Board: Value Hounds
Transocean LTD has been raked over the hot coals of hell by both analysts and the market for its ill-timed acquisition of Aker Drilling.
The announcement of the proposed acquisition was August 15 2011 and the market responded by dropping the price per share 15% to $50. RIG offered NOK 16.39 per share for Aker representing a 62% premium to the 30-day average price of Aker shares. The deal was an all-cash offer, funded by new debt and cash on hand. The price tag in total was $1.46 billion. Aker brings with it $1 billion in backlog and two ultra-deepwater semisubs with current contracts and options on two ultra-deepwater drillships under construction ($900 million due on delivery).
The price paid for Aker was 6.6X EBITDA – not an outrageous multiple. There is some debt, but a large portion is offset by restricted cash ($877 million). There are additional bonds and bank loans of a little over $1 billion. That adds to RIG’s debt burden. They have not commented on how it will be handled and it may simply be assumed
RIG share price recovered by late October, but the company was ready to disappoint shareholders again in Q3 and give analysts fresh ammunition to shoot down the acquisition and the company.
In the third quarter, RIG reported a net income loss of $71 million and loss per share of 22¢. Part of this was attributable to the Aker acquisitions as Rig settled the full amount of a forward exchange account at a loss of $78 million. Additionally, extended, unanticipated downtime for maintenance increased operating cost by $225 million. RIG has had a difficult year estimating maintenance time and costs and Q3 losses put investors in a selling frame of mind.
The acquisition does consume cash and increases leverage at a time when Transocean needs to focus on getting its decades old fleet up to specs. The aged fleet is a constant capex sink and is costing the company in downtime maintenance and lost contracts. There is a positive with Aker and that is two ultra-deepwater semisubs with contracts and options on two new-build ultra-deepwater drillships under construction. Aker also brings $1 billion in backlog. The acquisition is not a complete waste of cash.
Total debt to capital Q3 2012 was 35% and not particularly high by that metric.
Looking at interest coverage however, the ratio is only 2.3X and while marginally acceptable, is not a great cushion when adding debt—which RIG did for the acquisition. At the end of November, Transocean issued $1 billion in senior notes at 5.05% due 2016, $1.2 billion of 6.37% senior notes due 2021, and $300 million in 7.35% notes due 2041. These rates will change with any downgrades.
The above rates will increase by 0.25% for every notch RIG drops below investment grade. S&P and Fitch’s have them at BBB- -- just a notch above junk. Moody’s rates RIG a Baa3 --- a tick above junk. It will take only one step down to increase the interest rates by 0.25%.
Fitch Ratings downgraded Transocean debt one notch (on the verge of junk territory) in late August, after the Aker acquisition was announced. Standard & Poor's soon followed suit. Moody's put Transocean's credit rating on review for possible downgrade and reiterated its stance despite the recent equity offering December 5, 2011. Moody's said it expected the equity offering to raise between $1 to $1.3 billion in proceeds. On December 5, with 26 million share stock offering announced, RIG began its drop to $38 a share – a price it has not seen since 2004.
RIG has been woefully bad at estimating maintenance costs this year impacting earnings and keeping the company on the sidelines rather than participating in the recovery of offshore drilling. In November, shipyard related out-of-service time hit 33 rig months for the quarter —estimates had been for 24 months.
And Transocean lost a profitable contract due to extended downtime.
"The UDW drillship, which was under contract through January 2014 at a dayrate of $641k, was in the shipyard for BOP inspection and repair for 55 days in 3Q11, all of 4Q11, and is now expected to be in the yard all of 1Q12. If the contract is ultimately canceled and the rig is down for the first half of 2012 and returns to work at current leading edge rates, we estimate that it would be an approximate $0.25-$0.30 hit to our 2012 EPS estimate of $3.21.”
RIG’s current estimates of out-of- service time
Downtime trends for Q4 2011 and estimates into 2012 show decreasing days at present. Management feels visibility up to 15 months out is fairly reliable
Here is how the numbers come out over the next 4 to 5 quarters. Some information was not available. Downtime has been running at about 1000 per quarter.
[See Post for Tables]
There are downtime days and then there are downtime days.
I separated out standard jackups and swamp barges because downtime at their dayrates is not as critical. Swamp barges go for $90K and standard jackups get $70K to $120K. The loss is not comparable to a $300K to $700K deepwater ship or semisub.
Looking at the trends in deepwater and high spec units, 2012 is looking like an improvement over 2011.
Overall, downtime days was verging on 1000 days per quarter in Q2 and Q3 of 2011. Even counting the extremely unimportant swamp barges in the big picture, 2012 looks better. Swamp barges Q1 2012 add a significant outlier type increase that might be best ignored
Estimated leverage ratios
Taking the TTM operating income and adjusting the interest expense for the new debt and taking away the series B converts that will be paid off, gives an interest coverage ratio of 2.1X. An interest coverage ratio of 4X is the figure I generally like as a minimum. We don’t know what the future operating income will be and there is a reasonable chance the ratio can improve in 2012.
Aker brings some operating income with it. Aker’s TTM operating income was $156 million. If we add that to the ratio calculation the coverage is 2.3X and about what it is currently. The debt/capital increases to 39.5%.
I’m not Moody’s obviously. In my opinion, RIG is not dangerously overleveraged and I would not be inclined to downgrade them to junk if 2012 brings less downtime and the fleet puts in more days on the job. The interest is covered. Interest coverage is not a comfortable +4X ratio but at 2.3X it gives them cash left over after interest expense is taken out. Lower earnings before taxes resulting from increased interest should help lower the cash taxes paid—a silver lining that comes with debt and not with capital raised by issuing shares. The pay off of the 1.5% convertibles with the more expensive senior notes may not be the best deal they could make—cheaper debt is better debt. We do not have enough up-to-date data to know what the final debt structure will look like. It should be clarified when the 10K is released.
The 26 million shares issued to raise cash is dilutive and is an expensive form financing. I don’t like to see them do this as a shareholder and neither did market take it kindly. It is an 8% dilution. It is expected that some debt will be paid down with the proceeds. The new debt taken on at $2.5 billion would be whittled down to around $1.5 billion and interest payments decreased by as much as $50 million.
The dilution of shares has implication for the recently instituted dividend and it will see a decrease – more shares dividing up the $1 billion approved to pay four quarters worth of dividends.
Just 6 months ago, Transocean initiated a generous but perhaps ill-timed dividend. Shareholders have been paid $0.79 per share in the second and third quarters under a $1 billion payout initiative that went into effect before the end of the second quarter.
May 2011, at our annual general meeting, our shareholders approved the distribution of additional paid-in capital in the form of a U.S. dollar denominated dividend of $3.16 per outstanding share, payable in four equal installments of $0.79 per outstanding share, subject to certain limitations
This was a nice gesture by the company and perhaps engineered to keep the stock from falling endlessly—high dividends create some stability in share price. It has not worked for RIG because it appears that the dividend is in danger of being revoked as the company struggles with its capital structure and its cash flow.
Can the company pay the costs of debt, invest in capex and pay a dividend?
[See Post for Tables]
Transocean is keeping a significantly high cash stash available. The entire Aker acquisition could have been paid with cash on hand—the company chose to issue shares and senior notes instead. Part of the cash was slated for the Aker acquisition and part is held no doubt to cover legal expenses.
There are no reserves for the ocean of litigation facing them from the Macondo disaster. There is insurance coverage 0f $950 million ($50 million deductible).
RIG had a big win in Louisiana and is not going to be held accountable for the cleanup expanse in the tens of billions. They are still subject to civil liabilities and violations of the clean water act. This does remove one overhang from their future.
Capex for 2011 will be $1 billion with maintenance and BOP updates consuming a lot of cash.
The dividend is obviously putting stress on the cash flow and I would expect that when the current $1 billion commitment expires it will be withdrawn if not before.
If operating results improve, we might look for it again. It appears to have been instituted to put a floor under the share price and not as a way to return free cash to shareholders since there is very little free cash to spare.
Shares have rallied from the lows at $38 and until 2012 shows a return to profitability and better organization of the fleet with higher usage and less downtime, there may not be a lot of upside from the current price around $49. If the dividend is withdrawn, there is even less reason to hope for significant price appreciation.