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SeaDrill Limited (NYSE:SDLP)

Q4 2013 Results Earnings Conference Call

February 25, 2014 1:15 PM ET

Executives

John Roche - Head, Investor Relations

Graham Robjohns - Chief Executive Officer

Rune Magnus Lundetrae - Chief Financial Officer

Analysts

Robin Shoemaker - Citi

Jacob Ng - Morgan Stanley

TJ Schultz - RBC

Lukas Daul - ABG

John Roche

Thank you, and good afternoon, everyone. Welcome to Seadrill Partners Fourth Quarter 2013 Earnings Conference Call. With me today, I have a CEO, Graham Robjohns; and our CFO, Rune Magnus Lundetrae. Before we do get started, I just like to remind everyone, as I am sure everyone is aware that much of the discussion will not be based on historical fact but rather consist of forward-looking statements and are subject to uncertainty. If you look at page two of our presentation today, we articulate some of the key items in terms of forward-looking statements. For additional information and to view SEC filings, please visit our website at www.seadrillpartners.com.

With that, I’d like to turn over to our CEO, Graham Robjohns.

Graham Robjohns

Thank you, John, and good afternoon, everybody. If we start on slide three, we can see we have an agenda, as usual covering the highlights for the fourth quarter of 2013 and brief look at market outlook, growth opportunities, financial review and then we will revert at the end of the presentation to question-and-answer session.

Turning over to slide five and starting with Seadrill Partners fourth quarter highlights. We report net income attributable to Seadrill Partners Members of $62.6 million for the quarter and net operating income for the fourth quarter $134.4 million.

I should point out at this junction that whilst the company has acquired rigs obviously from Seadrill or interest in subsidiaries own and operate rig T-15, T-16, West Leo, West Sirius during the year. These acquisitions are deemed to be under U.S. GAAP organizations of entities under common control.

As a result, the company’s balance sheet, statement of operations, cash flows and changes in equity have been restated in accordance with U.S. GAAP to include the T-15, T-16, West Leo and Sirius as if the company had acquired those entities that runs and operate the rigs the entire period that the rigs are been under the common control of Seadrill. So in effect of course that includes the entire period of 2013. And therefore comparative numbers will include the results of the West Leo, the West Sirius, et cetera results.

So once we generate the distributable cash flow of $23.2 million and declared and have now paid the fourth quarter distribution at a rate of $0.4450 per unit, which is a 15% increase from the company’s minimum quarterly distribution set at IPO.

We obviously completed the acquisition of the company to own the tender rig T-16 from Seadrill for $200 and we announced a settlement agreement with the -- in connection with West Aquarius where we also increased the term of the contract by 18 months and providing an estimated net revenue potential increase of $337 million over that term.

The West Capella contract term was amended from five years to three years as a result largely a change in operatorship on the field and dayrate increase as a result of that reduction from $580,000 to $627,500 per day.

In December we completed the acquisition of the entities to own West Sirius and West Leo for $2.3 billion on 100% basis, obviously we acquired 51% of the West Sirius effectively and 30% of the West Leo. This was financed with intercompany loans and a $465 million equity offering.

As a result of those acquisitions, management has recommended a quarterly distribution increase of between -- has recommended a quarterly distribution increase to between $0.50 and $0.5125 on a quarterly basis.

Subsequent to the year end as recently announced of course Seadrill Partners completed $1.8 billion term loan B refinancing which included $100 million revolver. Proceeds of the refinancing have been used to repay existing indebtedness, transaction expenses and general company purposes.

The transaction was very well received. We had significantly over described demand and upsized from original contract and upsized of $1.7 billion and priced at the low end of the range of 3% over Libor and have subsequently fixed that interest payment with interest rate swapped to 5.5%.

As part of this transaction of course Seadrill obtained a rating, BB- from Standard & Poor's and Ba3 from Moody’s. This new structure creates a much more efficient debt capital structure for us and also is the first step and has creating a debt structure that is independent of Seadrill with significantly lowest amortization and allows us therefore to use more of our replacement and capital expenditure cash reserves to invest in new assets rather than paying down debt where we can earn obviously lot more on investment in assets than we do in ridding our sales of liabilities.

Turning over to slide six. We’ve had made some significant progress since our IPO. And we of course acquired the two tender rigs, T-15, T-16 which were option vessels at the time of the IPO. We’ve had an increase in the dayrates on the West Capella as I mentioned and the West Aquarius extension which also resulted in $75,000 a day increase in rates.

I think as we mentioned before the rigs that went into Seadrill Partners at IPO were partly chosen because they had rates that were not that leading edge rates. And I think the rate increases on the Capella and Aquarius demonstrates that ably.

We’ve also completed the five-year classings on the two of the rigs that we had in Seadrills partners at the IPO, the West Aquarius and West Capella. The West Sirius five-year classings was also finalized during 2013 and therefore the next five-year classing we have is, would be until 2015.

The West Sirius and the West Leo acquisition as I mentioned occurred in December and of course finally we completed $1.8 billion term loan financing. So all in all, a pretty eventful time and distribution increases 15% as of the end of 2013 from the IPO. Assuming management’s recommendation for an increase of between 12% and 15% for this year. So in Leo, that will take us up to a 30% distribution in increase since IPO.

Turning over to slide seven which supplemental information on the two rigs that were dropped down, the West Leo, the West Sirius, both submersible. The West Leo operates in West Africa, dayrate of $605,000 a day until June 2018. The West Sirius in the Gulf of Mexico as of July 19, the dayrate of $535,000 until -- sorry dayrate of $535,000 as of July 2014 until July 2019.

Slide eight has some numbers in metrics in connection with the acquisition of West Leo and West Sirius. You can see the purchase price is there. As I mentioned before because the West Leo and West Sirius were both acquired by the operating companies that Seadrill Partners part own, the one in which is 30%, one is 51%. SDLP’s share that purchase price, you can see on the right hand under this slide was $903 million and then there were some bank debt that was assumed as part of the acquisition and also we took on an intercompany loan which led $528 million as the equity portion of this transaction.

That was financed by a seller’s loan direct to Seadrill Partners from Seadrill at $70 million and the next issuance $466 million to cover the $458 million equity portion. The important thing to note, I think, here in connection with the debt is that all this debt, the bank debt and the intercompany loans have been or will be refinanced by the term loan B refinancing.

And again as I said before the management’s recommendation is to increase distribution as a result of this transaction and with effect from the distribution for the first quarter 2014 to between on annualized basis to between $2 and $2.05 per unit.

On slide nine, we have a summary of the term loan B refinancing. So on the right hand side, you can see Seadrill Partners structure and the two operating companies that I have been referring to Seadrill Operating LP that we have 30% of and Seadrill Capricorn Holdings that we own 51%. Those two companies make up the borrower group and the assets that are pledged as collateral under the term loan, the West Aquarius, West Capella, the West Leo and the West Sirius.

Turning over to slide 10. We target having sales in the top tier of distribution growing MLPs and to a large extent, I think we have achieved that 15% growth as I’ve said as of the end of 2013 and that will increase assuming those recommendations is accepted and to 30% growth since IPO as of the first quarter of 2014.

Turning to the market outlook. I think for those of you that listened to the Seadrill presentation. You’ve already seen this slide and discussion but I think it’s an important one that explains some of what’s going on at the moment in the broader market. In the top left, you can see that whilst oil prices have remained pretty stable, E&P spending having and while E&P spending has increased or it’s that just free cash flow has actually declined as cost of additional production have increased.

On the right hand side of the slide, you can see that whilst spending CapEx, appear greater for North American focused E&P, there are a number of examples. You can see on the bottom right-hand side of 2014, projects being pushed into 2015 and the spend reduction on projects split will likely lead close to lower overall production and in turn therefore, that will potentially lead to the higher oil prices in the future and thereby reversing that spend trend.

As E&P spend increases, after this current pause, we expect to see a significant increase in activity in the ultra-deepwater segment. Again, I think it was mentioned on the Seadrill call that ultra-deepwater currently produces around a million barrels today, which is expected to rise by 5 million barrels by 2020, which is clearly an extremely strong growth profile. And finally on the bottom left-hand side of this slide, you can see that ultra-deepwater production is cost competitive with other sources.

On slide 13, I think this further supports the increase in future rig demand. Here you can see that the rig count has increased quite significantly over time but oil production from offshore has actually declined. And that clearly signifies an increased rig intensity required to produce the same amount of oil, which points of course to much increased rig demand moving forward.

On slide 14, many of you’ve probably seen before but I think it shows that increased production potential from offshore translated into what it means for rig demand and the increase in production translates to round about 450 rigs at the end of 2020. And if you take current fleet and newbuild and potential retirements during the period between now and 2020, then we are going to need roundabout a 180 additional new rigs.

So, moving on to Seadrill Partners current fleet and potential dropdowns in growth, and we turn to slide 16 that sets out Seadrill Partners long-term contract coverage. This has grown by two rigs, of course since the last quarter, the West Leo, the West Sirius. They have significantly increased our order backlog to $4.5 billion and the average remaining contract term is now currently 3.7 years.

Turning over to slide 17, I think one of the things that really stands out for Seadrill Partners is the tremendous potential growth profile that we have moving forward on top of the growth that we’ve already achieved to date. The first avenue is from additional new rigs from Seadrill. This slide on slide 17 sets out Seadrill’s ultra-deepwater fleet.

The existing rigs that are in the MLP fleet are highlighted in black. And then, I guess the most obvious candidates that will be dropdown potential for Seadrill Partners are highlighted in gray of a two seven-year contracts, would be the West Auriga and the West Vela and then the West Mira that was actually contracted post IPO over which Seadrill Partners actually will have an option to acquire. But I don’t think it’s necessarily stops at those two rigs. There’s clearly an awful lot of potential as you can see from the number or rigs on this slide.

Turning over to slide 18, the second avenue is acquisition of additional interest in the operating entities that own our existing rigs. So, 70% of the operating entity that owns the Aquarius, Leo, the Capella and the Vencedor, and then 49% of the other operating company simply by acquiring an additional OPCO operating units. So we will eventually reach the point where we have 100% of those OPCO entities that of itself generates growth and distributions for Seadrill Partners.

Thirdly is the potential for long-term contracted jack-ups and jack-ups were never really part of the story of IPO. However, I think that market has changed quite a bit since the IPO, and we now have a significant number of modern high spec jack-ups on long-term contracts and best example of that I think is the five jack-ups that Seadrill have contracted into PEMEX for six-year contracts and that is potentially business, that is of interest to Seadrill Partners.

And then finally, I think there is -- if you like organic growth within Seadrill Partners, firstly as a result of the day rate increases that we’ve seen -- already seen extensions on our rigs at higher rate and also potentially rigs that will deliver into the sort of timeframe of 2017, [2015] and 2016 where we could see rate upticks, recontracting at that point could rise -- could give rise to further direct increases.

Turning to slide 19, we come to financial performance highlights. On slide 20, we have the income statement. Total operating revenues increased from $266 million to $282 million and net operating income from $118.1 million to $134.4 million. And improvements in both revenue and operating income have been both driven primarily by the fact that in the third quarter we had the $22 million West Aquarius revenue write-off in connection with its 18-month extension. And then in the fourth quarter, we’ve had the contribution from T-16, which is a newbuild that commenced operations by the end of the third quarter and that’s been offset by some downtime on the Capella and Aquarius 5-year classing and the Aquarius anchor chain repair requirement.

Net income has increased from $14.2 million to $62.6 million, that’s been driven by the improvement in operating income as I mentioned, but it’s also been impacted by a change in derivative financial instruments where we’ve moved from a loss of $11.8 million to a gain of $16.1 million. Of course, the vast majority of that movement is non-cash and relates to the mark-to-market valuation of interest rate swaps.

Turning over to slide 22, we have the balance sheet and as I said right at the start and same is true, of course, the income statement of the third quarter assets on the balance sheet here also include the West Leo and the West Sirius. I think the other thing to point out is that as our acquisitions from Seadrill are under common control as U.S. GAAP defines it that the assets going to the balance sheet at book value and not the purchase price.

Turning over to slide 23 on the liability side, I think the important thing to point out here is that of our debt excluding the intercompany revolver we have from Seadrill of $2.23 billion. As you can see down the bottom of the slide 93% of that is fixed to swap rate of approximately 1.64% and indeed subsequent to the quarter end, we will come up closer to 100% of fixed interest rates swaps.

Turning over to slide 24, we have the distributable cash flow and this unlike the income statements on the balance sheet is on a cash basis not on a GAAP basis, and therefore the Q3 results do not include West Sirius and West Leo results. And then in the fourth quarter, you can see the reconciliation from EBITDA of $171.9 and adjusted EBITDA of $168.6 million, then we have interest income less cash interest expense, cash tax paid and then the $54 million is adjusting for the earnings of the T-16, West Leo and West Sirius prior to the acquisition by Seadrill Partners. That leads us down to cash flow available for distribution of $62 million after we deduct estimated maintenance and replacement capital expenditure reserves, less reduction of $38.8 million for non-controlling interest gives us distributable cash flow for the third quarter of $23.2 million, up from $15.9 million in the third quarter.

Given distributions declared of $27.1 million, we had a coverage ratio of 0.86 times. I think the very important thing here to remember is that we issued around 16.3 million new units in the middle of December in connection with the West Sirius and West Leo acquisitions and those units were in existent at the record date when we paid the distribution for the fourth quarter so we’ve had in place a distribution for entire quarter on those 16 million units. If we redid this calculation and assumed that we paid the distribution pro-rata on those new units, we are only the 19 days that we owned the West Leo and West Sirius, the coverage ratio would be actually 1.08 times.

So finally to slide 25, the summary and outlook, we have made significant progress in 2013, doubled the fleet size, on track to reach 30% distribution growth since the IPO. We’ve taken up first step in praising our own debt structure and a much more efficient debt structure for the Seadrill Partners going forward. And of course, our writing has given us access to this market, another debt capital markets moving forward. There are some headwinds in the broad offshore drilling market, but I think the important thing at Seadrill Partner is completely protected from that. We have no exposure to 2014 dayrates and only the tender rig West Vencedor available in 2015.

And in fact in some ways it could be seen as a potential upside to us because the pause in spending is fundamentally limiting newbuild’s ordering activity in 2016 whilst the medium, long-term fundamentals remain intact and therefore with less newbuild spending that maybe put off in 2014, 2015 being pushed into sort of second half of ’15 and ’16, that’s going to potentially give rise to dayrate increases per rigs at a time when some of Seadrill Partners rigs come up for re-contracting.

And finally, we have an extremely visible growth profile and opportunities via acquisition from Seadrill, which provides us with extremely strong distribution growth, potential moving into the future.

With that, I will hand back to the operator and open up for questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) Want to move to our first question today from Robin Shoemaker of Citi. Please go ahead.

Robin Shoemaker - Citi

Yes. Hi, Graham.

Graham Robjohns

Hi, Robin.

Robin Shoemaker - Citi

Just my first question would be in -- with your current assets, do you anticipate any out of service time this year that -- or would we expect the utilization rate to be in the low-90s across all these assets for the full year?

Graham Robjohns

I think other than the -- we mentioned in the reports some downtime that we’re already aware of for a couple of the rigs in the first quarter. Our target at time is in the sort of mid-90s really, not the low-90s. We have, as I said, got no 5-year classing in 2014 and I think the only one we have in 2015 relates to West Vencedor the tender rig.

Robin Shoemaker - Citi

Yes, okay. And in terms of the debt refinancing you’ve done, is there a significant change in interest expense or do you have any guidance in that for our modeling purposes, interest expense per quarter under the new financing that you put in place?

Graham Robjohns

There will be some increase. I think we mentioned in the report that if that it was sort of slightly more generic rather than specific, but if you’re looking simply at refinancing those four rigs in the bank market at $1.8 billion, then it’d be around about $20 million odd less interest expense, but it’d be clearly significantly move around $160 million higher in utilization. That's not precisely comparison to current interest expense relative to term loan interest expense, but it’s kind of a reasonable indicator.

Robin Shoemaker - Citi

Okay. So with my last question to you then on the weakness in the rig market which you cited near-term weakness. Is there anyway in which that impacts the calculation of transfer pricing when you drop down a rig with the five-year or seven-year contract or is the contract itself essentially what drives the transfer pricing mechanism?

Graham Robjohns

No, particularly, no, I think, the contract is a key thing that drives the valuation and then comes the sort of the residual value expectation. And as you’ve heard me say and Seadrill say our view is that in the sort of medium to long term things actually look pretty good. So there shouldn’t be really a dramatic impact on valuations. That’s all.

Robin Shoemaker - Citi

Okay. Thanks a lot, Graham.

Graham Robjohns

Okay. Thanks, Robin.

Operator

Thank you. We now move to our next question from Jacob Ng from Morgan Stanley. Please go ahead.

Jacob Ng - Morgan Stanley

Hi, thank you for taking my question. I see that you've identified five jack-ups as potential dropdown candidates. But I was curious to know how you’re thinking about the mechanics for acquiring these units. Given that they have already been included into sea mix?

Graham Robjohns

Yeah. I think I’ll let Rune comment little bit as well. But I think the point, the main point that we’re making there rather than sort of saying we were going to drill those rigs down, was that it’s a very good example of how the jack-up market has changed since the IPO. And therefore modern high spec rigs with long term rates are something that the MLP will be interested to look at.

Rune Magnus Lundetrae

I think, the reason we wanted to highlight it, Jacob, is that it’s not why it’s pending in the next couple of weeks there. So it will be a little-bit premature to go in to technicalities of how we work. The reason we highlighted that we were pretty clear when we did the IPO. We didn’t think it would be likely to see jack-ups in the MLP. But I think what happens since then is that the dynamics of the jack-up market has changed.

And now I think, you do see longer term contracts in Middle East and then of course the sixth year contracts which is to our knowledge pretty much unprecedented. So I think we just couldn’t ignore those contracts when we do have this Seadrill Partners company. I think it would be a perfect drop-down Canada. So I think you have to be a little bit patient for us for respect to how the mechanics would work. But I think it’s also important to highlight that that’s jack-ups are now also possible drop-down candidates.

Jacob Ng - Morgan Stanley

Great, that’s all for me. Thank you. I’ll turn it over.

Graham Robjohns

Thanks.

Operator

Thank you. And now move to our next question from TJ Schultz from RBC. Please go ahead.

TJ Schultz - RBC

Hey, how are you doing? The comments been pretty consistent to target kind of the top-tier of MLP distribution growth, just does that correlate in your view right now to that target of 15% per year and do you have a target dollar amount of drops per year or has that expectation for the pace of drops changed at all recently?

Graham Robjohns

We don’t have a target dollar amount I think but if we are sort of targeting, I guess, as a baseline that sort of 15% plus but clearly as I have said there are an awful lot of growth opportunities here. So you should expect quite a lot of acquisition and quick activity going forward.

TJ Schultz - RBC

Okay. On slide 18, can you just expand on the bullet point of the kind of more efficient use of the replacement CapEx reserves, what the efficiencies allow and how that fits in with that kind of force like there?

Graham Robjohns

Yeah, sure. I think I mean unlike -- I think all the Marine MLP to this, unlike most of some traditional MLPs. We have maintenance CapEx reserve and we also have something called replacement CapEx reserve which goes to the fact that rig -- ultimately a rig has a fine at light so we build up a reserve over the rigs life to replace it at the end of its life.

What we effectively have been doing because we have been financing ourselves with bank debt historically is using that cash reserve to pay down debt on the rig. So effectively we are ridding our sales of the liability and obviously what you were on that is what you say in interest cost on now reducing the debt.

If your debt amortization is significantly lower than a big chunk of that cash reserve rather than being spent on reducing debt can be spend on new assets. So rather than buying a whole rig at the end of 30 years, you can buy one-third of the rig if you like every year. And by doing that, we are effectively earning our (inaudible) rather than saving interest cost of 4% or 4.5% or whatever it is. And therefore the replacement CapEx amount that we need to set aside reduces because we're earning and the earning accumulates quicker.

TJ Schultz - RBC

Okay, understood. Just lastly the sixty days collective downtime in the first quarter, has that already occurred or any potential impact into the second quarter for the downtime there and then if you could clarify for me on operating cost if you have a corresponding decrease or if you still incur cost during that downtime. Thanks. That's it.

Graham Robjohns

Most of have been incurred and one rollover into the second quarter. We do still, yes, pay operating costs during downtime.

Operator

Thank you. We’ll now move to our next question from Lukas Daul from ABG. Please go ahead.

Lukas Daul - ABG

Thank you. Good evening. I was wondering when you talk about acquiring more units and the rigs that you already own partially versus adding new rigs, can you talk about the parameters that you consider when you are making these decisions?

Graham Robjohns

Well, I think, simply in terms of what we have done to today, we have bought new rigs or parts of new rigs if you like into the operating company because at IPO, we only have four rigs which in terms of diversification is sort of is going to be at high risk, so that’s why we wanted to increase the number of rigs to reduce that rate, that was kind of the first parameter. So it will be some point in the future, when we look at acquiring units in the operating companies and there will be kind of effectively -- you rather than buying one rig, you are buying a share of three or four rigs, so the valuation process will be reasonably similar.

Lukas Daul - ABG

And so do you now feel that you have the critical mass that is desirable or would you like to expand it?

Graham Robjohns

It’s getting closer. But I still think you will see us buying new rigs as well as collecting company units.

Lukas Daul - ABG

Okay. And with the new term B loan in place, how do you think about financing these additional acquisitions, is it still fair to assume 50/50 that equity or...?

Graham Robjohns

Yes. Approximately, I think it would be sort of in the debt range of 50% to 60%, and equity range of sort of 40% to 50%.

Lukas Daul - ABG

All right. Thank you.

Graham Robjohns

Operator, I would like to open the floor to our last question here.

Operator

Certainly. Thank you. So our final question now comes from Michael Webber of Wells Fargo Securities. Please go ahead.

Unidentified Analyst

Hey guys. This is actually (inaudible) for Michael. How are you?

Graham Robjohns

All right. Yeah. Hi.

Unidentified Analyst

So, I just had one quick question regarding the West Vencedor, we think that all the other questions are really answered. I think that’s the only rig, which is coming up for re-charter in the 2015, have you guys initiated discussions with Chevron regarding a potential re-charter reset other charters yet, or can you give us any update in terms of that process?

Graham Robjohns

Yes, we have. It’s a little way up. But discussions have started. I’m being positive that certainly work down that for the rigs, so I think we are feeling reasonably comfortable without it.

Rune Magnus Lundetrae

At the current dayrate level as well. I think the dayrate level would be in the 2/10 or 2/30 to 2/40 range, which is -- which today’s current dayrate level is well within.

Unidentified Analyst

Okay. That’s all I had in mind. I think the announced already, all of my others questions already asked.

Graham Robjohns

Sure.

Rune Magnus Lundetrae

Thank you.

Graham Robjohns

Okay. Thanks, everybody. Operator, this concludes our call today.

Operator

Thank you. That will conclude today’s conference call. Thank you for your participation. Ladies and gentlemen, you may now disconnect.

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