Seadrill – The Driller For Mad Dogs And Englishmen

By Stephen D. Simpson, CFA | November 30, 2011 AAA

Investors in stocks like Transocean (NYSE:RIG) or Diamond Offshore (NYSE:DO) might not be feeling the love yet, but the offshore drilling market is actually starting to get better. With a very modern fleet, aggressive leverage and a healthy dollop of devil-may-care operating philosophy, Seadrill (NYSE:SDRL) is ready for that turn. The question for investors, though, is whether they can handle the risk and valuation that comes with arguably the most aggressive player in a highly cyclical sector.

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A Ho-Hum Third Quarter
The markets are still expecting the offshore drilling market to be more of a 2012 event, so Seadrill's third quarter earnings are not likely to be examined quite so closely. Revenue was okay, falling 4% from last year and rising 3% from the second quarter. Rates were not all that incredible this quarter, but utilization was quite good and the company is bringing more of its rigs under contract.

Profitability was a little disappointing. Although rig expenses did fall from last year, operating profit nevertheless declined and the company missed the consensus EBITDA target by about 5%. (To know more about EBITDA, read EBITDA: Challenging The Calculation.)

Encouraging Words About the Market
Seadrill management seemed pretty positive when presenting these results. In particular, the company believes that the ultra-deepwater market is starting to improve. At present, about 85% of the fleet is working in depths of 7,500 or less and management believes that rates are on a trajectory to top $550,000 per day by summer of 2012.

The jack-up market is more mixed. Specifically, this is really a market that is segregated by geography and rig quality. For premium rigs, like those offered by Seadrill, the market is getting better. That said, the Gulf of Mexico rig market is still pretty poor, with utilization running below 60% and rates still in a multi-year funk. That's a tough environment for the likes of Hercules Offshore (Nasdaq:HERO) and Parker Drilling (NYSE:PKD).

Seadrill has been holding off on signing more contracts in the expectation of higher rates, and the company is now getting them. In fact, the company now has only five existing rigs coming off contract in the next six months (and another 14 are under construction). Though that gives the company some vulnerability if rates really skyrocket, all in all Seadrill is in pretty good shape.

Ready to Go to 11?
Seadrill is not your normal offshore drilling company. Basically created by the same man who put together the struggling shipping company Frontline (NYSE:FRO), Seadrill is perhaps the hairy-chested lunatic of the field.

Forget the cautious new-build commitments and life-cycle management of Diamond Offshore has spent aggressively (and used debt to do so) to create one of the most modern fleets in the game - a key attractant for major oils like ExxonMobil (NYSE:XOM), Petroleo Brasileiro (NYSE:PBR) and Total (NYSE:TOT) in the post-Macondo world.

Moreover, the company pays a pretty considerable dividend and runs the business so as to reap as much cash flow as possible in the good times. Consequently, this is a company with a lot of debt and a lot of vulnerability to a prolonged down cycle.

The Bottom Line
Structured and run as it is, Seadrill will arguably benefit more than any other company from a recovery in the offshore market (an event that analysts have been expecting for about a year). It does not look cheap right now, but there's a good chance that Seadrill will get premium dayrates and solid contracts - arguably justifying a higher valuation than rivals like Transocean or Ensco (NYSE:ESV).

Transocean and Ensco are fine plays for that offshore drilling recovery, and ongoing demand for equipment should have Cameron (NYSE:CAM) on most investors' watch lists as well. But for sheer upside leverage to a strong offshore market and investor sentiment momentum, it may be hard to surpass the potential of Seadrill. (For additional reading, check out An Introduction To Corporate Valuation Methods.)

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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