One of the advantages of being a value oriented investor is that you are often finding undervalued businesses that also happen to be involved in industries that are out of favor but poised for a comeback. When those out of favor businesses and industries are on the verge of seeing rapidly rising demand for their products and services but have share prices that reflect three-year old fundamentals, the prospects for explosive short and long-term profits can make for truly compelling opportunities.
Those conditions all seem to be in place today in the offshore drilling industry in general and shares of Transocean Ltd. (NYSE:RIG) in particular.
What Created The Opportunity
In the case of Transocean and the entire offshore drilling industry, a tremendous opportunity has been created by an almost perfect storm of events that had huge negative implications for the industry. In June of 2008, prices for West Texas Intermediate crude oil, WTI as it is commonly referred to, was selling for about $133/barrel. By December of that same year, the price had fallen to $41. This was a crushing blow for the oil industry as many producers became unprofitable at that price.
Before the offshore drilling industry had a good chance to get back on its feet after the huge price collapse in the last half of 2008, it found itself faced with one of the great catastrophes in the history of the industry when, on April 20, 2010, the oil rig called Deepwater Horizon experienced a disastrous failure in the Gulf of Mexico. Not only did this incident create a public relations nightmare, it threatened to bankrupt a portion of the offshore drilling industry.
As if the situation could not get any worse for the offshore drillers, along came the discovery of massive oil and natural gas reserves trapped in shale formations and made economically viable by innovations in horizontal drilling techniques and hydraulic fracturing (fracking). Energy investors rushed to get a piece of this "new and innovative" source of domestic energy production and fled the perceived risk and cost of deep water exploration and drilling.
Shares of Transocean were devastated and plummeted from over $154 in June of 2008 to around $38 in March of this year, representing a decline of slightly over 75%. The price has recently recovered a bit to $45.38 but still languishes far below its previous high.
What Will It Take To Energize Transocean's Share Price?
The offshore drilling industry has been out of favor with investors for several years now. The share price of Transocean has been devastated over the last six years. That does not, however, mean that the company has not been improving its profitability during this time. Since earning $2.27/share in 2012, the company earned $3.87/share in 2013 and is expected to earn $4.29 in 2014. That represents an 89% increase in just two years, while the share price rose has risen only about 10%. I love to see rising earnings pushing up against a low and stagnant share price. I refer to it as value bottling. When more and more of something continues to be forced into a container that does not increase in size, eventually the container cannot hold the volume and pressure and it erupts. Rising earnings against a stable share price create exactly the same scenario in a financial sense. Eventually, the rising earnings will cause the share price to suddenly explode.
Another factor in favor of the offshore drilling industry at this time is the increasing turmoil being created in the Middle East oil producing countries and fundamentalist Islamic militias appear to be determined to take over Iraq at the moment and who knows where after that? Should the oil production capabilities of Iraq be disrupted and those of Kuwait or Saudi Arabia be even perceived as threatened, the price of oil could easily soar to $150/barrel or more. The share price of any business capable of helping the world replace that needed oil would obviously soar. Remember, the last time oil was near $140/barrel, Transocean's stock was priced at almost $155/share. The fact that no one seems to consider that a possibility right now reinforces my belief that it is completely conceivable. The biggest disruptions always occur when nobody expects it.
What Is The Main Risk In This Stock
One of the main keys to being a successful investor is being able to identify and quantify the risk involved in any potential investment. While there are a lot of existing positives in the offshore drilling industry in general and Transocean in particular, it would be foolhardy not to seek out the risk and attempt to understand it and evaluate the probability of occurrence.
The primary risk I see with Transocean is the proposition that a great deal of new drilling capacity is due to come into the market in the next two to three years. The orders for this equipment have been placed and the ships are being built. Of that there is no question. The question to ask is whether this new capacity will result in an oversupply of production capability or simply meet a growing demand for supply. I believe the latter is true.
For years, the world has relied upon a steady and growing ability of the Middle Eastern countries to supply the bulk of our oil related energy demands. However, look at the current unrest in those countries and the rise of religious fundamentalism and the threat it poses to the world's ability to have access to those resources. Is this a situation where any country would want to place the hopes of their energy dependence if they have any choice? I do not believe they will and deep water drilling will give them a choice. As the traditional suppliers become seen as more and more unpredictable, alternative sources will necessarily be sought and found. Offshore drilling is an obvious place to look.
While the potential risk of oversupply on the equipment side is real, I believe the risk is more than mitigated by turmoil in the countries that make up most of the existing source of supply. Unless you believe there will suddenly be peace in these Muslim dominated countries and the Sunni Muslims will join hands with the Shia Muslims and sing Kumbaya, you have to be at least somewhat uncomfortable with our dependence on those countries for our energy supplies and I imagine the rest of the world shares that view.
What Is The Potential Upside For Transocean?
This is not really a very difficult question to answer because we saw it in 2008 when oil prices reached about $140/barrel. At that time, shares of Transocean peaked just shy of $155. Given the current unrest around the globe at this time involving oil suppliers from Russia and their conflict with Ukraine to Syria and Iraq in flames many people think $140/barrel oil is currently a conservative estimate. Some analysts and forecasters are even calling for prices as high as $200/barrel or more. Should we experience that type of price level, it is easy to see Transocean returning at least to its previous high which would represent a gain of about 340% from the current level.
I like to be conservative in my estimates on valuations. For an industry with high barriers to entry and the requirement for very specialized expertise and one that supplies a product we must have to survive, I think a fair valuation is a multiple of at least the average of the overall market. Right now, that would value Transocean at between 15 and 17 times 2014 estimated earnings of $4.29/share and produce a fair value calculation between $64.35 and $72.93.
Probably the most common valuation metric used by investors is the price to earnings growth multiple. This metric multiplies the previous or current year's earnings by the projected 5-year earnings growth rate. The projected forward earnings growth rate for Transocean by the 22 analysts covering the stock is 18.7% per year. This calculation yields a potential fair value estimate of the business of $80.22/share.
Final Thoughts And Actionable Conclusions
Any way you look at it, Transocean appears to be a seriously underpriced stock that deserves consideration by any value oriented investor. Furthermore, even if it takes a bit of time for the market to rectify this error in valuation, the stock comes with a very attractive 5.35% dividend yield to reward shareholders while they wait for the big gains that are almost sure to come. To sweeten this deal even more, I have identified three very attractive opportunities for investors wishing to open new positions.
For the benefit of those who tend to be passive investors, shares can simply be purchased and held while waiting to be rewarded with a substantial long term gain and the earnings continue to grow and the price is returned to a more reasonable level based on its fundamentals. This approach should produce annualized gains of around 15% for at least the next 3 to 5 years.
Investors who simply cannot bring themselves to pay retail prices for anything can get paid to wait for a better price by selling the July 19, 2014 expiration put options at a strike price of either $45 or $44 dollars, depending on your risk tolerance and profit objectives. The bid on the $45 put option is currently $0.80/share and produces an immediate return of 1.98% on the $45 strike price of the contract for an annualized return on capital equal to 25.8% over the 28-day life of the trade. This position, if assigned, would put the seller into the shares at a net price of $44.11 (44-0.89) for a discount of 2.8% to the current market price. The bid on the $44 strike price put option is $0.51/share and results in an immediate return on total capital of 1.16% or 15.12% annualized over the 28-day life of the position. If the seller of these options were to be assigned the shares, the net price in the position would be $43.49/share and represent a 4.15% discount to the current market.
For impatient investors who want a decent profit and want it now, using a buy/write strategy to simultaneously purchase the shares and sell covered calls against those shares might just satisfy your appetite. If appears to me that the most attractive opportunity for this approach would be to purchase the shares and sell the $47.00 strike price, July 19, 2014 expiration call options against the positions. These call options are currently bid at $0.47, so the premium received would provide an immediate return of capital of 1.03% or 13.49% annualized over the 28-day life of the trade. Should the share price rise above $47 by July 19, 2014 and the shares be called away, the total profit realized would rise to $2.09/share or 4.6% for the 28-day position and produce an annualized return on capital of 60%. This is my personal favorite of the entry methods discussed, as it provides excellent short-term potential while also providing me with solid prospects for retaining the shares while boosting my investment yield with the call options.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in RIG over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.