Transocean Stock: High Upside Potential, Margin Expansion Visibility

Since the escalation in geopolitical tensions started, oil and gas stocks have outperformed the broader markets. As oil discounts the risk premium, it’s likely that Brent will continue to trade around the $100 level.

One way to benefit from positive industry tailwinds is through exposure to oil and gas exploration companies. Further, there are several onshore and offshore rig-services companies that still trade at attractive valuations.

Transocean (RIG) stock is one name that’s worth considering at current levels. I am bullish on the offshore drilling services provider with a medium-to-long-term investment horizon.

RIG stock is up 32% year-to-date. However, it seems that the best part of the rally is still to come. Let’s discuss the positive catalysts.

High-Quality Fleet

Through the phases of the industry downturn, Transocean has transformed its fleet.

As of January 2014, the average age of the company’s fleet was 21 years. Further, only 45% of the fleet was capable of ultra-deep-water and harsh environment services.

Currently, Transocean has an average fleet age of approximately 11 years, with 100% of the fleet focused on ultra-deep-water and harsh environments. This transformation is expected to benefit the company as the industry enters into a growth phase.

Having a modern fleet provides two main advantages.

First, Transocean has an edge over peers, and a younger rig is more likely to be contracted for the long term. This boosts revenue visibility. Furthermore, day rates are likely to be attractive for UDE and HE fleets.

Revenue Visibility and Potential Margin Expansion

Another reason to like Transocean is the company’s strong order backlog. As of April 2022, Transocean reported an order backlog of $6.1 billion. The backlog is front-end loaded with $3.6 billion in orders to be executed in 2022 and 2023. This provides the company with clear revenue and EBITDA visibility.

Transocean reported a fleet of 25 operating rigs. Currently, the company has 12 cold-stacked rigs and another two under construction.

However, with Brent above $100 per barrel, it’s likely that offshore drilling activity will accelerate. In the next few quarters, the cold-stacked rigs can potentially be operational. Estimates indicate that over the next 18-months, 48 rig years of contracts will be awarded. This provides visibility for revenue upside.

There are also reasons to be bullish from an EBITDA margin expansion perspective. In the company’s Q1-2022 conference call, CEO Jeremy Thigpen indicated that future day rates are likely to be above $400,000 per day as the demand-supply gap narrows.

As rigs go off-contract and new orders are awarded, Transocean is expected to witness margin expansion. This will translate into higher cash flows. As an example, Deepwater Titan, which is under construction, has a five-year contract with Chevron (CVX) at a day rate of $455,000. The contract is expected to commence in Q1 2023.

It’s also worth mentioning that 90% of Transocean’s contracts are with investment-grade companies. This reduces the probability of contract cancellation, even if market conditions are less optimistic.

Risk Factors

Oil has been trading above $100 after discounting the geopolitical risk premium. If geopolitical worries decline in the coming quarters, oil can witness some correction. Having said that, Transocean will continue to benefit, even if oil is trading around $80 per barrel.

There is also a possibility of a recession in the United States in 2023. It goes without saying that a recession in the U.S. will also imply a global slowdown or recession. In this scenario, the geopolitical risk premium will be offset by the potential decline in demand for oil due to a downturn.

Wall Street’s Take

Turning to Wall Street, Transocean has a Hold consensus rating based on one Buy, three Holds, and one Sell rating assigned in the past three months. The average Transocean price target of $4.72 implies 33.9% upside potential.

The Bottom Line on RIG Stock

As of December 2021, Transocean reported cash and equivalents of $1.4 billion. The company also has $1.3 billion in revolving credit facilities. Therefore, there is an ample liquidity buffer for near-term investments and debt repayment.

Also, if day rates firm up in the coming quarters, Transocean will have ample financial flexibility to deleverage. Over the next four years, the company has guided for debt reduction in the range of $2.3 billion to $3.9 billion. Any potential rating upgrade due to balance sheet improvements can also be a catalyst for RIG stock to trend higher.

Overall, Transocean has a modern rig fleet, and the company has navigated the worst for the industry. As oil remains firm, the company is well-positioned for upside regarding EBITDA and cash flows.

Given the factors discussed, it’s likely that Transocean stock will break out to the upside in the next few quarters. This will be especially true if EBITDA margin expansion is significant.

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