SeaDrill Still Looks Good in Deepwater

 | Jan 29, 2014 | 11:00 AM EST  | Comments
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The last few months have been tough for offshore rig lessors, whose profits are tied to Brent Crude prices and day rates for rig leases. The scare in emerging market debt, currencies and economic growth, if anything, makes the situation for the economically-sensitive commodities sector that much more volatile.

Offshore rig lessors, which are generally regarded as a bet on consistently high international oil prices, have been hit particularly hard. One of the most noticeable declines has been in SeaDrill (SDRL), a large-cap rig lessor. SeaDrill is a Bermuda-based company with mostly Norwegian management. The company is highly levered in various forms of debt but is also perhaps the best of all large-cap rig lessors.

SeaDrill generally has the highest rig utilization, the highest margins and often has the highest return on invested capital.  Even better, SeaDrill's U.S. shares pay a substantial dividend yield of 10.25%, a number which is high only because the stock has dropped by over 20% from its October high. At this price, SeaDrill is an "accidentally high yielder."

One of the most important things to understand about SeaDrill is its relatively high leverage. The chart above shows that on a debt to earnings before interest, taxes, depreciation and amortization ratio, SeaDrill is just about the most indebted among its peers. Net debt is over $10 billion. But let's look closer. SeaDrill took on debt when it was inexpensive to do so. The company used the proceeds to order a newer, more deepwater-focused fleet that will boost earnings as global deepwater oil activity is forecasted to grow steadily in the future. Most of SeaDrill's debt is fixed and much of what isn't fixed has interest rate swaps -- which reduce exposure to rate volatility.

Just under $1.5 billion in bonds will come due this year, according to the latest presentation. Management will probably have to refinance that amount. While SeaDrill would be affected by substantially higher rates, I believe that the company's growing EBITDA will help keep the situation under control.

An article from Barron's published on Monday cited a Barclays downgrade of deepwater rig lessors. The article warned that because older deepwater rigs are remaining operational these rigs would drag down day rates overall. The article's author, Ben Levisohn, wrote that SeaDrill could plummet by up to 52%. I don't believe that SeaDrill is immune to further downside right here, especially if the emerging markets situation continues to deteriorate. But a 52% drop seems too steep.

As one person commented online, SeaDrill has the newest fleet and most units are already under contract for the next three years. Furthermore, Barron's concern of rig oversupply just isn't shared by SeaDrill's management -- which sees continued strong demand for the newest deepwater and ultra-deepwater rigs.

Thanks to a bevy of brand new, ultra-deepwater ships which will come online over the next few years, SeaDrill expects to grow EBITDA to well over $4 billion by 2016 from around $3 billion in 2013. This could be hurt, however, if day rates plunge and stay low. IE believe much of that fear is unwarranted.

As long as the biggest conventional fields remain off limits to international capital and the world's shale oil reserves remain mostly untapped, deepwater operations will be the only supplement to maturing onshore output. As a result, deepwater activity will continue to grow. That means SeaDrill is quite a bargain at 10.35x trailing earnings and at a yield of 10.25%.

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