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Shares of Transocean (NYSE:RIG) saw some downside on Monday after analysts at Goldman Sachs (NYSE:GS) cut their stance on the shares.

While I don't see an imminent short term catalyst to unleash short term potential, other than a possible spike in oil prices, I like the long term potential of Transocean's business. The long term tightness in the oil market and demand for deepwater drilling should bode well for Transocean.

Goldman Sachs Is Becoming Bearish

Analyst Waqar Syed downgraded Goldman's stance on Transocean from "Neutral" to "Sell", while reducing the price target by three dollars to $50 per share.

Syed believes the recent performance, after shares have risen some 8% over the past month, is tied to index buying as Transocean will be added to the SP500 index after the close on Monday.

This temporary demand for shares ignores the weak macro fundamentals. Furthermore dayrates have fallen for deepwater rigs, while there are signs of weaker utilization/dayrate weakness. This is problematic as Transocean is facing contract renewal risks, with several contracts ending in the next six months.

Transocean is also facing structural challenges including an aging floater fleet, as it needs to make sizeable investments to upgrade its fleet. Finally, Goldman believes these trends are especially worrying as Transocean trades at premium price-earnings ratios to some of its competitors. Unfortunately the firm does not specify the peer group in these comments.

Valuation

Transocean ended its second quarter with $3.36 billion in cash and equivalents. The firm operates with a total debt position of $10.80 billion, for a net debt position of $7.44 billion. Note that the company is scheduled to release its third quarter results next week on the 6th of November.

Revenues for the first six months of the year came in at $4.59 billion, up 3.5% on the year before. The company reported net earnings of $624 million compared to a $294 million loss in the comparable period last year. Note that annual revenues of $9.5 billion should be attainable as earnings could come in around $1.2 billion.

Trading around $49 per share, the market values Transocean at $17.5 billion. This values equity in the company at 1.8 times annual revenues and 14-15 times annual earnings.

Transocean currently pays a quarterly dividend of $0.56 per share, for an annual dividend yield of 4.6%.

Some Historical Perspective

Long term holders of Transocean have seen very good returns, although investors who stepped in over the past five years have seen very poor returns.

The continued demand for oil, accompanied by higher oil prices and increased technical abilities in exploration efforts, have pushed up shares of Transocean from $25 in 2004 to highs around $150 in 2008.

Shares quickly fell back towards $50 in 2008 as the economy and oil prices fell of a cliff to after which shares have traded around these levels in 2012 and 2013. Note that shares were suffering from the Deepwater Horizon disaster as well, with Transocean supplying the rig to BP.

Between 2009 and 2012, Transocean has seen its annual revenues fall by a fifth to $9.2 billion. The company posted solid earnings in 2009 followed by a $5.8 billion loss in 2011. The company has now returned to profitability.

Investment Thesis

Investors grow increasingly more frustrated with Transocean's share performance. Its involvement in the Macondo disaster obviously put great pressure on the shares. That being said, shares of Halliburton (NYSE:HAL) and even BP have seen decent share price recoveries from their respective lows, while Transocean continues to trade at low levels.

The company continues to struggle in the meantime. While oil prices are still historically high, they continue to trade far below their peaks putting pressure on average daily rental rates for Transocean's rigs.

As the deepwater business is a long term growth business, it remains vulnerable to incidents. The use of leverage and the high fixed costs results in a great degree of operational and financial leverage, both up and down. Add to that the possibility for incidents, like the Macondo disaster, and it is easy to see why investors demand a great margin of safety.

Op top of that, investors have not seen stable dividend. Transocean initiated a fat $0.79 quarterly dividend in 2011, and has paid this amount exactly four times. While the company was pressured by hedge fund manager Cooperman, it cut the dividend altogether in 2012, to re-initiate a $0.56 quarterly dividend this year. While the current dividend represents an attractive 4.6% yield, such a policy does not create much trust.

Crucial for Transocean is the ability to boost operating margins, to justify a higher valuation. The company has a very solid backlog of $27.3 billion, nearly three year's worth of revenues at current rates. Yet prospects for margin expansion are largely tied to the "tightness" of the market and competitive position of its ships, which is slowly eroding as the average fleet is getting older. Note that an increase in pricing has huge implications for Transocean, as its deepwater floaters fetched some $507,600 per day over the past quarter. As such, only small price changes have a huge impact on the bottom line.

Therefore I remain cautiously optimistic. The yield looks attractive although the dividend history has been very shaky. That being said, there are no signs of financial stress as a modest re-bound in rates could spur much upside. The major catalyst to the upside in the short term could be a recovery in rates, supported by higher oil prices. As I don't see this materializing in the short term, I remain cautious for now.

I do seen long term potential for shares at these levels if the oil market remains relatively tight.

Source: Transocean: Long-Term Appeal Remains