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Transocean Deserves Better Than This

Covestor.com

A well-known trading strategy involves buying companies before they are added to the S&P 500 and shorting companies that are being removed from the index. Since so much money is invested either directly in index funds or with money managers who attempt to mirror the index's performance, additions and removals from the S&P 500 offer wild price swings that are dislocated from business fundamentals.

As a value investor, I welcome this dislocation as an opportunity to buy stocks cheaply. A recent example of the S&P effect is Transocean (RIG), the largest offshore driller of oil and natural gas in the world. With a high level of demand, RIG has excellent earnings visibility and a strong backlog of future business.

Typically, the market would pay a premium for high visibility. Last May, the shares were trading above $161, and the premium was evident. At the current price level of $52, that premium is gone, and the shares are now being offered to opportunistic investors.

Three main problems have combined to knock the share price lower. The first two are transient. With the expectation of higher corporate income-tax rates under the Obama administration, RIG decided to move its base to Switzerland. Doing so made the company ineligible to remain in the S&P 500. Forced selling by index funds caused the shares to drop swiftly.

The second issue concerns the large decline in oil prices. Since RIG is hired to extract oil from harsh locations, many felt its profitability and backlog would suffer. I view this outcome as unlikely. Most of the projects RIG operates are long term in nature and require substantial capital investment. I find it improbable that an energy producer would curtail an existing project for which it has already allocated capital.

A sustained period of very low energy prices could hurt the shares. However, that issue is three to five years down the road and should not drastically affect today's stock price. After all, with a current P/E of 3 and a market capitalization that is 40% of current backlog, management could use the earnings and cash flow to finance an LBO.

The third issue is RIG's high debt level. Long-term debt represents over 45% of its total capitalization. In an environment where banks are unwilling to lend, a high debt level can be devastating. However, 80% of RIG's debt is due in 2010 and beyond, and the company has stated its intention to use free cash flow to reduce its debt levels to a more manageable level.

While acknowledging the risk of buying a company with a potentially troubling financing issue, I believe RIG's current valuation offers a reasonable margin of safety.

Subscribers to my weekly newsletter EPIC Insights, were alerted to the positive fundamentals of RIG and bought these shares Monday morning at a price of $52.39. On a day where the Dow Jones Industrial Average dropped 0.9%, subscribers have an unrealized profit on RIG of 3.8%. While the one-day performance is attractive, I maintain a fair value estimate of $75. With RIG currently 27% below my price target, I like the risk/reward framework and recommend a long position as this week's fundamental trade.