Companies often talk about investing in the future as the way they'll grow for years to come. Seadrill (NYSE:SDRL) has epitomized that investment, spending billions to expand its footprint in the offshore drilling market.
But just how much are they investing in the future and how much money are they making on that investment? Using data from S&P Cap IQ we can look at how much Seadrill is spending to expand its operations over just maintaining its fleet.
How capital expenses can show us growth
One way to look at investment in the future is to measure capital expenditures versus depreciation of previous expenditures. When a large piece of equipment, in Seadrill's case an offshore drilling rig for example, is purchased the cost goes on the balance sheet as a capital asset. Then over the next three to 30 years, depending on the item, a slice of cost from that purchases is expensed in the form of depreciation on the income statement.
In theory, if a company is spending more on capital expenses than their depreciation expense, they're investing for future growth, not just replacing old equipment. So, why is Seadrill primed for long-term growth?
The billions Seadrill is spending on new rigs
To grow its business, Seadrill really only has two options. It can increase dayrates, which are set by market forces, or spend capital to buy new drilling rigs. This has been Chairman John Fredriksen's strategy since he founded the company and it has continued in a big way over the last five years.
Between 2009-2013, Seadrill spent $11.9 billion on new drilling rigs and recognized just $2.6 billion in depreciation. In other words, it's investing far more in growth than the cost associated with the aging of its fleet.
This isn't the end of Seadrill's growth either. You can see below that Seadrill is planning to acquire seven more rigs in 2015 and eight in 2016. This will do two things for Seadrill. It will help increase revenue as new rigs enter the market, but it'll also further improve its market position. We've seen in recent years that high specification and new drilling rigs are getting far more demand than older rigs, which are fighting for contracts based on price alone.
If Seadrill's strategy is correct, spending on new rigs will drive growth and strong profits in coming years. But just how much money is Seadrill making on its new drilling fleet?
Return on capital expenses
What's made Seadrill a top performing offshore drilling stock over the past decade are the returns it's made on past capital expenditures. One of the best measures of return on capital expenditures is return on assets, which in Seadrill's case are dominated by large assets. As you can see below, returns have accelerated in the past year.
The strong return on equity is due to debt Seadrill has used to leverage the earnings from new assets. But remember that leverage magnifies returns on assets both to the upside and downside. If returns on assets fall, it'll be magnified in returns on equity, which is the risk investors are afraid of in the low oil price environment.
Driving future earnings growth
There's no doubt that Seadrill is investing more than enough money on capital expenses to grow its business. In fact, capital spending and high returns on assets have driven Seadrill's stock growth over the past decade, and if new rigs are completed as planned that investment in future growth will continue.
The only question is whether or not high returns on assets and equity will continue now that drilling contracts are becoming more competitive. If returns remain high Seadrill will be a hot stock again and return to old highs. But if dayrates fall significantly the business could be in serious trouble.
Travis Hoium manages an account that owns shares of Seadrill. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill. 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.