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Transocean Stock Upgraded: What You Need to Know

Down 17% over the past 12 months -- and 83% over the past five years -- it hasn't been a lot of fun owning Transocean (NYSE: RIG) stock lately. But could it be that the suffering is coming to an end?

One analyst thinks so. Nearly a year after initiating coverage of the offshore oil driller with a sell rating, megabanker Citigroup announced this morning that it's finally relenting, and upgrading Transocean to neutral. (It's not as good news as a buy rating, granted, but at this point, beggars can't be choosers.)

Transocean shares are reacting positively to the upgrade, tacking on 2.4% in early Thursday trading. But what exactly is Citigroup saying about the company, and is the news good enough to justify investors' optimism?

Let's dig in and find out. Here are three things you need to know.


Is it all blue skies and clear weather for Transocean, now that it's been upgraded? Image source: Getty Images.

1. Better than expected

One year ago, Citigroup told investors that Transocean shares were likely to fall as low as $9 a share -- a nadir Transocean stock hit (along with the rest of the stock market) back in February. But the situation has improved since then, and with it, Citigroup's valuation estimate.

Specifically, Citigroup says that Transocean "has exceeded our expectation for cost reductions," helping to reduce the magnitude of its earnings declines. The analyst still warns that Transocean will be less profitable than other analysts expect, predicting 8% weaker earnings in 2018 than the consensus, for example. On the other hand, Citigroup warns that Transocean's "peers" will miss earnings targets by as much as 30% that year.

Result: The analyst still doesn't think Transocean shares are a buy, but it believes they're worth about $11 apiece, or 7% more than what they cost today.

2. Transocean versus everybody else

But what about those other "peers" Citigroup mentioned, which include rivals such as Noble Corporation (NYSE: NE) and Atwood Oceanics (NYSE: ATW)? According to Citi, across the deepwater industry, demand for new drilling continues to decline. In fact, the analyst predicts there will be "near zero deepwater contract signings in 2H 16," that active rigs will decline 30% in 2016, then fall 20% more in 2017. By 2018, there will only be about "140 active" floating oil rigs globally.

The analyst warns earnings before interest, taxes, depreciation, and amortization (EBITDA) among the several oil drilling companies it covers are likely to fall by more than half between 2016 and 2019. And in order to stay in business, Citigroup warns that these companies will need to issue new shares to raise cash for their operations. In particular, the analyst says Noble Energy will have to flood the market with $1 billion in new equity, diluting existing shareholders by as much as 40%, while Atwood Oceanics will need $1 billion in new cash -- twice the value of its current market cap.

In this context, Citi sees Transocean as one of only a very few companies that may be able to avoid diluting their shareholders with new share issuances. Now...how will they do that?

3. How?

Answer: Contracts. Citi says Transocean has a lot of them, and its "backlog is superior to peers." In this regard, Transocean's last earnings report noted that it had $13.7 billion in work backlogged as of July. That's worth more than 2.5 years of revenue, at Transocean's last-reported revenue run-rate, and lends some assurance that the company can weather the storm.

So Transocean will survive -- but is mere survival a good enough reason to own the stock?

The most important thing: Survival

It may well be. I admit that, on the one hand, things look pretty bleak for Transocean despite today's upgrade. On average, analysts who follow the company forecast a near-50% decline in earnings this year, followed by GAAP losses in every year thereafter -- $0.37 to be lost in 2017, then $0.76 in losses in 2018, then $0.55, $0.50. And on top of that, remember that Citigroup says the analyst estimates for Transocean look too optimistic by about 8%.

But at the same time, S&P Global Market Intelligence's survey of analyst predictions holds one glimmer of hope for Transocean investors: Even with GAAP earnings running negative, S&P Global says free cash flow should remain positive at least out as far as 2019. And if Transocean can keep generating cash in a oil market that's driving everyone else out of business, or at least forcing them to raise cash to remain in business, then there's still hope.

If the oil market perks up sooner than analysts expect, but not soon enough to save its "peers," Transocean could even come out of this latest oil crisis even stronger than it went in.

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Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he currently ranks No. 298 out of more than 75,000 rated members.

The Motley Fool owns shares of and recommends Atwood Oceanics. 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.