Revisiting Seadrill's Dividend Sustainability

| About: Seadrill Limited (SDRL)

I have seen a great deal of speculation on this site over the past few weeks regarding the future of Seadrill's (NYSE:SDRL) dividend. Indeed, I have weighed in on this myself by expressing concern over Seadrill's ability to maintain the dividend following the sale of the company's tender rig division. In this article, I will examine the sustainability and future of the company's dividend going forward.

The most important financial number when examining the sustainability of Seadrill's dividend is the company's operating cash flow. Unlike most companies, an investor cannot look at the company's earnings per share and compare it to the company's dividend (a metric known as the dividend payout ratio). This is because Seadrill has a number of investments and other financial instruments on its books that result in large fluctuations in the company's net income from quarter to quarter. Additionally, an investor cannot look solely at the company's free cash flow. In order to support its growth initiatives, Seadrill has historically maintained a negative free cash flow. Seadrill's financial model is, essentially, to pay out a significant portion of its operating cash flow in the form of dividends and use debt to finance its ambitious growth.

As most shareholders are by now no doubt aware, Seadrill is accelerating its fourth quarter dividend payment to this month in advance of the impending dividend tax hikes in the United States. Thus, shareholders as of the market close on December 3 (the day prior to the ex-dividend date) will receive total dividends of $1.70 per share. Seadrill had 469,121,774 shares of common stock outstanding on September 30. It will cost the company a total of $797,507,016 to pay out these two dividends to shareholders. The company only had $413 million in operating cash flow during the third quarter.

So clearly, Seadrill cannot afford to pay this accelerated dividend using its operating cash flow from the third quarter alone. Seadrill also only had $518 million in cash at the end of the third quarter, which is also not enough to afford this accelerated dividend. So, how is the company able to pay this accelerated dividend?

Seadrill's quarterly dividend is $0.85 per share. Therefore, paying this dividend costs the company approximately $395 million per quarter. The company can cover this solely with its operating cash flow, although it is left with a very small cash buffer after doing so. This is the reason for the company's debt load. Seadrill is essentially financing its rapid growth using debt while paying out most of the cash that its operations generate through dividends. It is a business model that bears some similarities to a REIT.

By the time of the payment of the third and accelerated fourth quarter dividends, Seadrill will have been collecting cash from its operations in the fourth quarter for most of the quarter. As a result, Seadrill almost assuredly has much more cash than the $518 million that its balance sheet would suggest. This is because the most recent balance sheet only shows the amount of cash that the company had on September 30. Seadrill will likely use some of this money to pay the accelerated dividend while using the cash on its balance sheet to pay the third quarter dividend.

This would have the effect of making the balance sheet in the company's fourth quarter report look considerably weaker than the balance sheet in the third quarter report. This is due to all the money leaving the company in the fourth quarter in the form of dividends. The absence of a dividend during the next quarter will allow the company to make up for this, however, and Seadrill's finances should be back on track by the first quarter of 2013 report. Alternatively, Seadrill may use short-term financing to obtain the money to pay the accelerated fourth quarter dividend. The company would then, conceivably, pay off this short-term loan with the money that would otherwise be used to pay the fourth quarter dividend on its regular schedule.

On November 5, Seadrill announced that it is selling its entire tender rig division to SapuraKencana Petroleum. The company will have no tender rigs remaining following this divestment, excluding the rigs that are going to be sold to Seadrill Partners (NYSE:SDLP). Therefore, Seadrill will no longer be able to utilize the revenues and cash flows that these rigs generate. This puts pressure on Seadrill's dividend. But, how much pressure? Seadrill does not break down operating cash flows by division; however, it does state revenue and operating income figures for its tender rig division. The company's tender rigs generated total contract revenues of $178 million in the third quarter and was able to convert $84 million of this into profit. Armed with this information, we can come up with a rough estimate of the cash flow generated by this division.

One commonly used proxy for operating cash flow is the company's EBITDA. This is not a perfect proxy in Seadrill's cash as its EBITDA is typically well above its operating cash flow. However, we should be able to calculate a rough approximation of the division's operating cash flow by adding the depreciation and amortization incurred by the company's tender rigs to the division's operating income. This figure works out to $99 million ($84 million operating income plus $15 million depreciation and amortization). If we subtract this from the company's $413 million of operating cash flow, it provides an estimate of $314 million of cash flow following the divestment of the tender rigs which is not enough to maintain the dividend at its present level.

In my analysis of Seadrill's third quarter, I stated that the company was adversely affected by rig mobilizations and downtime which reduced the company's operating cash flow below its potential. In the fourth quarter and into 2013, the company will be much less adversely affected by these factors and this will increase the operating cash flow produced by the company's floater and jack-up rig businesses. This will offset some of the decrease in cash flow caused by the loss of the tender rig division. However, this offset would not be sufficient to raise operating cash flows to the level needed to maintain the dividend at present levels until the company's newbuilds come online at the end of 2013 and throughout 2014.

There is, however, a way that Seadrill could maintain its dividend. Seadrill expects to receive around $1.2 billion in cash from the sale of its tender rig division. As it costs the company approximately $395 million per quarter to pay its dividend, this cash would be enough to enable Seadrill to pay its dividend for three quarters even if the company brought in absolutely no money over that period. However, the company will still be generating cash from its floater and jack-up rig units following the sale of its tender rig division.

The cash flow from these operations combined with using some of this $1.2 billion could allow the company to maintain its dividend until its new rigs come online. Seadrill has previously stated that it intends to use this money to invest heavily in its floater and jack-up fleets. However, Seadrill would still be left with a large pile of cash even if it does use some of this money to support its dividend in the short term.

Disclosure: I am long SDRL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.