The Market is Clearly Missing Seadrill's Long-Term Potential

Seadrill had a great year in 2013, and its conservative management practices make it less vulnerable to a slow-down in drilling spending.

Mar 3, 2014 at 10:38AM

Oil driller Seadrill (NYSE:SDRL) is under assault. Its share price cratered after releasing its full-year results, which were overwhelmingly positive. Revenue and profit is growing, and key metrics like utilization and average day rates are strong. And yet, the market isn't giving any credit to Seadrill for its success. In fact, shares of the oil driller are languishing near 52-week lows.

There must be something hidden deep within Seadrill's earnings report that foretells its demise. Otherwise, the market is simply missing Seadrill's strong growth and promising future. Now that its full-year report is out, it seems the latter scenario may be closer to the truth.

Seadrill's year in review
Seadrill posted strong results across the board last year. Its contract revenue rose 14%, driven by both new rigs coming on-line as well as an increase in day rates. In the fourth quarter, Seadrill brought its West Tellus, West Auriga, West Vela, West Tucana and AOD III rigs into service. This flowed through to the bottom line due to solid cost controls. Seadrill's operating income rose 17% in 2013 versus the prior year.

Seadrill's results compare very favorably to fellow driller Diamond Offshore (NYSE:DO), which struggled last year. Revenue and operating income both fell, due to a leveling off of day rates. In all, Diamond Offshore's operating profit fell nearly 17% last year, due to stagnant revenue and a notable increase in drilling expenses. Going forward, Diamond Offshore's cost structure will come under further pressure, as it plans to double capital expenditures on fleet upgrades in 2014.

While Seadrill wrapped up a great year, the market is clearly unconvinced in the company's near future. However, Seadrill's conservative management practices make it less vulnerable to industry volatility than the market gives it credit for.

Bumps in the road
Where Seadrill may have upset investors was in its near-term outlook, due to challenges encountered in recent weeks. Seadrill notes that day rates for ultra-deep water assets are declining, because oil companies are in a pinch. Oil majors have many financial commitments on their hands, including spending on capital expenditures, and providing dividend returns to shareholders. Moderating project returns mean there's only so much cash to go around, and oil companies have decided to trim capital budgets instead of reducing cash deployments to shareholders.

In its broad industry appraisal, Seadrill specifically cites findings from European major Statoil (NYSE:STO), a company that is bringing down capital expenditures and selling off assets. Statoil unloaded more than $4 billion in assets last year, and will cut spending by more than $5 billion through 2016. Seadrill notes further actions like these will have an adverse effect on oil drillers over the near-term.

Seadrill's operating advantage
However, Seadrill is well-prepared for any short-term slowdown in rig spending. That's because it operates a conservative business model that navigates its environment well regardless of Big Oil capital expenditure decisions. Seadrill has long maintained a policy of contract coverage. In other words, Seadrill has limited exposure to swings in commodity prices or industry capital expenditure levels. It cites the 2008 carnage as a specific example.

Despite oil prices collapsing from $140 per barrel $40 per barrel in a span of six months in 2008, Seadrill sailed through the downturn with limited damage to earnings, due to its solid contract coverage. The company is even less vulnerable now, because it has expanded on that practice. Seadrill has an estimated floater coverage in 2014 and 2015 of 96% and 66%, respectively. This gives it valuable insulation against severe declines in rig spending.

Seadrill: Opportunity lies ahead
Seadrill management is confident that the near-term dip in Big Oil capital expenditures is a momentary pause and not a cyclical downturn, driven by the fact that the trimmed spending is not due to a collapse in oil prices. The market is clearly worried that Seadrill's customers will suspend or cancel orders. While it's true that Seadrill has seen some pause in 2014 orders, these orders are simply being pushed to the following year rather than canceled entirely.

That's what gives Seadrill management confidence to increase its dividend and provide a double-digit yield. Signs abound that Seadrill's hiccups are short-term, and that the long-term opportunity remains strong.

As Seadrill fights to keep its yield high, check out these other 9 high flying dividend payers

Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Seadrill and Statoil (ADR). The Motley Fool owns shares of Seadrill. 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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