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Is Valaris a Buy?

Valaris (NYSE: VAL), formerly EnscoRowan, has spent the past several years repositioning its business to better compete in the challenging offshore drilling sector. The company took advantage of the industry's rough patch over the past few years by acquiring rivals Atwood Oceanics and Rowan, which created the largest offshore driller by fleet size. Those deals, when combined with the company's other moves to reduce costs, have it well positioned as the offshore drilling sector rebounds.

However, while industry conditions are improving, shares of Valaris have plunged more than 70% so far this year. Because of that, investors likely wonder if its stock is a screaming buy or a value trap. Here's a look at the case for and against buying shares of this energy stock.

The silhouette of an offshore oil drilling rig at sunset.
The silhouette of an offshore oil drilling rig at sunset.

Image source: Getty Images.

The bull case for Valaris

Valaris' acquisitions have transformed it into one of the largest, most diversified offshore drilling contractors in the sector. The company's diverse fleet allows it to meet the needs of almost any offshore drilling program. It boasts modern rigs capable of drilling in ultra-deepwater regions such as the Gulf of Mexico as well as those able to operate in harsh environments like the North Sea. As a result, it's exceptionally poised to benefit from the eventual rebound in the offshore drilling market.

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In the company's view, its fleet could generate significantly higher earnings if drilling activity improved. A moderately better market, for example, would see its fleet utilization rise from 65% during the second quarter to 85%. That improving utilization would help boost dayrates for jackups from $78,000 to $150,000 and floaters from $218,000 to $300,000. Under those better market conditions, its fleet could produce $1.6 billion of annual EBITDA. That's well above its cash breakeven level of $950 million in EBITDA, which would enable it to generate significant free cash flow. There would be even more upside if dayrates and utilization returned to their former peak levels. Under those market conditions, Valaris' fleet could haul in nearly $4 billion of EBITDA. That's a lot of money for a company that currently has an enterprise value of less than $7 billion.

Valaris' earnings potential suggests its stock has lots of upside. Adding to that view is the disconnect between the value of its assets and the company's market valuation. A third-party estimate, for example, believes Valaris' fleet is worth at least $11 billion. Meanwhile, the replacement value of its drilling rigs is an even higher $24.4 billion.

An offshore drilling rig in a storm.
An offshore drilling rig in a storm.

Image source: Getty Images.

The bear case for Valaris

While Valaris has a bright future if industry conditions continue improving, it's still struggling in the current environment. That was abundantly clear during the second quarter. The company only hauled in $548 million in revenue while recording $500 million in contract drilling expenses, $81 million in general and administrative costs, and $118 million in interest expenses. Overall, the company has only generated about $495 million of EBITDA over the last 12 months, which is well below its $950 million breakeven level.

One of the company's biggest cost burdens is the interest on its debt. It had $6.7 billion of total debt after closing the Rowan merger and the subsequent repurchase of some of its notes. That debt costs the company roughly $400 million of interest payments alone each year, which is a substantial portion of its breakeven requirement. Given that it's currently consuming cash, Valaris' net debt will keep growing, further weighing the company down.

Verdict: Valaris' debt makes it too risky to buy

On the one hand, it's easy to dream on Valaris' upside. The company has significant earnings growth potential as market conditions improve, and it trades at a substantial discount to the value of its assets.

However, at the moment, the company is losing a boatload of money. That's a concern given its large and expensive debt load. Those factors will likely continue weighing it down until its earnings rise above the current breakeven level. That's why I'd hold off on buying shares until it's clear that the company can get its financials back on solid ground.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com