Sometimes it makes sense to hunt for value in potential turn-around candidates. When looking for a turn-around candidate, other people's expectations don't matter. What does matter is your expectation and conviction. Ultimately, investing in a turn-around story is a form of time arbitrage. You form your expectation, and if you are right, one day in the future that will become the market expectation, and when that occurs you will profit from it.
One way of searching for turn-around stories is to identify highly cyclical sectors and industries, with adverse present macro themes, which you believe will reverse in time. And then, in the space identified, search for companies trading at a very, very low Price to Peak Earnings ratio.
Transocean (NYSE:RIG) is one of my favorite time arbitrage and turn-around opportunities. Today we have U.S. shale oil and gas supplies ratcheting up. We have Canadian oil sands flowing. We see excitement over fracking extending globally. We see geopolitical risks recede with Iran nuclear negotiations progressing. We see supply low marginal cost supply potential in Iraq. We see Libya normalize and return to markets and we hope to see the same in Egypt. We see very little supply side fear.
One the demand side, we continue to see slow growth because the global economy is still growing at a slow rate: IMF expects that global growth during 2013 was 2.9%, and they expect it to accelerate to 3.6% in 2014. A 2.9% growth rate is about 45% below potential long-term global growth rate of 4.2%. And if it does rise to 3.6%, it will still be 16% below the potential long-term growth rate.
With an acceleration in supply and sloth in demand, we get complacency in the continued hunt for new oil. At some point in time over the coming five to six years, we are likely to see demand escalate. And when that occurs, the response is inevitably drill-baby-drill. And drill offshore, because though it is a high marginal cost source, it's where the prospects lie. Even today, the ultra-deep-water fleet is at 100% utilization. And while much new supply is expected over the comings years, we must recognize that there is little by way of new build on spec: they come to market with a firm long-term contract. As the demand for offshore drilling escalates (one day!), the day-rates in the ultra-deep-water segment will strengthen. And then spill over into the deep, mid and shallow-water drill-ships, semi-submersible and high specification jack-up rigs. Today the day-rates in the ultra-deep-water segment are healthy are over $550-$600k. In time, these rates will rise, but the real fall-through to earnings will come as the rates for other floaters and high specification jack-up rigs strengthen with rising utilization rates.
There are several offshore drillers which can be considered strong turn-around candidates. I like Transocean because in another life and avatar I worked there: I like to believe I know the company well, and at a minimum, I am comfortable with them. During 2007, Transocean acquired Global SantaFe. In the same year it earned $14.14. At that time, the diluted shares outstanding were 318 million. Since then they closed the Aker transaction in 2011 and today the share count is at 360 million. When we adjust the recent peak earnings of $14.14 for the higher share count, we arrive at adjusted peak earnings of $12.47 in 2007 dollars. I have no doubt that at the next peak in the drilling cycle Transocean will earn at least this amount, adjusted upwards for inflation since 2007. Ignoring inflation adjustments to the $12.47 adjusted peak earnings, with the shares trading at $47.53 on January 15th, 2014, the multiple of peak earnings is 3.81.
Post the peace making agreement between Icahn and Transocean, an annual dividend of $3 will be paid out during 2014. This provides an attractive yield of 6.3% on the current price of $47.53. This should sustain you while waiting for the drilling cycle to turn.
What can we expect as a long-term price target?
Transocean comes with a beta of 1.38. In the very long-term, earnings can grow at least in-line with long-term global GDP potential growth rates of 4.2% in real terms; add to this global inflation expectations of 3.8%, and I am looking for very long-term earnings growth of 8%, with a long-term return on equity potential of 15%. To sustain growth at 8%, the company would need to reinvest (Note 3) 53% of earnings, with the remaining 47% being available to shareholders. An investor seeking a long-term return of 11.3% (Note 1) for a stock growing earnings at an annualized rate of 8%, at a time when earnings are at the target of $12.47 in a some years is $196 (Note 2). A level of $190 to $200 would not surprise me, but at the time of peak earnings, people are skeptical, so let's apply a 25% discount to this price to set up a target of $144.
If I can grow my capital three fold (Target Price/Recent Price = $144/$47=3.06) over the next five to six years, and can collect a return of 6.5% while I wait, I'd consider this long position a success.
(1) The Nominal Investor Return Expectation is calculated as Risk Free Rate + Beta * (Market Return - Risk Free Rate). I have assumed the risk free rate is presently at 3%, which is the level at which 10 year government bonds traded recently. The market return over the very long-term has been 9%. Thus for RIG the investor return expectation is 3% + 1.38*(9%-3%) = 11.3%.
(2) The Target Price (Present Value) is calculated as Adjusted Peak Earnings (1+ Growth Rate) * (1-Re-investment Rate)/(Nominal Investor Return Expectation - Growth Expectation). So for RIG it is $12.77 * (1+8%)*(1-53%)/(11.3%-8%)=$196.
(3) The Re-investment Rate is the Growth Rate/Return on Equity. For example if a person has a return on equity of 10% and earns $100, if he or she wishes to grow 6.5%, he, or she would need to re-invest $65 at the 10% return on equity to generate the 6.5% growth.