Signs of Transocean's Revival Run Silent, Run Deep

Uncertainty and stocks don't mix. For several months, that's meant flat performance in shares of Transocean Offshore(RIG), whose fortunes are inexorably linked to an anxiety-ridden drilling market and whose pending merger with Sedco Forex Offshore has only added another variable to a complex equation.

But with the stock trading at a discount to peers' based on cash flow, the deep-water drilling market showing signs of recovery and the merger offering Transocean a head start in coveted international waters, the shares are starting to look attractive, analysts say.

Flat Rig Transocean shares lag behind broader market, oil-service peers.

Source: BigCharts

Improving drilling prospects are uppermost in investors' minds as Transocean and Schlumberger(SLB) put the finishing touches on their deal, which will create the fourth-largest oil service company.

Eight months of solidly higher oil prices have dovetailed with the oil company budgeting season to bolster bidding activity, especially in the ultradeep market, as R&B Falcon(FLC) Chairman Paul Loyd noted in a recent earnings conference call. Further, fewer oil companies are farming out contracted rig time to other oil companies, indicating that operators are resuming drilling on projects they shelved when oil prices collapsed. "Discussions with major operators indicate [budget] expansions of 20% to 30% in 2000 compared to 1999, and they expect further increases in 2001," Loyd said on the call.

And in the ultradeep niche, or depths greater than 7,500 feet, "if you want a rig, you're going to pay for it," says Lewis Kreps, head of oil service research at Frost Securities. Although he sees pressure on Transocean shares until the merger closes, he rates them a strong buy. He likes the company's strong fleet and financial flexibility. His firm hasn't done underwriting for either company.

After the merger, Transocean Sedco Forex will be second only to Falcon in the ultradeep category. That's notable since oil companies have repeatedly indicated that they will increasingly rely on these relatively unexplored provinces for the bulk of their future reserve additions.

"The easy-to-find oil has been exhausted," says Tim Porter, a research analyst at Schlumberger shareholder HSBC Asset Management, so oil companies have to go offshore. He likes the earnings power of the new company, even though initially the deal is expected to be dilutive. "This deal isn't entirely favorable on a numbers basis, at least initially, but it is the right strategic thing for them to do," he says. The new Transocean "will be the biggest, baddest kid on the block and ultimately that will give [it] more pricing power."

Overseas Growth

Sedco Forex is particularly well positioned in Brazil and West Africa, the two most promising international drilling markets, according to market observers. Over the past five years, Sedco's largest customers have included Chevron(CHV) and Elf Aquitaine(ELF), both actively exploring offshore West Africa, and Petrobras, Brazil's state-owned oil giant.

"There's no question that there's going to be demand for these rigs" especially in Brazil, West Africa and the Gulf of Mexico, says Tom Marsh, a drilling analyst at Offshore Data, a Houston publisher that tracks rig markets. "The late unpleasantness in oil prices was a hiccup in the deep-water rig demand cycle," he says.

Even so, some expect next year's budget increases to hit later in the year. For the new Transocean, that means an earnings recovery may take a little longer. "That visibility is not going to be entirely there until you get budgets in," says David Thompson, an analyst at Colonial Management Associates in Boston, which holds both Schlumberger and Transocean.

Yet Transocean looks attractive relative to the sector just based on its current cash flow multiples for next year. Matthew Conlan, an analyst at Prudential Securities who rates the stock a strong buy, estimates that Transocean will generate cash flow of $3.65 per share in 2000, giving it a cash-flow multiple of about 7.5. Transocean shares traded at 27 1/2 Thursday. In comparison, Diamond Offshore(DO) trades at about 12 times Conlan's 2000 cash-flow estimates of $2.55. In addition, he says, the combined company will have much lower exposure to the 2,000- to 5,000-foot market, expected to be the weakest deepwater segment over the next 12 to 18 months. Prudential hasn't done underwriting for Transocean.

Upon completion of the merger, Schlumberger shareholders will be issued 109 million new Transocean shares, a volume sure to pressure the price. Schlumberger shares have been pressured lately as well, as some of its largest shareholders, including Fidelity and Capital Research, sold into second-quarter market strength.

Some investors may wait for the deal to close -- and for the shares to possibly fall below 25 -- before they buy, says Kreps at Frost Securities.

Any forthcoming weakness is a compelling reason to stock up on Transocean shares, says Thompson at Colonial, simply due to the improving fundamental outlook for the industry. The bulk of a driller's expenses are fixed, he says, and out of the entire sector, the "greatest pickup in earnings will be in rigs," he says. No pun intended.

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