Recently, JPMorgan Chase's Daniel Butcher and team said they think Seadrill (NYSE: SDRL) will require "major evasive action" to dodge "covenant breaches in 2016 or 2017":
Offshore driller Seadrill is exposed to backlog risk and low levels of new fixtures, due to a moribund offshore rig market, which is unlikely to fully rebalance this decade. Its newbuild rigs are uncontracted and due for delivery in the next 24 months, but Seadrill should be able to mitigate further capex via negotiations. Most high-value floater contracts expire in 2016/17, at a time when the offshore market needs to shed over 250 rigs to rebalance...Its share price implies its rigs are trading at 77% of peak construction cost but they average five years old. We see EBITDA risk vs. consensus of -5% in 2016 and -22% in 2017.
I agree with the JPMorgan team that evasive action is necessary. However, I try to look beyond what the market has already priced in. Here's my contention:
They have one of the newest and best fleets in the industry they should benefit immensely versus the competition when drilling ramps up again. The company has 93% economic utilization and is still cash flow-positive. The strong backlog and contract coverage should allow them to weather the storm in the short-to-medium term. This will help pave the way for long-term gains when drilling picks up again. Because Seadrill has one of the newer fleets in the industry it will help Seadrill secure new contracts as the market comes into re-balancing. The newer fleet combined with the backlog should help them weather the storm. Also, the modern fleet makes them a prime takeover candidate at 11% of tangible book value.
Figure Source: Seadrill Company Presentation
It cannot be overstated enough how important great operators are in commodity businesses. Management is well known as one of the best in the industry. Chairman John Fredriksen still owns around 25% of the company. He's built his fortune in the shipping and offshore drilling industry and is well known in the industry for being a best-in-class operator.
The company has proven itself to be incredibly shareholder friendly in the past, returning capital of about $6.2 billion to shareholders mainly in the form of dividends. The company is pulling back on share buybacks and dividends as it pays down debt. I believe this is the right move, as I expect buybacks and dividends to add to the catalysts when operations stabilize and turn for the better. The suspension of the dividend should help with liquidity and further pay down debt in the coming quarters. The company is willing to endure short-term pain for long-term success.
What to expect next
Let's make no bones about it: Seadrill is not a high-quality company. Excess debt is the killer of businesses, and it eventually comes home to roost in one form or another. Seadrill is no exception. However, the company is already priced for disaster. The stock is already down about 80% in the past 12 months. The question now is whether it will be able to weather the storm.
The answer depends on global oil prices. Prices have yet to stabilize, and although I think we're nearing the end of the downturn, time will tell and the ride will be bumpy.
Like many companies in distress, Seadrill offers an unusual asymmetric risk/reward profile. The company could be a zero, or it could become worth more than $10 per share. We know the negatives and how dangerous the environment is right now, and the situation is likely to persist into 2016 and 2017. However, the market may already be pricing in a potential bankruptcy or dilution of shares, as the company trades at about 11% of tangible book value.
Bottom line
Conservative investors may be more interested in many of the integrated oil and gas players, including ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX), British Petroleum (NYSE: BP), and ConocoPhillips (NYSE: COP). Also, midstream companies such as Phillips 66 (NYSE: PSX) are likely to do well in a lower oil-price environment as demand and profit margins pick up.
Taking a basket approach toward these depressed companies, rather than trying to pick the survivors, is another approach for conservative investors.
But as investors, we're in it for the long haul, and the value in Seadrill appears attractive at 11% of tangible book value. The company continues to decrease debt and capex, as well as push back delivery for new ships. It's a leader in the ultra-deepwater drilling industry, with a modern and versatile fleet, and it's run by one of the top operators in the industry. That industry is going through a structural change, but the world will continue to need offshore oil to fuel the growth of its countries. Investors could even take a conservative approach here by considering a combination of equity and bonds, and I may well purchase bonds in the next few days. The bottom line is that the risk-reward scenario looks intriguing at these levels for the enterprising investor.
