The majority of readers already know that Transocean (NYSE:RIG) agreed to sell 15 jack-ups to Borr Drilling. While Transocean itself has been surprisingly silent about the issue and offered no press release, news releases from both Borr Drilling and the Keppel FELS, the yard making Transocean newbuild jack-ups, confirmed the deal.
I have covered the news right after it went public on March 20. My quick take was the following: "At this point, I'm almost sure the deal won't be an upside contributor, but whether it could be a downside trigger remains to be seen".
Several days passed since the news went online, and both your author and the market had the time to think about this important development. In this article, I will lay out my thoughts on what this sale means in the short term, long term and how the deal will impact the industry and Transocean competitors.
The essence of the deal
A quick reminder: Transocean sells 10 existing jack-ups and 5 jack-ups under construction for a total consideration of $1.35 billion. These are existing jack-ups:
And these are newbuilds:
In its most recent 10-K, Transocean outlined total costs of all its newbuilds. Please notice that as a result of this deal, Borr Drilling will pay $216 million for each jack-up. The original price was $219 million. Later, Transocean agreed to pay more in order to delay jack-up delivery to 2020. Thus, Borr Drilling is paying $1.08 billion to the yard while Transocean gets rid of $1.14 billion of remaining newbuild obligations. As of December 31, 2016, Transocean has already contributed $280 million to the construction of newbuild jack-ups.
As the total consideration of the deal for Borr Drilling is $1.35 billion and Borr agrees to pay $1.08 for 5 jack-ups, the cash consideration for Transocean should be around $270 million. This is roughly the sum that Transocean already contributed to newbuild jack-up construction. In my view, this is no coincidence. In essence, Transocean agreed to give up all its high-spec jack-up fleet to completely reverse its deal with Keppel, as if it never ordered any jack-up from the yard.
The rationale for the deal as I see it was to sacrifice the jack-up fleet in order to get rid of future payments and get some money. This may seem a bit strange given the number of rigs involved, but when we look at the actual backlog details, we see that the jack-up segment was not a big deal for Transocean:
Given the recent transaction and the state of the market, I continue to expect that Transocean will gravitate towards the state where the company will have only UDW and HE floaters and other rigs will be gone through scrapping or selling.
How much rigs are worth?
This is a tricky question that deserves additional attention. The easy way to come up with valuation is to subtract the amount that Borr Drilling will pay to the yard from the total consideration and arrive to the conclusion that 10 jack-ups were worth $270 million. Then by simple math you arrive to $27 million per rig. Simple, but wrong.
The problem with this method is that it assumes that the price that Borr Drilling pays to the yard is a fair price, Quite obviously, it is not, due to the current market downturn and the lack of any prospects for newbuild orders for years to come. It is important to understand that the $216 million per newbuild rig is subsidized by the discount on the fleet of 10 jack-ups, which also have a contract backlog attached to them. In order to evaluate the deal, we should attempt to arrive to approximate valuation of the rigs rather than looking at stated price for newbuild jack-ups.
Previously, Borr Drilling, which was known under the name "Magni Drilling", purchased two jack-ups Hercules Triumph and Hercules Resilience for $130 million from Hercules Offshore, which was going through liquidation. Both rigs were built in 2013. It was surprising that the price exactly matched the $65 million that Ocean Rig (NASDAQ:ORIG) paid for the drillship Ocean Rig Paros. Nevertheless, that was a real transaction and it is an important data point by definition.
We should also keep in mind that the newbuild jack-up scene is crowded, and rigs are definitely not worth the same amount of money when they were ordered back before the oil price slump. I suggest that a 15% discount would be appropriate and I expect to see such a discount applied in future transactions (ultimately, someone will start buying all those rigs from yards). Perhaps, we will see even bigger discounts in future transactions.
Thus, each newbuild jack-up was effectively sold for roughly $180 million, with the remaining fleet selling for $450 million together with the backlog. Numbers seem to add up: imagine selling the 4 relatively new jack-ups for $65 million like in the previous Borr Drilling transaction, add about $60 million for the backlog and $120 million for the remaining 6 rigs. I don't insist that these numbers are necessarily precise, but in my view they should be close to reality.
Why we are doing these estimates when we could choose the easy way that I described above? The purpose of these estimates is to understand whether Transocean got a fair deal in current circumstances. Judging by the numbers, I arrive to the conclusion that Transocean got a normal deal given the current market environment. I would even state that Borr Drilling appeared to be a bit optimistic on pricing thanks to the money it was able to raise through equity offering. Now that Borr Drilling financed itself by issuing equity, it has the time to wait for the industry upturn.
Was the deal necessary?
So far, we have established two things. First, the essence of the deal was to trade the whole existing jack-up fleet to erase the previous deal with Keppel. Think of it as if Transocean got into a time machine, went back in time and eliminated the contract with Keppel right before it was signed by both parties. The cost of using this time machine was the jack-up fleet. Second, Transocean received a fair deal from Borr Drilling. The key to the pricing of the deal was Borr's ability to raise money through equity.
The next logical question is whether the deal was necessary at all. The deal is fair at today's circumstances. However, if you believe that offshore drilling will rise from the bottom and see the light of day again, you will view the deal as giving up on future opportunities. Transocean management sounded optimistic during the fourth-quarter earnings call, but now they acted as if they had a truly bearish assessment on the industry.
My interpretation of this sale is that Transocean felt insecure about its liquidity in the coming years as it will have to renegotiate the credit facility. The company has missed the perfect chance to sell equity at about $15 during the "window of opportunity" offered by the OPEC/non-OPEC deal. The desire to own equity was certainly present at the market. Even Atwood Oceanics (NYSE:ATW), a company that is in a significantly more difficult situation than Transocean, has managed to raise money on the market.
At a price of $15 per share, raising about $1 billion would have led to issuing 67 million shares or 17% dilution. This is a normal dilution that does not kill the stock as was evidenced last year by Ensco (NYSE:ESV). However, the company has either grim outlook for the jack-up market up to 2020 (which contradicts its public statement) or just missed the chance to raise equity and had to find another option as it felt pressed to improve the liquidity profile going forward.
I continue to believe that timing is not the best skill of the current management team, and I lean towards the explanation that Transocean missed the chance to raise equity but had to improve its financial condition before renegotiating credit facility.
Impact on Transocean
Note that the deal is yet to be confirmed by Transocean. If it goes as expected, Transocean will become a pure floater play. This should increase the volatility of the stock and could potentially lead to more upside in case Brent oil price breaks through $57.50. On the downside, current prices are insufficient to trigger any meaningful activity in the floater segment.
Transocean continues to be a part of the "survivor group" in the company of Diamond Offshore Drilling (NYSE:DO), Ensco, Rowan (NYSE:RDC) and Noble Corp. (NYSE:NE). The fact is that none of us has the crystal ball, and it's hard to evaluate whether the company gained strategically from the deal. Transocean received a fair price at the moment, so the impact on the current valuation is more or less neutral. The deal itself is hardly a value creator for Transocean and won't be an upside catalyst in the near term. The company needs upside in oil to see upward movement in its shares.
Impact on the industry
This deal is clearly another negative for the beaten offshore drilling industry. Remember, a few years ago when the oil downturn just started, we were talking about which company will be acquiring distressed assets from its poor competitors. The industry needs consolidation to improve efficiency and gain pricing power.
Unfortunately, the opposite is happening. New competition is emerging and buying assets from established players. This new competition manages to raise money through equity, meaning that existing drillers with all their chronic debt load problems will have to compete with debt-free firms. This is just bad.
Additional pressure on dayrates in the jack-up segment could not be ruled out. Companies with jack-up exposure like Ensco, Rowan, Noble Corp. and Seadrill (NYSE:SDRL) will certainly feel the presence of a new competitor in due time.
For Transocean and another floater player, Diamond Offshore, the big risk is that Pacific Drilling (NYSE:PACD) and Ocean Rig will emerge out of their restructurings debt-free or almost debt-free, putting additional pressure on the floater segment.
So far, the situation is developing according to the worst-case scenario. Oil is trading around $50 with the continuation of OPEC/non-OPEC deal under question. Majors favor shale investments over everything. Ongoing restructurings in the industry may lead to emergence of debt-free companies with new fleets. Scrapping pace is insufficient while newbuilds wait in yards, ready to be picked up by new competitors. No consolidation happens as key players are plagued by debt load and have to put balance sheet first, everything else second.
In short, I continue to view the whole industry as a great vehicle for speculative activity due to its volatility and a number of interesting stories at individual stocks. As for the longer term, I would like to see actual "green shoots". Objectively speaking, the news we are getting this year from majors' rush to shale to establishment of new offshore drilling competition is troubling.
Disclosure: I am/we are long DO.
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.
Additional disclosure: I may trade any of the abovementioned stocks.
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