Transocean's Value Proposition: Leading Driller Stays Afloat By Going Deepwater

| About: Transocean Ltd. (RIG)
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“The night is always darkest just before the dawn.” Yes, it’s a Spanish proverb and now a famous quote from a 2008 movie, but also something Steven L. Newman, President and CEO of Transocean Ltd (NYSE:RIG), might have thought to himself on several occasions after the April 20, 2010, explosion of the Deepwater Horizon, a 9-year-old semi-submersible mobile offshore drilling unit owned by Transocean, while operating on the BP-owned Macondo well in the Gulf of Mexico (GoM).

According to government reports published January and September 2011, the US government’s oil spill commission blames BP Plc and its partners for making a series of cost-cutting decisions and for failure to properly ensure well safety. It was also concluded that the spill was not an isolated incident caused by "rogue industry or government officials," but that "The root causes are systemic and, absent significant reform in both industry practices and government policies, might well recur."

In the days leading up to the disaster, BP made a series of decisions that complicated cementing operations, added risk, and may have contributed to the ultimate failure of the cement job. Transocean, responsible for conducting safe operations and for protecting personnel onboard as owner of the rig, and Halliburton (NYSE:HAL), which did the cement work on the Macondo well, also shared some of the blame, according to government findings.

A lot of speculation has arisen in recent months on a possible settlement between BP and Transocean between now and the February 27, 2012, trial date for the Gulf oil spill, but for the time being it’s indeed nothing more than market chatter and Transocean remains quite clear on its position with respect to the indemnity provision in the drilling contract with BP. This is what Newman recently said on the matter: “We have a clear indemnity in the contract, and it’s important to put that indemnity in context. That indemnity is a part of the contractual agreement between Transocean and BP... It reflects what risk we re-price in the marketplace, and many of those points we’ve made in our filing for partial summary judgment, which we submitted to the court on November 1... If BP fails to honor its promises, it doesn’t live up to its obligations, if the service community can no longer rely on the contract, it will have an overnight impact on offshore E&P. The cost structure will increase dramatically and only the largest companies will participate if we cannot quantify the risks, and I don’t think anybody wants that to happen.”

Turning to the operational side of the equation, it’s evident that Transocean’s business has been seriously impacted during the year and a half following the spill, clearly reflected in Transocean’s current market value. The real question of course is if the current share price is also a proper reflection of Transocean's ‘normalized’ earnings potential. In order to make a proper determination we require a fair approximation of Transocean’s underlying earnings power and we need to look at the major reasons for present-day earnings and market valuation to determine if these are temporary in nature or have fundamentally affected the investment thesis for Transocean for the long term.

Past performance is never a guarantee of future returns, but when you realise that $12.92, $13.41 and $12.53 were the EPS-numbers for 2007, 2008 and 2009, it’s safe to say the world’s leading drilling contractor has been significantly underperforming ever since April 20, 2010. EPS for 2010 came in at $5.68 and for 2011 the expectation is somewhere around $1.85, with $1.22 EPS from the nine months ended September 30, 2011, and a 4Q2011 consensus estimates ranging from $0.30 to $0.65.

An initial drag on earnings was the US government’s moratorium on deepwater exploration and drilling in the GoM following the Deepwater Horizon explosion and oil spill, which lasted through mid-October 2010. It took until March 2011 before activities in the GoM resumed in earnest, which was related to the issuance of new regulatory requirements and initial hesitation by the government to issue new drilling permits. Lost drilling time and opportunities in the GoM also resulted in activation of so-called ‘change in locale’ provisions, which are typically included in drilling contracts. This resulted in relocation of rigs to offshore projects in West Africa or Brazil, which takes valuable time, effort and expense.

Unfortunately the problems didn’t stop there. The US Minerals Management Services overseeing the offshore oil industry requires drillers to meet certain recertification requirements for the blowout preventer (BOP) on a drilling rig. According to Transocean, the Deepwater Horizon BOP underwent extensive inspections and maintenance on a regular basis, which were consistent with company policies and applicable regulations. However, it seems the BOP had not been ‘officially’ recertified after the 2001-2006 period as required. To be clear, Transocean employees testified that the BOP underwent pressure and function tests in the days preceding the explosion, including one the morning of April 20, 2010, that confirm the BOP was operating properly before the incident.

As a consequence, Transocean has seen a further reduction in near-term earnings and revenue efficiency (actual revenue divided by the highest amount of total revenue that could have been earned in the quarter) due to unusual shipyard costs and rig downtime. Often the critical path to returning a rig to service is heavily reliant on the support and performance of vendors and this has proved a serious bottleneck for Transocean this year. Transocean may be focused on developing a more collaborative relationship with its key vendors, getting more involved in their business and vice versa, but in the meantime rig downtime has been increasing as the entire industry is attempting to meet blowout preventer recertification standards and more stringent regulations. At the moment vendors are still building infrastructure and adding workers to meet increased demand from drillers.

Transocean’s most recent 3Q11 quarter was a perfect example of all this increased spending on BOP maintenance and overhaul activity. Among Transocean’s ultra-deepwater rigs, five rigs significantly underperformed: The Deepwater Expedition was taken out of service to overhaul the BOP, the Jack Ryan was undergoing significant maintenance to its BOP control system on location in Nigeria, the Discoverer Spirit generated lower revenue due to BOP repairs and undergoing mobilization to West Africa from the GoM, the GSF Explorer also underwent repairs to its BOP, and the Discoverer Enterprise was undergoing extensive acceptance testing by BP following being out-of-service earlier in the year. The Explorer, Spirit and Enterprise returned to operation rate in October, the Jack Ryan returned to operation in November and The Expedition earlier this month.

Interesting at this juncture is Transocean’s view on next year’s cost level and the status of its divestment program of non-core assets. 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, although next year’s shipyard expenditures will still remain at current elevated levels. 2012 operating and maintenance costs are estimated to be around $6.5 billion, compared with approximately $6.0 billion for the current full year.

The company is expecting non-core assets sales of $500 million to $1billion for 2012 and will continue to divest or spin-off assets to reduce its exposure to lower spec assets. Transocean is actively implementing a long-term strategy to focus on higher specification drilling by building and buying high quality floaters, jack-ups and long-term core workhorse rigs, and through upgrades on existing equipment. The company recently sold four rigs, some oil and gas properties and an interest in a joint venture. According to the company there remains significant interest from third parties to acquire its rigs.

The recent Aker Drilling acquisition, which closed October 2011, enhanced Transocean’s position in Norway, but also brought two heavy-duty ultra deepwater semi-submersibles to the fleet with about $900 million worth of contract backlog, and two ultra deepwater drill ships under construction in Korea. Along with the recent naming of the Transocean Honor, the first of four high-spec jack-ups under construction in Singapore, the company continues to increase its exposure to high-specification assets in what is clearly an improving market across all asset classes, especially in ultra deepwater.

Demand for both standard jack-ups and high specification jack-ups is improving, which is absorbing new builds coming out of the shipyard and is allowing reactivation of idle assets. The same improvement in demand can be seen in the mid-water market, with idle equipment being reactivated, utilization and day rates improving and increasing activity on the part of customers. The deepwater market is also starting to show signs of recovery, with higher day rates and increased demand coming from areas like Brazil, the Far East and Australia.

Ultra deepwater has been strong and continues to be a very attractive market. The limited remaining 2012 availability is quickly being absorbed in the marketplace and customers are already looking into 2013 and beyond. The ultra deepwater market is essentially fully utilized, with day rates exceeding $500.000 on occasion. Transocean’s current backlog is strong at over $23 billion and extends well into the future, with the vast majority of contract backlog coming from the high-spec floater fleet.

Transocean announced a $29.9 million equity offering (including $3.9 million green shoe) at $40.50 on November 29, 2011. Some shareholders were surprised to see this $1.2 billion share issuance, which implied an 8.5% dilution, as the initial expectation was that Transocean would issue a small amount of debt and use $3.3 billion cash on hand to meet its cash obligations of $1.7 billion for convertible debt due 4Q11, plus $1.2 billion for the Aker acquisition. But there are several good reasons for Transocean to have chosen this option, one being the company’s commitment to maintaining an investment-grade quality balance sheet “for the long-term benefit of the corporation that provides for financial flexibility ... to take advantage of opportunities when they materialize, and in a cyclical business it provides the Company with the sustainability through the cycle.”

The decision should also be seen in light of the fact ratings agency Moody's had put Transocean's credit rating under review, stating that Transocean ‘potentially’ could find itself ‘lacking financial flexibility’ given the Aker acquisition. After the equity offering Moody’s stated that “from a liquidity standpoint, when the recent equity offering proceeds are received in early December 2011, it will replenish most of the cash that was used to buy Aker Drilling, a transaction that closed in October 2011. Depending on the ultimate size of the current bond offering ($2.5 billion senior notes as we now know), RIG's cash balance could range between $2.2 and $3.7 billion, which provides some protection against an adverse outcome related to the Macondo well. RIG also has access to a $2 billion revolving credit facility that matures in November 2016.”

Apart from the credit rating, Transocean will have looked at this year’s disappointing revenue efficiency and unusually high rig downtime and cost level, and given the fact that shipyard costs will remain elevated next year, the company will want to maintain a higher than normal level of cash. Another reason will be ongoing Macondo expenses. Transocean’s historical cash position has been approximately $1 billion and speculation will continue that the additional $1-$2 billion could also imply a potential future settlement with BP.

Chevron (NYSE:CVX) had a minor oil spill last month off Brazil’s coast, with Transocean being the rig owner. Brazilian prosecutors have requested a court order to suspend Chevron’s and Transocean’s operations there permanently and Chevron has already been hit with a temporary drilling ban. Chevron has taken full responsibility for the spill and accused Brazil of overreaction since the beginning of the incident, as the Frade field spill was roughly 3.000 barrels, and there has been no impact on the coastline. Chevron’s Latin America chief Ali Moshiri made a point of commenting “I’ve never seen a spill this small with this size of reaction.” In the meantime Transocean’s rigs are continuing to operate in Brazilian waters.

On May 13, 2011 Transocean’s AGM approved a $3.16 dividend, to be paid in four installments. The third installment of $0.79 was recently paid with ex-date November 22, 2011. Recent investors assume that Transocean has historically maintained a similar quarterly dividend policy, but that is incorrect. The board will again decide on the dividend policy in February 2012, and if a dividend is maintained it could fall substantially from its current level of $0.79 per quarter, which is a 7.8% yield at current valuation. The company’s CFO Ricardo Rosa recently stated the following: "We have indicated that we are committed to a sustained dividend. But clearly we have to take all of the externalities into account."

When considering Transocean as an investment, you need to take into account the main competition, namely Ensco Plc (NYSE:ESV), Noble Corp (NYSE:NE) and Seadrill Ltd (NYSE:SDRL), with operational fleets of 71 units, 65 units and 48 units respectively compared with 135 units for Transocean (all numbers excluding newbuilds). Ensco has significant cost-cutting opportunities available following completion of its acquisition of Pride International on 31 May, 2011. Ensco is historically known for its cost-efficient approach, top-notch operating margins and a largely brand-new ultra deepwater fleet. The company has a current dividend yield of 2.8% and an attractive P/B of 1.1. Noble Corp took advantage of an uncertain rig market late last year to acquire Frontier Drilling, which greatly expanded its deepwater fleet at a reasonable price. Noble offers a solid management team, a current dividend yield of 1.6%, and a similarly attractive P/B of 1.1 like Ensco. All in all these two companies provide a good alternative for value investors looking for exposure in the drilling industry.

Seadrill, and its Chairman John Fredriksen - well-known from the recent Frontline (NYSE:FRO) saga - has been quite aggressive in leveraging the balance sheet, which along with a lofty P/B ratio of 2.5 may be a bit too rich for some value investors. On the other hand, a major selling point for Seadrill is the fact it owns one of the newest and most advanced rig fleets, which is of course a big plus post-Macondo. Increasing demand and a healthy credit market for drillers continues to support Seadrill's expansion, with earnings growth sustaining an attractive 9% yield. The key for Seadrill in the future will be to manage a growing fleet size, which has its own difficulties as we’ve seen, lower its debt-to-equity ratio once fleet size stabilizes, and keep a close eye on growing depreciation expenses and increasing operating and maintenance costs, like the other drillers. Seadrill announced earlier this month it may consider an IPO of its Brazilian subsidiary, Seabras Servicos de Petroleo SA, on the Sao Paulo Stock Exchange in the future.

Coming back to Transocean, we can now conclude that the company’s fleet size and the early move into deepwater drilling, with two-thirds of Transocean’s fleet coming from prior newbuild cycles, is now translating into relatively higher costs for the industry leader as its rigs need to meet tougher regulatory standards for equipment following Macondo. EPS will begin to rebound starting 2012 with net earnings per share of $3.30-$3.60, and expected $4.45-$4.85 for 2013. Although maintenance costs will remain elevated, the company is anticipating higher utilization in 2012 with a full year's activity for the Aker Drilling semisubmersibles. Transocean also expects that its annual effective tax rate will fall next year as profitability in certain low-tax jurisdictions improves.

Estimates on “normalized” EPS for 2012, without BOP shipyard costs and lost revenue due to rig downtime, are approximately $6.00, and expected to increase into 2013 and beyond. Current expectation is Transocean's Macondo-related indemnity with BP will continue to hold up in court and if some sort of out-of-court settlement would occur between BP and Transocean sometime next year every $1 billion would trim Transocean’s NAV by approximately $2.75 per share only, and could possibly prove to be a positive catalyst as it would remove some overhang from the stock.

Transocean currently sports a remarkable P/B of merely 0.6 and an average price target around the $60-$65 mark based on estimated EV of $31.5 billion and estimated 2012 EBITDA of $3.9 billion. Clearly the biggest argument against investing 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. Transocean is not for the impatient, but given current favourable relative valuation and the strengthening of Transocean’s long-term prospects, perhaps now is an opportune time to take a dip!

Disclosure: I am long RIG, ESV.