It's been a long and painful fall for Transocean (NYSE:RIG). Once seen as one of the best operators in the energy space, and deserving of a premium valuation as a result, Transocean has struggled with its involvement in high-profile accidents, unacceptable downtime leading to contract cancellations and various other operational shortcomings. While I wouldn't say that Transocean is completely in the clear again, nor back in Wall Street's good graces, the combination of improving operations and discounted valuation could make this stock an outperformer in 2013.

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Progress Evident in Third Quarter
Transocean is another one of those companies where the conventional reported financials don't necessarily drive the stock's valuation in the short term. That said, an earnings beat and backlog growth certainly don't hurt. Revenue rose 23% from last year's third quarter, and rose about 4% from the second quarter. Utilization continues to improve, as Transocean saw 81% utilization for its high-spec floaters (up from 79% in the second quarter and 67% last year). In fact, all of the company's major reported categories saw improved utilization on both annual and sequential comparisons, with total utilization improving from 63% last year to 77% this quarter.

A stronger focus on operational performance is also paying dividends through the profit lines. For better or worse, operating income and such aren't really followed too closely by many drilling company analysts or investors, but EBITDA did improve 80% from last year and 16% from the second quarter on a reported basis.

Efficiency Moving in the Right Direction
Transocean is also doing meaningfully better with its revenue efficiency. Revenue efficiency is similar to utilization, though it measures the actual revenue earned by a rig as opposed to its time in service. Transocean saw 94.3% efficiency from its ongoing fleet this quarter, up from 92.1% in the second quarter and 88.5% last year. Better still, efficiency in the ultra-deepwater fleet (typically the most lucrative segment) was even higher at 95.8%, above the company's target of 94%.

This is meaningful improvement, though management warned that the next quarter will likely see a small sequential decline and 2013 could be challenging due to rising costs across the industry. Rival drillers such as SeaDrill (NYSE:SDRL), Noble (NYSE:NE) and Ensco (NYSE:ESV) are ramping up their own operations as rigs come out of storage and shipyards, and equipment providers such as National Oilwell Varco (NYSE:NOV) are likewise looking to boost their own revenue. Nevertheless, I think Transocean deserves credit for the progress made to date, and I believe that moves such as increased standardization of procedures will pay dividends across the next cycle.

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Improving Market Conditions, but Loose Ends Still Need Tying Up
Drilling rates in operating regions like the Gulf of Mexico are improving (nearing or exceeding $600K/day at the high end), and oil/gas companies are increasingly willing to extend contracts out for multiple years. That's clearly a positive development for the industry, and the increasingly prevalence of multiyear deepwater deals are leading many drillers to contemplate following SeaDrill and forming MLP structures. That said, Transocean still has some work to do. Selling a collection of standard jack-ups to Shelf Drilling will help the company move up the technology curve, but this company no longer necessarily has the best fleet in the business. At the same time, the company still needs to resolve legal issues tied to the BP (NYSE:BP) Macando oil spill and the Chevron (NYSE:CVX) spill off the coast of Brazil. While I'm cautiously optimistic that Transocean is past the worst here, neither situation has been completely de-risked yet.

The Bottom Line
Unless investors want to argue that Transocean's missteps have permanently impaired the company, the stock looks too cheap today. Transocean has usually traded at a 7.5 times multiple to next-year EBITDA over the course of a cycle. Using current EBTIDA estimates, that works out to a fair value in the mid-$60s, making Transocean one of the cheaper stocks in the sector (an unfamiliar position for this stock). While I do appreciate that numerous risks still apply to Transocean (legal issues in Brazil, a recurrence of downtime issues, an overall decline in the energy markets, and so on), on balance I believe this looks like an interesting turnaround story for 2013.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.