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Downgrades: 3 Things You Need to Know About Transocean's Price Cut

By Rich Smith - Feb 17, 2016 at 12:00PM

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KLR Group cut its price target, true -- but it still loves Transocean.

With its stock down more than 50% over the past 52 weeks, Transocean (RIG 4.30%) shareholders are about due for some good news. Judging from a new report out of KLR Group, they're not going to get it today -- but stay tuned.

The news
Earlier this morning, New York-based financial advisor KLR Group announced it is cutting its price target on oil driller Transocean. As described in a write-up on StreetInsider.com, the 21% reduction in target price, from $19 to $15, sounds like pretty bad news. But hold up a sec -- is KLR actually saying you should buy Transocean?

As a matter of fact, it is. While KLR has taken away from investors the prospect of a 100%-plus profit on Transocean shares (which currently cost less than $9), the analyst remains optimistic about the stock. Here are three big things to keep in mind when you consider how to react to KLR's big cut.

Thing 1: Transocean is getting smaller
Here at Motley Fool CAPS, we don't know a whole lot about KLR. S&P Global Market Intelligence says the company only started up operations as recently as 2012, and according to our friends at StreetInsider.com, KLR only published a handful of ratings in 2014, and only began publishing reports in volume last year. Nonetheless, KLR already has some valuable insights into the oil and gas industry.

For example, at Transocean, KLR says "the market does not appreciate the transformation story under way" at Transocean, which has already retired two dozen older drilling rigs, cutting costs, and generally trying to free itself from "bloated overhead and inefficient processes from a lack of integration and consolidation of previous mergers." Focusing on this "low lying fruit," KLR expects Transocean to benefit from "cost savings" in the years ahead. 

Thing 2: Costs must come down
That's absolutely crucial to the investment thesis on Transocean. You see, despite the collapse of oil markets worldwide, Transocean is still swimming in cash. Trailing free cash flow at the company was $1.4 billion over the past 12 months, and Transocean only went truly free cash flow-negative once in the past five years.

As rigs come off contract, however, rates reset times are going to get tough for Transocean. S&P Global Market Intelligence data show normalized earnings declining steeply this year, then going negative in 2017 and for years thereafter. Although S&P sees Transocean continuing to generate positive cash from operations, capital spending could push Transocean into negative FCF territory as early as this year.

Thing 3: Time is running out
To escape that fate, costs simply must come down. At the same time, Transocean must act quickly to trim its $8.8 billion debt load while cash is available to service it. KLR says $1.7 billion in debt is coming due this year and next alone. Between cash on hand and the tail end of the company's formerly prodigious free cash flows, Transocean can handle the debt for now -- but time's running out.

And one more thing...
Granted, much of this forecasting is based on the presumption that recent difficulties in the oil market will continue into the future. That's a view I happen to share -- but this doesn't necessarily mean that KLR is wrong to be optimistic about Transocean.

I may be pessimistic about the oil market, and about Transocean's ability to generate positive cash profits in it as rig rates drop, and capital spending continues apace. But the fact remains: At last report, the book value of Transocean's assets was nearly $38 a share -- but its stock price is less than $9 a share. If these numbers mean what they seem to mean, you can buy Transocean's assets today for less than $0.25 on the dollar, just by buying the stock.

Much of this discount is probably explainable by the fear that Transocean will not weather the storm -- that its debt will catch up to it, and the ship will founder and sink. But Transocean's been in this business for more than six decades now, and survived more than one crisis in the oil markets in that time. If you want to bet on Transocean stock being as cheap as it looks -- bet on that fact.

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