Transocean Credit Analysis And Implications

| About: Transocean Ltd. (RIG)

Summary

Transocean's credit metrics for the next 12-24 months are likely to worsen, but the company is well-positioned to navigate the crisis.

I expect Transocean to repay debt maturing in the next 12-24 months instead of doing a debt refinancing.

The key concern is order backlog getting slimmer and EBITDA margin compression that is likely to happen after 2017.

Moody's was recently on a downgrade spree in the offshore drilling sector as the credit rating agency downgraded Transocean (NYSE:RIG) by three notches to Ba1, from an earlier rating of Baa3. There is no doubt that there is more pain ahead for the sector and challenging times will continue for the industry.

However, a few offshore drilling stocks are still comfortable when viewed from a credit perspective vs. others. This article discusses Transocean's credit metrics for 2016 and beyond to make some conclusions on the company's overall credit health for the next 12-24 months. The broad conclusion is that credit metrics might worsen, but the company can still navigate the crisis with the current backlog and cash flow visibility.

Starting the analysis with the company's backlog for 2016, Transocean has backlog of $4.2 billion for the year. This is likely to provide decent cash flow visibility through the year. Furthermore, Transocean has a backlog of $2.6 billion for 2017, with the order backlog getting reduced to $2.0 billion by 2018. While I will elaborate on the potential cash flows from the backlog, the point that I want to make here is that the company's debt servicing is likely to remain smooth even if there is minimal backlog addition for 2016 and 2017.

Coming to the cash flow analysis, Transocean expects operating cash flow in the range of $2.2 billion to $3.2 billion for 2016 and 2017. Even if the mid-range of $2.7 billion operating cash flow for these two years is considered, Transocean will be able to cover the next 24 months capital expenditure of $1.7 billion and still have $1.0 billion in free cash flow.

Transocean closed FY 2015 with total liquidity of $2.3 billion. If the free cash flow for 24 months is assumed, the company is likely to have a total liquidity buffer of $3.3 billion by FY 2017. Therefore, the company's capital expenditure is not a major issue and liquidity is likely to remain robust. Furthermore, with $3.3 billion in liquidity visibility, I expect Transocean to reduce debt in the coming 12-24 months.

With EBITDA also likely to be in the range of $3.0 to $3.5 billion for the next 24 months, I don't expect debt servicing to be an issue. I must, however, mention that leverage and coverage metrics can potentially worsen in the next 12-24 months. The reason for being bearish on the leverage and coverage metrics is that several rigs will go off contract during the next 24 months. I see two possible bearish scenarios: First, the rigs will remain off contract, thus reducing the backlog visibility and utilization potential. Second, the rigs are contracted at a significantly lower dayrate, and this translates into EBITDA margin compression in 2017 and beyond.

In my view, these are the two factors that Moody's has discounted when considering a three-notch downgrade. The offshore industry conditions are unlikely to improve through 2016 and for 2017; the recovery might be very sluggish. In other words, the order backlog will get slimmer and the backlog addition will come with meaningful margin compression (reduced operating cash flow beyond current orders at high dayrates). Potentially, even if all rigs are contracted beyond 2017, the cash flow can still remain sluggish with regard to the dayrate factor. This will have direct implications on the company's credit health.

However, I should mention here that the company's credit scenario does not point to a serious debt crisis (at least in the next 24 months). Therefore, Transocean is well-positioned from that perspective. With the current rating downgrade, I expect no additional downgrades for Transocean. A downgrade scenario is likely only if there is conformation that offshore drilling sector will remain depressed even through 2017.

In conclusion, I remain cautious on the offshore drilling sector. I am relatively positive on names such as Diamond Offshore (NYSE:DO), Noble Corporation (NYSE:NE) and Rowan Companies (NYSE:RDC) for investors who are keen on some long-term exposure to this depressed sector.

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

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.