RIG Races Forward

Fundamentals

Core Business Fundamentals

Transocean (RIG) derives its income from the Energy sector. This sector is in a strong fundamental uptrend and you can look at my prior posts on BP and SLB to see my perspective on the macro fundamentals. RIG’s fundamentals on a stand-alone basis are powerful too.

Demand for drilling vessels has been very high as the confidence in sustainable oil prices of $60 and above over the long term has remained strong. The offshore drillers have responded by significantly increasing capacity; today there are in excess of 69 jack-ups, 46 semisubmersibles and 41 drill-ships either under construction or on order. Several of these assets are being constructed backed by contracts for use following delivery; some are speculative builds too. Some of this new capacity will be offset by retirement of old and tired rigs, but a lot of it is incremental capacity, which will narrow the gap of unsatisfied demand for vessels.

The last few years, demand has been well over supply; fleets of the drillers have run at near 100% utilization. This has caused a massive rise in day rates. Once new supply comes onto market, day rates are likely to fall somewhat; I say somewhat because even after the new builds merely satisfy un-satisfied demand – at this stage I do not think excess capacity has been created. However, during periods of slow or no economic growth, fleet utilization will fall and day rates will tend to come down significantly.

For the drillers this is a risk, but it is a risk following a great opportunity – billions have been invested to create a glorious fleet; and much of this activity has been financed because of high day rates offered for firm contracts following delivery. What this means is that the backlog will pay for an impressive fleet and after the initial contract, drillers will own a great asset with several decades of income earnings capacity.

RIG’s fleet is focused on offshore drilling. The land based supply of oil has been exploited for several decades and it is likely that future opportunities for success will come from offshore exploration. At present, major oil budgets are capex constrained, however, once visibility of oil prices improves, it is likely that RIG will be a major beneficiary. RIG has a backlog of over $38.7 billion which should see it through this period of uncertainty.

Stable long term oil prices of $60 and over are a positive for deepwater drilling; deep and ultra deepwater drilling marginal costs are more than covered at these levels. With low marginal cost oil discovery expectations being low, offshore oil is the area likely to be in focus; particularly as the marginal cost of production is lower compared with oil sands and shale. The marginal cost to producers varies significantly by the environment and depth; the harsher the environment and deeper the depth, the higher the cost of exploration and the future marginal cost of production. RIG is by far the best in class in deepwater and harsh environment work. In addition, RIG’s fleet made up of jack-ups, semi submersibles and drill ships, has strong capability across the depth spectrum. This asset portfolio diversification across mid water, deepwater and ultra deepwater allows RIG the flexibility for profitable operations over a broad range of long term oil prices.

RIG is also tremendously innovative in its business. It has brought to the market, cost and time saving technologies including dual stack and dual drilling table vessels. It has also been a leader in developing vessels capable of drilling in harsh environments. Finally, it has continually pushed the frontiers of exploration by delivering vessels with capability of drilling in deeper water; today several vessels can drill in water depths of 12,000 feet.

RIG’s management is also hugely capable. It has led the consolidation in the industry to create what is by far the biggest and best offshore driller in the world. In the past decade, Transocean has brought together the assets and skills of Sedco Forex, R&B Falcon and Global SantaFe; this is no mean achievement. The management vision and single-minded pursuit of the offshore drilling business with a focus on deepwater is creditable. The opportunity for future growth through acquisitions is narrower. However, in this upgrade cycle, several less financially strong companies have built small but magnificent fleets; quality and asset focused (not size) acquisitions might be the next future acquisition opportunity.

Because the Company is what it is, it is able to attract and retain the best driller talent. The value inherent in this talent is unlocked through impressive training programs in every field; be it engineering, finance, QHSE or general management, amongst others. Individual goals are well aligned with those of the Company; compensation and benefits including stock benefit plans are used with great effect; in addition cross functional mobility is a powerful tool which allows truly high potential employees realize their full potential. The work force is diverse and totally globalized and yet the Company has instilled a value system which makes each employee uniquely "Transocean”. FIRST is not a useless mnemonic used by RIG to express its mission and values; FIRST STEP is not a meaningless training program which instills these values in employees; FIRST and FIRST STEP are what instills values consistent with corporate values in the individuals that make up the Company; it is what breathes life into the Company; it is what makes its governance strong; it is what leads to success.

Today, RIG’s management and asset quality sets the company apart from the competition; this together with innovation and capital requirement acts as a formidable entry barrier.

Leverage

For capital intensive business, I believe leverage adds significant shareholder value. Yet, I feel that debt levels where net debt divided by net debt plus equity exceeds 30%, the leverage adds risk to a level where shareholder interests are not best served. In RIG’s case I do not see the leverage as excessive even though the ratio is well in excess of 30%.

RIG’s leverage is in fact monetization of an existing backlog. The backlog was monetized and funds used to return value to shareholders through a $15 billion (approximately $30 per share) special dividend paid out during the Global SantaFe and Transocean merger.

Even today the backlog stands at $35.8 billion; the debt can be discharged from backlog assuming a 33% net margin on the backlog, leaving Transocean unleveraged and with a glorious fleet of assets with several decades of revenue earning potential. The financial risk to backlog is minimal as most of Transocean clients are investment rated companies. But Transocean is certainly not without risk; execution and commissioning of these magnificent new assets is no easy task – history suggests that Transocean will deliver, commission and execute; however, the risk of delays and start up problems remains.

On the face of it RIG seems over-leveraged. But for the reasons mentioned just prior, it's not.

	Q4 2008	Q1 2009
Sh Eq	17,167.00	18,120.00
LTD	12,893.00	10,924.00
STD	664.00	2,040.00
Cash and Cash Eq	1,296.00	1,414.00
Net Debt	12,261.00	11,550.00
Net Debt: Net Debt + Eq	42%	39%

Delivering and Returning Shareholder Value

RIG ceased paying a dividend during 2002. RIG did pay a special dividend of $15 billion (approximately $30 per share) during 2007 at the time of the Global SantaFe merger. It has also returned some value via share buybacks. But really, the shareholder value has been created, leaving the choice of when to capture returns to investors.

If you invested $100,000 in RIG during 1999, you would have acquired 3,574 shares. If the special dividend of $30 received in 2007 was reinvested at average prices during 2007, your stake would have risen to 4,638 shares. At average 2008 prices, that would have been worth $557,452; for an annual return of 19% annualized. At average year to date 2009 prices, the shares are worth $303,934; for an annualized return of 11%. At recent price of just over $80, the stock value comes in at $375,685 for an annualized return of 12.8%. All in all, shareholders in RIG have done pretty well. On the first trading day of 1999, SP500 was at 1,228 compared with 979 recently. In fact with the SP500 at 979 recently, the SP500 return since 1999 has been just about break after adjusting for dividend received.

I suspect it will not be long before Transocean seeks to return shareholder value via a buyback or dividends (regular or special); what we need to see is the backlog begin to grow once again.

Normally, I like dividends as part of a shareholder value return strategy. For Transocean, I believe the opportunities were such that not paying a regular dividend was a good choice. I also believe that dividends serve to widen the investor base; heightened investor interest is supportive to share values. But with interest in Energy already attracting high investor interest, a dividend was not so important when better growth opportunities were present.

During 1999 we saw RIG’s EPS at $1.13, by end 2008 it was $14.33; the annualized growth is 28.92%. Underlying earnings (earnings disregarding shares in issue) growth was over 34% annualized during this period. This growth was achieved as a result of strong fundamentals for the Energy sector in general and for deepwater drilling in particular. It was also achieved because of the consolidation in the industry led by M&A activity initiated by RIG. For 2009, I expect EPS to come in at $15.20. Near term EPS growth momentum can continue at high levels once the new builds swing into action at strong day rates. In addition to the expanded fleet as a result of past M&A activity we have a fleet of wholly or partially owned new assets which include: Discoverer Clear Leader, Discoverer Clear Americas, Discoverer Inspiration, Discoverer Champion, Dhirubhai Deepwater KG1, Dhirubhai Deepwater KG2, Discoverer India, Petrobras 10000 and GSF Development Driller III. All of these assets are backed by long term contracts commencing post construction; all of these assets are high performance, high specification dream machines. All of these assets mean that Trasocean is not yet at peak earnings potential.

During 1999, average annual share prices clocked in at $27.98 per share. By 2008 the annual average price was at $120.19; a growth of 15.81% annualized. Unfortunately during 2009, the year to date average price is $65.53 which has reduced the return to just over 8% annualized.

Valuation

Can this growth in EPS continue at this amazing rate? To my mind the answer is no. The industry is deeply cyclical; that will not change. In addition, fleet utilization of near 100% is unlikely to continue in perpetuity – consider that there has been a vast expansion in capacity during this upgrade cycle. While capacity expansion largely meets unsatisfied demand, there will be times when backlogs and oil prices are low; during these periods utilization will drop as will day rates. At $15.2 EPS, I do not see RIG at peak EPS because peak earnings potential will increase as the new builds start work. But I do not see $15.2 as anywhere near a future earnings trough either.

For a long term investor, I would look at an earnings trough of approximately $7.16. At this value I would value a notional payout ratio of 50%, with 7% annual growth at $96 for an investor seeking a long term return of 11% annually. For investors with shorter holding periods, I would look for $120 as an achievable exit target; longer term as backlog renews growth and confidence increases, I would not be surprised in movement towards $191 as a price target.

On the downside, RIG fell as low as $42. A lot of this was financial crisis related and a lot of it was selling by index investors as the stock left the SP500 when the company re-incorporated to Switzerland. The book value excluding goodwill is close to $30; however with replacement cost of drilling rigs where it is, I doubt that book value ex-goodwill provides any useful indication of value. In the future I believe $55 (book value) will provide firm support to the share price. On this value, I expect the management to generate a long term rate of return of 15% with ease.

As an ex Transocean employee, my views might be somewhat tainted; I have tried to remain neutral but I do have a great deal of admiration for the Company, its employees and its management.

Disclosure: Long RIG, SLB

Comments

[erics99:]

Thank you for your insight. Just to clarify, you worked for both Transocean and Schlumberger correct?

Jul 27 12:29 PM

[Shiv Kapoor:]

That is correct. I was with Schlumberger until 1999. When Transocean merged with Sedco Forex, I moved with the spin off to RIG. I left RIG a couple of years back to try my hand at something new before I past my sell by date.

On Jul 27 12:29 PM erics99 wrote:

> Thank you for your insight. Just to clarify, you worked for both
> Transocean and Schlumberger correct?

Jul 27 12:40 PM

[Doc 224899:]

Shiv,

What is the minimum oil spot price for profitable deep ocean oil production? $75? $80?

How much do you think that profit line will move as peak iron ore market conditions settle in?

Jul 27 04:45 PM

[Shiv Kapoor:]

In my view $60 is a price level which will be profitable for deepwater projects. On iron ore price impact on margins for drillers the impact will be limited because the upgrade cycle nears completion; I do not expect an unpriced margin impact of any significance..


On Jul 27 04:45 PM Doc 224899 wrote:

> Shiv,
>
> What is the minimum oil spot price for profitable deep ocean oil
> production? $75? $80?
>
> How much do you think that profit line will move as peak iron ore
> market conditions settle in?

Jul 27 09:57 PM

[jimp:]

Shiv,
What is a good/fair price to buy RIG for long term hold.

Jul 28 05:44 AM

[Shiv Kapoor:]

It really depends on your long term return expectations. If you are looking at 12% annualized, $76 is a decent entry. If you are looking for 15% annualized then $48 is the entry price. But remember, whatever price you pay, you will have to live with volatility; drilling is deeply cyclical - assuming $18 as peak earnings, it is likely that at some point in time, future earnings could come down to as low as $3 for a trough - and with earnings, share prices will rise and fall. It is futile to predict where the bottom could be, but my guess is that $53-$55 is as low as it should get. Keep in mind that this post and comment are no more than my own views; it is not advice; nor is it an an offer, solicitation or recommendation of any security in any specific jurisdiction - you really must research the stock yourself to decide an appropriate entry price and whether it is right for you.

On Jul 28 05:44 AM jimp wrote:

> Shiv,
> What is a good/fair price to buy RIG for long term hold.

Jul 28 06:36 AM

[jarco:]

Shiv,
Any opinion on NOV you'd care to share?

Jul 28 05:38 PM

[Shiv Kapoor:]

I like the Company - you can see my post on maxkapital.blogspot.co.... In my view, the results were good in the context of the time we live in.


On Jul 28 05:38 PM jarco wrote:

> Shiv,
> Any opinion on NOV you'd care to share?

Jul 28 09:27 PM