The Seadrill Conundrum

| About: Seadrill Limited (SDRL)

When it comes to investing, for me there is only one strategy: dividend growth. In keeping with this strategy, I've populated my portfolio with the likes of Wal-Mart (NYSE:WMT), Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), McDonald's (NYSE:MCD) and several other dividend aristocrats that are frequently found on lists of stocks to retire with. Since this strategy has worked so well for me, I find myself struggling more and more with my large holding of Seadrill (NYSE:SDRL) stock. Having fallen for the large dividend, the less disciplined me of one year ago loaded up on it in March 2011 for $37/share, and then again in September 2011 for $29/share. As of writing this, Seadrill makes up a little less than 17% of my entire holdings.

I'm in a strange situation with Seadrill. That 17% stake in my portfolio represents 30% of my dividend income. The rational side of me is saying that I can beat those earnings in the long run by switching to dividend aristocrats. In addition, there are several risks with the stock:

  • The dividend isn't a low, steady rate like JNJ or MCD and is therefore tied closely with profits. A steep drop in share price could do the same to the dividend
  • SDRL covers the high dividend with cash flow, leaving expenditures to be paid for with debt. This leaves the company with a very high debt to equity ratio compared with its competition, such as Noble Corporation (NYSE:NE) and Transocean LTD (NYSE:RIG)
  • Poor investment in drillships will leave the company with a large debt, a large fleet, and a low day rate to lease out the equipment - the dividend will inevitably fall
  • A catastrophic deep sea drilling accident could leave me with a huge loss overnight. It's been over two years since the Deepwater Horizon oil spill and Transocean has yet to fully recover its share price

Despite the risks, there are a few factors which have so far prevented me from selling:

  • The 8+% dividend. It might be yield chasing, but it's been making me a lot of money for over a year
  • That high debt to equity has left Seadrill with the most up to date fleet in the industry, putting it in a great position to attain steady profit for years
  • The company has a backlog of contracts, worth several billions of dollars, and keeping the ships booked for years

Since it doesn't fit in with my strategy, I hate to say it, but the reward outweighs the risk. I don't agree with continuing to hold onto debt while paying such a massive dividend, but it's so hard to complain every quarter when I check my account.

I don't plan on buying any more stock since I have so much already, but I think a pullback to the $30 level of August to October of 2011 would be too good of an opportunity for someone else to miss. I'd probably end up caving in and buying more.

To resolve my conundrum, I'll initiate the following two-part strategy:

  • Reinvest all dividends into dividend growth stocks, rather than back into Seadrill
  • At the $40/share level and above, sell call options to reduce my stake in the company to a more reasonable level. I don't think there's significant short term risk in the company, but if John Fredriksen decides to start paying back debt (which I honestly don't see happening), the share price could drop. The options will effectively lower my cost basis, while reducing my shares and earning me a good profit if they're exercised

For anyone that doesn't already have an overweight position, it's hard to not give a buy recommendation on a stock with an 8% dividend, overvalued or not. As long as the contracts keep coming in, the company should be secure. My warning with this is to look out for dropping day rates to lease the equipment. Seadrill is giving itself the most modern fleet at the price of a very high debt. If this fleet can no longer pay for itself, the dividend and the stock price will have nowhere to go but down.

Please leave comments below. If I got some information wrong, please correct me in a kind manner. Seadrill operates very differently from other dividend companies and I've seen my share of articles where the author got reamed in the comments.

Disclosure: I am long SDRL, MCD, JNJ, KO, WMT. 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.

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