We recently wrote an overview of Thornburg Value Fund (TVAFX) that provided a broad look at how co-managers Edward Maran and Connor Browne invest (see the article here). It’s hard not to “talk shop” when discussing broad investment themes, however, and the discussions that led to that article brought up some intriguing investment ideas. Two that seemed particularly interesting were Transocean (RIG) and Ensco (ESV).
Edward Maran sees three big issues facing Transocean: Liability for the Horizon oil spill; the subsequent deep water drilling moratorium; and the likelihood of increased industry regulation driven by the spill. Value Line analyst Ron Romaine shares these concerns and recommends that conservative investors “steer clear” of this issue for a while. That said, mutual fund managers are paid to analyze risks and take those that they believe will be financially fruitful.
Having read the contract between BP (BP), formerly known as British Petroleum, and Transocean, Maran believes that BP is solely liable for damages from the oil that leaked from the well on which the two companies were partners. That said, there are conflicting reports about maintenance levels on the Horizon drilling rig, which could provide a foothold for creative lawyers. Romaine notes these issues, but agrees that damage costs are likely to be minimal. So, while the disaster will clearly hurt results, the magnitude of the drop in the share price from a high of $163 in 2008 to the low $40s this year seems overdone and supports Maran’s expectation for solid long-term gains—and underpins Value Line’s long-term total return projections that run into three digits.
The drilling moratorium is another issue that is weighing on Transocean. The moratorium, at this point, isn’t a permanent stoppage, so this problem should eventually go away. However, there is the potential that Transocean’s customers could argue that the moratorium is a “force majeure” event that would allow them to void the long-term contracts that they signed. Maran notes that company management is confident that its customers will not be able to void their contracts. Still legal disputes will cost money even if Transocean prevails, which is why Value Line’s Romaine isn’t quite as positive about this issue. Even if contracts become an issue, the moratorium should eventually go away, making this concern a short-term one.
Longer-term, the deep water drilling industry is likely to face increased regulatory scrutiny. In fact, the magnitude of the BP disaster is likely to result in increased regulation throughout the oil drilling business, not just in the deep-water space. For Transocean, however, this isn’t likely to be a big issue because its fleet is largely up to date. Thus, any additional upgrades are likely to be minimal relative to other drilling companies. Moreover, Maran believes the market is pricing Transocean’s rigs well below their replacement cost—something that this value-focused manager can’t help but find attractive.
In the end, Transocean is a major player in the drilling space with operations throughout the world. Although the Gulf of Mexico is an important market, the company has the reach to move drilling rigs to wherever there is business. Although near-term results have inevitably been hurt by the Horizon issue, the longer-term picture looks fairly bright. Both Maran and Value Line’s Romaine expect investors to see the value in Transocean shares over the long term.
Maran notes that Ensco shares took a big hit from the same event that knocked down Transocean, even though Ensco had nothing to do with the disaster. In fact, the vast majority of the company’s rigs that operate in the Gulf are still operating normally since they are in shallow waters, and not affected by the ban on deep water drilling. In addition, foreign revenues make up the majority of this company’s profits, highlighted in the business description of the Value Line report.
The global fallout of an oversupply of drilling rigs, however, has pressured Ensco, a point that Value Line analyst Damon Churchwell highlights. The BP disaster is partly responsible for the oversupply, as rigs that would have been in the Gulf move to other regions. So, profits are under some pressure in the near-term. However, both Maran and Value Line’s Churchwell are positive about the long-term outlook—with Maran particularly pointed about demand increasing in the future (a support behind his selection of both Transocean and Ensco). On the regulation front, Ensco’s rigs are mostly of recent construction, which suggests that, like Transocean, any upgrading costs will be minimal.
One key issue that Maran pointed out was the company’s financial strength, as it has no “net debt.” This is to say that its modest $265 million of debt (just about 5% of the capital structure, as the Capital Structure box on the Value Line page shows) is dwarfed by its cash hoard of over $1.2 billion (which can be seen in the Current Position box on the Value Line page). Clearly, this company can withstand a little near-term weakness in earnings.
Maran also believes that the company’s management team is good and has positioned the driller well for the long term. It is his opinion that the market has failed to differentiate between this company and Transocean, where the concerns are more material. That said, he is quick to point out that Ensco doesn’t hold the same long-term recovery potential. However, for more conservative investors looking to play the BP disaster, it might be a good option, a fact with which Value Line’s Churchwell would agree.
Churchwell also points out that the company’s dividend yield, which is above the average of dividend paying stocks covered by Value Line, might be of interest. The payout was recently increased from 2.5 cents to $0.35 a share per quarter, a level that should be easily supported based on the cash the company has on its balance sheet.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.