SeaDrill: Fredriksen's Oil Adventure

Apr.20.06 | About: Seadrill Ltd. (SDRLF)

Travis Johnson submits: I purchased some shares in SeaDrill (OTC:SDRLF) today at $17 on the pink sheets. It closed in Norway this morning at 106.25 Norwegian Krone, which is the equivalent of $16.78 at the current exchange rate. I chose to buy shares on the pink sheets instead of on the Oslo exchange largely because it was cheaper and I didn't want to deal directly in a foreign currency, though the slightly higher price I had to pay made up for part of that difference.

I have been interested in getting some exposure to the energy market again after making a lot of money in it in 2004 and selling way too soon. While there are lots of attractive-looking companies in this general area, from oil sands to solar power, I think oil will remain the dominant fuel for at least a couple decades, and oil services and drilling companies appeal to me largely because of the increasing difficulty in finding and accessing new fields in unpleasant areas of the world. That's not to say that I'm not interested in alternative energy, but aside from MEMC Electronic Materials (WFR) and their exposure to the solar power sector, I have yet to invest in alternative energy (I wrote about this a while back, but still haven't found anything I want to buy).

I'm also still looking at a potential investment in Nabors (NYSE:NBR), which seems to be the strongest land driller in rough and inhospitable terrain, but many of the most compelling exploration opportunities are underwater, literally. I think the demand for offshore rigs and service vessels, and especially for equipment that can handle deep water and harsh conditions, will continue to grow. So I looked into sea-based drillers and related companies to mark my first return to the energy sector.

The big companies here have a lot to recommend them -- some of the major integrated companies, notably Petrobras (NYSE:PBR), have very strong deepwater capability, and the two big drillers, Transocean (NYSE:RIG) and GlobalSantaFe (NYSE:GSF), are probably good investments here as well.

But I like the small, aggressive growth nature of SeaDrill. According to the Oslo Bourse, SDRL has a market cap of about $6 billion (though that number's changing fast), smaller than RIG's 27 billion, GSF's 15 billion, and even half the size of Noble (NYSE:NE), which SDRL recently surprised when they beat them out in the competition for Smedvig.

And really, when in doubt while looking at investing in something on the high seas, follow a viking.

SeaDrill is the latest adventure of John Fredriksen, the modern day viking pillager who is generally considered the most successful entrepreneur in Norway. Following Fredriksen was a large part of my decision to pursue SeaDrill instead of an alternative driller or oil service company, since I think he'll follow the same strategy with SeaDrill as he did with Frontline (NYSE:FRO) in consolidating and leveraging a very diffuse and undermanaged industry. Frontline is the single most lucrative investment I've ever made (I haven't written about it much because I sold out before I started writing here).

SeaDrill is a new company, just about a year old, and was IPO'd on the Oslo exchange at the end of 2005. Fredriksen owns a bit more than 30% of it, just as he did with Frontline, I suppose because that allows him to have virtually complete control without using all his own money. Their mission is fairly clear; they want to be a significant consolidator in the offshore rig industry, and within five years, their goal is to become a leading drilling contractor with a focus on Asia, West Africa, and worldwide deep water areas, all of which should be high growth sectors. They plan to grow through purchasing new buildings and used rigs, acquiring other operators, and taking strategic positions in related companies.

The company looks well positioned so far, and I'm certainly not pessimistic even as I'm quite aware of the risks, both sector risks, which should be clear if oil plummets and people stop worrying about finding more, and financing risks, which are not new to Fredriksen's operations (more on that in a minute).

Taken from the press release issued when Smedvig's shares were called from the market, the combined fleet of Smedvig and SeaDrill will be fairly impressive: "a diversified and modern fleet of nine jack-up drilling rigs (including five under construction), seven semi-submersible drilling rigs (including five under construction), three ultra-deepwater drillships (including two under construction), two FPSOs and 13 tender rigs (including two under construction). A total of 34 units (of which 14 under construction)."

That's a big ramp up from the initial portfolio of less than a year ago, which consisted of just three 20-year-old jack-ups and two floating production vessels before they began their buying spree. The forced merger with Smedvig (which Fredriksen, in typical fashion, more or less stole from under the nose of Noble -- interesting Forbes article about that here), along with Mosvold, which had attractive new building orders and a large minority position in Apexindo, the big Indonesian driller, gives SeaDrill a good starting point. But if Fredriksen's history is any indicator, I expect they'll continue to aggressively acquire smaller operators and try to leverage large minority positions like Apexindo to gain control of more vessels and rigs. Clearly, investors are eager to get on board with this swashbuckler and see some serious potential here; shares have more than doubled in less than six months.

At their current rate, SeaDrill indicates that once their newbuildings that are now on order have been delivered SDRL, they will be the most modern and second largest operator of ultra-deepwater equipment (after Transocean). And with the Smedvig acquisition, they've also acquired excellent, seasoned management with experience in this specific business, something Fredriksen's executive team of Tor Olav Troim and Kate Blankenship, both of whom have been with him for a while and helped engineer Frontline and Ship Finance Limited, don't seem to have.

But do note, SeaDrill has only four of their own units working in the field as I type this (not including Smedvig). That will expand to six sometime this quarter and will grow quickly as acquisitions come online and the majority of their newbuildings are delivered over the coming two years.

That growth is what we're buying, but the financing for this growth is where we get into areas of dramatic risk and significant potential for outsize returns, especially because some of these mammoth deepwater drilling rigs can run up to $500 million new. Growth is going to be funded largely by taking on significantly more leverage (debt) than is the norm in this industry, and also by diluting existing shareholders (as they did when they issued a large number of shares to pay for their largest acquisition, Smedvig, which is now all but complete).

If the market turns down to any significant degree in the coming few years, SeaDrill will fall farther than its more stable competitors, but they will also be more heavily leveraged to any growth in the market, so I'm willing to take that risk. You can look at a chart of Frontline and see that the price fell to about $3 in late 2002 before rebounding to near $60 two years later (which doesn't even take into account the $20 or so of dividends that FRO spun off over the past couple years). That's similar to the kind of risk we run here, I'm afraid, and while I don't think we're at the top of the rig market cycle right now I also don't think I'm catching this at the bottom.

I think it's also possible that another Fredriksen company (or former Fredriksen company, as he no longer controls them) will play a role here. Ship Finance Limited (NYSE:SFL) was created as a way to finance tankers, initially buying up the Frontline (FRO) fleet and leasing them back to Frontline, which was basically financial engineering that allowed FRO to offload very valuable assets and become an operating company with lower book value but huge cash flows. It would not surprise me in a few years to see a similar relationship develop with SeaDrill, with SFL buying SeaDrill's fleet and leasing them back at relatively low long term rates for SeaDrill to manage and sublease to operators. Fredriksen has historically focused on cash flow and cash earnings, and on dividending out excess cashflow to investors, including himself. That's what made Frontline a great investment during the huge boom market for oil tankers from 2003-2005, and a similar strategy might work here as well.

And that also means that an investment in SeaDrill should certainly be considered a very long term investment. They're shooting for dramatic growth as they build a globally competitive company through acquisitions over the next five years, but this initial flurry of acquisitions means they have gotten pretty far ahead of themselves and have a lot of their potential tied up in newbuildings that are not yet delivered, so earnings are not likely to ramp up within the next quarter or two. Analysts are pegging this price as attractive because it represents something beteen 5X and 10X potential 2008-2009 earnings which is a lot farther out than most folks are really confident in estimating a PE ratio.

Current earnings are not great; it's long-term sector growth and an interest in riding on John Fredriksen's coattails that have me buying shares of SeaDrill here. I'll let you know if I decide to add any more energy positions to my portfolio, and I'll try to keep up on the SDRL news since they're very lightly covered on this side of the Atlantic. I look forward to riding this one for a long time, and with Fredriksen in charge I think it ought to be an interesting voyage.