Unearthing the Value Activist Carl Icahn Sees In Transocean

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Activist investor Carl Icahn is back in action, this time announcing a 1.56% stake in Transocean (NYSE: RIG)his latest venture into the oil and gas industry. According to the company, Icahn’s planned future purchase of Transocean shares would amount to at least 3.4 percent and make Icahn one of the top two shareholders, but it remains unclear as to whether he will take an activist role (see other stocks Icahn is an activist in).

The impending settlement and fallout from the Deepwater Horizon disaster of 2010, involving BP's drilling operation in the Gulf of Mexico, has kept the stock under pressure. Major peers Diamond Offshore Drilling (NYSE: DO), Noble Corp (NYSE: NE), Ensco (NYSE: ESV) and Atwood Oceanics (NYSE: ATW) have all outperformed Transocean since the Deepwater Incident. Since early 2010, Transocean is down over 40% and Diamond down 32%, but Noble is up 40%, Ensco 36% and Atwood 21%. For the recent round of hedge fund holding announcements, Transocean dominates the industry as the most popular contract drilling company (check out hedge funds that love Transocean). Since the disaster, Transocean still managed to hold its dominant drilling market share and dominate the Gulf of Mexico’s deep-water drilling. Fourteen of the total thirty-seven rigs actively drilling in the Gulf at a depth of at least 1,000 feet are owned by Transocean.

At the turn of the New Year, Transocean settled the Deepwater (Clean Water Act violation) case. The drilling company will have to pay $400 million in criminal fines and $1 billion in civil penalties. The penalties are to be paid over 5-years with about 70% to be paid by the end of 2015. Transocean had previously booked $1.5 billion as an estimated loss, and has $6 billion in cash on hand. The driller could have been on the hook for many more billions of dollars related to clean up expenses.

As a number of major oil and gas companies shift toward onshore exploration, there has been some neglect of offshore resources, especially since the Deepwater Horizon incident. The drilling backlog for Transocean alone is somewhere around $30 billion, and the backlog only further boosts Transocean's earnings capabilities and visibility into near term performance.  

The concerns that Icahn likely sees is Transocean's asset performance and debt. On a P/E basis, Transocean is relatively in line with peers, but its other metrics bring issues:

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>Transocean</strong></p> </td> <td> <p><strong>Diamond Offshore</strong></p> </td> <td> <p><strong>Noble</strong></p> </td> <td> <p><strong>Ensco</strong></p> </td> <td> <p><strong>Atwood</strong></p> </td> </tr> <tr> <td> <p>P/E</p> </td> <td> <p>11x</p> </td> <td> <p>14x</p> </td> <td> <p>9x</p> </td> <td> <p>9x</p> </td> <td> <p>8x</p> </td> </tr> <tr> <td> <p>P/S</p> </td> <td> <p>2x</p> </td> <td> <p>5.4x</p> </td> <td> <p>2.8x</p> </td> <td> <p>3.3x</p> </td> <td> <p>4x</p> </td> </tr> <tr> <td> <p>EBITDA Margin</p> </td> <td> <p>19%</p> </td> <td> <p>44%</p> </td> <td> <p>43%</p> </td> <td> <p>48%</p> </td> <td> <p>n/a</p> </td> </tr> <tr> <td> <p>5-Yr. Average ROI</p> </td> <td> <p>4%</p> </td> <td> <p>24%</p> </td> <td> <p>17%</p> </td> <td> <p>15%</p> </td> <td> <p>n/a</p> </td> </tr> <tr> <td> <p>Debt Ratio</p> </td> <td> <p>39%</p> </td> <td> <p>21%</p> </td> <td> <p>32%</p> </td> <td> <p>28%</p> </td> <td> <p>n/a</p> </td> </tr> <tr> <td> <p>Return on Assets</p> </td> <td> <p>-17%</p> </td> <td> <p>11%</p> </td> <td> <p>3%</p> </td> <td> <p>6%</p> </td> <td> <p>n/a</p> </td> </tr> </tbody> </table>


Transocean has been generating lower than average returns with subpar EBITDA margins and ROI/ROA ratios. This is where Icahn plans to help. He hopes to encourage management to monetize underutilized assets and pay down its 39% debt ratio. The driller has already started its move toward embarking on higher yielding assets and projects.

Transocean is still the largest offshore driller in the world. There's no doubt that Transocean is underperforming, but where is the hidden value? The real value does lie in their underperforming assets. Prior to the Deepwater disaster, Transocean traded at a 2.5x unlevered asset value (asset value less LT debt), but even after the recent announcement that the Deepwater case is settled, it still trades at only 2.1x. Assuming the stock should trade on 2.5x, the market price is undervalued by at least 15%.

Part of what Icahn hopes to do is to unlock shareholder value. Possible options include spinning off assets into an MLP, or selling some underperforming assets to reinstate its dividend. Transocean decided to suspend its dividend after making only four quarterly dividend payments. Prior to its 2010-2011 brief payments, the company had not paid a dividend since 2002. A reinstated $0.79 quarterly dividend payment would make for a 5.8% yield on its current share price.

Transocean has already been looking to monetize underutilized rigs, including selling thirty-eight jack-up rigs to Shelf Drilling for a total $1.05 billion. This transition reflects a move toward a greater deepwater focus, as jack-up rigs are used for developing shallow water reserves. The thirty-eight rigs sold to Shelf were expected to account for 10% of 2013 revenues, but the capital should be put to greater return on investment opportunities. One such opportunity is building four ultra-deepwater rigs for Royal Dutch Shell.

The contract will start in 2015 and run for ten-years at around $520,000 per day. The cost to build will be about $3 billion, but the ROI for just the Shell contract should be around 250%. The capital required to build the rigs will be a mix of its recent rig-sales to Shell and its solid free cash flow generation. Over the last twelve months, Transocean has generated some $2.7 billion in free cash flow.

Transocean is still an industry leader and with the overhang of the Deepwater case settled, the stock should be able to offer investors an attractive value opportunity. If Icahn has anything to do with it, this will include rearranging or dumping some assets to unlock capital for shareholders. Icahn has a variety of industry experience, owning stocks across the spectrum, from tech, retail and oil/gas of late. Icahn's Transocean investment comes after he made a move into Chesapeake in 2012 in an effort to shakeup management and enforce better asset management practices (read more about Icahn's Chesapeake investment).

mhargra has no position in any stocks mentioned. The Motley Fool recommends Atwood Oceanics. The Motley Fool owns shares of Atwood Oceanics and Transocean. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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