Recently I've been thinking about which approach to dividend investing is best - high yielding income with slower dividend growth or lower yielding but faster growing dividend stocks. I decided to run an experiment comparing a portfolio of each kind (and one a mix of both) to answer the question under real world conditions. You can see both portfolios here and here.
As I was researching my portfolios, I ran into a company that not only have I recommended to friends as an excellent high yield income stock, but also as a dividend growth stock. In fact, I've also recommended it to friends who were purely interested in high growth stocks who couldn't care less about dividends. The more I thought about this company the more I came to realize that every investor should own it because it constitutes a perfect storm of opportunity. In fact, it could be one of the strongest investments of the next decade, no matter what your preferred investment style. That company is Seadrill, (NYSE:SDRL) the second largest and fastest growing offshore oil driller in the world.
What makes Seadrill such an amazing opportunity? The combination of four things. First, it's a fast growing company, second it's incredibly undervalued. Third, it sports a beautiful 10.3% dividend, one that is sustainable and fourth, it has been growing its dividends at 15% annually for the last 5 years, including 11.8% over the last year. Combine these four characteristics and you have the makings for one of the greatest investments of our age. However, this optimistic thesis will only prove true if Seadrill can maintain its strong growth, the growth that allows it to sustain and grow its fantastically high dividend. What are the catalysts for this mega growth going forward? One of the greatest energy trends of all time, the rise of offshore oil drilling.
Consider this fact. In the last 13 years, 58 billion barrels of oil have been discovered at beneath 5,000 and 7,500 feet of water. Of this, only 3 billion has been extracted. Major investments in these fields are being made, including last week's announcement by Statoil that they will invest between $16-$20 Billion in the Johan Sverdrup oil field that is estimated to hold between 1.8-2.9 billion barrels. The field is located in deep, harsh environmental waters off the Norwegian coast. This is precisely the kind of oil extraction in which Seadrill's fleet of modern, advanced Ultra Deepwater Drillships specializes.
In addition, over the next 7 years Ultra Deepwater offshore drilling is expected to grow at 19%. Past 2020, 30% of increased oil production will come from offshore drilling. This means that the mega trend in offshore drilling, one that could last for decades, is what's going to fuel Seadrill into one of the greatest investment opportunities in our lifetimes.
Founded in 2005 with just five rigs, Seadrill has grown into the world's premier Ultra Deepwater Driller, with 49 rigs and another 20 under construction. Eleven of these rigs are 6th generation Ultra Deepwater Drillships, the most complex and sought after oil rigs in the world. The reason for this is that half the world's fleet of oil rigs is 30-plus years old and after the BP oil spill disaster, modern rigs with the latest safety equipment are in demand and fetching day rates as high as $656,000/day. The average day rate for these ships is $540,000/day, and the company has averaged 94-96% utilization rates over the last 3 quarters.
This means that these 11 new ships will be worth approximately $2.05 billion in annual revenue, assuming 95% utilization rates, when they are delivered over the next 3 years. That represents nearly 50% revenue growth in 3 years, just from the Ultra Deepwater Drillships. Don't forget there are 9 jack-up rigs being built and the average day rate for those is $224,000/day according to Seadrill's latest fleet status report.
CEO Per Wullf has stated over the last three quarterly conference calls that the utilization rate of the Jack-ups has been between 94% and 98%. If we assume 95% utilization and the same average day rate, then each additional Jack Up will be worth $77 million in annual revenue. That's $699 million/year in revenues from the Jack-ups, $2.05 billion/year from the Drillships for a total increase of $2.704 billion over 2014's projected $4.3 billion revenues, a 42.92% increase to 2016 projected revenues of $7 billion, assuming that day rates remain constant.
It's this kind of fleet growth that has management predicting 70% growth in EBITDA from $2.6 billion in 2013 to $4.5 billion by 2016, representing 20% annualized growth in gross earnings and cash flows. According to CFO Fredrik Halvorsen, speaking during the Q3 2013 conference call, the current contract backlog stands at approximately $20 billion. In addition, 83% of 2014 and 65% of 2015 have been contracted out. While day rates may have started to stall for older rigs, such as those owned by competitors Diamond Offshore, (NYSE:DO) and Transocean (NYSE:RIG), 8/11 of Seadrill's last Ultra Deepwater renegotiations have resulted in higher day rates. Looking at the same fleet status report from Q3 2013, we see the renegotiation rate for Seadrill's Jack-up rigs is even better, with 8 out of 9 new contracts being for higher day rates.
Yet what explains the recent 25% correction in Seadrill's price? Could the market be signaling that the boom in offshore oil drilling is coming to an end? The answer is no. A recent analysis by Citigroup and Barclays has called into question 2014 day rates because of decreasing utilization rates for Seadrill's competitors. Again, it's important to remember that Diamond Offshore's rig fleet is about 30 years old and Transocean's is 25 years old while Seadrill's fleet is 5 years old.
In addition, Seadrill's high debt level of $12.7 billion has served to make certain investors nervous about the sustainability of its dividend. When one factor makes the stock sink, the other factor can act to pile on and drive the stock into ridiculously undervalued levels. I'll address both concerns in order.
First, let's discuss competitor weakness in negotiating higher day rates for their rigs. In order to understand why this issue doesn't affect Seadrill one must understand why the age difference is so important. There are two key reasons. Older rigs, like older cars, break down more frequently and require more time in drydock. This is why Seadrill's competitors had average utilization rates of 80% for Ultra Deepwater Drillships and 82% for Jack-ups. Compare that to Seadrill's 95% for Drill Ships and 96% for Jack-ups averages through 2013 and you can see a major competitive advantage. Second, older rigs have less safety features, and after the 2010 Deepwater Horizon oil spill caused $42.2 billion in damage and nearly bankrupted BP (NYSE:BP) and Transocean, oil companies are willing to pay top dollar for the latest safety equipment and the industry's top safety record, which Seadrill holds. Combine these two facts and you get greater day rates magnified by greater utilization creating much stronger revenue/rig than its competition.
In addition, the report from Citigroup and Barclays mentioned decreased capital expenditure in the oil industry in 2014 and potential rig oversupply in the next few years due to new rig construction. They projected this to mean long-term weakness in day rates for offshore rigs. They warned investors of a potential 50% decrease in stock prices off their recent highs. This warning is what sent Seadrill's stock price tumbling from a high of $48 to $35 recently. The problem with this analysis is that it does not take into account the context of Seadrill and its different market position than its competitors.
As noted above, Diamond Offshore and Transocean's rig fleets are ancient, and they are spending massively over the next few years to replace them. This is what the majority of the new builds around the world are going toward fleet replacement. As Seadrill's management points out however, the increasing demand for Ultra Deepwater drilling through 2020 will require an additional 189 Drill Ships, while through 2015 only 15 are being constructed. This means that 174 additional Drillships will need to be constructed in just 5 years, or 34.8 per year.
Given that new Ultra Deepwater Drillships typically cost $600 million and take 3 years to build, Seadrill management is confident that the market for brand new, ultra advanced Drillships will remain strong. After all, in order to account for the projected increased demand for Ultra Deepwater Drillships alone, it will take $113.4 billion to build the 189 required rigs. No offshore driller - Seadrill, Diamond Offshore or Transocean - has announced anything close to that kind of expansion project. This likely means that Seadrill management is correct and on an annualized basis, the day rates for Drill Ships by 2020 will be higher than they are today. There may be temporary weakness in certain geographic regions for several quarters, but with Seadrill's aggressive new build program and higher future day rates, the company's contract backlog is likely to grow substantially over the next 6 years. This is what will support Seadrill's massive revenue and EBITDA (earnings before interest, taxes, depreciation and amortization, the equivalent of cash flow for highly capital intensive businesses) growth going forward. These in turn will support the dividend and dividend growth, which will fuel stock price appreciation.
Next, the debt. As stated Seadrill has a lot of it, $12.7 billion. However, it's at an average of 3.3% interest rate and amounts to $420 million in annual interest payments. In addition, 55% of it comes due after 2016 and the current interest coverage ratio is 5.1, meaning current cash flows are more than sufficient to service the debt. The debt that is coming due by 2016 is likely to be refinanced at rates that are still at historically low interest rates. In terms of building future rigs, Seadrill utilizes lines of credit through a well diversified consortium of financial institutions that specialize in oil rig construction and that are on outstanding terms with Seadrill. This means that future aggressive growth in rig new builds shouldn't be an issue, despite the high current debt.
One further thing to consider is Seadrill's recent spin off subsidiaries, Seadrill Partners LLC and North Atlantic Drilling LLC. Seadrill acts as the general partner to these MLPs and drops down its rigs, which the new MLPs, fresh from raising funds from public markets, buy from Seadrill. The bottom line is this: Seadrill as general partner retains the majority of shares as well as preferential treatment from its MLP subsidiaries. 77% of their income gets funneled to Seadrill, which can be used to pay down debt and build new rigs, yet the liability of operating those rigs falls purely on the subsidiaries. This protects the parent company in the unlikely event of a catastrophic failure akin to the Deepwater Horizon. It's a way of maximizing income and flexibility to maintain future growth while minimizing risk and liability. For the above reasons, Seadrill's large debt is not a sufficient concern to question the sustainability or growth potential of the dividend or company in general.
The kind of growth described above would be enough to satisfy any growth investor, but when you add in the fact that Seadrill is trading at massively undervalued levels, add a 10.3% sustainable dividend and top it off with a 10-15% dividend growth rate over the next 3-5 years, you have the potential for one of the greatest investment total returns of our time. Sound a little too good to be true? Let's take a closer look at each of these claims.
Undervaluation: Seadrill currently trades at 7.2 times trailing earnings and 6.5 EBITDA. Given the company's 50.52% net margins and 19.36% projected 5-year earnings growth rate, Seadrill trades at just 0.37 PEG. That means that under the "Growth at Reasonable Price" model, Seadrill could nearly triple in value and still remain reasonably priced.
As seen in the above graph, Seadrill's average TTM P/E ratio has averaged 11.32 since December 2009. Today's P/E ratio represents a 36.4% discount to where the company has traditionally traded.
If we combine the two approaches and use a discounted earnings growth model we see that Seadrill is ridiculously undervalued.
The way this model works is one takes the current earnings per share ($4.95) and projects forward 5 years using the consensus estimates for five-year annualized growth which is 19.36% discounted by 6.62%, the S&P 500's historical annualized return since its inception in 1957. This 6.62% serves as our "safe" return benchmark, the amount we could earn if we invested in an S&P 500 index fund and reinvested the dividends over a period of half a century. Next we multiply it by the average 5-year trailing P/E ratio. We do this because, whether a stock is undervalued or overvalued relative to its historic P/E ratio, regression to the mean indicates that over time the price is likely to return to the average valuation.
This gives us a reasonable estimate for the fair value of what a growth stock is worth. This doesn't take into account dividend yield or dividend growth, which can be reinvested back into the shares over time to increase the return even more. However, for our purposes it does give an overly conservative fair valuation of Seadrill as a purely growth company.
Plugging in our values we get ($4.95(1.1936/1.0662^5)*11.32= $129.05/share fair value today. This indicates that Seadrill is trading at a discount of 72.11%. Once again that is just the value of Seadrill as a growth stock. To value the company we must take into account the dividends, which have grown at an annual rate of 15% over the last 5 years. Over the last year management has raised the dividend by 11.76%. Given the projected and likely 20% growth in EBITDA over the next 3 years, a conservative 10% growth rate in the dividend over the next 5 years seems reasonable and would result in a sustainable dividend. Additionally, Seadrill's management is fond of raising the dividend every quarter as they have done so 9 out of the last 11. So taking this into account I modeled a 2.27% increase in each quarter's dividend. This annualizes out to a 9.38% increase each year, 10% growth discounted by 6.62%.
I am expecting $27.73/share in dividends from Seadrill over the next 5 years. Combine this with the growth valuation of $129.05 and we get a total fair value of $156.78, meaning Seadrill is trading at a 77.04% discount to its fair value according to my model.
If Seadrill reached that price within the next 5 years it would represent a 34.23% annualized return, fantastic to be sure. However, if you take into account dividend reinvestment then the total return jumps to 37.76% annualized returns. That represents a 387.92% increase in share price and why I am giving my five-year price target for Seadrill at $156.87.
In summary, I feel that Seadrill is a very rare company that combines all the benefits of growth, high yield and dividend growth into a single, expertly managed and very undervalued stock. The recent correction allows patient, long-term investors an opportunity to buy into one of the greatest investments of our time. In the process shareholders will get the chance to partake in decades of mega growth in high tech, offshore oil drilling, specifically Ultra Deepwater drilling. This will make billions in profits for those who are paying attention and willing to ride out rough patches the market is sure to present us in the next five years. Whatever your preferred investing style, whether it is growth, value, high yield or dividend growth, Seadrill provides something for everyone to love.