Transocean's Value Proposition, Part Two: Profit Soars, Macondo Settlement On The Horizon

| About: Transocean Ltd. (RIG)

When I wrote my first article on Transocean (NYSE:RIG), world's largest contract driller, back in December of last year, the company had just announced a $29.9 million equity offering to maintain an investment-grade quality balance sheet following its acquisition of Aker Drilling. As I mentioned at that time: "Clearly the biggest argument against investing in Transocean at this point is wanting to see operational improvements first. The biggest argument against waiting is that a return to historical "normal" operating margins and a corresponding EPS of $6.00-$8.00 will likely be preceded by a retracement in share price at the first signs from monthly fleet reports that rig downtime is finally under firm control."

Yesterday's after-hours earnings release for Q2 2012 was Transocean's clearest signal to date that the company's turnaround is finally upon us. Second-quarter profit beat analysts' estimates by a staggering 64.4%, as the company controlled costs to maintain its rigs, partly to satisfy more stringent safety regulations following the Macondo oil spill. Adjusted Q2 profit was 74 cents per share -- 45 cents was expected -- and nearly double last year's Q2 profit of 39 cents.

The company did report a bottom-line loss for Q2, but that was related to the decision to take an extra $750 million one-time charge in relation to the 2010 Deepwater Horizon-Macondo well disaster in the Gulf of Mexico. The company's Macondo settlement reserves now total $1.95 billion, as speculation of a potential settlement by Transocean and BP Plc (NYSE:BP), its client on Macondo, has picked up since late June after the U.S. Congress removed an obstacle to settling legal claims from the 2010 spill, when it approved a spending plan for the billions of dollars it expects the government to collect.

In January 2012, a U.S. court upheld portions of Transocean's indemnity agreement with BP, which had been leasing the Deepwater Horizon rig from Transocean, agreeing with Transocean that it wasn't liable for damage claims made for oil spilled below the ocean's surface. However, BP isn't required to protect Transocean from potential punitive damages or civil penalties under the federal Clean Water Act, according to the ruling, which means that Transocean still faces some potential liability.

Transocean's results also showed higher-than-expected revenue, with revenue rising 10% to $2.58 billion, compared to estimates of $2.49 billion. Operating and maintenance costs were up a less-than expected 5% to $1.6 billion as a result of rig maintenance, a persistent challenge for the company. The market has been targeting the lower end of the company's full-year forecast costs of $6.15 billion to $6.35 billion, and that range might be coming down.

Among the other items for Q2 was a $64 million gain on the sale of four shallow-water rigs. The company has already matched its 2011 total of four jack-up sales this year. Transocean is targeting $1 billion in divestment for 2012, as the company has put its Middle East rig assets up for sale -- all in all, about 30 rigs.

The company's revenue efficiency -- how much it actually earned compared with what it could have earned -- rose to 92.5% in Q2 from 90.6% in Q1, after dipping below 90% last year. The company is targeting a gradual improvement to the 94% mark, the 2009 pre-Macondo level.

Growing demand for rigs has tightened up the entire drilling market. In addition to Transocean's profit beat, Noble (NYSE:NE), Diamond Offshore Drilling (NYSE:DO), and Ensco (NYSE:ESV) -- three of the top five global rig contractors, with Seadrill (NYSE:SDRL) being the other contender -- all beat profit expectations. All have stated that strong demand for rigs has almost completed absorbed availability for 2012 and 2013 in the marketplace.

Excluding new builds under construction, Transocean currently has 131 units on the books, Ensco has 76 units, Noble 68, Seadrill 48, and finally, Diamond Offshore has 40 units at this time. These numbers change each quarter, depending on new builds delivered and older units divested.

Rental rates for ultra-deepwater rigs, the most complex and expensive drilling vessels, could climb in the region of 25-30% to over $700,000 a day by year-end from approximately $560,000 per day at the end of Q1, according to estimates. Some are already dubbing this move a "super spike." According to Baker Hughes (NYSE:BHI), the number of rigs operating in the Gulf of Mexico has risen 45% during Q2, to 45 from 31 a year ago.

Transocean's most recent fleet report, which also shows a long-awaited reduction in rig downtime, clearly illustrates the continued rise in dayrates across the board. Here some highlights:

Discoverer Deep Seas - Awarded a three-year contract for work in the U.S. Gulf of Mexico at a dayrate of $595,000 ($652 million contract backlog). The rig's prior contract dayrate was $450,000.

GSF Arctic III - Awarded a 17-well contract for work in the U.K. sector of the North Sea at a dayrate of $313,000 ($205 million contract backlog), consistent with the rig's recently-signed, three-month prior contract.

GSF Jack Ryan - Customer exercised a one-year option for work offshore Nigeria at a dayrate of $425,000 ($155 million contract backlog).

Transocean Marianas - Awarded a 280-day contract for work offshore Namibia at a dayrate of $530,000 ($148 million contract backlog). The rig's prior dayrate was $450,000.

Transocean Searcher - Customer exercised a one-year option in the Norway North Sea at a dayrate of $386,000 ($141 million contract backlog).

Trident 15 - Awarded a two-year contract extension for work offshore Thailand at a dayrate of $139,000 ($101 million contract backlog). The rig's prior dayrate was $100,000.

But it wasn't all good news yesterday, as a Brazil court ordered suspension of Chevron (NYSE:CVX) and Transocean operations. The two companies have 30 days to comply, and failure to do so carries a fine of $245 million per day. Chevron has already announced that it will appeal. Transocean could potentially lose $3.5 million per day in leases on 10 rigs, as the company's rigs make up approximately 10% of South America's drill fleet.

The decision would prevent Chevron from restarting production at its Frade field, which leaked a minimal amount of crude off the coast of Brazil last November, but it also affects Brazil's national oil company (NOC) Petrobras (NYSE:PBR) and BP, as the court order would also suspend drilling in nine other Brazilian fields that use Transocean's rigs.

Chevron has already accepted full responsibility for the spill, clearing Transocean of any liability in the matter. Chevron has stated it had underestimated the pressure of underwater oil deposits while drilling, thereby causing oil to rush up the bore hole and seep into the seabed.

Petrobras' CEO Maria das Gracas Foster will certainly not be happy with these controversial efforts by Brazilian independent prosecutors to get Chevron, and evidently Transocean, to pay for a spill of 3,700 barrels -- 1,000 times smaller than BP's Macondo disaster in the Gulf of Mexico.

She has been telling investors recently that she thinks a lack of drill ships is the main reason for her company's failure to increase output at the desired pace, so if this ruling stands, it may create as a big a problem for Petrobras as it has for Chevron and Transocean. The company is going to have far fewer drill ships, as Transocean leases 7 rigs to Petrobras, and one each to Chevron, BP and U.S.-based Vanco.

Brazil's petroleum regulator ANP has already said in its July report on the accident that Chevron could resume oil drilling and production work at its Frade field if it can address safety concerns and improve its procedures. The same report did not hold Transocean responsible for the problems in any way. Time will tell how this all plays out.

That brings us to Transocean's current investment proposition. The company is showing higher revenue and lower costs, backed by a sensible, realistic approach by management to firmly focus on improving results and controlling costs on one hand, and strategic divestment of less attractive assets on the other.

Ultra-deepwater has been strong, and continues to be a very attractive market. Rig availability is quickly being absorbed in the marketplace, and customers are already looking into 2014 and beyond at this point. The ultra deepwater market is essentially fully utilized, with dayrates continuing to rise. The vast majority of Transocean's current contract backlog is coming from the high-spec floater fleet, with backlog as of July 18 standing at $22.9 billion, a net increase of $2.3 billion since April. Since July 18, additional contracts totaling $144 million have been secured.

Cash flow from operating activities was $459 million for Q2, and fleet utilization was 66% in the second quarter, compared with 61% in Q1. That is a rather substantial improvement in one quarter. Transocean's fleet size and the early move into deepwater drilling, with two-thirds of Transocean's fleet coming from prior new build cycles, has meant relatively higher costs for the industry leader, as its rigs needed to meet tougher regulatory standards for equipment following Macondo.

EPS is also beginning to rebound this year, with net earnings per share estimates of $3.30-$3.60, and expected to rise to $4.45-$4.85 for 2013. Given yesterday's earnings surprise, estimates may be raised in the coming months. Although maintenance costs will remain elevated, the company is making good on the higher utilization it promised last year, also taking a full year's activity for the Aker Drilling semisubmersibles into account. Additionally, Transocean has stated that it expects that its annual effective tax rate will fall in 2012 compared to last year as profitability in certain low-tax jurisdictions improves.

Even though the global economic climate has been tough these last few years, the market for contract drilling remains on fire. As the availability of crude oil from onshore fields declines, more complex and expensive technology is required to produce oil and gas from deep and ultra-deep offshore areas. It is estimated that in 2012, the global oil and gas industry will register a total capex in excess of $1,000 billion. Capex from NOCs will increase from $448 billion in 2011 to $515 billion, up by 14.5%. Integrated oil companies (IOCs) will increase capex by 7.9% from $329 billion in 2011 to $355 billion in 2012.

Of course, there are risks with every investment, and Transocean is no exception. Although rig downtime has been decreasing, it remains a hot topic. Having the largest fleet tends to mean you also have the largest maintenance bill, especially as your fleet ages. The company expects 2012 shipyard activity to be concentrated on deepwater and mid-water rigs rather than ultra-deepwater rigs, which should result in lower revenue losses from out-of-service time compared with 2011, but 2012 shipyard expenditures will still remain at elevated levels.

Often the critical path to returning rigs to service is heavily reliant on the support and performance of vendors, and this proved a serious bottleneck for Transocean in 2011. Transocean may be focused on developing a more collaborative relationship with its key vendors, getting more involved in their business and vice versa. However, given Transocean's fleet size and the entire industry attempting to meet blowout preventer (BOP) recertification standards and more stringent regulations at the same time, there's always a possibility that rig downtime may take a turn for the worse. At the moment, vendors are still building infrastructure and adding workers to meet increased demand from drillers.

Divesting or spinning-off assets to reduce your exposure to lower spec assets is a good thing, but demand for those assets can always change. The market for standard jack-ups and high specification jack-ups has been improving along with the mid-water market, but these markets are simply not as attractive and profitable as the deepwater and ultra-deepwater market.

Most of the offshore mega-fields discovered in recent years, like Tupi and Jupiter in Brazil, are located in the pre-salt layer at a depth of at least 5.000 meters -- 16.000 ft. West Africa is another such hotbed of exploration, but activity is also ramping up in the U.S. and across Asia. IOCs and NOCs simply need all the deepwater and ultra-deepwater rigs they can get.

And it has to be said, Transocean continues to encounter strong competition, especially from Ensco Plc. Ensco has had significant cost-cutting opportunities available following completion of its acquisition of Pride International last year. Ensco is historically known for its cost-efficient approach, top-notch operating margins and a largely brand-new ultra deepwater fleet. This can also be said of Seadrill, which has been quite aggressive in leveraging the balance sheet, but does own one of the newest and most advanced rig fleets, like Ensco. This is a big plus, post-Macondo.

But the fact remains that, despite risks and increased competition, Transocean still provides the largest and most versatile fleet of mobile offshore drilling units to find and develop oil and natural gas reserves. Even after Macondo, the company stands out with more than 50 years of experience, 18,000 employees, and a fleet size almost two to three times that of its four primary competitors.

Given Transocean's favorable relative valuation, with a P/B of 1.06, a Forward P/E of less than 10, an average price target of $65 (and on the rise), the continued strengthening of the company's long-term prospects, and last but not least, resolution on Macondo finally visible on the horizon, perhaps now really is an opportune time to take a dip.

Disclosure: I am long RIG, ESV, BP, PBR.