Transocean’s Equity Is Concerning But Their ~13% Bonds Are Mouthwatering

 In Bond Investing, Investing Idea

transoceanSubmitted by Nicholas Bodnar via Seeking Alpha

Transocean (NYSE: RIG) is one of the few offshore drillers that still has notable backlog while appearing to be undervalued on a TTM basis. Furthermore, the debt situation looks manageable, which is always a plus in this industry. However, in the near term, there are still prominent headwinds, which will put pressure on the stock price. Future impairments, a top and bottom line squeeze and contract run-offs, tell me to avoid the equity. Interestingly, buying some of the debt below par, makes for a compelling near-term case.

Summary

With 28 ultra-deepwater floaters, seven harsh environment, five deepwater, 11 midwater, and 10 high spec jack-ups, you could say that RIG has one of the largest and diverse fleets in today’s market.

2.Ratios

Investment Thesis

RIG’s equity is undervalued on a TTM basis, but will become inflated as more contracts run-off and further impairments transpire. However, RIG’s business model is about as diversified as you can get on a strict offshore driller basis. This will ensure decent cash inflows for the next two or so years. Because equity value has a potential to be cut going forward, a more conservative play would be in the high yielding bonds. Today, you can pick up near-term callable bonds below par and lock in a ~13% yield, at low risk.

The Good

RIG has a diversified set of assets, which will allow them to have a decent sized chunk of backlog going forward. Furthermore, the company’s operations are geographically dispersed, which is a function of topline stability.

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Source:Recent Annual Filing

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Source:Recent Annual Filing

Despite the circumstances, the backlog has held up relatively well. Furthermore, the company has a decent backlog to make it through the next few years, ceteris paribus.

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Source:Recent Annual Filing

Finally, total average fleet utilization has only fallen ~10%, post-crash.

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Source:Recent Annual Filing

On a circumstantial basis, RIG has performed decently well given the challenging environment. However, management and even I believe that 2016 will prove to be even more challenging. On a long-term value basis, RIG could be a decent investment. Consequently, in the near term, there will be further impediments, which have a potential to inflate current equity valuations.

Equity Valuations Are Skewed and Will be Inflated

The reason why I am avoiding RIG’s common stock right now is because there will be further impairments and contract run-offs. Furthermore, I am expecting that there will be very little contract awards in 2016 on an industry wide basis. This means backlog will continue to decrease. All three of these negative aspects will put downward pressure on fundamentals, inflate forward equity valuations and decrease the stock price.

You could take my word that this will happen and we could move forward, but I would like to expound upon this idea for a bit.

Future Impairments Cannot Be Avoided

How hard is it to secure contracts in this market? Given the fact that RIG has 11 brand new rigs under construction, and none of them have contracts, well, hard is an understatement. What does it mean if brand new rigs cannot secure contracts? It means it will be even harder for older rigs to find stable work (RIG has a substantial amount of older rigs as assets).

Management stated that they believe that there will be very few drilling contracts awarded in 2016. This will not only put downward pressure on day rates, but it will also influence management to stack, scrap and sell further long-lived assets. As of December 31, 2015, RIG had five units classified as held for sale or scrap.

RIG also has six units classified as idle. Idle rigs are not in production and not earning any money. However, idle rigs still have the same operating costs as a rig that is in production. Notable industry headwinds will crunch RIG’s cash position and forward looking backlog. This will influence management to stack these idled rigs, especially if they are not contracted in the near term.

Investors should expect the ones from the late 80s and early 90s to get stacked first. If the industry continues to remain bleak, the other three from the year of 2009, should follow suit. The stacking of these rigs will throw more non-cash impairments on the income statement.

Further implication on future impairments is the average age of RIG’s fleet. For an example, the average year built of their ultra-deepwater floaters is 2005. The harsh environment floaters were on average built in 1993. Their five deepwater floaters have an average year built of 1979. The company’s mid-water floaters are 1982-era. Finally, high spec jack-ups were on average built in the year of 2003.

The relatively high age of the company’s fleet will force RIG to stack, scrap and sell these assets. Furthermore, these three S’s will force the company to impair their PP&E and/or accelerate their depreciation process.

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Source: Recent Annual Filing

Investors buying RIG on the basis of an undervaluation to TBV should reevaluate their thesis. Rigs are completely useless unless they are contracted. In fact, uncontracted rigs produce negative value due to upkeep costs. Furthermore, old rigs are near impossible to sell during cyclical downswings. This forces companies like RIG to sell below cost and/or get measly scrap value.Investors should remember that the company sold 17 rigs in 2015, for a low $35mm. As the offshore market continues to worsen in 2016, future impairments will transpire. An investment thesis based upon TBV is irrational and should be avoided.

Investors should remember that the company sold 17 rigs in 2015, for a low $35mm. As the offshore market continues to worsen in 2016, future impairments will transpire. An investment thesis based upon TBV is irrational and should be avoided.

Contract Run-Offs = Forward Inflated Revenue and EBITDA Metrics

According to the recent fleet status report, RIG has 25 rigs coming off contracts in 2016. Out of the 61 rigs that the company has (not counting ones in construction yards), this represents ~41% of the fleet coming off contract. Believing that all 25 rigs will find additional contracts post-2016 is comparable to betting the farm on the Apophis Asteroid passing through the keyhole in 2029. The majority of these rigs will most likely be stacked, further impairing the income statement and inflating valuation metrics.

If the company does not secure notable contracts, backlog will continue to dry up.

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Source: Recent Annual Filing

On a positive note, the company does have a decent amount of backlog going forward for the next two to three years. However, overall backlog is shrinking at a decent clip. Shrinking backlog is not good for forward valuation metrics such as EV/EBITDA and EV/Revenue. Thus, if backlog continues to shrink, valuation metrics on the basis of revenue and EBITDA will inflate in the future. Investors should note that this is a type of value trap in the near term.

Furthermore, with an oversupplied new build market and almost every offshore driller looking for contracts, there will be further pressure on day rates.

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Source: Recent Annual Filing

Thus far, day rates have been relatively stable despite the circumstances of the industry. However, there are a lot of suggestions that 2016 will be an inflection point on the basis of offshore drillers making it or breaking it. In desperate times, there are desperate measures. Investors should expect day rates to fall incrementally in 2016 from an increase in competition.

Why Near-Term Callable Bonds Make Sense

If you have not gone headfirst into RIG’s equity already, you may want to consider buying some of their bonds. The bonds that look the most attractive to me are the 7.375% RIG.GV securities. Here is a quick informational breakdown of these bonds…

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Source:Finra

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Source:Finra

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Source:Finra

There are a few benefits to purchasing these bonds over the common stock. The biggest benefit of purchasing these bonds over the common is risk management — a topic most retail investors discount. There is no denying it. The entire offshore industry will be facing major headwinds for a least the next year or two (if we are lucky).

Furthermore, and as stated above, there is very real potential for the equity to continue to get discounted. If you were managing someone else’s money, wouldn’t it be irrational to buy RIG’s equity at this point in time? Is not protecting your downside more important than focusing on how much RIG could appreciate in value?

 These ~13% yielders offer investors downside protection, upside to par and a decent income stream. Yes, there will be some volatility attached to this coupon. But the closer the coupon gets to the maturity date, further the spread between price and par will close. At the current price, there is an 11.36% upside to par.

Additionally, investors can lock in a solid ~13% yield while waiting for the par gap to close. This is a pretty good deal over the equity given the fact that the equity doesn’t pay anything and has a potential for near-term downside. Furthermore, who doesn’t like a stable double-digit yield?

Interestingly, the issue has the real potential of getting called early. This is due to the fact that almost every offshore driller has started to buyback discounted debt to lower leverage ratios. With $2.34bn on their balance sheet and an untapped $3bn revolver, RIG has more than enough potential to start calling some of their debt. Finally, the issue is for a low ball $250mm, with an ability to be called at any date. An early call will take income potential away, however, an investor can reinvest the profits from the par discount into another high yielding security.

Inclusively, I believe that RIG’s bonds offer much more value and downside protection for the investor focused on risk management. Yes, if oil reverts to historical highs in the next year, you will miss out on a huge move that equity holders will enjoy. However, if you are looking to generate alpha, there are better securities out there with much less risk and which are not based upon a commodity price reversion.

Risks

Customer concentration is a huge risk. RIG’s most significant customers are Chevron (NYSE:CVX) and Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B). In 2015, CVX and RDS accounted for 14% and 10% of consolidated revenues. Furthermore, 51% and 21% of existing backlog derives itself from RDS.A and CVX, respectively. Both of these companies are also highly leveraged.

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Source:CVX Yahoo Finance

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Source:RDS.A Yahoo Finance

If either of these customers is adversely affected by the cyclical downturn, they may cut contracts. The customer concentration is very significant and anyone who has a decent-sized position in RIG should do proper due diligence on both CVX and RDS.A as well.

Arbitration of termination fees is another risk in itself. Many retail investors who have gone headfirst into the offshore industry take termination fees as a given. This is far from the truth. Offshore drillers are not guaranteed termination fees. They may receive partial fees or none at all. Because of this, all valuation models should assume zero value in case of a cancellation (for conservative purposes).

Director compensation is pretty substantial.

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Source:Recent Proxy Statement

For being a part-time job, directors are paid in cash plus stock awards, which is dilutive to the owners of the business. Additionally, executives also take a decent chunk of change home every year.

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Source: Recent Proxy Statement

Investors should continue to monitor executive pay going forward. If executive pay is not reduced because of the downturn, there may be some slight governance issues. Furthermore, the compensation peer group and performance peer group contains companies that are not direct competitors to RIG and/or have totally different business models.

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Source: Recent Proxy Statement

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Source: Recent Proxy Statement

Conclusion

Inclusively, I am pretty bearish on the overall near-term outlook for RIG. There are a significant amount of contracts coming offline in 2016, which will hinder all TTM valuation metrics. Furthermore, the company has an overall older fleet, which will influence future impairments.

However, despite the circumstantial near-term headwinds, RIG’s bond issues offer a unique way to profit from this company. Additionally, the bond that I highlighted offers very low downside risk, a decent appreciation to par and a stable double-digit yield.

If you are looking for a way to invest in RIG and are not already heavily invested in the common, these 2018 callable bonds may be your best bet.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Sergey Sanko
Sergey had started an IncomeClub after years of being an investment advisor for high affluent investors and managing fixed income securities. He is the lead investment advisor representative and holds a Series 65 license. Sergey earned his Executive MBA degree from Antwerp Management School.
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