Hi Jim,

I'm curious to know how your valuation analysis of RIG stacked up against ATW? Is RIG that much better of a bargain right now?

Thanks,

-Dave.

I'm curious to know how your valuation analysis of RIG stacked up against ATW? Is RIG that much better of a bargain right now?

Hi Dave,

Through the expectations lens, Transocean is much the better value. Here are the corresponding numbers:

                            RIG      ATW
TTM FCF                    $2,946   $75 M (TTM to 6/30/10 for both)
# shares                    318.9    64.4 M
Share price                $62.90   $32.77
Discount rate               15%      15%
Expected growth 1-5 yrs     0.4%     29.5%
Expected growth 6-10 yrs*   0.2%     14.8%
Terminal growth**           0.0%      0.0% (kept the same between the two)
*While 1-5 years is varied by the Excel Solver, 6-10 years is set to half of the 1-5 years value.
**Terminal growth is usually set at 0% or 2.5%.

So, the market is expecting much more growth in FCF for Atwood than for Transocean at current prices (last night's close). That reflects, in my opinion, the uncertainty for liability currently weighing on Transocean's stock.

A note on liabilities and losses from legal wrangling. These fall under the category known as contingent liabilities. These are potential obligations that depend on a future event arising from a past event, such as a lawsuit. Accounting for a contingent liability depends on the likelihood that the future event will occur and the ability to estimate any future amount owed. It comes in three categories:

1) The future event is probable and the amount owed can be reasonably estimated. This is recorded on the balance sheet as a liability. Examples include vacation pay (expenses payable) and warranties.

2) The future event is remote (unlikely). These are not recorded and they are not disclosed in the financial statements.

3) The future event has a likelihood somewhere between the two extremes, that is it is reasonably possible. This is disclosed in the footnotes, but not on the balance sheet. For lawsuits, "a potential claim is recorded in the accounts only if payment for damages is probable and the amount can be reasonably estimated. If the potential claim cannot be reasonably estimated or is less than probable but reasonably possible, it is disclosed." (Financial Accounting, Wild, 3rd ed, pg 364) You can follow the progress of a lawsuit by looking at the footnotes. Only when it becomes pretty clear that the company will lose will it begin to take charges to set aside funds for paying out.

In other words, the market can speculate all it wants, but I expect that Transocean won't take a hit on earnings and it won't set up a liability account to pay lawsuits and fines for the Gulf incidence unless and until the payment becomes probable and the amount can be reasonably estimated. And the settling of the lawsuits and court cases could (and I expect, will) take years. While that will weigh down the stock in the near term (next year, maybe two), as it becomes clearer that the court battles will take a long time (and those expenses can be estimated more clearly), the market will become more comfortable again and the price should rise. Especially if the company actually grows FCF faster than is currently expected.

The question then arises, why did BP set aside the money it did and why did they take another $7.7 B hit on earnings this last quarter? In its case, I presume for two related reasons. Management feels that they have a better view on what is likely to be owed and the U.S. government forced it to.

Cheers,
Jim

Jim,

Very interesting, thanks. I think I'm getting it, except that when I do my own calculation, I get a 3.4% growth in order to match the $62.90 price with your assumptions above. Just curious... how many years do you go out for the analysis?

Second question.... I know DCF calculations can get you into trouble by giving you a false sense of security. Is there generally a certain margin you are looking for here when examining what the implied FCF growth rate is?

-Dave.

Hi Dave,

I'll post the math tomorrow when I have access to the spreadsheet on my work computer and we can see where we differ from each other.

For how much of a difference between priced in and what is obtainable will be sought, I'm still feeling that out. I've had the best success when the expected growth is zero or even negative (Apple in early 2009, Garmin in late 2008, Transocean today and last summer, and I'm sure there are others). When I've had the expectations match close to what analysts are expecting in their 5-year projections or what the company has actually achieved, then I've had less success (Teva Pharmaceuticals last summer, for instance).

So, obviously, a zero growth expectation is good, assuming that the company is viable. Tentatively, meeting analysts or history is not so good. Where to draw the line in between? Half way? I'll have to try it and see. The way that works out would probably play a role into how big a position I'd take (2% of total initial capital for least convinced, 4% for good with a couple of warts, 6% for strong conviction).

You can think of this portfolio as a painting. I've got the broad outlines brushed in with the expectations, a bit on position sizing, and how a set of criteria outlined by James Montier will play into things (haven't discussed that, yet), but the fine details are still being worked out. :-) However, I don't want the port or technique to get too mechanical and rule driven, either. After all, investing is still as much of an art form as it is a science.

Thanks for the questions and keep them coming!

Cheers,
Jim

Hi Dave,

Sorry for the delay in getting back to you. Earnings season is a busy time and we've got 22 companies (at least) in this week's SA update.

Here's the spreadsheet I used to get the 0.6% / 0.3% / 0% growth at 15% discount and $62.90 price for Transocean:

  Transocean Ltd.  RIG
  Latest stock price $62.90   11/1/2010

  Predicted price    $62.90                1       2       3       4       5       6       7       8       9      10    Term
                             Earnings   $2,963  $2,980  $2,997  $3,014  $3,031  $3,040  $3,048  $3,057  $3,066  $3,075  $20,497
  Discount rate       15.0%  Discounted $2,576  $2,253  $1,970  $1,723  $1,507  $1,314  $1,146    $999    $872    $760   $5,067
  TTM Earnings       $2,946
  Growth 1-5           0.6%
  Growth 5-10          0.3%
  Growth term          0.0%
  # shares            321.0

The TTM earnings is free cash flow for the year ended 6/30/10, the latest available at the time. CFFO - capex = 5022 - 2076 = 2946.

Earnings in year 1 is 2946 * (1 + 0.6%) = 2963. Year 2 is Year 1 * (1 + 0.6%), and so on, through Year 5. Then Years 6 - 10 uses 0.3% instead.

Terminal = (Year 10 * (1 + Terminal rate)) / (Discount rate - terminal rate)

The discounted numbers are the earnings number discounted back to the present, and are in the form: (Earnings Yr N) / (1 + Discount rate)^N

Then, add up all the discounted values (all 11) and divide by the # of shares to get the predicted price.

The inputs are the last stock price (the target for Excel Solver), the number of shares (on the end of the TTM period), the TTM earnings, the Discount Rate, and the Terminal growth rate. Growth Rate Yrs 5-10 is half of Growth Rate yrs 1-5 by definition. I then run Excel Solver to vary Growth Rate Yrs 1-5 so that the predicted price matches the latest stock price.

Hmm, just discovered a minor mistake. The number of shares should have been 318.9 M instead of 321.0 M. The latter was actually on 3/31/10, not 6/30/10. That changes the growth rates to 0.4% / 0.2% / 0.0%.

A very simple DCF model and, with Excel Solver installed (check the installed plug-ins to make sure or to add it), very easy to use.

Hopefully with that, you can see where your model and the above differ.

Cheers,
Jim

Him Jim,

I had an error in how I was calculating discounted value, so now I match your results. Thanks for posting the details!

The question now really is, in light of any contingent liability, what kind of growth is reasonable to expect going forward? Even 3% would say that RIG is worth $71 now. And as you mentioned, even if the liability becomes more certain, it seems like it will take a while to come to fruition. In the meantime, RIG can generate cash flow. I'm traveling now, but I'll have to take a look at the 10 Q/Ks when I get a chance.

-Dave.