Seadrill Is Worth Considering at Current Levels

Seadrill is discounting equity dilution and EBITDA margin contraction

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Mar 23, 2016
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When Seadrill (SDRL, Financial) announced fourth quarter 2015 results and indicated that the company will be going for restructuring in the first half of 2016, the stock gained strong momentum and touched year-to-date highs of $6.06 per share. Subsequently, the stock has corrected by 41% to $3.58, and the stock has been trading sideways for two weeks.

In my view, Seadrill has bottomed out after 40% downside, and these are attractive levels for exposure to the stock with a time horizon of three to six months. I am considering a limited time horizon as restructuring is the key stock upside trigger.

During the period Seadrill has corrected, oil has gradually trended higher, and it seems strange that higher oil prices have failed to generate positive momentum for Seadrill.

Seadrill is likely to announce restructuring in the first half of 2016, and that equity offering will be a key part of the company’s restructuring program. Therefore, the 41% downside after the big rally is due to Seadrill discounting the equity dilution factor. Once the restructuring plan is announced, the stock will resume upside; therefore this is a good time to consider exposure to the stock.

When Seadrill was trading at all-time lows, there was speculation on potential debt default, but I don’t see any debt-related crisis for Seadrill even when the offshore driller is significantly leveraged.

Seadrill has strong relations with bankers; once the company is able to provide sufficient cash cushion (through equity offering), it would not be difficult to negotiate with bankers on potential relaxation of covenants and restructuring of debt maturities. In the past, Seadrill has successfully negotiated with bankers on relaxing the debt covenants.

Even with depressed industry sentiments, Seadrill has a strong order backlog to service debt in 2016 and 2017. The key concern is new rig financing during this period coupled with debt maturities. However, resolution on both these points seems likely when Seadrill announces restructuring. In particular, it would be a big relief if Seadrill can cancel a few new rig deliveries.

Oil trending higher is a positive factor, but I don’t see strong recovery in the offshore drilling industry in 2016 and potentially into 2017. Even if oil trades at $50 per barrel or around those levels, exploration companies would still be tight on the break-even and several assets will not break even at $60 per barrel. New contracts for Seadrill will be at a significantly lower day rate on cost-cutting measures, and this implies EBITDA margin contraction in 2016 and 2017. This is another factor that is being discounted by the stock even as oil trends higher.

Overall, concerns still exist for the energy industry, but there will be good medium-term buying opportunities amid concerns, and Seadrill provides that opportunity at current levels. Once the company announces restructuring, 20% to 25% upside from current levels is entirely likely. However, I would still advise investors to remain cautiously optimistic and consider only small exposure to any energy name.

Disclosure: No positions in the stock.