Offshore contracting giant Seadrill Ltd. (NYSE:SDRL) announced its second quarter 2014 results on Wednesday, August 27. The company's results failed to meet the expectations of analysts and the market punished the stock due to this. I think that the market overreacted to this earnings miss, however, and still believe that there are some things in this report that make a strong case for an investment in the company at this level.
As my long-time readers are no doubt aware, it is my usual practice to provide the highlights from a company's earnings report when performing an analysis such as this. This is because these highlights serve to provide background for the analysis and frame the resultant discussion. Therefore, here are the highlights from Seadrill's second quarter earnings report:
- Seadrill reported total revenues of $1,222 million in the second quarter of 2014. This represents a slight increase from the $1,221 million that the company brought in during the first quarter.
- Seadrill had an operating profit of $476 million in the second quarter, down from the $890 million that the company reported in the first quarter.
- Seadrill reported an EBITDA of $641 million in the quarter. This represents an increase from the $624 million that the company reported in the first quarter.
- Seadrill reported a consolidated net income of $653 million or $1.29 per share. The company had a net income of $3,094 million in the first quarter, but the two figures are not directly comparable.
One of the first things that is likely to be seen by reviewing the highlights is that the company's operating earnings feel significantly compared to the first quarter. However, this is nothing to worry about. As I discussed in a previous article, Seadrill's operating income was positively impacted in the first quarter by a one-time gain on sale of the West Auriga drilling rig. This one-time gain was $440 million. Seadrill had no similar transaction in the second quarter. Thus, in order to properly compare the two quarters, we need to remove this gain from the company's first quarter results. Doing so reduces Seadrill's operating income to $450 million compared to $476 million in the most recent quarter. Therefore, the performance of Seadrill's basic operations actually improved on a quarter-over-quarter basis.
As I mentioned above, Seadrill's net income in the first quarter is not directly comparable to its net income in the second. This is because, in addition to the one-time gain from the sale of the West Auriga, Seadrill's first quarter net income also included a massive one-time gain caused by the deconsolidation of Seadrill Partners (NYSE:SDLP). This gain was $2,339 million. Excluding this gain would lower Seadrill's first quarter net income to $755 million. This is higher than what the company reported in the second quarter but remember that this figure still includes the $440 million gain on sale of the West Auriga. If this one-time gain is also excluded from the first quarter results then Seadrill's net income would show improvement on a quarter-over-quarter basis.
Seadrill has long had an impressive record of maintaining high rig uptime. The latest quarter was no exception to this. In the second quarter, Seadrill's ultra-deepwater fleet achieved a total economic utilization of 96%. This was an improvement over the 94% that the company's ultra-deepwater fleet achieved in the first quarter, a result which ultimately displeased Seadrill's Board of Directors. This means that Seadrill's ultra-deepwater fleet spent, overall, more time performing drilling duties than in the previous quarter. As offshore drilling rigs are only compensated by customers for time that they actually spend operating, the company's floater fleet in aggregate came closer to achieving its theoretical maximum potential revenue given the contracts that its respective rigs have. Thus, this is one reason why the company saw quarter-over-quarter revenue growth.
Seadrill's jack-up fleet did not perform as well, however. In the second quarter, Seadrill's jack-up fleet achieved an average economic utilization of 93% compared to 97% in the first quarter. This means that this portion of the fleet generated less revenue as a percentage of its theoretical maximum than it did in the first quarter. Fortunately, there is a reason for this and it is one that bodes well for the company's future. Earlier this year, Seadrill entered into a joint venture with Petróleos Mexicanos (PEMEX) for the long-term use of four of the company's jack-up rigs. Essentially, these four rigs are being transferred to a joint venture that will be equally owned by the two companies. These are the four rigs that had the greatest amount of non-operational time in the quarter and this non-operational time was due to the fact that the company was moving them to Mexico to participate in this joint venture. Once these rigs arrive in Mexico and begin their work under this joint venture, Seadrill should see the economic utilization of its jack-up fleet return to its previous levels. This will positively contribute to forward earnings growth.
There were some other positive developments in the second quarter and in this report that should enable the company to continue on its growth trajectory. In addition to the already discussed joint venture with PEMEX, Seadrill also successfully secured a contract for its new drillship, the West Jupiter. I discussed the full implications of this in a previous article. This new rig is scheduled to depart the shipyard sometime this month and will immediately begin travelling to Nigeria where it is scheduled to begin working for Total (NYSE:TOT) in November. Total will pay Seadrill a dayrate of $567,000 for the use of this rig. This will prove to be accretive to the company's revenues and cash flows at that time.
Seadrill also secured a contract for another of its new rigs, the West Saturn, last month. I also discussed this contract in detail in a previous article. In short, the West Saturn left the Samsung shipyard in South Korea and set sail for Nigeria to begin work on its first contract for a subsidiary of ExxonMobil (NYSE:XOM). This rig is scheduled to begin working on this contract in January and will be paid a dayrate of $633,750 over the three year contract duration. As with the West Jupiter, this rig will prove accretive to Seadrill's revenue and cash flow once it begins work.
Seadrill also has another rig that will be starting work on its first contract later this year. This rig is the West Neptune and it has secured a contract with LLOG Exploration to work in the U.S. Gulf of Mexico. The rig's construction was finished last month and it is now traveling to the Gulf of Mexico to start working on this contract in December. LLOG will pay Seadrill a dayrate of $570,000 over the three-year term of this contract. As with the other new rigs that will be beginning operations later this year, the West Neptune will prove accretive to Seadrill's future revenues and cash flows.
One of my favorite things about Seadrill's earnings reports is the way that the company provides an in-depth analysis about the current macroeconomic conditions in the drilling market. Seadrill describes the overall market for ultra-deepwater rigs as "challenging," although Seadrill is better positioned than most to weather through it. This is because of the company's focus on modern high-specification drilling units. As I have discussed in numerous articles in the past, the exploration and production companies that contract drilling rigs have expressed a marked preference for modern drilling units. While the market dayrates for all ages of rigs have declined since their peak last year, this customer preference for modern rigs has caused dayrates for these older rigs to fall much more dramatically than those of newer rigs due to the lack of demand. Overall, the market dayrates of modern drilling rigs have held up much better. This has resulted in fierce competition for contracts from those companies that own these older rigs as these companies have been bidding dayrates down in order to generate at least some cash flow from their fleets. In addition, those companies that have rigs coming off of their current contracts in the near-term have also been contributing some downward pressure on dayrates as they bid aggressively to secure new contracts and obtain some visibility into their future cash flow.
This situation looks set to improve going forward, which will be good for Seadrill but not for those companies that have a large number of old rigs in their fleets. There are currently approximately 300 floating rigs worldwide. 128 of these, or roughly 43%, are at least 25 years old. Approximately seventy of these rigs will need to undergo their classing survey by 2017. This is an inspection and maintenance program that offshore drilling rigs are required to undergo every five years. This survey can cost in excess of $100 million to perform. This high cost combined with the relative lack of demand for these rigs may lead many operators to conclude that it is not economical to perform these surveys and scrap the rig instead. This would significantly reduce the supply of rigs that are competing for contracts.
There are also signs that demand for ultra-deepwater drilling rigs will strengthen in the future. For example, Brazilian oil major Petrobras (NYSE:PBR) recently contracted its first rig in nearly three years. It is expected that Petrobras will need to renew the contracts of six rigs that will be expiring next year as well as contract an additional three or four rigs in order to acquire the ten rigs that the Brazilian company will need in order to complete its planned development of the massive Libra field. In addition, the energy reform process in Mexico may result in PEMEX seeking to put more rigs under contract and, if so, Seadrill is well-positioned to take advantage of any such opportunities due to its strong relationship with PEMEX as detailed earlier.
In past articles, I have stated that the jack-up market has been remaining strong despite the overall downturn in the ultra-deepwater market. That is still true, although Seadrill's management did express some concerns about this market due to the large number of new rigs that will be leaving the shipyard and joining the worldwide fleet. There are currently 139 jack-up rigs under construction and the fear is that these rigs will cause a supply glut when they begin operating. This is particularly concerning because the number of new rigs under construction is quite significant proportional to the 500 rigs currently in operation. However, approximately half of these 500 are past their expected life of thirty years and so there is a good chance that the various companies in the industry will be scrapping their old rigs as their new ones come online. If this, this would prevent a supply glut. In addition, it is not certain that all these rigs will ever be fully operational. During the recent industry boom, a large number of poorly capitalized companies were ordering rigs. As the standard industry practice is for the drilling contractor to pay 20% of the rig's construction cost upfront and 80% upon delivery, those companies that are constructing new rigs will have considerable expenses when these rigs are finished. A poorly capitalized company may not have the means to cover this expense. Thus, not all of these new rigs will actually enter the market.
As discussed earlier, the market was disappointed in Seadrill's results overall and punished the stock accordingly. However, this appears to be an overreaction. Seadrill itself appears to be quite well-positioned to weather the weakness in the industry and will reward a patient investor with a 10.75% dividend while its growth story continues to play out.
Disclosure: The author is long SDRL.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.