SeaDrill Rigged for Success

03/02/2012 4:31 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The tight market for oil drilling rigs boost companies that can expand aggressively, like this high-yield-paying Norwegian firm, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.

Scary financial engineering, or buying opportunity?

As is usual with SeaDrill (SDRL), some of both. But I think the final addition comes out on the plus side, and I’m going to buy shares (the New York traded ADRs, actually) of this very aggressive Norwegian ocean drilling company for Jubak’s Picks today.

SeaDrill announced another bit of financial engineering yesterday. Hemen Holding Limited, a company controlled by trusts established for the benefit of John Fredriksen, chairman of the board at SeaDrill, and his family, announced that it had sold 24 million shares of SeaDrill stock.

After the sale, Hemen will still own 109 million shares of SeaDrill. The company has about 470 million shares outstanding so a sale of 24 million shares amounts to about 5% of total shares.

SeaDrill’s American Depositary Receipts were down 3.1% yesterday, and today have fallen another 1.4% with the general market as of 12:30 p.m. New York time.

The selling news is enough to give anyone pause—after all, investors are rightly told to beware of stocks where insiders are selling massive numbers of shares. But I think, after looking at the deal, I’m going to recommend SeaDrill as a buy anyway—although I do think you might want to build this position slowly, in case the selling by Hemen drives the price lower in the next few days.

The sale by Fredriksen has more to do with his ambitions to buy a fleet of oil tankers for his new company Frontline 2012 than it does with any desire to cash out on SeaDrill. (Hemen also bought options to buy back the shares in the next 90 days.)

Fredriksen split his shipping company Frontline (FRO), where he is chairman, into two pieces in December, when it looked like Frontline might be running out of cash because of a collapse in day rates for oil tankers. Fredriksen’s strategy with his new company, Frontline 2012, is to buy capacity cheaply while the tanker industry is in turmoil.

Frontline 2012 bought ten oil tankers and the contracts for five more tankers still under construction from Frontline for $1.21 billion. Since then, it has ordered another six more tankers. So you might see where the cash from the SeaDrill shares could come in handy.

You buy SeaDrill with the understanding that financial engineering and Fredriksen go together. Unlike other drillers that work on keeping a strong balance sheet for the inevitable bad times in this cyclical industry, SeaDrill has always used its balance sheet aggressively by buying new rigs and then borrowing against them to buy more rigs.

It’s a strategy that works as long as the company can continue to tap financial markets for new funding, and as long as the market for rigs is tight enough that SeaDrill can cover its borrowing costs and then some.

(And I do mean then some. SeaDrill runs a very aggressive dividend policy as well—Fredriksen through Hemen does own 109 million shares, after all—with the trailing 12-month dividend yield at 7.76%, according to Bloomberg.)

I think the two recent rounds of three-year loans from the European Central Bank, which have put more than €1 trillion into the European banking system, have lowered the financial risk to investors from SeaDrill’s leverage. The odds that the European financial system will seize up are substantially lower than they were just a few months ago.

And day rates for ocean drilling rigs are climbing, as the oil industry puts the cash from higher oil prices into its exploration budget.

SeaDrill estimates that deep-water rig day rates will top $600,000 a day in coming months as the number of uncontracted rigs falls. You can see evidence of that in the company’s announcement this quarter of a signed contract for a new semi-tender rig still under construction.

One of the advantages that SeaDrill has in a tight rig market like this is that it has leveraged its way into a large fleet—50 rigs at the end of 2011 (second largest in the world, behind Transocean (RIG)—and a new fleet—the company had just 11 rigs in 2005.

With the oil industry putting a premium on up-to-date technology as a way to avoid a replay of the Deepwater Horizon disaster in the Gulf of Mexico, SeaDrill will earn premium day rates on its new fleet. (The company has another 14 rigs now under construction.)

I’d put a $49 a share target price by December 2012 on the ADR.

On February 29, SeaDrill raised its quarterly dividend to 80 cents an ADR, from 76 cents. The ex-dividend date is March 8. The dividend payout is scheduled for March 23. At the new dividend rate and at the $40.05 price at 3 p.m. New York time today, the projected yield is 7.99%.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.

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