An Analysis of Transocean’s Risk of Default
With the threat of potential clean-up and legal liabilities resulting from the Deepwater Horizon incident, the market appears to believe that Transocean’s (or the “Company”) risk of default has increased. This market belief has been demonstrated through the recent increase in Transocean’s credit default swap spreads. While the Company has increased its risk of default, that risk – in our opinion – remains small due to the following factors: (1) the Company is, in part, protected from the full magnitude of the clean-up costs through contractual indemnification, while the legal liabilities – if any – will be shared with the other involved companies; (2) the Company still possesses a strong and flexible balance sheet; (3) the Company’s fleet and current normalized operating earnings indicate that future earnings will most likely mitigate any additional liabilities from the Deepwater Horizon incident; and (4) the Company’s free cash flow backlog most likely provides enough cash to meet most, or all, of the currently existing contractual obligations. These factors, together, keep Transocean’s default risk small.
Transocean’s first line of defense against default comes in the form of the indemnification stated in the Company’s contract with BP and the history of contract sanctity that has prevailed in the offshore drilling industry. This indemnification should help protect the Company from incurring the all or a large portion of the clean-up costs. Yet, the possibility of gross negligence on Transocean’s part could override the indemnification, even if such evidence has not yet surfaced. At present, such a possibility currently appears to be low risk. Nevertheless, the Company will likely face some level of legal liability, the magnitude of which remains uncertain at this time. To protect against these potential liabilities Transocean has nearly $1 billion of insurance. Furthermore, due to the other parties involved with the Deepwater Horizon, Transocean will not likely be solely liable for all of any legal obligation. These factors, alone, help reduce the magnitude of the threat to Transocean, and thus keep the threat manageable.
In order to correctly assess the strength of Transocean’s balance sheet, one must analyze the Company’s existing covenants and contractual obligations. Failure to meet these would most likely trigger a default unless the creditors decided to waive it. At present, Transocean’s indentures and debt agreements have the following covenants: (1) restrictions on creating liens; (2) restrictions on engaging in sale/leaseback transactions; (3) restrictions on creating certain merger, consolidation or reorganization transactions; and (4) a maximum debt to total tangible capitalization ratio that must not exceed .60. The maximum (or total) debt to total tangible capitalization ratio is the only covenant that is a direct product of the Transocean’s operating results and balance sheet. As seen in the Exhibit 1, the total debt to total tangible capitalization ratio was approximately .47 and .48 for the financial periods ending March 31, 2010 and December 31, 2009, respectively, well below the .60 limit.
Although the current total debt to total tangible capitalization ratio is a historical metric with limited insight into the Company’s future financial strength, it does reveal that Transocean’s capital structure possesses a degree of flexibility. Basically, the Company has room to take a negative charge and/or increase its outstanding debt levels before breaching the .60 limit for the total debt to tangible capitalization ratio. To better understand the degree of flexibility present in Transocean’s capital structure, Exhibit 2 illustrates four hypothetical stress scenarios that the Company would have to encounter in order to achieve a total debt to total tangible capitalization ratio of .60. In all four scenarios, all financial line items are assumed constant with their levels on March 31, 2010 with the exception of the equity and debt adjustments.
One should note that these stress scenarios do not reflect the following relevant factors: (1) the Company may raise additional cash through the equity markets in order to reduce debt levels or payoff a legal obligation; (2) the Company currently has nearly $1 billion of insurance protection against liability losses; (3) any legal liability the Company may face will likely be fought in the legal system and could be delayed for a few years – allowing the Company time to improve its capital structure before taking on the full magnitude of the legal obligation; and (4) the effects of Transocean’s operational earning power and free cash flow are not involved in the scenarios. With the exception of the Company’s operational earning power, the above factors are relevant due to their ability to partially offset the effects illustrated in Exhibit 2 and provide an additional layer of resistance against potential default.
Regarding the effect of Transocean’s operating earnings and free cash flow, the Company’s probability of default decreases on positive operating results and increases on negative operating results. Historically, as seen in Exhibit 3, Transocean has generated relatively consistent positive operating results and has used the proceeds to continue to reduce its leverage. While, in the near-term, it is expected that Transocean’s operating earnings will decrease significantly in magnitude, the Company’s backlog, which largely consists of international drilling contracts, and position in the ultra-deepwater and high specification markets point favorably to continued positive operating results. Furthermore, in time, as the industry rebounds from the current downturn, Transocean’s current fleet will be able to achieve earning levels similar – if not greater – than those experienced in fiscal year 2009 and 2008. This is an important consideration, since the longer the Company fights any potential legal liability, the more time the Company has to achieve higher levels of operating results, which will lessen the relative impact of the potential legal liability. Nevertheless, any positive operating results in the near term strengthen the Company’s case for avoiding possible default.
Furthermore, Transocean’s backlog provides one with a level of visibility into the Company’s future free cash flows. To better assess the Company’s ability to meet its future contractual obligations and maturities, one should match these obligations against the Company’s backlog derived free cash flows. As seen in Exhibit 4, after adjusting Transocean’s estimates of its free cash flow backlog, the Company – even with near-term pressures on the offshore industry - appears able to meet all of its current obligations with the free cash flow backlog and its current cash balance (this subject was discussed more in depth in an earlier post with an earlier version of Exhibit 4). Thus, the Company’s free cash flow backlog reveals itself as another factor in reducing Transocean’s default risk. Nevertheless, one should remember that: (1) this backlog may not be fully realized or may only represent a portion of the Company’s actual future free cash flow; and (2) there are stiff termination fees charged for canceling contracts, which are likely to deter and decrease the risk of customers canceling contracts. It is our opinion, given the characteristics of Transocean’s fleet, that the actual free cash flow numbers for fiscal years 2011 through 2014 are likely to be greater than those derived from the backlog.
Again, the risk of default is always present regardless of its magnitude. It does appear that Transocean’s risk of default has increased since the Deepwater Horizon incident, but we believe the Company’s operational and financial attributes successfully limit such risk. Through the Company’s indemnification, strong balance sheet, normalized operating earnings, and free cash flow backlog Transocean has the tools to effectively handle potential legal liabilities as well as an industry downturn without worrying too much about the risk of default.
Full Disclosure: Long Transocean (Ticker: RIG) at the time of writing. Be sure to consult your investment advisor before making any investment decisions. This article is an opinion and the individual should conduct his or her own research before making an investment decision. Please see the disclaimer for more at: http://www.chainbridgeinvesting.com/disclaimer/.
Chain Bridge Investing (“we” or “CBI”) states at the outset that the opinions, judgments and derivation of thinking in this writing are solely Chain Bridge Investing’s. It is imperative that any judgment or valuation you take from information dispersed by CBI be examined within the context of your portfolio investment and overall objectives. To that end we urge you to contact your investment advisor or portfolio manager to insure that the information or suggestions proposed by CBI conforms to your needs and financial strategy.
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Tagged with Buy, Deepwater Horizon, Offshore Drilling, Oil, RIG, Risk of Default, Transocean
