Why Transocean Is Still a Buy

Why Transocean Is Still a Buy

On October 28, Transocean had its highest volume day of the year with 71.8 million shares traded. On average only 4 million Transocean shares trade hands on any given day. The reason for the high volume was that index managers were obliged to buy the stock as Transocean joined the S&P 500 index. Transocean replaced S&P 500 component Dell after Michael Dell and Silver Lake Partners took the PC maker private.

On the same day, Goldman Sachs analyst Waqar Syed downgraded Transocean from neutral to sell.

Reasons why Transocean was downgraded by Goldman
As reasons for his downgrade, the Goldman analyst noted that Transocean had an aging floater fleet and needed to make sizable investments to upgrade. He also noted that dayrates for ultra-deepwater rigs had flattened and that there have been signs that utilization/dayrates in deepwater may be weakening.

Given the weakening dayrates, they argued that there was less catalyst for upside movement.

Three reasons to be more optimistic
First, Transocean has a nearly $30 billion backlog including a $2 billion extension of two ultra-deepwater rigs in Gulf of Mexico for Chevron.

Only 14 of Transocean's 27 ultra-deepwater rigs are due for contract extensions next year. Of the seven ultra-deepwater rigs under construction, the earliest contract expiration is Q1 2017.

For half of Transocean's ultra-deepwater fleet, there may be time to rebound if dayrates do weaken.

Secondly, Carl Icahn owns Transocean. As of August, Carl Icahn owns almost 6% of Transocean and has been actively increasing his stake.

Many investors will remember that he invested in Netflix when it was $58 and sold it above $300 in about a year. Carl Icahn is an investing legend for a reason. He can sense good opportunities where the risk-reward greatly favors him. Given Carl Icahn's large stake, he thinks greatly of the offshore driller. By investing in Transocean, investors have the opportunity to have a cost basis around Carl Icahn's entry price.

Lastly, the long-term trend still favors offshore drilling. With the easily accessible oil gone, high oil prices are likely to stay. There are 48 billion barrels of oil in the Gulf of Mexico, and 50 billion more in Brazilian flats. Many fields are not developed and require the kind of deepwater rigs and expertise that only offshore drillers can provide.

Given the long-term favorable trend, offshore drillers are trading at very fair valuations given their growth prospects. Transocean may have to spend more to upgrade its fleet, but it is still great value with a 9.3 forward P/E and 5-year projected EPS growth of 22.7%. Diamond Offshore Drilling is also a good value with a forward P/E of 10 and 5-year EPS growth of 18%. It is more exposed to Brazil than most offshore drillers with 46.1% of its revenue coming from the country. As Brazil develops its pre-salt reserves, Diamond Offshore Drilling will see great demand. Of the group, Ensco has the lowest forward P/E ratio of only 7.90. It has projected 5-year EPS growth of 16.80%. It has the newest ultra-deepwater fleet with an average age of three years.

The bottom line
In my opinion, Transocean is showing signs that it may be ready to make a move higher. Because of long-term favorable trends and fairly cheap valuation, Transocean is still a great investment.

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The article Why Transocean Is Still a Buy originally appeared on Fool.com.

Jay Yao has no position in any stocks mentioned. The Motley Fool owns shares of Transocean. 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.

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Originally published