- 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.
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.
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.
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.
This article was written by
Stone Fox Capital (aka Mark Holder) is a CPA with degrees in Accounting and Finance. He is also Series 65 licensed and has 30 years of investing experience, including 10 years as a portfolio manager.Mark leads the investing group Out Fox The Street where he shares stock picks and deep research to help readers uncover potential multibaggers while managing portfolio risk via diversification. Features include various model portfolios, stock picks with identifiable catalysts, daily updates, real-time alerts, and access to community chat and direct chat with Mark for questions. Learn more.
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