The share price of Seadrill (NYSE:SDRL) has dropped by 23% since reaching its all-time high at $48.09 in September 2013. I believe this pullback has presented the best buying opportunity since the global financial crisis in 2008/2009 given the magnitude of the price drop and that market's concern on company is overblown (see chart below).
The force driving the pullback is primarily due to many investors' view that the current activity slowdown in offshore drilling market will drag on Seadrill's performance and its current dividend level is not sustainable. I think this belief is exaggerated due to the following reasons.
In the earnings call, management indicated that the current market slowdown is not a typical cyclical downturn as commodity prices remains solid. They also believed that the slowdown is just temporary as the industry's long-term growth fundamentals remain intact. It is estimated that ultra-deep water ("UDW") oil production would increase from 1 million barrel per day now to approximately 5 million barrel per day 6 years later as UDW and onshore unconventional reserves will contribute primarily to oil production growth over time to meet significant future demand. In addition, lower offshore oil production resulted from decreased offshore drilling spending would limit downside risk for oil price, presenting a firmer price outlook.
How would this trend affect Seadrill? I believe the negative impact is less than what the market has priced in. Given that the current slowdown is likely to be a short-term event, companies with relatively larger immediate fleet availability are expected to take a harder hit. Apparently, Seadrill is not one of them as the company is almost immune from near-term price pressure. Owing to a $20.2B backlog, 98% and 72% of the company's capacity has been booked for 2014 and 2015, respectively, assuming contracts for West Saturn and West Jupiter are booked (this is a realistic assumption as commercial terms for the contracts have been finalized and break-up fees are included if they fail to pass regulatory approvals).
Looking beyond 2015, I believe there remains a good level of business visibility because 1) the offshore market will likely recover from the current short-term weakness with supply becoming tighter and demand staying solid; 2) management indicated that a few projects have been delayed to 2015 and 2016 due to weak market demand and the delivery of these services by then should buttress the top line; 3) it has been increasingly difficult for companies with lower-generation rigs to secure good pricing and maintain sufficient utilization as requirements from oil companies continue to rise, and this trend should benefit Seadrill over time as the company has the highest quality fleet of drillers in the industry; and 4) offshore drilling demand in West Africa, Brazil, and Mexico remain very strong, and it is believed that the company can secure high margin contracts in these regions given management's continued effort to explore opportunities and favorable pricing trends in these markets.
In the Q4 earnings call, management made it very clear that the current dividend per share level ($0.98) is sustainable as the company plans to keep the dividend flat and will preserve 20% of net proceeds generated from future MLP dropdown for a dividend capacity fund.
Owing to the price weakness, Seadrill now trades at just 9.1x forward 2015 P/E multiple, which is at 42% discount to the same multiple (15.6x) for S&P 500 Index. I view this to be a dirt cheap relative valuation given that 1) the valuation discount averaged at just 21% in the past 12 months; 2) Seadrill's consensus long-term earnings estimate of 23.5% is more than double the average estimate of 9.5% for S&P 500 companies; and 3) the stock's 10.7% dividend yield is more than 5 times S&P 500's average at just 1.9%. By factoring in the long-term earnings growth potential, Seadrill only trades at 0.4x PEG, compared to S&P 500's 1.6x (see chart below).
Going forward, as Seadrill demonstrates its ability to weather the short-term headwind and proves the dividend sustainability, I expect the stock's P/E multiple to expand and move closer to the market level. At just 11.5x forward P/E, which is Seadrill's 1-year historical average, there would be a 25% upside from here even without considering the 10.7% dividend yield. Hence, I view the stock as a strong buy.
All charts are created by the author and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.