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There have been a lot of concerns about the debt levels of SeaDrill (SDRL) and investors are somewhat concerned about the situation. At a glance, it looks like the company will have trouble as the debt is too high - however, despite the dangerously high debt levels, the stock continues to do exceptionally well. The market must be seeing something in the stock that is not apparent to the naked eye. The stock is up over 400% during in the past five years and 20% in the past two years. Clearly, the growth in stock price has slowed down; however, it still remains extremely strong. In my previous article about the company, I wrote about the future prospects and the expected growth in revenues and cash flows.

(click to enlarge)SDRL Chart

SDRL data by YCharts

Some of the readers pointed out that writers at this platform give too much focus to positives or negatives - on one side, we have people focusing on the debt of the company alone and telling everyone how it is going to be the undoing of SeaDrill. On the other hand, we have writers who only talk about the positives and order backlog, which paints a rosy picture. As a result, investors are left confused sometimes and have trouble connecting them both and arriving at a conclusion. I agree to some extent as looking at one of these factors in isolation can be misleading. As a result, I have tried to take a broader look at the company, sector and the financial situation of the company to make it easier to understand for readers. Let's hope this effort clear some confusion present in the minds of the readers.

A Look at the Debt

Before we go deep into the analysis let's first familiarize ourselves with the debt of the company. The image below shows the total debt of the company.

(click to enlarge)

Almost all of the debt is in the form of credit facilities for SeaDrill. Credit facilities are usually taken to meet the working capital or short-term capital needs. However, SeaDrill has been using credit facilities to finance its expansion. The company has been financing new rigs by drawing down on its credit facilities. However, if we take a closer look at these credit facilities then we can see that most of these facilities are not completely drawn down. The company can get further cash from its already established credit facilities if need be. The debt reported here is the consolidated debt, which includes the debt of its subsidiaries as well. SeaDrill has been growing aggressively by adding more rigs as well as acquiring other smaller players in the sector.

At the moment, SeaDrill's total long-term debt is $12.7 billion, out of which, $2.65 billion is the current portion of long-term debt. The current portion will be paid during the current and it will likely be replaced with new debt. Furthermore, the company has $2.925 billion in bonds and convertible bonds outstanding. I will discuss convertible bonds outstanding and its impact on the capital structure later in this article. A total of $573 million worth of convertible bonds are outstanding at the moment for SeaDrill and $2.35 billion are outstanding in senior unsecured bonds.

Understanding the Debt and Its Impact on Future Financing

Now that we have familiarized ourselves with the total debt of the company, let's see what the difference is between the long-term bonds and credit facilities, and what will be the impact on the future financing. Corporations usually utilize two options for debt financing: banks and public. For public, the companies usually issue bonds with semi-annual coupon payments and the bonds are issued through an intermediary, generally an investment bank. The other option for the company is to directly negotiate with a bank, which is a quicker option but usually results in tighter conditions. At the moment, SeaDrill's debt is close to 67% of its total market cap, a big red flag for the banks when it comes to negotiating the debt. As a result, it is true that the future financing can be an issue for the company as most of the bank will deem the current debt levels to be too high. This might result in refusal of new financing or high rates. It is clear that the company has little room for new financing through banks. The second option can be used and SeaDrill can go to the public. At the moment, the company is working on its ratings process, which is expected to be completed in the first quarter of the current year. SeaDrill has been able to access the unsecured bonds market at attractive prices and securing a good rating might result in better financial flexibility. It can allow the company to access the bonds market in a better way.

Convertible Bonds and Other Sources of Financing

Other source of financing for any corporation is the capital markets. The companies can issue shares to raise capital to further expansion. However, SeaDrill is in a tricky situation when it comes to equity issue. At the moment, the yield on its stock is about 9.5%, substantially higher than the interest cost. As a result, issuing equity will be costly for SeaDrill compared to the debt issue. Furthermore, it will cause the dilution and there will be a negative impact on the stock price. Let's assumed the company wants to bring down its debt by $3 billion and decides to issue new shares and uses that cash to pay its debt. SeaDrill will need to issue 75 million new shares in order to reach that goal, which will cause substantial dilution. Moreover, annual dividend payments will rise by $285 million, and if we factor in the annual growth rate in dividends then the amount will further impact the cash flows. This can harm the future free cash flows of the company, which is not an option for SeaDrill at the moment.

It is fortunate for SeaDrill that its current outstanding convertible bonds are a small portion of its total financing. These bonds are due in 2017 and currently trade at a substantial premium to par value. Conversion price for these bonds is $29.87, and keeping in mind the current stock price; it is more than likely that these bonds will be converted to stocks. As I mentioned above, equity is much more expensive option for SeaDrill compared to debt. As a result, the company is not looking to issue more convertible debt, which is a clear indication that SeaDrill is unlikely to tap the capital markets. The company wants to continue to pay high dividend yield. That can only happen if the cash flows continue to grow and the cheaper financing option is used.

A Look at the Business and Growth

As I mentioned in my previous article, the current order back log of the company stands at $19.5, excluding the order for West Aquarius with PEMEX. Furthermore, the company is in advanced discussion for its 2014 deliveries. SeaDrill is extremely active in winning contracts for its rigs and most of the rigs have contracts before delivery. SeaDrill's assets are mainly categorized in the ultra-deep water segment - this segment has some of the highest day rates in the sector. Almost all of its assets fall in the premium bracket, which results in higher day rates than most of its competitors.

The off-shore drilling segment of the energy sector is growing at an exceptional rate as the energy companies are looking towards the unconventional reserves in order to replace their depleting reserves. Drilling companies have benefited a lot from this surge in demand for their services. There have been some concerns about the increased competition and oversupply of rigs - however, premium and ultra-deep water segment still has very strong demand. SeaDrill's portfolio has premium products that will continue to win contracts at attractive day rates.

SeaDrill Partners: Another Source of Growth?

SeaDrill Partners (NYSE:SDLP) will prove to be another source of growth for SeaDrill. The company is following in the footsteps of Kinder Morgan (NYSE:KMI) and dropping down its assets to SeaDrill Partners as KMI did with Kinder Morgan Energy Partners (NYSE:KMP). SeaDrill has been selling its assets to SeaDrill Partners - the formation of SeaDrill Partners will go a long way to solve the financing problem for the company. We have established that the high levels of debt have reduced the financial flexibility of the company. However, SeaDrill Partners is a new business that can take on loans as well as equity issue. First SeaDrill can drop down its assets and receive cash maintaining the control on the sold assets as it owns more than 77% of the partnership.

SeaDrill Partners recently issued new equity and the partnership intends to use the cash to make acquisitions. It is an astute move by the SeaDrill management as the partnership will be able to receive financing with ease and the future cash flows will continue to flow to SeaDrill. At the moment, SeaDrill Partners' day rates range from $487,000 to $580,000. Once the contracts end, the partnership should be able to enjoy higher rates as the current rates are lower.

Debt Ratios and Comparison with Peers

We have understood the debt and its impact on the future financing options - let's now look at the debt ratios of SeaDrill and its peers. The table below shows the ratios.

Ratios

SeaDrill

Transocean

Noble

Asset Coverage Ratio

1.63

1.97

2.82

Capitalization Ratio

0.62

0.41

0.37

Debt Ratio

0.69

0.54

0.47

Debt to EBITDA

4.73

3.19

2.58

Interest Coverage Ratio

5.12

4.24

10.39

I have used five ratios for the comparison. The first ratio is Asset Coverage Ratio: this ratio shows the ability of a company to cover its debt obligations with its assets. At the moment, SeaDrill is well covered as far as this ratio is concerned. The second ratio shows the capital structure of a company. According to the capitalization ratio, SeaDrill is financed 62% by debt and 38% by equity at the moment. Debt ratio also gives the idea about the liabilities of a company. This ratio is also considerably high for SeaDrill. The fourth ratio shows a company's ability to pay its incurred debt. Again SeaDrill's ratio is high due to the elevated debt levels. And finally, the interest coverage ratio - this ratio shows a company's ability to meet its interest obligations. SeaDrill should not have any issue meeting its debt obligations according to the ratio.

SeaDrill's ratios are poor compared to its peers indicating that the company has more debt burden than the other two companies. Transocean (NYSE:RIG) has large operations like SeaDrill and the balance sheet of the company is strong. On the other hand, Noble (NYSE:NE) is a relatively smaller player with total assets of about $14.6 billion. Its debt levels are also low ($4.6 billion); as a result, its coverage ratios are better than its peers.

Conclusion

After going through the filings of the company and taking a deep look at its debt, I can say that SeaDrill's debt is not a threat at the moment. The company is operating in a growing segment of the energy sector, which is capital intensive - the company needs to build rigs in order to grow, and for that purpose heavy capital investments are needed. Now we know that the company has made a commitment to paying high dividend yield, which has somewhat handicapped it when it comes to financing options. Equity financing has become an expensive option for SeaDrill. The only other option is the debt market.

The debt of a company starts to become a problem when the sources of revenue and cash flow start to decline. In SeaDrill's case, the revenue and cash flows streams are expected be stronger in future. Furthermore, SeaDrill Partners have given the company another option to grow. We are likely to see high growth in the drilling sector for another two-three years. I believe SeaDrill's portfolio will be extremely strong by the time this segment starts to enter maturity and the company will be able to pay some of its debt if need be. Moreover, typically most of the credit facilities are renewable and banks renew these facilities without any hassle if the company is able to generate enough cash flows. As I said at the start of this piece, looking at debt in isolation can be misleading. The most important factor is the company's ability to generate cash flows to meet its debt obligations, which I believe SeaDrill will continue to do.

Source: SeaDrill: Busting The Myth Of High Debt