Why Transocean Will Recover

By Stephen D. Simpson, CFA | August 05, 2010 AAA

There is no question whatsoever that these are very difficult days for Transocean (NYSE:RIG). Because of its role in the BP Gulf oil spill, the company finds itself under a microscope like never before, and it seems reasonable to assume that its is going to be facing legal trouble for years to come. All of this has taken a toll on the stock, which is now discounted based on the assumption of a very bleak future for the world's leading deep water driller.
But not so fast. Even if Transocean bears a larger share of responsibility for the oil spill, I don't think this affects the company's potential in the long term. For better or worse, deep water drilling is here to stay. Plus, Transocean is a leading operator in the field, and it would take years for another company to build a fleet that could rival Transocean's. To me, this means the company has above-average odds of recovering from this matter.

IN PICTURES: 7 Ways To Position Yourself For Recovery

The Quarter That Was
The oil spill and the drilling moratorium undoubtedly hurt the company's June quarter results, but it was not going to be an especially strong quarter anyway. Revenue fell 4% sequentially and 13% from last year, as the company saw relatively soft utilization and lower day rates. Although deep water day rates have held up (and were up slightly on a sequential basis), the rates for jackups fell by double-digit amounts from the March quarter.

Transocean is a company with strong operating leverage, but that cuts both ways. While the company enjoys strong profitability when rates are high and rig activity is robust, the reverse is also true. Even excluding costs related to the Macondo, the company's EBITDA fell 13% on a sequential basis, and overall results came up short of the average analyst guesses. (To learn more, see A Clear Look At EBITDA.)

The Road Ahead
It is easy to say that offshore drilling activity will pick up again and that rates and utilization will rise. The major question, though, is when? And what happens to the company in the meantime as management deals with the fallout from Macondo?

Right now, there is ongoing squabbling about exactly who is to blame in the accident, and to what extent. Transocean clearly had some problems - there were a variety of maintenance and quality control issues aboard the Deep water Horizon rig before the accident, and the company was late in maintaining the blowout preventer, which the company purchased from Cameron (NYSE:CAM). On the other hand, BP made a number of puzzling operating decisions and orders relating to the actual drilling process, and it appears that these decisions also had a direct causal link to the accident.

So, what happens to RIG? The company's future legal payouts are certainly a major unknown today, but it seems a near-certainty to me that the company will have to incur expenses to retrofit, modernize and otherwise update equipment on its rigs. Whether the United States and other sovereign governments impose new safety requirements or not, common sense dictates that drillers like Transocean, Noble (NYSE:NE), Pride (NYSE:PDE), Diamond Offshore (NYSE:DO) and Ensco (NYSE:ESV) are going to be spending money to correct any deficiencies in maintenance and equipment.

In fact, longer term, the industry may ultimately be glad it made the move. It is not unreasonable to think that some governments may go easier on their local operators (like China and China Oilfield Services), but that may ultimately limit their ability to go international if more countries raise the standards for companies wishing to operate in their waters.

The Bottom Line
I am generally very skeptical of using cash flow modeling for companies in industries like energy services. Still, I cannot overlook the fact that Transocean ends up looking cheap by this metric - a testament to just how badly beaten-up the stock really is. Even using more common metrics like forward EV/EBITDA, the stock still looks like a good deal.

Transocean certainly has major challenges to overcome, and not all of them (like overall market conditions) are within management's power to change. Still, this is a top-tier operator with a difficult-to-replace fleet and deep relationships with numerous major energy producers. Given that I believe offshore drilling is here to stay, I think adventurous investors ought to consider adding Transocean to their portfolios and waiting for the eventual recovery in business and stock multiples. (Learn more about oiling drilling, see Oil And Gas Industry Primer.)

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