Deutsche Bank issued a negative report on a number of offshore drilling companies. Transocean (NYSE:RIG), Ensco (NYSE:ESV), Diamond Offshore (NYSE:DO) all received sell ratings with price targets being cut across the board. An investor who had not been following the developments in the sector may have been taken by surprise as to the magnitude of the downgrades. The downgrade focuses on near-term supply of new rigs, which may lead to older midwater assets becoming obsolete, thus affecting DO and RIG the heaviest.
While agreeing with the facts presented in the report, I strongly disagree with its conclusions and especially with regards to ESV and RIG.
My assumption is that DB analysts got the cue from ESV's earnings report, where the company wrote down value of 8 rigs by 1.5 billion dollars. Four floaters (three of which are stacked and one has a contract expiring in December) were written down by 508 million and four others (all under long-term contracts) were written down by 990 million. These writedowns are non-cash and will not affect ESV's earning power at the least. Basically, one can think of it as accelerated depreciation, and as a matter of fact the sale or scrapping of five non-working rigs will actually help lessen supply in the market. The writedowns also should decrease company's cash taxes.
ESV does not have to replace cash flows generated from these 5 rigs, since there were practically none in the last quarter. Only one of those rigs was active at a day rate of 288K with a contract expiring in December. In the meantime, the company has two new drillships entering the fleet in 2015 (both under long-term contracts) and one more in 2016 (not yet contracted). Thus, from a cash flow standpoint, the writedown doesn't mean much in terms of longer-term earnings power. It's simply an accounting hit to the book value. The company can lower book value of its assets ad nauseum, but as long as the earnings power remains intact the market value of these assets will be determined by cash flows they generate.
ESV generated almost 1.3 billion in EBITDA in the first six months, which is a 30% increase compared to the same period last year, which supposedly was the peak year of the cycle. The company now trades at a laughable EV/EBITDA of 6.3, 8 times 2015 earnings (which is considered a trough year by many) and has a 3 dollar per share dividend. It is dirt cheap.
While ESV is cheap, Transocean is trading at distressed levels. The company crushed earnings and sales estimates. It reported 2.33 billion in sales and 1.61 in earnings per share. The street analysts were modeling 2.27 and 1.12. I was modeling this.
Deutsche is calling for 3.64 per share in earnings for 2014, and 2.30 in 2015. My previous article focused on what the street was expecting three months ago and how unjustified those numbers were. Since then practically every analyst decreased their estimates by about 10%, but DB's analysts are truly a joke. 3.64 a share would imply RIG making 0.60 a share for the next six months. RIG makes that much money in six weeks.
Their call on the dividend being a forced cut is complete nonsense, since RIG's normalized cash flow generation is around $4 billion a year, whereas dividend payment is $1.1 billion. In the latest quarter RIG increased its working capital by $325 million and still had operating cash flow of $636 million. I do not foresee additional increases in working capital, thus operating cash flow should approach $1 billion every quarter of normalized operations (i.e. average number of planned surveys and stabilized levels of working capital).
RIG can technically double its dividend and cover it with ease. That would really set a panic among shorts who hold 60 million shares or about 20% of the float.
Deutsche is calling for $2.30 a share in 2015. RIG will make that much in the first six months of 2015 based on the current fleet status report. Their target price of 27 dollars results in EV of $20 billion. 12 UDW rigs built since 2009 and 7 Harsh Environment rigs alone are worth that much in terms of their market value. What about the other 59 rigs that Transocean owns? Are they all obsolete?
It is downright criminal that people follow these clowns. The whole street will scramble to raise their earnings estimates for 2014 after this quarter's blowout numbers, because they were sheep and were all wrong. The highest estimate for this quarter was $1.30, that's 31 cents below what RIG reported.
The upcoming two quarters will be tough, RIG has three-four rigs en-route, eleven rigs going through planned surveys and upgrades and two more UDW rigs idle, bringing the total to four. That's 25% of the active fleet having full or partial downtime and increased expenses due to shipyard costs. Nevertheless, consensus estimates of 77 cents for each of the next two quarters are absolutely baseless. The company will beat them again and sheep will follow the herd and raise their numbers.
RIG's share price is trading at distressed levels considering company's earnings power. The market can stay irrational longer than investors can stay solvent. Good luck to all.
Disclosure: The author is long RIG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.