Easing Legal Issues, Lower Costs and MLP Creation Support Our $42 Estimate For Transocean

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Transocean (NYSE:RIG) is the world’s largest offshore drilling company which focuses on the deepwater and high-specification segments of the drilling market. The company’s stock has been underperforming the broader market this year, owing to an oversupply of rigs in the usually lucrative ultra-deepwater market, which has led to a weak near-term outlook for dayrates and rig utilization levels. Transocean is among the worst affected by this, given its older fleet and a large number of contracts coming up for renewal (see Why Transocean’s Stock Has Been Trending Lower). Despite the current weakness, we have a $42 price estimate for the company, which translates to an upside of more than 10% to the current market price. In this note, we take a look at some of the factors driving our price estimate for the company.

See Our Complete Analysis of Transocean Stock Here

Falling Cost Base

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Operating and maintenance (O&M) costs are the single largest cost driver for Transocean. Transocean’s O&M costs are on the higher side compared to the industry average, standing at over 50% of revenues. For instance, Seadrill, one of the company’s chief competitors, had operating costs of less than 40% of revenues. [1] However, Transocean has been taking steps to cut down its cost base by downsizing shore-based support infrastructure and eliminating some non-core functions. For this year, operating expenses are expected to fall in the range of between $5.1 billion and $5.3 billion, down from about $5.8 billion a year ago. During Q2, the company cut costs by roughly 11% year-over-year and around 5% sequentially to around $1.21 billion. The lower operating cost trend should help the company improve margins over the long term.

Positive Long-term Outlook For Offshore Drilling

Despite the near-term turbulence, we believe that the longer term prospects of the company and the broader offshore drilling market remain strong. Easily extractable onshore and shallow-water based reserves have been on the decline, leading oil and gas companies towards areas such as deepwater and ultra-deepwater exploration. While deepwater exploration is expensive, it is supported by reasonably high oil prices which allow oil and gas companies to earn acceptable rates of return. Transocean has a fleet of around 79 mobile offshore drilling rigs, which include high-specification floaters which comprise of ultra-deepwater, deepwater and harsh-environment drilling rigs. As the drilling markets transitions out of the phase of oversupply, we believe that the company could benefit meaningfully.

Easing Macondo Legal Troubles

Transocean’s legal issues related to the 2010 U.S. Gulf of Mexico oil spill eased significantly over the last week. The company owned the Deepwater Horizon rig that operated on the Macondo well which caused the largest U.S. offshore oil spill. On September 4, a U.S. District Judge cleared the company of gross negligence in its role in causing the spill, meaning that the company would not be liable for punitive damages. Although the company was not completely cleared of blame, the ruling should effectively remove much of Transocean’s financial risk related to the incident and clear the legal overhang over the stock.

MLP Creation  Gives Greater Financial Flexibility

Transocean recently created and listed an MLP company, called Transocean Partners (NYSE:RIGP), which holds interests in three of the company’s ultra-deepwater rigs located in the U.S. Gulf of Mexico (related: How The MLP Spinoff Helps Transocean). The MLP should allow the company greater financial flexibility, since it could move assets off its balance sheet and raise liquidity to fund dividend payments and acquisitions, while still maintaining control of the assets. For instance, Transocean could sell (or drop down, in MLP terms) some of its rigs to the MLP, which would in turn fund its purchase by selling additional equity units or by issuing debt. Since the MLP should be able to raise capital at lower rates, it could indirectly help to reduce Transocean’s cost of capital [2] and free up liquidity.

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Notes:
  1. Seadrill 2013 Form 20-F []
  2. Benefits of MLPs, Morningstar []