The merger of Transocean (NYSE:RIG) and Global Santa Fe (NYSE:GSF) is remarkable on a number of levels. First, it's pretty close to a true merger, a nearly extinct animal on Wall Street. While RIG has about twice the capitalization of GSF, and while RIG will be the name partner, the resulting company will be owned pretty much in proportion to the existing ownership.
The more interesting thing in terms of energy investing is that as the first major recapitalization in the deep water drilling segment, the deal marks the start of financial engineering and value creation in this sector. A significant result will be the distribution of $15 billion to stockholders of both companies.
“The $15 billion cash payment allows us to achieve a more appropriate capital structure and deliver immediate value to our combined shareholders,” GlobalSantaFe's Marshall said on Monday.
In effect this transaction is a mini-LBO. I say “mini” because if KKR had done the deal, the leverage would have been much greater. But even this moderate amount of leverage should be very beneficial to stockholders (not to mention allowing the company’s managements to breathe easier). Cash flow visibility in the deep water drilling area has never been better, so leveraging that cash flow will add significant value to these shares.
A couple months ago I compared the prospects for this group with the historical rise of cable television equities because of the similarities in their cash flow growth prospects. I forecasted consolidation and leveraged buyouts for the drilling and service sector. I also said that eventually such actions would mark a top and indicate a time to sell. I want to be more clear about this now.
The RIG/GSF merger does not indicate a top. It is only the start of a trend that has more to go. The market has mistakenly continued to treat the Drillers and Service Companies — and particularly those involved in deep ocean work — in their historical manner as cyclical businesses. Yes, the group has been cyclical and in the future there will still be an element of cyclicality as new capacity comes on stream. But the constant rise in the price of oil over the long term going forward means that in future decades there will be no end to the growth in drilling, particularly in deep waters (which make up 70% of the earth’s surface). Even as diminishing returns cause each drill ship to produce less and less oil, the rising oil price will make more drilling economical. That, my friends, is called secular growth.
So at 10 times or less projected '08 earnings (not to mention a lower multiple of cash flow), the drillers are still cheap. And for RIG and GSF, with new leverage applied to their in-the-bag growth over the next few years, the current price looks even more attractive. When we see these companies selling at 20 and 30 times projected earnings, and when KKR and their ilk own some of them, that may be the time to sell.
Disclosure: Author holds a position in some or all of the above-mentioned companies.
RIG/GSF 1-yr comparison chart