Here’s a suggestion to Mr. Icahn: Why not consider targeting one of the many cheap offshore drillers? Most have already booked up their rigs for a few years under long-term contracts at very attractive dayrates. These contracts provide very visible cash flows, so perhaps a recapitalization is in order?

You have a business for which the underlying assets are increasing in value, not deflating. State-of-the-art drilling equipment has not yet succumbed to the global deflationary pressures we see in businesses like cell phone and chip manufacturing. Cell phone manufacturing capacity is overbuilt yet still receives more and more capital investment worldwide -- good for consumers, bad for producers. But offshore drillers emerged out of a 20-year recession just a few years ago.
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Furthermore, while earnings visibility is very low at most technology companies, several offshore drillers know the next few years of earnings with a fair degree of confidence. To top it off, they’ll have very valuable rig fleets at the end of the high-visibility period. Who knows what the cell phone industry will look like?

Technology businesses are not considered as “capital intensive” as drillers, but in my view, the ever-present challenge of technology obsolescence more than offsets this. Carl Icahn’s efforts may pay off for shareholders in 2007, but they will magnify, or leverage, the shrinking shareholder base (shrinking due to share buybacks) to the downside of technology’s creative destruction.

Examining the Effects of GlobalSantaFe’s Cash Flow on Its Balance Sheet

When you buy a stock, you are essentially buying a claim on the company’s assets and the cash that those assets generate when they are put to productive use. If you look at the assets on a balance sheet from the bottom up, you see that the least liquid assets are toward the bottom and the most liquid assets are closer to the top. Management’s top job is to extract as much value out of these assets as possible, gradually converting them to cash over long periods of time:

Free cash flows will be so high that most of them must buy back hefty amounts of stock, raise dividends, or expand their rigs fleet quickly to avoid having too much cash pile up on their balance sheets. This is a nice problem for any company to have, but it puts them right in the cross hairs of private equity funds, aggressive peer acquirers, and activist investors like Carl Icahn.
Peak Oil has already occurred in many areas of the world including the U.S., the British and Norwegian sectors of the North Sea, and now Mexico.

What happens in every country after passing peak production? Demand for drilling skyrockets. The North Sea has been a very active offshore drilling market in recent years, and there’s no sign of a slowdown.

GlobalSantaFe maintains an indicator of industry health called the SCORE (Summary of Current Offshore Rig Economics). It compares the profitability of offshore rig dayrates with the profitability of dayrates during the 1981 peak of the offshore drilling cycle. When the SCORE index is at 100, dayrates equal “the sum of daily cash operating costs plus approximately $700 per day per million dollars invested.” (Source: GlobalSantaFe):
the profit generated by a typical offshore rig when the SCORE is 100 means that its owner is recouping his capital outlay in just four years. In the 130s, you can imagine how quickly rig owners like GSF are “monetizing” their rig fleets.

As for oil demand, it’s important to remember that higher prices are more likely to slow demand growth, rather than reverse it. Global oil demand hasn’t contracted on a year-over-year basis since the early 1980s. John Segner, portfolio manager of the AIM Energy Fund, puts these numbers into context in a recent Barron’s interview:

“China is still using only 6.5 million barrels of oil per day. We are using 20 million barrels per day here in the United States. China is 25% of the world population. The Chinese are getting off bicycles. They want air conditioning. They are getting housing. If China slows, it would just be a bump in the road. Oil-demand growth could slow down, but the chance of it going below 86 million barrels [per day], say, next year? I just don't see that happening. And I don’t see a lot of capacity growth. Supply-demand is still going to be tight.

“Energy [investments are] going to do very well. The multiples have been contracting for the better part of 12 months. And we are toward the end of that correction more than we are at the beginning of it.”

Drilling Rigs Will Inflate Faster Than Houses

Amid the rumors of a $100 billion private equity bid for Home Depot, I find it surprising that there has been little private equity interest in exploration and production (E&P) or oil field service companies.

Perhaps financial engineering could unlock some value for Home Depot shareholders, but there is only so much you can do with a large retailing business model. Plus, the company is still exposed to the housing bubble’s hangover. It’s impossible to quantify just how much “spec” building and home equity refinancing money found its way into Home Depot cash registers over the past three years.

HD’s price-to-earnings ratio when business is firing on all cylinders is a lot lower than when it’s not -- especially when you think about the effect of spreading lower sales across a high fixed cost structure (big box stores) and the financial burden of holding slower-turning inventory.

Home Depot may be a good buyout someday, but I think potential buyers can get a better price at some point over the next two years.

Think about the “leveraged” income strategy employed by most landlords. Assume that a landlord purchases an apartment building with a 10% down payment and a 90% mortgage. If rents provide enough income to offset mortgage interest and maintenance, the landlord is left in a position where his equity goes up and down by a factor of 10-to-1 with each fluctuation in the value of the apartment building.

Leveraged exposure to a long-term real estate bull market is how most real estate moguls have made their billions. If an opportunity comes along to borrow money at a low fixed interest rate and buy a cheap asset that is both inflating in value and throwing off income, it’s hard to lose.

Why not consider contract drilling businesses?

I’d bet that a fleet of drilling rigs will inflate in value at a faster pace than physical buildings over the next 10 years. I’d also bet that quite a few savvy investors recognize this and we’ll see more mergers, acquisitions, and private equity transactions as the energy bull market continues to roll on.