The offshore drilling sector has gone through one of the most challenging phases and as there are increasing hopes of sustained recovery in the industry, it’s a good time to pick long-term winners. In the current scenario, there are names in the industry that can surge higher in the near to medium term, and there are names that are worth holding in the portfolio for the long term.
Transocean (RIG, Financial) is one company in the offshore drilling industry that deserves a place in the long-term portfolio. It is important to note that Transocean has surged by 68% in the last 12 months, and a large part of the rally has come recently. It would make sense to gradually accumulate the stock on potential profit booking rather than take a big plunge in the stock at current levels.
I have mentioned in a few of my recent articles – and I would like to point out again – that in the past instances of OPEC production cut, oil has seen a two-year rally. With OPEC ready to access the supply-demand scenario again, I am bullish on oil trending higher through 2017. I wanted to mention this view at the onset as positive sentiments are likely to sustain for the offshore drilling industry. Company-specific fundamental factors will take the stock higher amid a broad level of positivity.
In a scenario in which industry conditions improve gradually, the first factor to discuss is the company’s order backlog. Transocean has one of the best order backlogs in the industry with revenue visibility of $2.7 billion for 2017 and $1.9 billion for 2018. I expect the order backlog for 2018 to swell through 2017. The current backlog will ensure that the company’s debt servicing is smooth and investment plans for the next few years can be largely met through internal cash flows.
To make things easier, Transocean has provided liquidity outlook for the next three years considering the cash flow from the current order backlog and the cash outflow resulting from capital investments and debt repayment.
As of September 2016, Transocean had total cash of $3.6 billion along with undrawn credit facility of $3.0 billion. With total liquidity buffer of $6.6 billion, the company is well positioned for the medium term. Also, as the chart below shows, the company’s OCF from current backlog will ensure that the cash buffer is at higher levels by December 2018.
While these are ballpark estimates, the key point is that Transocean will have ample financial muscles that will ensure that the company is well positioned for growth once there is sustained recovery in the industry.
Transocean also has an edge over peers considering the company’s fleet specifications. As of September 2016, Transocean had 29 ultra-deepwater floaters as compared to 19 for Seadrill (SDRL, Financial) and 14 for Ensco (ESV, Financial). Once industry conditions improve, I expect the UDW floaters to witness strong demand and will offer the best day rates.
Further, by 2020, Transocean expects UDW floaters to make up 55% of the fleet as compared to 52% in third-quarter 2016. By 2020, the high specification jack-ups will constitute 24% of the fleet as compared to 18% currently. Therefore, the fleet constitution will only improve with time.
Amid these positives, I expect EBITDA margin to remain under pressure as compared to peak offshore drilling activity prior to oil price decline. As rigs are recontracted, lower day rates will put pressure on key margins. This factor is discounted in the stock. However, investors should not expect day rates prior to the crisis to be seen even in the next 12 to 18 months.
Transocean is well positioned from an order backlog perspective, and the company does not have speculative new rigs that can put pressure on the balance sheet (as is the case with Seadrill). Strong financial muscles will help Transocean grow rapidly once industry conditions improve; with the current liquidity buffer, I would not be surprised if the company pursues asset purchases from distressed sellers in the industry. That will provide additional stock upside trigger.
Disclosure: No positions in the stocks discussed.
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