Transocean in Troubled Times - But Not for Long

Transocean (RIG) is a provider of offshore contract drilling services for oil and gas wells across the world. Transocean's primary activity is to contract drilling rigs, related equipment and work crews to drill oil and gas wells. The company also specializes in other technical aspects such as offshore drilling with a particular focus on deepwater and harsh environment drilling services. Transocean principally uses three types of drilling rigs: drill ships, semi submersibles, and jackups. The company also operates drill rigs, tenders, a mobile offshore production unit and platform drilling rig.

So why Transocean? Well, to start, Transocean is a big player in the deepwater market, an offshore segment with big barriers to entry due to capital expenditure commitments needed, therefore providing excellent safety amongst oil-related securities. The major investment thesis is four-fold: there’s major downturn protection, excellent upturn exposure, a really good cash position, and a potentially compelling valuation.

All of the above, in conjunction with a strong track record across all business segments, make this deepwater-centric driller one of the top picks within the sector.

Downturn Protection: Amongst most analysts, it has been shown quarter-to-quarter that one of the more compelling reasons to hold Transocean is its limited downside risk. Transocean's high contract coverage through 2010 represents a shield that should defend the bulk of its fleet from the worst, if not all, of the downturn in demand and pricing power across rig types.

The company also brings great upturn exposure to rising oil prices, and thanks to the ongoing reluctance of many of its clients to resume contracting 1+ years in advance, Transocean still has 48% of floater days available in 2011, representing meaningful EPS leverage to the next up cycle in floater-related demand that we expect to be well underway by that time. In 2012, 62% of floater days are uncommitted.

This really all boils down to capacity and the ability for Transocean to capitalize on the potential for oil demand to rebound after a rather soft 2008 following oil’s rush pre-recession.

The company’s cash firepower was once badly bruised and often mocked, but Transocean has taken great strides in revitalizing its cash position, to the point where the company’s backlog and normalized free cash flow generation potential give the company a lot of breathing room.

In a recent conference call, management reiterated Transocean’s strong liquidity position as the company currently has $1.3 billion in cash. Additionally, it holds a $2 billion credit facility which doesn’t mature for another four years and a $1.08 billion commercial paper backstop.

In total, the company holds $2.2 billion in unused bank capacity and over $3.5 billion in liquidity. Most importantly, Transocean’s $35.8 billion revenue backlog still provides a stable, visible earnings stream as 95% of the contracted backlog is with investment grade companies.

The company’s free cash flow backlog of $17.4 billion exceeds its debt level by $4 billion, which is close to management’s target of a $5 billion cushion.

The buyback program, given the uncertainty in the capital markets, is heavily favored over a dividend as a way to deliver value to shareholders due to the flexibility the buyback program provides in both dollar amount used and timing of share repurchases. The decision to refrain from paying out a cash dividend illustrates management’s leadership qualities and consciousness of current market conditions, a nice tell with regards to ensuring shareholder confidence in a good company.

Finally, out of the four dominating theses for investing in Transocean, the valuation of the company remains attractive by virtually every metric you can think about. With an enterprise value of approximately $37 billion, the stock is trading at 1.0x its backlog and 5.8x 2010E EBITDA. Transocean should trade between 95-105 based on a DCF model that forecasts up to 2013 and uses average FCF for terminal value estimation (based on 2002-2014 averages).

While some analysts believe the current rally is short-lived and due for a big fallback once oil recovers back under $60/barrel, others have hinted that oil can continue to push up into the 80s and even 90s.

The more and more oil pushes through such barriers, the less and less you’ll have to worry about Transocean’s viability and start enjoying the fruits of the oil being drilled.

As usual, risks that should be highlighted are the following: sustained weakness in customer economics, new-build program overruns, fairly high leverage, and cash return expectations. As always, commodity prices could also take a volatile tumble and erode at future profitability.

Comments

[isaac the t...:]

For diversity and liquidity- consider the ETF OIH which has its #1 holding being RIG at 10%.

Jun 14 05:39 PM

[Elitemaster:]

yepper, I have almost half of my portfolio in shares of RIG.. great company and poised for major uptrend in the coming years.. as long as you put your blinders on with the volitile jumps in prices caused by fluctuating day rates, over a long period of time this stock has an insanely great valuation - currently trades at ~$80/share, just wait until the next year or two when the global economy is in full gear, oil is back up at $140/barrel and RIG share price upwards of ~$160/share - I'm gonna be laughing all the way to the oil slicked bank.. nice article

Jun 20 02:33 PM

[bassmaster17:]

like the article.....pricing of this business is a complete joke...P/E 6, not to mention other metrics, I remember in 2000 when the cohort on CNBC said internet stocks with P/Es of 300 were cheap. Stupidity could drive it lower.

Jun 30 12:16 PM