Investor confidence in Transocean (NYSE: RIG ) has soared after the offshore drilling contractor agreed to pay a $1.4 billion fine over five years to resolve claims arising from the Gulf of Mexico oil spill disaster. The stock has already rallied an impressive 14% since the start of the year.
Clearly, investors are letting out a sigh of relief, now that the extent of Transocean's liability for its role in that fateful incident is no longer a guessing game. However, is the market's unbridled optimism a mere reaction to the news, or is it based on something more fundamental, more sustainable?
The story so far
There's no doubt that Transocean fell out of Mr. Market's good graces following the accident in April 2010. Since then, the company has lost almost 43% of its market value, even as worldwide demand for drilling rigs shot upward. Consider this: According to Baker Hughes (NYSE: BHI ) , the average worldwide rig count for 2012 was 3,518 -- a solid 31% jump from the total count in April 2010. Not surprisingly, competitors Seadrill (NYSE: SDRL ) and Hercules Offshore (NASDAQ: HERO ) have gained more than 40% each in market value during this period. Here's how things have played out visually:
So is there a reversal of fortunes ahead? I think so.
First, it's clear how much Transocean has to pay for damages in the Macondo oil spill. To cough up $1.4 billion over a period of five years isn't the most difficult of tasks for a company with assets exceeding $35 billion, including a cash balance of $6 billion and an operating cash flow of more than $2 billion in the past 12 months.
And more importantly, as of the end of the third quarter of 2012, Transocean has recorded a loss contingency of $1.9 billion on its balance sheet. I'd say that's a smart move. The only small worry is the $11 billion in debt and debt-to-equity of 92%. In the last earnings call, management indicated that the focus is on increasing operational prowess and reducing long-term debt to between $7 billion and $9 billion. And that takes me to the next point.
In the past 12 months, Transocean has operationally become leaner and meaner by shedding its standard jackup fleet -- a shrewd move from management. By divesting its shallow-water drilling rigs, Transocean not only raised $1.05 billion, but it also ensured that it can concentrate on the more lucrative deepwater and ultra-deepwater drilling.
Cash flows, too, have improved, with revenue efficiency for the third quarter of 2012 being the highest in the past three years at 94%. I don't foresee any dip in the near future. A couple of days back, I brought to Fools' attention the worldwide trend in higher exploration and production activity. Demand for deepwater and ultra-deepwater rigs is on the rise as big-spending E&P companies pump out the once elusive oil. To take advantage, Transocean has six more ultra-deepwater drillships and three high-specification jackups under construction.
Finally, management at Transocean knows what it's up to. First, it correctly predicted the probable damages that the company would need to set aside for the oil spill. Second, some of the top brains in the industry are working here. Esa Ikaheimonen took over as the CFO in November -- from the same position at Seadrill.
In all, the signs of a reversal in fortunes are unmistakable. Transocean looks ready to take off.
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