Should I Buy RIG Stock? 3 Pros, 3 Cons

A strong deepwater drilling market and more efficient use of its rigs helped Transocean stock (RIG) rock its quarterly earnings, sending the company’s stock up 7% on Thursday. RIG, which reported third quarter earnings after market close on Wednesday, beat Wall Street estimates on both the top and bottom lines.

RIG delivered an EPS of $1.37 — well above the $1.06 per share consensus, but 3 cents per share below the same quarter last year. Transocean’s top line of $2.56 billion was more than 5% higher than a year ago and beat analysts’ estimated $2.48 billion.

So is RIG stock a buy after its big earnings beat? Here are three pros and three cons:

RIG Pros

Deepwater drilling is a sweet spot: Despite the Deepwater Horizon disaster and the boom in fracking to access oil and gas reserves from shale formations, deepwater drilling and ultra-deepwater drilling is a lucrative business. In fact, it will increase significantly over the next decade. Spending on wells is expected to grow from $43 billion in 2012 to $114 billion in 2022. The deepwater sector has eclipsed onshore and shallow water sectors in the last decade, both in discovered volumes (41 percent) and value created ($351 billion).

Better operating efficiency boosts revenue: RIG boosted both revenue efficiency and fleet utilization in the third quarter to 94% and 83% respectively (up from 93.1% and 80% in the second quarter). That might not seem like a big deal, but company officials said those gains increased contract drilling revenues by a whopping $81 million — nearly half of the $161 million increase in Transocean’s consolidated revenues. Streamlining and other cost efficiencies could save RIG as much as $300 million per year.

Premium jackup rig investments should pay off big: Last year, RIG decided to exit the standard jackup and swamp barge markets in favor of focusing on more profitable ultra-deepwater operations. The company sold off more than 30 standard jackup rigs and is investing in sophisticated, specialized equipment like the Ao Thai — under contract to Chevron (CVX) in Thailand — which began operations during the third quarter. Many exploration and production firms and major oil companies are paying lucrative day rates for deepwater rigs; RIG’s average day rates surged to $392,400 in the third quarter, up from $376,200 a year ago.

RIG Cons

Deepwater horizon aftermath: Transocean, of course, owned the Deepwater Horizon drilling rig that exploded and sank in the Gulf of Mexico in 2010 while BP (BP) was drilling the now infamous Macondo well. RIG shares took it on the chin after the spill, and the complex litigation now winding its way through the federal court is likely to occupy some of the company’s attention for a while longer.

Construction requires huge capital investment: RIG currently operates 29 ultra-deepwater rigs — nearly one-fifth of the global supply. And there’s more investment to come: On Wednesday, RIG announced a $1.1 billion deal with Keppel Corporation’s (KPELY) shipyard in Singapore for the construction of five Super B 400 Bigfoot Class jackup drilling rigs. The rigs, which will operate in 400 feet water depth and drill to 35,000 feet, should be delivered between 2016 and 2017. That could be great for the company — unless demand drops due to regulations or excess rig capacity. The dry bulk shipping sector learned that lesson in the past few years: Owners ordered new ships when day rates were at their zenith, only to have the ships delivered in a sluggish economy. As a result, too much capacity and constrained demand caused day rates to plummet by more than 90%.

Competitors are bringing their ‘A’ games: The exciting opportunities in this market are not lost on RIG’s many rivals. Count on companies like Seadrill (SDRL), Rowan (RDC), Ensco (ESV), Diamond Offshore Drilling (DO), Noble Corp. (NE), Pacific Drilling (PACD) and Ocean Rig (ORIG) to keep jockeying for position in the coming years.

Bottom Line

Despite the headwinds, I think Transocean is well-positioned to take advantage of accelerated deepwater and ultra-deepwater drilling. RIG is doing a lot of the right things — in particular, driving cost efficiency and investing in the most profitable niche. As with any major capital investment there’s always risk in costly new builds, but Transocean’s management has a steady hand on the tiller. I also love the valuation: RIG’s price to earnings growth ratio is a cheap 0.53. RIG stock trades at just 9.3 times forward earnings and pays a 4.7% current dividend yield.

As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.

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