I'm not 100% sure where I sit when it comes to the role of an activist like Carl Icahn in the stock market.
I believe fully that the management of a publicly traded company should be held accountable to shareholders, and I really appreciate when activists step forward and force that accountability.
What makes me a little uncomfortable with someone like Icahn is that at no point in time does he really want to be a long term investor in a company. His operating method involves targeting an underperforming company and enacting change so that he can realize a short term profit.
I often agree with the changes that Icahn proposes and his targets are often well deserved recipients of his negative attention, but it worries me a bit that some of his requests may be for his interest in a short term profit and not for the long term best interests of a company.
Transocean (NYSE:RIG) - Icahn Has Some Demands
According to his recent 13D filing Icahn controls 5.43% of Transocean. That is over 20 million shares and at the current share price Icahn's position is worth a cool billion dollars.
At the end of 2011 I took a long look at Transocean but decided to pass on it as an investment for a couple of major reasons:
Concern #1 - A Questionable Acquisition
On August 15, 2011 Transocean announced that it had agreed to purchase Norwegian driller Aker Drilling for $1.46 billion which was almost double the then market price of Aker stock.
Given that Transocean doesn't exactly have a Berkshire Hathaway (NYSE:BRK.A) like balance sheet, and given that operations have not exactly been firing on all cylinders, the timing of this acquisition was not popular amongst shareholders.
Adding to the shareholder dislike was the fact that the price paid for Aker equated to about $800 million per Aker rig which most observers thought was at best fair and perhaps too high. Perhaps Transocean shareholders could understand a deal that was too good to refuse, but paying a fair price given the circumstances does seem a little questionable.
Concern #2 - Credibility of Management
Transocean shareholders were likely displeased with the Aker drilling acquisition. How Transocean management then funded the deal only increased shareholder unhappiness.
At the time of the deal Transocean paid $1.43 billion in cash for Aker and assumed $800 million of debt.
Shortly after that Transocean announced an offering of roughly 30 million shares of Transocean stock which represents 10% dilution to shareholders. And that offering of shares was at a seven year low for Transocean's stock.
Essentially, Transocean management funded an acquisition that was at best being done at a fair price with Transocean shares which were at their lowest price (and I'm sure management would suggest severely undervalued) in years.
Icahn's 13D has two proposals. He seems to share the concerns that kept me out of the stock.
The first of which involves replacing three of Transocean's directors. Not just any directors mind you, but three key directors. One is Chairman Michael Talbert who has been on the Board for twenty years. The other two directors are Thomas Cason and Robert Sprague who have served for 20 and 10 years respectively.
Icahn provides three reasons to support his belief that these three gentlemen deserve to be kicked to the curb.
Reason number 1 - The Questionable Global Santa Fe Transaction
In 2007, the same directors who are now using over $5 billion of capital to pay down low coupon debt at Transocean oversaw the purchase of Global Santa Fe ("GSF") while simultaneously leveraging the balance sheet to pay a special dividend. The GSF acquisition occurred at the height of a global bull market, and while the timing itself was unfortunate, focusing on timing obfuscates what we view as the fundamental problems with the acquisition.
We believe that in pursuing GSF, Mr. Talbert and the Board acquired a fleet which substantially increased the age and volatility of Transocean's asset base while simultaneously increasing financial leverage. Transocean paid almost $18.2 billion for the GSF assets which we believe are worth only $7.5 billion today, thereby destroying $10.3 billion of shareholder value.
Even using an estimate of Transocean's current net asset value of $68 per share to value the stock portion of consideration, the purchase price comes to $12.75 billion (about $11 billion at today's depressed market price) meaning that over $5 billion of shareholder value was destroyed using this metric.
Not only did the Board approve the purchase of old and volatile assets while simultaneously leveraging the balance sheet, but even the strategic logic behind this acquisition (as stated in the merger proxy) proved incorrect. This acquisition represented the pinnacle of a decade of deal making and consolidation, which Transocean justified under the premise that a larger company would benefit from cost savings, diversity and an "enhanced industry presence" according to their proxy statement. However, in 2006, before the GSF acquisition, Transocean was running SGA at 2.3% of sales and post the GSF acquisition for the last three years Transocean has been at 3.2% of sales. Clearly, the consolidation benefits never materialized. In comparison, while Transocean was busy paying top dollar for old GSF assets, Seadrill was building new assets and driving shareholder returns.
Reason Number 2 - A Questionable Aker Drilling Transaction
In 2011, Transocean purchased Aker Drilling in an apparent attempt to upgrade their fleet following the damage that we believe was caused by the GSF acquisition. Transocean purchased four rigs in the Aker Drilling transaction (two of which were still under construction) at a premium to new build construction costs. Although Transocean had the ability to utilize cash to fund the acquisition, instead, Mr. Talbert and the Board, in what appears to us to have been an emphasis on credit ratings over shareholder returns, issued almost 30 million shares of Transocean at $40.50 per share immediately after the acquisition of Aker Drilling. In essence, Transocean bought assets at a premium to net asset value and paid for them by issuing shares at substantially below net asset value, in our opinion destroying almost $840 million ($2.50) per share in value. As observed by Morgan Stanley:
"We estimate the secondary offering will create a total NAV loss of ~$837m, raising the implied value paid for the two semis by ~$419m apiece, thereby bringing the total implied amount paid for each harsh environment semi to a high ~$1.4bn. Conversely, at ~$43/sh, the implied value for each of RIG's UDW floaters (including the Aker rigs) is about $293m, a sharp difference from the "price paid" for the Aker semis." Ole Slorer - Morgan Stanley November 29, 2011.2
Reason Number 3 - A Flawed Go Foward Capital Allocation Strategy
The Board of Transocean is now endorsing a new plan whereby Transocean will invest billions of dollars in building low return assets and repaying low coupon debt, rather than returning capital to shareholders. Transocean is accepting lower returns on new build assets in exchange for long term contracts to reduce the volatility of their business. However, at the same time Transocean is using massive amounts of cash flow to reduce debt. In stark contrast to the GSF acquisition, in which Transocean increased volatility and leverage, Transocean is now going to the other extreme and decreasing both volatility and leverage thereby driving returns to below its cost of capital. In our view, a balanced approach to managing financial leverage and volatility would yield superior returns for shareholders.
Transocean's plan appears to use $8.75 billion of capital over the next several years to build new assets and reduce debt, generating an average after tax return of approximately 7%. The sheer size of this investment is equal to almost $25 per share. In fact, a $5 billion ($13.92 per share) investment in debt reduction would result in less than $200 million per year in after tax income ($0.57 per share). Based on an 8.25x 2015 P/E multiple, $8.75 billion of capital invested in this manner would only add $5.1 billion of value, thereby destroying another $3.6 billion of shareholder value. Furthermore, if Transocean chooses to pay down that much debt, the terms of the underlying debt documents will require Transocean to pay hundreds of million in debt prepayment penalties erasing even this modest benefit.
When I passed on investing in Transocean in 2011 a major reason was the Aker Drilling transaction that Icahn also cites as a reason to remove Transocean's three directors. I'm sure many other shareholders (some of them even long term) also aren't too happy with management over that deal.
Icahn's second proposal relates to his displeasure noted in item 3 above where he questions the decision to spend $5 billion reducing debt over the next several years.
Instead of that Icahn thinks Transocean should institute a $4 per share dividend which would return cash to shareholders immediately and force fiscal discipline on the Board of Directors which would then have to make do with less financial resources.
A $4 per share dividend on the 370 million shares outstanding means an annual payment of almost $1.5 billion by Transocean. The yield on the current $50 stock price would be 8%.
Personally, with each passing month I grow more fond of dividends. While dividends may not be the ideal way to maximize tax efficiency they do in my opinion force management to think more carefully about how dollars are spent.
I also however like to sleep at night. And I think the dividend proposed by Icahn is likely too big in relation to Transocean's current cash flow and balance sheet.
Transocean's cash flow from operations for the last three years has been $2.7 billion, $1.8 billion and $3.9 billion. That is an average of $2.8 billion per year.
Over that same period Transocean's capital expenditures have been $1.3 billion, $1.0 billion and $1.4 billion. That is an average of $1.2 billion.
That means that free cash flow per year on average has been ($2.8 billion less $1.2 billion) $1.6 billion. Icahn's proposed dividend would mean that all free cash flow is disbursed to shareholders.
Transocean has $11 billion of long term debt and $5 billion of cash as of December 31, 2012. While $5 billion of net debt isn't necessarily a concerning amount given the liquidity the large cash balance creates we do have to remember that this is a very cyclical industry.
I don't think Transocean has the balance sheet that would make paying all free cash flow to shareholders the ideal decision. Some of that cash should be retained to strengthen the company's balance sheet or grow cash flow.
Perhaps a dividend of half the size that Icahn suggests would be more appropriate with the other half of free cash flow going to debt reduction.
Note that all financial figures come from Transocean's SEC filings.