There are many stocks that deviate too much from my strict criteria and thus I do not follow them on a regular basis. However, while some stocks may be too risky, their bonds may offer a great risk/reward potential. This is exactly the case with Transocean (NYSE:RIG). While the off-shore drilling market is clearly oversupplied, with continuously plunging revenues and no bottom on the horizon, the 4-year bonds of Transocean currently offer a 6.5% annual yield to maturity with minimal risk of default. This yield should not be underestimated by investors, particularly given the zero-yield environment and the all-time high level of S&P (NYSEARCA:SPY), which should limit its future returns from now on.
First of all, while the price of oil has stabilized this year after a relentless bear market, there are still no bottoming signs in the off-shore drilling market. To be sure, the revenue of Transocean plunged 50% in Q2 over last year due to reduced day rates and lower utilization of its platforms. Thus its net income decreased 75% in Q2. Even worse, there are still no turnaround signs in the sector. Therefore, very few investors would dare to purchase the stock right now, as it is essentially a falling knife, already down 80% within the last two years.
However, while the future returns of the stock are highly unpredictable, the 6.5% bonds that mature in November-2020 have a quite different profile. More specifically, the company is very unlikely to go out of business within the next 4 years. To be sure, it has an extensive backlog of $13.7 B, which will greatly support the revenue of the company in the next few years, as shown in the chart below. Moreover, the quality of this backlog is high, as 78% of its contracts are with international oil companies, 13% of its contracts are with independents and only 8% is contracted with national oil companies, which bear a higher risk of early termination in general. In addition, there is no cancellation option without compensation in any of all these contracts. Consequently, the backlog of Transocean provides the company with great defense during the current downturn of the oil sector.
Moreover, investors should realize that there is a huge difference between the earnings and the free cash flow of a company during a downturn. While the two figures move in tandem over the long term, they may greatly differ in the short term and this is the case for Transocean. More specifically, as its market continues to be highly oversupplied, the company intends to drastically reduce its capital expenses in the next few years, from $3.4 B in 2015 to $1.3 B in 2016, $0.4 B in 2017 and only $0.1 B per year in 2018 and 2019.
Therefore, investors who consider purchasing the bonds of the company should not be misled by the expected 75% plunge in the earnings this year and the expected loss of $0.42 per share next year, as these figures include the high depreciation figures from the capital expenses of previous years. Instead those investors should realize that the free cash flows will be clearly sufficient to cover the debt obligations of the company in the next few years thanks to the drastic reduction of capital expenses. This is also confirmed by the outlook provided by the management:
While the above evidence indicates that it is very unlikely for Transocean to go out of business in the next 4 years, investors should also realize that the market does not offer a 6.5% annual yield for free. More specifically, the risk of the above mentioned bonds is that oil prices may plunge once again and not recover for the next 4 years. However, I consider this scenario to be extremely adverse and unlikely. As oil producers have cut their capital expenses by more than 50% in the last two years, the supply/demand relationship keeps improving in the oil market. Therefore, oil is likely to keep rising slowly in the next few years or, in the worst scenario, remain around its recent range. In either case, the free cash flow of Transocean is likely to be sufficient to cover its debt obligations.
To sum up, investors should realize that the bonds of a distressed company may have completely different prospects from its stock. This seems to be the case with Transocean. While the reported earnings of the company are plunging, depreciation is a non-cash expense and hence it does not affect debt servicing for the next few years. Therefore, the free cash flows of the company seem to be sufficient to cover the bond payments. A 6.5% annual yield for 4 years should not be underestimated by investors, particularly in the current zero-yield environment and with S&P around its all-time highs.
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.