Transocean: Market Is Pricing Extremely Pessimistic Scenarios

May.11.14 | About: Transocean Ltd. (RIG)

Summary

Market projections are unrealistically pessimistic.

2014 revenue will be $9.3 billion.

2014 net income will be at least 5 dollars per share.

Caledonia Offshore Drilling Company and Transocean Partners LLC pricing will provide valuation clarity.

I have read many articles on SA regarding Transocean (NYSE:RIG), and practically all of them are generally about simple financial metric analysis and are based on Wall Street analyst numbers. I have been in this business long enough to understand that you should have your own idea of what's going on with a particular company to generate excess returns instead of relying on someone else's numbers and views. I will present my view of the company and where I see the share price going in the next 12-18 months.

Since I am long RIG leaps, I'd like to present a somewhat tempered view of the company's results and outlook not to be blamed for being too optimistic. The first portion of this article will focus on the projected revenue, which is the sole reason why investors are currently concerned and which keeps a lid on the share price. I will also estimate costs and net income to see how my estimates compare to the current consensus numbers.

The second portion will attempt to provide basis for valuation.

Investors are worried about:

Revenue.

2014 1st quarter revenue came in at $2.34 billion, which was above consensus of $2.29 billion and was partially due to a somewhat unsustainable revenue efficiency of 95.7%. I look at the company's daily revenue released in detailed fleet status report (January, April) in order to project quarterly results. As such their January fleet status report showed daily revenue of approximately $26.5 million for 64 rigs. I am excluding revenue for Deepwater Millenium, Transocean John Shaw, GSF Grand Banks, and GSF Galaxy I as they were out-of-service through the entire quarter based on information in the April fleet status report. There was also partial revenue from DD1 as its contract ended sometime in February and it has been idle since.

Based on normalized revenue efficiency of 94%, 2014 first quarter revenue would have been $40 million less.

2014 April fleet status report shows daily revenue of $27.9 million for 67 rigs; however, I will exclude Polar Pioneer as it will be out-of service for almost the entire quarter and Sedco 714 and will arrive at $26.9 million of daily revenue. My estimate for the second quarter revenue will thus be $2.32 billion as 1.5% higher daily revenue will be offset by a 2.5% revenue efficiency drop as I'm forecasting a 93% efficiency. The management stated on the conference call that improvements in revenue efficiency may not be linear, and I'm assuming they expect it to drop a little bit. Current Wall Street consensus revenue is $2.29 billion for Q2. Total revenue for the first six months based on my own Q2 assumption will be $4.64 billion.

For all of 2014 the Street consensus is $9.17 billion or $4.53 billion for Q3 and Q4 total. Please note that the second half of the year has three additional days compared to the first half. In addition, two new rigs are coming into service in the second half and together at a daily rate of $1.195 million. So in order to attain a target of $4.53 billion, RIG's daily revenue would have to be 26.4 million, and excluding two new ships - $25.2 million at a 93% revenue efficiency. That would be a drop of $2.7 million per day from Q2 or about 7 rigs (average fleet revenue in Q1 was $413,000) out of contract for Q3 and Q4. Things are obviously pretty stagnant in the industry, but are they this bad?

RIG has 21 contracts up for renewal during the second half of 2014 with a total daily rate of around $9 million. Based on the overall softness in the market most of these contracts may be renewed at lower rates. My assumption is for a 20% drop in the average rate for these 21 contracts. Some may get renewed at a better rate, one or two may get stacked, but on average that would be my baseline pessimistic expectation. This would reduce a total of $1.8 million in daily revenue and I will project $4.65 billion for second half revenue with a 93% revenue efficiency and total 2014 revenue of $9.29 billion.

I should note that RIG's management stated that they expect to surpass 2013 revenue, which was $9.48 billion, but it also included around $400 million of drilling management revenue. They sold this business and report it now as discontinued operations. I will assume that company expects to surpass 2013 revenue, excluding drilling management figures.

Costs:

First quarter costs were not indicative of RIG's normalized cost structure due to shipyard maintenance cost timing. They were $110 million lower due to the timing of these costs. The company is forecasting $5.1-5.3 billion in O&M costs for 2014. I personally think that these will be slightly lower, but will use the average $5.2 billion for net income calculation.

G&A costs for the year will be $250 million, depreciation $1.1 billion and tax rate around 20%. Interest costs will be $480 million.

Earnings:

EBITDA: 9.29-5.2-0.25 = $3.84 billion

EBIT: 3.84-1.1 = $2.74 billion

EBT: 2.74-0.48 = $2.26 billion

NI: 2.26-0.45 = $1.81 billion

EPS: 1.81/0.361 = $5.01

Current consensus $4.31.

For 2015 consensus is even lower at $3.71 on sales of $9.05 billion. These figures do not jive. If we are to assume that indeed sales will drop to $9.05 billion, i.e. $26.7 million of daily revenue at 93% revenue efficiency, net income would still be much higher than $3.71. Please note that in 2015 Deepwater Asgard and Invictus will be operating for a full year at a combined daily rate of $1.195 million. So, in reality the Street assumes $25.5 million daily revenue for the current fleet in 2015, which is lower than current daily rate by $2.4 million or on average 9% lower prices/utilization. I find these numbers very pessimistic, but nonetheless let's calculate what earnings will be based on these low revenue figures.

O&M expenses would be $200 million lower as the full effect of cost-cutting will be in place.

G&A expenses will remain practically the same at $250 million.

Depreciation will be slightly higher to account for two new rigs $1.15 billion.

Interest will be 10% lower due to early retirement of $1 billion of principal in 2014, i.e. $430 million.

Taxes will remain at 20%.

2015 Earnings (assuming $9.05 billion revenue)

EBITDA: 9.05-5.0-0.25 = $3.8 billion

EBIT: 3.80-1.15 = $2.65 billion

EBT: 2.65-0.43 = $2.22 billion

NI: 2.22-0.44 = $1.78 billion

EPS: 1.78/0.362 = $4.91

There is no way RIG earns only $3.71 if sales are to be $9.05 billion in 2015.

Over 2014-2015 period the Street is currently underestimating RIG earnings by 1.90 dollars per share or 24%.

Valuation aspects

The closing stock price on Friday was $41.74, market cap $15.06 billion and EV $23.4 billion.

There are numerous financial metrics that will depict RIG as being cheap. The most important among them are EV/EBITDA below 6, P/E slightly above 8, and PEG around 0.5. However, in this article I want to focus on the value of Transocean based on the daily revenue of its fleet, or in essence on price to sales ratio and how it compares to dropdown transactions that Seadrill (NYSE:SDRL) did with Seadrill Partners (NYSE:SDLP). I believe RIG will follow the same blueprint with Transocean Partners LLC.

SDRL dropped down rigs to SDLP that had long-term contracts in place for a specific daily fee. The price that Seadrill Partners paid for these rigs is between 1800 and 2000 times the daily revenue, i.e. for West Leo rig that earns $605,000 per day Seadrill Partners paid around $1.25 billion, for West Sirius, which earns $535,000 per day it paid $1.035 billion, and for West Auriga, which earns $602,500 it paid around $1.24 billion. But wait, not only did Seadrill Partners pay such a price for high-spec rigs, it paid a similar price for T-15 and T-16 tender rigs and Seadrill's operating income metrics are only slightly better than those of Transocean. Seadrill's operating margin is 38.5%, while Transocean's is 29.5%. Seadrill pays a lot in interest and almost nothing in taxes, while Transocean pays substantially less in interest and slightly more in taxes.

Seadrill 2013 (% of revenue)

Transocean 2014 (% of revenue)

Revenue

5.28B (100%)

9.29B (100%)

EBITDA

2.75B (52%)

3.84B (40.8%)

EBIT

2.04B (38.5%)

2.74B (29.5%)

EBT

1.59B (30.1%)

2.26B (24.3%)

Click to enlarge

The reason for this small comparison is to prove that once Transocean establishes its MLP Transocean Partners LLC, it will be able to drop down rigs at prices somewhat similar to those that Seadrill charges Seadrill Partners.

Based on the daily fleet revenue of $27 million RIG's market cap at 1500 times daily revenue (which is a 20% discount to SDRL/SDLP transactions) would be 40.5 billion! That's more than 2.5 times higher than today. This MLP idea is an interesting way to sell the company in pieces for prices substantially higher than currently carried on the book. MLP investors pursue yield and given that dropdowns will ensure continuous growth of distributions, these dividend investors will be content with yields around 6-7% as is the case with SDLP. A 6.67% yield implies a 16 P/E ratio, which is double RIG's current P/E ratio.

SDRL made a killing with these dropdowns as evidenced by recognition of a $2.4 billion one-time gain as part of the deconsolidation of SDLP from SDRL's results. $2.4 billion gain on only 9 rigs (2 tender, 1 semi-tender, 2 drillships, and 4 semi-submersibles). Please also bear in mind, that while making $2.4 billion, SDRL did retain control of at least 50% of cash flows associated with operating those 9 rigs.

Similar outcome awaits RIG maybe not to the full extent of SDRL. Once the investing public is provided with pricing information on Caledonia Offshore and Transocean Partners LLC it will be clear as to what RIG will able to fetch for those assets. Whatever it is, it will most probably enhance company's value. I'm expecting RIG to trade at least around 70 dollars six-nine months after these transactions will take place, and I'm putting my money where my mouth is.

Disclosure: I am long RIG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.