With the recent news of European leaders planning to shore up the region's distressed banking sector, oil prices and oil futures are once again on an upward trend. An alternative to cashing in on this trend is to buy the stock of companies working for these cash-rich clients. In this article, I explore one such company, Seadrill Limited (NYSE:SDRL).
Seadrill can be used as a hedge against high oil prices while getting better dividend yields than some oil producers. Seadrill Limited is primarily an offshore drilling contractor providing services to the oil and gas industry worldwide.
Seadrill Outperforms Peers
For the past six months, Seadrill has outperformed its peers and the S&P 500. Since October 2011, its stock has gained 40% compared to S&P 500's 30%. Competitors Noble (NYSE:NE) and Ensco (NYSE:ESV) posted even lower gains with 28% and 25%, respectively. Industry leader Tranocean (NYSE:RIG) only managed about 12% during this same period.
Going forward, I think Seadrill can continue to offer an attractive upside for investors. I present several reasons for this assessment. One is that the industry outlook for offshore drilling is good because oil prices are expected to remain high in 2012 and 2013. The current outlook of oil prices will continue to drive demand for drilling because oil exploration companies and developing nations will continue to look and secure new sources of oil.
Another reason is that Seadrill has better than average utilization rate and day rate. It was even rumored that it declined $500k a day contracts in expectation of even higher offers. Prospects are good it can get them since reports say that supply of deepwater rigs for 2012 and 2013 is getting tight.
Seadrill's core advantage has been its expertise in ultra deepwater drilling and its premium rigs for the jack-up market allowing it to post much better gross margin of 61% compared to the leading players in the industry, Ensco at 48%, Noble at 42%, and Transocean at 24%.
Third, I see Seadrill maintaining its advantages at least in the short term of about two to three years. This is because I think the competition will need at least two years to threaten Seadrill. Capital would be a premium, especially in offshore drilling, since most players already have high levels of debt. Seadrill and its competitors have debts that are at least 45% of their market capitalization. Manpower is also a premium since skills and experience also takes time to develop. These factors make it hard for competitors to refocus or for new players to enter the field.
The ratings downgrade
However, concerns on sustainability surfaced recently with the downgrade of Seadrill by analysts from "buy" to "hold". Some investors may see this as a sign to sell.
My opinion is that Seadrill is still a good buy and that investors should not rush to write off its stock because of the downgrade. What Seadrill did operating-wise in 2011 was basically the same compared to what it did in 2010. Earnings per share in 2011 was $17.9 from revenues of $23.5 billion compared to 2010 figures of $16.5 and $24.4 billion, respectively. This shows that the basis of the downgrade was more about external factors.
Although I don't argue that future stock performance is seen to be inferior to its return the past six months but so are most of the alternative investments. Seadrill stock is still worth considering mainly because there are few alternative investments that would give a better return per level of risk than this stock. I don't think investors should worry about the market for offshore drillers getting saturated since reports say the outlook for demand is rising for offshore drillers.
Value for investors
The main disadvantage of Seadrill stock is its relatively expensive price. Its forward price-to-earnings ratio of 9.95 is higher than (supplied by Yahoo Finance) competitors Ensco and Noble with forward price to earnings ratios of 6.85 and 7.46.
The market is penalizing Seadrill with a lower valuation because of its first-quarter earnings slumped 53% over a year-earlier period and its predominant operations in ultra deep water drilling instead of the fairly safe jack-up rigs. If this is the case, then this presents an opportunity, because one-off items mask Seadrill's better than expected first quarter of 2012 results. In addition, the company overcomes its risks through the evident strong demand for this type of drills and through charging a premium for them.
Another selling point, Seadrill's dividend yield of 6.90% is also attractive, which is about four times the yield of 10-year government securities. Its also higher than Ensco's 3.20%, Noble's 1.90% and Transocean's 5.50%. This makes Seadrill an attractive choice for dividend investors. I also see Seadrill's dividends as sustainable because, as pointed above, its current level of revenues and net margin can be maintained for at least two years.
On another measure, the stock value is around $25 based on the dividend growth model. Stock appreciation prospects add further to value since payout ratio is less than 20%, which overall could go as much as $50.
Seadrill has alot of value because of its fairly new set of rigs, operating performance, and overall industry outlook. It has about 14 rigs in the pipeline that can fill up its future growth prospects. However, returns may be not maximized if the stock is bought at its current price.
I recommend investors buy on a pullback to 30$ and then hold for two to three years before exiting. At 30$, investors would be buying the stock at a price to earnings ratio that is less than the S&P 500's. Two to three years would be a safe estimate for a timeframe that Seadrill can hold its competitive advantage, and that oil prices would remain high.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.