With a 10.5% Yield, Seadrill Ltd. Is a Bargain

Over the past three months, offshore rig lessor SeaDrill has has declined by over 20%. With high demand for the newest deepwater rigs, Seadrill should be able to grow its earnings substantially until 2017. In the meantime, you can also enjoy a 10.5% dividend yield.

Feb 4, 2014 at 3:18PM

Since late January, the S&P 500 index has fallen by about 6%, from 1840 to to about 1740. Although this has thus far been a mild pullback by many standards, in events like these there are often sectors and industries that get beaten up disproportionately, and this pullback has been no exception. One of those industries is offshore rig leasing. Offshore rig lessors' profits depend on dayrates for the rigs, which they lease out to operators. Because offshore operations are very capital intensive, many rightly regard the rig lessors as a leveraged bet on high global oil prices. 

It is, perhaps, for this reason that offshore drilling companies have seen their stocks tumble the most. Seadrill (NYSE:SDRL), a Bermuda-based driller with mostly Norwegian management, has seen its U.S. shares drop a gigantic 20% since just October of last year. And despite that steep decline, Seadrill's operational performance has been great since then. This article will go over three reasons why this offshore rig lessor is worth your consideration at this discounted price. 

A young, deepwater fleet

Sdrl Udw 

Seadrill Investor Relations

The chart above shows that Seadrill has among the youngest and most deepwater-focused fleets, easily beating both Ensco (NYSE:ESV) and Transocean (NYSE:RIG) in both fleet age and deepwater focus. This is a good thing for a few very important reasons. First, a majority of new offshore oil discoveries are now happening at depths exceeding 5,000 feet, so the future of offshore drilling activity will be in deepwater and ultra-deepwater. Second, because supply for deepwater and ultra-deepwater is the most constrained, and because drilling at these depths is very capital intensive, dayrates for these types of rigs are also the highest and carry the greatest profit margins. 

Second, the Macondo disaster in 2010 has ushered in a heightened need for safer, state-of-the-art rigs. As such, operators are putting a premium on newer vessels. It is for these two reasons that I believe Seadrill is better positioned than either Ensco or Transocean. Seadrill spent money during the tougher years of 2009 and 2010, kept a long-term view, and took on debt when it was cheap to do so while many of the company's competitors were too afraid to spend.

Earnings growth 

Sdrl Ebitda Growth What To Expect

SeaDrill Investor Relations

Thanks to the new additions to its fleet, which are expected to come online over the next few years, Seadrill expects to grow EBITDA from around $3 billion in 2013, to well over $4 billion by 2016. Of course, this could be hurt if day rates plunge and stay low, but I believe much of that fear is unwarranted. Much of the world's traditional oil producing nations are finding it difficult to increase production onshore. As long as the shale remains off limits in most of the rest of the world, offshore oil activity will continue to increase.With a young, deepwater-focused fleet, Seadrill will be at the forefont of that.

A high and sustainable dividend
One big concern of retail investors is Seadrill's 10.5% dividend, which seems too good to be true. A cursory look at the company's balance sheet shows that Seadrill cannot pay its dividend from cash flow. The reason for this is primarily Seadrill's capital spending, which in 2012 amounted to over $1.5 billion and is on course to be perhaps over $2 billion this year, compared to only $1.59 billion in operating cash flow in 2012. 

Looking deeper into the company's financials, in 2012 Seadrill paid $1.97 billion in dividends but took in only $1.59 billion in operating cash flow. This, however, was due to a $1.4 billion "other non-cash" charge which masked a year of otherwise great results. That charge was in fact due to a decline in mark-to-market value of an unrealized derivative, and there will be no cash transaction until that derivative runs its course and is realized. When considering that charge as only a one-time event, operating cash flows would have been $3.8 billion, compared to a dividend of just under $2 billion. In my opinion, as long as Seadrill can manage its debt and continue expanding EBITDA earnings, this juicy 10.5% dividend yield will be secure. 

Bottom line
Seadrill has the youngest and most deepwater-oriented fleet, which should afford the company a measure of protection should oil prices come down. As new ships come online between now and 2016, Seadrill's earnings should rise and the need for capital expenditure should decline. At more than 20% off its October highs, Seadrill is a bargain right here. 

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Casey Hoerth has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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