It’s been a painful journey for Seadrill (SDRL, Financial) in 2014, and the stock has declined by 44%. In my earlier articles, I was of the opinion that one needs to wait before considering exposure to the stock. I believe that current levels are attractive enough for considering Seadrill. This article discusses the reasons for considering the stock as a buying opportunity with a long-term horizon.
Before talking about the valuations, I would like to warn investors that Seadrill can potentially reduce dividends when the company declares its results towards the end of this month. Seadrill offers a current dividend yield of 17.4%, and I believe that the dividend yield will decline to pre-crash levels of around 10%.
Investors can consider this negative, but I believe that this will be a positive step from the company’s financial health point of view. A reduction in dividend will help the company conserve its cash flow for payment of new rigs that are due for delivery in 2015 and 2016. The company will certainly need debt to fund the delivery of new rigs. However, dividend reduction will be a good idea in turbulent times as the company needs to stay comfortable on the debt servicing front.
Another reason for reducing dividends is the fact that a number of rigs will be going off-contract in 2015 and when these contracts are renewed, the likely day rates will be lower than the existing day rates. While the markets have discounted this point in the stock price, the dividends also need to be adjusted accordingly.
I am discussing this point in details as investors need not panic when dividends are cut. A likely dividend cut will be healthy for the company in the long term even if it brings some disappointment in the near term. I therefore expect a good accumulation range to be $20-$23 for the stock as the markets can react negatively (as a first reaction) to a potential dividend cut.
On to the point of valuations, Seadrill is currently trading at an EV/EBITDA of 9.47, which is attractive also considering a PE (2015E) of 7.1. While the company’s stock has suffered on lower oil prices and challenging day rates, it should be remembered that Seadrill has one of the most modern fleets in the industry and with more new rigs to be delivered in 2015 and 2016, the company’s modern rig will be a big positive when markets recover.
Modern rig owner like Pacific Drilling (PACD, Financial) is also trading at an EV/EBITDA of 9.71 and this means that Seadrill is trading largely in line with industry valuations. Seadrill is certainly larger in size than Pacific Drilling, but both companies have a modern set of fleet.
I also want to point out that investors need to be patient with Seadrill as strong recovery in stock price will come only after there is substantial recovery in oil prices along with renewed strong activity in the offshore drilling industry.
I believe that both these factors will be positive within the next 1-2 years. The decline in oil prices is temporary and a weaker dollar coupled with geopolitical tensions will send oil prices higher over the next 1-2 years. As oil prices move higher, also from demand coming from emerging markets, offshore drilling activity will also recover.
As Morgan Stanley also suggests, investors should stock with Seadrill for recovery in 2016. I believe that this is a good time to buy the stock because it makes little sense to buy Seadrill once the stock has resumed its upwards journey and is 20% or 25% higher from current levels. The depressed sentiments are a good time to buy quality businesses and Seadrill is certainly a good business to own for the long-term.
Even in the downturn, the company’s EBITDA interest coverage remains healthy and investors should therefore not be concerned about debt servicing. While the debt is likely to increase with delivery of new rigs, so will the EBITDA as the rigs are operational. But I do expect 2015 EBITDA to be weaker than 2014. Recovery in EBITDA margin is likely to come on or after 2016.
In conclusion, Seadrill is trading at attractive valuations after a big correction in 2014. Both external and internal factors have contributed to the decline in the stock. However, the company’s fundamentals and long-term prospects remain bright, making the correction an excellent buying opportunity.
