Transocean stock: is a credit event imminent? (NYSE: RIG)


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This article focuses on the July 7 S&P Global Ratings notice that downgraded the issuer credit rating of Transocean Ltd. (NYSE: R.I.G.) to CCC-. The linked press release is not behind a paywall, but requires registration. S&P rings the alarm that RIG is likely to undertake a distressed debt swap or debt restructuring within the next six months. I think this downgrade hasn’t received enough attention on Seeking Alpha, but it’s important to address its merits, as it likely has a significant influence on the stock price.

As I explain below, I find S&P’s analysis to be retrospective and based on incorrect assumptions about the deepwater drilling market. To be fair, most RIG investors would probably agree that any bullish thesis needs to consider 2023 debt maturities. However, I also think recent events have reduced the likelihood of a credit event, and it is now lower than 2021. That’s why the timing of the S&P downgrade is a little odd, to say the least.

Background

Transocean is well known on this forum and hardly needs an introduction. My bullish thesis hasn’t changed much since January:

Transocean: Get ready for the daytime rate inflection point

The bottom line is that after several painful years of fleet attrition, the resumption of offshore activity is driving utilizations up again. As usage increases, daily rates don’t move much initially. But once utilizations are between 80% and 85%, daily rates start to increase significantly and can get quite high.

We finally seem to be around this “inflection point” and daily rates are starting to increase significantly. Some highlights from RIG’s State of the Fleet Report Update:

  • Deepwater Invictus has secured a two-well contract extension in the US Gulf of Mexico at $375,000 per day.
  • Transocean Spitsbergen has won a firm contract for nine wells in Norway at $335,000 per day, plus two one-well options at $375,000 per day.
  • Deepwater Mykonos was awarded a 435-day contract, plus options for up to an additional 279 days in Brazil at around $364,000 per day.

One of two new 8th generation drillships will operate at $455,000 per day starting in the first quarter of 2023. The Gulf of Mexico leads the way, but it looks like other regions are starting to follow as well. Higher daily rates and longer contract terms not only improve cash flow, but also increase rig valuations. The latter can be useful during refinancing discussions.

Recent posts from other Seeking Alpha contributors are also bullish on RIG. These two articles just came out in July:

Transocean: the recovery of the industry is accelerating – Buy

Transocean is better valued than Valaris – 2 companies in an undervalued industry

Second quarter earnings also appear to be a “beat”, indicating that the company’s fortunes are improving:

  • Total contract drilling revenue was $692 million, compared to $586 million in the first quarter of 2022;
  • Adjusted EBITDA was $245 million, compared to $163 million in the first quarter;
  • Net loss of $0.10 per share vs consensus expectation of $0.14 loss; and
  • Last but not least, Transocean is now announcing that on July 27, it amended its undrawn $1.3 billion credit facility to extend the maturity date from June 22, 2023 to June 22, 2025; the extension should be good news although the borrowing capacity appears to be reduced to $774 million through June 2023 and $600 million thereafter.

FSR announcements will obviously take a few quarters to be reflected in earnings, but on the face of it, the second quarter seems to support the improvement thesis.

Credit downgrade

Given the improving fundamentals, I was surprised to see S&P downgrade RIG’s credit rating. Quoting the S&P press release:

Swiss offshore drilling company Transocean Ltd faces large debt maturities and large capital expenditures over the next year, while the offshore drilling market has stabilized and shown only a modest improvement so far.

Over the next six months, we believe it is likely that the company will undertake a debt swap, debt restructuring or other transaction that, depending on the specific terms, could be considered distressed.

As a result, we downgraded our issuer credit rating on Transocean from “CCC” to “CCC-”. At the same time, we downgraded our issue-level rating on the company’s secured debt to “CCC+” from “B (recovery rating:”), our issue-level ratings on its secured debt senior unsecured and unsecured at ‘CCC’ of ‘CCC+’ (recovery rating: ‘2’), and our issue-level rating on its unsecured debt at ‘CCC-‘ of ‘CCC’ (rating of covering: ‘3’).

The negative outlook reflects Transocean’s unsustainable leverage, heavy debt maturity schedule, large capital expenditures (capex) and the possibility that it will execute a debt swap or debt restructuring that we could consider struggling over the next six months.

For reference, a recovery rating of “3” implies that holders of unsecured debt will recover between 50% and 70% of what is owed to them. This looks very bearish because S&P is essentially implying that equity could be worthless in 6 months.

Does S&P know something the RIG bulls don’t?

Equity is a residual claim on the assets after the debt has been repaid, so if S&P is convinced that the debt won’t be fully repaid, that’s a huge problem for RIG shareholders.

Let’s examine the logic of S&P:

Transocean has taken steps to improve its liquidity, but it still has significant debt maturities and investment needs over the next two years.

Specifically, S&P is referring to $646 million due over the next 12 months plus $895 million later in 2023, as well as payments of $430 million by the end of 2022 for the two ships of 8th generation drilling. S&P acknowledges that RIG has $911 million in cash plus an undrawn credit facility of $1.3 billion through June 2023 (now extended through 2025, but with reduced borrowing capacity), but nevertheless concludes that the situation will lead to a credit event.

Here is the management perspective, as summarized in a June corporate presentation:

transoceanic;  PLATFORM;  projected liquidity;  debt;  revolver

Presentation of the company Transocean

It was obviously important to sustain the Revolver beyond June 2023 and meet operating cash flow targets. But even after scheduled debt repayments, RIG appeared to have at least $1.4 billion of headroom. Now it looks like borrowing capacity under the revolver is being cut in half, which should still provide adequate liquidity, and Transocean won’t need to repay the facility until 2025.

To me, it looks like RIG should survive until 2023. While after the second quarter results we have some hindsight, I’m a bit puzzled as to what S&P assumed and why they found the scale of RIG liquidity worse now than in 2021 when WTI (CL1:COM) crude oil averaged in the $60s.

Despite the recent strength in oil prices, the offshore drilling industry has been slower to recover than expected, and we expect daily rates and contract terms to be below levels seen in the last bull cycle in the US. less over the next few years.

Ouch. It makes it look like it was written in the fall of 2020, though. Here’s a nice visual from RIG’s presentation that shows dayrate gains over the past few months:

transoceanic;  PLATFORM;  Drilling Daily Rate Fixtures

Presentation of the company Transocean

I think we’re definitely well into the $300,000s and we’re already seeing devices in the $400,000s. I’m not sure the $175,000-$200,000 daily rates of a few years ago will return anytime soon.

We expect offshore activity to be slower to return than onshore areas given the higher upfront costs, longer lead times and high operating risk.

This is probably a valid point, but S&P is again referencing conventional wisdom (no pun intended) from a few years ago. However, there are already signs that the US shale is peaking, with the exception of the Permian. The global energy crisis is unlikely to be resolved without a new call for offshore resources.

Transocean has the largest order book in the industry, but it is expected to continue to decline for at least next year. We do not expect Transocean’s backlog to increase significantly before the end of 2023.

Well, that hasn’t aged well. The July 25 FSR, released shortly after the downgrade, reported an additional backlog of about $650 million. This is no small addition to a total of $6.2 billion.

We believe rates on new business will likely be below average levels in 2018-19.

I don’t see how $300,000 – $400,000 is less than $200,000. Assuming S&P means new originations entered into in respective years, not old contract rates prior to 2014 which might have been still high through 2018.

RIG bonds have indeed fallen with the 30% correction that has affected the entire energy sector, but now seem to be starting to rise again:

transoceanic;  PLATFORM;  obligations ;  2025

Markets Insider

So, to sum up, S&P’s stated rationale for the downgrade doesn’t seem to hold water. Credit rating agencies of course have access to management and other resources that I don’t, so they may see something else that is not stated in their public statement. But somehow their whole analysis seems retrospective. It would also be inconsistent with the higher ratings they were awarding at the end of 2020 and 2021 in a weaker environment for the industry.

The take-out sale

Transocean is a very risky investment and the 2023 debt maturities should be a consideration for anyone invested in the stock. Overall, I’m bullish on RIG because I think strong industry improvements will push it through 2023. But the risks are there, so I wouldn’t bet the farm on the business. Of course, if RIG avoids bankruptcy, leverage will increase as has happened with many smaller E&P companies in 2020. Other drillers, who have already gone bankrupt and have cleaner balance sheets, won’t see so many “couples”. “

In this context, the downgrading of S&P’s credit rating and the insinuation that we are less than 6 months away from a distressed restructuring are indeed very worrying. However, after reviewing the reasons given by S&P for the downgrade, I have the impression that they do not take into account the latest developments in the deep water sector. I think we’ve seen plenty of evidence so far in 2022 that driller fundamentals are much better than what S&P is depicting.

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