- Ultra-deep water fleet of the company will continue to fetch attractive day rates.
- The debt should not be looked at in isolation.
- The modern fleet of SeaDrill should ensure high day rates in the future.
- The concerns about the oversupply may have been blown out of proportion.
SeaDrill (SDRL) is one of the highest yielding stocks in the market. As a result, the yield and its sustainability will always be questioned by the market. SeaDrill is not alone in this boat - any stock offering such a high dividend yield will be under the microscope and the ability to sustain dividends will be questioned. Investors expect continued growth in dividends, which is impossible for any business no matter how strong the track record as the industry life-cycle will catch up and the business in question will have to adjust its strategy and cash distribution accordingly.
We have seen high-yielding stocks slash dividends in the past - CenturyLink (CTL) and Frontier (FTR) are two examples. However, can we compare the telecom industry with the off-shore drilling industry? Are both these industries at the same stage of industry life-cycle? The answer is no. Off-shore drilling is at the early stages of growth and it will take some time to reach maturity. Usually, companies operating in growing sectors tend to retain cash in order to pursue future growth opportunities and pay dividends as the industry life-cycle reaches maturity. However, in SeaDrill's case, we are seeing a very different approach to the business - the company pays most of its cash flows to the investors and employs heavy leverage to fund capital expenditures.
Financing Decisions and Debt
Ideally, a company will opt to use internally generated cash to expand; however, there are a lot of factors that companies take into account while making a financing decision. Some of these factors are interest rates, outlook of the sector and the ability to meet interest payments. The first factor has played the biggest role in SeaDrill's strategy. To understand this point, we will have to take a small tour through the history of the company.
SeaDrill was incorporated in 2005, three years before the financial meltdown that crippled the global economy. Soon after the incorporation of the business, the day rates hit all time high in 2007, which alerted the management to the massive growth opportunity available to the company. A year later, the financial meltdown presented the opportunity for the businesses to raise money at historical low costs. As I mentioned in my previous article, most of the debt for SeaDrill is at low interest rates and almost all of its debt is in the shape of credit facilities (most of these are not completely utilized, giving the company to raise further cash). SeaDrill has used this debt to finance its ultra-deep water rigging fleet, which fetches some of the highest day rates in the sector. I have analyzed the debt of the company in detail here.
The second factor is the outlook for the industry. As I mentioned above, the industry is at the growth stage and most of the industry experts believe it to continue growing at an exceptional rate. The growth rate in the industry gives these companies surety to generate cash flows and meet debt obligations. As a result, leverage is high in the sector. I mentioned in my last article that SeaDrill's current debt to EBITDA ratio is just above 3, which is expected to come down to close to 2.5 over the next two years as the company expects its EBITDA to reach $4 billion. Despite taking on more debt, the company will be able to decrease its debt-to-EBITDA ratio.
The Fear of Falling Day Rates
The biggest fear that has hit the sector is the possibility of a decline in day rates and oversupply of rigs. Again, there are two major factors being ignored here. First, the demand for ultra-deep water rigs remains strong and it will likely remain strong due to the technical needs. Second factor is the elimination of the older rigs. A large number of new rigs will be replacing older, obsolete rigs. SeaDrill's fleet largely consists of 6th generation ultra-deep water rigs that are fetching high day rates and the demand for these rigs is high.
The biggest threat for off-shore drilling arises from accidents - newer rigs are better at security and decrease the chances of accidents - lesser accidents mean lesser liabilities in the shape of penalties and law suits (Macondo incident comes to mind), hence the willingness from the energy companies to pay premium prices for the services of the expert drilling companies. I will go as far as to say that SeaDrill will be able to secure contracts at impressive rates even if the sector sees a decline in day rates, which I believe is unlikely in the short term.
Finally, the macroeconomic factor - oil prices are expected to remain high due to the recovering global economy and increased manufacturing activities. As long as the oil prices remain high, the cost to drill off-shore will remain under control for the energy companies. As a result, the drilling activities will remain strong. As I mentioned in my previous article, BP (BP) is just one example of these energy companies - BP plans to invest $4 billion in the Gulf of Mexico annually - SeaDrill's most recent delivered rig is contracted to BP in that region until 2020.
Another important factor to consider is the subsidiaries and SeaDrill Partners (SDLP). SeaDrill is dropping down assets to SeaDrill Partners and receiving cash. Furthermore, as the company is the majority shareholder, the cash distributions will flow back to SeaDrill. On the other hand, SeaDrill's subsidiaries are operating in some of the most difficult environments - North Atlantic Drilling has its whole fleet in the North Sea, a region with harsh environment - as a result, these rigs fetch high day rates. Cash from subsidiaries flows to SeaDrill in the shape of dividends.
The issue of high debt is real, but as I have said before, it can be misleading if looked at in isolation. Furthermore, the issue of day rates may affect the sector in the future, but I do not see it affecting SeaDrill in the short-medium term. As a result, I believe the dividend is under no threat in the short term. Furthermore, any dip in stock price should be looked as an opportunity to buy as I believe the industry growth prospects and the position of the company will result in increased earnings and cash flows.