Why I Just Bought Shares of Seadrill

There is that one moment when you suddenly become certain about a certain financial decision you have been debating for quite some time. I just had one of those moments, and it convinced me to buy shares of Seadrill (SDRL).

One of Peter Lynch's tenants of investing is to invest in what you know. So I guess more and more companies I'm looking at investing in are in the energy sector since a majority of my work here at The Motley Fool revolves around energy. The offshore market and Seadrill have given me lots of mixed signals over that time. In one breath, the world's unquenchable thirst for oil means that exploration will continue to unprecedented depths of the ocean, but in the next, there are concerns of "too much, too soon" from Seadrill and its competitors. There were also concerns whether Seadrill was the best investment among its peers.

Source: Seadrill media relations.

Over the past several months, there has been a very telling sign that gave me the courage of my convictions, and I want to share what that was and my overall investing thoughts on this company. For those who are less familiar with Seadrill or the offshore world in general, check out this quick industry overview.

The one aspect I really like about the company
The actual business of rig companies isn't exactly the most exciting enterprise -- they all are, for lack of a better term, rental equipment companies. What makes Seadrill stand out in this rather dull industry, though, is its ability to command such a high price premium over its peers. Seadrill's fleet of jackups and floating rigs command premiums of 30% and 16%, respectively, on the open market.

The reason that Seadrill's fleet is able to command such a premium in comparison to competitors like Transocean (RIG -2.29%) and Diamond Offshore (DO) is that Seadrill's fleet is newer and built to higher specifications. While there is direct correlation with age and price for rigs, you can easily see in the company's fleet status reports that newer, high-spec rigs are in greater demand. Since Seadrill's overall fleet is considerably newer than any peer that has more than 10 rigs in its fleet, it is able to maintain that high price premium.

Source: Rig Fleet status reports.

These high dayrates ripple through the entire income statement. Seadrill's 60% gross margin is the best in the business, and its net income margin of 53.7% -- which is also bolstered by investment income in other offshore companies Archer and SepuraKencana -- is almost 20 percentage points above its closest competitor. With margins that high, there is quite a bit of wiggle room to take on bigger growth opportunities like its industry-leading newbuild program. Seadrill has over 20 rigs under construction today, which will increase its fleet size by more than 30% within the next two years. 

The two things that finally convinced me to buy
Perhaps there is no quote from Warren Buffett more appropriate for offshore rigs than "Only when the tide goes out do you discover who's been swimming naked." Recently, there have been concerns that the offshore rig market is heading for a downturn since so many companies were adding new rigs to their fleets -- none more so than Seadrill -- and big-name spenders like ExxonMobil and BP were all signaling that they would be spending less on capital expenditures to enhance shareholder value. 

Because of this, Seadrill wasn't even my preferred choice for offshore rigs. I was slightly concerned about the ability of Seadrill to weather the storm of a down market because of its high debt level, the capital it was spending on building new rigs, and the rather large dividend payments it makes. These things caused me to look at another player in the space, Ensco, that had a much cleaner balance sheet and a growing fleet of new, high specification rigs and at the time could be had for a cheaper price. 

As these past few months have unfolded, though, something very interesting has been happening at Seadrill. Despite this down market, the company has not only been able to secure contracts to keep 94% of its fleet working for the rest of 2014, but the price for those contracts are increasing when some of its competitors are seeing contract dayrates decrease. In fact, Seadrill's fleet could be in a position to take some contracts away from its competitors. According to Bloomberg, 28 lower specification from competing companies rigs are slated to come off contract this year, most of which aren't Seadrill's.

Source: Bloomberg Industries.

A recent trend in the offshore market is that high-specification rigs like Seadrill's have been taking contracts from the older deepwater and midwater rated rigs like those in Transocean's and Diamond's fleets. What this shows is that in the rig market, the integrity of a company's assets are just as important -- if not more -- than the integrity of the balance sheet. So if I'm going to make a long-term investment, I'm going with the best assets.  

The other aspect that finally drew me into buying shares today was the price. After taking a beating over the past six months on those very fears of a weak offshore market, Seadrill shares are trading at a price-to-earnings ratio of 6.36, which is at a considerable discount to its peers as well as the S&P average of about 18. I'm not completely certain if shares will continue to fall or not, but from a long-term buy-and-hold strategy I'm comfortable buying at today's prices and would even be tempted to pick up more if shares were to fall even further. 

Something that concerns me, but not enough to stay away
Two of the more eye-popping aspects of Seadrill are the company's high debt load and its near-astronomical 12% dividend yield. This means there are some pretty large contractual obligations, and some investment banks are downgrading the stock because Seadrill has been using things such as drop-downs to its master limited partnership Seadrill Partners (SDLP) and selling off some of its investments in the aforementioned offshore drilling companies to fund budgetary shortfalls. These fears are compounded by concerns that as newly constructed rigs are ready to come out of the yard, they will not get sufficient dayrates to cover these payments.

I'm not overly concerned about this because even if these new rigs were to take contracts for less than Seadrill's normal premium rate, it is likely that the company will be more than able to generate cash flow from these assets to cover these payments or even start to pay down some of this debt level. According to Seadrill, its cash flow breakeven for its floating rigs is $305,000 per day, which is well below the $554,900 average dayrate for these type of assets. While I'm not completely blown away but its EBITDA to interest expense ratio -- at 5.88 today -- it's enough to not keep me up at night. 

Source: Seadrill investor presentation.

Another thing to consider is that starting in 2015-2016, several other companies' legacy assets will start to retire, which should result in a pickup in rig demand. With over 66% and 64% of Seadrill's floating and jackup fleets already contracted out past 2015, respectively, the company is in better position to weather the storm than most of its peers.

Source: Data from Riglogix, Chart from Bloomberg Industries.

Is there a chance that things could get rocky over the next year or two? Absolutely. Seadrill's management has already said that it will not increase its dividend payment for the foreseeable future and that it was not planning on buying new rigs anytime soon. However, the market beyond these next couple of years looks very promising, and Seadrill's fleet looks best positioned to tackle that market. 

What I'm watching as I own shares
For the next couple years or so, I'm going to keep a watchful eye on the contracts it can secure for its uncontracted rigs. Between now and the end of 2015, there are 14 new rigs that are slated to come online and 9 rigs that will see their contracts expire. Getting these rigs on the water and generating revenue will be critical. As long as these rigs can secure contracts at reasonable rates, then Seadrill should be in a good position to start tackling that debt situation and potentially start increasing its dividend again.

What a Fool believes
Seadrill isn't a perfect stock, but I think that I have a pretty good grasp of its flaws as a company and the potential upsides were enough to convince me that now was a time to buy. I haven't written about the purchase before now because of The Motley Fool's trading rules and disclosure policy, but the incremental changes in stock price between now and then shouldn't change anyone's opinion on the stock. It certainly hasn't changed mine.