Description

BIG PICTURE: If you are looking for a 3x or 4x you can stop reading now. I believe RIGP is realistically a 2x (inclusive of dividends) by YE 2016 with very limited downside. It has new, high specification assets, trades below book value, has no debt, and has the potential for future dropdowns from the parent.

Pillars of Recommendation

·         Guilt by Association: Transocean Partners has been overly tied to the negative news surrounding its parent company, Transocean, and the broader oil woes. This is classic baby-with-the-bathwater scenario

·         High Quality Assets: Transocean Partners owns a controlling interest in two ultra-deepwater (“UDW”) drillships and a UDW semi-submersible rig that are among the newest on the water, being built in 2009 and 2010 (compared to a weighted average fleet age of approximately 20 years for the industry). UDW assets command much higher dayrates than other offshore rigs and most of the offshore oil discoveries are now occurring in the UDW space making them more attractive relative any other offshore drilling.

·         Strong Balance Sheet: Transocean Partners has no L/T debt within their capital structure, providing for strong optionality with respect to dropdowns.

·         Dropdowns: Dropdowns by the parent company right now = great for the MLP. Financed by debt, a dropdown would be very accretive to earnings and value.

·         L/T Leases to Strong Counterparties: Transocean Partners’ ships are subject to long-term leases that are non-terminable to two of the highest quality counterparties in the space, BP and Chevron. The first lease expires in November of 2016 with the remaining two expiring in 2018 and 2020.

·         Contract Backlog: Total “secure” revenue (contract backlog) generated from the 3 leases is expected to be $2.3 billion of which Transocean Partners (at 51% interest) is entitled to approximately half. With 95% efficiency and historical net margins of about 40% this would translate to $440MM in “secure” earnings.

Background

·         Transocean Partners (or “RIGP”) is an MLP that was spun off from the parent, Transocean Ltd. (“Transocean”, “RIG” or “Parent”) on August 5^th of 2014 as a result of a battle between activist investors and Transocean. The purpose was to recapitalize Transocean and “allow for greater financial flexibility” (i.e. generate $$$ for the premium over intrinsic value that the market was giving) and to reduce Transocean’s cost of capital.

·         Similar to its parent, Transocean Partners operates offshore drilling rigs. Specifically,  Transocean Partners owns a 51% interest in three UDW vessels (the Parent owns the remainder):

o   Discoverer Inspiration: an ultra-deepwater drillship that began operations in 2010 and is contracted by Chevron through April 2020;

o   Discoverer Clear Leader: an ultra-deepwater drillship that began operations in 2009 and is currently under contract with Chevron through Sept. 2018; and

o   Development Driller III: a UDW semi-submersible rig that began operations in 2009 and is currently contracted to BP through November 2016.

·         Transocean has the largest fleet of offshore vessels. Specific to UDW, the only other large player is Seadrill (SDRL or SDLP).

·         The RIGP IPO (7/14) was priced at $22.00 a share (63% higher than the recent price of $13.50).

·         52 week range was $11.55 to $29.43 as of 3/5/15.

Source: 3Q14 10-Q, Yahoo Finance, Forbes (http://www.forbes.com/sites/greatspeculations/2014/06/25/how-the-mlp-spin-off-helps-transocean/)

Effective Ownership

·         Transocean Partners is structured with 41.4MM common units and 27.6MM subordinated units. RIG owns all of the subordinated units and 21.3MM of the common units.

·         The effective split is 29% public equity (non-parent) / 71% Transocean (parent)

Capital Structure

·         RIGP has no L/T debt in its capital structure and thus retains optionality for future dropdowns at attractive interest rates. It does operate with some revolving S/T credit facilities which are de minimis and I will not talk about further.

Contracts

BP and Chevron are on the hook for leases that do not expire until late 2016, 2018 and 2020. These leases do not have an early termination options in their contracts. I’ve come across several sources, a few below, indicating that RIGP’s L/T contracts should be insulted from the turmoil in the oil markets through the term of contract and only bear risk at the time of re-contracting (where we will likely see lower dayrates if oil does not stabilize) and in the event of a counterparty’s default, which based on a credit analysis of BP and Chevron does not appear likely.

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[Over the past 5 decades (and many downcycles), offshore drilling rig contracts have been carefully honed by the legal teams of the drilling contractors to protect them from exactly the sort of action Total took today.

Unlike many land rig contracts, which allow for early terminations with a lump sum fee, offshore rig contracts, particularly deepwater contracts, prohibit operators from ditching the rigs early. This sort of protection is necessary because of the capital investment offshore rigs require.]

Source: http://oilpro.com/post/9507/now-ultra-deepwater-rig-contract-cancelled-early-drilling-dominoe

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[Previous action from the government mandated shutdown of drilling is the U.S. G.O.M. also leads to the conclusion that these leases are non-terminable in relation to the price of oil.]

Source: http://www.wsj.com/articles/SB10001424052748704123604575323152052188536

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[Offshore it is a bit of a different story. Operators generally don't have early termination clauses without being on the hook for the full contractual value (dayrate times days remaining in contract). This is why you see an active sublet market in deepwater - operators that are done with rigs early will try to sublease them to other operators to get out of the contractual cost. But as demand dries up and more rigs compete for work, subleasing extra time is not as easy as it was in the tight market of 2010-2013. We can't say for certain whether Total had an early exit arrangement in this deal, but we do think some operators this cycle may test driller's resolve and see if they can back out of these agreements. You may have a defacto early termination buyout occur in these cases if the two companies agree on some sort of settlement that compensates the driller for a % of the lost value. But again, this challenges the sanctity of offshore drilling backlogs - a very dangerous path for the drillers to start down...]

Source: http://oilpro.com/post/9507/now-ultra-deepwater-rig-contract-cancelled-early-drilling-dominoe

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Competitive Advantage in Offshore Drilling

·         While Transocean provides offshore drilling from shallow to UDW, RIGP is focused on new, high specification UDW drillers. The UDW offshore segment commands the highest dayrates and has the highest barriers to entry with the average upfront investment in a UDW driller around ~$600 million. The largest two companies in this space are Transocean (about 13 UDW units) and Seadrill (13 UDW units with 2 under construction). Other players in the space have smaller UDW fleets ranging from one to five ships. As mentioned previously, Transocean (RIG and RIGP) and Seadrill (SDRL and SDLP) essentially command the UDW segment which is important as additional supply is likely to be cut off after current construction projects are completed. Remember, there are high upfront costs which cannot be justified until commodity prices stabilize. In the long-term this will set up the UDW segment to be supply constrained in the latter half of the decade (when RIGP is exposed to re-contracting) and will also protect UDW dayrates from drastic declines. Additionally, while RIGP does not currently have any long-term debt, Seadrill Partners is approximately 50% levered and is not in a position to continue to grow earnings through dropdowns until the oil environment stabilizes. While Seadrill’s ICR was approximately 4x as of 3Q14, they have several factors that will likely cause their earnings and coverage to decline in the S/T and generally make them a less attractive investment than RIGP (although still attractive in the L/T). While SDLP has a more diversified fleet, this just means more contract rollover, giving the edge to RIGP. Additionally, while putting all your eggs in one basket is usually not a good thing, non-UDW ships, semis and jackups contract for much lower dayrates, have lower utilization, lower barriers to entry and are generally subject to short-term leases that do not provide the same protection. Contrast this against RIGP which has 3 long-term leased UDW floaters and it is clear that RIGP is in a better position at the moment.

Sources: Transocean Fleet Status, Seadrill Fleet Status, Seadrill 3Q14 10-Q and 2013 10-K, Motley Fool

http://www.deepwater.com/investor-relations/fleet-status-report

http://www.seadrill.com/our-fleet?rig=d2b23381-41ab-4a12-bfe6-87d293e8b9fc

http://www.fool.com/investing/general/2013/12/10/deepwater-drilling-has-a-bright-future.aspx

Insider Transactions

·         Some insider buying on December 9, 2014 and December 12, 2014 at price levels between $15 and $18 a share. Another insider buy occurred at $13.75/share on March 3, 2015.

Purchase Options / Dropdowns:

·         Under an agreement with Transocean, RIGP has the right of first offer for the remaining ownership interest in each of the RigCos, should Transocean decide to sell. Additionally, under the agreement within a period of 5 years (beginning 8/5/14 and ending 8/4/19), RIGP will be given the option to purchase a 51% or greater interest in any of Transocean’s six ultra-deepwater drillships: Invictus, Thalassa, Proteus, Poseidon and Conqueror. The purchase price would be the greater of FMV or Construction Cost, plus transaction costs. Assuming a dropdown price of between $800mm and $900mm financed primarily with debt, the addition to earnings would likely be between $0.40 and $0.55 per rig so you can see the value. On the 2/26/15 earnings call the CEO reemphasized that any dropdowns would be primarily financed through debt so there is little risk of diluting current shareholders.

Industry Outlook

·         In the near to midterm, I expect the pace of offshore contracts to slow substantially in conjunction with the significant uncertainty in oil and S/T oversupply of rigs . We have already seen this starting to occur as utilization rates are dipping lower and contracts are being signed at lower rates. The current environment will likely cause an industry shakeout with less efficient, older assets potentially being decommissioned.

·         According to a recent article, 212 semisubmersibles, jackups and drillships were under construction or awaiting construction in 2013 which compares to 143 in 2012 and 127 in 2011. This burst of activity has increased the rig count substantially although the supply woes are somewhat offset by the fact that most ships are produced only once commitments are in place (i.e. there is minimal spec. shipbuilding). With a likely slowdown and possible shakeout in the industry through 2016, contracts will likely be harder to come by with newer more advanced rigs likely to prevail.

·         Through Transocean Partner’s relationship with its parent company (the largest deep water drilling contractor) and its fleet of newer vintage UDW rigs, it is well positioned to weather future market oversupply and benefits from a bevy of competitors with S/T contracts, high leverage, less brand recognition and older rigs.

Source: http://www.outfoxthestreet.com/2011/03/factbox-on-average-offshore-rig-age.html

Source: http://www.offshore-mag.com/articles/print/volume-74/issue-7/rig-report/deepwater-drilling-rig-fleet-faces-short-term-slowdown-long-term-growth.html

Source: http://www.fool.com/investing/general/2014/05/13/these-offshore-drillers-have-made-a-big-mistake-2.aspx

Earnings

·         In 3Q14, RIGP generated $57 million in earnings on net margins of 42%. Of this $57 million, $22 million was generated prior to IPO and $35MM was generated post IPO.

·         Of the $35 million post IPO, $18MM was related to the non-controlling interest and $17MM ($0.24/share) was allocated to the controlling interest. As 38.6% of earnings ($22MM/$57MM) was Pre-IPO and not eligible to RIGP in 3Q14, prorated earnings would have been $28MM ($17MM actual + {$22MM/2} Pre-IPO), 64.7% higher than reported earnings.

·         Bearing in mind that RIGP has fixed, L/T contracts, this revenue stream is durable in the near term and we can extrapolate and say that ttm earnings would be more accurately reflected between $1.60/share and $1.70/share ($28MM*4/67MM shares), oppose to the $0.52/share currently listed on most public sources.

·         Looking ahead to forward earnings, my forward earnings forecast for 2015 is $1.90/share (this compares with $2.40/share derived by sell side analysts). I believe that the sell side analysts are on recreational substances, are accounting for dropdowns on day 1 or did not appropriately consider the scheduled maintenance that was planned and did occur in 1Q15. In any case, I will not be upset if they end up being correct. At a price of $13.50 my forward earnings generate a multiple 7x.

·         Note: Earnings were lower in 4Q14 due to planned maintenance that caused 4Q14 to be less reflective of ongoing operations. Please feel free to read the 10-K and 10-Q financials and come to your own conclusions.

·         Note: Earnings are relatively transparent as the budgeted depreciation is a fairly accurate estimator of on-going capital needs.

Dividends

·         Being an MLP, the majority of earnings are paid out as dividends. In 3Q14 RIGP earned $0.24/share post-IPO and distributed $0.225/share to shareholders.

·         Most public sources just recently (past few weeks) began reflect the dividend correctly at $1.45/share (10.75%) instead of $0.90/share/year ($0.225*4). The $1.45/share is reflective of minimum annual distribution going forward until the re-contracting of DD3 in 2016.

o   “We intend to pay a minimum quarterly distribution of $0.3625 per unit per quarter, which equates to approximately $25 million per quarter, or approximately $100 million per year in the aggregate, based on the number of outstanding common and subordinated units.  At October 28, 2014, we had 41.4 million common units and 27.6 million subordinated units outstanding.”

o   In February 2015 the distribution was $0.3625/share as planned.

Conservative Valuation Methodology

·         I have relied on 3 methodologies: a custom “secure earnings” build-up approach, a forward price-to-earnings multiple, and a discounted FCF.

o   The “secure earnings” build up has been presented previously but will be re-summarized and expanded here. According to the most recent financials, the contract backlog, a representation of the contract day rate multiplied by contract days remaining, shows that the three contracts in place should generate $2.3B over their remaining lives. This is allocated as follows:

§  Discoverer Inspiration: $1.14B (contract expiration of March 2020; dayrate of ~$550k)

§  Discoverer Clear Leader: $830MM (contract expiration of August 2018; dayrate of $590k)

§  Development Driller III: $330MM (contract expiration of November 2016; dayrate of $431k)

o   The total of $2.3 billion is adjusted for efficiency which has typically ranged from 90% to 100%. Using 95% the effective gross revenue is $2.2B. Historically, RIGP has operated near a 40% net margin and so the projected earnings for this $2.2B would be $875MM. Since RIGP only has a 51% interest in the rigs, RIGP’s share would be approximately $440MM. These earnings are considered secure and so Transocean Partners’ “secure earnings” estimate through 2020 is $440MM. Keep in mind that this is extremely conservative as it assumes ships vanish as soon as their current contract expires and no further income is generated from those ships. The second component of the build up is the net book value of Transocean Partners’ ships. Their historical cost net of depreciation is $1.97B. RIGP’s share is approximately $1B. Taking their bulletproof earnings plus the book value yields a market cap of $1.4B. Rounding down to an even integer let’s just call it $20/share. This would represent a 50% gain over the current price of $13.50. Note: this is conservative as I assume CA cancels out liabilities, but aggressive in that TVM is not applied to the earnings.

o   The forward price-to-earnings multiple is based upon a forward estimate of $1.90/year which assumes no incentive or production bonuses, no dropdowns and includes scheduled maintenance. This places the P/E around 7x which is roughly in-line with the industry’s current depressed forward price-to-earnings multiples, however; it is worth noting that RIGP has the added protection of fixed contracts through 2020 which most other E&P’s do not have. Considering the relative durability of the cash flow stream, the high dividend payout, and the safety/optionality allowed by the current lack of leverage it does not seem unreasonable to think that RIGP should re-rate between a 10x and 15x of current earnings once oil stabilizes (notice I didn’t say recovers). This provides at price target of $19.00/share (a 40% increase) to $28.50/share (a 110% increase). This is before accounting for any dividends in the interim, which you can conservatively tack on at about 10% pre-tax/year.

o   DCF: is derived as the net income of the business plus depreciation and amortization less on-going capital needs. RIGP’s on-going capital needs appear to be well covered by the depreciation estimate and current are fairly representative of “owner earnings” or FCF. Assumptions made in the DCF include 3% annual escalations on the contracts as well as re-contracting at 75% of the current dayrates upon rollover (the earliest of which occurs in November 2016). I have been following the recent re-contracting of other vessels and believe that if the contracts rolled today RIGP’s vessels would likely only command 60%-70% of what they currently are. All efficiency and operating ratios are based upon historical ratios as well as comparables.  The results of the DCF is a $17/share valuation (a 25% increase to the recent per share price of $13.50), based upon a 12% discount factor and an assumed 13x multiple of earnings in the 5^th year.

Conclusion

I have placed a 2-3 year conservative price target of $17 to $23/share, based on the information above, which only considers what is in place today. In my base case where you see one dropdown by YE 2016, RIGP would likely see an increase in earnings of around $0.40 to $0.55 (discussed previously), leading to a valuation of between $22 and $28. Further, in my optimistic case where there are two dropdowns by YE 2016 my target price is between $27 and $33. Based on a weighted average target of $25/share by 2016 and a 10% dividend yield, I believe that RIGP is positioned to generate respectable returns on the downside and offer a 2.75x on the upside

Risks

The following are what keeps me up at night with RIGP:

·         Due to the relative valuations of RIG and RIGP it might make dropdowns somewhat difficult to execute and there is always uncertainty surrounding the timing of a dropdown.

·         Oversupply of rigs in the short term has created a supply and demand imbalance which will likely negatively impact dayrates and utilization. RIGP’s contracts have a long enough term that I believe they will be affected to a lesser extent than others in the industry, however; it will still be important to monitor Development Driller III’s re-contracting as it approaches expiration in November 2016.

·         The continued volatility and supply-demand imbalance in oil will negatively impact the industry as a whole and, if prolonged for several years, will significantly reduce future earnings for offshore E&P as dayrates are significantly reduced and utilization decreases.

·         RIGP could certainly trend lower in the S/T. Significant negative news including layoffs and bankruptcies in the energy sector (particularly among offshore drillers) which are likely to occur (and would actually be a positive for RIGP as it would signal reduced competition) could push stock pricing further downwards – there just isn’t blood in the street yet.

·         If BP and Chevron are allowed to terminate their leases for a cash settlement, this would significantly impact the analyses and conclusion presented.

·         Similarly, if BP or Chevron are unable meet their commitments the analyses and conclusion are negatively impacted.

·         Transocean (the parent) owns a majority of the shares outstanding and thus has a controlling interest in RIGP and its rigs. The MLP structure is relatively untested for offshore drillers and it remains to be seen how public shareholders’ rights will be represented when they run contrary to Transocean’s.

Catalyst

·         Dropdowns – it’s not a matter of if, but when

·         Stabilization of oil prices

·         Increased analyst exposure