Are Transocean, Seadrill, and Ensco PLC's Dividends Too Good to be True?

On paper, oil drillers such as Transocean (NYSE: RIG  ) , Seadrill (NYSE: SDRL  ) , and Ensco PLC (NYSE: ESV  ) look like ideal picks for income investors. After all, they each sport huge dividend yields of at least 5%, with Seadrill's 10% yield leading the pack. This towers above the dividend yield of the overall stock market.

And yet, none of these oil drillers have received much love from investors over the past year. In fact, their share prices barely budged while the S&P 500 Index rallied. This has to do with the questionable outlooks facing the oil drillers, primarily the potential a tighter supply and demand balance for oil rigs. As oil majors see less compelling returns on new projects, they're cutting capital expenditures that are likely to lead to lower day rates and utilization for oil drillers.

This begs the question: can the oil drillers afford their massive dividend payouts, or is the market justifiably skeptical whether these yields are sustainable?

Uncertain fundamentals weigh on valuation
The slowdown in offshore drilling activity is already weighing on the sector. Transocean's cash flow dropped 10% last year versus 2012, even after excluding a one-time $560 million payment associated with the 2010 rig explosion in the Gulf of Mexico.

Making matters more dubious is that fact that there's a bump in the road that the oil drillers will have to face in the coming months. Transocean, Seadrill, and Ensco have all warned investors to expect a near-term slowdown, as demand for oil rigs is soon to slow. The big question for the deep-water oil drillers is how prolonged the upcoming pullback will be.

Ensco expects its current-quarter revenue to fall 5% versus the prior quarter. For the remainder of 2014, Transocean expects its high-specification and mid-water floaters to both experience lower demand and declining utilization.

That's why it's critical for the oil drillers to show that the impending dip in rig demand is not a prolonged one, especially since they're jacking up their dividend payouts. Ensco yields nearly 6% after doubling its dividend just since late 2012. Transocean pays a 5.5% dividend, and its management recently proposed a $3.00 per-share payout, which would boost its yield up to 7.3% annualized. Seadrill is even more ambitious with its distribution. It recently upped its quarterly payout slightly and offers a huge 11% yield.

With the potential for deteriorating profits on the horizon, is it reasonable to question whether the oil drillers can afford such lofty payouts?

Management teams trying to soothe investors' fears
The first reason for investors to feel confident about the oil drillers' payouts is that they can easily afford them. Each of them generated more than enough in profits to support their lofty payouts, as indicated by their payout ratios. Transocean's $3 per-share payout would represent 77% of its trailing earnings from continuing operations. Ensco's payout ratio is an even more modest 49%,  while Seadrill's 2013 payout ratio stands at 66%.

Plus, Transocean, Seadrill, and Ensco are each extremely confident in their future outlooks, which is why they have no fears of raising their dividends in the face of a near-term dip in drilling activity. Transocean and Ensco are selling off older rigs and reducing costs to boost profits. Despite the prospect of revenue falling this quarter, Ensco still believes the near-term bump in the road won't affect the whole year, and expects 2014 revenue to grow by at least 5%.

Meanwhile, Seadrill is confident based on prevailing operating conditions which are still supportive. Management draws a distinction between this year and previous industry slowdowns. For example, oil prices are still acting as a tailwind. And, Seadrill maintains tight contract coverage for its rigs, which allow it to generate consistent earnings regardless of capital expenditure cuts by its key customers. To that end, it has an estimated floater coverage of 96% this year.

Keep your faith in the oil drillers
On the surface, Transocean, Seadrill, and Ensco look like tantalizing buys based on their relatively cheap valuations and huge dividend yields, when compared to the broader market. However, a closer glance at the industry's underlying fundamentals paint a much less certain picture. The oil drilling industry is about to confront a stiff headwind in the form of lower rig demand, as members of Big Oil cut back on capital expenditures.

Nevertheless, the management teams of all three want their investors to know this is a short-term issue. They believe the long-term fundamentals of oil drilling remain extremely positive, due to the world's seemingly insatiable thirst for oil, particularly in the emerging markets. As a result, it seems like their sky-high dividend yields are still secure.

OPEC's worst nightmare works very closely with these companies

OPEC is on edge due to this company's potential
Imagine a company that rents a very specific and valuable piece of machinery for $41,000… per hour (that’s almost as much as the average American makes in a year!). And Warren Buffett is so confident in this company’s can’t-live-without-it business model, he just loaded up on 8.8 million shares. An exclusive, brand-new Motley Fool report reveals the company we’re calling OPEC’s Worst Nightmare. Just click HERE to uncover the name of this industry-leading stock… and join Buffett in his quest for a veritable LANDSLIDE of profits!

Read/Post Comments (1) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 31, 2014, at 11:45 AM, awallejr wrote:

    Except there isn't a lower rig demand for deep sea rigs which SDRL provides. In fact there will continue to be a shortage over the years as SDRL management has advised. Furthermore SDRL has set up a special fund where they will be adding 20 pct of proceeds from sold rigs with 80 pct to apply to debt. They just sold one for $790 million.

    Big oil simply has no choice but to drill deeper if they wish to replace their ever depleting reserves.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2896688, ~/Articles/ArticleHandler.aspx, 9/2/2015 12:31:03 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Bob Ciura

Bob Ciura, MBA, has written for The Motley Fool since 2012. I focus on energy, consumer goods, and technology. I look for growth at a reasonable price, with a particular fondness for market-beating dividend yields.

Today's Market

updated 3 hours ago Sponsored by:
DOW 16,058.35 -469.68 -2.84%
S&P 500 1,913.85 -58.33 -2.96%
NASD 4,636.11 -140.40 -2.94%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

9/1/2015 4:02 PM
ESV $17.09 Down -1.02 -5.63%
Ensco CAPS Rating: ****
RIG $13.71 Down -0.52 -3.65%
Transocean CAPS Rating: ***
SDRL $7.54 Down -0.50 -6.22%
Seadrill CAPS Rating: ****