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On Monday, Seadrill (SDRL) highlighted on the Q2 earnings call that deepwater drilling remains a very hot sector with limited available rigs for the next couple of years. This was a theme highlighted at the beginning of the year as drilling in the Gulf of Mexico had picked back up.

The company provides offshore drilling services to the oil and gas industry worldwide. Its services include drilling, completion, and maintenance of offshore wells; production drilling and well maintenance; and well services. The company owns a fleet of offshore rigs and has 18 new builds under construction.

While the adjusted earnings slightly missed estimates, Seadrill continues to see huge demand for its rigs and tightness in the market for the next few years. The company has one of the youngest fleets in the industry and continues to benefit from an aggressive new build program.

Q2 2012 Highlights

The company reported the following highlights for Q2 2012:

  • Seadrill generates second quarter 2012 EBITDA*) of $634 million.
  • Seadrill reports second quarter 2012 net income of $554 million and earnings per share of $1.12.
  • Seadrill increases the ordinary quarterly cash dividend by $0.02 to $0.84.
  • Seadrill commences operations with the ultra-deepwater new builds West Capricorn and West Leo in the Gulf of Mexico and Ghana respectively.
  • North Atlantic Drilling Ltd (NADL) secures a two-year extension for the semi-submersible rig West Alpha, with a total revenue potential of $410 million.

The most important highlight for the quarter was the new contracts for over $7B that will be discussed below. The record backlog now exceeds $20B.

Market Conditions

Seadrill continues to see strong fundamentals in the offshore market as oil prices remain high and new discoveries lag production. The company continues to believe oil companies with strong balance sheets will fund further offshore exploration with limited rigs available for contracting.

The ultra-deepwater floaters (> 7,500 ft water) segment remains a primary focus. This segment remains less sensitive to market conditions with contracting at multi-year levels and daily rates in the $550K to $650K range.

The company sees a supply demand imbalance as contracting activity increases while announced new builds are declining. It estimates that fewer than 5 rigs are available for 2013 pushing 2014 rigs into focus. The company does not see the units under construction meeting global end demand; hence Seadrill is actively negotiating for additional new build units.

The premium jack-up rigs (>350 ft water) remains strong as well with high contracting activity and increasing day rates. The utilization rate in the sector has remained above 90% while the average rig age exceeds 20 years.

The demand for fleet renewals remains strong and new builds attract premium rates as customers prefer to utilize the safety and efficiency benefits of newer, high specification units.

New Contracts

Seadrill had several significant signed contracts subsequent to the Q1 report.

Exxon Mobil (XOM) exercised the last optional well for the West Alpha, extending the contract expiry to August 2014. Then, the company agreed to a two year extension of the contract at the agreed upon daily rate of $548K.

The most important contract was on the new build drillships West Auriga and West Vela, and a third drilling unit currently in operation. The combined package involves 19 rig years and a potential contract value of $4B, including mobilization fees for the new build units.

The company received several new contracts for tender rigs including the T11, T17, and the West Setia.

The three ultra-deepwater drillships West Polaris, West Gemini, and West Capella received commitments. The West Polaris will have a five-year commitment with an undisclosed client at a daily rate of US$642,000, the West Gemini and West Capella has received an aggregate of 7 years commitment for work in West Africa. These contracts have an estimated total revenue potential of approximately US$2.8 billion.

The combined contracts exceeded $7B. That amount far exceeds the expected revenue for 2012 of $4.4B. The company expects this backlog will generate plenty of cash flow over the next several years to solidify the dividend.

Valuation

The stock trades at a forward PE of 11.5 with the expectation of earning $3.57 in 2013. It also provides an 8.2% dividend yield with the quarterly rate raised to $0.84.

With the strong backlog and solid new build program, investors should be able to assume a 15%+ growth rate making the PE very cheap.

Other stocks in the sector such Ensco (ESV), Noble (NE), and Transocean (RIG) offer cheaper valuations, but those companies are stuck with older rigs and less aggressive new build programs.

Conclusion

The growth potential remains strong for Seadrill. The company has a successful new build plan and a focus on deepwater drilling that is very appealing in the current market dynamics.

The company has an aggressive payout plan that is questionable with the debt it takes on to build rigs. Though it receives sizable contract lengths, the average contract of between 2-3 years isn't long enough to pay all the debt if the oil market craters.

Another favorite in the sector is Atwood Oceanics (ATW) that undertook an extensive new build program focused on ultra-deepwater rigs and premium jack-ups. The company trades at an even cheaper forward PE of just 9.

For investors looking for a large cap dividend, Seadrill probably offers one of the best options though the stock is very aggressive for a conservative portfolio. Investors looking for a cheaper value might look at Atwood that is typically overlooked for the big players in the sector.

Source: Going Deep With Seadrill

Additional disclosure: Please consult your financial advisor before making any investment decisions.