Mergers between drilling contractors are notoriously difficult to arrange, but Transocean Sedco Forex Inc. seems to have the process down pat. In August-just eight months after Transocean Offshore and Schlumberger's Sedco Forex unit closed their merger to become the world's largest offshore drilling contractor-the company scooped up the sizeable R&B Falcon Corp. in an all-stock deal worth $8.8 billion. This acquisition is the company's latest move in a massive growth program that began in 1996, when Transocean ASA of Norway merged with Sonat Offshore Drilling Inc. "In fact, it was the Transocean and Sedco Forex merger that gave us the financial capacity to undertake this merger with confidence that we can retain our investment-grade debt rating," says J. Michael Talbert, president and chief executive officer, Transocean Sedco Forex. Indeed, only the world's largest drilling contractor could have successfully negotiated a purchase of R&B Falcon, analysts say. Though R&B Falcon executives had pulled the company out of the 1998 downturn, they still had a lot of work ahead, as the company had $3 billion in debt. Transocean Sedco Forex is acquiring that in the deal. "They've done a great job of getting to this point," says Joe Agular of Johnson Rice & Co. in New Orleans about R&B Falcon's leadership team. "But it's probably a shrewd move to go ahead and capitalize on the market and combine [to create] a much stronger company. The alternative would have been to wait for another year or two for the market to continue its ascent and generate the kind of cash out of operations that would strengthen the balance sheet." The deal creates the world's third-largest oilfield services company-behind only Halliburton Co. and Schlumberger Ltd.-with a $17.7-billion market capitalization. Transocean Sedco Forex was already the largest offshore driller with a $12-billion market cap, and R&B Falcon had the world's largest offshore fleet with 139 rigs. The new company's fleet would total 211 rigs. To compare, Pride International has 55 offshore rigs; Ensco International Inc., 53; Noble Drilling Corp., 47; Diamond Offshore Drilling Inc., 45; Global Marine Inc., 32; and Marine Drilling Cos. Inc., 18, according to the companies. The transaction is expected to be immediately accretive to cash flow, modestly dilutive to earnings per share in 2001, and accretive thereafter. Transocean anticipates that it will be accretive immediately on a cash earnings basis. The market endorsed the merger quickly. Soon after the announcement, R&B Falcon rose to around $28 per share, about $3.50 higher than a week earlier. Meanwhile, Transocean Sedco Forex, after dropping $4.50 on announcement day, quickly rebounded to around $59.50, or slightly above its 52-week high. It has since topped $60. The combined company's debt-to-total-capitalization ratio is expected to be 31%, up slightly from Transocean Sedco Forex's 27% ratio. Analysts were not too concerned. Lewis Kreps, an oil-service analyst with Frost Securities in Dallas, says the figure is right at the industry's average. He revised his 2001 earnings estimates on Transocean from $2.40 to about $2.10. "Just a 10% or 15% correction," he says. Adds James Crandell of Lehman Brothers in New York, "I think this is a company that's going to generate sizeable free cash flow in the coming years and can use that cash flow to pay down debt." Both companies' newbuild programs are just about complete and won't be a drain on cash flow any time soon. Some 17 new rigs will be delivered by the end of first-quarter 2001. Executives estimate the company will save about $50 million a year in operating costs. However, cost savings isn't generally the prime motivator behind drilling-contractor mergers, analysts say. Driller mergers grow market share and help expand into new key markets. That looks to be the case with Transocean Sedco Forex. Through the deal, the company gains a presence in the key Gulf of Mexico shelf market and grows its already large market share in the ultra-deepwater basins of the world. "Historically, you would say that the shallow water Gulf of Mexico and inland [drilling] barge fleet of R&B Falcon would not have seemed to fit strategically with Transocean Sedco Forex," Talbert says. "Whereas the R&B [drilling] barge fleet and shallow-water Gulf fleet is not the fleet I would have probably asked for two or three years ago, as I sit here today with no exposure to the North American gas market, I see it as a fleet that is going to be a substantial contributor to the company at least in the near- to intermediate term." The new company is the undisputed king of the deepwater. There are 31 rigs on the world market capable of drilling in 7,000 feet and deeper-about 60% of which belong to the combined company. How this will affect day rates remains to be seen. Some analysts predict that rates for rigs capable of drilling in more than 7,000 feet of water will strengthen somewhat, but the details depend on the merged company's strategy. "It's a Catch-22," says James K. Wicklund of Dain Rauscher Wessels in Dallas. "Do you alienate the oil companies by manipulating and holding assets to get higher day rates in the near term, which would probably make them go elsewhere for some of the newbuild construction? Or do you play nice with the oil companies and try to get a lot of the newbuild construction going forward? Their strategy at present is unclear. There will be, in my opinion, some small incremental benefit in terms of day rates, and they will be slightly more efficient in terms of scheduling." Wicklund added that the duo didn't compete very often for ultradeep work anyway. "Most 7,000-foot-and-deeper [rigs] are negotiated contracts rather than bid contracts," he says. The biggest stumbling block in drilling mergers such as this is valuation; in this deal, the valuation seems to be fair for both companies, analysts say. FLC shareholders will receive 0.5 newly issued RIG ordinary share per share of FLC, resulting in the distribution of an estimated 100 million shares. Based on RIG's August 18 closing price of $57.69, the 100 million new shares would be worth $5.8 billion. "I think last time they got together, Transocean was only willing to do a deal based on market value," Crandell says. "But this time they were willing to convey some kind of a premium...So I think the price is fair at this point for both parties." Wicklund says R&B Falcon investors may have been a little disappointed that the premium, based on the August 18 close, was 16%. "Typically these deals are done with at least a 25% premium," he says. Kreps says he was surprised more of a premium wasn't paid-his target price on the stock had been about $33, whereas the 16% premium placed the purchase price at $28.84. The transaction is expected to close by March 31, 2001. The combined company will retain the Transocean Sedco Forex Inc. name and RIG ticker on the New York Stock Exchange. Principal offices will remain in Houston, and the company will employ approximately 15,000 people worldwide. No personnel changes are anticipated in Transocean Sedco Forex senior management positions. The board may increase to 13 members-the 10 current members plus three new directors designated by R&B Falcon. The question now is how the rest of the pack will react. Consolidation among drilling contractors has been predicted and promoted for some time. When Transocean and Sedco Forex merged last year, many analysts thought other drilling contractors would follow suit quickly. "Everyone said, 'Wow, those two guys got together and it's going to cause a flurry of further consolidation,'" Wicklund says. "And no one consolidated. So this company is doing it again now. [Further consolidation] didn't happen the first time, why should it happen the second time?" Kreps says the two recent Transocean deals have emphasized the deepwater market, and the industry could benefit from a consolidation among jack-up specialists such as Global Marine, Noble Drilling, Ensco International and Santa Fe International. However, he says, Transocean may not be finished. "I'm sure everybody will be looking over his or her shoulders," he says. "They could buy almost anybody."