What is Still Cheap

My earlier blog with this title has grown like Topsy.  It's very long.  Throughout, my answer to the question of cheap was ... Transocean!  Its stock, its bonds, everything.  Now I know that opinions differ.  For two years now, a solid majority of stock (and bond) analysts have clawed away at the company.  A solid majority recommend sale of the stock, and consider the bonds to be dead money.  Moody's bond downgrade to Caa1 is the exclamation point.  Yet, quarter after quarter, Transocean rolls along, beating consensus earnings projections, retiring debt, husbanding money and managing future cash flows with finesse.

[3/13/17.  Why Transocean in particular?  Aren't there dozens (hundreds) of other companies equally mis-priced, with equal, or superior, prospects for recovery?  YES.  Yes indeed.  So why haven't I dug in, investigated, analyzed, probed deeply, and come up with a comprehensive list?  The answer is not complicated.  I'm just one guy with just so much time to spend on this obsession.  It would be safer to have a long list, but the task grows geometrically as you expand that list.  I don't need thirty outliers, as long as I'm right about THIS one.]

In the last year, the company has retired about $1.2 billion in near-term debt and issued $2.4 billion in longer-term debt (maturities in 2023 and 2024).  While the terms of one issue were onerous (9%), the most subsequent issues, backed by recently delivered drilling rigs, are a more modest 7.75% and 6.5%.  Note the positive trend in financing costs.

Moody's will undoubtedly squeal even louder than before, pointing out that all the new issues are senior to older, longer-term debt.  That's true.  That seniority thing, though, is a liquidation issue.  IF the company defaults, then the newest debt will be paid first, to the disadvantage of the older debt.  To me, the vital point is that the new money pretty much insures that Transocean won't default at all.  It solves the company's cash flow issues well past the critical year of 2020.  That year's $2.5 billion of capex and debt maturity threatened the company's fragile cash hoard.  The additional cash cushion provided by new debt floats the company over the next five years of financial rocks.

Once I became convinced that Transocean's near-term challenges had been addressed, I bought quite a lot of debt maturing in 2018 and 2020.  All of it has floated to and above par.  Even more interesting is the recent action in later maturities, like my go-to Global Marine bonds (7% of 2027).  After bottoming to a sick-making 42, they are now flirting with 80!  Now that's still a depressed price, with a present yield of 8.75% and a potential total return of 42%, assuming a two-year return to par.  So, the bargain is intact.  It's just not as spectacular as before.  Add a bit of margin, though, and the two-year return could easily rise to 80%.

The company is still at the mercy of oil's murky cycle.  With it now floating near $50 a barrel, there will be little money to be made for awhile.  But still, some.  Transocean has a fairly robust backlog (about $12 billion), so will undoubtedly pull in between $2 and $3 billion in gross revenues for awhile.  Lean and mean, with a good cash cushion, it will be ready for the upturn.  As a bond investor, I really don't care if Transocean thrives in the long run.  Mere survival is very much OK with me.  In the meantime, I'm being paid, very handsomely, to wait.

February, 2017.  I probably should wait until Transocean posts its 2016 full-year results before commenting further.  But, I'd like to be a bit out front, and take a pot shot or two at the ratings agencies.  Recent price action in Transocean bonds has been very strong.  Since my last update, the Global Marine bonds have topped 90.  That's a very large move, and directly contrary to the drastic ratings downgrades issued both by Moodys (Caa1) and S&P (B-).  I've stated before that Moody's is in the midst of a hissy-fit.  S&P's B- for Global Marine, contrasting with its B+ for all the other Transocean issues, is also just weird.

These guys seems to miss every boat.  Back when the bond was trading near 40, their ratings were far higher.  Then, just as the bond began a huge recovery, they decided to issue punitive downgrades.  The very actions Transocean took to shore up its balance sheet were treated as disasters by Moodys and S&P.  Investors, though, seem a bit shrewder.  Global Marine price improvements have matched the supposedly "stronger" Transocean action point for point.  Buyers of all issues seem to understand that improving the balance sheet for the company as a whole makes each and every individual bond stronger, not weaker.  As to the supposed difference between Global Marine (a wholly owned Transocean entity) and Transocean itself ... well, there really is no meaningful difference.  S&P is splitting hairs, assuming they even understand that Global Marine is just another Transocean obligation.

February 26, 2017.  Year-end results for 2016 are in, and confirm exactly what I've been predicting.  Most striking is that the company's cash position is now about $3.1, up over $700 million from a year ago.  Mark Mey, at the company's earnings call for 2016 summed it up:

"We are certainly washing cash right now. We have over $3 billion of cash. I’d like to take you back 12 months so the last year this time when oil was trading at $26 a barrel, capital markets were firmly struck for off-shore drillers, that’s what the change. So, we have a full capital market option available to us whether it's secured, unsecure or any other type of instrument that we’re going to put in the balance sheet. So, I don’t feel that we’re under pressure at the moment to enhance liquidity. We will take opportunities as they provide themselves to us."

For a bond investor, this near-incoherent utterance is nevertheless music to the ears.  Even though the company is still experiencing falling revenue, the capital markets are no longer concerned about the company's ability to pay its debts.  So, they are increasingly willing to lend Transocean money.  The company's ability to obtain increasingly favorable credit terms during 2016 bodes very well for 2017 and beyond.  

The first order of business will (I suspect) be to renew and extend its $3 billion line of credit.  Much like a HELOC (home owner's line of credit), the money can be drawn, paid back, and drawn again at the company's discretion.  The flexibility this provides cannot be overstated.  

The effect on Transocean's debt pricing is steadily clearer: everything is rising, even the most far-dated issues.  I expect that nearly one will hit (and exceed) par in 2017.  At that time, the game will be over for me (and you) as buyers of Transocean debt, but most certainly not as holders.  Just as my Goldman Sachs purchases of 2008 and 2009 are still nestled in my portfolio, spitting out predictable bi-yearly payments, so will the Global Marine bonds and their longer-dated sisters.  

March 9, 2017.  And Now the Missing 10K!  After the very soothing conference call announcing excellent financial resuls for 2016, Transocean then muddied the waters by delaying the release of its 10K form, the "official" statement of earnings.  The company cited unspecific issues with controls relating to tax accounting.  This delay was received badly; the stock and bonds all dipped, wiping out the nice bumps following the news conference.  Uncertainty scares people, particularly bond investors.  Many sell first, then decide what it all means.

Now, ten days later, the 10K is on file. The delay certainly didn't mean they had to start from scratch. So, what's going on, and how serious is it?  There are sections in the 2016 10K that shed a little light.  It's about income tax accounting:

"Specifically, the execution of the controls over the application of the accounting literature to the measurement of deferred taxes did not operate effectively in relation to: (1) the remeasurement of certain nonmonetary assets in Norway, (2) the analysis of our U.S. defined benefit pension plans liability and associated other comprehensive income and (3) the realizability of our deferred tax assets and the need for a valuation allowance."

Transocean pays very little in income taxes right now, $107 million, down from the 2015 $200 million figure.  I think that's important.  A sharp movement up or down would still be small, relative to the company's cash flow and balance sheet.  And that's ultimately, exactly what the 10K eventually says.

Attached are two letters from Transocean's auditors, Ernst and Young.  They are both dated March 6, 2017.  

The first is harsh: "In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Transocean Ltd. and subsidiaries has not maintained effective internal control over financial reporting as of December 31, 2016, based on the COSO criteria."

The second, though, is a plain-vanilla endorsement of the company's publicly released results for 2014, 2015 AND 2016:

"In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Transocean Ltd. and subsidiaries at December 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein."

Bottom line: the company is getting a sharp rebuke for sloppy accounting practices, the impact of which are "immaterial".   I suspect Mark Mey's head is on the chopping block for professional sloppiness (just look at the vapid way he talks), but Transocean's recent stellar results are the real deal.  

I suspect the two letters explain the 10K delay: Ernst & Young needed to complain about financial controls, Transocean needed the auditors to validate the bottom line.  It took ten days to iron it all out.

Is the recent price weakness a buying opportunity?  Probably, but I'm kind of stuffed right now.