This article is part of our Rising Star Portfolios series.
Offshore oil drilling rig operator Transocean (NYSE: RIG ) was the first purchase I made for the Messed-Up Expectations portfolio just more than six months ago. At the time, I believed it would end up as a midsized position at 4% of starting capital to invest. I filled that out just more than a month later, after the price had risen about 10%.
Today, after continuing to follow the company through two additional quarters of operations, I've changed my mind on how large a position this company merits within my portfolio. I'm going in for a third round.
Improving balance sheet
One of my initial concerns was the company's debt level. Transocean's total debt approached $12.9 billion when I made the first purchase; today it stands at $11.2 billion. The company expects to reduce that further, by approximately $1.7 billion this year. In addition, the company's net debt position has decreased every single quarter since it leveraged up its balance sheet back in late 2007; it now stands at $7.4 billion. In other words, management is paying attention to the balance sheet.
Furthermore, the company is initiating a regular dividend for the first time in nine years, dependent on shareholder approval. Such a move tends to impose more fiscal responsibility upon management, which is a good thing.
A legal orgy
The other initial concern I had was the unknown legal exposure from its role in the Macondo well incident in the Gulf of Mexico a year ago. That's been at least partially resolved this past month as BP (NYSE: BP ) sued Transocean, blowout preventer contractor Cameron International (NYSE: CAM ) , and Halliburton (NYSE: HAL ) , which cemented the well. Of course, Transocean sued BP in return, and BP's partners on the well, Anadarko Petroleum (NYSE: APC ) and Mitsui, also chimed in against BP. Halliburton sued BP and Transocean, as well.
This orgy of lawsuits is not unexpected, and the ultimate result remains unknown, but at least it's out in the open now, which reduces uncertainty to some extent. These lawsuits will test the indemnification clauses in Transocean's contracts with its customers, which Transocean expects to be upheld. Actually, I expect the various parties to eventually reach some sort of settlement, but that's likely a few years down the road.
A major point of my investment thesis is that the world still needs a lot of oil, and that drillers will be kept busy going after it. That's holding true. Activity is picking up and, according to Transocean management, the market for rigs is tightening up. Petrobras (NYSE: PBR ) is trying to fill its immediate needs as it works on oil finds off Brazil's coast, and customers are signing up rigs around the world. Transocean is beginning to bring rigs it had previously removed from service ("stacked" in industry jargon) back into play. All of these bode well for Transocean's cash-generating prospects.
Based on the above, I took another look at the expectations currently built into Transocean's price. At yesterday's close of $66.24, the market is expecting the company to grow its trailing free cash flow of $1.9 billion by 9% per year for the next five years, 4.5% for the following five, and then 2.5% after that (discounting at my usual 15% hurdle rate). While not as low as they were when I first purchased shares, this level still seems below what the company can do. Over the past five years, the company's actually managed 20% annual growth in FCF. If Transocean can get even halfway there, at 15% for the next five years, the shares would be worth at least $90 today.
Tomorrow, the Messed-Up Expectations port will buy one more position in Transocean, about $380 worth, and make this a full 6% position.
After you add Transocean to MyWatchlist, come discuss the company's results on my Messed Up Expectations discussion board or follow me on Twitter.