Transocean Ltd.: A Good Investment Opportunity

| About: Transocean Ltd. (RIG)
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Transocean Ltd. has recently announced its Q1 FY 2014 results that beat analysts' estimates regarding its revenue and earnings, due to its improved fleet revenue efficiency rate and cost-cutting initiatives.

The spin-off will enable Transocean to focus more on its deep-water and ultra-deep-water operations, as they are the company's more productive assets.

The high prices of oil and gas will support growth in expenditure by oil companies.

The massive potential reserves available and the technological developments will make exploration in deep sea more feasible.

Transocean Ltd. (NYSE:RIG), the world's largest offshore drilling contractor, has recently announced its Q1 FY 2014 results that beat analysts' estimates. The company has also confirmed its plans to spin off part of its fleet, as agreed between the company and one of its biggest supporters, activist investor Carl Icahn, last year. Therefore, in this article, I will shed some light on the company's financial performance in Q1 FY 2014, along with a discussion on the initiatives the company is planning to enact.

Performance in Q1 FY 2014

Transocean earned revenues of $2.34 billion in Q1 FY 2014, that is 7.1% higher than the $2.18 billion in revenues earned by the company in Q1 FY 2013 (see table below). The $2.34 billion earned by the company in revenues in Q1 FY 2014 also exceeded the consensus estimate of $2.27 billion.

Source: RIG Q1 FY 2014 10K Filing

The company's revenue from contract drilling witnessed a 7.1% growth, driven by the improved fleet revenue efficiency rate of 95.7%, compared to 88% logged in the same quarter previous year (see table below). Revenue efficiency is the ratio between actual contract drilling revenues for the measurement period and the maximum revenue calculated for the measurement period. The maximum revenue is the greatest amount of contract drilling revenues the drilling unit could earn for the measurement period.

Source: RIG Q1 FY 2014 10K Filing

Looking forward, the company disclosed that it has secured an additional $470 million worth of contracts after the backlog fleet status report of $26.1 billion that existed as of April 17th, 2014.

Source: RIG Q1 FY 2014 10K Filing

The company reported per share earnings of $1.25 in Q1 FY 2014, beating the consensus estimate of $1.03 by $0.22. The $1.23 earnings per share logged by Transocean in Q1 FY 2014 are also 40% higher than the $0.88 earnings per share posted by the company in Q1 FY 2013. The improvement in the company's bottom line in Q1 FY 2014 was a result of the management's cost-control efforts. The company's costs and expenses witnessed a 5.8% drop to $1.60 billion in Q1 FY 2014 from $1.70 billion incurred in Q1 FY 2013 (see table above). The company's operating and maintenance costs and expenses for Q1 FY 2014 slipped 6.4% to $1.27 billion from $1.35 billion incurred in the same quarter last year. Overall, the lower maintenance and shipyard costs, in addition to the company's cost-cutting program drove the improvement in the company's bottom line in Q1 FY 2014.

The Spin-off

According to a regulatory filing, Transocean is going to spin off some of its fleet. This decision is being regarded as part of the company's strategy of undertaking cost-cutting measures by divesting its non-core assets. The strategy was agreed on last year as part of a larger understanding between Transocean and Carl Icahn, who heads the Icahn Group. The two settled on the terms after months of proxy war. In the arrangement, Transocean agreed for a dividend payment of $3 out of the additional paid-in capital. The two also agreed to restore Samuel Merksamer to the board, while adding Vincent Intrieri, and decreasing the overall count of the board of directors from 14 to 11. In return, the Icahn Group agreed to vote in favor of the company's board nominees, as well as other suggestions that will be offered at the annual meeting in FY 2014.

The latest spin-off plan will see Transocean stripping eight of its 21 mid-water floaters that entered service in 1970s and 1980s from its current fleet of 78 rigs. The rigs intended to be divested are capable of operating at depths of around 1,800 feet, with drilling capabilities of around 25,000 feet. The majority of Transocean's existing fleet consists of either deep-water or ultra-deep-water rigs, with Transocean owning 12 of the former and 27 of the latter. Thus, the recent move reflects the fact that the company is intending to focus more on deep-water and ultra-deep-water operations.

According to the company, the divestment move will result in the formation of a separate entity, to be named Caledonia, that will focus on operations in the UK's North Sea. Transocean disclosed that the UK's North Sea will remain a significant market for the company and that it is committed to upholding its existence in the region. Caledonia is expected to be formed in the second half FY 2014. Ultimately, Transocean is expected to form the new entity under a Master Limited Partnership (MLP), with an initial public offering to be made some time later.

In order to remain competitive in the offshore rig space, Transocean needs to exuviate some of its older rigs. Not only does the company need to add space for the new rigs and have a rig fleet similar to that of Seadrill Ltd. (NYSE:SDRL), but many of the company's older rigs are approaching the end of their economic lives. Transocean has already begun adding new high-specification offshore drilling rigs to its fleet, as it is getting ready to capitalize on the growth and increased drilling activities in FY 2014.

Offshore Drilling Industry Outlook and Final Take

Most of the available crude is now being drilled deeper and deeper under the sea bed, so the shedding of mid-water rigs makes sense for Transocean. Deepwater is emerging as an increasingly significant focus area for oil companies around the globe. This is because of the massive potential reserves available in deep seas and the technological developments that are making exploration and production more feasible.

Additionally, activity in the oil and gas upstream industry is mainly driven by the outlook for oil and gas prices, as it influences the capital spending of the oil companies. Crude oil prices have seen some firmness over the previous few years, and are expected to remain at high levels till 2016 (see graph below).

Source: Knoema

The natural gas prices will also continue rising in the coming years (see graph below).

Source: Knoema

These higher prices could boost the return on investments for oil and gas projects and escalate the spur for oil and gas companies to take part in more exclusive and challenging plays, such as deep-water and ultra-deep-water. According to the consulting firm, Wood Mackenzie, the number of deep-water exploration, evaluation, and development wells drilled each year is likely to surge from about 500 per year in 2012 to nearly 1,250 per year in 2022. The outlook for deep-water spending also appears favorable. Expenditures are anticipated to increase from about $43 billion in 2012 to approximately $114 billion in 2022, growing at a CAGR of around 10%. The higher drilling activity will present a promising demand for offshore drilling rigs. To meet the demand, another 95 deep-water rigs will need to be built between 2016 and 2022.

Transocean is one of the companies that is well-positioning itself to capitalize on growing deep-water and ultra-deep-water activity, provided its strong asset base and contract backlog. By divesting its low-specification shallow water rigs, Transocean has been rationalizing its shore-based support infrastructure to focus on the smaller overall rig count. The ultra-deep-water rigs are among the company's most productive assets, as they have a revenue efficiency of about 92%, along with utilization rates of about 96%. The company expects these initiatives to bring annualized savings of around $300 million beginning FY 2014.

The other players in the oil and gas offshore drilling industry are also scaling back to cut expenses, and are investing in a newer fleet of rigs. Transocean's latest move appears to be a step in that direction. The company performed well in Q1 FY 2014 in comparison to Q1 FY 2013, and also managed to beat analysts' estimates for revenue and earnings comfortably. Analysts expect the company will post a $4.47 EPS for FY 2014. Considering the company's efforts to further improve its financial position and performance and optimism from the industry, I believe the company is a good investment opportunity, and therefore, it receives a buy rating.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a Gemstone Equity Research research analyst. Gemstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Gemstone Equity Research has no business relationship with any company whose stock is mentioned in this article.