Is Seadrill's High Yield Safe?

Seadrill's 10.5% yield might look too good to be true considering the difficulties in the oil drilling industry. But its positive long-term outlook means this is one dividend you can confidently buy today.

Jul 14, 2014 at 10:53AM

Offshore oil driller Seadrill Ltd. (NYSE:SDRL) has a strong fundamental catalyst working in its favor. That's the strength of long-term demand for oil, particularly in emerging economies around the world.

Unfortunately, the oil drilling industry is grappling with a near-term hurdle. Oil majors are cutting capital expenditures due to disappointing returns on new projects. This is coming at a direct cost to oil drillers, which are experiencing softness right now.

That's caused share prices of oil drillers like Seadrill and Transocean (NYSE:RIG) to fall, as their earnings reports reflect the tough sport they're currently in. But investors shouldn't be overly concerned about the bearish short-term outlook. Provided you take the long view, Seadrill has plenty to offer you.

First and foremost is its huge dividend, which you can confidently buy today.

Don't be dissuaded by the bumps in the road
Seadrill yields an astounding 10.5%, towering above others in the industry. Even Transocean, whose 6.6% yield is nothing to sneeze at, pales in comparison.

One of the reasons for Seadrill's huge yield is that its share price has declined over the past year, due to a pervasive negative sentiment surrounding global oil drilling. Consider that Seadrill's share price is about 20% off its 52-week high. Another reason is that's it's steadily increased its payout for several quarters in a row.

Indeed, Seadrill's fundamentals have suffered as members of Big Oil cut back on new rig orders. Last quarter, Seadrill's performance looked far better than it really was. Earnings per share clocked in at $6.54, which in itself would represent 18% growth from Seadrill's EPS in all of last year. But the company benefited from several one-time items that inflated its performance.

Last quarter, Seadrill realized non-recurring financial items totaling $2.2 billion which sent EPS soaring. This includes a large one-time gain related to a deconsolidation of Seadrill Partners. In addition, Seadrill realized $316 million in gains from asset disposals. The company sold several rigs, including the West Auriga, that boosted earnings last quarter.

But not all is well, and this is easy to see by looking past all the one-time items. Seadrill's operating revenue fell last quarter. And, if you strip out the gain on disposals, net operating income actually declined by $102 million. That's because Seadrill experienced extended periods of inactivity. For example, utilization of its floaters fell by three percentage points.

By contrast, Transocean performed well in the last quarter. Fleet utilization expanded by three percentage points, and the company experienced fewer out-of-service days. In all, revenue increased 7%.

Nevertheless, Seadrill's near-term headwinds haven't stopped management from raising the dividend anyway. The company raised its distribution again last quarter, to its current level of $4 per share annualized.

Why management has the confidence to raise the dividend
You might instinctively worry about a company raising its dividend in the face of weakening fundamentals. And, in most cases, that's definitely reason for concern. But Seadrill management is entirely confident in what the future holds. Importantly, it believes that the current slow-down is a short-term dip and not a long-term deterioration.

What separates this downturn from previous ones is that oil prices are still supportive. As opposed to 2008, when oil prices collapsed, Seadrill believes that commodity prices at these levels still incentivize energy companies to drill. That should result in resumed contracting activity sooner rather than later.

And, while its floaters saw lower utilization last quarter, management believes the day-rates of its floaters will be protected thanks to solid coverage. Seadrill's contract coverage of its floaters stands at 96% for 2014.

The bottom line
Seadrill offers a whopping 10.5% dividend yield, thanks to its falling share price and repeated dividend increases over the past year. While you might be reluctant to buy an extreme high-yielder with declining fundamentals, an important caveat needs to be considered. Seadrill sees a recovery in global oil drilling happening soon and maintains its view that the long-term industry fundamentals are extremely positive.

Indeed, oil demand is still robust, particularly in developing economies across the world. That's what gives Seadrill management enough confidence to raise its dividend in the face of near-term headwinds. You should be equally confident in Seadrill's huge yield.

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Bob Ciura 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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