Transocean (NYSE ticker: RIG) is my traditional value investment pick for 2009. The company trades at a 3.3 PE in a business with strong fundamentals, and has less short-term exposure to contract cancellations than its nearest competitor, Diamond Offshore (NYSE ticker:DO), which trades at a higher multiple. RIG has been knocked down unreasonably due to removal from the S&P 500 on reincorporation to Switzerland, and I expect a bounce back as we saw when ACE was removed for reincorporation in July. In addition, there is a strong possibility that the company will start paying a dividend or institute a stock buyback in 2009.
Transocean operates a fleet of 130 offshore drilling platforms (with another 10 being built), concentrated primarily in rigs that are suitable for deep-water drilling. Deep water is the primary focus of large-scale offshore oil exploration, because most of the shallow water resources have already been explored.
The cost to remove a barrel of oil from the ground for deep water is higher than for shallow water, with the breakeven coming at around $60 per barrel. Given the long lifetime of exploration projects and production after resources have been identified, the demand for deep-water drilling rigs depends primarily on long-term expectations for oil prices. While I do not expect oil to return to $120 per barrel anytime soon, current futures trading has oil at $60 per barrel in January 11, and steadily increasing going forward, so the markets are projecting that deep water drilling will be at least marginally economical.
Relative Valuation Metrics
Almost any way you break it down, RIG is trading at a significant discount to DO:
Trailing 12 month PE: RIG 3.4x, DO 5.3x
Price to 2009 analyst-expected earnings: RIG 3.1x, DO 5.2x
EV to trailing 12 month EBITDA: RIG 5.4x, DO 15.5x
EV to Operating Cash low: RIG 6.6x, DO 22.6x
The only major metric where Transocean outperforms is EV to net asset value (as estimated by Morgan Stanley), with RIG at 88% versus 81% for DO.
Backlog and Exposure To Weaker Customers
For the next two years, RIG has (per Morgan Stanley estimates) approximately 95% of its 2009 expected EBITDA covered by contract backlog, with 80% coverage in 2010. Diamond Offshore is similarly positioned, with 95% covered by backlog through 2009 and 75% in 2010. This doesn’t give the full relative value picture, however, since RIG’s contracts are to players with significantly better credit quality. If the recession is prolonged, RIG is likely to have less business cancelled:
Independent Oil Companies and Large Exploration and Production Companies: RIG 62%, DO 40%
National Oil Companies (excluding Petrobras and PEMEX): RIG 30%, DO 10%
Petrobras: RIG 4%, DO 20%
PEMEX: RIG 0%, DO 5%
Small E&P companies: RIG 4%, DO 25%
Petrobras is a bit of an unknown (certainly compared to the Shells and BPs of the world), and PEMEX can cancel its contracts at will. My bottom line is that I believe that both RIG and DO are cash cows that will easily survive the global recession, but, in the worst case scenario of widespread breaches of contracts, DO has greater exposure to the weaker hands.
Price History Versus DO/S&P Deletion
RIG’s stock has fallen from 103% of the per-share DO price three months ago to 76% now. The major factor in this relative decline has been the deletion of RIG from the Standard & Poors index on December 18, 2008 (RIG, as did several other companies that had incorporated in the Carribean to avoid paying US taxes, reincorporated in Switzerland, making it ineligible for membership in the S&P US indices). RIG is currently trading more than 30% below its pre-deletion price, on no major news, while DO is down 16% over the same time period.
Ace Ltd. (NYSE ticker: ACE) was removed from the S&P 500 on July 17 for reincorporation. Like RIG, ACE underperformed into the index deletion date (in ACE’s case, by about 10%). ACE bounced back nicely in the six weeks following the move; while I can’t guarantee that RIG will do the same, I think that value investors are awakening to the fact that RIG was unfairly punished by the market upon deletion.
Dividend and Stock Buyback
Another reason for RIG’s underperformance compared to DO is that DO pays out almost all of its income as a dividend, whereas RIG does not currently pay a dividend. This difference has grown in importance as many investors have looked to dividend yield as a touchstone for allocating their now greatly diminished investment capital.
It is also a difference that is easy to remedy. RIG does have 10 new platforms in construction, and about 50% of its enterprise value is in the form of debt (versus no debt for DO), so it is not going to match DO’s yield, but with the company bringing in nearly $5 billion in operating cash per year (versus a $15 billion market cap), there is considerable speculation that RIG will institute either a dividend or a stock buyback. Management has been silent on this topic, though they have said that they expect to keep significant debt on their balance sheet, so I don’t expect it all to go to debt prepayment.
Long RIG Short DO?
So, now that I have extolled the virtues of Transocean versus Diamond Offshore, why is this a long RIG idea rather than a pair trade writeup? There is no question, I would be happy to buy RIG and sell DO, but I think both companies are trading at such low multiples that I think both are significantly undervalued, so I’d prefer hedging with an onshore driller or a general market hedge to the RIG-DO pair.
Both companies, at the height of the commodity bubble, were trading with PEs over 30, and both traded at twice their current PEs just 3 months ago. While, no doubt, the collapse in the price of oil is a factor in their long-range prospects, they have rarely traded at PEs below 5x even in recessions, and their cash flows are far more stable than those of E&P or integrated oil companies. If I were less bullish on deep-water drilling, I’d be recommending the pair instead.
·A strong downturn in oil prices from a deeper and more prolonged recession than is currently anticipated would make some deep-water projects uneconomical
·RIG is 50% levered, so widespread contract cancellations coupled with a drop in oil prices would be painful (though I still think that DO, with its lower quality backlog, is more vulnerable)
If you have access to Morgan Stanley research, that firm published a Global Offshore Rig Review on December 19 that examines the industry and the individual stocks in some detail. It is one of the better research pieces I have seen recently in any industry.
1) Recovery from post-S&P500 deletion decline in price
2) Institution of dividend or share buyback in 2009