Valuation Implications of the Transocean/GlobalSantaFe Merger

Yesterday morning the market woke up to an announcement that Transocean (RIG) would buyout fellow drilling company GlobalSantaFe (GSF) in a deal that would create the world’s largest fleet of offshore drilling rigs. The combined company will be worth upwards of $50 billion, and will be able to offer a line of rigs that should be able to handle nearly any offshore location in the world. What does this deal imply about the state of energy?

First, checking the valuation of the deal says that Transocean isn’t picking up GlobalSantaFe on the cheap - at least by traditional metrics. GSF will end up going for about 11.75x EBITDA on a trailing basis; private equity normally wouldn’t pay more than 8x EBITDA for a deal. So is this deal outrageously overpriced? I wouldn’t jump to such conclusions without doing some mental math (an admittedly risky proposition, though). GSF is being taken over at essentially no premium, and the deal is largely financed through a debt-for-equity recapitalization that is going to provide current stockholders with a substantial cash payment.

To that end, this deal doesn’t make GSF seem any more overpriced than it was at market’s close on Friday - and I believe that GSF was about fairly priced then. What makes this deal interesting is that the remaining stockholders are going to be holding such a levered company that if the market for drilling rigs holds, they are going to be rewarded in a truly exceptional fashion. Using Anadarko’s (APC) debt-financed acquisition of Kerr-McGee and Western Gas as a proxy for interest rates, I expect the RIG-GSF financing should be secured for around 6.5% (that is where I remember Anadarko’s notes being priced up to). If so, this rate works out to somewhere between a 35-50% discount on cost of debt capital versus equity, and considering the weightings of debt-equity ($15 billion in new debt), that swap alone should add 10-15% to the value of this combined company. If you begin to add up costs savings, then the numbers become even more impressive, but I’ll save those forecasts for the investment bankers.

Another factor to be considered: GSF is being bought for 3.5x book value. This is a company with approximately 70-75% of the value of its assets locked up in PP&E - one would assume that to be carrying value of the drilling fleet. The rates for drilling rigs have been going through the roof, particularly the deepwater rigs that Transocean owns, although the shallower water ones GlobalSantaFe have are in high demand as well. The point of this is that GlobalSantaFe’s current assets just about offset the total liabilities. This leaves the value of the PP&E to stand against the value of the deal - essentially meaning Transocean paid 4x the carrying value of PP&E. I know companies are very conservative about writing up the value of assets, but use this to your advantage - as long as energy companies are reluctant to come out and say the end of cheap oil is here, there are going to be values in the energy sector that will be head-slappers in hindsight. Remember how Transocean’s deepwater drilling platforms are even more valuable than GSF’s shallow water rigs? Perform a valuation of Transocean’s fleet using the same criteria as just done on GSF. Current Assets net of Total Liabilities leaves a $3.2 billion hole, ignore the Goodwill, and take RIG’s PP&E and mark it up fourfold. The sum is $27 billion; now the price to the new-and-improved book value is a measly 1.23x. Know anyone who would like to buy a company with 35%+ profit margins and a 20%+ ROE for that multiple over book? Presumably, one could mentally mark up Transocean’s rig value by more than 4x if that is the appropriate mark up for GSF, but I don’t want to sound any more outrageous than I already have.

Thinking about the energy sector this way shows that there are still values out there, which is probably why you have just about every drilling and services stock up big today. There has already been some consolidation in the sector - think Hercules’ (HERO) acquisition of TODCO (THE) - and all signs point to another deal coming sooner or later, if only to mount a serious competitor to the new Transocean. The big names that might come together in some form or another - Diamond (DO), Ensco (ESV), Noble (NE), Pride (PDE), and Rowan (RDC) - were all up around 4% in sympathy with GSF and RIG. With the very active call volume in RDC of late on the August $47.50s, I wouldn’t be surprised if we saw a move in that direction first.

Disclosure: none