There have been several articles published over the last several weeks regarding the sustainability of Seadrill's (NYSE:SDRL) dividend so the last thing that investors in the company need is yet another one. I have not read all of these analyses but the ones that I have read completely ignored one simple fact that is true with all companies but is particularly important with Seadrill: A company's ability to pay dividends is not dependent on its accounting earnings (net income) but on its cash flow. This is because a company's net income is impacted by several things that do not actually represent money that leaves the company. A good example of this is depreciation and amortization which reduces a company's income for tax purposes but which is not an actual payment that the company makes. In the case of Seadrill, the company has numerous investment holdings which require regular mark-to-market adjustments that can result in big quarterly swings in the company's net income even though these adjustments do not actually produce or cost the company any actual money. However, a dividend represents a real outflow of cash. This is the reason why we need to look at the company's actual cash inflows and outflows when analyzing its ability to pay its dividend.
It is also important to look at the sources from which a company receives its cash in order to determine its ability to sustain its dividend. A company could pay out a high dividend by floating a chunk of new equity or by taking out a loan to get the money to pay the dividend. However, a dividend that comes from such a source is not sustainable in the long-run. This is why it is important to look at where a company is getting the cash to pay its dividend.
In the third quarter of 2013, Seadrill had a net cash from operations of $533 million. This was the highest level that the company has achieved in 2013, excluding perhaps the fourth quarter (the results of which have not been released yet). This figure tells us the amount of money that Seadrill brought in the door through its regular operations (i.e. from the contracts for its rigs) less interest, taxes, and operating expenses. Thus, this is the actual amount of cash that Seadrill made on a sustainable basis in the third quarter of 2013. During the same quarter, Seadrill paid out a total of $434 million to its investors in the form of dividends. So far, so good. At present, Seadrill's ordinary business is producing more cash than the company is paying out in dividends.
However, things are not quite so simple. Seadrill's operations may be generating enough cash to pay its dividend but part of the company's appeal to investors is its high growth rate in addition to its high dividend yield. So, are the company's operations generating enough cash to finance this growth in addition to paying the dividend? The answer to this question is unfortunately no. Offshore drilling rigs, particularly ultra-deepwater ones, are large and complicated machines that require considerable skill applied over a long time period in order to build. For this reason, they are also quite expensive to build. For example, a single ultra-deepwater semi-submersible or drillship usually costs between $600 and $700 million (this cost varies depending on the rig's design, specifications, and on soft factors such as the company's relationship with the shipyard) and takes about two years to construct. Therefore, offshore drilling contractors, particularly fast growing ones, tend to have very high capital costs. Seadrill is no exception. In the third quarter, Seadrill spent a total of $840 million on "Additions to newbuildings" and an additional $144 million on "Additions to rigs and equipment." Thus, Seadrill had total capital expenditures of $984 million in the third quarter. Clearly, this spending is much higher than what Seadrill brought in through its regular operations, even without accounting for the dividend.
It is not atypical for Seadrill to be unable to finance its newbuilding program, which is the primary reason for the company's high capital expenditures, solely by using the cash that it brings in through its regular operations. In fact, the company usually has a negative free cash flow. So how is the company paying for all the rigs that it has under construction? It has mostly been using debt. Seadrill's strategy is essentially paying out most of the money that it brings in from its regular operations to investors in the form of dividends while simultaneously taking out loans to expand its rig fleet. The company then leases out the new rigs that it built with debt at a price that is sufficient to cover the payments on the loan that was used to build the rig and increase the company's net cash from operations. Over the past few years, this has worked out quite well as oil companies have demanded more rigs than what were available, supporting high dayrates for offshore drilling rigs and also making it relatively easy for contractors to secure favorable contracts for the use of their rigs.
However, offshore drilling is very much a cyclical industry, as it goes through periods in which oil companies demand more rigs than are available and periods in which oil companies are cash constrained and do not demand offshore drilling rigs in such high quantities. Seadrill's strategy, as discussed in the previous paragraph, increases the company's vulnerability to an industry downturn compared to a company that used a lower amount of leverage to finance its growth. This is because Seadrill needs to secure contracts for its new rigs that generate enough cash to cover its financing costs. Unfortunately for Seadrill, it appears that the current industry slowdown is resulting in the company having some difficulty securing contracts for its new rigs.
Seadrill has two ultra-deepwater (three if Sevan Drilling's fourth rig is included) and one jack-up rig scheduled to leave the shipyard in 2014 that have not yet secured contracts. The jackup rig is particularly concerning because its construction is scheduled to be complete in the first quarter of 2014. Seadrill will need to secure a contract in short order for this rig to avoid having it become a cash drain but the slowdown in the offshore drilling market appears to be making that a much more difficult proposition than it would have been a year ago. Seadrill purchased this rig, Prospector 3, for a total all-in cost of approximately $250 million back in November but the company did not state where it got the money. If Seadrill simply paid cash for the rig (it had $551 million in cash at the end of the third quarter) then that would increase the company's flexibility regarding that specific rig since there are no financing costs to worry about. However, even if Seadrill did finance the purchase of Prospector 3, Seadrill's other operations are strong enough that the company should be able to carry the loan without the cash flow from Prospector 3 until it secures a contract for the rig. More concerning are the two ultra-deepwater rigs, West Jupiter and West Carina, which are scheduled to be delivered in the third and fourth quarters that do not yet have contracts. However, it is the same story here. Seadrill can likely carry the financing costs for these two rigs without generating any cash flow from them should it fail to secure contracts for them.
One factor that significantly increases Seadrill's ability to weather a temporary industry slowdown is its massive revenue backlog. The revenue backlog is revenue that Seadrill is contractually obligated to receive due to its current rig contracts. Seadrill does not have to negotiate new contracts with anyone in order to receive this money, all it has to do is continue operating and maintaining its rigs over the terms of its existing contracts. As of November 22, 2013, Seadrill's revenue backlog was $19.5 billion, $16 billion of which is attributable to the company's floater fleet. Seadrill had total consolidated revenues of $1,280 million in the third quarter so this revenue backlog would theoretically allow the company to operate for 15 quarters, or nearly four years, at its present levels without ever signing another contract. Unfortunately, that theory will not completely work in reality. Seadrill has seven jack-ups that will be coming off contract in 2014 that have not yet secured new contracts to begin work on after they have completed work on their current contracts. Should the company fail to secure new contracts for these rigs then it will see its revenue and cash flow decline regardless of the revenue backlog, although this could be partially offset by a few new ultra-deepwater rigs that are starting work on their first contracts this year.
In previous articles, I have stated that the current slowdown in the offshore drilling industry appears to be hitting the low end of the market much harder than the high-end, premium market in which Seadrill operates. This is the reason why Seadrill's management stated in its third quarter results announcement that Seadrill is unlikely to be significantly affected by the market downturn. While this still does appear to be true, the dearth of contract announcements recently even at the high end of the market could indicate that oil companies are retrenching further than they were at the end of 2013. There are also indications that the market is adequately supplied. These factors could result in difficulty for Seadrill due to its need to secure new contracts to replace its expiring ones and for its newbuilds.
In conclusion, Seadrill's dividend is probably sustainable, at least in the short-term. While the company is facing a potential revenue decline in 2014, it may be able to offset this with the new ultra-deepwater rigs that will begin work in 2014. However, it is unlikely that the company will see much revenue growth this year unless it manages to secure new contracts. Personally, I am perfectly okay with that as the dividend alone is adequate return. However, I will begin to worry if the company hikes its dividend again without announcing new contracts as I am skeptical about Seadrill's ability to sustain a higher dividend given the present conditions. Most forecasts point to this industry downturn lasting for no more than a year or so. Should that prove to not be the case and the soft market lasts for longer than a year then the dividend may be under pressure. Investors may want to hedge their downside risk with put options or a bear collar just in case but overall the company still seems to be able to maintain the dividend at the current level barring extended weakness in the offshore drilling market.
Disclosure: I am long SDRL. 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.
Additional disclosure: I am short call options against SDRL.