Seadrill: Reckless or Shrewd?

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

Seadrill Ltd. (NYSE: SDRL) has been criticized for their aggressive Capital Expenditure (capex) program which is largely funded with debt. While it is true that their interest-bearing long-term debt to equity ratio (LTD/E) at 1.33, is 2 to 4 times higher than their peers, this does not mean that their debt load is excessive. As will be shown, Seadrill can afford its capex program and has shrewdly used low interest debt to expand and modernize their fleet, allowing them to nearly double their sales from 2008 to 2011, while sales for their more conservative peers have declined. Moreover, Seadrill has consistently grown their backlog year after year. And finally, their dividend is safe.

Seadrill Took Advantage of Historically Low Interest Financing

For the last 3 years, interest rates have been at all time lows. (See, http://www.wsjprimerate.us/prime-rate-chart.htm and http://www.wsjprimerate.us/libor/libor_rates_history-chart-graph.htm.)  SDRL took advantage of these historically low interest rates to greatly expand their fleet from 23 rigs at the end of 2008 to 48 (12 co-owned) today with 18 additional rigs under construction.   In 2010, the year of their largest expansion from 26 to 40 rigs, they paid an average interest rate of only 2.56% according to their 20-F annual report. Their average reported interest rate for the years 2008-2011 varied from 2.6% to 3.5%.

Meanwhile, Transocean Ltd.'s (NYSE: RIG) and Diamond Offshore Drilling, Inc.'s (NYSE: DO) fleets actually declined from their peaks in 2009 of 138 and 47 rigs, respectively to 129 and 40 rigs as of their latest fleet reports. In 2010 when SDRL had 16 rigs under construction representing 40.0% of their existing fleet, RIG and DO had only 4 rigs and 1 rig, respectively, under construction representing just 2.9% and 2.2% of their existing fleets, respectively. Although DO has gotten considerably more aggressive in their building program with 5 rigs under construction or 12.5% of their existing fleet today, RIG is only building 6 new rigs or just 4.7% of their existing fleet.

  

<table> <tbody> <tr> <td>Year</td> <td>Existing Fleet</td> <td>Rigs Under Construction</td> <td>Rigs Under Construction vs. Existing Fleet</td> <td>Average Calculated Interest Rate</td> </tr> <tr> <td><strong>2011</strong></td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>DO</td> <td>46</td> <td>3</td> <td>6.5%</td> <td>5.6%</td> </tr> <tr> <td>SDRL</td> <td>43</td> <td>16</td> <td>37.2%</td> <td>3.5%</td> </tr> <tr> <td>RIG</td> <td>134</td> <td>6</td> <td>4.5%</td> <td>4.9%</td> </tr> <tr> <td><strong>2010</strong></td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>DO</td> <td>46</td> <td>1</td> <td>2.2%</td> <td>6.1%</td> </tr> <tr> <td>SDRL</td> <td>40</td> <td>16</td> <td>40.0%</td> <td>3.9%</td> </tr> <tr> <td>RIG</td> <td>138</td> <td>4</td> <td>2.9%</td> <td>5.8%</td> </tr> <tr> <td><strong>2009</strong></td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>DO</td> <td>47</td> <td>0</td> <td>0.0%</td> <td>3.3%</td> </tr> <tr> <td>SDRL</td> <td>26</td> <td>8</td> <td>30.8%</td> <td>4.2%</td> </tr> <tr> <td>RIG</td> <td>138</td> <td>5</td> <td>3.6%</td> <td>5.7%</td> </tr> <tr> <td><strong>2008</strong></td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>DO</td> <td>45</td> <td>0</td> <td>0.0%</td> <td>5.4%</td> </tr> <tr> <td>SDRL</td> <td>23</td> <td>12</td> <td>52.2%</td> <td>3.8%</td> </tr> <tr> <td>RIG</td> <td>136</td> <td>10</td> <td>7.4%</td> <td>5.3%</td> </tr> </tbody> </table>

Based on their lower debt loads, you might think that RIG (LTD/E 0.68) and DO (LTD/E 0.34) would have paid lower interest rates than SDRL. But, you would be wrong. In the table above, the Average Calculated Interest Rate was obtained by dividing the total interest paid (both capitalized and expensed) by the total debt as of December 31. As you can see, SDRL obtained the most attractive financing.

Seadrill's Capex Program Has Paid Off

As can be seen from the following table, SDRL's sales rose 99% from 2008 to 2011, while those of their more conservative competitors, DO and RIG, fell 6.3% and 27.9%, respectively. 

 

<table> <tbody> <tr> <td> </td> <td> </td> <td><strong>DO</strong></td> <td><strong>RIG</strong></td> <td><strong>SDRL</strong></td> </tr> <tr> <td>Yr. ending 12/31/08</td> <td>Sales (M$)</td> <td>3,544</td> <td>12,674</td> <td>2,106</td> </tr> <tr> <td>Yr. ending 12/31/11</td> <td>Sales (M$)</td> <td>3,322</td> <td>9,142</td> <td>4,192</td> </tr> <tr> <td>Yr. ending 2008 vs. 2011</td> <td>Change in Sales (Y/Y)</td> <td>-6.3%</td> <td>-27.9%</td> <td>99.1%</td> </tr> </tbody> </table>

In addition, of the three, only SDRL's backlog has consistently increased from 2009 through the latest quarter. SDRL's backlog increased 32.7%, while DO's and RIG's backlogs decreased by 2.5% and 34.0%, respectively. More distressing for RIG and DO investors, both companies lowered their backlog estimates as of 3/31/12 vs. 12/31/11, while SDRL raised theirs. (More on the effect of these companies' investment decisions and fleets on their sales and also profitability can be found in two previous articles: (http://beta.fool.com/p366/2012/06/21/why-investors-should-care-about-offshoredrillers-/5831/) and (http://beta.fool.com/p366/2012/06/25/offshore-drillers-sales-are-nice-but-profits-are-s/6204/).

Clearly, SDRL's investments are paying off, but can they afford their resulting debt?

Can Seadrill Afford Their Aggressive Capex Program?

SDRL relies primarily on debt to finance their capex. Their Cash Flow from Operations (CFO) is not sufficient to fund their capex. To determine whether SDRL can afford their debt load, first let's see if there are any problems paying the interest. In the following table EBIT is Earnings Before Interest and Taxes and Interest Coverage is EBIT divided by the total Interest paid.

<table> <tbody> <tr> <td>Period Ended</td> <td>Total Debt in $M</td> <td>EBIT in $M</td> <td>Total Interest in $M</td> <td>Interest Coverage</td> </tr> <tr> <td>03/31/12</td> <td>10,668</td> <td>579</td> <td>99</td> <td>5.8</td> </tr> <tr> <td>12/31/11</td> <td>10,447</td> <td>2,039</td> <td>368</td> <td>5.5</td> </tr> <tr> <td>12/31/10</td> <td>9,592</td> <td>1,702</td> <td>371</td> <td>4.6</td> </tr> <tr> <td>12/31/09</td> <td>7,396</td> <td>1,781</td> <td>308</td> <td>5.8</td> </tr> <tr> <td>12/31/08</td> <td>7,437</td> <td>181</td> <td>281</td> <td>0.6</td> </tr> </tbody> </table>

Typically you want to see Interest Coverage of 1.5 or higher.  No sweat, except for 2008.  That was clearly a rough year and SDRL responded by reducing their capital spending in 2009 among other things.  The point is, they successfully dealt with the liquidity problem.

Second, can they repay the principal as their debt matures?  The following table is from SDRL's 6-K filing for the period ended March 31, 2012. Note: Total Debt here does not include $534 million owed to a related-party.

The outstanding debt as of March 31, 2012 is repayable as follows:

 

<table> <tbody> <tr> <td> <div><span>(In US$ millions)</span></div> <div><span>Year ending December 31</span></div> </td> <td> </td> <td colspan="2"> Debt</td> <td> </td> </tr> <tr> <td> <div><span>2012</span></div> </td> <td> </td> <td> </td> <td><span>1,285</span></td> <td> </td> </tr> <tr> <td> <div><span>2013</span></div> </td> <td> </td> <td> </td> <td><span>2,266</span></td> <td> </td> </tr> <tr> <td> <div><span>2014</span></div> </td> <td> </td> <td> </td> <td><span>1,610</span></td> <td> </td> </tr> <tr> <td> <div><span>2015</span></div> </td> <td> </td> <td> </td> <td><span>1,789</span></td> <td> </td> </tr> <tr> <td> <div><span>2016 and thereafter</span></div> </td> <td> </td> <td> </td> <td><span>3,284</span></td> <td> </td> </tr> <tr> <td> <div><span>Effect of amortization of convertible bond</span></div> </td> <td> </td> <td> </td> <td><span>(101</span></td> <td><span>)</span></td> </tr> <tr> <td> <div><span>Total debt</span></div> </td> <td> </td> <td> </td> <td><span>10,134</span></td> <td> </td> </tr> </tbody> </table>

Last year SDRL had CFO of $1,816 million which was over $500 million higher than in 2010.  So, if they do as well this year as last year, their CFO would easily cover the principal due.  However, in this same 6-K, the company mentioned that they are in advanced discussions to refinance a credit facility that matures in July and have received strong interest from both investors and US banks for this business at attractive terms for this amount plus as much as 70% more.  So, whether SDRL pays their short-term debt (STD) with cash or refinances it, it will not be a problem for now.  In addition, they are also considering a Master Limited Partnership (MLP) to partially finance 4-6 rigs, which would reduce their current shareholders' risk and potentially eliminate some of the outstanding debt.

Doesn't Seadrill Have Negative Working Capital?

Working Capital is defined as Current Assets minus Current Liabilities.  In their March 31, 2012 quarterly report, SDRL reported current assets of $1,943 million and current liabilities of $2,819.  So, technically, they had negative working capital.  However, $1,558 of their current liabilities was STD. Accounting rules permit excluding any STD, that is being refinanced,  from existing current liabilities.  Since SDRL is already exploring refinancing, subtracting STD from their current liabilities, reduces them to $1,261 million.  So, because of the refinancing, SDRL does not have negative working capital and their current ratio is 1.54 not 0.68 as has been reported elsewhere.

Okay, But Is the Dividend Safe?

One of SDRL's attractions to investors is their generous dividend-- 9.11% as of July 2, 2012. Dividends are to be paid from earnings (net income) or CFO. No investor wants to see a company borrowing to pay the dividend. It just isn't a sustainable situation. So, is SDRL making enough money to easily pay their dividend or is a cut in the near future?

SDRL just raised their quarterly dividend in the latest quarter. Companies worried about having enough money to pay the existing dividend don't increase it. But nevertheless, let's take a closer look.

Dividend Coverage of 1 or more means there is sufficient cash to pay the dividend. As the following table shows, SDRL has had sufficient cash to pay the dividend except in 2008.

 

<table> <tbody> <tr> <td>Period Ended</td> <td>Net Income in $M</td> <td>CFO in $M</td> <td>Dividends in $M</td> <td>Dividend Coverage</td> <td>CFO divided by Dividends</td> <td>Cash Left after Paying Dividends in $M</td> </tr> <tr> <td>03/31/12</td> <td>439</td> <td>454</td> <td>379</td> <td>1.16</td> <td>1.20</td> <td>75</td> </tr> <tr> <td>12/31/11</td> <td>1,482</td> <td>1,816</td> <td>1,440</td> <td>1.03</td> <td>1.26</td> <td>376</td> </tr> <tr> <td>12/31/10</td> <td>1,172</td> <td>1,300</td> <td>990</td> <td>1.18</td> <td>1.31</td> <td>310</td> </tr> <tr> <td>12/31/09</td> <td>1,353</td> <td>1,452</td> <td>199</td> <td>6.79</td> <td>7.28</td> <td>1,253</td> </tr> <tr> <td>12/31/08</td> <td>-123</td> <td>401</td> <td>688</td> <td>-0.18</td> <td>0.58</td> <td>-287</td> </tr> </tbody> </table>

 

To improve their liquidity, the dividend was eliminated after September 30, 2008 until December 7, 2009.  

Another factor to consider in SDRL's dividend's safety is whether they are in compliance with the debt covenants imposed on them by their lenders—bankers and investors, because these people can require SDRL to suspend or reduce the dividend.  As of their latest quarterly report, they were.

But, any company, even a cash rich company, can decide to reduce or suspend its dividend.  Consider DO.  In 2010, they reduced their "special dividend," which is paid every quarter, from $1.875/share to $0.75/share, where it remains today.  At the time, their current ratio was 3.0  Today, it's 5.20. Did they invest that cash for shareholders' benefit?  As can be seen in the first table above, not really.

Why is SDRL So Generous with Their Dividend?

To SDRL's credit, when they restored the dividend, they paid shareholders $0.50/share.  The following March, they raised the dividend 10% to $0.55/share.  And, they raised the dividend almost every quarter since then.  As a shareholder, I like to see my companies share the wealth, especially if they are not investing it for growth.

My theory is that when top management holds a large stake in the company, they are more likely to care about sharing the wealth.  DO's CEO, Lawrence Dickerson, owns a measly 6,558 shares as of their last report.  Wow, a whole 0.005%.  SDRL's CEO, John Fredriksen's trust, Hemin, owns over 109 million shares or 24.6%, having just increased their stake by 600,000 shares on June 27, 2012.  SDRL shares account for nearly half of Mr. Fredriksen's fortune http://www.forbes.com/profile/john-fredriksen/. So, who do you think identifies more with his shareholders?

Conclusion: Seadrill is Shrewd

Seadrill's timely investment in their fleet has certainly paid off. Yes, their debt load is higher than their competition, but they can afford it. The fact that they were and are able to obtain attractive financing suggests that lenders are confident in their ability to repay. Their dividend is safe. I'm a believer and you should be too.

 


p366 owns shares of Seadrill, Ltd. The Motley Fool owns shares of Transocean and Seadrill, Ltd. Motley Fool newsletter services recommend Seadrill, Ltd.. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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