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.
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Bob Ciura owns shares of Ensco. 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.