Transocean (NYSE: RIG) has recently published form 424B3 - the details of its merger proposal for Transocean Partners (NYSE: RIGP). It's an interesting document and, of course, Transocean Partners' unitholders should read it to decide whether they vote for or against the merger on November 11.
For others, the document is a unique way to look at what companies and their financial advisors actually think about the current market situation. In order to arrive to an ultimate merger proposal, financial advisor has to value both companies and Transocean and Transocean Partners should bargain to obtain better conditions for their shareholders.
In the comments sections of previous articles here on SA many Transocean Partners' unitholders expressed their grief related to the merger. In short, the common thesis could be formulated this way. Transocean Partners unitholders are offered to trade shares of a debt-free company which pays a regular distribution for a debt-laden driller with plenty of stacked rigs and no dividend.
The offered premium (15%) seemed too low for Transocean Partners' unitholders. The form 424B3 revealed that the initial premium offered by Transocean was 5%, while Transocean Partners' management demanded a 27% premium. Interestingly, in the process of bargaining, Transocean pointed to the fact that Transocean Partners' distribution was unsustainable.
The biggest problem for Transocean was the fact that Transocean Partners did not serve its initial purpose of a drop-down vehicle for Transocean's rigs. Oil prices crashed almost immediately after Transocean Partners was created, and Transocean was unable to unload rigs and debt to Transocean Partners at mutually attractive conditions. In this situation, Transocean Partners became useless and siphoned cash to outside shareholders.
While Transocean's reasons for merger are clear, Transocean Partners' motives for merger are constantly questioned by investors. In my view, the reason is simple - a company with just 3 rigs has no place in the future offshore drilling market. We have not yet seen any signs of a rebound, and the ultimate rebound may be slow and painful for small companies as dayrates will likely stay near lows for quite some time.
In this light, Transocean Partners could be forced to eliminate distribution in order to preserve company as a going concern. Distribution elimination will crash Transocean Partners' units on the stock market and shareholders will suffer material losses with muted prospects for recovery.
The most intriguing part of the filed prospects is the quantitative valuation part by the financial advisor, Evercore. The company has prepared two cases - the base case and the sensitivity case, which should reflect a more negative scenario. In my view, the sensitivity case was not negative enough to be considered seriously, so let's focus on the base case - the company's base view of the future. Here's how it was presented by Transocean:
1. Current market cycle is assumed to last through 2017 with little recovery in dayrates.
2. Dayrates begin to rise in 2018 and ramp through 2021 to Transocean management's view of normalized dayrates.
3. Rigs are assumed to operate at contracted rates through current contracts, then rigs work at market dayrates.
4. Cold and warm-stacked rigs are reactivated through 2020 with a run-rate fleet of 54 operating rigs and 8 cold-stacked rigs.
In my view, this is an optimistic picture rather than a base-case view. For dayrates to begin rising in 2018, jobs should start increasing in 2017. Currently, there are no signs that the number of new jobs will outweigh the number of rigs that roll off contracts in 2017.
This condition is the first obligatory step for dayrate improvement. If more and more rigs are available for work, why dayrates will ever increase? Transocean's view of a run-rate fleet at 2020 is also optimistic given the fact that the company has almost thirty stacked rigs.
Now let's look at Evercore's valuation of base-case scenario for both Transocean Partners and Transocean.
1. Discounted cash flow analysis $8.08 - $10.67
2. Discounted distribution analysis (CAPM model) $10.55 - $14.28
3. Peer group analysis $11.48 - $19.66
4. MLP premiums paid analysis $12.58 - $13.97
1. Discounted cash flow analysis $5.19 - $26.94
2. Peer group analysis $0.57 - $25.01
Here you can see a classic example why fundamental analysis is as much art as it is science. What actionable idea do you get when looking at the results saying that the stock should likely be valued in the $0.57 - $25.01 range?
This also illustrates what I believe is the key point behind the opposition to the merger - Transocean Partners' unitholders are offered to trade a lower uncertainty situation (3 rigs on contracts) to a bigger uncertainty situation (many rigs, multiple variables and possible scenarios).
Evercore's results will certainly interpreted by some investors as a sign that Transocean's offer was too low. However, I would like to highlight that numbers rely on a base-case scenario, which could be too optimistic. Also, the numbers do not show the market's possible reaction to the distribution cut or elimination if challenging market conditions persist.
The recent Transocean's transaction, the $600 million bond offering, received a 7.75% interest rate despite having a new rig on a very long-term contract as a collateral.
While being a necessary move for Transocean, the bond offering reveals the true state of the offshore drilling market and the fact that lenders don't see any contracts as immune to termination (in contrast with Transocean's base-case scenario, which implies that all contracts will not be terminated).
In my view, Transocean Partners' unitholders got a chance to get out of a potentially risky investment at a rather attractive level after collecting multiple cash distributions. Most likely, a decent number of Transocean Partners' unitholders will not like the idea of staying invested in Transocean and will sell its units before the merger. At the same time, the merger definitely looks good for current Transocean shareholders due to increased cash flow from 3 rigs and decreased G&A costs.
One of the most interesting things to discuss remain actual views of Transocean's management on the prospects of the offshore drilling market.
The company states that its base-case scenario implies improving dayrates in 2018 yet rushes to finance the new rig at a 7.75% rate. I hope we will hear more from Transocean's management when the company reports its third-quarter results on November 2 after the market close.
In all, I believe that the merger is a rather good deal for both parties and that it will actually happen because market conditions dictate the logic of the merger.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.