Seadrill (SDRL), the Bermuda-based offshore drilling services company, this week reported its quarterly- and nine-month results. Trading around $38.50, SDRL features an $0.85 quarterly dividend, which provides a projected 8.83% annual yield. With such an exceptional yield, the question for an investor, clearly, is "Can the company sustain or even increasing the dividend?"
While it's not always readily apparent, SDRL is controlled by legendary Norwegian businessman John Fredriksen, whose family company Hemen Holding controls 23.2% of SDRL. Reputedly SDRL's dividend provides Mr. Fredriksen with a very large part of his annual income. Logically, then, one can assume that he will do everything he can to have SDRL maintain the dividend.
A quarter is too short to draw valid conclusions so let's look at SDRL's [unaudited] financial statements for the nine months ended September 30, 2012 [available at Seadrill.com]. While the Statement of Income is always interesting - operating revenue was up about 4% over the same period a year ago - and so too is the Balance Sheet, experienced business people and investors know that the Statement of Cash Flows is always the most important document. Earnings can be manipulated, but it takes cash to pay employees, vendors and dividends.
The three sections of the Statement of Cash Flows are (1) Cash Flow from Operations, (2) Cash Flow from Investing, and (3) Cash Flow from Financing. They add together and the sum is the net increase or decrease to cash.
The first is the key, and the single most important number in any company's financial statements is Cash Flow from Operations. If a business isn't generating real cash from ongoing operations, then all the rest is "smoke and mirrors." For the nine months SDRL generated $1.349 billion from operations, primarily contract revenue.
SDRL's Investing cash flows are much more complex. Essentially, we need to separate real capital expenditures [Cap Ex] from the rest of the section. Additions to rigs, equipment and buildings totaled $1.334 billion. The rest of the items in Investing do not reflect actual investment in the business.
The two most important parts of Cash Flow from Investing are (1) net proceeds from debt, and (2) dividends paid. In total SDRL realized $0.942 billion in borrowings between new debt sold, and debt paid down. Dividends paid equaled $1.217 billion.
The table below summarizes what we've learned so far:
|Cash Flow from Operations||$1.349 billion|
|Cash Flow from Investing [Cap Ex]|
|Cash Flow from Financing|
|Net Debt borrowed||$0.942|
|Net Total Cash Flow||($0.260)|
A couple of points are initially noted. First, initially almost all of SDRL's cash generated from operations was needed just to pay cap ex, leaving essentially no cash at all to pay dividends. This needs further study. Looking at the Statement of Cash Flows provided by the company when quarterly results were announced, the $1.334 billion in cap ex consisted of $0.243 billion "Additions to rigs and equipment" plus $1.091 billion in "Additions to Newbuildings." Since only $243 million of the cap ex is actually required to maintain the current business, the amount of cash from operations is actually sufficient to cover the dividend.
Second, to cover the overall shortfall - which reflects $1.091 billion in "growth" cap ex - SDRL borrowed $942 million in additional debt. But this still left the company $260 million short of being able to pay the dividend. Where did that money come from?
SDRL's CFO turned to two unusual and generally non-recurring sources to cover the dividend cash shortfall. In Investing there is a $116 million source titled "Change in margin calls and other restricted cash." Lenders or derivative counter-parties, for instance, sometimes require companies maintain specified minimum cash balances, or similar restrictions. SDRL apparently was able to get this reduced by $116 million. The rest of the cash came from another generally non-recurring source. Under Investing we also see $219 million came in from "Proceeds from realization of marketable securities." Apparently SDRL had securities assets, which it sold.
Our table above now looks like this:
|Net Total Cash Flow||($0.260) billion|
|+ Freeing of restricted cash||$0.116|
|+ Sale of securities||$0.219|
|New Total Cash Flow||$0.075 billion|
[Note: figures may not precisely match company's financials as certain miscellaneous accounts were omitted]
While there are a number of good things going on with Seadrill's business, which positively impress investors, the suatainability of the dividend is obviously of major importance. Frankly, at 8.5%-9.0% and occasional future dividend increases, even if the stock never went up most investors would get a satisfactory return. However, a hard-nosed cash-based analysis shows that SDRL appears to be really struggling at present to be able to fund newbuild growth and pay the dividend and it has to rely completely on financing activities as cap ex consumes virtually all its cash from operations. The company has a vigorous newbuild plan with 19 rigs under construction and the success of these newbuild additions and ongoing contract rates, in my opinion, will drive SDRL's future - and its dividend.