Transocean: Dividend Sustainability And Benefits Of The Newly Created MLP

| About: Transocean Ltd. (RIG)
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Is the dividend safe?

What level of revenue decline will endanger dividend sustainability?

What is Transocean Partners LLC and what is RIG's ownership in it?

Was there any benefit from the formation of Transocean Partners LLC?

It's tough to write about companies with share prices sitting at 10-year lows. It is difficult to sound optimistic in the face of such underperformance, especially considering how well the general market has done over the past several years.

Nevertheless, there is a large segment of investors who focus on out- of-favor companies and Transocean (NYSE:RIG) fits that mold perfectly. This article will attempt to analyze the dividend sustainability and benefits of the newly created MLP, Transocean Partners LLC (NYSE:RIGP).

1) Is the dividend safe?

In theory anything can happen, but as an investor we have to concentrate on the most probable scenarios and then back out our internal optimism to give proper weight for probable negative developments. With this said, here are the figures:

Total annual dividend payment is $1.1 billion and is approved by the company's shareholders for two more quarters, i.e., until March 2015. So the question pertains to next year's dividend. Will Transocean keep the dividend? Does it have enough cash flow to keep it? Let's calculate:

2015 Revenue is projected to be $8.7 billion.

The last two quarters show that costs are stabilizing at $1.25 billion. On the conference call, the management stated that costs will be higher for Q3 due to high amount of contract prep expenses and a higher-than-average number of rigs going through inspections, but should drop towards Q1-Q2 levels thereafter. In addition, cost cuts will result in additional $100 million of savings throughout 2015. Therefore, contract drilling costs for 2015 should be around $4.9 billion. Interest payments, principal payments, taxes, and G&A show $1.1 billion of cash outlays. Maintenance capex is $800 million. Macondo payments are $260 million next year. Subtracting these items from revenue results in $1.64 billion, which is more than sufficient to cover $1.1 billion in dividend payments.

But what about newbuild payments? What are RIG's capex obligations for 2015? These obligations are $1.2 billion and they will be funded by dropdowns to RIGP (two UDW 51% dropdowns), and if necessary, by an untapped $3 billion dollar credit line. This whole analysis assumes that Transocean is unable to sell its UK midwater business. The sale of Caledonia would bring in additional cash, but for now let's assume it does not take place in 2015.

Conclusion: RIG's dividend is safe

2) But what if the situation deteriorates further? What levels of revenue/utilization would put sustainability of the dividend in question?

For the dividend to be unsustainable, annual operating cash flow should be below $1.9 billion. For this to occur and assuming the cost structure is fairly stable, i.e., lower revenues cannot be offset with lower costs, then annual revenue of $7.5 billion is the line in the sand. Until then, all talk of the dividend being cut is unsubstantiated.

$7.5 billion of annual revenue entails the following scenario:

UDW average fleet dayrate of $450,000 (currently $540,000 for 29 rigs) and UDW utilization of 70%. For this scenario to play out, 2015 UDW contract renewal rates must average $360,000 and eight UDW rigs must stay stacked/idle completely throughout the year. For comparison, only one rig is currently idle, and only one rig has a rate below $360,000.

In addition to UDW low revenue/utilization, 50% of the midwater and deepwater fleet needs to be completely idle throughout the year. That is 6 deepwater rigs and 11 midwater rigs.

I find this scenario highly improbable as it implies that the vast majority of 2015 expirations will remain idle. Many were predicting this same outcome for 2014 renewals and that has not been the case, and 2014 earnings estimates have been climbing since the Q2 report.

Conclusion: a dividend cut is not probable.

3) How does Transocean Partners LLC benefit RIG shareholders?

First things first: RIG owns 70.8% of RIGP. The underwriters have exercised their over-allotment option and non-RIG owners have 20.125 million units. Total units are 68.9 million, RIG owns 27.58 million subordinated units and 21.21 million common units. Minimum distributions are set at $0.3625 a quarter. Subordinated units automatically convert into common units in 2019, provided annual distributions are at least $1.45 per unit. For quarterly distribution purposes, common units have prevalence over subordinated only in case RIGP fails to make minimum distribution payments.

RIG also owns IDRs, which allow the company to receive a higher proportion of distributions above a certain threshold level. This level is $0.4168 per quarter. RIGP owns 51% of three UDW rigs, which means RIG owns the other 49% coupled with 70.8% ownership of RIGP.

This means that RIG shareholders still own (0.49 + 0.708*.51 = .8511) 85% of the dropped down rigs. Only 15% of those 3 rigs has been actually sold for proceeds of $440 million, valuing each rig on average at 983 million. Another way to put it in perspective, RIG received $440 million of cash for selling $42 million of annual EBITDA.

Now that the general explanation is out of the way, back to the question: how does RIGP benefit RIG shareholders?

This structure allows RIG to unlock value, i.e., sell property valued at $600 million-700 million on the book for $1.1 billion-1.2 billion. Since RIG's share price is depressed and trading below book, RIGP allows it to maximize value based on discounted cash flows generated by dropped down assets. DCF values are close to double of net asset values for UDW fleet. For instance, Seadrill (NYSE:SDRL) recently dropped down West Auriga to Seadrill Partners (NYSE:SDLP) for $1.24 billion, and RIGP's share price appreciation will allow RIG to "sell" its assets at similar values and book substantial gains.

By conducting these transactions, RIG is able to receive upfront cash and use this cash to pay for newbuilds and/or reduce debt. The logic is as follows: order a newbuild for X, get a long-term contract in place, sell for 1.5-2 times X and order a new rig to replace older assets. Skeptics would say that dropdowns for a price higher than book value is a shell game, but SDLP's and RIGP's share price appreciation tell a different story. There is a large segment of investors willing to pay market price for stable ever-increasing cash flows, and RIG has several more candidates to be dropped down in the near future with Deepwater Invictus as the most logical choice for the next dropdown.

Conclusion: RIGP benefits RIG by maximizing the value of certain rigs with longer-term contracts and by providing an alternative financing structure to pay for newbuilds and modernize the fleet.

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.