Why Transocean Is Heading To $50

May.12.14 | About: Transocean Ltd. (RIG)

Summary

As the entire sector began to rebound due to improved demand, it wasn’t an issue of whether Transocean would beat estimates, but by how much.

With the company's strong backlog and ample cash supply, all of the signs are pointing upward.

With a noticeable increase in global energy spending, I project Transocean's fair value to reach $50 in the next 12 to 18 months, which suggests 20% upside potential.

Since reaching a high of $55.74 last November shares of offshore drilling giant Transocean (NYSE:RIG) have lost as much as 30%. The stock closed Friday at $41.74, down more than 14% year to date. Investors are still struggling to make sense of the company's next direction.

While Transocean has done well rebounding from the Macondo disaster, which, alongside BP (NYSE:BP), cast Transocean for villain status after a rig explosion spilled 200 million gallons of crude oil into the Gulf of Mexico, operational issues such as unplanned downtime has hurt the company's profits.

Transocean's recent decline suggests that investors have moved on to other energy plays such as Cameron International (NYSE:CAM) and National Oilwell Varco (NYSE:NOV), which are regarded as better operators. But after the company's solid first-quarter results, Transocean shows that it can still energize.

Helped by significant higher day rates, the company posted first-quarter revenue of $2.34 billion, which beat average estimates by $70 million and exceeding last year mark of $2.18 billion by 7%. The company benefited from strong demand in its high-spec floaters, which contributed close to 75% of the total revenue. The mid-water floaters and high-spec backup rigs accounted for a combined 23% of revenue. The remaining revenues came from rig activities, integrated services and others.

The company reported earnings of $1.43 per share. Aside from beating estimates by 41 cents, this topped last year's mark of 94 cents per share by more than 50%. Equally impressive was the $672 million in operating income, which was up 40% year over year, topping last year's mark of $479 million. The strong profitability was helped (in part) by a 6% decline in total operating and maintenance expenses.

Unlike previous quarters, the company had minimal issues with downtime as total average day rates jumped 14% year over year to $413,100. This significant increase demonstrates that management's efficiency improvements are beginning to work. But this shouldn't have come as a surprise, given the better-than-expected results already in hand from National Oilwell Varco and Cameron.

As the entire sector began to rebound due to improved demand, it wasn't an issue of whether Transocean would beat estimates, but by how much. If there are any concerns, however, it has to do with the company's aging fleet, which suggests significant capital investments may be around the corner, which may impact long-term profitability. Note, that is also something rivals, including National Oilwell Varco has to address.

For Transocean, it's not as if the current fleet, which posted a slight 2% decrease in average daily revenue, is suddenly falling apart. And even if the company had to make these long-term investments, management is not lacking the capital needed to fund these improvements. And let's not discount that management is looking to divest its drilling services segment by the end of this year, which will help Transocean achieve a higher-yielding asset base as it trim its assets.

What's more, the company plans to spin-off 8 out of 21 mid-water floaters. As it stands, Transocean has 78 rigs, and the spin-off will allow the company to decrease its costs and invest in high-margin ultra-deepwater rigs. This is because the ultra-deepwater rigs yield the highest day rates.

All told, this was one of Transocean's best performances. I'm not suggesting that this company is flawless. But with the company's strong backlog and ample cash supply, all of the signs are pointing upward. And with a noticeable increase in global energy spending, I project Transocean's fair value to reach $50 in the next 12 to 18 months, which suggests 20% upside potential.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Wall Street Playbook's energy sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.