With OPEC agreeing on its first production cut in eight years, offshore drilling stocks have seen a strong rally. Among the names in the sector that look attractive, Transocean (RIG, Financial) is worth discussing. Among the many positive factors that will be discussed, the company reported strong quarterly numbers and the stock surged 44% since reporting third-quarter results. We will discuss why this upside trend is likely to be sustained in the coming quarters.
Company overview
Transocean Ltd. is an offshore contract drilling services provider to oil and gas companies. The company currently owns or has partial ownership interests in 57 mobile offshore drilling units, including 29 ultra-deepwater floaters, seven harsh environment floaters, four deepwater floaters, seven mid-water floaters and 10 high specification jack-ups. Transocean has its prime focus on the building and expansion of harsh environment and ultra-deepwater floaters. I will discuss about the fleet expansion in a separate section.
Coming to the company’s revenue generation model, Transocean provides contract drilling services that involves contracting drilling fleet-related equipment and crew primarily on a day-rate basis. In general, the company works on long-term contracts with oil and gas exploration companies, which ensures clear revenue visibility.
Merger with Transocean Partners
One of the significant initiatives by Transocean in the recent past was its decision to merge with its subsidiary, Transocean Partners. As of July 31, the company agreed to acquire all of Transocean Partners' (RIGP, Financial) outstanding units in a share-for-unit merger transaction. In the merger, each unit holder would receive a 15% premium to Transocean Partners’ closing price on July 29. Some of the key positives of this merger are:
- After the merger, Transocean will have 100% ownership of Transocean Partners and thus would have indirect 51% ownership interests in Discoverer Inspiration, Discoverer Clear Leader and Development Driller III, which are currently owned by Transocean Partners. With Discoverer Inspiration and Discoverer Clear Leader, an additional backlog of $1.1 billion is expected for Transocean.
- Since Transocean Partners will cease to trade publicly, there will be significant benefit in terms of simplified administration and governance and tangible cost savings. This would also help in a better liquidity management and liquidity profile of the company.
- Further, annual cash distribution of about $29 million will further improve the company’s liquidity position in a situation where most of the drilling companies are struggling to survive.
Managing liquidity
Transocean has sufficient liquidity to meet its capex requirement for the next two years. Considering decent operating cash flow and current cash and cash equivalents, the company is well positioned to meet its debt obligations.
As of Sept. 30, Transocean had cash and equivalents of $2.5 billion. If we include proceeds from the recently issued senior secured debt, the company’s total cash position stands at $3.1 billion. In June 2014, the company had entered into a five-year revolving credit agreement of $3 billion, which further adds to the company’s liquidity.
Apart from the finances, Transocean expects operating cash flow of $1.4 billion to $1.9 billion, which is sufficient to meet the company’s capital expenditure requirement of $1.2 billion through 2018. Due debt of $2.6 billion can be easily met with $3.1 billion of cash, leaving the company with sufficient liquidity as of Dec. 31, 2018.
Fleet expansion
Transocean has the largest combined fleet of high-specification UDW and HE floaters, including 17 newly built floaters added Ă‚ and delivered since 2008. In addition to this, two more contract backed drillships will join the company by 2018. During the quarter, a high-specification ultra-deepwater drillship, Deepwater Conqueror, was added. The rig is in a five-year contract with Chevron and will start contributing to the EBITDA and cash flow.
It is important to note the company aims to expand its fleet from 51% of UDW floaters and 18% of high-specification jack-ups in the third quarter to 55% and 24%, respectively. With a more focused approach based on the mix of fleet and its high-specification, Transocean is better positioned to demand competitive day rates. In turn, this would have an impact on the company’s cash flow and revenue once the offshore market starts recovering. In the foreseeable future, day rates will remain relatively depressed.
Contract backlog and strong customer relationships
As discussed above, a well-managed fleet will attract customers and that could be seen in the company’s contract backlog. Transocean has the highest total contract backlog with $12.2 billion, as compared to its peers Noble Energy (NE, Financial), Diamond Offshore (DO, Financial) and Ensco PLC (ESV, Financial).
In addition to a solid contract backlog, Transocean also has an extensive customer base with companies like Anadarko and Exxon Mobil. A strong customer base reduces the chance of contract cancellations, thus constant cash flow is expected.
The company’s order backlog for 2017 remains decent, which will ensure Transocean can manage debt obligations as the offshore drilling market recovers.
Conclusion
Transocean has done well in remaining fundamentally strong in difficult times and the merger with Transocean Partners is one such positive step. Transocean also has a good fleet mix that will result in strong improvements in the backlog once there is sustained industry recovery.
Also, considering an EBITDA margin improvement of 51% in spite of the $400 million decrease in revenue, the company has been managing its operating expenses well. To some extent, this will offset the decline in EBITDA margin due to lower day rates.
Considering the factors discussed, I believe that the 44% rally is justified and as oil moves higher, I am expecting more upside for Transocean.
Disclosure: No positions in the stock.
Start a free 7-day trial of Premium Membership to GuruFocus.
