Have Low Expectations Already Been Priced in for Transocean Ltd.?

Drilling stocks have come under pressure this year due to slower demand from oil and gas companies. For example, Transocean is down 14% year to date, Seadrill dropped 10%, and Noble Corp. lost 16% of its market value. Drilling companies have always been generous dividend payers, and the recent downside has boosted their yields. Despite this, these stocks continue to see selling. However, it is possible that the worst had already been priced in for some of these companies.

Transocean could lift its dividend
Transocean stated that it is committed to a sustainable and growing distribution of capital to shareholders, and its Board will recommend approval of a $3 per share dividend at the 2014 Annual General Meeting. At the current share price, this move will lift the yield to 7.1%.

In comparison, Seadrill yields 10.31% and Noble yields 4.83%. At first glance, Seadrill looks like a superior bet, but its dividend yield comes with increased risk. Seadrill is a highly leveraged company that depends on its ability to refinance its debt at reasonable rates. So far, Seadrill was successful in executing its strategy and has built a young fleet, which is an advantage in the current environment.

Transocean also has a significant debt level, although it is lower compared to Seadrill's. Transocean's big advantage is that the company has only $322 million in debt maturities in 2014, which is favorable for its near-term cash flow.

Be prepared for a two-year slowdown in the drilling market
While oil and gas producers cut back on their spending in order to increase their cash flow, drilling companies continue to supply the market with new rigs. This results in pressure on rig day rates. Transocean expects day rates for high specification ultra-deepwater rigs to average $500,000-$550,000, lower than in the previous quarter.

Nevertheless, Transocean ordered two more rigs that will be delivered in the second quarter of 2017 and the first quarter of 2018. Both Seadrill and Noble will take delivery of a significant number of new rigs this year. All in all, it looks like we can expect further downward pressure on day rates in the coming months.

The question is whether lower rates will put enough pressure on companies' cash flows to put their dividends under question. In my view, Transocean is unlikely to experience cash flow problems in the near term, given its solid backlog of $27 billion. In addition, the company possesses significant liquidity with more than $3.2 billion of cash on its balance sheet.

Bottom line
The dividend yield is the factor that protects drilling stocks from further downside, as income investors are tempted to rush in to receive attractive payments. In my opinion, Transocean demonstrates a healthy compromise between the risk and the yield.

The company's debt strategy is less dependent on the availability of financing than Seadrill's. What's more, Transocean has a target to reduce its long-term debt to a level below $9 billion from the existing $10.4 billion.

Betting on a drilling company is not be for the faint-hearted, and one should be prepared for possible downside in the short term. In the long term, oil and gas companies will have to increase their demand for rigs in order to replace their reserves. This will result in higher day rates for rigs and significant upside for drillers.

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The article Have Low Expectations Already Been Priced in for Transocean Ltd.? originally appeared on Fool.com.

Vladimir Zernov has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and 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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