Which Drilling Company Should You Buy?

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Transocean (NYSE: RIG) had actually recovered nearly all of its losses from the Deepwater Horizon disaster in early 2011, but has since slumped. While the stock is up 14% so far this year, about even with the S&P 500 but it is down about 27% over the last two years while the index has risen by about the same percentage.

Higher drilling activity increased Transocean’s revenues by 10% in the second quarter of the year compared to the same period in 2011; this was about in line with the improvement that the company saw in the first quarter. While dayrates were slightly down, utilization was up significantly. However, steep operating and maintenance costs caused Transocean to veer into unprofitability versus the positive earnings it had posted during the first half of last year. Cash flow from operations improved because of changes in working capital, but overall we do not feel particularly positive about where the company currently stands.

Transocean trades at 10 times forward earnings estimates, as Wall Street analyst consensus is for the company to generate $4.46 in earnings per share next year. That represents a large increase from what it is expected to report this year, so we think the value status this multiple implies could be deceptive. With Gulf activity still a bit questionable going forward, we would say that oil prices would have to rise- despite heavy onshore activity in U.S. shale fields- in order to drive up demand for contract drilling operations.

Transocean was oil billionaire T. Boone Pickens’s largest holding in its 13F portfolio at the end of June, as BP Capital reported owning about 230,000 shares of the stock (find more stocks that T. Boone Pickens liked). Steve Cohen’s SAC Capital Advisors also liked Transocean LTD during the second quarter, adding shares for a total of 3.5 million shares (research more stocks that SAC owned). Carlson Capital, managed by Clint Carlson, nearly doubled its own stake, closing June with 1.7 million shares of the stock in its portfolio (see more stock picks from Carlson Capital).

ENSCO (NYSE: ESV), Seadrill (NYSE: SDRL), Noble Corporation (NYSE: NE), and Pacific Drilling (NYSE: PACD) are four offshore drilling rig operators that we think make for good peers for Transocean. There’s considerable variation among these companies’ P/E multiples, but the sell-side generally agrees that they, like Transocean, are going to see high earnings growth next year- in each case the forward earnings multiple is well below the figure tied to trailing earnings. ENSCO and Noble both trade at 8 times forward estimates, a slight discount to Transocean, but we’d consider Transocean the market leader in the industry and its market capitalization is somewhat higher than these two peers. ENSCO and Noble, however, have been experiencing very strong growth in revenue- up 90% and 44% last quarter versus a year ago, respectively- which has also bled through to their bottom lines. These companies may make better buys than Transocean, and also lack the stigma (and continuing legal troubles) of being associated with Deepwater Horizon.

Seadrill is a bit more expensive than these companies on a forward basis, at 11 times estimated earnings for 2013. The bullishness from analyst continues in full throat here- the five-year PEG ratio at Seadrill is a remarkably low 0.4- so if an investor is going to take their estimates on faith Seadrill is quite cheap. However, we are not sure that quite this much optimism is warranted, and might prefer a company which requires less growth in order to justify its valuation. Pacific Drilling is by far the smallest of these offshore drillers, at a market cap of $2.2 billion. According to analyst projections it is also the most expensive, carrying a forward P/E of 21.We don’t see anything particularly attractive in its business or financials, and so we’d avoid it as well.

Transocean is recovering, and if it can meet expectations than it will end up being a good value and have substantial upside from any rises in oil prices that occur over the next several years. However, our overview is that Ensco or Noble might be safer picks and should deliver similar value to Transocean in any given macro scenario.

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This article is written by Matt Doiron and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. The Motley Fool owns shares of Transocean and Seadrill, Ltd. Motley Fool newsletter services recommend Seadrill, Ltd.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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