If finally got around to writing and analyzing one of my favorite holdings at the moment.
1 The Company
Transocean, by its market cap, is the second-largest offshore drilling contractor in the world. Transocean has as of April, 2010, 25 ultra deepwater rigs (plus 3 under construction), 16 deepwater rigs, 5 harsh environment, 25 mid-water floaters, 10 high specification jackups, 55 jackups and 2 swamp barges. Transocean rents floating mobile drill rigs, equipment, and personnel to operate them at daily rates to oil and gas companies at a daily rate. The average daily rate in 2010 was $282,700.
1947 - Southeastern Drilling Company (Sedco) founded in Texas, U.S.
1953 - Southern Production forms The Offshore Company to design and construct the world's first jackup drilling rig and merges The Offshore Company with Danciger drilling operations.
1984 - Schlumberger acquires Sedco.
1992 - The Offshore Company becomes Sonat Offshore Drilling Inc.
1993 - Sonat spins off its drilling subsidiary with an initial public offering of Sonat Offshore Drilling Inc. (SODI), based in Houston.
1996 SODI acquires Norwegian group Transocean ASA for US$1.5 billion.
2007 Transocean announced a merger with GlobalSantaFe Corp or US$17 billion. The merger was completed on Nov. 27, 2007. At the time, the two companies were the world's two largest offshore rig operators.
2008 Transocean was replace in S&P 500 by Equitable Resources as it moved its headquarters to Switzerland to take advantage of lower taxes.
2011 Transocean announced acquisition of Aker Drilling for $2.23 billion.
Drilling Management Services
- Drilling, Testing and Completion
- Well Design, Planning & Project Cost Estimation
- Subsea Design and Engineering
- Logistics and Procurement Services
- Production Technology
- Pore Pressure/Fracture Gradient Prediction
Oil & Gas Services
- Geological, geophysical, & reservoir engineering
- Equity participation
- Field development capability
- Accepted exploration & development Operator
Transocean drills in almost all the major oil producing oceans, from Norway to Brazil and to Southeast Asia. Here is a map of where they have their equipment from the 2010 annual report:
Their size is one of their main advantages. The company also has a history of “firsts” in the offshore drilling business. It was the first driller to deploy jackup drillup rigs; the first with dynamically positioned drillship for exploration; the first one with oil and gas exploration well drilled in more than 10,000 feet of water. These technical innovations and the history shows that Transoceans’ technical leadership can help it capture the lion's share of the exploration industry, which is going to move into more hazardous and harsh environments when the known oil and gas reserves run dry.
The oilfield services consist of several large and well respected companies like Schlumberger, Haliburton, Baker Hughes, Diamond Offshore, Weatherford, Seadrill, Ensco, Noble and more. Transocean competes more closely with Noble, Pride International and Diamond Offshore.
- Noble has 66 rigs which are deployed from Gulf of Mexico to India.
- Diamond has around 44 rigs, 21 are deployed in Gulf of Mexico, the rest in Brazil Malaysia, Asutralia, New Zealand, Egypt, Vietnam, Middle East and the North Sea.
- Ensco has a fleet of 45 ships with average age of under seven years. It is one of the youngest in the industry.
All these companies have deepwater capabilities and they create competitive pressure for Transocean. But Transocean’s deepwater fleet alone is larger than Diamond's entire fleet. Size is definitely on Transoceans’ side. More threatening in my opinion is theentrance of major oil companies like Schlumberger and Baker Hughes in the deepwater industry. These companies have the necessary capital and capabilities to develop strong and new products in this area. The following table shows the Offshore drilling industry metrics for 2010. As we see that the number of Transocean rigs is quite close to Noble, Diamond and Ensco put together.
|Offshore Drilling Industry Metrics for 2010||Transocean||Noble||Diamond Offshore||Rowan Companies||Ensco|
|Average Fleet Utilization||69.5%||78.5%||67.4%||57.1%||69.4%|
|Average Number of Offshore Rigs||141||65||46||28||49|
Transocean was rated as an industry leader for a long time. But since the merger with GlobalSantaFe in 2007, its reputation has suffered considerably. According to Energy Point Research, an independent oil service rating firm, Transocean was ranked among the top deep water drillers in “job quality” and “overall satisfaction” during 2004-2007. In 2008 and 2009, the surveys rank Transocean near the bottom. Although even in 2008 and 2009, Transocean has been ranked first in in-house safety and environmental policies and in the middle for perceived environmental and safety record. The bad press after the Deepwater accident has further tarnished its image.
Barrier to Entry
As one would understand, offshore drilling requires large amount of fixed assets with prices of around $300 million and up to $1 billion per rig. There is also a high cost of maintaining this equipment when the business slows down. Transocean has a high fixed cost in maintaining the rigs in working order even when they are sitting idle. This creates a significant loss and penalizes the rig operators when the utilization rate falls. The utilization rate of Transocean was 90% in 2007-2008. The utilization rate during recent quarters has been between 55-66% (in 2011).
As an oilfield services company, Transocean's fate is intimately connected to the fate of the oil and gas industry as a whole. I discuss here several risks associated with Transocean and the industry as a whole.
Gulf of Mexico
On April 21, 2010 Transocean-owned semisubmersible drilling rig, Deepwater Horizon, exploded and sank killing 11 and critically injuring 126 crew members. The sinking rig severed the riser pipe that connects the well head to the rig and oil began leaking into the Gulf at an estimated rate of between 5,000 to 19,000 barrels per day.
The government is seeking recrimination against three main parties it holds responsible for the accident: BP (BP) (who owned the well), Halliburton (NYSE:HAL) (the cementer) and Transocean (the drill operator). On April 21, 2011 BP filed a $40 billion lawsuit against Transocean, Halliburton and blowout-preventer manufacturer Cameron (NYSE:CAM).
According to a NYTimes article dated Oct. 7, 2011, hundreds of thousands of people and businesses have filed for emergency payments from the $20 billion BP fund administered by Kenneth R. Feinberg. More than $2.2 billion has been paid so far in emergency money to those affected by the spill. Mr. Feinberg announced the rules for those settlements in November 2010 after consulting with lawyers, state attorneys general, the Department of Justice and BP.
If we look at the effect it will have on Transocean, we find that the Transocean rig was fully insured. Transocean has released the operating contract of the Deepwater Horizon — it has with BP. The contract indemnifies Transocean even in the case of negligence. However, even this disclosure is not enough because the investors fear that this may not hold water in court and the court can decide to levy penalties against Transocean due to the scale of the disaster.
In a recent development, one-quarter owner of the well Andarko (APC) has agreed to pay $4 billion to BP. Still, Halliburton and Transocean are denying payment. BP claims that every single safety system and device and well control procedure on the Deepwater Horizon rig failed. Transocean on the other hand maintains that "The Deepwater Horizon was a world-class drilling rig manned by a top-flight crew that was put in jeopardy by BP, the operator of the Macondo well, thorough a series of cost-saving decisions that increased risk — in some cases, severely."
Furthermore, the oil spill has potential to significantly affect the growth and development of the offshore drilling industry by bringing new safety regulations. During 2007-2010 exploration in the Gulf region grew 43%. The Gulf of Mexico produces 30% of the U.S. oil output and is an important source of revenue for oil majors like BP. The potential dangers deepwater rigs possess has been laid bare by the accident and can end up creating stricter safety and environmental regulations.
The commercial register in Zug, Switzerland, where Transocean is now based, rejected Transocean’s application for $1 billion in dividend payments. The regulators are pressuring Transocean to postpone payouts to shareholders until clarity of the liability Transocean faces due to the accident. Transocean is looking to bypass this by paying dividend by par value repayment which does not need regulatory approval.
The indemnification of Transocean against even negligence although makes BPs case weak in my opinion. But Transocean will not be able to pay the damages which BP seeks. Investors who believe that it may come to pass, should stay away from Transocean.
Transocean is moderately leveraged. The debt-to-equity ratio currently stands at 0.43, which is the best it has been since 2001. To put it in perspective, the competitors of Transocean are shown in the following table.
As we see, Transocean has one of the best balance sheets barring ESV, NE and SLB. The company has $11 bn of debt which is down from $14 bn in 2008. The current portion of debt stands at $2 bn. Around $2.4 bn is due in 2012-2013, $1.1 billion in 2014-2015 and $4.2 bn thereafter. Transocean has $3.3 bn in cash, which is much larger than the $2 bn it needs to pay this year. The company will be able to meet its obligations quite comfortably if no additional liabilities arise. Transocean's liquidity ratios are quite good. The current ratio stands at 1.23 and the quick at 1.5.
None of the liquidity ratio are out of line with the historical average. Transocean has managed its balance sheet quite fantastically, given the capital intensive nature of the business.
The balance sheet is not very comfortable if we take in the large liabilities that may arise from the Deepwater Horizon accident. Furthermore, Transocean has approved $1 bn in dividends to the shareholders when the cash is scarce. In this respect, the Swiss regulators may have been right to stop the payment until there is more visibility about the liabilities Transocean may face.
Staying in Deepwater
Transocean is investing almost everything in its deepwater future (there are 10 ultra-deepwater units being built in 2010) and ignoring other areas like Middle East. Other oilfield service companies like Weatherford (NYSE:WFT) and Halliburton are also invested in the middle east which is going to see tremendous growth as new technologies are going to help extract more oil from the mature wells. Transocean is going to miss out in this area but this is one of the reasons why I like Transocean more. It has a niche in providing services in the harsh environments of the ultra-deepwater offshore drilling and it is planning to develop itself into one of the go-to companies for these services. Also, the technology needed to succeed in the Middle East is a totally different beast (drilling onshore) and is also very expensive. The success of such technologies will depend on more expensive oil than, say, the offshore drilling.
Drilling in the deepwater is expensive. For companies to remain profitable the base oil price is around $70 a barrel. During the financial crisis, oil prices took a dip to $62 a barrel and the demand for deepwater rigs dropped. More and more rigs were sitting idle. Offshore drillers need money even when the rigs are sitting idle and this is an additional risk. However, oil prices are slowly recovering and they are currently at $87 a barrel. This is good news for offshore drillers. But investors need to remain cautious about this risk. With new economies like India and China coming into picture, and with huge population growth and appetite, I would bet against low oil prices in the long term.
Investors also worry about the long-term profitability of Transocean as national oil companies increasingly move to bring more operations in-house. For example, Brazil's massive pre-salt oil fields (Tupi oil field) are one example of how difficult it is going to be to look for oil. Technically, this should benefit Transocean immensely. Instead, Transocean will miss out on much of the Brazil’s deepwater investment and Petrobras is trying to develop its own expertise in this area. The expertise can also be translated to major oilfields in Africa and elsewhere. Analysts deem it unlikely that Petrobras will be able to achieve this but investors should not ignore this risk either.
The company has an aging fleet, with the median unit age of 19 years. Understandably, different fleet segments have different ages. The technologically complex rigs are much younger. The ultradeepwater rigs, for example, are just 10 years old while standard jackups are on an average of 29 years old. This implies that the company has been investing more heavily in the complex and technically complex rigs. If we look at the capex, the average capex during 2001-2005 was $500 million, while it is $2 billion during 2007-2010.
Let's look at a series of charts to describe the growth Transocean has achieved. The charts will show the last decade in book value, revenue and EPS.
In 2010, Transocean's net income was $988 million (69% decrease from the previous year) with operating revenues of $9.6 billion (17% decrease from the previous year). The Mexico drilling moratorium played a huge role in this decrease in productivity. As we discussed earlier, loss in drilling activity bit Transocean twise by losing revenue for the idle rigs and the cost of maintaining these drills. The moratorium has been lifted and Transocean expects the revnue to be higher in 2011 due to increased productivity and its acquisition of Aker. The full impact of the regulations due to the Deewater accidents are although up in the air.
|10Y average revenue growth||22.78%|
|10Y average EPS growth||19.78%|
|10Y average FCF growth||45%|
Being a capital-intensive business, it is nice to see that Transocean produces a lot of free cash flow. The cash flow of Transocean is given in the table with its major competitors:
Comparing Transocean with its major competitors we see how well it has managed to generate cash flow, even during a major disaster. Let's look at the capex of Transocean:
Transocean is also in control of its capital expenditure and I only have good things to say about its cash management and capital allocation.
If we look at Transocean’s margin in the last decade we see that since 2007 the margins have been going down. This is easy to explain. The price of oil has significantly dropped since then. Oil was fetching more than $100 during 2007 but has since dropped significantly and during 2009 was selling for as little as $40.
If we look at the industry as a whole, Transoceans’ ROIC has suffered in the recent past. An industry-wide comparison shows that Transocean has the worst ROIC apart from WFT.
|Company||Gross Margin||Net Margin||Profit||Total Exec Pay2009-2010% of profit||ROIC‘10|
But if we look at this for the last decade, we see that times were definitely good for Transocean before the price of oil collapsed and the rig explosion. The average ROIC in the last five years has been greater than 12%.
|Return on Invested Capital %||2.36||-26.89||0.17||1.47||7.36||14.05||15.67||13.88||10.10||2.96|
5 Valuing Transocean
|Free Cash Flow||2.5b|
|10Y EPS growth||20%|
If we look at Transocean we see that it has managed an EPS growth of nearly 20% in the last decade, and the forward P/E stands at 9.2. The current price of $54.56 a share by Graham’s formula of Value=EPS*(8.5+2g), where g is the growth rate one expects for the next 7-10 years, gets us a growth rate of 4.85%. This is when the EPS has been significantly affected due to the moratorium and slowdown in the productivity. With a forward P/E of 9.8, the expected EPS is $5.84 a share, and plugging in we see that the market expects a growth rate of 0.4% for Transocean.
If we see this another way, with a 4% projected growth rate, a margin of safety 66%, and a current AAA bond yielding 4.9%, the current discount for Transocean is 70% and the fair intrinsic value is $184.81.
Discounted Cash Flow
The discounted cash flow method tells us that the value of a business is the amount of money one can squeeze out of it by looking at the FCF for a long time and then discounting them to its present value. We also need to add the money we will get from the sale of the business (the book value).
The current book value of Transocean is $66.82. The FCF in 2010 was $2.5 billion ($1 billion in TTM). Assuming our base as $1 billion of FCF and no growth with 20% discount rate, the cash Transocean will generate will be 1+1/1.2+1/(1.2)^2+ … = $6 billion. Per share this is $18.75 (320 million shares in 2010). Adding the book value, we get a fair value of $83.37. The current price is a 33% discount. Seen another way, the market expects that the company will have a negative free cash flow growth rate.
Let's look at the valuation across the industry. The table below gives us all the data for doing a DCF calculation on these companies.
- All calculations are done on a 20% discount of FCF and no growth in FCF. People may disagree with the choice. Obviously SLB can do better and the market thinks so. But you are paying for the certainty. The current price of $67 means that the market expects the FCF to grow at the rate of 10% forever (with 20% discount).
- We also note that DO, RIG, NE and SLB are fairly consistent FCF generators. HAL is okay, and WFT, SDRL, APC, ESV are quite bad. In fact, SDRL is losing money a lot. But this is due to the fact that SDRL has made significant cap-ex and can look forward to a profitable period.
6 Recent News
On Oct. 5, 2011 S&P downgraded Transocean to triple-B-, which is just above junk category. From Reuters:
'The downgrade follows Transocean's announcement that it has completed the
acquisition of Aker Drilling ASA,' said Standard & Poor's credit analyst
Lawrence Wilkinson. The funding of the $2.2 billion acquisition with a
combination of cash and assumed debt will result in a weaker financial profile
at a time of soft operating performance. In addition, the acquisition will
likely delay the improvement of credit protection measures relative to what we
had previously considered.
In our view, Transocean's operating performance will likely continue to be
pressured over the next several quarters, as the industry adjusts to the
addition of 45 newbuild floating units to the global fleet over the next two
years. Roughly half of these units still do not have contracts, which will
likely put pressure on contract renewal dayrates for older, lower
specification floaters. In addition, lower overall activity levels in the Gulf
of Mexico could intensify competition if rigs in the Gulf of Mexico seek work
outside the region. Standard & Poor's anticipates that oversupplied conditions
will likely lead to continued weakness in spot dayrates and result in reduced
profitability for rigs subject to contract renewal. Further, lower
specification floaters will be subject to increased idle time and stacking.
The rating outlook is negative, reflecting our view of the uncertainties
surrounding the company's Macondo-related liability exposures and the
prospects for continued weak profitability over the near term.
Acquisition of Aker
Transocean announced an all-cash voluntary offer to acquire 100% of Aker Drilling for NOK 26.50 per share or $1.43 billion.
- The offer price of NOK 26.50 per share represents a 62% premium to Aker Drilling's 30-day average price of NOK 16.39 per share. The transaction will be funded using existing cash balances and debt facilities.
- Further strengthening Transocean's industry leadership position, Aker Drilling's sixth-generation ultra-deepwater, dual-activity fleet comprises two harsh environment, semisubmersible drilling rigs on long-term contracts in Norway and two drillships under construction in Korea.
- In addition to contributing approximately $1 billion in backlog, the transaction is expected to be immediately accretive to Transocean's earnings.
Steven Newman, president and CEO of Transocean Ltd., said, "Aker Drilling is an excellent strategic fit for Transocean. It allows us to enhance our position in Norway where we have enjoyed a long-term presence and excellent customer relationships. Aker Drilling's high-quality people and state-of-the-art offshore drilling fleet will ensure that we continue to deliver outstanding service to our customers. This transaction also demonstrates our commitment to enhancing shareholder value by continuing to invest in high-specification assets to drive long-term growth."
With $1 billion in backlog, I do not think that Transocean overpaid significantly for the deal. Furthermore, I agree that it is a very good fit for Transocean. I do feel slightly less comfortable about the time of this acquisition. I agree with S&P that Transocean needs to preserve cash as it is possible that the global economy may take a tumble again and take oil prices with it.
7 Bottom Line
To recapitulate our pitch:
- Transocean has managed a phenomenal growth rate of 20% in revenue and EPS for the past 10 years.
- It may have to face significant liabilities and claims for the recent explosion of one of its rigs in the Gulf of Mexico. Although, its contract with the well owner BP clearly states that Transocean will face no liabilities even in case of negligence on its part.
- The offshore oil drilling industry has significant barrier to entry in terms of the harsh environment in which they operate and the amount of capital expenditure needed to profit from the exploration and drilling.
- The fair value of Transocean is around $83.75. It is trading at a significant discount to its intrinsic value both by DCF calculation and Graham’s formula.
I am long on WFT and RIG. I may buy more if the price of RIG goes below $45.