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1 M I I L ONG FU N D E LECTION ME MO TR A N SOC E A N TO: FROM: MII Managers Hunter Armistead, Sector Head and Senior Analyst, MII Third Year, Majors: Commerce and Economics SUBJECT: Transocean (NYSE: RIG) DATE: December 1, 2008 Selected Financial Metrics: Valuation Measures Market Capitalization 21.34B Enterprise Value 34.90B Trailing P/E Ratio 4.57 Forward P/E Ratio 4.27 PEG Ratio (5 yr) 0.31 Price/Sales 1.86 Price/Book 1.33 Other Financial Data Profit Margin 38.43% Return on Assets 13.52% Return on Equity 36.28% Operating Cash Flow 4.68B Levered Free Cash Flow M Debt/Equity 0.92 Current Ratio 1.791

2 52wk Range: Business Description: Sector: Basic Materials, Oil & Gas Drilling & Exploration Transocean Inc. is a leading international provider of offshore contract drilling services for oil and gas wells. As of February 20, 2008, the company owned 139 mobile offshore drilling units. As of this date, their fleet included 39 High-Specification Floaters (Ultra-Deepwater, Deepwater and Harsh Environment semisubmersibles and drillships), 29 Midwater Floaters, 10 High-Specification Jackups, 57 Standard Jackups and four Other Rigs. The company also has 8 Ultra-Deepwater Floaters. Transocean s mobile offshore drilling fleet is one of the most modern and versatile fleets in the world. Their primary business is to contract these drilling rigs, related equipment and work crews, primarily on a dayrate basis, to drill oil and gas wells. Transocean specializes in technically demanding segments of the offshore drilling business with a particular focus on deepwater and harsh environment drilling services. The company also provides oil and gas drilling management services on either a dayrate basis or a completed-project, fixed-price basis, as well as drilling engineering and drilling project management services. Transocean also participates in oil and gas exploration and production activities. Transocean s shares are listed on the New York Stock Exchange under the symbol RIG. Drilling Fleet Description: Transocean principally operate three types of drilling rigs: Drillships Semisubmersibles 2

3 Jackups Most of the company s drilling equipment is suitable for both exploration and development drilling. Likewise, most of Transocean s drilling rigs are mobile and can be moved to new locations in response to client demand. As of February 20, 2008, Transocean s fleet of 139 rigs included: 39 High-Specification Floaters 18 Ultra-Deepwater Floaters 16 Deepwater Floaters 5 Harsh Environment Floaters 29 Midwater Floaters 10 High-Specification Jackups 57 Standard Jackups 4 Other Rigs 2 barge drilling rigs 1 mobile offshore production unit 1 coring drillship As of February 20, 2008, Transocean s fleet was located in the Far East (21 units), U.K. North Sea (19 units), Middle East (18 units), U.S. Gulf of Mexico (16 units), Nigeria (13 units), India (12 units), Angola (11 units), Brazil (8 units), Norway (5 units), other West African countries (5 units), the Caspian Sea (3 units), Trinidad (3 units), Australia (2 units), the Mediterranean (2 units) and Canada (1 unit). High-Specification Floaters are specialized offshore drilling units that are categorized into three subclassifications based on their capabilities. Ultra-Deepwater Floaters have a water depth capacity of 7,500 feet or greater. Deepwater Floaters have a water depth capacity between 7,500 and 4,500 feet. Harsh Environment Floaters have a water depth capacity between 4,500 and 1,500 feet, and are capable of drilling in harsh environments. Midwater Floaters have a water depth capacity of less than 4,500 feet. High-Specification Jackups consist of Transocean s harsh environment and highperformance jackups. Drillships are generally self-propelled, shaped like conventional ships and are the most mobile of the major rig types. All of Transocean s High-Specification drillships are dynamically positioned, which allows them to maintain position without anchors through the use of their onboard propulsion and station-keeping systems. However, drillships are typically limited to calmer water conditions than those in which semisubmersibles can operate. Transocean s three existing Enterprise-class drillships and five of their seven additional newbuild drillships will be equipped with the company s patented dual-activity technology. Dual-activity technology includes structures, equipment and techniques for using two drilling stations within a single derrick to perform drilling tasks. Dual-activity technology improves efficiency in both exploration and development drilling. Semisubmersibles are floating vessels that can be submerged to lower thier hulls below the water surface during drilling operations. Typically, semisubmersibles are better suited than drillships for operations in rougher water conditions. Transocean s two operating Development Driller-class 3

4 semisubmersibles are equipped with their patented dual-activity technology. Jackup rigs are mobile self-elevating drilling platforms equipped with legs that can be lowered to the ocean floor. These rigs are generally suited for water depths of 400 feet or less. Thesis Points: Strong Position to Benefit from Offshore Drilling Demand In November 2007, Transocean merged with Global Santa Fe, making it the world s largest offshore drilling contractor by market cap, and the largest in the world by fleet size, with a drill rig industry market share of 20%. The new Transocean fleet is more than twice the size of the next largest competitor, giving the company a powerful hand in the industry. With shallower wells yielding less, and high potential income from high oil prices, oil and gas companies are paying very high rates to oilfield services companies who can drill all over the ocean. Transocean has 38 deepwater drills (most in the world), and has 8 more under construction. Contract durations across much of the fleet are growing and rig demand continues to outpace supply, especially for deepwater rigs. Deepwater rigs are likely to see strong demand for several years and Transocean faces much less competition with their large fleet. Transocean's deepwater technology (dual-activity mentioned above) is patented by the company and gives them a competitive advantage. This means that when other oilfield services companies build new deepwater rigs or rig upgrades that use the technology, they must pay a percentage to Transocean. VAR: Report from Plunkett Research, Ltd. Offshore oil production has been rapidly growing in importance worldwide Today, the average oil well in the Gulf of Mexico flows over 30,000 barrels of oil daily 100 times the rate of flow of an average onshore U.S. well In the Gulf of Mexico, rig count has gone up to 75 from 49 a year earlier Newer, extremely deep-water wells flow at even greater rates Watch for extensive, extremely deep exploration in other parts of the world, including offshore Brazil, the west coast of Africa and the Arctic Circle, to capitalize on the technology developed for use in the Gulf of Mexico Floating rigs are needed because they can be used in deeper waters as explorers search in harder- to-reach places and harsher climates VAR: Nina Rach, The Oil and Gas Journal High prices drive a lot of drilling in North America Worldwide drilling set a record in August 2008, with 3,523 rigs operating Brazil dominates Latin America in offshore drilling Petrobras has been signing long-term contracts to ensure that it has sufficient capability to drill its increasing offshore portfolio Petrobras has yet to order 28 deepwater rigs that it will need in Transocean controls about 24% of global offshore fleet after merging with GSF Drilling contractors continue to make significant capital improvements in their fleets Construction backlog is up 36% from a year ago 4

5 There are no signs that the demand for oil and natural gas will abate, and continuing high prices should promote continued drilling Large Order Backlog Transocean s backlog, which extends into , has increased to $41.1 billion (as of October 2008) from $37.8 billion at mid-year. Importantly, Transocean s contracts are take or pay commitments that cannot be canceled by customers as long as the rig operates as designed (this includes oil prices declining to any price). In the past, one company (BP) tried to cancel a contract and went to court. Transocean won easily (The companies are on good terms and BP is still one of Transocean s biggest customers). In essence, the contracts and the related revenue backlog they create are as safe as the underlying credit of the client in the contract. Management estimates that over 90% of its backlog is tied to investment grade rated companies and 70% of the backlog is associated with clients whose debt is at least A-rated or national oil companies. I feel that the risk of these contracts has been largely overestimated by investors because of the current economic conditions. Transocean s clients have been in the business for a long time and plan to do business far into the future. Therefore, their clients are unlikely to breach for no reason because they know they would get taken to court and lose. Worldwide Lags in Rig Production Will Drive Dayrates Up VAR: Andrew Gould, Schlumberger Ltd. Conference Call Worldwide, 93% of jackups, 97% of semi-submersibles, and 100% of drillships are being contracted Only a few new offshore rigs coming online in 2008 This makes significant offshore equipment growth in 2008 relatively unlikely - and will probably drive up oilfield services rates significantly over the next year Transocean has the largest fleet in the industry and is increasing its exposure to the market. Until 2010, only 15 rigs will be available for leasing, and the company owns seven of them. Furthermore, with eight deepwater rigs in production, the company will be ready to compete at around the same time other firms start putting out new rigs. Transocean s dayrates are the highest in its history (recently signed a contract for newbuild ship with XOM at $650,000 a day). However, Transocean s management has done an excellent job in balancing short-term contracts at very high rates with long-term contract with good market rates. Historical Dayrates Average Dayrate $105,100 $142,100 $211,900 Average Capital Utilization 79% 84% 90% Source: 2007 Annual Report 5

6 Average Dayrates Thereafter High-Specification Floaters $ 353,000 $ 393,000 $ 416,000 $ 443,000 $ 439,000 Midwater Floaters 294, , , , ,000 High-Specification Jackups 150, , ,000 Standard Jackups 153, , , , ,000 Other Rigs 50,000 56,000 68,000 68,000 65,000 Total $ 234,000 $ 270,000 $ 293,000 $ 304,000 $ 397,000 Source: 2007 Annual Report With its superior technology, capital, and reputation, Transocean has also been able to charge more for its services than its competitors: Average Dayrate Average Fleet Utilization Avg Number of Rigs Sources: 2007 Annual Reports Transocean Noble Rowan Companies ENSCO International $211,900 $139,948 $156,200 $139,882 90% 95% 94% 91% Financial Strength Gives Advantage Over Smaller Competitors Though the current economic crisis does not bode well for many companies, it could help Transocean relative to their competitors. The credit crunch will give Transocean advantages as smaller drillers will struggle to finance projects. With lots of improvements and building scheduled, Transocean can step in to satisfy the demand. The company expects to spend $2.8 billion in capex in 2008, including $1.9 billion in newbuild capex, $200 million for two deepwater upgrades, and $700 million of remaining capex for upgrades, spares, maintenance capex, and other activities. The company set a 2009 capex budget of $3.0 billion. Specifically, the company expects to spend $1.9 billion for newbuilds and $1.1 billion for upgrades, spares, maintenance, and other. Transocean s management also recently quantified the impact from an accounting change for the company s $6.6 billion of convertible debt that can be settled in cash. For 2009, the company estimates the accounting change would boost reported non-cash interest expense by $200 million. The accounting change would result in a healthier balance sheet, as the convertible debt will be split 6

7 into its debt and equity components. Despite an elevated level of debt, Transocean s liquidity position remains comfortable, with $1 billion in cash, approximately $1.4 billion available on its revolver, and a $1.5 billion commercial paper backstop. Transocean also has operating cash flow of nearly $5 billion. This year, the company used $2.5 billion of its cash flow to reduce its outstanding debt. The company s interest coverage ratio for the past 12 months has been around 12. Dayrate declines in Brazil and Norway because of a strengthening dollar have hurt the stock. However, I think many investors fail to see that a stronger dollar is actually a slight plus because a large portion of operational expenditures is denominated in local currencies. Also, most of the dayrates for the company are denominated in dollars. Transocean s merger with GSF also strengthens the company financially. They have been able to benefit from economies of scale and have used their sheer size in the market to negotiate favorable contracts. VAR: Gail Actuary, TheOilDrum.com Risks: The bigger companies with good cash flow and a low cost of production are in a much better position than smaller, more leveraged firms The credit squeeze has already put some of the smaller players out of business (Ex. Catalyst Energy Group) Petrobas in Brazil recently ran into a problem with suppliers who promised more than they could deliver when it awarded contracts for building 20 deep-water drilling rigs to Brazilian firms with little experience in deep-water drilling. Many of these firms were not able to borrow the money they needed to finish the oilrigs they had promised. Because of the credit squeeze, many oil and gas companies are finding it necessary to limit their investments to what they can finance with cash flow. In the Canadian oil sands, both Suncor and Petro-Canada have pushed back plans to purchase upgraders, at least partly because of cash flow considerations. US natural gas producer Chesapeake Energy cut its spending plans three times within a month. Falling Oil Prices Offshore drilling is the most complex and expensive means of accessing oil. Therefore, if oil and gas prices fall, it would be the first method to be eliminated. Though WTI is currently trading at around $54, it is unlikely that the company will be materially impacted in the short-term because its contacts are already signed. Management estimates that as long as oil prices remain above the $60-$65 level, companies can profitably explore and develop deepwater projects. It is important to note that the oil companies are betting on the future prices of oil when they sign contracts with Transocean. If you look at indicators like the NYMEX Crude futures, they predict that oil prices will be above this breakeven price by later next year. Academic models, like the International Energy Agency s World Energy Outlook, also forecast rising oil prices in the future. However, oil forecasting is notoriously 7

8 tricky, and spot prices could very well fall in the future. Rig Out-Of-Service Time Minimizing out-of-service time is one of Transocean s biggest concerns. They must limit delays for repairs and upgrades because they can keep the company from starting contacts that pay higher day rates. Anything from weather to breakdowns can cripple a rig. Also, any rig not under contract represents a large opportunity cost for the company for each day that it is out of service. Though the company has average margins, its return on capital employed (ROCE) is often lower than its competitors. To help, Transocean recently changed its budgeting process in an attempt to manage expenses more efficiently. The company also reduced its 2009 downtime expectations to 2,745 days from 3,006 days previously, reflecting lower scheduled downtime for Other Deepwater (-67%) and Jackup (-18%) segments, which more than offset higher downtime for the Ultra-Deepwater (+15%) and Other Floater (+11%) rig fleets. Lower-Than-Expected Cash Flows The merger with GSF increased Transocean s debt by about $15 billion. The company raised $8.5 billion by issuing $6.0 billion in convertible senior notes due in 2037 and $2.5 billion in senior notes with various maturity dates. The company plans to pay down the debt over time with its high cash flows. Cash flows could be lower than Transocean expects, but this will be unlikely given the company s current backlog and interest coverage ratio. Lower cash flows would also reduce the planned capex. Large Customers As of August 2007, the pre-merger company got 54% of its revenues from the major integrated oil companies, 24% from national oil companies, and 21% from independent oil companies. Because the company has relatively few customers, the loss of any significant contracts would have strong, negative effects on Transocean's long-term revenue stream. I think that this is extremely unlikely, however, given Transocean s dominance and strength in the industry. Though oil companies demand will most likely fluctuate, completely ending a relationship with Transocean would significantly diminish their offshore production capabilities. Summary: After evaluating the risks and benefits of taking a long position in Transocean, I would strongly recommend buying the stock. The stock has been unjustly valued for a variety of reasons. Falling oil prices and worries about the company s strength of their contracts have crushed the stock recently. In addition, many hedge funds and mutual funds have been forced to sell their positions as they try to remain afloat in the current economic situation. Though the company has extremely high cash flows, its indebtedness has scared away investors. Despite its solid fundamentals for the long-term, the stock is trading at an extremely low price. The company has dominant market positioning and a new fleet of state-of-the-art deep-sea drillers coming online in the next few years. The industry outlook is extremely bullish, and Transocean stands to reap the majority of the benefits in the future. I think that this is a great value stock and would be a nice addition to MII s portfolio. 8

9 Ideas for MII: I think that MII has taken a lot of very good steps in improving the club over the past two years that I ve been a member. I like how the communication has improved between the managers and the other members of the club, particularly concerning the selection of stocks. I think that it would be good to give investing seminars at the beginning of each semester to teach members more about investing. I think that a lot of people come into MII having no exposure to investing, and it s very confusing to follow the presentations, etc. without any background knowledge (I was definitely one of these people when I first joined). It would improve the presentations, questions, and quality of the club as a whole. I think that it might also be fun to have an alumnus from Wall Street who was in MII come back and talk to us about his work once a semester. I think that taking a trip (rather somewhere close by like Richmond or somewhere far away New York) to see a venture capital firm, investment bank, etc. would also be a great experience for members. 9