Transocean: Capped Upside

Summary

• Transocean made a couple of deals in 2017 that weren't supportive of the market leader status in deepwater drilling.
• The company lists some of the best contracts in the floater segment though the analyst estimates aren't reflecting this positive scenario.
• All boats should rise with a market recovery in 2018, but the upside in Transocean is capped.

Typically, market reactions to mergers are misguided. Mergers after a long rally in a sector can signal a desperate move to maintain growth. The market can send the related stocks higher though the reality is that the buyout company is overpaying at peak prices. On the flip side, a merger of two companies in a weak sector can be sold off assuming the worst for the new entity though consolidation helps reduce competition and usher in a sector recovery.

The question is whether Transocean (NYSE:RIG) falls into the second category with the deals made in 2017 at the cycle low. The prime focus is on the purchase of Songa Offshore SE for $3.4 billion, including assumed debt. The offshore driller stock had been in a major downturn since 2013 before fluctuating the last couple of years around $10 set up a major breakout, if Transocean got the deal right.

Disappointing Deals

Transocean actually dipped initially following the deal before the stock rallied for the next couple of months. The company paid a large sum for the rigs in a weak market suggesting Transocean won't actually see the benefits with book value per share taking a hit.

The biggest problem with a recovery in the deepwater sector is that shale drillers are willing to sell oil at below $50/bbl. At the time of the deal, RF Lafferty was bullish on Transocean with a $15 price target that still offers over 50% upside half a year later. Analyst Jaime Perez acknowledged that oil prices are the biggest problem:

...the key component in planning for long-term offshore projects is the price of oil. We are seeing signs of operators planning to restart their offshore projects but we believe that they may delay sanctioning projects if oil continues to fluctuate below $50 per barrel.

The recent stability of oil prices over $60/bbl and the recent consolidation in the industry that includes the Ensco (ESV) acquisition of Atwood Oceanics sets up an industry for recovery, yet the stock isn't rallying in part due to the deal to dump jackup rigs for next to nothing and pay the premium price for Songa Offshore.

A big part of the problem is that deal didn't seem to accomplish the goal of consolidating the industry to where rigs are taken off the competitive block to help improve day rates. Songa Offshore has a backlog of around $3.7 billion now primarily attributable to four Cat-D harsh environment rigs under long-term contracts to Statoil ASA (STO).

Source: Transocean Energy Summit presentation

Sure the deal effectively increases the backlog of Transocean to $12.8 billion in February after closing the transaction, but the offshore driller is buying specific harsh environment rigs all contracted to one customer. Not only will these rigs not participate in any recovery, but the risk is that Statoil finds a way to exit the contracts via performance issues.

As one can see from the annual backlog chart, Transocean bought Songa Offshore to solidify the backlog levels from 2019 through 2023. All four rigs have dayrates in the $450/k range. The gigantic risk is that Statoil isn't so compliant and the energy giant becomes a nearly 50% customer in these key years.

Even worse for Transocean shareholders looking to participate in an industry recovery as speculated by RF Lafferty, this deal caps the upside potential. Instead of buying depressed assets, Transocean actually paid market values for these four rigs with a price of $3.4 billion including assumed debt equating to $850 million per rig. Of course, this assumes the other three rigs provide no value.

On the other side of the scale, Transocean sold the jackup fleet to Borr Drilling and took a $1.59 billion charge on the divestiture. The deal was announced in March 2017 at the trough of the oil market. The deal price was listed at $1.35 billion with Transocean obtaining $320 million in cash for the deal, but the offshore driller gave up $155 million in backlog and previous payments for the five jackups under construction in excess of the net cash received (via Fun Trading).

In essence, Transocean dumped 10 rigs at a negative cost in order to save ongoing maintenance costs. One has to assume the offshore driller would obtain a far better deal now.

Going Forward

What matters is the going forward operations that now consists of 47 floaters. The Q4 results weren't promising with a revenue efficiency rate of only 92.4% and a sharp $110 million sequential decline in revenues. Business was still far from reaching a bottom though oil prices rebounded.

The addition of Songa Offshore brings analyst revenue estimates for 2018 up to $2.9 billion. The company though is still expected to produce sizable losses which again begs the question why Transocean made the Songa Offshore deal at market prices, especially considering the suggestion that RIG already has the best contracts in the industry.

Source: Transocean Energy Summit presentation

The analyst estimates don't suggest Transocean is any better than other offshore drillers despite having these top notch contracts. If anything, this prevents the company from obtaining the new deals as the market improves that do offer upside. A lot of these contracts are already at dayrates of $500/K and locked in long term.

RIG EPS Estimates for Next Fiscal Year data by YCharts

Takeaway

The key investor takeaway is that the deals only appear to cap upside while shifting the risk to include customer concentration. Transocean already proclaims to have the best contracts in the floater category so my goal is to review the combined Q1 results and Q2 guidance to see where the company is on the operational side.

Similar to other offshore drilling stocks, Transocean trades far below book value. The stock will rally toward book value as the market improves, but these deals only appear to cap the upside going forward.

Analyst’s Disclosure: I am/we are long ESV. 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.

The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.

Comments

[Mike112]

well I hate to burst your bubble as I am a 101 year old or am I a just a 12 year old.
Well we can be anything you want on this post so what does it matter what you say. You could also be pushing another stock for your own reasons.
Who knows and who really cares.
What you said doesn't matter to me or a lot of other RIG investors who wholeheartly invest our hard earned money into RIG because we know it will be going significantly higher in the not too distant future. Take it or leave it but grow thicker skin when someone disagrees with your negative review of any stock you want to talk down.
Why don't you pick a stock you want to buy and then talk positively about that stock.
But your probably one of those short buyers, hence the negative reviews.
Have a nice life...

[Bulldog67]

Mike,

Did I bruise your 101 year old ego or your 12 year old ego by challenging your statement about "best in class"? Sounds more like the 12 year old ego based on your reaction.

Hopefully you will learn to value those comments that differ from your opinion as a chance to rethink or evaluate your own opinions. I love to hear when someone has a different opinion than mine - and I often learn from that experience! RIG may become the best stock on the NYSE for the next 3 years, but if you go back and re-read my comments, maybe I at least gave you some food for thought. So may I suggest you are the one who should grow a thicker skin and take opposing opinions as a learning experience rather than as an insult. When other posters make strong statements, I often just want to see their thinking.

Still waiting to hear your reasons behind your "best in class" statement. (Besides the stock is going up!) :-)

And I sincerely hope you make it a great day (and have a nice life)!

[trump1]

BD,

Here are my thoughts. DW drilling will be affected by Permian production growth. Currently, the IEA has a very high production estimate that most question. The concentrated drilling of the sweet spots is the most economical oil to be had. Are the sweet spots drying up? If yes, cost per barrel will rise. If Permian production is capable of rising at such a fast rate will talent be the bottle neck? There is a shortage of truck drivers currently. Pipeline construction is a must to meet growth capacity. What are the odds that the pipelines will be completed in time?

I think infrastructure bottlenecks, talent shortages, and sweet spot depletion, must all be solved to meet the IEA forecast. In watching some CeraWeek interviews these three issues came up and XOM and PXD did not seem to speak with confidence when addressing these issues. What are your thoughts and have you tuned into CeraWeek at all?

NOTE: One of the speakers, I don't remember his name, said trucking oil from the Permian to Cushings adds $12 to the cost of a barrel of oil.

What are your thoughts? Thanks in advance!

[Bulldog67]

trump1,

You are learning that many OSD investors take the "Ostrich Approach" when it comes to onshore oil and gas production (both shale and conventional). "Hear no evil, see no evil, speak no evil" .....and it will go away!

Clearly if one reads or listens to the E&P presentations, more dollars are being directed to onshore production. The main reason is that there is a quicker payback, and that helps with cash flows and dividend coverage for the majors. OSD, especially the UDW area, entails many more up front costs, and the payback can be up to 7-10 years.

Now I am not in the camp that believes "OSD will never return". Clearly, with past production of up to 30% of total oil needs, it is not going to go away. I also believe in time it will recover. Where I disagree with the OSD bulls is on timing, as I think it will likely be a late 2019 event or later - maybe even 2020 or 2021. My reasoning: 1) onshore production is continuing to ramp up and is taking a larger percentage of E&P budgets - meaning less money for UDW & 2) Given the huge number of idle rigs, I believe it will take longer for supply & demand to return to balance thus causing day rates to rise to profitable levels.

A couple of years ago I sold all my OSD holdings, and have actually made some good profits on the short side since then. For example, I made good money shorting NE & RIG when they ran up in sympathy with rising oil pricing earlier this year. I have in the past year moved my energy money into the pipelines where I am getting paid very nicely with their distributions. As you correctly pointed out in your comment above, there is a shortage of necessary pipelines, some storage, and processing of oil and gas.

Obviously the biggest negative with shale production is the rapid decay rate of new wells. However, advances in technology are lengthening those decay rates, and allowing reworking of existing wells to produce more oil and gas.

I am waiting comfortably collecting my high yields while patiently waiting for an opportunity to re-enter the OSD area. However, I am in no hurry and will admittedly be "late to the party"!

Keep asking those excellent questions of the SA community!

[WhyNotBuy]

The chess master and his competitor have exactly the same chess pieces. Yet one rises to victory as the other falls. What constant in this equation remains undefeated. It is the skill of the management team - so any analysis must consider this as a checkmate key. I have placed my bet on Adam Peakes at NE as the Chess Master, knowing well that a worthy match can outlast time itself. Do not waste the time between moves. Accumulate brothers before the clock ticks and tocks along the up cycle thus marking the end of this chapter of the dollar war. IMHO

[trump1]

Interesting interview with CEO of Total. He makes some interesting points on what a short cycle play is. Its really about how contracts are written to allow for the start up and shut down of a project in a timely manner. Enjoy.

Special Dialogue with Patrick Pouyanné, Chairman of the Board & CEO, TOTAL S.A.

http://bit.ly/2D8Fs01

[trump1]

I recently listened to the CeraWeek discussion titled "North American Oil: The supply disrupter with Timothy Dove". I found it very interesting especially regarding the need for infrastructure to support shale growth (Pipelines, talent, refineries etc.). I provided a link below for those interested in listening to it.

http://bit.ly/2G2woN2

[Bulldog67]

trump1,

Thank you for including the above link. It was a very interesting discussion, and as an owner of some of the pipelines, I found it of great interest!

[jacht]

Absolutely right...best case for RIG is a bunch of high margin rigs with a concentrated client. Worst case scenario they don't participate in the oil market upswing.

[trump1]

* TRANSOCEAN CEO SAYS THE RIG FIRM COULD HAVE $5-6 BILLION IN LIQUIDITY IN 2019, ALLOWING IT TO EXPLORE STRATEGIC OPPORTUNITIES

[HelloCash]

I read that from reuters. But what is the source of this statement?

[trump1]

Thigpen said in conference call liquidity at end of 2019 will be 2.2 - 2.4B add that to revolver of 3B and you arrive at 5.4B in liquidity.

[Stone Fox Capital]

trump,
Don't need liquidity to explore strategic opportunities. Can always use stock. Besides do you really want $RIG buying some more assets at premium values?

[brendan37]

esv is in worse shape than rig. too much debt and for esv's sake they better hope for increased prices very soon or else... rig is the offshore driller and thats the bottom line.

[Stone Fox Capital]

$RIG is the offshore driller with capped upside....basically summed up my article with that comment.

[Bulldog67]

Brendan,

Actually if you looked at their balance sheets, you would discover that RIG is more leveraged than ESV (total debt / capital of 43.0% for RIG compared to 40.3% for ESV). Also ESV has done a great job of extending their debt (RIG has also). ESV does not have any meaningful debt coming due till 2024.

Since RIG has more older rigs (than ESC) that need to be retired, RIG will incur more impairments in the future than ESV. That means more equity wiped off the BS, further leveraging the company.

Your comment: "for ESV's sake they better hope for increased prices very soon or else." Same holds for RIG!

[trump1]

RIG has a more guaranteed revenue stream because of their backlog. Backlog is what allows you to weather the storm longer. ESV is lacking backlog and has lots of old iron.

[Henrik Alex]

Good article but the Borr Drilling jackup deal is mischaracterized here, most likely because the author is referring to another author who got the transaction mostly wrong.

"In essence, Transocean dumped 10 rigs at a negative cost in order to save ongoing maintenance costs. One has to assume the offshore driller would obtain a far better deal now."

In fact, Transocean was more or less forced into this deal to get rid of $1 billion in newbuild obligations with Singapore-based shipyard Keppel FELS as the company is still negotiating with its lenders to extend its currently undrawn $3 billion revolving credit facility (due in early 2019). There would have been no chance for an extension with these payment obligations kicking in right after the new facility would have been put in place.

In order to unload the material newbuild obligations for five new jackup rigs to Borr, Transocean had to sweeten the deal by adding its existing jackup fleet, otherwise Borr wouldn't have been interested.

While it is true that Transocean might have been able to sell its existing jackup fleet at a somewhat higher price, the company never had an option to do so. Either they would have been left with those heavy newbuild obligations and faced non-renewal of the credit facility next year or agree with Borr's conditions.

Even today, this deal would not look much different from a pricing perspective given the newbuild obligations involved. There's basically no other driller than Borr in the market that could afford a transaction of this size, so they determine the price. Particularly as there were so many stranded jack-up assets readily available at the time of the deal (and still are, just look what Borr has accumulated over the past few quarters).

In sum:

Transocean had no choice. The deal wasn't done to save some immaterial maintenance costs but to get rid of the newbuild obligations. In effect, Borr purchased 15 rigs from Transocean (10 existing, 5 newbuilds).

Lastly, the remaining backlog of the fleet didn't go to Borr. Transocean remained the beneficiary.

[Taymere]

Henrik, Thanks for shedding light on that. There is more useful 411 in your short comment than in the entire article.

[Bulldog67]

Henrik,

I am glad you caught that as I was going to comment. Your comments are spot on - needed to get rid of future CapEx liabilities in order to renew the credit line. While the expiration of their credit line is a little over a year away, I would think that RIG wants to get it renewed ASAP.

Also think buying the backlog associated with Songa was to help in renewing LOC, given they bought cash flow over the next few years. Otherwise, why pay such a high value for the 4 working semis from Songa - turned over about 30% of ongoing company to Songa shareholders.

[trump1]

For 2017, IEA had 95.58 million b/d, when the actual demand figure was 97.9 million b/d. That's a delta of 2.32 million b/d.

For 2018, IEA had 96.68 million b/d, when IEA's own forecast is for 99.1 million b/d this year. That's a delta of 2.42 million b/d.

IEA perennially underestimates global oil demand growth, and as a result, the supply/demand forecast in the years ahead is usually always skewed to the downside (for price).

This means lack of upstream capex => supply deficit on the horizon.

[canyonwlf7]

Correct

[trump1]

Insiders buying big time. =)

http://bit.ly/2FkXY6U

[Bulldog67]

trump1,

You might want to look at the SEC filings before stating that insiders are buying big time. According to the SEC reports, Thigpen and others received stock under LT incentive plans. They then turned around and sold part of their new stock to pay their tax liabilities.

The only actual true purchase by an insider was by Frederik Wilhelm Mohn who bought 1 MM shares on March 1st and another 1 MM shares on March 2nd. It also appears that Perestroika bought 2 MM shares until you read the footnotes. They clearly point out that Mr. Mohn is holding his shares within a fully owned company named Perestroika.

Thus in reality, only one insider, Mr. Mohn, bought 2 MM shares of stock on the open market. While that is clearly a vote of confidence by one director, I would not classify it as "insiders buying big time"!

[instanton]

Of course, everybody knows that Frederik Mohn did formerly own 45% of Songa Offshore. 3rd generation in one of the richest families in Norway.
He certainly made a big fortune with selling Songa Offshore. Rumor tells, he started with a huge fortune to begin with.

[trump1]

Agree. I jumped the gun on that one. I have no problem admitting when I am wrong. It would be nice to see others admit when they are wrong.

[trump1]

Long-suffering investors in shale remain jumpy, alert for any indication that the industry may be faltering. Last week Houston-based Carrizo Oïl & Gas reported problems including more water than it had expected being produced along with its oil in the Permian, and a cut in the expected recovery from its wells in the Eagle Ford.

[Mike112]

author is long ESV - No wonder he is so negative on RIG.
RIG has been and is still best in class and best buy going forward within the offshore drilling industry.
All that is needed is oil companies to start drilling offshore once again which they most definitely will or there will be a massive shortage worldwide because shale can not achieve the finds and production levels needed to prevent it.

[canyonwlf7]

Mike gets it

[Bulldog67]

Mike,

"RIG has been and is still best in class."

Would you please share with the rest of us the specific analysis you did to arrive at that conclusion?

Could it possibly be their balance sheet? NO! Compared with RDC, DO, ESV, and NE, RIG has the 4th most levered BS, ranking just above NE.

Could it be the quality of their fleet? One has a weak argument here given that a good percentage of their fleet is close to retirement.
47 total rigs (not counting the 2 JU's that have been sold nor the 2 NB's that don't have a date for completion) - 23 rigs are less than 10 years of age; another 7 rigs are 10-18 years old, and 17 rigs in their fleet are more than 18 years old. Lots of old iron, several of which will most likely never work again.

Could it be fleet utilization? Nah, hard to argue this with 2 idle rigs and another 17 stacked. Thus 19 out of 47 rigs (40.4% of their fleet) is currently not working.

Could it be that you are saying their earnings power will return to the $10+ per share we saw 5-6 years ago? Nah, that can't be it as RIG had 127 rigs in those days, and most were working at day rates we will likely not see for years, if ever. Currently maybe 35-40 competitive rigs versus 127 rigs a few years ago means RIG has a substantially reduced earnings power, even when day rates increase. Also don't forget that management gave Songa shareholders about 30% of the ongoing business (equity plus convertible bonds when converted into equity) in that merger. Means a lot more shares outstanding.

Could it be backlog? Bingo! I will give that one to you as RIG has bought the largest backlog in the industry.

Now does having the largest BL in the industry make one the "best in class"? ESV might disagree with you since that company was just rated the #1 offshore driller for the 8th consecutive year in an independent customer satisfaction survey.

So Mike, I anxiously await your analysis as to why you think RIG has been and still is best in class.

[User 39328056]

Great comment BD! I appreciate your insights. What are your thoughts on DO? If we ever see the end of this downturn it will be interesting too see how DO/Loews decide to renew their fleet.

[trump1]

EVs blah, blah..... Did you forget electricity is produced with fossil fuels? Unless you know lots of solar powered electricity plants?

[ckarabin]

Offshore will never come back! Too much equipment chasing too few drillers. As long as shale can keep increasing output and without the risk on long term variability in oil prices, then few will take the risk of drilling multiyear projects where you can never be sure what you will get for the production. Face it, offshore is just too risky now compared to shale.

And that only gets worse if EV's start to replace gasoline and global demand starts to peak out. Who wants to be stuck with a bunch of long term projects that produce at high cost when the oil market peaks out forever?!

[trump1]

In 2015, shale oil producers on average used 3,300 tons of sand per well, according to Petronerds, a consultancy. By last year, that had almost doubled to 6,100 tons per well. Delivering that much sand to the well site requires up to 250 truck movements.

[canyonwlf7]

Where would you suggest the world replaces 30% of supply (offshore)? It won't come from Shale (6%), EV will have no significant effect for decades, Offshore is coming back, its naive to think otherwise, are you a millennial? I bet you are!

[Stone Fox Capital]

cka,
Offshore is already coming back, but shale and EVs are definitely threats. Still doubting that shale can grow market share significantly beyond current levels as wells deplete fast.