Do you want the good news first, or the bad news? Well, the good news is that it would be hard to imagine a worse year from Transocean Ltd (NYSE:RIG) than 2011 was. The bad news is, well, pretty much everything else. I am always reevaluating all of my holdings, including Transocean. As detailed below, I conclude it is a weak hold based on valuation, and unless it materially improves (unlikely to happen within the next six months) it is at the top of my list for chopping once I have more thoroughly evaluated all other options.
Background: I initiated my Transocean position on December 3, 2010. It was a small "test" position, with a unit cost of $71.18/share. My thesis had three parts: 1) the worst of the Gulf Spill was over, and operations would improve; 2) I evaluated the lawsuits (I'm a lawyer in real life) and concluded that the legal risks were overblown and the indemnifications were likely, in a fair world, to be upheld; and 3) I believed that deep sea oil exploration would become more and more necessary in a world of diminishing resources. On August 8, 2011 I upped my position, at $49.78/share, by 166% as measured by the number of shares, or by about 120% as measured by original basis costs. On January 10, 2012, at $39.97/share, I upped my position by a further 93.75% as measured by number of shares, or by about 60% as measured all around by original basis costs. As of today, the price is $43.14/share. Needless to say, this has not been a winning investment so far. Because my original investment was so small, and my largest numerical add was at $39.97, it has not been a major loser.
Subsequent Events: What I'm most unhappy about is the failure of at least one of my theses, and the negative events that have transpired since my purchase. First, I was totally right about the legal validity of the indemnifications Transocean had with BP (NYSE:BP). This was an obvious call for anyone with legal training and faith in the justice system, because the indemnification language I saw quoted was totally unambiguous. (Indemnification here means that BP was required to pay Transocean's share of compensatory damages relating to sub-surface oil spills, which was the main enchilada, and also that Transocean was not responsible for BP's losses.) Unfortunately, it appears this was too obvious, and was either priced into the stock when I bought, or was overshadowed by subsequent events. So it seems that what I perceived as my primary edge was no edge at all.
Regarding the third part of my thesis, it turns out fracking is releasing lots of controversy, but also tons of oil as well as the more publicized natural gas. This has bad implications for expensive deepwater oil drilling. Some companies can drill oil in the Bakken Shale, for example, at a cost of less than $10/barrel. Deepwater drilling is much more expensive.
But the worst immediate news was the October 1, 2011 impairment of goodwill, and the December 2011 9%+ stock equity dilution.
Equity Dilution: The equity dilution is a relatively obvious thing. Pursuant to page AR-82 of the 2011 Annual Report, on the Consolidated Statements of Equity, in the beginning of 2011 Transocean had 319 million shares. It issued 29.9 million new shares during the year, which was a 9.4% dilution of the equity of existing shareholders. These shares were offered in December 2011 at a price of $40.50/share, and netted Transocean $1.2 billion, per page AR-40 of the 2011 Annual Report. So essentially the company was willing to sell itself in December 2011 for 20% less than what I had paid for my first stock-add in August 2011. This reflects poorly on me.
Goodwill Impairment & Accounting Change: But the worst thing going on with Transocean recently was the goodwill impairment, which was HUGE. Per page AR-81 of the 2011 Annual Report, at the end of 2010 Transocean carried $8.132 billion in goodwill on its balance sheet. For a basic definition of goodwill, see here. That was written down (impaired) by $5.229 billion (with a 'b') in October 2011, leaving $3.205 billion on the balance sheet for the end of 2011. This represented a writing down of over 64% of Transocean's goodwill assets. Billions down the drain.
Because goodwill represents typically the excess, over book value, paid for a company in an acquisition, what this impairment basically amounted to was an admission by Transocean that it wildly overpaid for GlobalSantaFe in its July 2007 "merger", at the height of the last bull market, for $18 billion. As of today $6 billion of that, or 1/3, has now been written down as goodwill impairment. Break open the bubbly! (And of course, like all deals, that deal was hailed at the time. For more generally on my highly negative attitude towards both M&A and divestitures, see my recent article on Abbott Labs.) While no premium was paid at the time -- with additional debt being taken on and paid out to shareholders instead, in 2007 Transocean traded at over 3 times book value. I have not taken the time to find historical figures for pre-merger GlobalSantaFe, but likely it was similarly-priced. In retrospect, more than 3 times book value was wildly overvalued for capital-intensive, low-moat companies that do not rely on intangible assets like brands and trademarks (compare Coke (NYSE:KO) in that regard). And now you see the final unwinding of that. Or do you?
Accounting Shenanigans? Keep in mind that $3.205 billion in goodwill remains on the balance sheet. Morningstar states that $2.9 billion of this relates, STILL, to the GlobalSantaFe acquisition. The huge 2011 goodwill impairment took place because of a mandatory yearly quantitative review that Transocean must do, as described in multiple places in the 2011 Annual Report, including at page AR-87. Goodwill is tested for impairment by "comparing the carrying amount of the reporting unit, including goodwill, to the fair value of the reporting unit." Id. Essentially, Transocean looks at the carrying value on the books, and compares that to a discounted cash flow analysis valuation of the reporting segment, to see if it is overvaluing the business on its books. Id. Note that the 2011 impairment was just the latest and greatest following a billion dollar-plus impairment in 2010, and a $330 million impairment in 2009. (Thus, Transocean is also a good example of the informal rule that one goodwill impairment is nearly always followed by more.)
So that's all relatively simple. But guess what? In September 2011 the FASB "simplified" the rules for calculating impairment of goodwill in the following way: rather than do the standard, mandatory quantitative two-part test for whether and how much to impair goodwill, a company gets to perform a "qualitative" preliminary analysis to see whether "it is more likely than not that the fair value of a reporting unit is less than its carrying amount and whether the two-step impairment test is required." See 2011 Annual Report, page AR-89. Campers, I submit to you that this is bonkers. To review, "qualitative" means no numbers. This means that a former English major (such as me) gets to make a judgment call, and decide whether or not to bother valuing the reporting segments or company and calculating the difference between reported assets (including goodwill) and the actual free cash flow generating capacity of the unit or company. So it gets to decide, theoretically, to stick its head in the sand.
Keep in mind that per the FASB, the rule change was driven by private companies -- small ones, who complained that it was too costly and time-consuming to constantly have to perform these calculations. I question that, per se. But I really question it as regards large public companies like Transocean, which already have huge compliance and accounting departments. Despite the purported origin of the concerns (with private companies), the FASB made the new rule applicable both to private companies and to public companies. And on page AR-89 of its 2011 Annual Report, in the wake of a $5+ billion mandatory impairment of its goodwill, lo and behold, Transocean adopted the rule!
Imagine if this new rule had existed a year ago. If so, Transocean could have reached a "qualitative" conclusion that no calculations were necessary, and this titanic impairment might not have happened this year....
Let's take a step back. In Howard M. Schilit's classic investing book, Financial Shenanigans: How To Detect Accounting Gimmicks & Fraud in Financial Reports, he writes on page 64, "[i]n many cases, an accounting change -- even a permissible one -- is an attempt to hid an operational deterioration." That is particularly true where the accounting convention adopted was designed primarily to apply to a different type of company or industry. And here the new "simplified" accounting rule was designed for private companies, yet has been adopted by Transocean, following a titanic impairment of goodwill.
I humbly submit to you that Transocean is unlikely to come to the "qualitative" conclusion anytime soon that this two part goodwill calculation is required, I am sad to say. (However, after adoption of the new rule, it did raise the prior 2011 goodwill impairment based on its prior calculations by another $100 million or so in first quarter 2012 -- though keep in mind this was based on the prior required analysis structure, after the cat was out of the bag.) And I further submit to you that the remaining $3.3 billion or so in goodwill on Transocean's balance sheet ($2.9 billion of which still results from the GlobalSantafe transaction) will likely turn out, in large part, to be donkey droppings, though this will not be known for some time. Whether this is true will depend to some extent on how well the market for deepwater drilling turns around, so this is a chicken-and-egg scenario.
That also provides a more charitable rationale for Transocean's decision: it does not want its goodwill impaired based on temporary industry dislocations, such as those of the past few years. The problem is that life has been, is, and will be filled with "temporary" dislocations, and investors and companies have to account for them not as aberrations from a perfect "norm," but as the norm. Methinks Transocean seeks breathing room to treat both its still-existing goodwill, and also goodwill it may acquire in the future via acquisitions, more optimistically than is likely warranted. And that, in my non-expert opinion, is not good news for investors, however pure-hearted are the intentions of Transocean's management.
Valuation: My regular readers know the cornerstone of my valuation analysis and investment process is a discounted free cash flow analysis (such as the one Transocean must perform to test the value of its goodwill, if it decides to test the value of its goodwill). My latest sheet is here. I use an estimated WACC of 10% as my discount rate.
Over the past four years from December 2007 to December 2011 Transocean's free cash flow has declined at an annualized 18% rate, for obvious reasons. However, there has been a rebound, with TTM free cash flow up 16.99% "annualized" from the December 2011 figure of $765 million. It is still nowhere near the 2008 high of $2.751 billion.
If you look instead (as one should with cyclical companies) at the average of Transocean's free cash flow over the past five reporting periods, you come up with a $2.058 billion average. That is exceedingly likely to decline as the average is recalculated over the next year or two, because no estimate I have seen indicates earnings and free cash flow will soon rebound to 2008 or 2009 levels. Morningstar, for example, estimates 2012 operating income of $2.1 billion, as opposed to over $5 billion from 2008, and operating cash flow of only $2.4 billion. If you assume $1.4 billion in capex, free cash flow in 2012 is likely to come in around $1 billion. If you add that into the average, you get down already to a $1.88 billion average free cash flow for this cyclical business. If you assume pretty nice free cash flow growth through 2014, including 20% rebound growth in 2013 to $1.2 billion, your average goes down to $1.74 billion. You get the point.
My sheet is currently set up to reflect starting free cash flow of $1 billion, which is my estimated amount of 2012 free cash flow. This plus my 10% WACC and an assumed ten 6% growth rate implies an intrinsic valuation of about $46.00/share. So the stock by this analysis is mildly undervalued by a bit over 6%.
Informal Sanity Asset Valuation: Also per Morningstar, the net asset value of Transocean's rigs is $55 billion. If you subtract out the $13.4 billion in debt that Transocean has, that's a net tangible asset valuation of $41.6 billion. If you assume a 50% discount for salvage, that's still $20 billion or so left over. Compare this to Transocean's current market capitalization of $15 billion and change, and you have another reason why so many say this stock is cheap.
Conclusions: There is a lot of uncertainty here. If RIG can get back to 2008 profitability levels anytime soon, it's worth $90/share, easily. More likely it is worth between $40 and $55/share. Pessimism from my DFCF calculation is tempered by my knowledge of how well Transocean can do when all thrusters are firing. It is also tempered by my analysis of the value of Transocean's assets. Notwithstanding the impairments to goodwill, the tangible value of Transocean's rigs, even assuming sale at severe discounts, is much higher than the stock's current price. I think sales of older rigs is likely. I think additional dilution is possible. I am planning to hold for now, but I will actively look to sell within the next few months if I see an obvious place to park the money. Among my current holdings, this stock is on my hit list. I think I did not sufficiently value it when I initiated my position, and at every step of the way since then my assumptions have proved either to be too optimistic, or premature. The time is swiftly approaching when the cord needs to be cut. Do you disagree? Agree? Please let me know in the comments! Thank you.
Additional disclosure: I am long RIG as described in the article. I am actively considering exiting my position, but I do not plan to do so over the next 72 hours.