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Risk Rises in Seadrill to Challenge Share Price, but 10% Dividend Yield Looks Safe
05/29/2014 5:30 pm EST
Due to less demand, many oil companies have cut their capital expense budgets, so MoneyShow's Jim Jubak has decided to cut risk by selling the stock out of one portfolio, however, he's keeping it in another because he doesn’t see any near-term danger to the payout.
With Seadrill (SDRL), right now it’s not about the earnings (or even the EBITDA); it’s about the debt.
On May 28, Seadrill reported first quarter earnings of 65 cents a share, 2 cents below Wall Street consensus. Revenue dropped 3.5% from the first quarter of 2013 to $1.22 billion vs. the $1.41 billion consensus.
Seadrill is a member of my Jubak’s Picks portfolio and my Dividend Income portfolio. Yesterday I added another deepwater driller Ensco (ESV) to the dividend income portfolio. Ensco carries a lower yield 5.8% (to Seadrill’s 10.5%) but also much less balance sheet risk. The question is, given the cyclical slump in the deepwater drilling sector, do you want to have this much exposure to the sector?
Today, I’m going to say, “Let’s cut the risk a bit” and recommend selling Seadrill out of my Jubak’s Picks portfolio. I’m going to keep it, for the moment, in the dividend income portfolio because I don’t see any near-term danger to the payout.
Let me explain this decision.
The problem for the sector is that oil companies have cut, and continue to cut their capital spending budgets. That means less demand for drilling rigs and lower day rates.
The problem for Seadrill is that the company had an aggressive program for adding new rigs coming into this slowdown. That’s an especially important problem for this company because unlike less aggressive competitors, Seadrill doesn’t wait until it has a contract for a new rig before ordering it from the shipyards. In a sector slowdown, the worry is that new Seadrill rigs will hit the water without a contract at a time when contracts are hard to get.
The company has dealt with this problem in two ways. First, Seadrill has stretched out the delivery of those new rigs by about six months or more. That has pushed some of the 2014 schedule into 2015 and some of the 2015 deliveries into 2016. Second, Seadrill has set up a plethora of limited partnerships that are serving as financing vehicles. A rig owned by Seadrill might, for example, get sold to Seadrill Partners (SDLP). Seadrill Partners has raised money for this purchase by selling units in the public market (with a current yield of 6.14%.) After the purchase Seadrill Partners gets the cash flow from the rig that it now owns. Seadrill itself gets the purchase price to use to pay for those new rigs or to pay down debt or to make interest payments on existing debt.
Some Wall Street analysts have rightly pointed out that this strategy works only as long as Seadrill Partners and the other funding entities set up by Seadrill can tap the public markets for funding at a reasonable cost. The rigs that these partnerships are buying are working under contract already so investors don’t have to get worried about the partnerships’ ability to distribute cash unless this downturn lasts so long that the current contracts expire and market conditions don’t permit their renewal at comparable rates. So far that’s not an issue but Seadrill’s partnerships do have a full schedule of financing this year. If/when the price of these partnership units falls, these partnerships will wind up paying more for that financing.
In other words, part of the risk in Seadrill is that the down cycle for the sector will last beyond the 2016 horizon that the company now projects.
Within that period, Seadrill feels confident—at least the company sounded that way in its May 28 conference call—that the relative youth of its drilling fleet will shield it from the worse effects of a sector slowdown. Seadrill noted that oil industry demands for drilling in increasingly deep water makes the newest rigs—what the company calls Generation Six—more valuable than Generation Four and Five rigs that can’t work in these deeper waters. That makes it likely that the rigs that will be taken out of service in this slowdown—“stacked” is the industry term—will be predominantly older rigs. Which gives the newer rigs owned by Seadrill (and by recent pick Ensco) a good shot at continuing to gain contracts and at relatively higher rates.
The company’s point is a good one, I believe, but again the logic depends on the length and severity of the cyclical downturn.
I’m willing to wait out the cycle at this point, if I get paid to do it. I think the likelihood is, however, that continued softness in the drilling sector over the next quarter or two will make it very hard for Seadrill’s share price to move up. (Frankly, I’d be happy if it managed to hold its $38 to $40 range.) Which is why I think that Seadrill with its 10.5% yield remains a more attractive dividend play—and belongs in a portfolio that is focused on income—than it does as a capital appreciation play.
And that’s why I’m selling it out of the Jubak’s Picks portfolio but keeping it, for the moment, in the dividend income portfolio. The caveat is that this one needs very careful watching since you certainly don’t want to see a permanent loss of capital that eats through all the dividends that Seadrill pays out. (By the way, I think the announcement of an increase in the quarterly dividend to $1.00 from 98 cents is essentially window dressing. I’m not sending it back, mind you, but I’m not seeing it as a major affirmation of the company’s strategy either.)
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of Seadrill as of the end of March. In preparation for closing the fund at the end of May, as of the end of March I had moved the fund’s holdings almost totally to cash.
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