Seadrill (SDRL, Financial) recently reported its 2Q15 results and amidst the bearish industry outlook, there are reasons to be positive on the stock. Seadrill is a value investment at current levels after the stock declined by 37% in YTD15 and by 79% in the last year. This article discusses the key reasons to be bullish on Seadrill.
Before moving to the main discussion, Seadrill doesn't seem likely to surge any time soon and therefore the investment horizon has to be for two to three years. In addition, I would caution investors that big exposure should be avoided in the offshore drilling sector. While the sector has value, investors still need to be cautiously optimistic.
Coming to company specific factors, I will provide a forward-looking analysis followed by key points in the recent results. The first point to note is that Seadrill has a firm order backlog of $1.0 billion for the remainder of FY15 and an order backlog of $3.0 billion for FY16. While Seadrill had an EBITDA margin of 57% for 1H15, even if a conservative EBITDA margin of 50% is considered for the remainder of FY15 and for FY16, Seadrill is positioned to generate $2.0 billion in EBITDA in the next 18 months. This would also imply an operating cash flow well in excess of $1.0 billion for the next 18 months.
The point is that, even if Seadrill fails to add to the order backlog in FY16, the company can still navigate the difficult times on the back of a strong order backlog. Therefore, Seadrill is well positioned to survive and generate decent cash flows even if industry conditions remain difficult through 2016. I focused on this point because Seadrill has mentioned that it expects industry conditions to remain challenging in the coming year. The potential to generate $2.0 billion in EBITDA also means that the company’s current debt level is not a concern and debt servicing will be smooth in the coming year.
Another important point from a cash flow perspective is that Seadrill recorded cash inflow from sale of business of $1.2 billion in 1H15, and this includes the recent disposal of West Polaris. With Seadrill looking to maintain a sound financial profile and avoid meaningful increase in debt, I expect more asset sales to come in the next 12-18 months, and this will provide liquidity for newbuild investment or debt reduction.
In the last quarter, Seadrill also made progress related to deferring of two floaters and eight jack-ups with two shipyards. This has resulted in FY16 capital expenditure decline from $2.1 billion to $1.75 billion while the capital expenditure in FY17 has increased to $1.1 billion from an earlier estimated $370 million. I believe that the offshore industry is likely to witness recovery in FY17 and Seadrill can potentially get contracts for new rig deliveries during that year.
A strong relationship with bankers is another point that works in Seadrill’s favor in these challenging times. I don’t see any difficulty in relaxing of covenants further in FY16 if there is a need. In addition, financing the new deliveries is unlikely to be an issue even if it is likely to come at a relatively higher cost of debt due to industry conditions.
Seadrill’s order backlog for FY17 is approximately $2.0 billion, but I expect the company’s order backlog (especially for FY17) to improve in the next 12-15 months. I am of the view that oil prices have bottomed out with production now declining in the U.S. and with the markets discounting the Iran oil supply factor. While oil is unlikely to surge immediately, I expect oil to gradually trend higher in FY16, and this will help improve the outlook for offshore drillers.
In conclusion, Seadrill is trading at attractive levels and investors who have the patience to hold the stock for 2-3 years can certainly consider exposure at current levels. However, as I mentioned at the outset, one need to be cautiously optimistic and small exposure can be considered instead of a big plunge in the stock.
