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Transocean’s Acquisition Is a Mixed Bag

Aaron Levitt
Too Much Risk for Not Enough Reward on Transocean Stock

Source: Katie HauglandVia Flickr

Left for dead. That’s the only way to describe the offshore drilling sector. For Transocean (NYSE:RIG) and its peers, years of low oil prices resulted in very low stock prices. And in many cases offshore drilling players filed for bankruptcy. So when there is any positive news about the sector, investors go gaga. That’s what happened when RIG announced its buyout of its struggling rival, Ocean Rig (NASDAQ:ORIG). Investors initially cheered the deal, bidding up RIG stock and Ocean Rig stock.

The question is: should they be cheering? On further inspection, Transocean may not be getting its money’s worth and there’s a lot to dislike about the buyout. In the end, the owners of RIG stock are getting a very mixed bag, indeed.

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A Big Acquisition for Transocean

Transocean and ORIG have a lot in common. Back in the halcyon days of $150 per barrel oil, both companies were deepwater drilling kings. As some of the biggest operators of advanced rigs, the pair was able to rent each of its rigs for more than $600,000 per day. And energy firms were happy to pay Transocean that fee to obtain large amounts of oil.

However, when oil prices crashed and then stayed low, both RIG stock and Ocean Rig stock were hit hard. With oil under $50 per barrel, it just doesn’t make a ton of sense to drill in the Gulf of Mexico or the North Sea. Day rates plunged, and the companies’ profits quickly turned into losses. Because of this, RIG stock and Ocean Rig stock have basically floundered. In fact, RIG did more than flounder; it filed for bankruptcy and its equity was given to the first lien holders.

Oil has rebounded, and the outlook of the top players in the sector- such as RIG, Ensco (NYSE:ESV) and Noble (NYSE:NE) – is finally starting to improve. The rebound has lead to some deal making and the acquisition of smaller, less capitalized rivals. ESV purchased Atwood Oceanics, while RIG acquired Songa Offshore. Transocean’s buyout of ORIG is a continuation of that trend.

Under its new deal, RIG will pay roughly $2.7 billion in cash and stock for Ocean Rig. Transocean’s shareholders will own about 79% of the new company. The deal will add nine drill ships and two harsh-environment semisubmersibles to  Transocean’s fleet. Moreover, ORIG has two drill ships currently under construction that will be completed in 2020. All in all, the deal will boost Transocean’s overall fleet size to 57 and create the world’s largest offshore driller. Furthermore, the combined firm will own some of the most advanced drilling ships.


A Couple of Red Flags for RIG Stock

Given the benefits to RIG’s fleet, it’s easy to see why traders initially praised the deal. But the euphoria may not be 100% justified. There are a few wrinkles in the deal that need to be explored.

For starters, there’s debt with a capital “D.”

Yes, ORIG is debt-free, thanks to its bankruptcy. But Transocean isn’t debt-free, and the deal has only made it more debt-laden. At the end of the second quarter, RIG had total debt of nearly $10 billion with just over $1.8 billion due in one year. In order to carry out the deal, Transocean will tap its revolving credit line for an additional $750 million.

That’s a lot of debt, considering that RIG’s total market capitalization is only $5 billion. To make matters worse, Transocean’s cash flows appear to be deteriorating. In the second quarter of 2018, its cash flow from operating activities came in at just $3 million. That’s down from $103 million in the first quarter of the year and more than $319 million in the same period of 2017.

So management is loading up on debt while its business deteriorates.

Secondly, those extra rigs that Transocean is getting may be not be useful. The market for drilling rigs is pretty saturated. That saturation and lack of real demand have forced Ocean Rig to cold stack six of its rigs. Taking a rig out of cold stacking is very expensive, and many drillers actually scrap rigs rather than bring them back online.  Given that Transocean has its own cold-stacked fleet, recently retired several rigs to the scrap pile and plans to scrap a rig from the Songa deal, it may not need ORIG’s ships.

Transocean May Be Making a Mistake

On the one hand, the deal makes sense for RIG. It gets a bigger backlog, access to more advanced rigs, and a higher market share. On the other hand, Transocean is taking on a lot of debt for rigs that it may not need.

With the deal expected to be approved by shareholders, the question is, what should owners of RIG stock do? This may be a case of playing the waiting game. With oil prices rising, deepwater drilling makes more sense and demand for Transocean’s fleet could increase. As a result, taking ORIG’s vessels out of cold stacking could be worthwhile. The deal could actually wind up boosting Transocean stock.

However, I’m not so sure I’d load up on RIG stock. There are a lot of moving parts to the deal, and it looks like management is adding debt at just the wrong time

In the end, new shareholders may have to pass on RIG stock, while current owners of RIG stock may be best served by holding onto their shares. Only time will tell if the transaction pans out for Transocean stock, but right now it doesn’t look like a great deal.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

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