Expect better from Transocean

How messed-up market expectations can work in your favor.

By Motley Fool Pick of the Day Nov 30, 2010 12:40PM

For our pick of the day we turn to Fool Jim Mueller, who employs the "expectations investing" strategy of Michael Mauboussin. Here, Jim shows us why Transocean's low expectations are providing us with a buy opportunity.

 

Rex Moore, Motley Fool Top Stocks editor

 

I think Transocean (RIG) is a buy right now because of Mr. Market's messed-up expectations. Let me explain.

 

As Michael Mauboussin described in Expectations Investing, most analysts build elaborate models on what they think will happen for a company in the future, often for several years into the future. But there are a couple of big problems.

 

First, predicting the future is really, really difficult. Make one change about how fast a business will grow revenue, for instance, and the predicted value of the company can change drastically. Second, the models can get very complicated, with lots of moving parts, and each affecting the result. You could be right on nine variables out of 10 and that one wrong one could cause you to miss a great investment.

 

Instead, Mauboussin suggests turning things around a bit and looking for a stock whose current price shows the market is expecting a level of growth much lower than reasonable analysis would predict, and that the company has shown it can achieve. I think Transocean is a good example.

 

The company
Transocean is familiar to us as the company that operated the fateful Deepwater Horizon for BP (BP), the oil drilling rig that sank in the Gulf of Mexico. But it's more than that. Transocean is the world's largest offshore drilling contractor with 139 rigs currently operating around the world. Locations include the Gulf of Mexico, Africa, the North Sea, South America, and Southeast Asia. Only 12 of those rigs operate in the Gulf.

 

It contracts the operation of these rigs to various oil companies, such as ExxonMobil (XOM), BP, and Anadarko (APC). These companies pay Transocean a "dayrate" ranging from $50,000 to $650,000 per day, depending on the type of rig. Ultra-deepwater rigs, those that can drill in water up to 40,000 feet, command the most, while standard jackups command the least.

 

The risks
Unfortunately for the company, and probably contributing to the low expectations, 11 of the 12 rigs in the Gulf are ultra-deepwater and right now they are mostly not operating. When (or if) all those rigs can get back to work isn't known yet, despite the U.S. government lifting its moratorium on drilling in the Gulf recently. One reason is that tougher regulations will certainly be coming, which will cost money to satisfy. Europe is also considering toughening its regulations, and other regions will likely follow suit.

 

Yet another concern is the ability to negotiate high dayrates going forward. Many rigs have moved out of the Gulf, increasing competition elsewhere. If Transocean follows, that competition could hold down what it can charge.

 

Finally, there is legal liability to worry about. Despite having indemnity clauses in its contracts, investors are concerned that Transocean will be found at least partially responsible for the oil spill in the Gulf. How much that liability might be is unknown, but it could potentially run into the billions.

 

So why am I buying?
Transocean brought in just under $3 billion in free cash flow over the past four quarters. At a stock price of $63.36 and using a discount rate of 15%, that implies the company can grow that number by just 0.7% for each of the next five years, then by 0.4% for the following five years, followed by no more growth forever.

 

Now consider the following. Over the past five years, Transocean has grown free cash flow by an average of 41.7% per year. Over the past year, it managed 4.9% growth. Given the concerns above, yes, it might have a bit of a problem growing free cash flow for the next couple of years. But, a lot of that concern is going to be resolved over the next few years with the likelihood of higher expectations baked into the price, which means higher prices.

 

And, between it and its competitors, it has the lowest expectations at current prices. Noble (NE) is expected to grow at 8.5% for five years, 4.3% for five years, and 2.5% after that. Diamond Offshore (DO) is expected to do 15.2%, 7.6%, and 2.5%, which might be a bit high, as it actually shrank free cash flow by 12.9% between the years ending June 30, 2010, and June 30, 2009 -- the same period Transocean grew its free cash flow.

 

Wrapping up
All in all, Transocean provides a compelling opportunity to take advantage of some really low expectations from the market. I believe Transocean will either be able to restart those rigs in the Gulf or move them, and it is bringing three more rigs on board shortly. The world's demand for oil is not declining despite what happened in the Gulf, and Transocean will continue to play a leading role in extracting it while adapting to new regulations.

 

Buffett reminds us that we pay a hefty price for a cheery consensus. There is definitely not one surrounding Transocean today, but waiting until the risks are resolved will not serve us well.

 

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. Click here to see all of our Rising Star analysts (and their portfolios).

 

Fool analyst Jim Mueller owns shares of Transocean, BP, Noble, and Exxon. He works for the Stock Advisor newsletter service, where Apple is a recommendation. The Fool owns shares of Apple, ExxonMobil, and Noble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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