Seadrill: Beware The Unsustainable Dividend

Feb.10.14 | About: Seadrill Limited (SDRL)

Over the past thirty years, investing in dividend and dividend-growth stocks has been a pretty successful strategy with companies like Johnson & Johnson (NYSE:JNJ) and Coca-Cola (NYSE:KO) delivering fantastic returns while providing investors with peace of mind. For investors in retirement, generating income is also a critical goal, which makes dividend stocks even more attractive. Today, interest rates remain extremely low with the 10-year yielding only 2.6-2.7%, which will barely cover inflation. As a consequence, we have seen more income-oriented investors flock to stocks with vehicles like Master Limited Partnerships ("MLP") gaining traction. However, a focus on the dividend can backfire when a company cannot support the payment and is forced to make a cut to the payout. Unfortunately, I believe Seadrill (NYSE:SDRL) is one such risky dividend stock.

Click to enlarge

There is no denying it: Seadrill offers fantastic current income. In fact, shares currently yield a whopping 10.3%. Now, this yield is exceptionally attractive. However, a high yield is often more of a warning sign than a sign of strength. When the market believes a dividend cut is likely, shares tend to fall, which bloats the current yield. Once that dividend cut comes, the projected yield fails to materialize. Sometimes of course, the market is wrong and shares are unfairly punished, which makes the high-yielding stock extremely attractive. Still with long run equity returns in the 8% area, a 10.3% yield is a major warning sign. In Seadrill's case, this warning sign is well deserved.

Seadrill is an operator of deep-water and ultra-deep-water rigs with 69 offshore ships that it leases to exploration and production companies. The company is aggressively expanding its fleet with 21 rigs under construction. 3 of these 21 ships currently have contracts upon delivery, and these 21 rigs require remaining installment payments of $6.5 billion. Including its existing rigs, the company's backlog totals $19.5 billion. Unfortunately, we are seeing weakness in the deep-water rig market with day rates falling. Many companies like Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP) are refocusing on onshore opportunities with U.S. production growing dramatically.

Between oil sands in Canada and areas like the Permian Basin in the United States, more cap-ex dollars are being focused onshore, which puts pressure on higher risk deep-water projects. Now, oil remains a scarce commodity, so offshore demand is still strong, and many firms continue to spend billions offshore. Moreover with Mexico planning on opening the Gulf to foreign companies, there should remain solid demand. Now, these projects require high oil prices to be profitable and worth the risk. Increased U.S. output has put pressure on oil prices, which in turn cuts the demand for off-shore activities. As a consequence, SDRL's un-contracted rigs will face pricing pressure. Moreover as existing contracts expire, renewals over the next two years are in danger of being lower than current rates, which will put downward pressure on revenue and profits. Overall, the deep-water market is mildly weak. In 2014, SDRL should earn about $3.50, so it will be paying more in dividends ($3.80) than it will earn. This is a major warning sign.

Moreover, expanding the fleet is not cheap. As a consequence, Seadrill has been aggressively adding to its debt balance. At the end of 2009, Seadrill carried $6.6 billion in debt (most recent financial statements are available here). At the end of the last quarter, it carried $13.6 billion in debt. Capital expenditures ($2.7 billion) also far exceed operating cash ($1.2 billion). As a consequence, I expect Seadrill to continue to add debt to fund its expansion. As SDRL is expanding in a market that is starting to soften, this debt may prove to be extremely costly for shareholders.

Now, many bulls like to point out that the company generates significant EBITDA (earnings before interest, taxes, depreciation, and amortization). In fact, EBITDA is running in the $2.5-$3.0 billion range, and management continues to argue it EBITDA will total $4.5 billion in 2016. Now, this forecast assumes a strong offshore rate market, which we simply are not seeing. It is also worth noting that EBITDA is a dubious valuation measure for such a capital-intensive business. Given the cost of these rigs and their finite life, investors need to consider depreciation, maintenance, and replacement cost. Nonetheless, with its current EBITDA rate, bulls argue debt is not much of a concern as debt to EBITDA of 4-5x is not obscene. Further with annual interest expense of about $400 million, the company generates enough cash to pay interest.

I don't disagree with this assessment. Seadrill is not a company that faces bankruptcy risk in the immediate or medium term. Frankly, I would be stunned if there were a bankruptcy in the next 5-7 years. However, that does not mean that the dividend is safe. At its current rate, the annual cost of the dividend is $1.78 billion. If we subtract this from EBITDA, we are left with about $1 billion. Suddenly, debt to EBITDA is 13x and EBITDA to interest is less than 2.5x. Based on its operations alone, Seadrill is a highly indebted company, but that debt load is sustainable. Once you factor in the dividend payment, Seadrill becomes a dangerously levered firm. The simplest way to solve this problem is to cut the payout.

Further, this dividend earnings payout ratio is greater than 100%. In 2014, the dividend payment will be within 10% of operating cash flow. In other words, Seadrill will continue to add debt to fund its new rigs. At some point, Seadrill may be forced to cut its dividend and use that cash to fund new projects and pay down the debt. The dividend is too large of a drain on EBITDA, earnings, and cash flow, and when you factor it out of these figures, the debt load becomes a lot bleaker.

Let's assume even that Seadrill is correct about its 2016 forecast, and that it generates $4.5 billion in EBITDA. By 2016, it will likely carry $20 billion in debt, which will have a higher average interest rate as rates rise. Let's assume the dividend is held constant, EBITDA ex-dividend would stand at $2.7 billion, so the company's leverage ratio would stand at 7.4x, which is still highly levered. Interest expense will likely be at least $650-$700 million, giving it a mediocre EBITDA to interest ratio of 4x. Seadrill would remain very exposed to a downturn or refinancing problem, and maintenance expense will be higher as some of its ships age. Its current dividend is barely sustainable in 2016 when EBITDA will be over 50% higher.

The current dividend jeopardizes SDRL's finances while the deep-water market is moving against the company while it aggressively expands. This 10.3% dividend yield is a sign of weakness not strength as the company will likely be forced to cut its payout in the next 2-3 years to avoid adding too much debt. While this yield is attractive, investors should sell SDRL. Given the state of its balance sheet, I would be hesitant to pay more than 8.5-9x earnings to reflect its large debt load. I would sell SDRL until it reached the $28-$30 level.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.