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Is Transocean as Good a Buy as it Seems?

Sunday - 6/30/2013, 2:53pm  ET

Offshore driller Transocean has not been earning much money over the last year compared to its market capitalization of $17 billion, but the company experienced a decent first quarter and Wall Street analysts are highly optimistic about its future. Consensus forecasts predict that Transocean will earn over $6 per share in 2014, making for a forward earnings multiple of only 8 -- clearly in value territory. With earnings expected to increase further beyond that point, the five-year PEG ratio is 0.4; again, at least on the surface, this is an appealing value metric.

A closer look at Transocean

Contract drilling revenue rose 7% last quarter compared to the first quarter of 2012. Pre-tax income was about flat if we add back an impairment charge to last year’s figures and if we also ignore some discontinued operations from Q1 of 2012 which contributed to net losses. Earnings per share were $0.88, so the forward earnings estimates represent a significant projected increase over what the company has been doing if we annualize last quarter’s numbers. Cash flow from operations was fairly low as the company made significant investments in working capital.

Transocean recently reinstated its dividend, with a plan to make quarterly payments of $0.56 per share. At current prices, that comes out to an annual yield of 4.7%, which we, at Insider Monkey, think does make it an intriguing opportunity for income investors. Offshore oil, particularly in the deepwater and ultra-deepwater zones where Transocean might have more of an advantage over competitors, is particularly expensive to drill and so, we would be skeptical that the company will hit analyst targets without a rise in oil prices. Still, an improvement to $4 in EPS does not seem unreasonable and would make for a P/E of 12, essentially in value territory.

We track quarterly 13F filings from hundreds of hedge funds and other notable investors, using the included information to help us develop investment strategies. We have found that the most popular small cap stocks among hedge funds earn an average excess return of 18 percentage points per year (learn more about our small cap strategy). Billionaire Carl Icahn has taken a large stake in Transocean, and has been pushing for the company to pay even higher dividends (see Icahn's stock picks). Omega Advisors, managed by billionaire Leon Cooperman, reported a position of 3.2 million shares as of the end of March (find Cooperman's favorite stocks).

Comparing Transocean to its peers

Transocean’s peers include SeaDrill , Ensco, Noble , and Diamond Offshore Drilling . Ensco and Diamond are actually close to value status in terms of their trailing earnings, with P/Es of 11 and 13 in those terms, respectively. With the sell-side being bullish on offshore drilling overall, significant earnings growth is expected at these two companies as well and so their PEG ratios are also each less than 1.

Diamond experienced a decline in revenue and earnings in its most recent quarter compared to the same period in the previous year, while Ensco did considerably better; the company also pays a dividend yield of 3.5%, and seems like it would be worthy of further research.

SeaDrill is actually a very high-yield stock, with its quarterly dividend payments of over $0.80 per share resulting in a yield of about 9%. It is valued at 17 times trailing earnings; note that this means that the company’s payout ratio is over 100%, and so we aren’t sure how sustainable its current dividend would be. Noble also features a trailing P/E of 17, though analysts are expecting higher earnings growth here than at SeaDrill. In fact, the stock boasts a forward earnings multiple of 8, which is in line with where Transocean is valued. Revenue and earnings were each up about 25% in the first quarter of 2013 versus a year earlier.

Conclusion

We consider offshore drilling to be a pretty interesting industry: of the five companies we’ve mentioned here, two are fairly cheap in terms of their current business, two have annual dividend yields of over 4%, and the remaining one has been delivering quite high growth and is valued at less than 20 times its trailing earnings.

As such, we think that value or income investors could identify multiple prospects in the space. The flip side of this, however, is that Transocean does not seem as generous on the dividend front as SeaDrill and might not be as good a buy as some of its peers from a value perspective given how dependent it is on future EPS growth.

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