Why This Driller Looks Attractive Despite Its Recent Rally

Piyush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Crude prices have been hovering around the $100 mark for most of the year, which has made oil exploration a profitable affair (again). But hydrocarbon land reserves are depleting while inflationary pressures are adding up. This has made exploration of high margin oil fields almost a necessity.

This is one of the reasons why Seadrill (NYSE: SDRL) has been growing rapidly, despite having a debt ridden balance sheet.

Hefty dividends

Seadrill has a relatively higher debt/equity ratio of 220%, as compared to Transocean’s 70% (NYSE: RIG) and Ensco’s 40% (NYSE: ESV). On top of it, Seadrill sports a huge dividend payout ratio of 102% as compared to Ensco’ 30.4% and Transocean’s 85% (proposed).

On a quarterly basis, Seadrill paid out $0.85 per share, which aggregated to a quarterly payout of $398 million ($0.85 per share * 469.18 million shares). But its quarterly operating cash flows stood at just $241 million. To meet the shortfall, the company had to raise cash from various sources.

Although its trailing 12 months (TTM) operating cash flow of $1.59 billion are enough to cover its TTM dividend payout of $1.57 billion, the bottom line remains that Seadrill is over extending itself. The company also recently hiked its quarterly dividends to $0.88 per share (payable on June 20), but there is ample evidence that its cash flow situation could improve in the coming quarters.

Fattening cash flows?

From the chart attached below, it's evident that Transocean has been repaying its debt, while its peers have been accumulating liabilities. This is because Transocean isn't fully utilizing its resources, and is sitting on massive cash and cash equivalents of $3.68 billion. This has not only lowered its ROE, but also hampered its overall growth. Carl Icahn owns a 5.4% stake in the company, and he has been trying hard to shake-up things to revive growth. But he has been unsuccessful so far.

<img alt="" src="http://media.ycharts.com/charts/02727c25960e46bd10d7771492cc045c.png" />

Meanwhile Ensco's long-term debt has inflated faster than its peers. This is because of Ensco's acquisition of Pride International for $7.3 billion, carried out in 2011. This may have inflated its long-term debt to $4.83 billion, but has also allowed the driller to enter Brazilian and West African markets. The financial benefits of the acquisition began showing up late last year, which is why its fiscal year 2012 EPS grew by an impressive 70%.

Similarly, Seadrill’s high debt levels can be attributed to its recent acquisitions. The driller had acquired a 33.75% stake in Asia Offshore drilling for around $54 million, in November last year. This move would not only boost Seadrill’ operating cash flows, but allow the company to enter new Asian territories. Meanwhile Asia Offshore would use cash from the proceeds to order a new rig.

Recently, Seadrill also acquired an ultra-deep water semi-submersible rig for $590 million. Its overall utilization rate (quarterly) rose from 86% to 92% on a sequential basis, and a new addition to its fleet will be helpful in sharing the rising workload of its operating rigs.

Besides that, the company has also ordered four new jack-up rigs for around $920 million, which are expected to be delivered by 2015. It is estimated that each jack-up rig has the potential to generate $100 million in annual revenues, which will eventually add to Seadrill’s operating cash flows.

Valuations

From the standpoint of valuations, all three companies appear to be undervalued on a forward earnings basis.

<table> <thead> <tr><th> <p><strong>Company</strong></p> </th><th> <p><strong>Forward P/E</strong></p> </th><th> <p><strong>PEG</strong></p> </th><th> <p><strong>ROE</strong></p> </th><th> <p><strong>Gross Margin</strong></p> </th><th> <p><strong>5 yr. EPS growth est.</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p><strong>Seadrill</strong></p> </td> <td> <p>11.8x</p> </td> <td> <p>0.68x</p> </td> <td> <p>19.39%</p> </td> <td> <p>59.32%</p> </td> <td> <p>25.12%</p> </td> </tr> <tr> <td> <p><strong>Transocean</strong></p> </td> <td> <p>8.43x</p> </td> <td> <p>0.8x</p> </td> <td> <p>6.18%</p> </td> <td> <p>29.93%</p> </td> <td> <p>23.46%</p> </td> </tr> <tr> <td> <p><strong>Ensco</strong></p> </td> <td> <p>7.78x</p> </td> <td> <p>0.41x</p> </td> <td> <p>10.73%</p> </td> <td> <p>52.9%</p> </td> <td> <p>27.1%</p> </td> </tr> </tbody> </table>

However Seadrill enjoys the highest ROE along with the highest gross margins.

<img alt="" src="http://media.ycharts.com/charts/f678b7c8fe9f79ff054aa21b9a29464d.png" />

Its trailing price-earnings multiple (P/E) of 17 may seem high and even drive investors away, but the metric has actually declined significantly over the last year. There is a divergence in Seadrill’s P/E ratio and its share price, which suggests that its shares could head north (if its P/E is going to regain its value).

Final words

As of now, both Ensco and SeaDrill appear to be solid investments options. However Seadrill’s recent spurt of acquisitions coupled with a high dividend yield, seem to offer more value than Ensco. Obviously SeaDrill is more leveraged than its peers, but since it's a fast growing company with a high ROE, I believe that its pros outweigh the cons.


Piyush Arora has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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