- Seadrill is best positioned to take advantage of a rebound in capex.
- Debt burden is manageable.
- Sell-side analysts have exaggerated macro problems.
Recent Price: $36.20
Recently, sell-side analysts have been trashing Seadrill (NYSE: SDRL), stating that an oversupply in offshore drilling rigs, softening day-rates, a negative industry outlook, and its current debt load all point to poor prospects. While I believe some of the sell-side worries carry merit, I do not believe that SDRL's situation is as bad as they claim. Seadrill is in the best position to take advantage of a rebound in oil company capex, as the company has the youngest offshore drilling fleet (around 83% out of its total fleet have/will be built between 2008-2015) out of all of its major competitors, and with regulations getting stricter for oil companies following the Macondo oil spill in 2010, offshore drillers will be forced to invest in new rigs (or upgrade old rigs) and undergo more rigorous safety inspections. I believe Seadrill's debt burden is manageable and future growth inevitable. On an EV/EBITDA and P/E basis, SDRL is worth around $50 a share by the end of 2015, implying ~40% upside.
Seadrill is an offshore drilling contractor that provides offshore drilling services to the oil and gas industry. It serves major integrated oil companies, independent oil and gas producers, and government-owned oil and gas companies. As per its most recent 10-K, Seadrill's 5 largest customers were Petrobras (15% of revenue); Total (14% of revenue); Shell (10% of revenue); Exxon Mobil (11% of revenue), and Statoil (9% of revenue).
Why Sell-Side Worries Are Overdone
The main concerns surrounding the sell-side argument are 3-fold: there is an oversupply of offshore drilling rigs; there will be a downturn in day-rates; and Seadrill's debt-load will pose a problem as worries become realized. While it is true that major oil companies have lessened their capex in their upstream divisions, much of the reason surrounds the increase in depletion rates for existing reservoirs, thus setting the stage for a rebound in capex in 2015 and 2016 in emerging areas (Africa, Brazil, the Gulf of Mexico, and Mexico among others). Beginning in 2012 the company went on an investment spree and ordered 23 drilling rigs. Currently, ~54% of Seadrill's fleet was built between 2008 and 2013, and if I add on the rigs that will be delivered within the next 2 years, the percentage of new rigs climbs to ~83% of the total fleet. It should also be pointed out that Seadrill has the most modern fleet out of its major competitors, with the average Floater and Jack-up age of ~5 years for Seadrill, and ~14 years for Ensco and Transocean (Ensco owns the 2nd youngest floater fleet, and Transocean owns 2nd youngest Jack-up fleet).
Following the Macondo oil spill incident in 2010, regulation from federal and industry sources started to become stricter, thus limiting the usage of older units by oil companies. Heightened regulation presents offshore drillers with 2 options: spend hundreds of millions of dollars to purchase upgrades for aging rigs, or invest in new rigs completely. According to Seadrill, "[I]t has been shown from the prior cycles that such upgrades carried out by several of our competitors has had a materially lower return than Seadrill's focus on building a modern high specification fleet (Q4 2013 Results)." Seadrill is confident that its already large backlog (~$20 Billion, which is almost 2x larger than Ensco's) will continue to grow as its newbuilds obtain contracts. Seadrill stated in its most recent quarterly that it expects growth in excess of 20% year over year in 2014, and it even estimated that it will hit ~$4 Billion in EBITDA in 2015, implying a forward EV/EBITDA of ~7.6x, and a forward P/E of ~7.57x (assuming a net income margin of 27%, which forgoes any non-recurring gains and assumes a 16% tax rate).
On the subject of day-rates: forecasting day-rates, as put by Per Wulff (the current CEO of SDRL), is "pure guess-work." I believe it would best suit any value-investor's time by looking at Seadrill's history, as opposed to making conjectures about the future of day-rates. Revenue has compounded at a rate of 24% from 2006 to 2013; its average ROE taken from the same period has been around 28%, and its gross and operating margin has averaged 54.3% and 40.5%, respectively. It is also interesting to note that my calculations take into account the recession years, in which the price of Brent averaged ~$60 a barrel compared to the now $100+ a barrel. Seadrill has proven that it can withstand significant cycles, as even in 2009 it was able to grow its revenue in excess of 50% year-over-year, with 94% of the revenue coming from contracts. Going forward, I see growth continuing along in steady fashion as macro conditions paint a positive picture, leading me to believe that sell-side worries are very temporary, and a "reversion to the mean" seems likely.
On the subject of debt: Seadrill uses a significant amount of leverage; its current debt/EBITDA stands at ~5x, with its average debt/EBITDA standing at ~4.6x using 2012 as the starting year. Seadrill's aggressive strategy required the significant issuance of debt, and I believe much of the exaggerated worries surrounding the solvency of the company is mitigated by its substantial, and growing ~$20 Billion backlog, which dwarfs Ensco's and is currently holding strong as Transocean has seen an almost 10% decline in its backlog. As of Q4 2013, Seadrill's interest coverage ratio is ~4.6x, which is considered to be investment grade by S&P (-AA) and shows the company's ability to pay off its debt obligations. It is also worth mentioning that Seadrill will begin to grow FCF as capex is expected to die down as newbuild orders cease. I believe the company could fetch FCF yields between 5%-9% beginning in 2016 (assuming capex run-rate between $1.25 billion and $2 billion, and an operating cash/EBITDA ratio of 60%).
I used P/E and EV/EBITDA to calculate a range of fair values for Seadrill. Much of the offshore drilling industry is trading at depressed single-digit multiples, which suggests (falsely, this time) that peak earnings may be a factor. Currently, Seadrill is trading at a forward EV/EBITDA and P/E of ~7.6x and ~7.57x, respectively, which I believe is illogical given the almost tech-like growth the company will be experiencing within the next few years. I dug into the company's history, and found out that it has historically (since 2011) traded at a range of 9.5x-11x EV/EBITDA, and 12x-18x P/E.
Estimating that the company will hit $7.5 Billion in revenue in 2015, $4.03 Billion in EBITDA (assuming 53% EBITDA margin-the average of the past 4 years), and 4.32 in EPS, I applied the 9.5x multiple to EBITDA and the 12x multiple to EPS. Here are the results:
Fair value 2015'
The Bottom Line
- The reduction in oil company capex has been caused by the need to maintain older reservoirs, thus setting the stage for a significant rebound for E&P over the next 2 years as oil companies flock to emerging reservoirs.
- The temporary setback in the offshore drilling industry should revert back to the mean, as the price of oil is still trending strong upon the backdrop of strong demand from emerging markets.
- Seadrill's significant, and growing ~$20 billion backlog points to strong future financial growth.
- Seadrill's strong history of high margins and revenue growth, even amidst the recent global economic crisis that occurred in 2008 (it was able to grow revenue in excess of 50% year-over-year in 2009, with 94% of the revenue made up entirely of contracts), suggests that the company will continue to perform well during this minor setback.
- There's always a chance that another global economic disaster might be just around the corner. If such an event did occur, the price of Brent would decline substantially, along with day-rates.
- If a significant rise in interest rates were to occur, Seadrill would face the risk of not being able to pay off debt. While the company's growing revenue backlog indicates continued growth, there is always the chance that the backlog could decrease.
- Natural disasters can strike, and there is always the risk that rigs will break (no matter how new).