Rig Downtime Challenges Persist for Transocean
The 2012 outlook for the offshore drilling firm appears very difficult.
We still believe the long-term earnings power of its fleet is in the range of $6-$10 per share annually, a far cry from the estimated $1.51 a share that the firm will earn in 2011. However, this more normalized level of earnings is now further away than it was in early 2011. Furthermore, we believe Transocean's numerous short-term issues--which include managing its rig downtime, management's credibility after several poor quarterly performances, the all-cash payout for the Akers rigs amid Transocean's deteriorating financial condition, and the sustainability of the dividend--obscure the more attractive long-term picture. In our view, these issues will continue to weigh on the stock throughout 2012.
Transocean Faces a Number of Challenges in 2012
Transocean has struggled with rig downtime in 2011. We believe multiple factors are at work here. First, Transocean's deep-water fleet is generally older than peers' as a consequence of its historical leadership, and newer rigs such as Ensco's 8500 class are better equipped initially to meet more stringent customer maintenance demands. Second, we believe Transocean's Macondo-related legal issues have distracted the management team. Third, we believe the firm's large rig fleet is actually making things harder to manage, with numerous rigs coming and going from shipyards concurrently. Fourth, Transocean simply has not planned well for its rig downtime, as its original rig downtime forecasts for 2011 will probably be off by more than 100%.
However, external challenges need to be resolved as well. There are large servicing and certification equipment bottlenecks, particularly with blowout preventer and pressure-control equipment, which may take well into 2013 in order to fully address. Part of the issue is that the rig equipment industry is highly consolidated; National Oilwell Varco, Cameron, and GE Oil & Gas are the primary vendors, and they are struggling to keep up with aftermarket services demand. Cameron plans to invest another $100 million-$120 million in aftermarket services capacity globally. National Oilwell Varco said it has delivered more than 120 offshore rigs during the past few years, and many of them are coming off the 12-month warranty period and are now purchasing spare parts and services. If we combine the demand from these new rigs with the higher demand for aftermarket OEM services from the existing offshore rig fleet post-Macondo, the equipment players are operating in an almost ideal environment. Operators are demanding that any blowout preventer issues be addressed immediately rather than letting the driller rely on the multiple redundancies built into the equipment. Drillers are exploring having two blowout preventers on a rig so they can switch to a backup and limit the downtime. As a result, we expect significant pricing power for the rig equipment industry.
These internal and external challenges have shown up in Transocean's quarterly numbers. After several quarters of improving numbers, revenue efficiency (actual revenue divided by the highest amount of total revenue that could have been earned in the quarter) for ultra-deep-water and deep-water rigs dropped to 86.4% and 87.7%, respectively, in the third quarter from 89.3% and 93.9% last quarter. Indeed, out-of-service costs increased to $417 million in the third quarter from $243 million last year. We expect out-of-service costs to be around $1.5 billion in 2011 and $1.6 billion in 2012, a sharp increase from 2008's $743 million. While 2011 maintenance is mainly focused on deep-water rigs, we expect jackups and mid-water rigs to see more downtime in 2012. In our view, Transocean's rig downtime issues will begin to recede in 2013, as the firm should have addressed the maintenance issues with the majority of its fleet by this point, and the supply chain constraints should have diminished.
Rig downtime forecasts from Transocean also have been very inaccurate, which indicate poor planning on the part of the company. In the third quarter of 2010, Transocean forecast rig downtime levels of 43 months for the next three quarters. Actual rig downtime was 62 months. Transocean's other forecasts also have proved poor. In the fourth quarter of 2010, Transocean forecast 47 months of downtime for the next three quarters, but actual rig downtime was 108 months. In the first quarter of 2011, Transocean forecast 43 months of downtime across the next nine months, but the actual rig downtime over the next two quarters was 71 months; we wouldn't be surprised if the final three-quarter figure for rig downtime approaches 100 months. Transocean appears to be using planned rig downtime that was already scheduled for rig surveys to squeeze in numerous other rig aftermarket services at the same time, such as blowout preventer recertification, which adds more downtime. Given the scale of the rig downtime forecast misses during the past few quarters, we believe Transocean is struggling to communicate effectively to its suppliers what its needs and plans are for its rigs. As a result, the suppliers are unprepared for the additional work. Therefore, rig downtime and costs continue to increase for Transocean.
Management's credibility is also in question following several very difficult quarters and missed forecasts. The team originally indicated that the rig downtime issues would moderate toward the end of 2011, but now it appears that 2013 is a more likely scenario. The all-cash Akers deal in an environment where Transocean’s financial condition is weakening is also damaging. We still do not have a resolution on the ultimate Macondo liabilities, and while we believe they will prove immaterial, we're not entirely sure of the wisdom of making a large all-cash acquisition without closing out the matter. However, we do think the deal was reasonably priced and eventually will add value for the company.
Furthermore, while we appreciate CEO Steven Newman's efforts to work around Swiss legal quirks to initiate a $1 billion dividend, the wisdom of this endeavor is now in doubt as Transocean's cash flows continue to deteriorate. The timing couldn't be any worse, as Transocean obtained shareholder approval for the dividend in May. We expect 2012 earnings per share to be about $3.09, which will struggle to cover the dividend payout. We also expect 2012 operating cash flows to be around $2.4 billion, which means Transocean is likely to have to rely on its $2 billion credit line as well as its recent planned debt and equity issuances to fund the $1 billion dividend payout (or consider a dividend cut within a year of initiating it), $1.2 billion in capital expenditures, and $1.9 billion in debt maturities in 2012. The $1 billion impairment charge against its jackup fleet and handing out safety bonuses to the executive team for 2010 performance before reversing course and donating the bonuses to charity are also negative items that mark Newman's tenure to date. Overall, we still view the team as a solid long-term steward of shareholder capital. We view the firm's refusal to build rigs on speculation as a healthy signal, but the team and company have clearly struggled in 2011.
Competitive Advantages Intact
Structurally, we still view Transocean's competitive advantages as intact, as its current operational issues do not diminish the value of its deep-water expertise. Deep-water oil is still growing in importance, and we estimate it will contribute around 30%-50% of the incremental global oil production supply over the next decade. Furthermore, the ultra-deep-water market is actually strengthening, as rig day rates recently crossed $500,000, and the rig market toward the end of 2012 appears to be tightening. Thus, as Transocean gradually resolves its downtime issues, the incremental earnings benefits from the stronger deep-water market will also become apparent.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.