Can The Songa Deal Result In A Turnaround For Transocean?

Unlike the onshore oil and gas companies who have found ways to deal with the ongoing commodity downturn, the offshore drillers continue to bear the brunt of the slump in commodity prices over the last three years. This has finally pushed the offshore market into a consolidation phase, wherein the leading names in the industry are looking to acquire distressed yet good quality assets at attractive valuations in order to survive the slowdown.

The latest deal in the industry is the Transocean-Songa deal announced earlier this month. The deal has a total consideration of $3.4 billion, and is expected to close by the end of 2017. While the transaction will add a contract backlog of $4.1 billion to Transocean’s existing backlog, the absorption of debt and equity dilution component of the deal were not appreciated by the market, causing the offshore driller’s stock to tank more than 13% in the days following the announcement of the deal. Here we take a brief look at the pros and cons of the deal, and its overall impact on Transocean.

See Our Complete Analysis For Transocean Here

Source: Google Finance

Positives Of The Deal

• Higher Contract Backlog – The key objective behind the acquisition of the Songa Offshore is to expand Transocean’s dwindling contract backlog. At the end of July 2017, the Swiss company held a backlog of $10.2 billion, significantly lower compared to what it was a couple of years ago. Since the commodity markets are far from reaching the 2014 levels anytime soon, the fate of the offshore drilling markets remains bleak. Consequently, even market leaders like Transocean are unable to grow their contract backlog organically. In such a situation, the Songa deal comes as a blessing for the company, as it will expand its existing backlog by $4.1 billion (extending up to 2024). Although Transocean already has the largest contract backlog in the industry, the incremental backlog is likely to augment its top-line in the coming quarters, and reinforce investor confidence in the company. Accordingly, we believe that the increased backlog will enable the company to remain afloat at least until 2019, even without a turnaround in the offshore drilling markets.

• Improved Presence In North Sea – Apart from contributing to Transocean’s contract backlog, the Songa deal brings along four “Cat-D” harsh environment semisubmersible drilling rigs on long-term contracts with Statoil in Norway, and three additional semisubmersible drilling rigs that are currently idle. This implies that not only will the offshore contractor acquire additional rigs that will boost its fleet, but it will also enjoy a chance to attract new work with clients such as Statoil, and strengthen their relationship. Further, the deal will enhance the company’s presence in the North Sea, which had reduced over the last couple of years after it scrapped eight rigs in the region. Since North Sea has become one of the most desirable offshore markets, improved presence in the region will be an upside for Transocean in the long term.

• Cost Synergies – One of the most logical rationales behind an acquisition is the cost savings that are derived from it. According to Transocean, the Songa deal is likely to realize annual cost and operational synergies of $40 million, of which $25 million will be related to general and administrative expenses. At a time when the company is struggling due to low daily rates, these cost synergies, if realized as expected, will enable the company to keep its profits in the black for a few more quarters.

Negatives Of The Deal

• Higher Debt – Over the last two years, Transocean has proactively worked towards reducing the large amount of debt on its books through early repayment and/or refinancing its debt at lower rates. As a result, the company has managed to bring down its long term debt obligations from around $9 billion in 2015 to about $6.5 billion at the end of the latest quarter. However, with the recent deal, Transocean plans to assume $1.7 billion of Songa’s existing debt, taking its total debt to $8.2 billion. Of this, $1.7 billion of debt will be due for repayment between 2017-2019. Although the company can utilize its existing cash balance and cash flows from operations to pare down this amount, a large chunk of its debt (around $3.5 billion) will become due in the 2020-2022 timeframe. If the commodity markets, along with the offshore drilling demand, do not revive until 2019, it would become very difficult for Transocean to meet its debt obligations. Also, the increase in debt is likely to be accompanied with higher interest expense for the company, which will weigh negatively on its bottom line.

• Significant Equity Dilution – Not only does the Songa deal entail the absorption of a large amount of debt, it also includes a component of equity dilution for Transocean’s shareholders. The company has promised to give $540 million in equity to the shareholders of Songa Offshore on the completion of the deal. This would amount to an equity dilution of approximately 24% for the shareholder of Transocean. Clearly, the investors did not seem pleased with this, which has caused the stock to plunge sharply post the announcement of the deal.

• Convertible Bonds Leading To Further Dilution – Under the terms of the deal, the offshore driller will also provide convertible notes worth $660 million with a maturity of five years and an annual interest rate of 0.5%, payable semi-annually. These notes have an option to be converted at a price of $10.28 per share, which includes a premium of 22.5% on the reference price set by the company. If these notes are converted into equity in the future, it would lead to further equity dilution for the company’s shareholders, which will not be welcomed by them.

• Upfront Cash Payment – Lastly, the deal also includes a one-time cash payment of $480 million to the shareholders of Songa Offshore. Given that the company has a notable amount of debt coming due in the coming years, coupled with its weak cash flow position, this upfront cash payment could hamper its liquidity in the short term.

Our Take

Having discussed the pros and cons of the Songa deal, we conclude that while the transaction will provide the required boost to Transocean’s backlog and enhance its North Sea presence, it is highly likely that the deal turns out to be an expensive one for the company in the long term, largely because of its large debt and equity dilution component. That said, the recovery in the commodity markets and offshore drilling demand could turn the tables positively for Transocean.

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