outset of the second year post restructuring, we believe shareholders will be focused on two interdependent priorities: continued closing of the significant trading discount to fundamental asset values and implementation of a best-in-class return of capital policy.
Unlocking value
Beyond benefitting from its unique operational leverage to rising dayrates, we believe the best way for Valaris to close its valuation discount is through attractive disposals of jackups, linked to an immediate return of capital to shareholders. While lifting market values towards NAV, we believe such disposals and distributions could be a highly attractive way to realise value and demonstrate strong shareholder focus, as further supported by Valaris having two large shareholders represented on the board.
A competitor recently sold three jackups in a yard for a price of c. $107m per unit (or c. $125m incl. startup costs). Lodbrok estimates that Valaris’ share price implies $38m per premium jackup, implying c. 180% upside to a NAV based on this recent transaction. For illustration, we estimate a sale of 10 jackups at $107m each would imply a PF Q1 cash of $1,320m net of all debt (incl. CARES tax and sale of JU-113 and JU-114), equal to 45% of the market capitalization. If hypothetically all 33 premium jackups in the fleet were sold at $107m each, we estimate Valaris would have net cash position of $3.8bn, compared to a current market cap of c. $3.0bn, implying a negative -$0.8bn of value for one of the largest floater fleets in the world and the ARO JV. Even at a meaningful discount to $107m per rig, such disposals could be highly attractive, and we believe shareholders would welcome immediate events over waiting for potentially higher prices if that would entail greater process uncertainty.
Capital returns and balance sheet normalization
The Valaris share price has seen a 38% pullback from recent highs, despite what we see as firmly improving industry fundamentals. Part of the share price decline is possibly due to selling by unnatural shareholders following the debt restructuring, leading to supply of shares which is currently not met by commensurate demand due to the recent market turmoil and lack of specific events to drive investor attention. We believe that any capital return exercises – be it dividends or share buybacks – could serve to alleviate these dynamics, and that companies sitting on net cash positions amidst large share price declines could be seen as sending a weak message if they do not consider buybacks (or dividends that allow shareholders to reinvest themselves).
We believe part of Valaris’ valuation discount may be attributable to what we consider an inefficient and defensive balance sheet. As of Q1 2022, the company had $578m of unrestricted cash, before proceeds from a $125m jackup disposal and a $97m CARES tax refund, for a PF unrestricted cash of $800m against $550m of debt. The cash position since emergence has afforded the company stability as it sought to reactivate its fleet and get to positive cash flows, while providing an opportunity to evaluate cash funded acquisitions. However, the company has told the market it turns free cash flow positive in H2 2022, and in the most recently announced drillship contract, it seems that most of the reactivation costs were covered by the customer. Moreover, with the strong sector recovery, we believe any large-scale M&A is likely to be equity based. Consequently it is our opinion that the cash on the balance sheet, beyond what is required for non-reimbursable reactivations and day-to-day operations, offers limited strategic or financial flexibility at this stage. We believe Valaris’ statement of having the “strongest balance sheet in the offshore drilling sector” may be increasingly translating to current and prospective shareholders as having an inefficient and defensive balance sheet in a healthy and improving market.
Having followed this industry over a long period, we recognise it is highly cyclical. We were part of the recent restructuring, which eliminated $7.1bn of Valaris’ debt, and, together with other long-term investors, we committed to injecting $500m of new capital in the summer of 2020 when oil prices were in the $40s. The restructurings of Valaris and its peers have rendered the wider drilling sector much more robust, and we struggle to foresee a return to conditions during which the current balance sheet was established. Key peers like Seadrill, Diamond and Noble/Maersk all restructured their balance sheets in recent years, and none of those have net cash positions like Valaris. We believe retaining cash for what we consider highly unlikely scenarios, given the prevailing market conditions, could be inconsistent with principles of healthy corporate governance. Thus we would consider it appropriate and in the best interest of shareholders if Valaris immediately sought to distribute any excess cash and – over time as credit markets permit – establishes the right level of debt on its balance sheet.
Bond amendments
The only debt in the company is a bond that was issued last year to a group of shareholders that included amongst other four of the six largest shareholders in Valaris as per recent filings. The bond indenture was negotiated under some of the industry’s most challenging times and consequently does not offer the company appropriate flexibility in the current market. Today there is a significant market cap, a large number of asset transactions to support valuations, and a backdrop where dayrates and commodity prices have drastically increased since the bond was priced, rendering it highly over-collateralised. The bond is not callable before 2023, but given the improved risk profile of the instrument, we believe it would be straightforward for the company to negotiate any desired flexibility through amendments – particularly given the overlap between bondholders and shareholders. We firmly believe that waiting until the call date in 2023 before addressing the bond could leave Valaris unable to pursue the interests of stakeholders in the interim. To us it seems sensible to immediately seek amendment of the indenture to allow for appropriate capital return policies and debt levels.
Summary
In summary, we believe Valaris’ value proposition is its unique position of having the lowest rig valuations, the highest operating leverage to a rapidly improving market, and balance sheet flexibility that allows for a best-in- class capital return policy. We believe it could be attractive for shareholders if Valaris:
- capitalises on the high prices paid for jackups in asset transactions relative to its share price value,
- swiftly adapts its indenture and balance sheet to reflect the vastly improved market conditions, and
- immediately returns any excess capital to shareholders and continuously evaluates further distributions.
Inaction in times of sharp share price decline, despite rising dayrates and a defensive capital structure, may be seen by the market as a lack of belief in the prospects of the business, and we are confident the company will seek to ameliorate such concerns through rapid action. We believe there is tremendous value potential if the board continues to be proactive. As stated, we are highly supportive of the company and confident the directors will take the right actions to maximise shareholder interests.
Please note that this letter is intended to provide transparency on our perspectives as shareholders, and as we want to remain unrestricted and public, we do not seek any direct feedback on its contents.
Sincerely,
Mikael Brantberg
Chief Investment Officer
Lodbrok Capital LLP
Joachim Bale
Partner
Lodbrok Capital LLP
Contacts
Lodbrok Media Contacts
Nepean
nepeanlodbrokteam@nepean.co.uk
