Fitch Downgrades Transocean's Credit Rating, Should You Care?

| About: Transocean Ltd. (RIG)
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Summary

Fitch downgraded Transocean two notches with a negative outlook.

Transocean bonds are up 30%-50% since a three-notch downgrade by Moody's in February.

Should investors care?

The short answer is "yes", as an investor one should actively seek to understand the rationale for credit upgrades and downgrades. However, from the standpoint of market timing, rating agencies are typically very late as evidenced by Moody's three-notch downgrade in mid-February at the trough of bond prices.

Fitch may not fair any better but only time will tell. For now, what investors should do is evaluate merits for Fitch's downgrade, so let's delve into the most important aspects of the downgrade.

1) Fitch thinks net debt/EBITDA will be 5.7 times in 2017 and will remain around 5.5 times through-the-cycle

2) FCF profile will be largely cash-flow neutral in 2016-2017

3) Dayrates on high-spec sixth-gen equipment will average $275k/day

4) No dropdowns to RIGP

5) An option to improve liquidity with secured debt

6) Stabilization in dayrates and utilization expected in the second half of 2018

I obviously have my own views, which is why our managed accounts have significant amounts of Transocean's (NYSE:RIG) 2016-2018 debt. I don't believe there is anything that could threaten RIG's ability to pay off its debt at least until 2020. More so, the current capex schedule should help RIG decrease net debt towards $5 billion at the end of 2018 and further in 2019.

Given those assumptions, RIG's EBITDA in 2017-2018 must decline towards $1 billion to have a net debt/EBITDA ratio above 5.5, which is the primary reason why Fitch and Moody's have downgraded RIG's debt.

My current 2016 EBITDA estimate is $1.65 billion whereas my 2017-2018 EBITDA estimates are very conservatively at $1.1-1.2 billion. I see upside risks to my 2017-2018 numbers, but for now, that's my base case scenario. These numbers basically assume that Transocean will have only 20-22 floaters operating throughout 2017 and 2018, implying 60% of the fleet being stacked or idle for the next 30 months.

2016 2017 2018
$ billion $ billion $ billion
Rev 4.01 3.16 3.45
OPEX + G&A 2.35 2.06 2.25
Depr 0.87 0.89 0.93
Int 0.35 0.35 0.32
Tax 0.16 0.11 0.11
Min 0.03 0.03 0.03
Income 0.25 -0.28 -0.19
Capex 1.42 0.55 0.31
FCF 0.02 0.41 0.44
Debt year-end 7.3 6.6 5.5
Cash year-end 1.3 1 0.4

The table above shows my current base case assumptions. Interestingly, these assumptions do not differ substantially from Moody's and Fitch's current analysis. However, unlike the rating agencies I believe the current offshore drilling macro environment is depressed beyond reason.

The world discovered only 20% of oil it consumed in 2015 and sooner or later the market will have to react to these unsustainable discovery rates. Exploration has to be resumed, otherwise, the price of oil will shoot higher as reserves deplete further. These developments won't help offshore drillers in 2016 or in 2017, but starting with 2018 and especially as we enter the new decade, there will be a pressing need to restart offshore drilling to satisfy increasing demand.

RIG's current stock valuation is probably fair given 2017 and 2018 EBITDA projections, but there is potential upside once industry trough is passed. The million dollar question is when and there are various opinions on this matter. I think the price of oil will start discounting lower levels of supply as early as mid-2017 implying that offshore drillers will see higher utilization and ultimately higher dayrates by early 2018. It's been a rough ride since late 2013 and it may last another 12-18 months, but now there is clearly a light at the end of the tunnel.

Disclosure: I am/we are long RIG, RIG BONDS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.