Transocean: Regulations Hampering A Good Investment

Jul. 9.14 | About: Transocean Ltd. (RIG)

Summary

Improved revenue efficiency rate and cost-cutting initiatives have helped Transocean beat analysts' estimates regarding its revenue and earnings in the first quarter of FY 2014.

The company may be facing trouble as the 20-year tax holiday for North Sea drillers is going to expire.

Transocean, along with other offshore drillers, is facing changes in regulations, which are still not favorable for drillers.

Transocean (NYSE:RIG) reported that revenues improved by 42.7% in the first quarter of FY 2014 compared to the first quarter of FY2013. The company has demonstrated a pattern of positive earnings per share growth over the past two years. During the first quarter of FY 2014, Transocean increased its bottom line by earnings of $1.25 compared to $0.88 in the previous year. I don't expect an improvement in earnings in the coming quarter because of the end of the tax-free period in the North Sea and the additional operating costs implemented in new regulations regarding drilling, which I will discuss in detail later in this article.

The company underperformed despite its growing revenue. Revenues slightly increased by 7.1% compared to the industry average of 11.1%. The company's net operating cash flow has increased to $136 million or by 28.30% when compared to the first quarter of last year. Despite an increase in cash flow, Transocean's cash flow growth rate is still lower than the industry average growth rate of 43.93%.

Moreover, during the first quarter of FY 2014, Transocean significantly reduced its operating and maintenance expenses compared to the first quarters of both 2012 and 2013. The reduced operating and maintenance expenses support the company's plan to improve its bottom line in the current quarter. In the oil and gas industry average total expenses are comprised of around 91% of revenues so if the company wants to maintain its profitability it should control its operating expenses. However, this is may prove to be quite difficult considering the facts I discussed above.

Furthermore, if we analyze the growth in revenues and profits along with movement in the company's stock price and dividend yield it becomes evident that there is an inverse relation between them. The company has utilized its net earnings to reward shareholders but along with that shareholders have been facing a decline in capital yield since December due to negative perceptions in the market.

Offshore Drillers:

Transocean, along with other big offshore drilling companies, has suffered a drop in its prices. Transocean went down by 16% this year, Seadrill (NYSE:SDRL) and Rowan (NYSE:RDC) have declined 15%, and Diamond Offshore (NYSE:DO) and Atwood Oceanics (NYSE:ATW) have fallen 13%. The decline in their share prices was because of negative perceptions surrounding the industry regarding current change in regulations and the end of the 20 year tax holiday period in the North Sea. Transocean was one of the companies that enjoyed this tax holiday for the past twenty years. The tax change should raise about 5% of total rig market revenues.

Despite a recent series of negative data points for offshore drillers, including lower-than-expected day rates for floating rig fixtures, further signs that the jack up market is slowing, and the inability of unconstructed new builds to find long-term commitments, interest is beginning to be piqued by value investors. Barclays analysts continue to remain constructive on the long-term outlook for the drillers. I totally agree with them that the seemingly compelling valuations for the offshore drillers represent a value trap.

Impact of New Regulation:

The introduction of new and more stringent regulations due to the oil spills in the past has made deep-water drilling activity prohibitively expensive for exploration and production companies and this is making many projects marginal. This could hamper Transocean's future earnings as the demand for deep-water drilling might be hampered by the regulations.

The new rules, issued by the Interior Department's new Bureau of Ocean Energy Management, Regulation and Enforcement, tighten standards for well design, blowout preventers, safety certification, emergency response, and employee training.

The bureau estimates that compliance with the added regulations will cost the deep-water industry $183 million per year, largely for changes in well design and the requirement that operators maintain sub-sea robots to operate blowout preventers in case primary control systems fail.

Although the suspension of the moratorium takes effect immediately, offshore operators will first have to submit new applications showing they have complied with the tougher rules and have their rigs inspected. Officials said they expect at least some of the rigs to be operating again by the end of the year although they are uncertain about when the first permit might be cleared.

I believe that the moratorium could cost billions of dollars in lost income and force thousands of layoffs. This suspension affected 33 deep-water drilling rigs but that number has shrunk to about two dozen now awaiting new permits to go back to work.

Conclusion:

The whole offshore drilling industry is facing depression due to changes in regulations with every stock falling in the past year. Despite the previous positive earnings report showing increased top and bottom lines, the stock suffered because of unfavorable news regarding regulations. Financially, the dividend yield is pretty high and continues to increase as the price of the stock decreases. Technically, the stock should go up on the basis of positive factors but due to the deteriorating sentiment in the industry, expectations of earnings will shrink next year.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within 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.