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Sweet Buyout Music for R&B Falcon

Transocean Sedco Forex and R&B Falcon stir up the oil patch with an $8.8 billion merger agreement. The new company will be an industry giant, but it will need to realize its future growth prospects quickly if it is to support its large market valuation.

By Brian Graney (TMF Panic)
August 21, 2000

After a slight reprieve for most of this year, oil consolidation stormed back onto the business news headlines today with a vengeance as deepwater drilling specialist Transocean Sedco Forex (NYSE: RIG) announced a deal to acquire fellow offshore drilling contractor R&B Falcon Corp. (NYSE: FLC) for a total consideration of $8.8 billion, including a hefty $3 billion in assumed debt.

The deal is ambitious on at least a couple of fronts. For starters, the acquiror itself is all of eight months old, the result of the $3 billion merger of Transocean Offshore and former Schlumberger (NYSE: SLB) unit Sedco Forex last December. Seeing the new Transocean Sedco Forex this hungry for another acquisition so soon is somewhat surprising, although it fits in with the company's strategic approach of being the go-to contract driller of choice for the oil and natural gas industry.

R&B Falcon currently operates the industry's largest fleet of marine drilling rigs with 139 units of all shapes and sizes, including barge and jackup rigs, semisubmersibles, and drillships. They will join Transocean Sedco Forex's current fleet of 72 units.

But despite the difference in the number of drilling units, Transocean Sedco Forex is the bigger revenue generator, with a revenue run-rate for the current year around $1.2 billion compared to R&B Falcon's revenue run-rate of $839 million. That figure underscores the advantage and premium product nature of Transocean Sedco Forex's expertise in ultra-deepwater drilling, which is poised to be one of the industry's best long-term growth areas.

But even with its inferior business economics, R&B Falcon is still an attractive acquisition target due to its strong position in shallow-water drilling in the Gulf of Mexico and its presence in the natural gas market, which are also future growth areas. On a conference call today, the combined company's management team stated that they believe the industry is in "the early stages of an extended growth cycle," highlighted by the opportunities in deepwater and natural gas.

The companies will need to be right about those growth prospects, as justifying the merger any other way will be a challenge. Unlike the merger activity over the past few years in oil field services and exploration and production, the benefits from wringing out cost savings will be few. In contract drilling, most of the costs of the business are with the rig fleet itself, so the only way to seriously alter the cost structure is to cut the fleet's size.

Still, the combined company is expecting to eventually realize about $50 million in annual cost savings from the merger, mostly in general and administrative areas. However, that will fall well short of offsetting the cost of the company's large debt load, seeing that R&B Falcon's interest expense alone has recently been around $50 million per quarter. Since the deal is structured as a purchase, there's the additional issue of goodwill, which is expected to total a whopping $4.5 billion. Amortized over 40 years, that works out to another $28 million item each quarter below the new company's operating income line.

Amazingly, despite the higher debt service costs and the new non-cash charges for goodwill, the new Transocean Sedco Forex is only expecting its accounting earnings to drop "modestly" in fiscal 2001, with management giving a rough forecast of a 10% decline from their initial plan. That seems a bit of a stretch at first glance, although the company did say on the call that the Street's estimates for 2001 earnings for both companies as separate entities were probably "a little bit aggressive" to begin with.

On the flip side, cash flow per share is expected to rise immediately, with a double-digit boost seen in the first year after the deal's completion. If the new Transocean Sedco Forex hopes to maintain its debt ratings and implied enterprise value of $22 billion, those high-growth expectations will need to be fulfilled.

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