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Take the Chance and Buy Cheap for a Big Win

April 28, 2014 | About:

Accidents in the oil and gas industry have grave repercussions. Usually, the environmental damage and material losses associated with oil spills and gas explosions, have the potential to stall activities right away. Most important are the market synergies unleashed by such dramatic events. These, have profound effects on daily tasks with a lasting consequences over exploration, production, and transportation. A clear example is the requirement of double hull in the U.S. after the Exxon Valdez incident.

The Deepwater Horizon had a less visible effect but was no less important. First, new regulation prompted the development of new equipment. Second, companies active in the Gulf of Mexico are turning to Norwegian companies for their expertise. One of those companies is Seadrill (SDRL), which experienced a decline in stock face value. Hence, the drop may offer investors an opportunity to invest in a strong and competitive firm.

Analysts Don’t Always Get It Right

Five financial institutions issued a report on Seadrill, and four of them downgraded the stock. Out of the four in question, three granted the stock a “Neutral,” while Zacks gave it an “Underperforming” rating. On average, the face value target price remains above the $35 mark. However, the stock sunk below that mark at the beginning of March. The fact added further uncertainty about the company’s future performance, but did not stop the stock from making a comeback during the last week.

Recent improving performance responds to a series of indicators. First, Seadrill reached 94% utilization for floaters and 98% utilization for jack-ups. Second, new contracts for jack-up units ensure visible revenue growth for the company. Third, management decided to use future cash flows for the repayment of debt, rather than paying dividends. Hence, shareholders may not see a great reward in the beginning. But, investors while secure a share of the youngest fleet in the industry. Most important is the expansion of operations in the Gulf of Mexico, where three rigs are already pumping profits.

Another positive cue into the strength of Seadrill is the double-digit top and bottom-line growth reported for the first quarter of 2014. That did not stop analysts from downgrading the stock. A reasonable explanation for that behavior is the company’s high debt. Currently, debt-to-cash ratio stands at 200, comfortably above competitors Transocean (RIG), Ensco (ESV) and Diamond Offshore (DO). However, this is an issue management is progressively addressing, for example, with the cancelling of outstanding debt with the proceeds from asset sales.

A Questioned, but Proven Models That Delivers

Although high debt levels turn into trouble, and Seadrill is not far from them, it is important the model continues to deliver profits. In other words, debt levels for the company are high because it invests on capital, not due to an unprofitable business model. Most telling are the yearly improvements shown by total assets, net income and capital expenditures since 2009. At the same time, the average day-rate has climbed for all services: jack-ups, floater and tender rigs, and economic utilization has risen by 4% to 97% during the last two years.

When looking forward, Seadrill will benefit from the current demand for Norwegian know-how in relation to deepwater activities in the Gulf of Mexico. As of today, three jack-up rigs and a semi-submersible rig are on their way, in addition to one drillship, a semi-submersible and a jack up rig already operating in the area. Also, management displayed an important market reading ability, taking over rising opportunities while generating hundreds of millions of dollars in gains for shareholders.

Seadrill currently trades at 6.4 times its trailing earnings, carrying a 45% discount to the industry average. Moreover, it pays $0.85 in quarterly dividends, meaning the recent price drop took annual yield to 10.70%. Most important, the company holds one of the highest returns on capital and equity of the industry. And the confidence in the firm not shown by financial institutions has been demonstrated by the high quantity of new purchases during 2013. The company has a well-proven business model, which will began to address debt levels and reduce shareholder benefits in the short term. Nonetheless, it remains one of the best options for a long-term investment.

Disclosure: Vanina Egea holds no position in any of the mentioned stocks.

About the author:

Vanina Egea
A fundamental analyst at Lone Tree Analytics

Visit Vanina Egea's Website


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