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The Battle Over Capital Allocation at Transocean

Transocean faces some interesting dividend and director proposals at its May meeting.

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 Transocean (RIG) CEO Steven Newman just can’t catch a break. Only a month into the job, he faced the Macondo blowout, and dealing with the aftereffects has consumed most of his time during the past few years. Now, after a string of successes in the past few quarters, Newman has to deal with activist investor Carl Icahn’s demands, which include a dividend of $4 per share and the replacement of three board members. In our view, Icahn’s demands threaten to derail a series of balance sheet and operational improvements during the next few years that we believe will create significant long-term shareholder value. This battle is crucial for Transocean, because it revolves around one of the most pressing issues for the firm today: Newman’s efforts to create shareholder value, which include capital allocation.

Icahn’s Strategy
Icahn is correct in two respects: Transocean can support a decent-size dividend while meeting its fleet reinvestment needs, and shareholders would likely benefit from a de-staggered board where all members are up for election every year instead of over several years. Beyond these two issues, we think little of Icahn’s proposals, as they show a questionable understanding of the dynamics of the offshore drilling space, Newman’s decision-making abilities, and his capital allocation efforts.

Icahn is proposing a dividend of $4 per share, or a $1.4 billion annual payout for Transocean, at the May 2013 annual meeting. If enough shareholders vote for the proposal, regardless of what the board thinks, under Swiss law, Transocean is bound to initiate the dividend. This scenario is different than most situations in the United States, where shareholder proposals are not binding and the board can disregard them. Icahn’s $4 dividend proposal, along with his assertion that Transocean’s dividend strategy should be to pay out at minimum 85% of net income, is remarkably ambitious, in our view.

We think Icahn’s dividend proposal overlooks the highly cyclical nature of the industry, which makes maintaining a $1.4 billion dividend very unlikely. Transocean was forced to halt its prior $1 billion dividend payout in 2012 as its results deteriorated and its investment-grade credit rating came under pressure. In addition, Transocean has already noted that deep-water rigs are coming off contracts without immediate follow-on work, which could cause a flattening in day rates and more competition for work in the near term. Second, Icahn assumes the capital intensity of the industry will be lower going forward, as drillers complete their current newbuild programs and start to generate considerable free cash flow. However, we think drillers need to reinvest in their fleets consistently over time to maintain their competitive position. Transocean’s need to do so is particularly pressing given its older rig fleet. Rigs older than 10 years are more vulnerable to replacement by more-advanced newbuilds, in our view. If Transocean wanted to replace its 49 midwater and deep-water assets built between the 1970s and 1990s with newbuilds at $600 million a rig, we estimate it would cost nearly $30 billion in capital expenditures to do so. As a result, we see continued asset sales in Transocean’s future, but also a continual need to reinvest in the fleet to replace declining earnings from older and less capable assets.

We also question Icahn’s second proposal, to replace three board members with ones better suited to putting together a drilling MLP. None of his proposed nominees have any offshore drilling experience, two out of three lack any oil and gas background, and all have been or are now associated with current or past Icahn entities. Only John Lipinski has any relevant experience here, as he successfully managed to IPO an MLP, CVR Refining, in January 2013. In addition, while we think a background in highly cyclical industries can be applied to offshore drilling--and the board is already well stocked with offshore drilling experience--we are more concerned about adding to the board directors who agree with Icahn’s aggressive capital allocation policies.

Furthermore, Transocean recently hired Esa Ikaheimonen, former CFO of Seadrill, which successfully launched the first driller MLP with Seadrill Partners SDLP in late 2012. Transocean has also refreshed its board over the past two years, with six new directors being added and a seventh being proposed at the May meeting. As a result, we think Transocean already has the best talent in place to successfully pursue an MLP if the company deems it value-enhancing to shareholders. We'd also point out that Transocean was already actively exploring this option before Icahn’s arrival on the scene. Given Transocean’s large deep-water fleet, we think it is one of the best-positioned offshore drillers to pursue an MLP. The large number of rigs Transocean owns would let it drop down assets with different contract expiration dates in a way to ensure smooth distribution coverage in the event of a cyclical downturn.

Finally, we think during the course of Newman’s tenure, Transocean has allocated capital reasonably well and made a number of positive value-creating moves. Newman’s tenure started in March 2010, just before the Macondo blowout in April of that year. We don’t blame Newman for Macondo, and ultimately, Macondo would have probably occurred with any contractor’s rig, given the complex interplay of events that caused the blowout. Newman has made substantial progress on fixing the fleet downtime issues that have plagued the firm since Macondo, with revenue efficiency and out-of-service costs now close to pre-Macondo levels. In our view, these issues were largely inherited from the prior management team, as an aggressive M&A strategy meant the firm’s fleet was largely made up of rigs that other contractors had built and maintained at varying quality levels. We also give Newman credit for replacing his top officers--the CFO, general counsel, COO, chief of staff, and controller are all new to their positions as of 2012. The board has also undergone a refresh during Newman’s tenure, and if Curado is added to the board in 2013, he will be the seventh new director added to the board since 2010.

Newman’s tenure hasn’t been without its issues, and there was an ugly stretch in late 2011 and early 2012 when he seemingly could do no right by shareholders. The Akers acquisition of four drilling rigs for an estimated $783 million per rig was a full valuation in our view, and the all-cash nature of the offer quickly came back to bite Newman. He was forced into issuing nearly 30 million shares in the low 40s shortly after the deal was complete, which was well below our fair value estimate and value-destroying, in an effort to defend the balance sheet as credit agencies were considering a rating downgrade to below investment grade. Given this balance sheet error, the CFO departed Transocean shortly afterward for a position at Subsea 7 SUBC.OL. In early 2012, as the firm’s operational results and liquidity position continued to suffer, Newman had to end the $1 billion dividend payout just a year after initiating it, which was a significant blow to his creditability, in our view, as it reflects poorly on management’s ability to manage the business. Completing the ugly stretch, as the result of a 2007 agreement signed with Quantum Pacific over two jointly owned rigs, Transocean was forced into issuing another 8.7 million shares well below our fair value estimate to buy the rigs from the venture at a full valuation of $820 million per rig. Given that the agreement was signed prior to Newman’s taking over the CEO position, he couldn’t do anything about it, but it completed a frustrating period for shareholders under Newman’s tenure.

However, throughout the past year, we’ve seen a string of successes for Newman, which indicates that he can create shareholder value. Adding Esa Ikaheimonen, Seadrill’s former CFO, was a brilliant move, as Ikaheimonen is well positioned to pursue a drilling MLP given his background at Seadrill. The four-rig newbuild announcements with Shell also added rigs at approximately 12% IRR for a $3 billion capital investment. This is clearly value accretive for shareholders and adds modern rigs to an aging fleet while improving Transocean’s competitive position. The Shelf Drilling sale of 38 drilling units was another smart move, as the rigs made up nearly 30% of Transocean’s fleet, involved about 3,000 employees (or 16% of Transocean’s workforce), and contributed operating losses for the past two years. Transocean received $568 million in cash after working capital adjustments and preference shares worth $196 million that pay a 10% dividend per year, which can increase to 14% over the next year. Transocean is also expected to supply operating and transition services that will cost $60 million-$80 million in 2013. The deal values the units at about $18 million-$20 million per rig, which we consider reasonable as it might have taken years for Transocean to dispose of the drilling units in single transactions. The reduction in complexity and the removal of the commodity units, as well as the announcement of the $1.4 billion Macondo settlement in early January 2013, removed several key concerns for Transocean shareholders in quick succession. The fact that Newman is now considering further value-enhancing efforts for shareholders such as a driller MLP--which could lower Transocean’s cost of capital--streamlining the organization to be more efficient, and adding more newbuilds with a contract in place, thus ensuring an excellent IRR, are all indicators that Newman’s decisions are beneficial for shareholders. Overall, we’d award Newman with a B- grade for his efforts during the past few years.

Why Transocean’s Strategy Should Create More Value
While Transocean introduced its new strategy after Icahn’s, we believe it has been considering how to best allocate its capital for some time, as it has repeatedly discussed the topic on its conference calls. Transocean’s capital allocation approach can be defined as follows:

  • Pursue a $2.24 dividend (or $805 million) payout, with the goal of protecting its investment-grade rating.
  • Reduce its $12.4 billion debt load to $10.4 billion by the end of 2014, as it pays off the $1 billion debt maturity this year and another $1 billion in debt by the end of 2014.
  • Continue to study prospects for a Transocean MLP.
  • Opportunistically pursue newbuilds with a contract or purchase under-construction rigs without a contract to avoid adding additional supply to the market.

 

We think Transocean’s strategy will ultimately generate more value for shareholders than Icahn’s. First, we think Transocean’s dividend proposal of $2.24 per share strikes a more reasonable balance between capital reinvestment in the fleet and return of capital to shareholders. If we compare Transocean’s proposed payout with the rest of the industry’s payouts, we think Transocean looks very reasonable. We consider Diamond Offshore’s and Seadrill’s payout ratios as too high and ultimately unsustainable, as Diamond appears to be in the midst of a very long-term decline as its midwater rigs gradually become less competitive, while Seadrill’s payouts are largely financed by very high levels of debt.

Icahn’s large dividend payout becomes more damaging if we compare the impact of the two plans on Transocean’s balance sheet over time. Under Icahn’s plan, at the end of 2017, Transocean’s debt/capital ratio remains in the mid-40s, which means its options for pursuing further newbuilds are very limited. Notably, our forecast assumes a fairly healthy deep-water market during the next few years, whereas in the case of a cyclical downturn and a 30%-40% decline in day rates, these metrics would look far worse. Transocean’s plan provides it with more flexibility to refinance debt maturities as they come due and to pursue opportunistic newbuild contracts or acquisitions. It also provides greater protection during a downturn, rather than forcing the company to pay out essential capital to shareholders. For example, as the four-rig Shell contract shows, Transocean needs to invest substantial capital up-front without the corresponding earnings boost until the rigs start being delivered in 2016 and 2017. Transocean is in advanced negotiations for the construction of a newbuild rig for delivery in 2015, which makes the company’s need for cash more acute.

Moody’s has indicated that if its calculations of Transocean’s debt/EBITDA (which includes pension, taxes, and operating leases liabilities) are greater than 3.0 times for any length of time, it would be inconsistent with an investment-grade driller. Redirecting substantial cash toward a large dividend payout and away from debt reduction, which until now has been Transocean’s sole focus, is not consistent with meeting the debt/EBITDA leverage targets. We also think shareholders will likely penalize Transocean’s higher leverage levels and resulting greater exposure to the industry’s cyclicality with a lower multiple, at least until shareholders are more confident in Transocean’s operational turnaround. That said, in a downgrade scenario, based on the current credit markets, we do not believe interest costs will increase materially for Transocean until perhaps 2015, when $1.1 billion in 2015s are due, which could result an incremental $20 million in annual interest expense. We also do not see a below investment-grade rating as a negative for Transocean’s competitive position, since, despite a far weaker balance sheet, Seadrill has landed large contracts with some of the most important deep-water customers.

The other option that Transocean can pursue with its plan is acquisitions. At the right price, acquisitions can provide an immediate earnings boost, let Transocean modernize its fleet faster, and give it an opportunity to engage in more-aggressive asset sales of older, less-capable rigs with less risk to its earnings profile and balance sheet. We think there are several acquisition targets that Transocean may consider--Pacific Drilling PACD, Ocean Rig ORIG, and Vantage Drilling VTG. Of the three candidates, we think Pacific Drilling is the most attractive, since even after assuming a 15% control premium, which still implies an 80% stock price premium, Transocean can still acquire the rigs at a 20% discount versus ordering them with a two-year delivery schedule. That said, the likely heavy use of debt to pursue any deal along with the assumed debt from the driller will likely force a downgrade to below investment grade, and Transocean has been focused on maintaining its investment-grade status. An acquisition of Pacific Drilling or Ocean Rig will likely mean that the acquisitor will assume over $3 billion in debt, which will add another EBITDA turn of leverage at minimum for Transocean. In addition, Transocean’s dividend announcement indicates that it doesn’t see any better opportunities out there for its capital, which means it may not see any value in acquiring any of these rigs.

However, we believe the existence of a Transocean MLP would make acquisitions a potentially attractive option. Seadrill Partners is trading at about 13 times 2013 EBITDA and 12 times 2014 EBITDA, substantially higher than Seadrill’s current multiples. We would expect a Transocean MLP to enjoy similar EBITDA multiples to Seadrill Partners. Given that Transocean trades at a lower multiple than Seadrill, an MLP strategy could provide Transocean with a relatively greater benefit. An MLP could be stocked with a mix of older and newer rigs from Transocean’s fleet with differing contract lengths to ensure a stable distribution payout, while the sheer size of Transocean’s fleet would give it a nearly unrivaled path for future distribution growth through dropdowns. An MLP would provide a ready source of capital for these rigs and ultimately lower Transocean’s cost of capital, making acquisitions such as Pacific Drilling or Ocean Rig more affordable. For example, as Transocean would likely be able to drop down newer deep-water and ultra-deep-water rigs at close to $850 million per rig to its MLP, dropping down 2-3 rigs per year would raise $1.6 billion-$2.4 billion in capital for fleet investment. Alternatively, Transocean could fund an acquisition of Pacific Drilling for $679 million per rig by utilizing an MLP and dropping down six to eight newer rigs or the entirety of its older midwater rigs and just one deep-water rig. The impact on our fair value estimate would also be positive, as our net asset value for Transocean’s 24 operating ultra-deep-water rigs built in the last decade would increase to $20.4 billion or $850 million per rig ($57 per share) from $14.4 billion or $600 million per rig ($40 per share), as the rigs would be valued as dropdown candidates rather than at replacement value. Transocean also has another 49 midwater and deep-water rigs that we value at around $9 billion in terms of a market cost that also could be worth more to an MLP. At this stage, Transocean has yet to indicate whether it intends to fully pursue an MLP option, but Seadrill took about a year to proceed through the process, which likely makes any Transocean MLP a 2014 event.

Impacts on Moat Trends and Transocean’s Valuation
The influential proxy advisory agency ISS, which holds sizable sway over how many institutional shareholders vote their proxies, has recommended that shareholders vote for a $2.24 dividend as well as add Icahn director nominees Jose Maria Alapont (a former CEO of Federal-Mogul) and Samuel Merksamer (a managing director at Icahn Capital) to Transocean's board. ISS indicated that Icahn’s third nominee, John Lipinski (currently the CEO of CVR Energy), serves on too many boards to be of use to Transocean, and many of the improvements under his tenure at CVR seem more related to structural changes in the refining market than to his managerial acumen. The new directors would replace Michael Talbert (currently Transocean’s chairman of the board) and Robert Sprague. Both Talbert and Sprague were recommended to be replaced owing to their long tenures on the board at 20 years and 10 years, respectively (including Sprague’s GlobalSantaFe tenure), which encompassed the GlobalSantaFe acquisition as well as the events relating to Transocean’s Norwegian tax issues (in Talbert’s case).

 

We see the dividend recommendation as a significant win for Transocean, while the director recommendations are more concerning. ISS clearly agrees with Transocean that a $2.24 dividend is more sustainable, as it provides more balance sheet flexibility as well as lets Transocean pursue an appropriate amount of fleet reinvestment. As a result, Transocean has the opportunity to deploy capital toward its fleet and potentially stabilize its negative moat trend. In our view, the director recommendations (Alapont and Merksamer) are more indictments of the poor decisions that Talbert and Sprague oversaw rather than a full-throated endorsement of Alapont’s and Merksamer’s expertise. For a variety of reasons, such as lack of offshore drilling experience and limited knowledge of the specialized operator-contractor model, we’re not enthusiastic to see the pair added to the board. However, we recognize that shareholders can choose to ignore ISS’ recommendations, which we hope will be the case. We also realize that shareholders may choose to go with ISS' recommendations. In our view, if two of Icahn’s nominees were added to the 14-member board (currently 12 independent members, but this would increase to 13 with Talbert’s replacement), they would make up only a small portion of the board, and without the dividend approval, they would have less influence.

If the May meeting results in the triumph of Icahn’s proposals, we don’t plan on changing our fair value estimate, but we do think that if Transocean is forced to pay out a larger dividend, its ability to reinvest in its fleet to maintain its competitive position over time will be compromised. We think an Icahn win will reinforce our negative moat trend, and if the dividend is maintained and Transocean doesn’t seek to eliminate it at the 2014 meeting (which we consider a possibility), Transocean’s fleet will gradually be surpassed by more technically advanced rigs, leading to lower day rates and shareholder returns.

If Transocean’s proposals win, we do not anticipate changing our fair value estimate, but we think the firm will have the ability to stabilize its negative moat over time. Some of the key items we’ll be watching will be the decision on whether to pursue a drilling MLP, which we think makes sense, additional newbuild announcements (with or without a contract in place), and opportunistic midwater and deep-water asset sales to free up cash for newer and more-advanced rigs. A potential acquisition of Pacific Drilling, depending on the deal structure and price, could be a significant win for the Transocean as well even if the firm loses its investment-grade rating. Finally, we’ll be keeping a close eye on revenue efficiency and out-of-service trends to ensure that Transocean’s fleet management and operational practices remain solid. A combination of some or all of the above events would merit an upgrade to a stable moat trend, in our view.

Regardless of the outcome of the annual meeting in May, we think investors should refocus on Transocean after a lost year in 2012, particularly as its operational changes and organizational changes take root. Transocean has struggled through nearly two and a half years of downtime issues relating to its older fleet and not necessarily understanding the baseline condition of its rigs, which is an outcome of the firm’s M&A activity over the years, particularly with GlobalSantaFe in 2007. However, it has implemented many changes since Macondo, including obtaining third-party certification for 24 out of its 27 ultra-deep-water rigs and 42 out of 64 of its active floaters. As a result, the firm’s revenue efficiency numbers and out-of-service cost trends have been improving while peers (notably Seadrill) have increasingly run into unplanned fleet downtime issues around well control over the past few quarters as fleet utilization has been in the mid-to-low 80s compared with the 90s historically. We think as these trends result in numbers that are more reflective of pre-Macondo levels, Transocean’s earnings should continue to increase.

We think the complexity surrounding Transocean’s story has greatly diminished during the past few months, letting management pursue more low-hanging fruit that should translate into more positive operational catalysts. The Macondo settlement with the U.S. Department of Justice for $1.4 billion has removed the majority of the uncertainty around any Macondo-related liabilities. In addition, the sale of 38 commodity drilling units to Shelf Drilling removes units that added substantial complexity to Transocean’s operations, and generated operating losses of $42 million in 2011 and $183 million in 2012. The removal of these overhangs should help investors focus on two key attributes that offer substantial upside for Transocean during the next 12-18 months. First, the large amount of uncommitted fleet time from 2013-16 in healthy deep-water and ultra-deep-water markets highlights the opportunity for lucrative contract resets to more profitable market day rates. For example, ultra-deep-water day rates have increased more than 40% since mid-2011 to just above $600,000 a day. Second, Transocean has been focusing more on streamlining its organizational structure to better close the margin gap between the firm and its peers. The company is aware of the long-standing 500-1,000-basis-point gap in gross margins between itself and its peers, and given the fleet changes following the Shelf transaction, it can now focus on instituting a more efficient overhead structure.

Transocean has remained tight-lipped on what exactly this initiative entails at this stage, indicating that we may see measurable progress here in 2014, but given the size of the gap, any success would be upside for our forecasts. Transocean has disclosed that it is focusing on being more efficient about its shore-based and rig operating costs, but any cost reductions in 2013 will be offset by restructuring costs. If Transocean’s gross margins can reach 45% by 2017, roughly on par with current industry average, our fair value estimate would increase to $82 per share. In a more bullish scenario, a 50% gross margin would potentially drive our fair value estimate to nearly $100 per share. In any case, we think Newman is well positioned to deliver substantial shareholder value during the next few years.

Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.