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Drill Below The Surface To Find The Hidden Well Of Value In Seadrill

June 26, 2014 | About:

I am always looking for industries that are critical to the survival of civilization as we know it but have fallen into disfavor with or simply being ignored by the mainstream of investors. Energy production is one of those crucial industries that the world can’t live without and offshore drilling is the industry segment that has become its ugly stepchild.

Between the lingering fear that remains from the Deepwater Horizon catastrophe that occurred on April 20, 2010 to the explosion on the scene of onshore horizontal drilling and hydraulic fracturing in the U.S. shale formations, what little thought most people give to the offshore oil and gas industry today is either very negative or very little. That makes our opportunity very big!

Looking Beneath The Surface For Real Value

The offshore drilling industry is filled with well-run businesses that are attractively valued. Several of them also offer very generous dividends for today’s zero interest world. At first glance, this industry is loaded with bargains. However, very few of us can afford to take positions in all of them so it is important to select the best choice. As it turns out, what I now believe to be the current best choice would not have been my selection after I had made my preliminary first pass.

As a value investor, my first concern is the safety of my capital and I generally want to buy businesses that have little to no debt. The business I have uncovered today has a debt to equity ratio of 1.15. Normally a number like this would cause me to run for the nearest exit. However, one of the things I learned watching private equity operators work is that while most debt is bad, there is such a thing as good debt. In a business sense, debt that allows a business to generate returns on equity far in excess of the cost of the debt and the overall industry average is actually leveraging capital in a very efficient manner and can lead to enormous percentage gains in the percentage return on equity for shareholders.

Debt can also be a good thing if the company easily generates enough cash from operations to service the debt and the use of the borrowed funds will provide the business with a competitive advantage in the market. Today’s selection delivers on both accounts. It borrowed heavily when with interest rates at historic lows while investing the money in the most modern and efficient equipment in its industry while demand for the equipment was at a low. This allowed the company to buy the best equipment available at the lowest prices possible and pay for it with money borrowed at some of the lowest rates in my lifetime. Sweet deal and very shrewd on the part of management. Even after taking on this high debt load, the business still generates enough cash to cover its interest payments 13.27 times over. This number soundly beats the industry average of only 7.39 times interest coverage even though my target company has a debt to equity ratio about 50% higher than the industry average of 0.71.

The business that almost slipped past my notice is Seadrill Limited (SDRL) and, believe it or not, the conditions I have just described are the worst part of the financial aspects of this offshore drilling company.

Insist On Being Rewarded For Allocating Capital

If we are going to be successful as small investors, we must insist on only purchasing shares in businesses run by people who understand that their job is to reward shareholders handsomely for the use of our capital. With a current dividend of $4.00/share and a yield of 10.2%, Seadrill certainly appears to be treating its shareholders very well indeed. However, it is critical to assure ourselves that the dividend rate is secure. It is.

Seadrill’s dividend only requires a payout ratio of 34.52% which is not only easily sustainable; there is still lots of room to comfortably raise the exiting payout. I generally consider payout ratios under 45% to be very comfortable.

The price to cash flow for Seadrill is a very reasonable 10 times. This means it would only take the company 10 years to earn enough spendable cash to buy itself at the current price. It could issue bonds at 5%, pay the interest and still have 5% free cash left over to pay the private owners. While 5% might not seem like much, you have to realize that the people who would be collecting it would have also borrowed all of the money required to buy it through the sale of those 5% bonds. It is hard to find an investment where you could buy it all with borrowed money and still take out 5% of the market value every year for yourself. This is a cheap business.

So, What If Rewarding And Cheap Is Not Enough?

It is unusual for me to find myself in a position where I cannot find more opportunities than I have available capital with which to take advantage of them. This is a very good problem to have as an investor as it allows me to be very particular as to where I allocate my capital.

Three of my favorite overlooked metrics for valuing businesses are returns of equity, assets and capital. The most important pure metric for me is the 5-year return on equity. That reveals how rapidly management is increasing the unencumbered value of the portion of the business owned by the shareholders. In my mind, this metric can be used to compare one business to another without regard to the individual industries in which they are involved and provide an excellent way to compare either businesses in the same industry or two or more businesses in completely different industries. Seadrill has produced a 5-year average return on equity of 29% per year compared to the industry average of only 8.86%. 29% annual return on equity is the kind of number normally reserved for pharmaceutical or software, not a drill company (as evidenced by the industry average of 8.86%).

Seadrill also outperforms its industry counterparts when it comes to producing returns on assets and capital as well. In these two areas it has delivered 5-yr annual returns of 8.4% and 8% respectively compared to the industry averages of 4.5% and 5.26%.

Now, if you think that you would have to pay a high premium to the rest of the industry to acquire a company that is outperforming its counterparts so dramatically and, like me, you would be mistaken. Seadrill is currently trading at a very reasonable multiple of 13.06 times estimated earnings for 2014 which is actually slightly below the industry multiple of 13.9 times earnings.

But, just to sweeten the pot a bit more, Seadrill’s forward 5-year estimated earnings growth rate is projected by analysts covering the stock to be 23.7% per year while the industry average is expected to grow 17.7%. If Seadrill’s share price simply traded at a multiple of the current year’s estimated earnings time the 5-year projected growth rate, the share price would have to rise about 50% from the current level.

In October of 2012, shares of Seadrill were changing hands at $41.95 and the business was going to earn $2.35/share for the year. Right now, shares are trading 6.6% below that price but the business is expected to earn $3.00/share this year or 27.7% more than it did in 2012. Rising earnings and decreasing share prices are like an untapped oil well deep beneath the floor of the ocean. There is great upward pressure building and when the release point it reach, it is going to explode upward in dramatic fashion and in both cases, those involved in the operation at that time are going to be showered in profits.

Final Thoughts And Actionable Conclusions

The energy services industry is one that the world as we know it cannot live without. The offshore drilling industry is a critical aspect of the industry’s ability to supply the energy that will be required to meet the long-term needs of the human race as living standards continue to rise around the globe. And, unlike the businesses involved in the hugely popular onshore drilling and hydraulic fracturing industries, offshore drilling is being pretty much ignored today and is, therefore, attractively priced.

I always like investments that offer more than one attractive approach to opening a new position. Seadrill fits the bill here quite nicely. There are two potential ways to open a new position that I find quite appealing right now.

The first attractive option available is for the more passive investor seeking to take a position and kick back for three to five years while enjoying annual returns of 15% to 20% through dividends and capital gains as the stock price moves toward fair value, which I calculate around 15 times free cash flow or $60/share.

The second option, and my personal favorite, is to employ a buy/write strategy where the stock is purchased and simultaneously one covered call option is sold for each 100 shares of the stock purchased. The advantage to using a buy/write strategy is that my broker only charges me commissions as if I had only made one trade instead of two. Based on Wednesday’s closing prices, the July 19, 2014 $41 strike price call options had a bid/ask spread of $0.25 to $0.30/share. Selling call options at the bid would result in an immediate premium equal to 0.64% of the $39.19 price of the stock. Over the 23-day life of the options, this would produce an annualized rate of return on the capital of 10.15% plus the 10.2% dividend yield. If shares of Seadrill were to close above $41 on July 19th, the shares would be called away and the option seller would collect a short-term capital gain of 5.25% plus the 0.64% option premium for a 23-day gain of 5.24% or 83.15% annualized rate of return on the full amount of capital allocated to the trade. According to my option probability calculator, there is a 71.16% chance these covered call options will expire worthless and I will simply keep the premium collected and the shares as well.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 20 years. On July 20, 2012 he launched the Self-Made Millionaire Tracking Portfolio with a portion of his capital as an aid to teach younger members of his extended family how he built his own investment portfolios and maintains them today.

Ken's Self-Made Millionaire website now has subscribers in at least 13 countries and the Self-Made Millionaire Tracking Portfolio has delivered a 28.36% annualized rate of return on capital between July 20, 2012 and June 21, 2014.

In late December of 2013, Ken added the Maggie's Money Mountain Tracking Portfolio to his website to show young investors with limited capital how he would invest and trade an account with $4,500 in order to grow it at a compounded rate of 12% annually. From December 30, 2013 through June 21, 2014, this account has produced an actual return of 26.05%.

Visit Ken McGaha's Website


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