Source: Seadrill Ltd.
Back in July, I wrote an article that was pretty critical of a series of moves by Seadrill Ltd. (SDRL) management. The company changed course before the worst could happen, but the end result wasn't pretty, and in short, the company had to exercise a number of convertible notes both early, and at a premium, to avoid potential harm to those investors.
While the whole thing was ugly, and I wasn't pleased with the poor handling of capital, I decided to hang on to my shares because I was still pretty comfortable with the people running the company, and the long-term opportunity still looked great.
Here we are today, and the stock has continued to fall since. It's now down 28% since the beginning of July:
Should I have sold my shares in July? What's happened to send the stock price down so much? Let's take a closer look.
Recap of the opportunity and risks
The short version is that the long-term potential for Seadrill remains essentially unchanged. Even though management announced in the most recent earnings call that it was taking the foot off the pedal of newbuild orders, Seadrill still has by far the youngest and most capable fleet in the offshore drilling business. Even without ordering any more newbuilds for the next year or so, there are 16 new ships already ordered that will be coming online over the next couple of years.
Sure, there will be some short-term weakness in the offshore market (read: in the next year or two), but the majority of this weakness will affect older and less capable operators much more heavily than it will affect Seadrill, because Seadrill has more ships that can drill in deeper water and harsher conditions than its competitors do.
On the quarterly earnings call in late August, CEO Per Wullf brought up two statistics that highlight how Seadrill really is better positioned than its peers for the future. First was a comparison of Seadrill's fleet to the competition. The average Seadrill peer has 38 ships in its fleet that were built before 2000, while Seadrill only has two. Simply put, Seadrill's fleet is decades more advanced than its competitors, making it the best positioned of the offshore drillers.
The second statistic paints a picture of concern, but also how the proper context makes what looks like a risky situation into one that puts Seadrill in the driver's seat again. There are around 500 jackup rigs in operation offshore globally, with another 140 or so newbuilds currently in some stage of construction. Combined with the current softness, this paints a picture of dayrates getting hammered as the market becomes oversupplied with assets.
However, Wullf also points out that close to 250 of the current jackup rigs in operation are more than 30 years old, meaning that these rigs can't participate in the vast majority of new offshore discoveries, because they can't reach that far underwater, drill deep enough in the ground, or operate in those conditions. Seadrill management is relatively secure in their ability to navigate the rough waters in the near term as the asset base resets over the coming years.
Managing capital allocation to prevent double-whammy
Since the debt debacle a couple of months ago, Seadrill has indeed taken steps to slow the growth of its debt – at least for now. While some of the decline in the stock price is tied to the company's decision to slacken the pace of expansion, there are also fears that even high-spec ships will see reduced dayrates in the near term.
If this happens, the risk for Seadrill is twofold: The company pays an outsize amount of capital to support its enormous dividend, which management says it will sustain for now. If dayrates drop significantly enough, the company's massive debt -- and the large cost to service this debt -- could force management to reduce the dividend so as to service the debt.
This could lead income-seekers to exit the stock, which in turn would send the stock price falling. Double-whammy.
However, it looks like this is very unlikely. Management is readying the company to deal with this possibility by slowing the pace of expansion for now. The offshore market will work through the current short-term uncertainty around dayrates. This will give Seadrill time to revisit its growth strategy and make the best tactical decision around newbuilds once there's more certainty around demand and dayrates.
Selling? What about buying today?
Honestly, I think Seadrill is a buy today. Much of the pummeling the stock has taken is related to short-term risks that haven't changed at all, and nothing material that's altering the story.
The reality is, the opportunity and the risks are largely unchanged today versus what we knew earlier this year. The offshore market will continue to bifurcate, and short-term softness will be the reality. But looking out two or more years into the future, Seadrill is still most likely to be the best-positioned operator in the deepwater, ultra-deepwater, and harsh-condition segment of the offshore drilling industry.
With that said, I'm keeping management on a short leash, because it's critically important that they stay laser-focused on capital allocation while the market remains soft. The stock could fall farther, but the business is not in worse shape today than it was when the stock was 25% higher. In truth, it could be stronger.
