What Does a Balance Sheet Analysis of Transocean Tell Us?

Image Source: BP

Anyone who has read even a sentence of Benjamin Graham's The Intelligent Investor will know that, to him, buying stocks is heavily predicated on the story told by a company's balance sheet. Sometimes, little secrets tucked away in those assets and liabilities can provide a huge advantage to investors who find them. So today, let's take a good hard look at the balance sheet of Transocean (RIG -2.69%) to see if there are any nuggets of knowledge that could give us a leg up over other investors. 

Why you should care and what matters
I'm not going to lie, looking up and down a balance sheet can be pretty boring, especially when you aren't quite sure what you are looking for. Things like noncurrent deferred tax liabilities and long term loans receivable can force you to spend more time digging for definitions than actually analyzing the company. Don't let these items be too offputting, though, because the balance sheet can help you determine the financial health of the company as well as understand how much the assets a company owns are worth.

So, as a simple guide, let's focus on three key themes when looking at the balance sheet of Transocean: financial health, efficiency, and value. 

Financial health
One of the greatest fears for an investor is that a company he or she owns goes bankrupt. So pretty much the first thing people look at on a balance sheet is a company's debt and how the company can pay off those debts over time. Two very important metrics worth looking at to determine financial health are the debt to capital ratio and the interest expense to EBITDA ratio. Debt to capital paints a rough picture of the financial structure of the company by giving the percent of capital that is debt. Companies with higher debt to capital ratios will normally have to fork over lots of operating income to cover those expenses, and sometimes it doesn't leave much for investors afterwards. So it's also important to take this metric in context with interest expense to EBITDA because it shows the company's ability to cover its obligations. If a company has an interest expense to EBITDA ratio of less than 1, then it pays more in interest than what it can generate. 

Here's a quick look at how Transocean's financial health stacks up overall and in comparison to its peers. 

Source: S&P Capital IQ

Offshore rig companies have a tendency to have higher debt to capital ratios than many other industries because they have to add high cost assets -- new rigs -- on a pretty regular basis. In this case, Transocean has a pretty reasonable debt to capital compared to its peers and the industry in general, but its ability to cover those expenses with earnings is considerably weaker than others.

Efficiency
It's not the size that matters, it's how you use it!

That sentiment is as apt at describing a company's assets as anything else. A company can have billions of dollars of property, plant, and equipment, but what the heck is the point if they can't actually generate revenue or earnings? A way that we can evaluate this is by looking at three metrics: asset turnover, the working capital ratio, and the return on assets.

Asset turnover is the total annual revenue a company generates divided by its total assets and shows a company's ability to generate revenue. The working capital ratio is the company's current assets -- things like cash and inventory -- divided by its current liabilities -- accounts payable, debt that needs to be paid that year, things like that. It measures how well the company deploys its current assets: less than one means it could run into short-term issues with creditors, and high numbers suggest the company isn't efficiently deploying its current assets. Finally return on assets is net income divided by total assets, and it shows the ability for that company to drive profitability from its assets.

Let's see how Transocean stacks up here.

Source: S&P Cap IQ

A couple things you need to know about the rig industry. First, it will have very low asset turnover because sometimes not all of its rigs are generating revenue because of maintenance. Also, since it is a relatively high margin business, revenue is a little less important. Also, as companies can depreciate their assets over time, the asset base looks lower and might give higher returns on assets. That is part of the reason why a company with an old fleet like Diamond Offshore can have a higher return on assets than a newer fleet like Seadrill. Based on these numbers, Transocean looks to be right in the middle of the pack, and does a pretty good job of efficiently deploying its current assets. 

Value
Benjamin Graham loved value, which he coined as a margin of safety when buying companies. The margin of safety is the concept that a company's assets are valued so cheaply that you are pretty much guaranteed a return. Someone with a real-obsessive streak might go through every line item on a company's balance sheet to determine if there are some little secrets hiding in the larger numbers like an extremely overvalued piece of property.

To someone who doesn't have weeks on end to travel and evaluate each piece of equipment personally, though, there is a way to get a rough picture. Two metrics here are a company's intangible asset ratio and its price to tangible book value. The intangible asset ratio lets you know how much of a company's assets are tied up in things you can't see or touch. For some companies intangibles can be very valuable -- what is Coca Cola without its brand or a tech company without patents? -- but for others they may artificially inflate its value. Then we have price to tangible book value, which is market capitalization divided by total tangible assets. This basically shows what Wall Street thinks a company's physical assets are worth at any given moment. 

Let's go to the tape:

Source: S&P Cap IQ

As you might suspect, most rig companies don't have much in terms intangible assets. Brand isn't really a thing for them, and most have grown organically through building their own rigs versus buying competitors -- looking at those numbers above, I'll give you one guess which one has made a big purchase in that past few years. The one thing that is very surprising here is that so many of these companies are trading either close to or even below tangible book value. The rig market has not been kind lately, but Transocean and Diamond Offshore trading below tangible book value means either 1) Wall Street is stupid, or 2) the value of some of its rigs is higher on the books than what they are really worth. Both companies do have some of the oldest fleets in the business, but overall these numbers look awfully tempting for even a shrewd value investor such as Mr. Graham.

What a Fool believes
We can surmise a few things after looking at Transocean through its balance sheet. First, it's a very capital intensive business -- just look at those return on asset and asset turnover numbers again. So investors who are looking at this space should keep that in mind if you are picking between a rig company and a company in another sector. Second, rig companies, especially Transocean, are really cheap right now. A lot of that has to do with the fact that the rig market is stacking up to be a very rough one for the next couple years. However, someone who has the luxury of sitting on a company like Transocean for a very long time might look at today as an opportunity to buy at bargain basement prices.