Why Transocean LTD Stock Has Plunged 21% in 2014

Transocean is stuck in a tough time for offshore oil drilling. But its high dividend yield provides nice consolation until its industry conditions improve.

Aug 28, 2014 at 9:40AM

Oil driller Transocean LTD (NYSE:RIG) has had a rough ride so far this year. It's suffering under the weight of a difficult period for its industry. Oil companies are shying away from new rig contracts, because returns on new projects undertaken over the past year have proved to be disappointing. That's caused a soft patch for drilling, due to a supply glut and weakening demand.

This is what has caused Transocean's stock price to fall through the first eight months of the year. But despite these headwinds, Transocean is navigating the tough climate fairly well. Its underlying performance hasn't deteriorated nearly to the extent its share price performance would suggest.

Transocean stays afloat

In its recently concluded fiscal second quarter, revenue fell just 1.5% year over year. Looking further back, there's nothing alarming about Transocean's performance. Over the first two fiscal quarters, revenue and operating profits are up 2% and 32%, respectively. Transocean has effectively secured enough contracts to keep revenue growth intact, and has also significantly reduced costs.

To be sure, a few key metrics are slipping. For example, Transocean's fleet revenue efficiency dipped to 95%, from 95.7% in the first quarter. Fleet utilization was flat, at 78%. To improve these metrics, the company will target significant cost reductions. Management sees the potential for approximately $800 million in margin improvement by the end of next year.

That being said, Transocean is faring much better than some other oil drillers. For example, Diamond Offshore Drilling (NYSE:DO) reported 8% lower revenue last quarter, and a very concerning drop in profit. Diamond Offshore's operating profit fell by nearly half last quarter, due to significantly higher drilling expenses. Operating expenses climbed 12% last quarter. In addition, the company has warned investors it will have to spend much more this year to upgrade its fleet, which will put further pressure on profits.

However, it's likely Transocean's near-term weakness is temporary. Oil prices continue to be supportive of oil drilling activity. And, Transocean holds an impressive revenue backlog that should fuel future growth. To that end, its total backlog from continuing operations stands at $26.1 billion. Of this, the company has $9 billion in opportunities spread out from 2018-2027.

Portfolio upgrading strategy in process

To be sure, Transocean management is aware of underperformance in ultra-deepwater drilling, due to a global supply glut. This has pushed day rates down, and will make for a much harsher competitive environment going forward. That makes it imperative for oil drillers such as Transocean to upgrade their fleets, which it has done.

Since 2011, Transocean has aggressively sold off older rigs. In that time, it's divested 63 non-core rigs and has received more than $2 billion in proceeds. This will be reinvested in upgrading its fleet, which is a necessary and savvy move. That's because it's wise for the company to sell these rigs now at a profit while it still can. And, Transocean's new-build strategy includes 16 completed high-specification rigs that have been put into service since 2009. Its current new-builds involve nine ultra-deepwater drillships, five of which are contracted already, as well as five more high-specification jackups.

Attractive cash returns

In the meantime, Transocean is aggressively returning cash to shareholders to provide a solid return until the operating environment improves. Its current $3 per share annualized payout yields a hefty 7.8%, because management has aggressively raised the dividend over the past few years. This is a very attractive payout for investors who like to receive income from their investments.

The bottom line is that Transocean is in a tough period for its industry, in which some of its customers are cutting back on new drilling contracts. In addition, Transocean is spending a lot of money to upgrade its fleet. This has caused the company to be free cash flow negative over the first six months of the year, due to high capital expenditures.

The market isn't expecting much, which explains Transocean's poor stock price performance to start the year. But, assuming the industry headwinds don't last forever, Transocean's drop could represent a good buying opportunity.

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Bob Ciura 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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