transocean report (2010)

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Transocean Analysis

Prepared by: John R. Pangere

July 2010

Sources: Transocean Ltd. Company filings and presentations, ETrade, Personal Calculations

Transocean, Ltd. (NYSE: RIG)

Date of Report: 7/14/2010 Shares Outstanding (Millions): 320

Current Price: $52.36 Institutional Holdings: 70.5%

52-week range: $41.88-$94.88 Fiscal Year Ends: 31-Dec

Average Daily Volume: 16,658,000 FY 2009 Net Income (Millions): $3,159

FY 2009 EPS (Reported): $9.84 Book Value, as reported (Millions): $20,559

FY 2009 P/E: 5.32x Market Cap. (Millions): $16,670

Dividend Yield: 0% Price/Book Value: 0.79x

Index Membership: NYSE Industry: Oil Services

Business Description:

Transocean, together with its subsidiaries, is the largest provider of international offshorecontract drilling services for oil and gas wells. Their particular focus is on deepwater and harsh

environment drilling services. Most of the company’s revenue is derived from dayrate contract

drilling. In addition, the company provides oil and gas drilling management services, drilling

engineering and drilling project management services, and oil and gas exploration and

production activities. The company was founded in 1919 (then known as Danciger Oil and

Refining Company) and is headquartered in Zug, Switzerland.

Investment Thesis

With the recent decline of nearly 50% in market value over the last 52 weeks due to the Gulf

of Mexico oil spill, the company is selling at a compelling valuation. The Gulf of Mexico oil

spill, due to the explosion and sinking of the drillship Deepwater Horizon, has pushed shares of

the company to sell at a discount to its book value and a loss of nearly $15 billion in market cap.

Currently, the book value (as adjusted by my estimates) is approximately $58.50 per share,

$5.50 less per share than the stated book value of the company based on their FY2009 annual

report. The adjusted book value represents the reproduction cost of the assets if a competitor

were to enter into the offshore business and reproduce all the assets currently held by RIG.

Adjustments include the loss of the Deepwater Horizon and a reduction in assets by the total

amount of debt the company currently holds.

With the shares trading at $52 per share, the shares can be bought at a discount of

approximately 11% adjusted book value. Historically, the company trades at a premium tobook value of approximately 2.5x over the past 5 years, with a high of 5x and a low of 1x. The

current book valuation compares favorably with the Oil & Gas Drilling industry, which currently

sells at approximately 2.3x book value, with the average of the company’s 4 closest competitors

at 1.46x book value.



Transocean Analysis


July 2010


A return to historic book valuation would provide a 180% gain from current prices (best casescenario), while a return to the average of the company’s 4 closest competitors book value

multiples would provide a 65% return.

The company has proven to be very profitable. Over the last 5 years, the company has had an

average net margin of approximately 33% of sales. Again, the market is discounting the shares

of the company due to the uncertainty of the oil spill, but the company earned just over $3

billion in FY2009, or $9.84 per share from continuing operations. With the stock around $52

per share, this implies a price-to-earnings ratio of approximately 5.3x. On a trailing 12-month

basis, the company earned approximately $2.9 billion, implying a price-to-earnings ratio of 5.7x.

Historically, the company has a price-to-earnings ratio of 15x on average over the last 5 years.

The company has sold at a low price-to-earnings of 4.3x and a high of 38.5x over the past 5

years. The current industry price-to-earnings ratio is approximately 19x, with an average price-

to-earnings ratio of the company’s 4 closest competitors of 9x. The current price of the

company is favorable with the current price-to-earnings ratio near its 5-year low.

On a trailing-twelve-month basis, a return to the historic company average price-to-earnings

ratio would provide a return of nearly 160%, while a return to a modest 9x earnings would

provide a return of 56%.

The company has been able to pass on higher costs to its customers. The contract dayratesfor the company’s fleet has steadily increased over the past 3 years from approximately

$210,000 per day in 2007 to $271,000 per day in 2009, an increase of 28.5%. Even though

revenues have been steadily decreasing since FY2008, part of the decrease has been offset by

higher rates being charged to customers. With this kind of pricing power, the company should

be able to offset the majority of any declines in sales of future operations.

The company produces a large amount of free cash flow to use at its discretion. Over the last

3 years since the merger with GlobalSantaFe, the company has averaged approximately $2.5

billion in free cash flow (defined as the cash provided by operations, plus depreciation and

amortization, less capital expenditures, taxes and interest). In FY2009, the company collected$2 billion in free cash flow. Cash flow for FY2010 is expected to increase, despite an expected

fall in revenues, due mainly to reduced capital expenditures (as seen below from the

comparison of Q1 2010 and Q1 2009).



Transocean Analysis


July 2010


2009 2008 2007 2006 Q1 2010 Q1 2009

Operating Cash Flow $4,974 $5,769 $3,059 $1,637 $1,066 $1,287Capital Expenditures $3,052 $2,208 $1,380 $876 $379 $708

Free Cash Flow $1,922 $3,561 $1,679 $761 $687 $579*Numbers in millions

This free cash flow can be used in several ways, such as to increase the cash position of the

balance sheet or to repay debt. In addition, the company has authorized a share repurchase

program of up to $3.2 billion worth of shares (approved in 2009 and of which it has purchased

$200 million worth of shares at an average price of $81.63 per share), and a cash dividend,

approved by shareholders, of $3.11 per share beginning in July of 2010. The cash dividend will

currently provide shareholders a yield of 6%. The average yield of the industry is 2.5%.

Simply put, Transocean uses approximately half of its operating cash flow (on average, $4.6billion over the last three years) and reinvests it back into the business. The rest it uses to

reduce debt and add more cash to the balance sheet (thereby, strengthening its financial

position), buy-back shares, and beginning in July, issue a dividend to shareholders. The

dividend will cost approximately $1 billion to implement, which the company has proven it has

the capacity to generate.

The company has a strong balance sheet. Since the merger with GlobalSantaFe, Transocean

has been strengthening their balance sheet. After initially taking on more debt to merge with

GlobalSantaFe (as many other companies that acquire their competitors do), they have been

steadily reducing the debt on their balance sheet (numbers in millions, except

Debt/Debt+Equity ratio):

2007 2008 2009

Cash 1,241 963 1,130

Debt 17,257 13,557 11,717

Net Debt 16,016 12,594 10,587

Equity 12,571 17,167 20,559

Debt/Debt+Equity 0.56 0.42 0.34

A stronger balance sheet allows the company more financial flexibility in order to weather a

downturn in offshore oil production.



Transocean Analysis


July 2010


Investment Risks

Uncertainty regarding the outcome of potential litigation and costs associated with theDeepwater Horizon accident. Transocean has been named in a number of lawsuits stemming

from the oil spill and the outcome and costs associated with those lawsuits could take a

number of years (the Exxon Valdez spill took 19 years to be decided in court). There were 11

deaths, 9 of whom were company employees, when the Deepwater Horizon exploded. The

company maintains insurance coverage of up to $10 million per occurrence and $50 million in

aggregate for crew personal injury liability and $950 million liability coverage exclusive of the

personal injury deductibles. The company is at risk for any claims over $950 million.

Uncertainty regarding potential future off-shore drilling regulations in the US. While off-

shore drilling is already heavily regulated in the US, the oil spill may push lawmakers to increasethe already stringent regulations causing a substantial increase in operating costs in US waters.

In FY2009, the company generated 19.3% of revenues from operations in the US ($2,239

billion). Increased costs and/or any stoppage of drilling in the US could impact revenues

causing the stock to decline further. For instance, if operations were to cease in the US (worst-

case scenario), assuming revenue and costs of goods sold declined proportionally with all other

costs remaining the same (see table below), a 20% loss of revenues from the prior year, all else

being equal, would indicate the following (numbers are in millions excepts per share amount):

Sales (net) 9,245

Cost of Goods Sold 4,112

Selling, General &Administrative 209

Depreciation 1,464

Total Operating Expenses 5,785

EBIT 3,460

Interest expense (479)

Other Income (expense) (net) (351)

Pretax Income 2,630

Income Taxes - total 526

Net Income (loss) 2,104

Shares fully diluted 321

EPS per fully diluted share 6.55

At an earnings per share of $6.55, a meager price-to-earnings ratio of 9x would value the shares

at $58.95 per share, and a return to the historic ratio values the shares at $98 per share.



Transocean Analysis


July 2010


Any loss from the company’s largest customer, BP, could result in depressed revenues. BP

accounted for 12% of company revenues in FY2009. Any loss of business from BP couldmaterially impact the company’s profitability. The loss of the Deepwater Horizon will reduce

2010 revenues by approximately $126 million. While $126 million is a very small percentage of

total revenues, a total loss of revenues stemming from BP (another worst-case scenario)

amounts to $1.4 billion per year. Assuming this decline (as above) would indicate the following

(numbers are in millions, except per share amounts):

Sales (net) 10,781

Cost of Goods Sold 4,626

Selling, General & Administrative 209

Depreciation 1,464

Total Operating Expenses 6,299

EBIT 4,482

Interest expense (479)

Other Income (expense) (net) (351)

Pretax Income 3,652

Income Taxes - total 730

Net Income (loss) 2,922

Shares fully diluted 321

Earnings per fully diluted share 9.10

As above, a return to a modest 9x earnings would indicate a value of $81.90 per share, and a

return to the historic price-to-earnings ratio would indicate a value of $137 per share.

In addition, the following chart represents the drillships currently under contract with BP:

Rig Location

ContractStartDate

Expiration Date

CurrentDayrate

EstimatedOut ofServiceDays Notes

DiscovererLuanda Angola

FY2010Q3

FY2017Q3 $430,000

*UnderConstruction

DeepwaterHorizon USGOM

Sept.2007

Sept.2013 $497,000

*Lost inaccident

GSFDevelopmentDriller II USGOM

Nov.2008

Nov.2013 $580,000 10

DevelopmentDriller III USGOM

Nov.2009

Nov.2016 $403,000



Transocean Analysis


July 2010


Sedco Express Angola June.2005 June.2010 $188,000

*Contracted to

Noble EnergySept. 2010Paul B. Loyd,Jr. UKNS

Apr.2009

Mar.2012 $485,000

GSFConstellation Trinidad

Aug.2009

Aug.2010 $110,000

*Contracted toTotal Sept.2010

*USGOM is the US Gulf of Mexico

A breakdown of the expected revenues from BP for FY2010, adjusted for the loss of the

Deepwater Horizon, are as follows:

2010 Revenue from BP (Estimated)Discoverer Luanda $ 58,050,000

Deepwater Horizon $126,735,000

GSF Development Driller II $205,900,000

Development Driller III $147,095,000

Sedco Express $ 33,840,000

Paul B. Louyd, Jr. $177,025,000

GSF Constellation $ 26,400,000

Total $775,045,000Adjusted for loss of DeepwaterHorizon $693,040,000

Even with the loss of the Deepwater Horizon, the impact on revenues is limited. BP still has

several ships under contract for various periods of time in locations worldwide. If Transocean

were to lose BP as a customer, it would not happen until the length of the contracts on all ships

contracted to BP run their course. Note: There was a loss of revenue due to the recent

moratorium on offshore drilling in the US. The moratorium was found to be unlawful, but the

amount of revenue generated from the USGOM is still uncertain.

The price of oil can materially affect the number of drillships utilized in any given year. The

oil services business is highly cyclical, and any fall in the price of oil may cause fewer contracts

for drilling operations due to less profitability for the company’s customers. In the past year, as

the price of oil has declined from its high of near $150 per barrel, the utilization rate of thecompany’s rigs has also declined.



Transocean Analysis


July 2010


Potential Catalysts:

1. Any claims against the company involving the Gulf of Mexico oil spill are dismissed :While it is highly unlikely the company will not incur any costs associated with the oil

spill, the possibility exists that they will be cleared of being totally at fault. Transocean is

mainly an oil and gas drilling company, not an exploration company such as ExxonMobil

or BP.

According to Transocean’s latest SEC filings, the company’s contracts are written in such

a way as to hold them harmless in the event of a blowout of the well and any

environmental damage associated with such a disaster. In the case of the Deepwater

Horizon accident, BP, the customer in this case, has agreed that they will indemnify

Transocean from the costs associated with the accident, except for lost revenue to thecompany. According to Transocean’s latest quarterly report for the first quarter of

FY2010:

“Under our drilling contract for Deepwater Horizon, the operator has agreed, among other

things, to assume full responsibility for and defend, release and indemnify us from any loss,

expense, claim, fine, penalty or liability for pollution or contamination, including control and

removal thereof, arising out of or connected with operations under the contract (other than for

pollution or contamination originating on or above the surface of the water from fuels,

lubricants, motor oils and other substances, as to which we similarly agreed to assume

responsibility and protect, release, and indemnify the operator). The operator has also agreed,

among other things, (1) to defend, release and indemnify us against loss or damage to the

reservoir, and loss of property rights to oil, gas and minerals below the surface of the earth and

(2) to defend, release and indemnify us and bear the cost of bringing the well under control in

the event of a blowout or other loss of control.”

This bodes well for Transocean since the estimated cleanup costs of the spill are in the

multi-billions. While there will be other costs the company will incur due to the

accident (mainly litigation), the company should benefit from not having to provide

substantial amounts of money for the cleanup associated with the accident.

2. A rise in the price of oil : Oil is essential for economies worldwide to operate without

interruption. Until there is a better, cheaper alternative, oil will be produced andconsumed by the world. According to the US Energy Information Administration, the

world as a whole consumes 84 million barrels of oil per day, an increase of nearly 10

million barrels per day from just ten years ago. In addition, with developing nations

such as China and India requiring more and more oil to continue their development,



Transocean Analysis


July 2010


consumption of oil may increase even more substantially over the next ten years than it

did the previous ten years.

3. Reduction/sale of unused and/or less profitable fleet. The company generates the bulk

of its revenues from its fleet of high-spec and mid-water floaters. The following table

represents the utilization of ships by type of drillship:

Utilization Q1 2010Avg. DailyRevenue

High Spec Floaters

Ultra-deepwater Floaters 88% $486,000

Deepwater Floaters 71% $383,800

Harsh Environment 98% $400,100Midwater Floaters 67% $331,600

High-Spec Jackups 63% $166,000

Standard Jackups 53% $133,100

Other Rigs 50% $72,700

Total Fleet 66% $295,700

Taken together with the utilization rates of their less profitable drillships, the company

may be able to unlock larger margins and reduced expenses with a disposition of the

less utilized and less profitable fleet while concentrating solely in deep water, harsh

environment and mid-water areas.

Recommendation:

Upon my review of Transocean’s company filings and taking into account the Deepwater

Horizon accident, I believe the recent selloff in the company’s stock is overdone. It is true that

there is uncertainty regarding future offshore drilling operations in the US, but given that the

majority of the company’s revenues come from outside of the US and the fact that oil is

essential for the world economy to continue production, the problems the company currently

face will be compensated for through their continued and future offshore operations.

Based off of my calculations and assumptions, I believe that Transocean is worth, at the very

least, $81 per share, more than 50% above the closing price as of Wednesday, July 14, 2010.

The company is still selling at a discount to its book value, but I suspect that that will not be for

very much longer. I feel that the stock is safe to buy up to my calculation of adjusted book

value of $58 per share. In addition, while the upcoming dividend may be attractive to those



Transocean Analysis


July 2010


seeking dividend income from their investments, my opinion is that those funds set aside for a

dividend payment are better used to buy back shares at the current price.

I will continue to monitor Transocean as an investment until I believe my thesis no longer holds

true. The 2nd

quarter of 2010 earnings are due out shortly, so a clearer picture of the impact

from the Deepwater Horizon incident may emerge at that time.

Appendix:

Comparison of Transocean and 4 largest competitors:

Company Current Price P/E Price-to-Book

Transocean 52.36 5.32 0.82

Noble 31.87 5.10 1.23

Diamond Offshore 65.91 6.95 2.52

Ensco 41.61 8.27 1.07

Pride 24.68 16.03 1.01

Average of 4 competitors 9.09 1.46

Comparison of Transocean and 4 largest competitors pre-accident:

Company Price P/E Price-to-Book

Transocean 88.77 9.02 1.39

Noble 42.42 6.79 1.64

Diamond Offshore 91.01 9.60 3.48

Ensco 46.91 9.33 1.21

Pride 31.01 20.14 1.27

Average of 4 competitors 11.46 1.90

Oil Consumption/Production Comparison:

Consumption 2009 Production 2009 Consumption 1999 Production 1999

US 18686 9000 19519 8993

China 8200 3991 4363 3317

India 2980 879 2031 765

World 83737 84000 75758 74849Obtained from US Energy Information Administration website: www.eia.doe.gov

http://www.eia.doe.gov/



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