Transocean: The Bear Case Goes Far Beyond Decreasing Deep-Water Dayrates

Transocean LTD. (RIG), an industry leader in the offshore drilling industry, currently trades at the bottom of its 52 week spread, has a 9.43 price to earnings multiple and pays a 5.2 percent dividend. The company appears to be a bargain but appearances can be deceiving. Last week, numerous downgrades came on anticipation of a deep water bear market, which is most likely due to an on shore oil boom. Deep-water oil drilling is the most expensive and least profitable for the oil exploration and production industry. With the price of Texas light sweet below ninety eight dollars per barrel and with an abundance of more cost effective opportunities on land and at shallower depths some analysts believe dayrates will continue to slide. I'm a Transocean bear myself, but my reasoning goes far beyond the outlook of the deep-water market. Transocean is likely about to miss Q413 earnings due to lower than expected operating efficiency and Q1 '14 guidance from Transocean reveals that downtime is likely going to make it nearly impossible for the company to live up to analysts' current Q1 '14 expectations, even under the best possible circumstances.

Q4 '13 Earnings:

Average forward earnings per share are a financial metric I created and use to analyze off shore drillers. They are explained in better detail in my article: "Seadrill Offers Dividend and Growth" .

In the tables below a slight variation average forward earnings per share are used to calculate fourth quarter EPS. The table on the left is a visual breakdown of analysts' current expectations. The table on the right is an estimation of Transocean's fourth quarter performance. The calculations conclude an earnings miss is more than likely.

(click to enlarge)

Are These Calculations Correct?

Some may question whether the numerical breakdown of expectations for Q4 '13 is correct. Couldn't analysts be expecting around 91.68 percent revenue efficiency and a much higher profit margin? The average revenue estimate for the quarter is 2.37 billion and the average EPS estimate is 0.76. Since the average revenue and EPS estimates in the table on the left match up with the average analyst estimates the percentages must be correct.

Source: Yahoo Finance

Q1 '14 Outlook:

Guidance from Transocean on the January FSR indicates they are expecting significant downtime in Q1 '14. The amount of downtime expected in Q1 '14 is a slight improvement over the prior quarter. However, 1st quarter is shortest quarter of the year. There are only 89 days as opposed to the 92 days in Q4 so what little operating efficiency improvement there was will be negated by the three fewer days in the quarter. Therefore, analysts must be expecting profit margins to increase, but increase in profit margins in inconsistent with the amount of downtime expected. Generally speaking, unexpected downtime equates to unexpected expenses. Because of this I immediately became a skeptic of the Q1 '14 average estimate of 1.03 USD per share.

Analysts covering the offshore drilling industry are very much aware of how many days are in each quarter. The amount of days in the quarter explains why they would expect a decrease in revenue while expecting operating efficiency to increase. Furthermore, since they're expecting an increase of 27 cents per share without much improvement to operating efficiency and fewer days in the quarter, they must be expecting profit margins to rise substantially. Under the best possible circumstances Transocean would need phenomenal revenue efficiency of 93.77 percent and their profit margin would have to grow over four percent to 15.81 percent, up from 11.56 percent from the prior quarter. Given the recent guidance from Transocean pertaining to downtime, revenue efficiency anywhere near 93.77 percent is impossible. Based off of Transocean's own downtime expectations they should have a revenue efficiency of 91.58 percent. Even if their profit margin improves in accordance with expectations they still fall short and again this is in the best possible scenario.

The Best Possible Scenario Assumes:

1. Transocean won't suffer any down time (other than the 16 days mentioned below) after the beginning of February on the GSF Development Driller 1, GSF Development Driller 2 and M.G Hulme Jr. rigs. There are currently no replacement contracts for those rigs listed on the fleet status report. The fleet status report is current as of January 16th 2014. If new contracts aren't currently in place, or if the situation isn't resolved immediately, it would be impossible for Transocean to meet current expectations under any conditions. Guidance from Transocean indicates the company expects 16 days downtime from GSF Development Driller 2 and 0 downtime from the other 2 rigs.


2. Deepwater Frontier's contracted day rate will be increasing from 534,000 USD to a 565,000 USD. The company is expecting 14 days downtime from that rig in the first quarter. For the purpose of my estimate I used the expiring dayrate of 534,000 USD although it's possible the downtime could occur during the new contract period at the higher rate.


3. The best case scenario assumes the amount of shares outstanding will not increase during Q4 '13 or Q1 '14. The difference between shares outstanding and shares issued is approximately 1,000,000.


4. The best case scenario assumes profit margin won't be affected by downtime unexpected by analysts. Generally speaking unexpected downtime equates to unexpected expenses.

Conclusion:

Transocean is not as cheap as it appears; the short term outlook is severely bearish. The company will likely fall short of analyst's Q4 '13 expectations. In addition to falling short of the Q4 '13 expectations, I expect to see revisions to a number of the Q1 '14 estimates because the estimates are undoubtedly high. It appears Transocean cannot meet those expectations under the best possible circumstances. Analysts are likely waiting for Transocean to provide the February fleet status report, which will contain information needed to make revisions. It would be wise to hold off on purchasing Transocean until later in the year, possibly Q2 '14, to see if ultra-deep water dayrates continue to slide. Investors interested in initiating a long position will have a better understanding of the deep water market outlook and how it will effect Transocean; the stock will likely be much cheaper at that time.

A complete list of my downtime deductions is available in my SA Insta Blog

Source: Transocean: The Bear Case Goes Far Beyond Decreasing Deep-Water Dayrates

Disclosure: I am long RIG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am long RIG puts (More...)

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