Due to increased Global energy demand aided by advanced technology, that in turn is reducing costs and improving safety, the tide has turned and it has become economical for companies to pursue deep-water reserves. As leading major E&P companies such as Exxon (NYSE:XOM), Chevron (NYSE:CVX) and Petroleo Brasileiro SA or Petrobas (NYSE:PBR) have increased their presence in deep-water regions, they have increased CAPEX spending to support these developments. Over the next five years, the offshore drilling services market is expected to grow from $73.1 billion in 2013 to $121.1 billion by 2018. This is an expected growth of $48 billion or a compounded annual growth rate (OTCPK:CAGR) of 10.6%.

A company that has set itself up very well to capitalize on this trend is Seadrill Limited (NYSE:SDRL). Seadrill is a leading offshore deepwater drilling company, aiming to be their customers' most important partner in making oil and gas available in a safe and cost-effective manner. The company operates a versatile fleet of 64 units that comprises drillships, jack-up rigs, semi-submersible rigs and tender rigs for operations in shallow to ultra-deepwater areas in hard and benign environments.

With a strong global ultra-deepwater market along with Seadrill's newer fleet that has 27 new rigs under construction (including 11 drillships and 2 harsh environment semi-submersibles) waiting in the wings, the future looks promising for the company, but all of these construction commitments have come at a cost. So what about the debt?

## Thesis

The Thesis of this paper is to look at the debt side of the company, examine how the market is responding to it and using DCF valuations calculations, estimate the risk for the shareholder.

Having an understanding of a company's debt and liabilities is a key component in understanding the risk of a company. An understanding of these factors will aid in the decision to invest, not to invest, or to stay invested in a company. There are many metrics involved in understanding the debt of a company, but for this article, I will look at Seadrill Limited's total debt, total liabilities, some debt ratios and WACC.

*1. Total Debt = Long-Term Debt + Short-Term Debt*

Total debt is the sum of long-term debt, which is debt that is due in one year or more, and short-term debt, which is any debt that is due within one year.

- 2009 - $6.622 billion + $774 million = $7.396 billion
- 2010 - $8.611 billion + $981 million = $9.592 billion
- 2011 - $8.574 billion + $1.419 billion = $9.993 billion
- 2012 - $8.695 billion + $2.066 billion = $10.761 billion
- 2013 TTM - $8.521 billion + $2.873 billion = $11.394 billion

SDRL Total Long Term Debt data by YCharts

Seadrill's total debt has increased since 2009. In 2009, the company reported a total debt of $7.396 billion. In 2013 TTM, the company's total debt increased to $11.394 billion. Over the past 4 years, Seadrill's total debt has increased by 54.06%.

*2. Total Liabilities*

Liabilities are a company's legal debts or obligations that arise during the course of business operations, so debts are one type of liability, but not all liabilities. Total liabilities is the combination of long-term liabilities, which are the liabilities that are due in one year or more, and short-term or current liabilities, which are any liabilities due within one year.

- 2009 - $9.652 billion
- 2010 - $12.100 billion
- 2011 - $12.327 billion
- 2012 - $14.129 billion
- 2013 TTM - $14.386 billion

SDRL Liabilities data by YCharts

Seadrill's liabilities have also increased over the past 5 years. In 2009, the company reported liabilities at $9.652 billion; in 2013 TTM, the company reported liabilities at $14.386 billion. Over the past 5 years, Seadrill's liabilities have increased by 49.07%.

Based on the information above we can see that Seadrill Limited has a significant amount of debt on its balance sheet. Currently, the company has a total debt of $11.394 billion and liabilities at $14.386 billion. Over the past five years, the total debt has increased by 54.06%, while total liabilities have increased by 49.07%. In the next section, I will look at the total debt and liabilities and compare them to the assets.

*3. Total Debt to Total Assets Ratio = Total Debt / Total Assets*

This is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt. It is calculated by adding short-term and long-term debt and then dividing by the company's total assets.

A debt ratio of greater than 1 indicates that a company has more total debt than assets; meanwhile, a debt ratio of less than 1 indicates that a company has more assets than total debt. Used along with other measures of financial health, the total- debt-to-total-assets ratio can help investors determine a company's level of risk.

- 2011 - $9.993 billion / $18.304 billion = 0.55
- 2012 - $10.761 billion / $19.632 billion = 0.55
- 2013 TTM - $11.394 billion / $21.801 billion = 0.52

Over the past three years, Seadrill's total-debt-to-total-assets ratio has decreased slightly. In 2011, the ratio was 0.55 while in 2013, the ratio decreased to 0.52. This indicates that since 2011, the company has been adding more asset value than total debt. As the number is currently below 1, this states that the risk to the company regarding its debt to assets has decreased slightly since 2011.

*4. Debt ratio = Total Liabilities / Total Assets*

Total liabilities divided by total assets. The debt ratio shows the proportion of a company's assets that is financed through debt. If the ratio is less than 0.5, most of the company's assets are financed through equity. If the ratio is greater than 0.5, most of the company's assets are financed through debt. Companies with high debt/asset ratios are said to be "highly leveraged." A company with a high debt ratio or that is "highly leveraged" could be in danger if creditors start to demand repayment of debt.

- 2011 - $12.327 billion / $18.304 billion = 0.67
- 2012 - $14.129 billion / $19.632 billion = 0.72
- 2013 TTM - $14.386 billion / $21.801 billion = 0.66

Based on the two ratios above that compare the total debt and liabilities to the company's assets, we can see that Seadrill has financed many of its assets through debt.

## The Two Scenarios

In the section below, I will establish two different scenarios. The scenarios use the DCF calculation to establish the current value for the company. Scenario 1 includes the total debt within DCF calculation, while scenario 2 excludes the total debt. Based on these two scenarios, we should get an idea of what the market is valuing within the company and establish the downside risk to the shareholder.

## Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt metric is useful, because it gives an idea as to the overall rate being paid by the company to use debt financing.

This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt the higher the risk.

*5. Cost of debt (before tax) = Corporate Bond rate of company's bond rating.*

- Morningstar rated Seadrill's bonds "B"
- Seadrill Limited, Hamilton 6.5%, Rating of "B" = 6.5%
- Current cost of Debt as of October 2, 2013 = 6.5%

According to the S&P rating guide, the "B" rating is - "More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments." Seadrill Limited has a rating that meets this description.

*6. Current tax rate (Income Tax total / Income before Tax)*

- 2011 - $189 million / $1.671 billion = 11.31%
- 2012 - $232 million / $1.437 billion = 13.04%
- 2013 TTM - $240 million / $2.643 billion = 9.08%

2011 - 2013 TTM 3 year average = 11.14%

Over the past three years, Seadrill limited has averaged a tax rate of 11.14%.

*7. Cost of Debt (After Tax) = (Cost of debt before tax) (1 - tax rate)*

The effective rate that a company pays on its current debt after tax.

- .065 x (1 - .1114) = Cost of debt after tax

The cost of debt after tax for Seadrill Limited is *5.77%*

**Cost of equity or R equity =** Risk free rate + Beta equity (Average market return - Risk free rate)

The cost of equity is the return a firm theoretically pays to its equity investors, for example, shareholders, to compensate for the risk they undertake by investing in their company.

- Risk free rate = U.S. 10-year bond = 2.59% (Bloomberg)
- Average market return 1950 - 2013 = 7%
- Beta = (MSN Money) Seadrill's beta = 1.93

Risk free rate + Beta equity (Average market return - Risk free rate)

- 2.59 + 1.93 (7-2.59)
- 2.59 + 1.93 x 4.41
- 2.59 + 8.51 = 11.10%

Seadrill has a cost of equity or R Equity of 11.10%, so investors should expect to get a return of 11.10% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

(*Please note that this is the CAPM approach to finding the cost of equity. Inherently, there are some flaws with this approach and that the numbers are very "general." This approach is based off of the S&P average return from 1950 - 2013 at 7%, the U.S. 10-year bond for the risk free rate which is susceptible to daily change and MSN Money beta.*)

## Scenario 1: Valuation Metrics Including Total Debt

In this scenario I will include all listed total debt.

## Weighted Average Cost of Capital or WACC

The WACC calculation is a calculation of a company's cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this states a decrease in valuation and a higher risk.

By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances.

For this calculation, you will need to know the following listed below:

Tax Rate = 11.14% (Seadrill's three-year average Tax Rate)

Cost of Debt (before tax) or **R debt** = 6.5%

Cost of Equity or **R equity** = 11.10%

Debt (Total Liabilities) for 2013 TTM or **D** = **$14.386 billion**

Stock Price = $46.61 (October 2nd, 2013)

Outstanding Shares = 469.09 million

Equity = Stock price x Outstanding Shares or **E** = $21.864 billion

Debt + Equity or **D+E** = $36.250 billion

**WACC** = R = (1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - .1114) x .065 x ($14.386/$36.250) + .111 ($21.864/$36.250)

.8886 x .065 x .3969 + .111 x .6031

.0229 + .0669

= 8.98%

Based on the calculations above, we can conclude that Seadrill pays 8.98% on every dollar that it finances, or 8.98 cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0898 plus the cost of the investment for the investment to be feasible for the company.

## Valuation DCF Including the Total Debt

In the section below, I will use the Discounted Cash Flow valuation to find a valuation for the stock price of Seadrill. In the 1st valuation, I will include the total debt of the company.

## DCF Valuation Including Total Debt

Even though there are variations in calculating this formula, this model is based off of a terminal value of $27.760 billion and a WACC of 8.98%. The terminal value $31.924 billion is based off of the company trading at 23X EBITDA. In my opinion using a terminal value of $31.924 billion based off an estimate of 23X EBITDA is fair. Using the DCF valuation method which includes debt, I have concluded that Seadrill's stock has a value of $24.94 per share.

## Scenario 2. Valuation metric excluding total Debt

The first step is to eliminate the total debt from the WACC formula. We can do this by subtracting the total debt from the liabilities. This will give us the liabilities without total debt.

## Weighted Average Cost of Capital or WACC

In this valuation, I will eliminate the total debt. Please note that I have maintained the liabilities (which includes total debt) within the WACC formula.

For this calculation, you will need to know the following listed below:

Tax Rate = 11.14% (Seadrill's three-year average Tax Rate)

Cost of Debt (before tax) or **R debt** = 6.5%

Cost of Equity or **R equity** = 11.10%

Debt (Total Liabilities) for 2013 TTM or **D** = **$2.992 billion**

Stock Price = $46.61 (October 2nd, 2013)

Outstanding Shares = 469.09 million

Equity = Stock price x Outstanding Shares or **E** = $21.864 billion

Debt + Equity or **D+E** = $24.856 billion

**WACC** = R = (1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - .1114) x .065 x ($2.992/$24.856) + .111 ($21.864/$24.856)

.8886 x .065 x .1203 + .111 x .8796

.0007 + .0976

= 9.83%

## DCF Valuation Excluding Net Debt

In this valuation, I will eliminate the net debt. Please note that I have maintained the liabilities (which includes net debt) within the WACC formula.

Within this calculation, I have eliminated the total debt from the formula. Using the exact same calculations as above only eliminating the debt, I have concluded that Seadrill's stock has a value of $48.10 per share.

## Conclusion

Even though I believe this is a leading company within a sector poised for significant growth, if you buy this stock, it is important to know what you are paying for. Based on the information above, when you are buying this stock at this price point in the market, I have established that you are buying the stock excluding the debt. This does poise some significant risk to the shareholder because if the market was to "change its mind" and begin to value the debt behind the company there is significant downside risk.

As I believe this stock is a buy at this point in the cycle, I do not believe this is a buy and forget type of stock. If you decide to buy this stock at this point in the market, I think this is a stock that you need to keep a close eye on and if market valuations begin to change be ready to exit.

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