Seadrill (NYSE:SDRL) is an undervalued offshore driller that has had its price cut primarily due to negative analysts' short-term forecasts of the industry. However, I believe that the company is better-positioned among its peers. Let's discuss what the future holds for Seadrill.
Position Among Peers
Seadrill's cash flow from operations increased by almost 7% primarily due to strong utilization rates. It generated 94% utilization for its floaters and 98% for its jack-ups, while other oil drillers are seeing slowed demand. Seadrill has a more solid and positive position than other drillers such as Diamond Offshore Drilling (NYSE:DO) and Transocean (NYSE:RIG). Last year, Diamond's operating profit fell nearly 17% due to increased capital expenditure and comparatively lower day rates. The problem seems to be prolonging in the near future as Diamond is planning to double its capital expenditure on fleet upgrades.
Similarly, Transocean also performed poorly. Its cash flow fell by nearly 30% in the last year as a result of an amount paid in settlement with the Department of Justice. Even on the operational front, the company faced extended downtime on certain rigs that caused declines in both utilization and fleet efficiency. Seadrill is not confronted with any of the problems its competitors are facing. Moreover, it recently announced that it had secured new contracts for jack-up units for West Tucana, West Telesto, West Ariel and West Prospero. Moreover, the contract for West Mischief has also been extended by four months. The company expects the four new contracts and one extension will accelerate the revenue potential of the company by $319 million.
Due to these contracts, Seadrill now has 92% of its jack-up capacity contracted for 2014 and 64% for 2015. So the total order backlog for the jack-up fleet now stands at $4.4 billion, with the remaining contract period at approximately 2.6 years. Because of the new contracts, Seadrill now needs to secure contracts for about a third of its 2015 jack-up fleet. It appears that Seadrill should not be having any problems despite the slowing down of the offshore drilling market.
It is a fact that the big players in the oil industry are cutting down their capital spending budgets, but this trend is least likely to affect Seadrill. After the spill of in 2010, the demand for newer and safer rigs emerged. Seadrill has been the most active in responding to this demand. It has taken debt to build new rigs, and as result, Seadrill has the youngest deepwater fleet of all the major rig operators.
What about Debt?
The competitive advantage of the youngest deepwater fleet will keep yielding desired results for the company for many years to come, but this competitive advantage comes at a price. The relatively higher debt volume has been the only factor that is hindering the stock from reaching higher levels. Seadrill's biggest issue is its debt burden.
The majority of the company's debt facilities require it to pay an annual interest rate of 3% plus LIBOR which is around 0.55%. So if the interest rate rises, the company would have to pay more interest. The company has around $13.5 billion in interest-bearing debt, meaning that the company paid an annual interest rate of 3.3% to sustain the debt. The problem of huge debt is what is hurting the company. Having realized the problem, management has indicated that the future cash flows are to be utilized in paying off the debt rather than increasing dividend payments.
Besides the growth, the company is offering around 12% dividend yield to investors. Considering the overall investment, Seadrill's annualized dividend of $3.92 per share is excellent. However, in the long term, Seadrill is least likely to increase its dividend. In the fourth-quarter earnings release, management gave an indication of the future policy and observed that the future cash flow will be utilized to upgrade the fleet and to strengthen its balance sheet. Even if the dividend is not raised in the near future, Seadrill still yields almost double the majority of its competitors.
The best feature of investing in Seadrill is its massive dividend yield. It was offering investors an 11% yield that was increased after its fourth-quarter results and now stands at 12%. Moreover, the company's 2014 fleet capacity is contracted out, and it can now focus on next year. So despite the slowing offshore drilling market, Seadrill stands to ensure higher revenues.
It has been trading at a 5-year expected PEG ratio of 0.49. Given the visible growth prospects, the company seems to be undervalued. Although the debt remains a huge problem, the company indicated that future cash flows will be utilized to lessen the burden. Therefore, I recommend buying the stock.
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.