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Is Seadrill's High Yield Safe?

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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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 July 14, 2014, at 11:49 AM, awallejr wrote:

    The deconsolidation was a one-time deal but assets sales should absolutely be counted. All leasing companies make money off sales of the assets.

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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.

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