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Transocean Business Strong, Margins Iffy

Investors will be drilling for answers on the company's margins.

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Boom times in the oil patch are good news for offshore driller


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, which owns about 40% of the rigs capable of deep-water drilling. The good news kept coming Monday morning, as RIG announced that three of its deepwater floating rigs have been awarded oil-drilling contracts with combined potential revenue of nearly $900 million.

RIG reports results for the fourth quarter Tuesday, and Wall Street expects revenue of almost $740 million and earnings per share of 48 cents. Current estimates for 2006 are revenue of $4.1 billion and earnings per share of $4.35. However, although business is strong, investors will be listening for answers on how the company intends to increase its operating margins.

Business Is Good

Drilling contractors are taking advantage of the run-up in energy prices, and this has increased expenditures by exploration and production companies. Transocean was the result of mergers including Sonat Offshore, Transocean ASA, Sedco Forex and R&B Falcon. As a result, the firm has more than 160 fully owned or partially owned rigs, inland drilling barges and other drilling assets.

Unfortunately, many production platforms and offshore drilling units sustained significant damage from hurricanes in the third quarter. This hurt results, and may also squeeze profits in the fourth quarter. Investors on the fourth-quarter earnings call will also want to know the source of upcoming growth. The higher-growth areas are higher risk, and are centered in politically unstable areas or areas subject to higher levels of regulatory scrutiny.

Demand for rigs has pushed dayrates up significantly, and demand is not likely to be eased by new supply, since shipyards are unable to deliver an order for a new rig until 2009. Thus, dayrates on RIG's high-spec submersibles are now more than $400,000 per day. Dayrates in general for RIG have increased over 30%, on average.

RIG has 34 high-spec rigs, with 82% now in use. The firm also has 21 other floaters with 71% in use, and 25 jack-ups with 77% in use. RIG's current average contract length is approximately one year. Total revenue backlog is approximately $11.5 billion.

Financially, Transocean is in good shape, and has authorized $2 billion of stock repurchases. The acquisition binge appears to be over, as RIG continues to shed underperforming assets. The proceeds have been used to pay down debt, and the debt/equity ratio at the end of the third quarter stood at 0.19.

Nevertheless, despite the upswing in business, RIG is having a difficult time earning its cost of capital. Revenue needs to grow above 6%, and RIG must expand its operating margins to around the 25% level, well above its historical average of around 17%. So even though business is strong, RIG will need to address its margins and returns on capital in this quarter's call.

At the time of publication, Stavetski was short OIH.

Edward J. Stavetski founded Pembroke Capital Management in 2002. He is the chief investment officer and manages money for individuals, small-business pensions and small foundations. PCM's investment style is large-cap and small-cap value. Before founding PCM, Stavetski was director of research for Pitcairn Trust Company, a family office and mutual fund company; chief investment officer and managing director of PNC Advisers, the investment management and trust division of PNC Bank, and senior portfolio manager for Rorer Asset Management, an investment advisory firm managing individual and institutional portfolios. He graduated with a bachelor's degree from West Virginia University. He is a member of the Association for Investment Management & Research (AIMR) and the Financial Analysts of Philadelphia. He is also a board member of Financial Analysts of Philadelphia and serves as vice-chairman of AIMR's professional development committee.