Transocean's Valuation Drivers
Transocean is the dominant leader in the offshore contract drilling industry. Currently the company controls 18% of the existing global fleet and more importantly controls 26% of the contracted market for deepwater rigs. Specifically, Transocean's rig fleet mix favors the deepwater and consists of 73 floaters (i.e. 50 semisubmersibles and 23 drillships) and 63 jackups (not including three under construction). Deepwater rigs under contract currently number 54 while the contracted jackup total equals 33 rigs. In combination, Transocean's market share for rigs in operation globally is 17% of the 523 contracted rigs.
We back tested a valuation method using operating metrics such as utilization, dayrates, and company fleet size to arrive at a formulaic approach for valuation to then compare against historical prices for Transocean's common shares (NYSE: RIG). Using this analysis we were able to observe what the stock market is ascribing as Transocean's financial exposure to the Macondo oil spill of last year. Based on our analysis, the market is predicting that the impact of the spill on Transocean's financial future could range from $3 to $4 billion dollars.
Using this analysis we also provide a forecast of Transocean's future valuation should the firm's utilization continue to track to levels displayed in the most recent month, July 2011. By our calculations, Transocean's current run rate using preliminary July data suggests that its valuation would improve nearly $1.9 billion, or $5.89 per share, if utilization rates in August and September mirror July's current levels.
Another factor we found that could work out favorably for Transocean in the future is its likely reinstatement to the S&P 500 Index. Recall that in December 2008, Transocean's shares were removed due to its corporate re-domestication to Switzerland. Last year, the S&P 500 changed its rules on this matter and noted twenty firms that were now eligible for inclusion into the S&P 500 index (Transocean's shares were on this list). Since that time, six of the 20 firms have been added back during the course of typical attrition across the index. At the current pace of attrition, it seems likely that Transocean's shares would be added back to the S&P 500 within the next five years (assuming the firm continues to meet the criteria for inclusion).
Understanding the Market's Reaction to the Marianas Damage
Transocean's share price recently suffered a setback on news that the Transocean Marianas, a semisub that had just completed a job for ENI, was damaged during preparations to mobilize for its next project. Specifically, RIG's common shares fell 3% to $62.23 on July 6th versus the prior day's close.
One of the items that investors scrambled to understand in the immediate aftermath of the news was the impact the damaged rig could have on near-term future earnings. There is an old saying on the Street that the pricing of securities by the stock market at times resembles a voting machine and at other times a scale. While some pundits may have argued that the one day sell-off of RIG's shares was from the gut and likely an overreaction; we will show you another interpretation that supports a more pensive "weighing" of the situation.
We took the one-day change in price and divided it by next year's consensus P/E estimate from the day prior to the incident. By reverse engineering the Price-to-Earnings ratio, we arrive at the implied impact that the damage to the Marianas may have on Transocean's earnings. Based on our calculations, the change in price suggests the market viewed the Marianas EPS impact as roughly 20 cents per share. Interestingly enough, by taking a financial approach (i.e. multiplying one-year of the Marianas' revenue by a reasonable margin assumption and dividing by the share count) we find that if the Marianas were out of commission for a year it would result in lost earnings of approximately $0.21 per share. Thus, taking the approach that the market is in fact generally efficient, we see that the market on the day of the news was bracing for the Marianas to be out of commission for approximately one year.
Should future speculation support a shorter duration before the Marianas returns to operations, then we would expect this to be positively reflected in the share price of Transocean as lost earnings power is presumed recouped.
The fact that these two numbers are so close is not a coincidence. Investors and traders alike do such calculations on a daily basis as they evaluate perspective investing ideas.
Applying The Market's Logic to the Macondo Oil Spill
While our analysis of the Marianas may be a quick and dirty way to analyze a situation, using similar logic to look back at the Macondo blowout has some interesting implications related to the evaluation of Transocean's current share price. We took the days between the time the blowout occurred until when the U.S. government indicated that sweeping changes and reform were looming. By comparing Transocean's change to the average of its peers; we find the difference in share price performance serves as a proxy for the market's valuation of Transocean's future financial exposure to Macondo.
The date that the BOEMRE (previously MMS) under the direction of Interior Secretary, Ken Salazar, first announced sweeping reforms was May 11, 2010. The reason we chose this time frame is that it is unclouded by the uncertainty surrounding the government's revamping of the permitting process for drilling offshore. Prior to this point the market was expecting manageable changes to the industry. The days after this point were marked by months of uncertainty about when the industry would restart.
During this three week period that we just identified, the broader markets were trending down and oil prices were also waning. Thus, to isolate the impact of the Macondo oil spill, the downtrend in the overall markets needs to be stripped out. Furthermore, the markets were anticipating that the blowout would cause the costs of drilling to subsequently increase. This also would need to be extracted from the share price drop. We took a simplified approach to these factors by assuming that Transocean's peers experienced a decline solely from these two factors and measured the group's average pull back over this three week period.
What we found was that offshore drillers (excluding Transocean) experienced a 10.6% reduction in share price from the time of the Macondo blowout until the Department of the Interior first announced sweeping changes to the MMS and the industry. Transocean's share price, on the other hand, declined 20.9% during the same timeframe. Thus, the difference between the two is what we will assume the market perceived as Transocean's ultimate future exposure to the Macondo oil spill. By our calculations, the market originally placed a $3 billion valuation on Transocean's ultimate exposure.
Again, it is interesting to juxtapose how the market is gauging future events with a more empirical look at the situation. Using a formulaic approach to discern the enterprise value of publicly traded offshore contract drillers, we found a very consistent pattern for pricing based on the most recently reported utilization, dayrates, and rig fleet size. We applied our method to the last ten quarterly reports for Transocean and found that actual enterprise value based share price varied with our calculated method (using its publicly reported operating metrics) by an average of 3% per observation.
One week after Transocean reported 1Q11 results its share price was trading at a 10% discount to our calculated proxy for enterprise value (EV) using operating metrics from the same report. Bringing that valuation forward to today, Transocean's EV, using its 7/15/11 closing share price, is now $4 billion below our formulaic estimate of EV. Effectively, the overhang due to the incident has grown from approximately $3 billion to nearly $4 billion.
If you only look at year-to-date results comparing Transocean's (NYSE: RIG) share price against its peers, RIG has underperformed of late. However, this comes after its shares bounced 87% from a low last summer of ~ $45 (when containment efforts of the oil spill were first shown as successful last July) to its recent high of $84 in early March. This compares to an overall average gain of 64% for its peer group during the same period. So, aside from adjusting to factors that have put pressure on Transocean's share price, like its $1 billion impairment charge (taken to lower its jackup fleet's book value) and lowered utilization rates, some of the downward trend in Transocean's shares may have come at the hands of investors locking in profits by closing out trades entered last year.
Utilization rates for Transocean are beginning to improve relative to overall industry trends. The following chart illustrates the gap between Transocean's utilization and the industry, which has averaged ~ 8 percentage-points, in recent months. In July (still in progress) this gap appears to be shrinking. Specifically, the July variance to date is 4.8%, 380 basis points less than the prior month. Moreover, the narrowing is due solely to Transocean's utilization improving versus the global average.
We would note that this improving utilization trend, that we are just now picking up on, would get reported with Transocean's 3Q11 financial results. So, if you adjust Transocean's 1Q11 operating metrics by the change in utilization we are currently picking up, it would imply an increased estimated market capitalization of $1.9 billion or $6 per share over our valuation estimates. We would also note that utilization during the second quarter of 2011 was down slightly versus 1Q11. It is our belief that the downward trend in share price over the past three months is the market adapting to the utilization diminution in the second quarter. Thus, in our opinion, the risk/reward relationship is now pointing to greater rewards in the future considering utilization rates are likely understood to be as bad as they are going to get for the company.
Floater Utilization Rates
Both the industry's and Transocean's utilization rates have been trending unfavorably for the past two years. Considering the longer nature of deepwater contracts, utilization trends are a lagging indicator of drilling sentiment. Additionally, Transocean's high concentration of deepwater rigs in the Gulf of Mexico makes the relative underperformance over the past four quarters quite understandable. As the permitting issues in GOM continue to improve, we would not be surprised to see the gap narrow as time elapses. Furthermore, as we will show in the next table, Transocean's current utilization in the GOM is now better than industry averages.
Of the six primary regions, Transocean is tracking at or better than industry levels for utilization in half. Of the three regions with superior performance, the Gulf of Mexico stands out the most. Not only is Transocean beating the region's average for rigs in these waters, its market share for contracted rigs is nearly half the total. Besides the GOM, Transocean is also strong in the African and Latin American Markets. These three regions are significant from a global perspective because of the higher levels of exploration activities and growth associated with each.
Jackup Utilization Rates
For the most part Transocean's jackup fleet is spread evenly across the global waters with the exception being North and South America, where the company does not have a presence in either. Transocean's current jackup utilization rate of 48% overall is tracking better than it was in the first quarter of 2011. In terms of concentration, Transocean has the largest part of its jackup fleet working in the Asia Pacific waters.
The dayrates that Transocean charges its customers are tracking favorably versus industry comps. For its deepwater assets, Transocean's fleet commands dayrates that top the industry in all three categories (i.e. Midwater, Deepwater, and Ultra-Deepwater). This is quite impressive considering that Transocean controls 26% of the entire floater market. Having a larger concentration of rigs servicing the deepwater markets is also good for Transocean's backlog. Transocean's backlog for its floating rigs is 2.2 rig years on average, quite favorable to the industry's average of 1.6 years for floating rigs. So not only is Transocean charging higher rates, on average it has also done a better job than the industry at locking down longer terms.
Eligibility for Inclusion Into S&P 500 Index Reinstated
In December 2008, Transocean's shares were removed from the S&P 500, due to its corporate re-domestication to Switzerland. In May 2010 the S&P 500 announced that it had changed its definition for what constituted a U.S. company. Furthermore, in June 2010, the S&P highlighted twenty firms that because of the definition change were now eligible for inclusion in the S&P 500 index in the normal course of additions going forward (Transocean's shares were on this list).
In the year since these two announcements, six of the 20 firms originally listed have been re-added to the S&P 500. At the current pace of attrition, it seems likely that Transocean's shares would get added back to the S&P 500 within the next five years, assuming the firm continues to meet the criteria for inclusion.
While there has been much research and debate as to whether the long-term value of a firm is enhanced by being added to the index, there is little refuting that in the few weeks after inclusion, a company's share price benefits from the change.
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Manages 46 Offshore Rigs
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