After Slashing Its Dividend, Seadrill is Still the Best Offshore Drilling Stock to Buy Today

By Markets Fool.com

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Image source: Seadrill.

Seadrill shareholders undoubtedly have been disappointed by the recent performance of the stock, which has fallen72% in the last six months alone. But the offshore driller might still be positioned well ahead of competitors, not only because it has a young fleet of rigs, but because management has already made the tough call tosuspend its dividend.

Competitors such asTransocean and Noble would probably like to do the same, but they saw what happened to Seadrill's stock when it stopped the payout. That could scare them away from reducing or suspending their own dividends, but at what long-term expense? Painful steps to achieve long-term success are sometimes necessary, and that's one reason I think Seadrill is the best stock in the offshore drillingindustry.

Long contracts for drillships help give Seadrill a constant source of cash flow. Image source: Seadrill.

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Why dividends should be slashed in offshore drilling
Offshore drilling stocks are down due to uncertainty over when oil prices, and by extension offshore drilling contract activity and dayrates, will recover. Companies can rely on contracts that are already signed and in their backlog, but they can't have the same confidence on future contracts and cash flow.

Seadrill appears to have plenty of contracts to cover its costs for the next two years, and without a dividend, the company should have excess cash flow to fund newbuilds or pay down debt.

To gauge financial certainty at Seadrill and its two rivals,I compiled each company's reported backlog for the next two years, an estimate of ongoing operating expenses, newbuild obligations, and planned dividends.As you can see below, Transocean and Noble have significantly less certainty than Seadrill because their backlog and operating costs don't leave much room for error once 2016 hits.

Financial Gauge

Seadrill

Transocean

Noble

2015 Backlog

~$6.5 billion

$6.2 billion

$3.1 billion

2016 Backlog

~$5.9 billion

$3.8 billion

$2.2 billion

Annual Op. Ex (based on Q3 2014)

$3.3 billion

$6.6 billion

$1.5 billion

2015, 2016 Newbuilds

~$3.8 billion

$2.8 billion

n/a

Annual Dividend

$0

$1.1 billion

$388 million

Debt

$13.8 billion

$10.4 billion

$4.7 billion

Source: Company earnings releases.

Transocean, in particular, is weighed down by its newbuild and dividend obligations over the next two years. If the market downturn persists, Transocean as early as this year might notmake enough cash to pay its dividend; it would have to pile on more debt to fund newbuilds and a payout. That's not a position any company wants to be in.

However, just eliminating its $1.1 billion annual dividend obligation would give Transocoean flexibility to fund its own operations and debt repayment.

Cutting dividends is tough work
Management at Transocean and Noble probably want to cut or even eliminatethe dividend to open up some breathing room financially. But companies are hesitant to reduce dividends for a number of reasons, even if it's the right move for their business. Some investors see a consistent dividend as a sign of steady operations and panic when that payout is cut. The dividend might offer a false sense of security, but in the stock market, emotions often drive short-term price movements.

Other investors use a dividend as income, so if the payout is cut there's no reason to own the stock. Both reasons can cause investors to flee just on the mention of a dividend cut.

Investors should be looking now at where these companies are positioned today and how they will grow or profit in the future.Seadrill has the youngest fleet in the industry and I think it's well positioned to recover if and when oil prices rise and there is dividend payment pressuring its balance sheet. But it's also trading for a great value. Seadrill's shares trade for 4.3 times 2015 earnings estimates compared to a 7.5 multiple for Transocean and 8.4 times for Noble.

The pain of Seadrill's dividend cut has already been taken, so investors buying now are getting a stronger company at a cheaper price. If oil recovers the upside for investors is tremendous.

The article After Slashing Its Dividend, Seadrill is Still the Best Offshore Drilling Stock to Buy Today originally appeared on Fool.com.

Travis Hoium owns shares of Seadrill. 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.