Race on $RIG

by Shiv Kapoor
Quant & AOM Editor
Gurgaon, India (DYDD)

Today, $RIG’s management and asset quality sets the company apart from the competition; this together with innovation and capital requirement acts as a formidable entry barrier.

And this is why I am not pleased to see Icahn come on board as an owner in Transocean.  $RIG is one hell of a company.  $RIG has great asset quality; great people quality; great management quality.  But bad luck has dogged them the last few years.  The last thing you want is an activist shareholder, trying to tell management how to do their jobs.

And now we know his game; he stuck out his grubby paw and demanded a dividend of $4 per share!  This is by no means an absurd demand.  Consider that the smaller Diamond Offshore pays an ordinary dividend of $0.50; but it has a history of paying regular special dividends taking the total dividend payout to $3.50.  I don’t think a dividend is a bad idea.  But in my view, a company with deeply cyclical earnings should not commit to a dividend of more than 60% of bottom cycle core earnings ex items; in the case of $RIG, I suspect the maximum dividend should be limited to $ 2 to $2.50 per share.  And then, special dividends and buybacks can be executed from time to time, to return value from the higher earnings during periods of normality and the drilling up cycles.    All said and done, I am impressed with the fact that Icahn has managed to buy up over 5% of the company, and the prices have remained below $57; hats off to him.

$RIG is by far the best in class in ultra-deep-water, deep-water and harsh environment work. In addition, $RIG’s fleet made up of high specification jack-ups, semi submersibles and drill ships, has strong capability across the depth spectrum. This asset portfolio diversification across mid water, deep-water and ultra-deep-water allows RIG the flexibility for profitable operations over a broad range of long term oil prices.

$RIG is also tremendously innovative in its business. It has brought to the market, cost and time saving technologies including dual stack and dual drilling table vessels. It has also been a leader in developing vessels capable of drilling in harsh environments. Finally, it has continually pushed the frontiers of exploration by delivering vessels with capability of drilling in deeper water; today several vessels can drill in water depths of 12,000 feet; and with drilling depth capability of over 40,000 feet.

$RIG’s management is hugely capable. It has led the consolidation in the industry to create what is by far the biggest and best offshore driller in the world. In the past decade, Transocean has brought together the assets and skills of Sedco Forex, R&B Falcon and Global SantaFe; this is no mean achievement.

The management vision and single-minded pursuit of the offshore drilling business with a focus on deep-water is creditable. The opportunity for future growth through acquisitions is narrower. However, in this upgrade cycle, several less financially strong companies have built small but magnificent fleets; quality and asset focused (not size) acquisitions might be the next future acquisition opportunity. And of course there is value to be squeezed from disposition of non-core assets. Though most of that has been achieved; with the not too pleasing, sell-out of the shallow water drilling business to Shelf Drilling, funded mostly by Castle Harlan, CHAMP Private Equity and Lime Rock Partners.

Because the Company is what it is, it is able to attract and retain the best driller talent. The value inherent in this talent is unlocked through impressive training programs in every field; be it engineering, finance, QHSE or general management, amongst others. Individual goals are well aligned with those of the Company; compensation and benefits including stock benefit plans are used with great effect; in addition cross functional mobility is a powerful tool which allows truly high potential employees realize their full potential. The work force is diverse and totally globalized and yet the Company has instilled a value system which makes each employee uniquely “Transocean”. FIRST is not a useless mnemonic used by $RIG to express its mission and values; FIRST STEP is not a meaningless training program which instills these values in employees; FIRST and FIRST STEP are what instills values consistent with corporate values in the individuals that make up the Company; it is what breathes life into the Company; it is what makes its governance strong; it is what leads to success.

$RIG is really very under-valued for the long term investor.  Drilling is a deeply cyclical business.  $RIG’s ex items core earnings are well capable of fluctuating at around a core long term ex-items earnings of $12, with falls to $4 and rises to $24 and over during the course of a cycle.  The drilling business has a very sensitive fall through rate; as rig utilization rises, constricted supply leads to disproportionate increases in day rates.  Conversely as rig utilization drops, surplus supply leads to disproportionate falls in day rates.

On the downside, surplus supply gets limited because rig owners start cold stacking rigs and remove them from the fleet which has a tendency to stabilize day rates close to and just over break even.  But when rig utilization moves up; once the cold stack assets have returned to active work, the day rates spike; because there is a very long lead time for that next asset that E&P companies want to drill their wells.  The impact on profitability is huge; when day rates rise, a very large part (probably about 80%), of the delta in day rates fall through to the bottom line.

It’s not that the industry is without its risk.  We all saw the risk crystallize into an adverse event with Deepwater Horizon.  In addition we know that $RIG’s business focus is deep-water.  And there is a threat that during times of low demand growth for oil, the theatre of deep-water will be ignored, as E&P companies shift focus to shale oil and low marginal cost land sources with a higher degree of geographic and political risk.  But in the very long term, deep-water is here to stay, for new sources of oil are still required, even with sub 1% demand growth rates.  The risk is there, but so too is the reward potential.

On NeuroQuote, $RIG displays a buy rating and a NeuroScore of 62.  Investor interest comes from a vast variety of investor styles as well as portfolio selection styles.  Statistical scores for value (67), growth (57) and technical (100) are strong.  In normal circumstances, I would be worried about technical being too strong, but for $RIG, I suspect the strength in technical could last much longer.  $RIG’s forward PE is 11.80.  Its forward five year earnings growth expectations are 29%; this looks high, but it is not because $RIG is just coming off what looks like bottom cycle earnings.  Insider and institutional ownership is strong at over 60%.  The technical position is strong with share prices 10%, 18% and 21% over the 20, 50 and 200 day moving average.  RSI is high at 83.  Beta is surprisingly low at 1.17, with weekly and monthly volatility at 1.34% and 2.3% respectively.

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