Transocean (RIG) shares were up sharply after Jefferies upgraded shares to Neutral from Underperform with a $13 price target. Even as the company still faces challenging market conditions, Jeffries stated that it was increasingly comfortable with Transocean’s positioning.
What was the reason for the upgrade, and does this signal a buying opportunity?
Cost Savings Potential
Jeffries sees "material" operating expense savings potential as the company resizes its footprint to meet shifting demand levels. It’s difficult to see where Jeffries expects the cost savings to come from.
Cost of goods sold is the chief area for cost reductions as SG&A as a whole is fairly low to begin with. While COGS looked bloated for much of 2012-2014, the company has brought it back below 100% of gross profit levels. With gross profit expected to fall steeply after the current backlog rolls off, the company can merely expect to keep COGS expenses in-line with falling profitability.
A Strong Liquidity Position
Jeffries also lists a “strong liquidity position” amid a challenging market. With the stock price down to 1994 levels, it does look like the company is managing its liquidity well. Debt to equity is still below 100% (not ideal, but respectable for a company in its position) and cash levels are roughly 40% of long-term debt. The Alt-Z score is also not too dire yet at 0.6.
However, the financial position for the company has the potential to erode quickly. While net income has fallen precipitously, the company has been able to manage positive free cash flow by rolling back capex and having high levels of non-cash charges.
Still, if net income remains negative, it’s only a matter of time before free cash flow plummets. For example, after posting big net income losses in both 2003 and 2012, RIG went on to post flat or negative free cash flow in the following reporting periods. This would put the company into financial stress quicker than Jeffries may anticipate.
And while the company has enough EBITDA to cover its $1.0 billion in debt maturing on June 30, 2016, and $1.1 billion in debt maturing on June 30, 2017, expect refinancing to come at a higher cost considering the industry risks.
A "Better Appreciation for the Quality of the Fleet and Overall Operations"
Jeffries final reason for upgrading the stock is due to the quality of its assets. Unfortunately, none if this helps you much in a massive industry downturn. Transocean already has several rigs going off-contract in 2016, and it will be difficult to re-contract the rigs in current market conditions.
Currently, the company has six stacked rigs and seven idle rigs in its fleet, with this number expected to continue increasing. Even if rigs are contracted, dayrates will be dramatically lower, impacting both revenues and cash flow.
Conclusion: Tough to Go All-In On RIG
If oil prices remain below $50, it’s fairly clear that you should avoid RIG shares. While there are reasons to like it more than peers, this will be little consolation as the company becomes increasingly stressed. Even a modest oil rebound would do little given the amount of idle supply out there (ie. depressed pricing). Unless you’re anticipating a huge rebound in oil prices, you should avoid any investment in RIG.
