Seadrill Ltd (NYSE:SDRL) is deep into penny-stock land these days. A low-priced stock is often a bad investment. Just because it’s cheap, doesn’t mean it’s a bargain. Too often, while there can be huge gains in penny stocks, the risks are huge, as well. Given its recent problems, SDRL stock is not what it once was.
Seadrill used to be a high-flying company. Its shares traded in the double digits, offered a 10%-plus dividend yield, and appeared to be run by a brilliant manager. That perception has now changed.
Regardless of its past merits, the company has fallen on hard times. Its subsidiaries, such as North Atlantic Drilling Ltd. (NYSE:NADL), have lost virtually all their value. Drilling activity has declined sharply as the price of oil has remained persistently low. And now, even Seadrill looks to be facing a real risk of bankruptcy.
Trading for less than 50 cents a share, investors have to ask: Is SDRL stock a bargain here, or is it likely heading all the way to zero?
Let’s take a look at the pros and the cons.
Chapter 11 Risk: Seadrill built its empire on debt, big piles of it. Had oil prices held up, this strategy might have earned shareholders a fortune. But oil plunged before the company’s mortgaged assets were out of hock.
This has left the company with an untenable debt position. Seadrill is trying to address that risk, actively renegotiating with the bondholders. Management has said that it intends to finish up the process by July 31.
The trouble, though, is that the company has maintained that current common stockholders will likely receive “minimal recovery”. This suggests that the debt holders, as is generally the case, will get the lion’s share of new Seadrill equity as a result of any restructuring.
Overvalued Stock: With more than 500 million shares outstanding, SDRL stock is worth more than investors might think, even at 45 cents a piece. Do the math and you’ll get a market cap of around $225 million.
That’s a rather large figure for a company likely to enter bankruptcy. Most success stories surrounding bankrupt stocks generally hinge on the common equity’s market cap falling to a far lower level. Creditors may well hand out a few crumbs to existing SDRL stock holders, but they’re unlikely to give up anything close to $225 million in value necessary to justify today’s price, let alone enough to cause the stock to rally.
Bitter Economic Headwinds: Seadrill’s situation is particularly dire since the E&P sector remains deeply depressed. Each successive quarter see more of Seadrill’s rigs go off contract, causing revenues to further decline while the company’s interest burden remains unwaveringly high.
Any new contracts Seadrill can get are coming at far lower prices. A new contract for the West Freedom rig in Colombia, for example, will yield less than half the day rate that it had previously earned. Seadrill’s debtload is simply too high to endure such drastic erosion of revenue.
If the price of oil were already recovering, it’d be easier to take a gamble on the stock turning around. But with Seadrill’s operating position getting worse, there’s little reason to think the common stock has enough time to ride out the downturn before it is put out of its misery.
Chapter 11 Isn’t the End: While there is a good chance that Seadrill will file for bankruptcy protection, that isn’t necessarily the end of the road for SDRL stock owners. Creditors often give the owners of existing stock a small portion of the ownership position in the newly restructured company.
Seadrill is a viable business, still generating meaningful cash flow. The problem here is the excessive debt load; the company would have value if its interest burden weren’t so high. As such, the new equity should retain substantial value.
It’s impossible to know at this point just what share of new equity the current owners will get, however.
Heavily Shorted: As of most recent data, bears have sold short 22% of Seadrill’s stock. That is a high level. Short sellers have good reason to bet against SDRL and, so far, their positions have been quite profitable.
However, they are still pressing their bets, given that the stock is trading under 50 cents per share.
Due to many speculators’ preference for low nominally priced stocks, a 50-cent stock tends to rip to $2 or $3 in a short period of time far more frequently than you might expect. Also, most brokerages put heavy margin requirements on sub-$5 and sub-$2.50 stocks, making it harder for short sellers to maintain their positions as the price squeezes.
For anyone wanting to short SDRL, it’d be safer to wait until the company performs a reverse split and gets the stock back to a higher nominal level.
Rosneft Deal Extended: Seadrill has extended its agreement with Russian oil giant Rosneft. The pact commenced in 2014 and originally ran through May 2017. That’s now been extended until 2019, giving Seadrill a significant backlog of Rosneft projects that have been delayed due to low oil prices.
Rosneft recently stated that it intends to spend more than $8 billion on offshore projects over the next five years. Unfortunately, much of Rosneft’s Arctic oil isn’t economic at $50/barrel. However, the Russian energy giant seems committed to more development as soon as pricing improves. And Seadrill, particularly via its North Atlantic Drilling subsidiary, is positioned to benefit.
SDRL stock is little more than a gamble at this point. For shareholders to win, they need good results from the ongoing debt restructuring discussions. And, they need the price of oil to turn up, too. Time is likely to run out before that happens.
Had the drilling industry already turned the corner, it’d be easier to make a bet on Seadrill. But with the company’s revenue still falling, it’s hard to imagine a scenario where shareholders make out. With around $10 billion in debt, the company’s burdens are simply too big given the current drilling sector outlook.
For those that want exposure to the offshore oil market, a debt-free company such as Frank’s International NV (NYSE:FI) gives you far more time to wait for the market to turn.
As of this writing, Ian Bezek was long FI. You can reach him on Twitter @irbezek.