Seadrill Has Some Good News For Investors, But It Could Be A Value Trap

| About: Seadrill Limited (SDRL)

Summary

Seadrill will exceed this year’s cost reduction target.

Seadrill has also deferred delivery of rigs, which should have a positive impact on liquidity and lower capex requirement for 2016.

The company benefits from having one of the most modern, high-quality asset base in the industry.

Its shares are priced just 0.11 times book value.

But its still not a buy.

Seadrill (NYSE:SDRL) has lost more than 90% of its market value since oil's slide began in the final quarter of 2014. One of the world's largest offshore drilling contractors is now a small-cap company valued at just $1 billion. But earlier this week, Seadrill's CEO Per Wullf gave some good news to investors by saying that their cost cutting efforts have been going better than expected.

Seadrill increased its focus on curtailing costs back in 2014. In November, the Hamilton, Bermuda-based company said that it was targeting cash savings of more than $600 million for 2015 and $200 million for 2016. On Sunday, Wullf told Bloomberg that the company is positioned to exceed the 2016 target.

Seadrill has also been successful in delaying the delivery of several new rigs. Most recently, the company deferred the delivery of drillships West Aquila and West Libra from Q2-2016 to Q2-2018 and Q1-2019 respectively. This was a sensible move given the day rates have fallen substantially from the peak of $650,000 three years ago and offshore drillers are finding it increasingly difficult to retain existing customers, let alone sign new contracts. Seadrill itself is offering floating rigs for $300,000 for a one-year-contract and is willing to go as low as $160,000 for shorter term work.

Besides, the deferral has also improved Seadrill's liquidity outlook. The delivery of rigs is often accompanied with a final payment to the shipyard. The latest deferral, for instance, has allowed the company to delay the final payment of $800 million for the two ultra-deepwater rigs by more than two years, which should also bring down this year's newbuild capital budget. I believe Seadrill will likely report further newbuild delays this year, which will improve its liquidity and lower the capex requirement.

The greater than expected reduction in cash costs and the latest deferrals is a step in the right direction that should have a positive impact on the company's cash flows moving forward. It also helps that Seadrill does not pay any dividends, which eases the burden on cash flows (Seadrill suspended dividends in Q4-2014). The company is also renegotiating contracts with oil producers to bolster its backlog which stood at $6 billion at the end of Q3-2015.

What I also like about Seadrill is that it has one of the most modern, high-quality asset base in the industry. Seadrill's fleet primarily consists of sophisticated semi-submersibles, drillships and jack-ups that were built less than eight years ago and can drill in water depths of 350 to 12,000 feet. The management has also done an impressive job of lowering the cash flow breakeven costs for semi-submersibles and drillships from $475,000 - $525,000 in 2014 to $250,000 - $300,000 in 2015 and for jack-ups from $150,000 a year ago to $90,000 - $100,000 in 2015.

Due to the above-mentioned factors, Seadrill not only remained profitable (on an adjusted basis) but also generated strong free cash flows in the first nine months of 2015. But despite these positives, it is difficult to get past Seadrill's weak balance sheet. The company carries $11 billion of debt, or $10.2 billion of net debt, which dwarves its market cap and has significant near term maturities. Analysts believe that the company, which has the most levered balance sheet in its peer group, may be forced to sell equity and restructure debt in the new future. Tapping into the equity markets is going to be costly, particularly since the company's shares are already trading near multi-year lows.

Image: Seadrill Q3-2015 Results

As noted earlier, Seadrill's shares have fallen substantially in the downturn. As a result, Seadrill stock is cheap, priced just 0.11 times its book value. I believe much of the risk associated with Seadrill's elevated debt profile is already priced in the shares, but this could be a value trap.

The macro environment is certainly not getting any better as both Brent and WTI crude continue to hover in the low-$30s. The recent weak manufacturing data from China has heightened concerns regarding the demand of commodities from the world's second largest economy. Meanwhile, Saudi Arabia and Russia haven't made any meaningful cuts in oil production while Iran and Iraq are determined to increase crude volumes. This could delay the offshore drilling market's recovery.

Although the oil price environment continues to remain highly uncertain, what is fairly certain is that oil producers will keep avoiding the capital intensive offshore drilling projects. Meanwhile, the offshore drillers will continue to battle with an oversupply of rigs by 94 units, according to Morgan Stanley's recent estimates, despite the ongoing scrapping activity. That's going to keep a lid on day rates. The only factor that could fuel Seadrill stock's rally is if the company figures out a way to improve its financial health, perhaps by restructuring debt, which looks like a tough task. For these reasons, I believe investors are better off staying on the sidelines for now.

Disclosure: I/we 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.