Seadrill: High Earning Visibility Makes It A Buy

| About: Seadrill Limited (SDRL)

Seadrill's stock price (NYSE:SDRL) has plummeted by 6.11% in one day after the company announced its third quarter 2013 earnings and missed analysts' estimates. Seadrill reported earnings of $315 million up by 46% YoY but down by 82%QoQ.

Seadrill is an offshore drilling contractor that provides offshore drilling services to the oil and gas industry throughout the world. It has three operational segments; Floaters, Jack-up rigs and Tender Rigs.

Although Seadrill missed analysts' earnings estimates and experienced a decline in its stock price the company's stock still has an upside potential due to an expected growth in the company's future earnings.

Third Quarter Earnings Report

The inclusion of Sevan Drilling as well as jack-up and tender rigs entering the fleet increased Seadrill's YoY and QoQ revenues by 17.2% and 0.24% respectively. The growth was partially offset by the disposal of the tender rig fleet.

The operating margin in the third quarter of 2013 declined on both a yearly and quarterly basis. The higher operating expenses due to new rigs entering the fleet and higher general and administrative expenses due to the consolidation of Sevan Drilling resulted in a decline in the operating margin of 103 basis points YoY and by 319 basis points QoQ.

The company's adjusted net income margin, excluding the effects of non-recurring expenses and gains, has declined by 213 basis points on a yearly basis and 400 basis points on a quarterly basis.

Adjusted diluted per share earnings for the third quarter of 2013 were $0.78 per share compared to $0.69 per share in the third quarter of 2012 and $1.25 per share in the second quarter of 2013.

Capital Expenditure

During the third quarter of 2013, Seadrill received one ultra-deep water drillship, the West Tellus, one ultra-deep water semi-submersible, the Sevan Louisiana, three high-specification jack-up units, the West Castor, West Oberon and West Telesto and one tender rig. Besides that, Seadrill currently has 21 rigs under construction.

The company will further increase its capital expenditure over the next two years. Since Seadrill operates in a highly competitive industry the increase in capital expenditure should improve its ability to provide more services to customers and eventually bringing greater opportunities to expand the company's revenue base.

Acquisition of Prospector 3

Seadrill has announced it will acquire the company that owns the yard construction contract of the new build high specification jack-up rig Prospector 3 for a total purchase price of $235 million. The Prospector 3 is scheduled to be delivered in the first quarter of 2014 and has a water depth capacity of 400ft and drilling depth of 35,000 ft.

The jack-up will provide a more stable drilling environment for Seadrill and provides the company with an undeniable investment opportunity.

Strong Order backlog

Seadrill maintains an order backlog of approximately $19.5 billion. The order backlog for Floaters fleet is $16 billion, Jack-up fleet's order backlog is $3 billion and the Tenders' unit backlog is $500 million. The backlog excludes the PEMEX Heads of Agreement and West Aquarius. The chart below shows the value of the company's backlog for the next few years. Seadrill has received orders from some highly recognized companies such as British Petroleum (NYSE:BP), Petrobras (NYSE:PBR), Exxon Mobil (EXOM)and Statoil (OTC:STOIY).

Source: Investors Presentation

The West Aquarius project has a total revenue potential of approximately $337 million. The operations of the project have been extended through April 2017. The PEMEX agreement has a total revenue potential of more than $1.8 billion and the cumulative duration of the contracts is more than 30 rig years.

In 2013, 100% of the company's backlog was contracted. In 2014, 94% of the floater fleet and 69% of Jack-ups will be contracted. The contracted backlog provides a guarantee for future earnings and will also generate visibility for dividend capacity.

Attractive Dividend Yield

Seadrill provides a better dividend yield to its investors compared to its rivals in the industry. The company's dividend yield is 5.8% compared to the industry average of 2.5%. In the recently reported quarter, the company's management increased the quarterly dividends by 4 cents to $0.95 per share.

The company's EBITDA is projected to grow due to strong backlog and lower leverage so the dividend can be further increased. The increase in dividends reflects an improvement in the company's free cash flow and the inauguration of new builds operations this year.

Industry Outlook

The future outlook for offshore drilling and exploration remains bright as worldwide demand for oil and gas continues to increase. However, the prices for oil and gas are forecasted to decrease in the future as Iran has won an easing of certain sanctions on oil, gold and other precious metal for six months after a deal to curb its nuclear program.

Since Iran is the fourth largest producer of oil and the second largest producer of natural gas this deal would increase the oil and gas supply, especially in the Middle East and Asia. This in turn would result in a decrease in the worldwide prices of these commodities. This could reduce the level of activity in the offshore oil and gas industry in the rest of the world and this would negatively impact the company's operations and revenues. Since Seadrill currently does not have any plans to operate in Iran this deal would only increase the risks for the company.

Final Takeaway

Seadrill's operating margin has declined as a result of the entering of new rigs but these new rigs will improve the company's future revenues. The projected level of capital expenditure over the next two years and the acquisition of Jack-up rigs will improve the company's capabilities in deep-water drilling activities which are in high demand within the oil and gas industry.

The company's strong contracted order backlog for 2013 and 2014 along with its West Aquarius and PEMEX projects guarantee solid revenues and earnings in these two years. If the industry is hurt by Iran's deal in the upcoming months, Seadrill's strong backlog will provide it with immunity against this decline.

The growth in earnings would bring a further growth in dividends paid to the investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.