- In recent times, stocks in the offshore drilling segment have been punished by markets on account of a soft industry outlook.
- Transocean is trading at a price near the low-end of analyst estimates.
- The extrapolation of near-term expectations into a long-term outlook has led to potential alpha of 305 basis points for Transocean.
- Transocean is priced to deliver strong long-term returns through a combination of alpha and beta-driven gains.
- A rise in beta is on the cards on account of an anticipated change in capital structure, and the asset mix vis-a-vis competitors.
Why look at Transocean (NYSE:RIG) now?
Firstly, Transocean is a large cap stock. This gives it a defensive character relative to small and mid cap stocks, which appeals to me when I perceive the markets are expensive. Secondly, given that the 2014 dividend is expected to be $3, the stock delivers a yield of over 7%, which is a significant premium to the market yield. This too adds defensive characteristics to the stock. Thirdly, I believe that we are now either in, or fast approaching the late or mature-phase stage of the economic expansion. As I mentioned in a recent post, during such periods, the energy sector has displayed a historic tendency toward outperformance. Fourthly, if the energy sector does outperform, this stock's beta of 1.25 will help drive superior total return via the generation of returns driven by beta. Finally, Transocean as recently priced, includes potential alpha. Alpha is the difference between actual returns and risk-adjusted returns an investor should expect from a stock. When a high-beta stock includes potential alpha, upside is created by the high beta, while total return potential is driven even higher, because we earn returns from alpha in addition to the beta-driven gains. The good news is that the alpha protects downside, should expected beta-driven gains fail to materialize.
Analyst price expectations
Recently, Transocean traded at $38.84. From Yahoo Finance, we know that thirty analysts expect an average price target of $45.50 (median $45), with a high target of $60 and a low target of $36. Thus, $38.84 is pretty close to a decent bottom fishing price. We know the price, and we know analyst perception of future price. Does the current price reflect good value?
Quantitative analysis of the behavior of market participants
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better. Recently, some of the output of the Alpha Omega Mathematica [AOM] model is being published online, and you can see a list of the top and bottom 20, for large, mid, and small cap stocks here. You can view additional information for any specific stock here. You may find differences between the data displayed below in this post and the data on the website: this is because I run the model for a coverage universe of all stocks listed in the US with a market capitalization of over $100 million, whereas the website uses a different coverage universe.
That system provides an AOM Overall Score of 53% and a hold rating for Ensco (NYSE:ESV), 52% with a hold rating for Transocean, 62% and a buy rating for Seadrill (NYSE:SDRL), 50% and a hold rating for Diamond Offshore (NYSE:DO) and 43% and a hold rating for Rowan (NYSE:RDC). Let's have a look at some data for these companies to see why.
Source: MaxKapital Archives using data from Financial Visualizations
The focus is on Transocean in this post, I covered Ensco and Seadrill in separate posts. People select stocks to a personal style bias, and so we have value, growth, momentum, balanced and agnostic-styled investors.
This table below gives you information to help you determine whether your stock selection style bias is satisfied by the stock in question. For Transocean, it suggests that valuation is very attractive. However, momentum is as ugly as it can get. Growth expectations are low, while ownership and return quality are acceptable. A combination of ugly momentum and solid value is often an indicator of great future returns.
Source: MaxKapital Archives
Some investors like to select what they see as the best stock in a sector. Others prefer to select what they see as the best stock in an industry. And there are yet others who simply want to own what they see as the best stock available, without regard to the sector or industry in which it operates. These are the three main capital allocation styles. For Transocean, it is a hold across the board, except for value investors seeking to allocate capital in the energy sector, who would be inclined to buy.
Source: MaxKapital Archives
The stock selection model is a point-in-time model. And it suggests that the stock is attractively valued. So we might believe that Transocean is attractive. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe. We do not know whether the stock is priced to deliver a long-term return in line with our expectations.
Mathematically, the worth of Transocean is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 1.25, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? This beta of 1.25 differs from the beta that you will find in most places, because it is based on a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge toward one. You can read more about where I get my estimates for long-term market returns and equity risk premium here. The required rate of return is calculated as Risk-Free Rate plus Beta Multiplied by Market Return less Risk-Free Rate. Thus, for Transocean, we should be targeting a long-term return of 11.6875%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year to year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. I believe sustainable earnings can be estimated as the six-year median earnings per share. Determining cyclically-adjusted earnings for Transocean is terribly difficult because of costs associated with the Macondo incident, as well as because of goodwill and impairment in value of long-life assets occurring as a result of past M&A activity. Since the drilling market is presently perceived as being weak, I will use the consensus estimates of $4.82 as an estimate of sustainable earnings. This estimate is conservative: my estimate of cyclically-adjusted earnings, after eliminating what I hope were non-recurring items in the post-Macondo era came in at $5.75.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. I expect Transocean will pay out approximately 60% of earnings via dividends and buybacks (about 50% via dividends and another 10% via buybacks) over the long term.
If we use a very long-term growth expectation of 3.95%, Transocean is worth $38.84. Transocean Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 103.95% * $4.82 * 60% / (11.6875%-3.95%) = $38.84. At this price, it is likely that an investor with a return expectation of 11.6875% will be satisfied.
The growth estimate implied by the current market price of 3.95% is low. Given the weak outlook for the industry in the coming months, this slow growth expectation is likely justified for the near term. But for market prices to price it as a long-term expectation is nothing short of ridiculous. In my view, given Transocean's significant and continuing capital expenses over the past few years, it can be expected to grow at a faster rate: in forward years, I would look for nominal growth of at least 7%. That is, 2.5% in real growth, plus price growth driven by global inflation rates estimated at 3.8%, and a little bit more on pricing gains driven by supply constraints and rising marginal costs of new production. If I am right, the spread between the 3.95% growth priced by markets and a 7.00% growth expectation is 3.05%: this represents potential long-term alpha. An adjusted payout ratio of 60% implies that 40% is available for investment in operating expenditure and capital expenditure to drive growth. Generating growth at 7.00% would require a return on equity of 17.50% on the 40% of earnings retained and reinvested: that is a challenging but achievable target for incremental equity invested together with modest leverage in new-build offshore drilling rigs.
Alpha is the difference between actual returns and the risk-adjusted return expectation, which I estimate at 3.05%. Since we have a risk-adjusted return expectation of 11.6875% for Transocean, a long-term investor targeting a risk-adjusted return of 11.6875% will end up earning a return of 14.7375% (of which, over 7% comes via a dividend).
An investor with a shorter time horizon might do quite well too. A price target of $60 implies confidence in long-term earnings growth rising to 6.55% from 3.95% at present. Transocean Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.55% * $4.82 * 60% / (11.6875%-6.55%) = $60. Given weakness anticipated in the offshore drilling market, such a hike in short-term growth expectations is unlikely for now. In a year to eighteen months, perhaps there will be better visibility in drilling programs in the E&P industry for 2016. But we all know that the markets respond ahead of performance. And then there is that generous dividend yield, which soothes the indignities of price declines.
I believe Transocean would be rightly valued at $66. Offshore drilling is a highly cyclical industry. And when the up-cycle commences, long-term growth expectations rise higher than they should, just as they fall lower than they should during the down-cycle. Pricing negative potential alpha of 2% (compared with positive alpha of 3.05% at present) would give a three-to-five year target of at least $117.
Company-specific fears associated with the impact of near-term weakness in the drilling market on Transocean's older assets means that the blood of investors is flooding the deep waters of the ocean. They say it's a good time to buy when blood flows on the street - I expect that holds true for blood flowing in deep waters too. In my view, Transocean offers the highest long-term upside gain in the offshore drilling industry, because company-specific near-term expectation negativity has overwhelmed long-term expectations.
To conclude the "The Drillers Take It All" series, I will close by saying that in my view, Transocean offers the best total return potential. However, the fleet mix relative to competitors, together with possible deterioration in balance sheet quality indicated by the recent dividend hike, and the plan to build speculative new-builds, suggest that beta will rise in the coming years. Thus, Seadrill offers a better risk-adjusted total return. Ensco, on the other hand, offers a solid and safer return.
The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.
If you alter your risk-free rate assumptions, you will need to evaluate how that will impact market return expectations and the equity risk premium too. You will also need to think about how the risk-free rates will impact long-term growth. If you alter the adjusted payout assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stock's beta and stock return expectations.
There is a high degree of inter-connectivity between beta, growth, adjusted payout ratios, risk-free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas which I hope will help.
1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is, Long-term Return Expectation minus Long-term Growth Rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast-growing stock, where there is great confidence in forward growth expectations. And higher for stocks where the confidence in growth is low. In the very long term, the growth risk premium has tended towards 4.5% for the market.
2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings.
3. When you look at long-term growth rates, remember it is not next year's growth or the next five years' growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rate for some years, reversion to market growth rates, and finally, a terminal growth rate. The terminal growth rate used by many is the risk-free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five-year forward rate, and then assume growth shall revert to being in line with market growth expectations for the following 45 years. What this signals is that I am willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On Excel, you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years, as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].
4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the payout ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher-than-industry leverage implies higher financial risk. Which implies a higher beta, and a market return expectation. If you see a low beta with higher-than-industry leverage, you may want to compute a bottom-up beta for the company, instead of one generated using regression analysis.