Deep Dive $RIG – If Carl Icahn is Interested, We’re Interested

by Enis December 6, 2013 7:34 am • Commentary

Carl Icahn was on the cover on TIME magazine this week.  He’s become one of the wealthiest pure investors in the world (passing George Soros in overall wealth in 2013).  And his recent track record on stocks like NFLX, HLF, and AAPL has been remarkable.

During such a stellar run for Mr. Icahn, RIG has been one of the few stocks where he has not had immediate success.  In fact, one look at the multi-year weekly chart of Transocean, and you would think that the stock market has been mired in stagnation rather than a raging bull:

RIG weekly, Courtesy of Bloomberg
RIG weekly, Courtesy of Bloomberg

The stock has not appreciated for many years, and actually trades around the same level it did all the way back in 1996.  This is a $20 billion offshore drilling company that has hardly appreciated in nearly 20 years.

Icahn owns more than 5% of the company, an almost $1 billion investment, so no small fry stake, even for a big boy like him.  Icahn only got involved in the stock earlier this year, so he’s not a burned long-time investor.  He began to push for changes, and recently received many of his desired concessions from the RIG board and management.  He wanted a higher dividend payout, and RIG management agreed to raise it to $3 per share next year.  He wanted more cost cuts, which the board agreed to as well, targeting $800 million by the end of 2015.  Finally, the board also accepted his plan to spin off some of the firm’s assets into a master limited partnership (MLP) by the middle of 2014.

This major agreement between Icahn and RIG led to a quick 15%+ rally in early November, from around $47 to near $56.  But the stock has faltered ever since, giving up more than half the gains and closing below $50 yesterday.  Why is there no enthusiasm for RIG?  

RIG has been plagued by several major issues over the past few years.  First, the BP oil spill in the Gulf of Mexico in 2010 hurt RIG perhaps most severely.  The company has not earned more than $1.50 in any quarter since the spill, compared to every quarter between Q1 2007 and Q2 2010 above that figure.  Transocean’s potential growth and operations were permanently affected, as the company noted:

In March 2012, we announced our intent to discontinue drilling management operations in the shallow waters of the U.S. Gulf of Mexico, a component of our drilling management services operating segment, upon completion of our then existing contracts.  We elected to exit this market based on the declining market outlook for these services in the shallow waters of the U.S. Gulf of Mexico as well as the more difficult regulatory environment for obtaining drilling permits.  In December 2012, we completed the final drilling management project and discontinued offering our drilling management services in this region.

The decline in offshore drilling in the Gulf of Mexico also hurt the global offshore drilling market as rigs were diverted to other regions.  The company had significant operating leverage, as sales only fell 25% between 2009 and 2011, but earnings fell fell almost 90%, as RIG’s fixed operating costs were much stickier despite the fall in revenues.  Since the spill, RIG management has been focused on reducing its cost base, disposing of non-core assets, and reducing its debt load.

Problems in offshore drilling are not unique to RIG.  Competitors like Diamond Offshore (DO) and Hercules (HERO) have also struggled in a weak macro environment for offshore drilling.  However, opportunities in offshore drilling are not limited to the Gulf of Mexico.  As long as oil prices remain above $70-$80, many exploration companies will be willing to develop deep offshore wells.  Of course, the risk for the offshore drillers is a permanent fall in the price of oil around the globe.

More importantly for the short-term outlook, sales have stabilized, and actually rose 4% in 2013 as global day rates for offshore drills increased a bit.  Analysts project sales to increase 5-10% over the next 3 years, with earnings increasing 10-25% given the permanently lower cost base.

On a fundamental basis, the company earns less than 50% of what it did in 2007, 2008, and 2009, around $4 per share in 2013.  The company’s valuation metrics are on the cheap side – 7x EV/EBITDA, 11x P/E, 1.1x P/B.  The price/book ratio is particularly revealing since this is not a financial company, but rather a company with tangible, valuable assets, to which investors assign little incremental value.  However, the stock has generally found a floor in the 0.75 to 1 area for the P/B ratio.  Here is the 20 year chart of the ratio:

[caption id="attachment_33394" align="alignnone" width="507"]Price/Book ratio for RIG, Courtesy of Bloomberg Price/Book ratio for RIG, Courtesy of Bloomberg[/caption]

Even as earnings have totally disappointed over the last 5 years, investors have been willing to pay for the underlying asset value of Transocean as a company.  That has really been the floor in terms of valuation from an investor perspective.  The fact that the P/B ratio is still near 1 implies quite limited downside for the stock.  If the company can improve its earnings power, then expect strong stock appreciation.  But even if operations don’t immediately improve, an investor in RIG is likely risking only 20-30% (based on book value) for a potential 50-100% return over the next couple years.

RIG is an interesting value investment here based on fundamental metrics and Icahn’s involvement.  The key risk to me is a potential decline in oil prices to levels where offshore projects become unprofitable.  Barring that, the risk/reward for a stock like RIG is skewed to the upside, after the woes it has experienced since that 2010 disaster.  We’ll keep our eye on this one on the long side – piggybacking off of Carl Icahn has been a rather profitable affair for good reason.