Description
Summary
This is a very simple idea. Transocean has lost ~$8B (or 28%) of its market capitalization since the tragic explosion of its Deepwater Horizon rig on April 20, 2010. At current levels, we believe the stock is very inexpensive on both earnings and cash flow metrics and also trades at a significant discount to both the market and replacement value of its assets. Our work indicates that, despite some headline risk, RIG bears little legal/financial responsibilty for the disaster in the GOM. Additionally, near-term catalysts exist that should halt the decline in the stock price and cause it to reverse course back to the $90+ prices we saw immediately prior to the explosion.
Brief Background
Transocean (RIG) is the world's largest drilling contractor. Created by the merger of Transocean and Global Santa Fe in 2007, RIG operates a fleet of 20 deepwater drillships, 25 deepwater semi-submersibles, 32 midwater semi-submersibles, and 66 jackup rigs. Importantly, its fleet contains a number of "high specification" vessels capable of drilling in the world's harshest and most difficult environments. Numerous conversations with those involved in the oil drilling business indicate that RIG is the "best of breed" in offshore drilling contractors -- high quality assets, experienced people and great customer relationships. Despite recent headlines, RIG is also considered by those in the industry to be among the safest (if not the safest) contractor in the world.
The Explosion
I am not going to spend much time on the tragic Deepwater Horizon explosion that happened on April 20, 2010. Anyone who has been paying the slightest bit of attention knows the basic facts of the case. What is less well understood is RIG's potential liability for the cleanup, pollution remediation, and commercial lawsuits. The salient points are as follows:
- RIG was fully insured for the Deepwater Horizon and will receive $560MM (as of May 6, 2010, they had already collected $481MM of this) from their insurers.
- Since shortly after the explosion, BP has waged a somewhat bizarre PR battle, attempting to shift blame to RIG for the accident. While we are not privy to the specifics of the BP/RIG contract for the Deepwater Horizon, we have spoken to several industry contacts (including those who negotiate such contracts for major IOCs, maritime lawyers, and industry consultants) who are intimately familiar with standard contracts. Our contacts have uniformly assured us that it is the operator of the well (BP) who assumes the responsibility for initial cleanup, remediation of any blow-out related pollution, and any commercial lawsuits (fisherman, etc.) that may arise from this accident. I would further note that the US government has consistently made it clear that they view this as BP's mess and expect BP to pay for it. Finally, I would recommend a perusal of RIG's Q12010 earnings call. While they provide limited detail, RIG's CEO and management team give forthright answers to questions regarding their financial liability for the accident.
- We have heard speculation from within the investment community that even though they may not be legally responsible for any of the costs associated with the accident, that BP may force RIG to share blame/costs associated with the cleanup. We believe this is false for a couple of reasons.
- First, BP needs RIG more than RIG needs BP. While BP represents ~15% of RIG's annual revenues, the market for high specification deepwater assets remains relatively tight. RIG is BP's largest drilling contractor, and should BP "fire" RIG, the entire industry would know it had BP over the barrel in terms of pricing. As an aside, which I'll refer back to momentarily, I find all the public finger pointing interesting, b/c despite the nasty barbs BP has hurled at RIG, it is RIG's high specification semi-submersible Development Driller III that is currently drilling the relief well that will ultimately stop the flow of oil from Macondo; RIG's high specification drillship Discoverer Enterprise is standing by to recover the oil and perform liquid separation processes.
- RIG really can't agree to pay any damages it does not legally owe as this would create an insurance nightmare for them (and the industry.)
The Opportunity
The market hates uncertainty, and the current state of affairs regarding the accident and ensuring oil spill have created it in abundance. How big will the oil spill be? How much will it cost to remediate? When will the well stop flowing oil? What caused the failure of the well and subsequent explosion? What will happen to offshore drilling? We don't claim to know the answers to these questions, but we do believe we have some insight into when the situation will gain clarity. More importantly, we believe the amount of value that has been destroyed in the "spill stocks" (BP, RIG, HAL, CAM, APC) generally and RIG specifically has been excessive and creates an opportunity to buy an excellent franchise at a dirt cheap valuation.
| |
RIG |
BP |
APC |
CAM |
HAL |
| Shares |
321.0 |
3130.9 |
480.0 |
225.0 |
902.0 |
| Current Price |
$65.93 |
$46.60 |
$57.36 |
$37.60 |
$28.32 |
| Price 4/20 Close |
92.03 |
60.48 |
73.94 |
46.04 |
33.31 |
| MCAP Lost |
(8,378) |
(43,456) |
(7,958) |
(1,900) |
(4,501) |
| Delta % |
-28% |
-23% |
-22% |
-18% |
-15% |
At current prices (~$66), RIG is trading at the following metrics on our 2010 and 2011 estimates:
| RIG |
2010E |
2011E |
| EPS |
$8.50 |
$11.00 |
| P/E |
7.8x |
6.0x |
| |
|
|
| Levered FCF |
$9.35 |
$15.00 |
| Yield |
14.2% |
22.7% |
| |
|
|
| Unlevered FCF |
$7.60 |
$13.50 |
| Yield |
7.6% |
13.5% |
| |
|
|
| |
Best Case |
Worst Case |
| Replacement/Mkt Value |
$110.00 |
$75.00 |
| % Discount |
40% |
12% |
Simply put, the dislocation and uncertainty caused by the Deepwater Horizon incident have caused RIG to trade far below a reasonable valuation. Even if we are off by several hundred million dollars (vs. management's estimates of $200MM of costs related to the accident) in our estimation of the impact on RIG's financials, at 7.8x an improving earnings stream and double digit levered and unlevered forward FCF yields and at somewhere between a small and enormous discount to the replacement/market cost of its assets, RIG is very cheap.
Risks
Near-term headline risks are obvious. We are under no illusions that the stock will begin to meaningfully appreciate until the flow of oil from the Macondo well is brought under control. We believe that the risk to a substantial or prolonged change in offshore drilling in the US is very small. While drilling off the eastern seaboard of the US or the coast of California probably just got even less likely, that is not a meaningful driver of demand for RIG's services in the first place. The GOM accounts for ~30% of US oil supply (~2.3MM barrels/day.) The MMS is the 2nd largest producer of US government revenues after the Internal Revenue Service. While deepwater drilling may be a tad unpopular right now, I would submit to you that both the populace and their politicians would find $150/barrel oil far less popular.
As is by now clear, we feel very good about the near-term actual risks to RIG as a result of the Deepwater Horizon incident. We also feel very good about its long-term prospects as the highest quality and largest offshore drilling contractor in the world. Over the long (5+ year) term, IOCs and NOCs will have to continue drilling offshore and in ever deeper waters, for the same reason that Willie Sutton robbed banks -- because that's where the oil is. We do acknolwedge that there is intermediate term (6 to 18 months) risk as a number of newbuilds begun during the oil "super spike" of 2007-8 enter the market in late 2010 and 2011. Our analysis suggests that the majority of this capacity will be soaked up rather quickly. We also believe that any new safety/regulatory requirements that come as a result of the Deepwater Horizon incident will actually accrue to RIG's benefit. If safety is of paramount importance, who would you rather have: the largest and best operator in the industry or newly built rig that, while shiny and pretty, does not have experienced crew or an established reputation? Net-net, we acknowledge that leading edge dayrates could come under some pressure over the next 6 to 12 months, but again, at these valuation levels, we feel we are being more than compensated for that risk.
Catalysts
We believe there are a number of potential catalysts that could play out in the near-term to halt the decline in RIG's stock price.
- This sounds obvious, but all of the "spill stocks" need for the well to stop flowing before they can go up. Attempts such as the "top hat" dome BP is attempting to put in place this weekend and the so-call "junk shot" of filling the open hole with debris may or may not work. What definitely will work is drilling a relief well to extract the oil and ultimately seal the well. BP has consistently guided to 6o to 90 days to complete this. However, our conversations with industry contacts indicate that RIG's Development Driller III is making rapid progress on drilling the well and is in fact on pace to break all existing records for time to complete a well of this depth. As of yesterday, we have heard reports that the drilling has already reached 9K to 12K feet (vs. target depth of 18K feet.) On that basis, the relief well could be done within a month, which would be a positive surprise for the market (and RIG would get the praise for drilling it so fast, to boot.)
- Aggressive share buybacks. The company has a significant share repurchase plan in place, and while they were a bit reluctant to commit to executing it aggressively given current market uncertainty, they now have the opportunity to buy back shares in the mid-$60s, while they were buying them back in the mid-$80s last month.
- Earlier this week, S&P changed their requirements for inclusion in the S&P500 (RIG was kicked out of the S&P500 when it changed its country of domicile to Switzerland for tax purposes.) Based on our reading of the rules, RIG could very well be re-inserted in the S&P500 later this year.
- Clarity from Petrobras regarding their drilling program for the Tupi deepwater field. To date, they have insisted that any rig working for PBR must have at least 65% of its content sourced from Brazil. From a practical standpoint, this is nearly impossible, unless PBR wants to build/own/operate the rigs themselves. The Brazilian governemtn would like to use PBR/Tupi as a means to create shipbuilding related jobs in Brazil, but doing so would result in a slowdown in the development of the Tupi field. Our contacts suggest that given the choice, PBR/Brazil will choose accelerated developmentof the Tupi reserves -- as this situation develops, it will create significant demand for deepwater rigs in the 2012-2018 timeframe and help alleviate concerns about coming supply increases.
Catalyst
- Macondo well stops leaking.
- Share buybacks.
- Inclusion in S&P 500.
- Tenders from Petrobras.