I have remained bearish on offshore drilling stocks since the second half of 2014. While I have always maintained that Seadrill (SDRL, Financial) has healthy credit metrics, investors can still avoid exposure to the stock.
Seadrill is trading at attractive valuations, and long-term investors can consider small exposure to the stock at these levels. These are the key points in the company’s 3Q15 results.
Investors should note that a “neutral” view does not necessarily imply that the stock will bounce back immediately from oversold levels. There is minimal downside risk from these levels and meaningful upside potential considering a long-term horizon. It is worth noting that, even after Seadrill missed earnings estimates and the company reported a $1.8 billion loss on write-downs, the stock trended higher by 2.4%. This is an indication of bounce from oversold levels.
Geopolitical tensions are increasing globally, and this has contributed to some rally in oil. In particular, the Middle East being the focus zone, oil can rally further if tensions remain elevated.
Coming to the positives, even in the current scenario, Seadrill has order backlog of approximately $3.1 billion for the remainder of 2015 and for 2016. For 3Q15, Seadrill reported EBITDA margin of 55%. Considering the same EBITDA margin for the next five quarters, an order backlog of $3.1 billion would roughly translate into EBITDA of $1.7 billion. This clearly implies that Seadrill is unlikely to face any debt servicing-related issued over the next 15 months.
Further, Seadrill also has an order backlog of approximately $1.8 billion for 2017. According to the management, the offshore drilling market is likely to remain challenging through 2016 with recovery likely in 2017. If this holds true, Seadrill can see robust backlog addition for 2017. However, even a backlog of $2.0 billion to $2.5 billion will ensure that the company’s debt servicing is smooth for 2017. I am analyzing the credit perspective as that’s the single biggest risk for offshore drillers. Nearly all offshore drilling companies have leveraged for growth during good times.
While the order backlog is a positive, the concern that I see in the foreseeable future is related to the company’s new rig program. As of September, Seadrill still had $3.9 billion in yard installments with a major portion due in the next 12 to 24 months. If challenging times sustain, Seadrill will have to increase debt to take delivery of new rigs that can potentially remain uncontracted. However, Seadrill is negotiating the delivery timelines with the yards, and the outcome remains to be seen. This is one point that investors need to watch closely.
From an investment perspective, I see the following point from the management as the crux of the investment idea:Â “It is important to recognize that we are in a cyclical business. The longer this downturn lasts, the more robust the recovery will be when it happens. Seadrill is in a position to capitalize on the upturn with the most modern fleet and world class operations."
When recovery starts, it is likely to be swift, and the stock will move higher accordingly. Current levels are for value investment and not when the markets are well into the recovery phase. Still, small exposure to the stock is recommended with the risk of industry conditions remaining challenging into 2017.
Seadrill expects $30 million lower EBITDA in 4Q15 as compared to 3Q15. The company’s 2016 outlook is also fairly clear on considering the firm order backlog. In my opinion, the negatives have been discounted, and the stock has minimal downside but meaningful upside potential from current levels.
Disclosure: No positions in the stock
