Full Throttle Ahead

02/25/2014 12:00 pm EST

Focus: MLPS

Jim Jubak

Founder and Editor, JubakPicks.com

This company has managed to differentiate itself from all the other deepwater drilling fleet companies, writes MoneyShow's Jim Jubak, who thinks it offers plenty of advantages for adventurous investors.

Seadrill (SDRL), the owner of the world's second largest deepwater drilling fleet, knows only one speed—full throttle ahead. And right now, that's making investors and traders nervous. The Norwegian company has eight drill ships, three semis, and 11 jackup rigs on order, at a time when day rates for rigs are slipping and worries are rising about oversupply due to oil company cuts in capital spending.

Shares of Seadrill, that traded as high as $47.78 on September 18, have tumbled to close at $37.68 on February 24. That's a drop of 27% in five months. That drop in share price has taken Seadrill's dividend yield up to 10.11%. That's not all a result of a falling share price though—the company raised its dividend payout by 4% in the fourth quarter. (Seadrill is a member of both my Jubak's Picks and Dividend Income portfolios.)

That's a very attractive yield—unless, of course, the yield is signaling deep trouble at the company or in its sector.

We're talking about a sector that, historically, has been subject to big swings, as companies order lots of rigs during flush times when the day rates that oil companies will pay are high, and then see all those orders create an oversupply of rigs that sends day rates tumbling. Most of the companies in the sector cope with those swings by building strong balance sheets that can withstand the rigors of an extended downturn.

Seadrill has never worked like that since John Fredriksen put the company together in 2005. Seadrill uses leverage, lots and lots of leverage, to get the most cash flow it can out of its rigs in the shortest possible time. Seadrill typically finances a rig with debt rather than cash flow and then uses sales and leasebacks to recoup cash from those rigs as quickly as possible, rather than over the 30-year lifetime of a rig. Right now, for instance, Seadrill is using a master limited partnership, Seadrill Partners (SDLP) to raise cash in the financial markets. Seadrill Partners then uses that cash to buy assets—such as drilling rigs—from Seadrill itself. Seadrill owns about 80% of Seadrill Partners (which yields 5.6% currently). Selling rigs to Seadrill Partners lets Seadrill leverage cash for its building program (without diluting existing shareholders). In addition, the structure gives Seadrill enhanced liquidity—the company can sell the partnership units it owns far more easily than it could sell a rig—if it needs to raise cash. And the structure of the limited partnership gives Seadrill an added dividend payout if cash available for distribution exceeds payouts established in the master limited partnership offering for common and subordinated partnership units. (This structure is currently a big favorite at Seadrill. Last year, the company created another partnership North Atlantic Drilling (NATDF). North Atlantic Drilling currently pays a 10.34% yield.

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These financial structures—a hallmark of a Fredriksen company—do indeed provide useful leverage, some downside protection, and a high dividend yield to owners of Seadrill stock (including Fredriksen, who owns about a third of the company's shares).

But the ultimate direction of Seadrill shares depends on whether the recent slippage in rig day rates—down to $575,000 in November from $600,000 on average for deepwater rigs, Pareto Securities estimates—is a temporary blip or the beginning of a cyclical downturn.

Looking at Seadrill's customers, I'm inclined, so far, to the temporary blip camp. Seadrill is heavily exposed to Mexico's Pemex, for example, and that national oil company looks to be increasing its deepwater drilling in the Gulf of Mexico. In November, Seadrill announced a tentative agreement with Pemex for five jackup rigs.

There's good reason to believe that, even in the current market, Seadrill will be able to collect premium day rates. Seadrill's fleet is heavily biased toward deepwater and ultra deepwater rigs, which earn the highest rates. 92% of Seadrill's floaters are ultra deepwater rigs. (Ensco (ESV) has the second highest concentration of ultra deepwater rigs at 55%.) And the company's fleet is substantially younger—again increasing day rates—than those of competitors. Seadrill's average floating rig is just a little over five years old. The next youngest fleet, that of Ensco, averages 12 to 13 years old.

Seadrill itself believes that supply of drilling rigs will remain tight. The company is seeing customers push out drilling projects by a year rather than cancel them and it points out that delivery of new ultra deepwater rigs looks to peak in 2014. In the jackup rig segment, the extreme age of the fleet has led to a pickup in scrapping and salvage, beginning in 2011.

I certainly wouldn't call Seadrill a dividend stock for the cautious. But, at better than a 10% yield, I think you're getting well paid to ride out the current drop in the share price. As of February 24, I'm leaving my target price at $49 a share, but stretching it out to February 2015.

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 may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Seadrill as of the end of December. For a full list of the stocks in the fund see the fund's portfolio here.

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