What: Shares of offshore contracted drilling company Transocean (NYSE:RIG) finished Tuesday unchanged at $19.05 after an early morning swoon following changes to its dividend policy, its management team, and following a huge price target cut from research firm Deutsche Bank.
So what: Over the long holiday weekend Transocean announced that its board of directors had recommended an annual dividend of $0.60 per share ($0.15 per quarter), which is an 80% cut from the $3 it had been paying out annually. A dividend cut was widely expected by Wall Street and investors following the precipitous drop in oil prices since the summer.
Additionally, Transocean announced that Steven Newman was stepping down from his role as President and Chief Executive Officer of Transocean, as well as giving up his board seat. Until a permanent replacement is found Ian Strachan will be the interim CEO.
However, the real blow may have come from a price target cut by Deutsche Bank and covering analyst Mike Urban. According to Urban, whose firm maintains a "sell" rating on Transocean, reducing the dividend will save about $800 million per year, but continued investments in its fleet will result in "negative free cash flow for the foreseeable future."
Specifically, Urban and his team listed projections of $8.5 billion in capital expenditures between now and 2018, $4.5 billion in debt maturities, and roughly $6 billion in cash from operations. Based on Urban and his firms' forecast, additional equity is likely to be required. With that in mind, Deutsche Bank lowered its price target on Transocean to $6 from $16. This implies that Transocean could fall 69% from where it closed on Tuesday.
Now what: The question that investors have to ask themselves here is whether or not Transocean is headed for a 69% drop in its share price?
On one hand, there's plenty of reason to be concerned. Transocean's fleet is getting older, and older drilling rigs will have more trouble finding work as newer drilling rigs are brought online. Utilization rates for rigs in excess of 20 years tend to fall off rapidly, so Transocean may find it has no choice but to scrap its oldest rigs and move on. It's also being steered without a full-time CEO and is paying out just 20% of the dividend it once was. From a shareholder standpoint there's plenty to be worried about.
But, on the other side of the coin there are two positives. First, regardless of the price of oil there will continue to be a demand for offshore drilling. As emerging market economies begin to industrialize their need for oil will only climb, giving Transocean an abundant source of future orders. Also, Transocean is very cheap by historical standards with a forward P/E of nine, a price-to-book ratio of just 0.5, and an enterprise value to EBITDA of less than four.
Ultimately, I believe caution wins out here, although I don't believe things are as dire as Deutsche Bank makes it out to be. As long as oil prices don't remain below $60 for an extended period of time (think two or more years) I believe Transocean will have enough operating cash flow to cover its debt and CapEx. While it may not be a buy just yet, I personally doubt it falls another 69%.