Transocean: Value & Dividends

Company Profile

Transocean (RIG) is one of world’s largest offshore drilling contractors, accounting for approximately half of world’s supply of deepwater drilling rigs. The company traces its roots to the early 20th century and in the course of its history pioneered many technologies critical to modern offshore drilling.

Transocean has a large fleet of various classes of rigs and ships: from standard jackup rigs to ultra-deepwater rigs able to drill under 12,000 feet of water. Revenues are quite well diversified geographically, with US representing the largest segment (22% of total revenues in 2010), with Brazil, UK and India representing 14%, 12% and 9%, respectively.

Transocean has grown rapidly in the past decade, significantly boosted by the merger with GlobalSantaFe in late 2007. The company has received significant negative publicity after the explosion on its Deepwater Horizon rig and the subsequent oil spill in the Gulf of Mexico in 2010, which became the largest oil spill in recorded history.

Competitive Position

Transocean owns (or co-owns) and operates 136 mobile offshore drilling units, including 48 High-Specification rigs (Ultra-Deepwater, Deepwater and Harsh Environment), 25 Midwater Floaters, 9 High-Specification Jackups, and 51 Standard Jackups. Four High-Specification Jackups are also under construction. The NY Times estimated that the company owned almost half of all deepwater platforms in the world in 2010. Therein lies one of Transocean’s strengths: its size and market share mean that whenever someone contracts a deepwater rig, there is a good chance that it will be from Transocean.

Size and the accompanying economies of scale isn’t Transocean’s only competitive advantage. The company has a history of being “the first” in the offshore drilling business: it was the first to deploy jackup drilling rigs more than 50 years ago (these have legs that allow a rig to stand on the ocean floor); the first to drill year-round in the North Sea; the first to be able to drill under 10,000 feet of water (when the standard was 3,000 feet); and it was the first to announce being able to conduct two drilling operations from the same ship simultaneously. In September 2009, Transocean’s Deepwater Horizon rig set a record for the deepest offshore well at 35,050 feet. These achievements demonstrate Transocean’s innovation and technological leadership, which is extremely important, because as known oil and gas reserves run dry, exploration is going to move into increasingly hazardous environments with extreme conditions, with deep waters being the main target. Transocean is likely to be the prime candidate for providing equipment for such projects.

However, Transocean’s market leadership seems to have weakened since the merger with GlobalSantaFe in 2007: customer satisfaction and job quality indicators dropped from top ranks in 2004-2007 to the very bottom in 2008-2010, according to Energy Point Research.

The company has an ageing fleet, with the median unit age of 19 years. Different segments of the fleet have different ages, with the more technologically complex rigs being much younger. For example, the Ultra-deepwater fleet is just 10 years old, High Specification Jackups – 13 years and Deepwater – 14 years, while Standard Jackups are 29 years old. This suggests that the company has been investing more in high-specification rigs in the recent past. Transocean’s financial statements show a significant intensification in capital expenditures in the past five years: in 2006-2010, the company spent on average $1.8 billion per year on capex, while in the previous five years, the annual average was just $290 million. It appears that Transocean is betting on the deepwater drilling market.

The large amount of expensive fixed assets required in this business acts both as a barrier to entry (with prices of up to $1 billion per rig, not many can afford one), and as a ballast when business slows down. Transocean has a high level of fixed costs associated with maintaining rigs in working shape even when they are idle. This creates significant operating leverage that penalizes the company when utilization rates fall. At the same time, positive operating leverage is limited when utilization reaches its maximum because it’s impossible to add rigs quickly when demand exceeds supply, and dayrates can’t be cranked up easily due to contractual terms. In addition, at least some of Transocean’s 18,000-strong workforce is represented by unions (the company doesn’t specify the exact number but it has faced strikes in the past), which further restricts the company’s ability to quickly adapt to changing economic environment. Transocean’s flexibility appears to be almost the same as the maneuverability of its mammoth rigs.

Transocean’s business faces numerous risks: environmental, health & safety, legal, and regulatory. Moreover, the risks usually travel in packs, compounding each other: a single accident not only causes environmental damage, but it can also injure employees, affect third party individuals and businesses, as well as raise compliance concerns from various government agencies, leading to penalties, tightening regulations, and even license suspension. The explosion on Transocean’s Deepwater Horizon rig (also known as the Macondo incident) that left 11 people dead and caused a huge oil spill in the Gulf of Mexico in 2010 materialized pretty much all possible operational risks in one form or another (except for penalties and license recall, which remain a possibility since the official investigation is still open). In addition to the loss of the rig (covered by insurance) and lost business from the associated well (about $0.6 billion), the accident has broader implications for Transocean.

The US Department of Justice has already filed a lawsuit against involved parties (including Transocean) alleging violations of various acts, while the US Coast Guard has concluded that Transocean had numerous safety failures prior to the accident (denied by Transocean, of course). Should the official investigation conclude that Transocean indeed was to blame, the company may face multi-billion dollar charges. BP agreed to cover the costs of the cleanup, but has filed $40 billion worth of lawsuits demanding compensation from other parties, including Transocean, whose liability is normally limited under drilling contracts. Other implications include tighter safety regulations for the whole industry, which require upping the technical specifications of rigs and increasing operating costs to comply. Reputational damage shouldn’t be ignored either. Although Transocean has not been found guilty, the fact that it was its rig casts a shadow on the whole company, raising doubts about its safety policies and ability to execute complex projects.

A lot of controversy surrounds the accident. The Deepwater Horizon rig received an award from the U.S. Minerals Management Service for its 2008 safety record, and on the day of the accident, BP and Transocean managers were onboard to celebrate seven years without a lost-time accident. Moreover, Transocean declared that 2010 was “the best year in safety performance in [the] company’s history.” Of course, if Transocean recognized the Deepwater Horizon accident as a failure of its own safety measures, it could be construed as an indirect admission of guilt – not something the company would want to do.

A Wall Street Journal investigation suggests that Transocean’s safety record was deteriorating after the GlobalSantaFe merger and prior to the accident, as the company’s share of incidents in the gulf jumped from 33% to 73%, in contrast to the share of rigs in the gulf, which grew from 30% to just 42%. The merger was seen by some industry players as a direct cause of the deterioration.

BP (owner of the Macondo well) was Transocean’s most significant customer in 2010, accounting for about 10% of the company’s revenues, with a backlog of $2.9 billion in February 2011. It is not clear if BP remains a major customer now, but the accident and the subsequent lawsuit from BP may negatively affect the relationship between the two companies and may reduce Transocean’s revenues further. It is unlikely, however, that the two companies will cease doing business together forever.

Transocean has demonstrated active tax management in recent years: the company moved its registration to Switzerland in 2008 to take advantage of the lower corporate income tax. This was not the first such move for the company, as in 1999 it moved from the US to the Cayman Islands. At the same time, Transocean has unresolved disputes with tax authorities in the US, Brazil and Norway. Unfavorable resolution of these disputes could create liabilities exceeding $1 billion, which would materially affect Transocean’s financial position.

Despite the significant negative publicity from the Deepwater Horizon accident and numerous risks associated with it and with the general business of Transocean, there is one significant factor that can make Transocean an attractive long-term investment: oil. Global energy demand keeps growing and alternatives are still far from replacing fossil fuels. All this is compounded by the desire to improve independence from imported energy. At the same time, “easy” deposits of oil and gas are being depleted, driving petroleum producers into increasingly tougher locations, while the rising price of oil also makes it profitable. There is no denying that Transocean is a technological leader in its market, able to deliver solutions in some of world’s harshest environments. If Transocean maintains a tight grip on its safety practices, restores job quality levels and manages risks associated with the Deepwater Horizon accident carefully, the company’s future could be very bright.

Growth and Profitability

Transocean more than tripled its revenues in the past decade, but suffered declines in the last two years. Transocean’s revenues appear to follow the economic cycle and the price of oil (correlation coefficient between revenue and price of oil is 0.80), suggesting that the current decline in revenues (see Table 1) is most likely temporary and as soon as the global economy recovers, so should Transocean’s business.

Given the degree of operating leverage that we mentioned earlier, profitability took a nose dive in 2010 (Chart 1 and Table 1). Currently, the company is near the breakeven point, compared to the 10-18% historical average ROE and to industry’s 11.31% and competitors’ TTM ROE 8.4%.

While FCF has outperformed revenues (growing more and shrinking less), earnings actually suffered much greater declines than revenues (see Table 1), as the effects of operating leverage were compounded by the effects of financial leverage.

Financial Health

Transocean is moderately leveraged, with debt to equity ratio currently at 0.53, slightly below the 10-year average of 0.61, but higher than the peer median of 0.34, which matches the industry average. The company’s $11.1 billion of debt (including $1.9 billion current portion) is quite comfortably spread out in relatively small portions across the next 27 years (the largest annual amount is $3.3 million due in 2037). In addition, Transocean has $1.9 billion available under a revolving credit facility. Current portion of debt is less than $3.4 billion in cash, so the company should be able to meet its obligations if no additional liabilities arise.

Transocean’s liquidity ratios are close to 10-year averages: current ratio is at 1.50 versus the average of 1.61, while the quick ratio is at 1.23 versus 1.33; the cash ratio is at 0.76 versus the average of 0.62. Transocean’s quick and current ratios are worse than competitors’ median of 2.06 and 2.44, respectively, but compare favorably with industry averages of 0.84 and 1.2. Interest coverage is at 7.8 versus competitors’ median 13.4 and industry average of 1513.

The balance sheet structure isn’t exactly comfortable, given that large liabilities may arise from the aftermath of the Deepwater Horizon accident and tax disputes, which can drain the cash reserves amid deteriorating profitability and cash generation. In addition, Transocean has approved the distribution of approximately $1 billion in dividends, to be paid in quarterly installments from qualifying additional paid-in capital (recent changes in Swiss taxation legislation allow paying such dividend without incurring income tax for shareholders, which is 35% otherwise). The dividend appears to be an effort to please investors as Transocean hasn’t got much to boast right now, and we would prefer the company to accumulate a larger cash balance until the official investigation of the Deepwater Horizon accident is complete or business environment improves.

VALUATION

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A forward P/E of 8.8 P/B ratio of 0.7 suggests that Transocean is considerably undervalued. Transocean may be discounted versus its peers due to the Deepwater Horizon investigation, as well as due to disappointing financial performance in recent quarters. A favorable conclusion of the official investigation should remove part of this discount. It is notable that Transocean is currently yielding over 6% in terms of dividends. We believe that their backlog, in addition to insurance coverage for potential liability claims, will allow the Company to safely maintain their dividend payments, setting a floor on share price. Free cash flow generation has been strong and we expect earnings to pick back up to low double digits by 2014-2015.

This stock is not without risk so it is recommended for value-oriented investors with a long time horizon. Transocean is currently trading at a ~38+% discount to its intrinsic value of $81 based upon a weighted intrinsic value model. For the discounted cash flow model, a discount rate of 11% and 5-year free cash flow growth rate of 10% was assumed. Given the cyclicality of the industry and unpredictability of earnings, we require a 40% margin of safety. At a Margin of Safety of 40%, the target acquisition price for Transocean is $49.

Disclosure: Recently acquired shares at $44.50 and $48.00. I am long RIG, XOM.