Transocean: The Street Does Not Understand This Company

Jul.23.14 | About: Transocean Ltd. (RIG)

Summary

IPO of Transocean Partners LLC is priced 50% above RIG's fleet comparable value.

Transocean's ultradeepwater fleet has a value equal to its current EV based on IPO pricing.

Investors' myopic focus on negative earnings estimate revisions keeps RIG severely undervalued.

Transocean (NYSE:RIG) issued an amended S-1/A, which provided pricing detail for the Transocean Partners LLC IPO (Pending:RIGP). This article aims to extrapolate the value of Transocean's entire fleet based on this particular transaction.

Transocean has announced creation of Transocean Partners LLC, which will be an MLP-like structure. The new structure will own 51% of three ultradeepwater rigs operating in the Gulf of Mexico. Those three rigs are:

Discoverer Inspiration - daily rate of $526,000 through March 2015; contracted until April 2020, daily rate increases to $585,000 from April 2015

Discoverer Clear Leader - daily rate of $569,000 through September 2014; contracted until September 2018, daily rate increases to $590,000 from September 2014

Development Driller III - daily rate of $428,000, contracted until November 2016

Current average daily rate for three rigs - $507,666, will increase to $514,666 from September 2014

Estimated EBITDA for the 12 months ending September 2015 - $283 million. Estimated revenue $577 million. Estimated out-of-service days - 21.

Implied market cap at the middle of IPO's assumed price range: $1.4 billion. Implied market value of these three rigs $2.75 billion. Consequently, EV/EBITDA 9.7 and EV/Rev 4.76

Now let's review Transocean's entire UDW fleet. Based on July's fleet status report, Transocean had 29 UDW rigs in its fleet. Two of those rigs are idle (Development Driller I and Sedco Energy) and two others (Deepwater Asgard and Deepwater Invictus) will commence operations in the third quarter of 2014.

Current average daily rate: $567,000 (does not include Asgard and Invictus, which have rates $595,000 and $600,000). This daily rate is 10% higher than RIGP's average rate.

Estimated revenue: 27 active rigs producing $570,000 revenue per day totals to $5.617 billion per year. All these rigs have incentives built into contracts, which average out to 2%. That is an additional $110 million. Revenue efficiency for UDW fleet is historically around 95%.

Total revenue prior to out-of-service days equals = 5.617*1.02*.95= 5,443 billion.

Projected out-of-service days for the next four quarters are 1,081 for UDW rigs. Total revenue lost equals 1,081*570,000 = 616.7 million

Total revenue including out-of-service days = 4.826 billion

EBITDA margin (based on RIGP filing) around 50%

Total EBITDA for RIG UDW fleet: 2.41 billion.

Valuation (based on RIGP filing) EBITDA * 9.7 = 23.37 billion

Valuation (based on RIGP filing) Revenue * 4.76 = 22.97 billion

Bear in mind this valuation is for the UDW fleet only. Based on yesterday's closing price of 43.66 the entire enterprise is valued by the market at 24.3 billion, which is only 1 billion above the UDW fleet value.

The market currently projects 7 Harsh Environment rigs ($490,000 daily revenue per rig), 12 deepwater rigs ($380,000 daily revenue per rig), 21 midwater rigs ($370,000 daily revenue per rig), and 10 jackups ($160,000 daily revenue per rig) for a grand total of $1 billion. To keep the article factually correct, it is necessary to note that 4 deepwater rigs and six midwater rigs are stacked or idle.

Nevertheless, the active portion of non-UDW rigs account for 45% of company's revenue and 40% of EBITDA with many rigs contracted through 2015 and into 2016. Consequently, the value of non-UDW fleet should reflect its input into the company's cash flows. At 4 times revenues (which is a 20% discount to UDW fleet) this segment would be valued at 16 billion, bringing total company EV to 39 billion or 15 billion more than what market currently assigns. Subtracting 10 billion of debt, the implied market cap would be 29 billion or 80 dollars per share.

So, what's keeping the lid on the price of the shares and what amount of idle and stacked rigs would justify the current market price?

The industry is experiencing a cyclical downturn due to a hefty amount of new supply. Rigzone shows that the number of active rigs today equals the number a year ago, however the utilization has dropped from 87% to 80% due to 67 new rigs entering supply. Obviously, this supply has affected Transocean's ability to renew contracts and the number of stacked rigs and those held for sale has increased substantially. Nonetheless, these observations need to be quantified to see what level of idle time justifies current price levels.

Total EV for Transocean is 24.3 billion based on a share price of 43.66. At a company-wide normalized EV/revenue figure of 4 this would imply that RIG would be fairly valued if revenue drops to 6 billion. For this to happen 10 UDW rigs should be without a contract and half of the remaining fleet is idle or stacked. Basically, the market is pricing a situation that NONE of the rigs up for contract renewal in the next 12-18 months will get new contracts.

Analysts have been overzealous in their quest to smash earnings estimates down. As the estimates have been drifting downwards the share price has been actually improving. For the past three months the share price (dividend-adjusted) has increased close to 6%, whereas earnings estimates have gone down, especially hard for 2015 and 2016. The current 2015 estimate is 3.49-3.58 and 2016 estimate is 2.81! 2016 will see deliveries of three new UDW ships already contracted out and three new high-spec jackups, yet earnings estimates are lower than in 2015. Large investors will stay on the sidelines until earnings begin to be revised upwards, but 30 million new shorts since February are all mostly underwater and would provide major buying impetus once earnings visibility improves.

Even if it does not improve for awhile, the current share price offers major downside protection due to market's large discount of RIG's assets. A sustainable dividend also puts a floor under the current price.

To summarize:

RIG's UDW fleet alone is worth company's current EV.

Additional dropdowns to RIGP will continue to extract value, which the street currently does not recognize.

As pessimism reigns the share price holds steady, which is a sign of seller exhaustion and the slightest good news will move the stock price higher.

Disclosure: The author is long RIG. 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.