3 Stocks Investors Think Will Continue to Sink

Short interest in Transocean, Diamond Offshore Drilling, and Hercules Offshore is surging, which suggest share prices will continue to sink.

Apr 9, 2014 at 12:40PM

Transocean Barents

Photo credit: Transocean 

Shares of offshore drillers are off by nearly 13% so far this year. According to some investors the worst is still to come. At least that would explain why short-sellers are piling into the stocks of Transocean (NYSE:RIG), Hercules Offshore (NASDAQ:HERO), and Diamond Offshore Drilling (NYSE:DO).

That sinking feeling
Short-sellers have been really piling into Transocean over the past four weeks as short interest is up 34.6%, followed by Hercules Offshore at 32.4%. Overall, the short interest ratio in all three is higher than 5.5, with Diamond Offshore Drilling the highest at 6.51. Meanwhile, Transocean's short interest ratio is three-and-a-half times higher than its historical average.

All of this suggests investors expect these three stocks to continue sinking -- and it's easy to understand why: Despite strong revenue backlogs, all three have a number of drilling rigs without a contract for 2014. For example, as the following slide from a Hercules Offshore investor presentation shows, the company does have several rigs available later this year and throughout next year.

Hercules Offshore Outlook

Source: Hercules Offshore Investor Presentation (link opens a PDF)

So, while the company has a revenue backlog in excess of a billion dollars, some investors see the uncontracted availability as a liability, which is why they are shorting shares.

Meanwhile, short-sellers are emboldened by the fact that a number of Wall Street analysts are cutting price targets on offshore drillers. Diamond Offshore recently saw its price target cut by a number of analysts. Further, five analysts now rate Diamond Offshore a sell, while 15 have it rated a hold, and just one rates it a buy. It's a similar story with Transocean as several analysts have recently cut price targets on its stock as well. Meanwhile, seven analysts rate it a sell, compared to 15 with hold ratings, and just three buy ratings.

Brighter days ahead
While analysts and investors are increasingly bearish on these stocks, all three companies are pointing to better days ahead. Hercules, for example, noted that recent lease sales in the Gulf of Mexico show that the industry is still very bullish on its prospects.

Meanwhile, Transocean sees just near-term softness as projects are being delayed to 2015. Moreover, the long-term supply imbalance in its core ultradeepwater segment remains and that suggests a very strong future for Transocean. The company sees the industry growing from the 500 deepwater wells it drilled last year to a future of drilling more than 1,250 wells a year by 2025. To get to that number the industry potentially could add another 215 deepwater rigs, so today's oversupplied market should dry up in the future.

Discoverer Luanda

Photo credit: Transocean

Further, the current market slowdown could end up being a long-term opportunity. For example, Hercules used the last downturn to acquire its main competitor. It ended up making that deal just before demand began to improve. Because of that we could see these companies capitalize on opportunities to grow at the expense of weaker rivals.

Investor takeaway
While these stocks could continue to sink in the short term, the current turbulence in the market looks to be a long-term buying opportunity for investors. Transocean looks especially compelling as it continues to high-grade its fleet, which could include an MLP of slower growth assets combined with a much higher dividend. So, while investors think its shares will continue to sink, over the long term the company appears poised to deliver strong returns.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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