Shares of Seadrill (NYSE:SDRL) took a beating following its third quarter earnings report. Earnings missed on high expectations and investors were possibly not pleased with yet another dividend hike. I do realize that this sounds contradictory at first sight.
Rather than discussing the actual results, most investors are worried about the growth strategy resulting in sky high capital expenditures, while the company pays out super-steep dividends, acting as if it is a true cash cow.
These investments and payouts result in increasing debt. While this is sustainable as long as the market remains strong, many out there have fear if things turn for the worst. I feel a lot of investors would sleep much better if the company would actually lower its dividend in the short to medium term. Lower immediate payouts could alleviate leverage concerns which many have out here.
Third Quarter Results
Seadrill generated third quarter revenues of $1.28 billion, up 17.2% on the year before, with revenues generally coming in line with consensus estimates.
Net earnings were up by 45.8% to $315 million on the back of sales growth, operating leverage and lower foreign currency losses.
Diluted earnings per share were up by 50% to $0.60 per share. Despite the jump in earnings, analysts were looking for even higher earnings at $0.68 per share.
Looking Into The Results
Revenue growth was strong on an annual basis, but jumped up merely 1.0% on a consecutive basis. Oil firms are delaying some investments to preserve cash, resulting in flat to slightly lower rates over the quarter.
The inclusion of Sevan Drilling, the jack-up rigs AODII and West Tucana were offset by disposals in Seadrill's fleet. As such, Seadrill ended the quarter with 19 floaters, 18 jack-up rigs and 3 tender rigs currently being in operation. The average economic utilization rate remains very high at 97%.
Revenues from the floater business rose by 28.4% to $867 million, making up the majority of its revenues. The jack-up rigs generated revenues of $283 million, up 39.4% on the year before. Revenues from tender rigs fell by 78.7% to just $38 million following the sale of these activities.
Despite the solid growth in revenues, on an annual basis, operating income fell by a full percent point to 36.8% of total revenues.
Seadrill ended the quarter with $551 million in cash and equivalents, while the firm holds $316 million in marketable securities. Total debt stands at $13.6 billion, for a net debt position of around $12.7 billion.
Revenues for the first nine months of the year came in at $3.81 billion, up 16.8% on the year before. Net earnings more than doubled to $2.51 billion on the back of a $1.26 billion gain on the tender of the rig business.
At this pace annual revenues of $5 billion are achievable, as earnings could come in around $1.7 billion on an operational basis.
Trading at $42.50 per share, the market values Seadrill at $20 billion. This values equity in the firm at 4 times annual revenues and 11-12 times normalized earnings.
Seadrill currently pays a quarterly dividend of $0.95 per share, for an annual dividend yield of 8.9%.
Some Historical Perspective
Over the past decade, investors in Seadrill have seen very strong results. Shares rose from $10 in 2006 to highs of $35 in 2008.
Shares fell back towards $5 in 2009 after which they have steadily risen to highs of $45-$50 this year. Note that investors have received very high dividends in the meantime adding to these returns.
Between 2009 and 2012, Seadrill has increased its annual revenues by a cumulative 38% to $4.5 billion. Net earnings fell from $1.26 billion in 2009 to $1.11 billion last year. Both revenues and earnings are set to increase markedly this year.
Note that the outstanding share base increased by some 10% in the meantime.
Seadrill is the world's biggest offshore driller, being founded back in 2005 by shipping, marine and transportation mogul John Frederiksen.
The softness experienced in the quarter would be "temporary" according to the firm itself, blaming softer demand behind a stagnation in rates which hurt profits. Note that utilization rates remain very high and the firm remains committed to the favorable long term outlook of the industry. As usual Seadrill's key customers are the big oil majors in the world including Exxon Mobil (NYSE:XOM), Total S.A. and BP Plc (NYSE:BP), among others. Given the fact that not many oil companies can operate these kind of deep floaters, Seadrill relies for nearly half of its revenues on these three names.
To meet further expected growth going forwards it ordered another 4 ultra-deep drill ships at a price below $600 million per rig, scheduled to be delivered in the second half of 2015. Another 2 jack-ups rigs were ordered around $230 million per rig, scheduled to be delivered a year later. In total, the firm has 21 rigs being under construction at the moment. Seadrill remains committed to growth, given its huge $19.5 billion order backlog, which represents nearly 4 times annual revenues expected in 2013. The confidence of the firm should be the main driver behind the hike in the quarterly dividend to $0.95 per share, a reason alone why investors would want to buy into the shares.
While I am aware that there is a lot of discussion on past article about dividends, debt, payout ratios and cash flows, I am willing to present my case. On an accounting basis the dividend hike is aggressive as payout ratios in terms of earnings exceed the 100% ratio by far. This is especially true as Seadrill hiked its dividend again by four cents to $0.95 per share for a yield of around 9%.
While some are arguing that when though times hit the industry, Seadrill could cut capital expenditures to zero, I am not convinced. In this case cash flows should be defined as earnings plus depreciation. Over the past quarter, earnings totaled $315 million while depreciation charges totaled $192 million. The suggested dividend of $0.95 per share, or around $446 million, is 88% of depreciation and cash flows over the quarter, leaving little room to de-leverage even when though times hit.
Therefore an investment in Seadrill remains a leveraged bet on continued rosy market conditions in the deepwater drilling market. If things turn for the worst the "capacity" to deleverage is not that great, only if the company cuts its dividends while reduces capital expenditures to a bare minimum. Given Seadrill's price movements, especially in the 2009 crisis, I don't have to remind investors just how dangerous a high leveraged position can be.
The huge investments in the fleet are great, but investors cannot have both. I don't think investors should applaud the recent dividend hike, and I feel a lot more investors would be much happier with management, and get a better night of sleep if the company would simply pay out $0.50 per share a quarter.
Right now I feel that concerns about Seadrill's higher dividend and the implications on leverage outweigh the positive benefits or stance of investors to a higher dividend. I feel that the company could actually boost the value by cutting the dividend at current levels.