Transocean Has Value, But Badly Needs Growth

By Stephen D. Simpson, CFA | November 07, 2011 AAA

Feel free to start performing, Transocean (NYSE: RIG); we're all waiting on you. While Transocean often finds itself in lists of top energy service ideas, the company's five straight missed quarters are making it harder and harder to stay optimistic on this leading offshore driller. Although the long-term fundamentals for offshore exploration are indeed strong and Transocean shares look like a value stock, investors will have to be patient here, as management must not only rebuild performance, but rebuild Wall Street's trust as well. (To know more about value investments, read: 5 Must-Have Metrics For Value Investor.)
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A Miserable Third Quarter
If there was good news in Transocean's third quarter report, it was pretty much limited to the absence of any kraken attacks on the company's equipment. Revenue fell 4% from the second quarter, and 3% from last year, on lower utilization rates caused by downtime issues. Although rates are not terrible, the company had the worst performance in its highest-margin segments.

Lagging revenue was about two-thirds responsible for the company's big miss, but operating performance wasn't stellar either. EBITDA dropped 38%, compare to third quarter last year, and operating income was down by more than 50%. Even if the tax rates were normalized, Transocean only delivered about one-third of its expected earnings; this is the lowest return on replacement costs I've seen from Transocean, in years. (To know more about EBITDA, check out: EBITDA: Challenging The Calculation.)

Downtime Problems Could Linger
By the sounds of it, equipment companies like Cameron International (NYSE: CAM), National Oilwell Varco (NYSE: NOV) and General Electric (NYSE: GE) are going all-out to try to meet demand, but are coming up short. While these companies are all adding capacity, that does not come online overnight and other companies like Diamond Offshore Drilling (NYSE: DO), SeaDrill (Nasdaq: SDRL) and Ensco (NYSE: ESV) have their needs, as well.

It's worth wondering if Transocean management erred in being too conservative on new builds and maintenance, when activity was lagging. Clearly the company is looking to catch up, but its putting some real strain on the company's performance.

Still a Good Business Long Term
On the plus side, Transocean did book about $1.7 billion in business this quarter. What's more, companies like Statoil ASA (NYSE: STO) and Petroleo Brasileiro (NYSE: PBR) continue to advance expanded offshore exploitation plans. While other majors, like Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX), have been talking a lot about their onshore efforts, offshore is still where many of the large finds are, these days.

The Bottom Line
By many metrics, Transocean is too cheap. For starters, this is a leading offshore drilling, trading with a dividend yield about 6% and the dividend should be relatively secure. The company is also trading at about 60% of its replacement cost, a level that drillers don't typically see, unless rig rates are plummeting. Now, to be fair, the company is earning extremely low returns on its asset base, so it may be foolish to think it should get full credit right now. Still, if the company can return to past levels of performance, and there aren't too many reasons to doubt that right now, it's very cheap.

For better or worse, it is common to value stocks like Transocean on multiples of year-ahead EBITDA. Using a full-cycle average multiple, Transocean should be worth something in the low $70s. Keep in mind, though, that estimates have been heading lower and Transocean has yet to prove it can staunch the bleeding. However, even at a reduced target like $60, this stock would seem well worth a look from risk-tolerant investors.

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At the time of writing, Stephen D. Simpson did now own shares in any of the companies mentioned in this article.

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