Source: Flickr user Steve Straiton.
What: Shares of offshore drilling contractor Transocean (RIG +1.39%) limped higher by $0.09, or 0.6%, in Wednesday's trading session despite facing a price target cut by investment banking firm UBS.
So what: According to UBS' covering analyst Angie Sedita, who maintained her firm's "neutral" rating on shares of Transocean stock, anywhere from 50% to 60% of Transocean's highest-margin-generating ultra-deepwater rigs, or UDWs, could become idle sometime in the next year.
Based on Sedita's and her team's analysis, Transocean already has eight of its 31 UDWs idle, and another nine of its UDWs are due for renewal in 2015, along with eight midwater and four deepwater rigs. Sedita notes that "rigs will be challenged to find contracts," and "over the last 3-4 months we have seen almost no floater contract awards." Sedita estimates that idling eight floaters would cost Transocean $728 million per year, or $320 million if they were cold stacked (essentially shut down), and that additional idled rigs are likely.
With that said, Sedita dramatically reduced her firm's 2015 and 2016 full-year EPS estimates for Transcoean from a profit of $1.36 and $0.41 in FY 15 and FY 16 to new estimates calling for a profit of $0.69 in 2015 and a loss of $0.75 per share in 2016. Ultimately, Sedita and UBS cut their price target on Transocean by $2 to $16 from a prior target of $18.
Source: Deepwater Horizon Response via Flickr.
Now what: With the bad news pouring in on a regular basis for Transocean, the question investors need to ask here is whether this pessimism represents a buying opportunity or is a clear sign to keep your distance.
There are obviously two sides to this coin. On one hand, offshore oil demand is going to remain intact to some degree even with WTI and Brent crude trading well below their summer highs. Expected long-term increases in oil demand from developed and industrializing markets should put a floor under oil prices sooner rather than later and allow Transocean's rigs to fill what should be robust global drilling contract demand.
On the other hand, Transocean's fleet is getting old. Older rigs have more maintenance issues, they're less efficient at retrieving underground assets, and they don't command as high a dayrate as newer rigs. What this means for Transocean is that its older rigs are losing out on contracts to newer fleets and that it may just have to eventually put some of its older rigs out to pasture.
Transocean's $2.9 billion in cash is also a concern even with an 80% dividend cut. Between planned capital expenditures, debt interest payments that could rise if Transocean's debt rating is downgraded further, and the need to update its fleet to remain competitive, it's possible Transocean may need to raise cash in order to meet a capital shortfall.
While I certainly wouldn't lump myself entirely in the bear camp here, I can see plenty of reasons for Transocean to head lower from its current levels. My personal suggestion is that if you want to invest in the contract drilling space, you should forget Transocean and look toward companies with newer fleets as they likely have a better chance at long-term success.
