Transocean is the midst of a very difficult next 2-3 years and appears to be a highly asymetric short throughout its entire capital structure.

 

The Offshore Drilling Rig market is on the tail end of a 5+ year bull market cycle, and of course the industry found a way at the peak to extrapolate not just a steady demand growth rate, but an accelerating demand growth rate, right as demand was leveling off.  The supply-demand dynamics are well known and highly consensus among invetors, and ODS-Petrodata (whole street uses them) can be used to corroborate the wave of newbuild (uncontracted) rigs coming online, along with the 1st wave of (3yr) contract rollovers from the boom period, combined with the current "theme" among IOC companies of "capital discipline."  Morgan Stanley, ISI and DNB (Norwegian) have good data snapshots of the macro environment.

 

While Supply-Demand concerns are fairly obvious and well-known by the market, I think there is still downside in three key areas: 1) pricing - since the drilling market hasn't seen real cyclical pressure in 10-ish years, and never with the new (5th-7th) generation of rigs, investors don't appreciate how commodity markets are going to price to disincentivize supply; 2) margin capture - in a somewhat game theory driven market, where barriers to exit are large, you're going to see management teams try to preserve option value (with very expensive carrying costs) that will significantly erode current EBITDA margin capture expectations; 3) rig retirements: very few people bake in what are likely to be the true rig retirements among operators with lower specification rigs.

 

This is predominantly a Deepwater Floater analysis, and Transocean is the largest player in this market.

The analysis is in comparing Operating Costs, and Relative Efficiencies across 3rd/4th, 5th, and 6th/7th Gen drilling rigs, all of which have unique characteristics.  The key backdrop is that for years, each generation of drilling rigs added the capability to drill in deeper water, but not necessarily to drill at a faster rate (or much other efficiency advantage), however the 6th/7th generation rigs are primarily focused on significantly decreasing per well drilling time (as the rig market sort of outpaced the E&P market in terms of water depth capabilities).  The vast majority of 6th+ gen rigs are not fully utilizing their water depth capabilities and are simply coveted for both drilling efficiencies, the capacity to hold a 2nd Blowout Preventer (which saves downtime as inspection/maintenance is frequent post-Macondo), and larger deck capacity (which decreases the number of trips you need from supply vessels, and is therefore worth real money to an E&P).

 

To try to make this easy to follow, I would pull up Ole Slorer's (at MS) May 8 report, where he lays out rig-level re-contracting pricing for Transocean as well as RIGs April 17 Fleet Status Report.

 

If you believe that you need to see rigs get retired, then to model the "trough" operating environment, you start working from the low-specification rigs, upwards.

3rd/4th generation operating costs are ~$140-160k/day;  Day-Rates are currently trending from~$250-300k/day-->$180-200k/day (as you would expect in a commodity environment, towards marginal short-term opex);  Note: these rigs all have 5yr inspections which can lead to upwards of $50mn in capex to keep the rig compeitive/safe, at which point owners will likely choose to cold-stack the rig;  Coming out of cold stack would require $50-100mn of capex and therefore we'd assume these are gone forever).  These are rigs generally built in the 70s and 80s.  the Sedco series of rigs for Transocean are an example - you'll notice MS models ~$200-250k/day recontracting rates (you could convince yourself there's downside but let's just use this as a starting point, and note that MS is lowest on the street for '16 EBITDA).  In reality you should have a few of these "scrapped" in your model (MS has 2, more likely to be ~6).

 

5th generation rigs are where it gets interesting;   Operating  costs are ~$180-200k/day;  Currently these are pricing around $400k/day, however if they are foreced to compete with 4th gen rigs for jobs, while they can drill in deeper water, they only offer well time efficiencies of around 10% if comparing drilling environments that both 4th and 5th gen can compete in, which is most of the upcoming well programs).  A key dynamic is at work here: these are relatively new (<15 year old rigs) and therefore owners will have a hard to swallowing "cold stacking" these rigs, which may be virtually impossible anyways due to regulations around "self propelled" vessels and maintaining the necessary Coast Guard certifications, which leads to stacked operating costs being almost as high as working operating costs (ie: a Large Barrier to Exit);  Transocean has the largest fleet of 5th gen rigs, with 9 coming up for recontracting over the next year.  MS models ~$300k/day for these recontracts;  You could convince yourself that trough pricing here is ~10% over your trough 3rd/4th gen pricing assumption (it gets pretty ugly so we'll just use the $300k/day).  The key question is how quickly 3rd/4th gen rigs are retired and whether or not a 5th gen rig needs to be "warm stacked" for a long period of time (and who chooses to take that pain) - it's counter-intuitive and unusual to model an operating rate environment that does not incentivize stacking a rig AND to model the stacking of rigs - something that the street is doing currently;  Normally you have to model the rates to such a point that it incentives stacking;

 

6th/7th generation rigs are much more durable from a value perspective, though there is a lot of supply coming online in the next 2 years.  Operating costs here are ~$220-240k but these ships offer well drilling time efficiencies of 30%+ vs. 5th gen rigs, and in some cases are the only rigs that can compete for a tender (if you need a 2nd blowout preventer which is increasingly mandatory in the Gulf of Mexico and other places).  Newbuild costs for these are ~$600-650mn/rig;  while rates peaked out >$600k/day, break-even (9%) unlevered IRRs can be achieved around the $450k/day day-rate number, a number rates are quickly approaching (0% IRR would be in the mid-300s day-rate);  With a long-enough time horizon, these rigs will certainly be worth replacement value, as unless you believe global oil prices are <$100 forever, we will continue to need to drill in deeper, more technical offshore environments.  If someone would want to hedge this oil price risk/assumption, Transocean would be a very cheap put option on oil prices to the extent it could have solvency issues in a lower pricing scenario.

 

Note this is a relatively simplistic analysis and there are nuances for different operating environments, which lead to higher nameplate rates, but usually have corresponding costs/risks.

 

Also note that this analysis all assumes a relatively healthy level of demand growth continuing;  to the extent demand actually flattened out or declined (almost certainly just an oil price call), this could be a much more dire looking set of circumstances.

 

I think I've laid out a framework above to model "trough" operating conditions, which we would never want to base a perpetual multiple on;  This is the most likely bull case for the stocks, that you'll see rates "normalize" in 2017, the issue being that generalists are using a "boom" cycle over the last 5 years as a barometer of "normal";  To me normal is where the industry earns its cost of capital and therefore I would simply use the ~$450k/day for 7th gen rigs, a 25% discount for 5th gen (<$350k/day), and a 10% discount for 3rd/4th gen rigs (each pricing in the ineffeciencies all-else-equal of those rigs).  You'll find these day rates are not particularly different than the "trough" we/MS laid out (perhaps suggesting our trough is still too high or that the upside is only 10-15% in reality). 

 

The Transocean backdrop is that they were a leader in 5th gen rigs, but failed to see the logic in investing in 6th/7th gen and so were disintermediated by other (some startup) companies;  They capitulated at the peak and committed to building new rigs on spec;  Icahn stepped in and wanted them to pay a $4/share dividend just as the market was starting to roll over (shareholders voted for $3/share recently);  But as you will find comparing RIG to other companies; they are Last in Contracting for '15-16;  First in 5th generation exposure, and First (Worst?) in Balance Sheet Leverage.

 

These are very straightforward companies to model and therefore we can reference MS's assumptions and corresponding EBITDA estimates;  For 2015, they have RIG at $3bn of EBITDA, and for 2016 ~ $2.7bn (though if you look closely they uptick most of their dayrates in 2H16 for an unexplained reason, if you normalize for this $2.5bn is probably a better number);

 

Gross Debt is ~$10.3bn;  Market Cap is ~$15.4bn;  Cash is ~$2bn (note: $1.3bn of this is "minimum" operating cash for working capital purposes and I would not necessarily subtract in your EV calculation as "free"/non-operating cash)

 

Using these EBITDA streams, subtract $500mn/year for interest expense, use a 17-20% cash tax rate, and ~$1bn/year for maintenance capital;  appears to leave $750mn-1bn of deployable free cash flow per year;  Icahn got them to pay $1.1bn/year in dividends (questionable - the company will admit this);  and they're in non-cancelable newbuild (some uncontracted) rig programs for capex commitments of $1.5-2bn/year to upgrade the fleet, essentially all of which needs to be funded by external sources of capital;  Their stated strategy is to somehow MLP certain of their best contracts (which is both small ~$500mn/year in drops, and not clearly accretive, given the company appears to trade at ~8.3x EBITDA already), and to sell off all of their 3rd-5th gen rigs (again, this would be almost certainly at less than 6x EBITDA which is equal to ~$300mn/rig @$350k/day rates - I believe this is  close to what these rigs were new constructed for 10 years ago, which is aggressive); Public comp's for these rigs trade at ~4x EBITDA, so hard to see public or private markets paying accretive multiples for these rigs.

 

On a multiples-based valuation, I think its hard to convince yourself that these should trade at >6x EBITDA on a rig-level basis;  this would lead to upwards of 50% downside for RIG equity given the balance sheet leverage;

 

The street will try to do an NAV-based valuation, which is valid in theory but in which they improperly value 3rd-5th gen rigs, which are moving towards obsolescence and are likely more properly valued as a DCF or remaining contracts;  I would guess ~$550-600mn/rig for 6th/7th gen rigs, <$300mn for 5th gen rigs (MS has $375mn), and <$150mn for older rigs (MS at $50-140mn) - 5th gen is clearly the debate in the market and RIG is the most leveraged to this debate;  It would appear RIG trades at a 30%+ premium to true NAV/private market value;

 

From a credit perspective, you could conceviably have a scenario where Gross Debt grows by $1-2bn/year and sitting in 2016 you're at $12-14bn on a $2.5bn EBITDA stream, substantially overlevered;  To the extent the company has any issues accessing capital markets and/or you have a demand decline for rigs, you could have a real solvency issue, making the credit a somewhat asymettric short in my opinion (spreads ~150-200bps currently);  I also like that the equity and credit combined short helps to minimize the number of "outs" the company has if you only have 1/2 of the cap structure on (ie: they could do big equity issue or just torch the IG bond market and issue away).

 

Icahn is somewhat of a wild card though it appears he got fairly unlucky with timing of the cycle - I think the biggest risk to the short, is he realizes whats going on and starts issuing equity en masse to buyout other companies with newer rigs - would love to hear thoughts on any other potential "outs"/strategies that could prove the short thesis incorrect.  All feedback appreciated!