SeaDrill (NYSE:SDRL) has come a long way since 2005 when its fleet consisted of 11 drilling rigs. Today, the outfit is the second largest contract driller by enterprise value and boasts a growing portfolio of roughly 60 rigs. SeaDrill posted second quarter revenue of $995 million - down slightly from the prior quarter - while operating profit held steady at $430 million, buoyed by an uptick in the contribution from its deepwater rigs.
As readers who bought SeaDrill based on my buy recommendation in this May 2010 article may already know, SeaDrill remains my favorite contract driller for several reasons.
For one, the stock tends to trade at a premium to its peer group because of the company’s ample quarterly dividend, which equates to a 9.5% yield at the current share price. This sky-high yield has captured the fancy of income-hungry investors, particularly in an environment where corporate bonds and many dividend-paying equities offer scant yields and little upside potential.
The stock’s stratospheric dividend yield has enabled the company to grow its market capitalization substantially since its primary listing shifted from Oslo to the New York Stock Exchange.
But investors who bet on high-yielding fare must closely scrutinize the sustainability of the firm’s underlying business rather than assuming that it will pay the same dividend (or higher) in perpetuity. When the operating environment deteriorates to the point that the company must slash its dividend, investors suffer a double whammy: Not only is their income stream reduced, but the stock also pulls back significantly in the wake of such an announcement.
Consider the case of tanker operator Frontline (NYSE:FRO), another company partially owned by SeaDrill’s Chairman John Fredriksen. The firm announced a second quarter dividend of $3 per share in August 2008, the height of the commodities bubble. Today, the embattled company pays a quarterly dividend of $0.02 per share. Meanwhile, the stock price has plummeted by 88% since Aug. 27, 2008, undone by high break-even costs on the company’s tanker fleet and a glut of excess capacity that threatens to depress day rates until at least 2012 (for more, click here).
Fortunately, the outlook for SeaDrill is much sunnier. With roughly $8 billion in debt, the company has taken on significant leverage in an effort to grow its fleet. But management has invested the proceeds wisely, assembling the industry’s second-largest fleet of deepwater drilling rigs - a business line that boasts strong fundamentals.
Faced with maturing fields and sluggish reserve-replacement rates, the world’s major exploration and production companies will continue to invest heavily in deepwater developments over the long term. On the other side of the equation, rising global demand for oil and natural gas should incentivize long-term investment in deepwater fields.
SeaDrill’s near-term outlook is also bullish. During a conference call to discuss second quarter earnings, CEO Alf Thorkildsen noted that the number of ultra-deepwater rigs has declined significantly over the past six months and that customers continue to book newly built rigs before the vessels even leave the shipyard. Management also noted an increase in customer inquiries regarding vessels with contracts that roll off in coming quarters.
With management expecting day rates on ultra-deepwater rigs to tick up to around $500,000 per day in the back half of the year, the company actually plans to hold back some of its units to take advantage of an expected rise in pricing. Much of the increased demand for ultra-deepwater rigs will come from Brazil and West Africa, though Thorkildsen also noted that he expects activity in the Gulf of Mexico to pick up significantly in coming years:
What I see is that the demand side in 2011 is very strong. That will have a spillover effect into 2012. We see extension of contracts, we see new contracts and most importantly is that there are significant discovery both in Africa and in Brazil particularly which is of interest. We have not seen the effect yet on Gulf of Mexico, but I am also very optimistic going forward into that market. The permits are still not up to the same level as before Macondo, but we see that there is an increase in permits and we know that it is a very prospective deepwater area and I am therefore somewhat more optimistic that we will have a better balance between supply and demand for all the newbuilds in 2013.
In addition to SeaDrill’s outsized exposure to deepwater drilling - dynamically positioned floating rigs generated 66% of the firm’s second-quarter revenue - we also like the company’s commitment to assembling a modern fleet. In fact, 51 of the company’s 60 drilling rigs were built after 2000.
At the end of the second quarter, its fleet of deepwater drilling rigs sported an average age of two years. These high-specification rigs are in high demand among oil and natural gas producers, particularly in a post-Macondo world. The firm also boasts the largest and most modern fleet of jack-up and tender rigs in the industry, providing the firm with a distinct advantage over firms with older fleets.
Thorkildsen highlighted the increasing bifurcation of the jack-up market during a recent presentation at Barclays Capital’s CEO Energy-Power Conference:
We see in that (the jack-up) market a fantastic and a dramatic bifurcation of this business. The old jack-ups, there are 100 of them at the moment which are either cold stacked or warm stacked. At the same time, we see that our modern jack-ups get us and provide us a very decent return. I have never seen a market like that before where at one time we have laid up jack-ups and at the same time we have very decent return. That bifurcation is not only coming into the jack-up market. I also believe it is coming into the floater as well as the tender rig business. For SeaDrill, that has been one of the strategies of, therefore, only have very modern equipment and I think we will benefit from that going forward.
In the second quarter, management noted rising demand for jack-up rigs in the Asia-Pacific region (an area in which the firm has a strong foothold) and the Arabian Gulf, a market it entered with its acquisition of Scorpion Offshore in 2010.
SeaDrill has invested judiciously in its growth, weighing the costs of newly built vessels versus acquisitions. For example, the company recently paid $54 million for a one-third stake in Asia Offshore Drilling, a company with three $185 million premium jack-ups under construction. Under the terms of the deal, SeaDrill will oversee the marketing and operation of these units upon delivery.
After ordering new rigs before many of its competitors, the firm also has the option to purchase nine additional newly-built rigs at locked-in, a distinct advantage as the cost of new rigs increases and near-term delivery slots fill up.
Thorkildsen summed up the best reason to invest in SeaDrill during a Sept. 6 presentation to analysts: “While other major drillers are spending cash and ... replacing their aging fleet, SeaDrill (is) identifying and selectively growing its already modern fleet at attractive rig prices. That is how we think we want to create value for our shareholder. That's the story.”
With a growing fleet of high-specification rigs, SeaDrill should continue to increase its earnings and dividend. Meanwhile, the company’s outstanding contracts increased to $12.2 billion in the second quarter, which, combined with a profit margin of roughly 60%, should provide ample support for the firm’s dividend.
Disclosure: I am long SDRL.