Last week, Seadrill (NYSE:SDRL) reported quarterly results that left the bulls optimistic but also provided fodder for bears (financial data and press release available here). While shares fell 5% on the results, they subsequently rallied back to erase some of the losses over the balance of the week. After combing through these results, I am increasingly convinced that Seadrill's dividend may prove to be unsustainable over the long-term. While the company may be able to grow out of its current problems, all investors must understand why there is risk to the payout and the stock price. After examine the risk, each individual investor can decide whether or not the potential reward is worth it.
In the fourth quarter, Seadrill grew revenue by 20.5% to $1.47 billion as it continues to expand its rig count, though as you will see below that expansion is not cheap. EBITDA was a strong $768 million, and utilization rates were solid at 94% for floaters and 98% for the jack-up fleet. Net income of $281 million was a bit light, though many investor do prefer to look at EBITDA and future cash flow potential.
Long term debt rose in the quarter to $11.9 billion from $10.1 billion. Total net debt increased to $13.9 billion from $12.6 billion. The company's operations generated $1.7 billion in cash during 2013, but the company invested $3 billion as it expands its rig count. Seadrill continues to invest far more than it generates, which is why it turns to the debt market to finance investments and the dividend. Financing activities generated $1.7 billion in cash last year.
Seadrill management also suggested that the near term outlook for the industry is weaker than anticipated as major oil companies cut their cap-ex budget. Seadrill expects some pricing pressure, especially for older vessels in 2014. As a consequence, the company is trying to limit its exposure to 2014 contracts by pushing floater availabilities into 2015 when the company expects demand to pick back up. By doing this, SDRL is trying to avoid locking in low day rates for several years, instead locking in contracts later but at a higher price. However, this strategy is predicated on the belief that demand will pick back up in 2015, which is very uncertain. Some oil companies are in the process of cutting their cap-ex budgets over the next three to five years, which would suggest the environment beyond 2014 will still be weaker. Others are focusing their cap-ex dollars on natural gas, fracking, and onshore oil, which will leave demand for offshore rigs relatively lackluster. In other words, expecting a solid rebound in rates in 2015 may prove to be too optimistic.
Many investors own Seadrill for the dividend, so they were pleased that the company increased the quarterly payout by three cents to $0.98. While this dividend is not covered by free cash flow, the board is confident it will be sustainable as new rigs come online (there is an order backlog of $20.2 billion). In an effort to ensure the sustainability, SDRL is creating a dividend capacity fund, which functions like a rainy day fund. 20% of the proceeds from dropdowns to its MLP, Seadrill Partners (NYSE:SDLP), will go into this fund and be returned to shareholders over the next twelve months through the dividend. In other words, asset sales will provide a source of funding for the dividend.
It is important to recognize that so long as Seadrill has access to the debt market its dividend is safe because it can always borrow to make the payout. However, a dividend funded by debt and asset sales is not sustainable in the long run unless free cash flow improves dramatically. At the current pace, the dividend is now $3.92 per share. After factoring in a larger asset base but lower day rates, I expect SDRL to earn $3.40-$3.55 in 2014, so Seadrill will pay out more than it earns, which is a definite warning sign.
Seadrill is also now carrying $13.9 billion in debt, which far exceeds the $6.6 billion it was carrying at the end of 2009. The dividend will cost about $1.83 billion this year, which is 7.6% higher than 2013's operating cash flow. In 2014, EBITDA should improve to about $2.5-$3.0, which would suggest operating cash flows of $2.0-$2.4 billion. Now, the company also continues to invest aggressively in growing the fleet to meet that $20 billion backlog. Between the dividend and cap-ex requirements, Seadrill will need to continue to raise $1-1.5 billion annually through debt issuance, asset sales, and perhaps equity raises through 2016. When a company is significantly free cash flow negative, paying out a 10%+ dividend is extremely aggressive and risky.
The Seadrill dividend is not going to be cut in the immediate term; I think that is clear. However, the dividend policy forces SDRL to issue exorbitant amounts of debt to fund growth. At some point, Seadrill will have too much leverage and will likely be forced to cut the dividend. Right now, debt to forward EBITDA is 5x, which is not conservative but not dangerous. However if you factor out the dividend payment, that ratio increases to a very dangerous 14x. The dividend is substantially increasing the effective leverage at Seadrill.
It is certainly possible that Seadrill is right that the offshore market improves dramatically by 2015. If this is the case, SDRL can lock in higher rates as contracts expire, which together with a larger fleet will dramatically increase cash flow. If this is the case, the company can eventually turn free cash flow positive (probably around 2017-2018), start to pay down debt, and maintain the dividend policy. If the market continues to be soft though and it renews contracts at weaker rates, cash flow will be constrained and a dividend cut may be necessary.
Seadrill is an extremely levered play on the off-shore drilling market. Further because it pays out the vast majority of operating cash flow while maintaining a massive investment budget, its dividend is impacted by small changes in cash flow and credit market funding. With major oil companies cutting and refocusing cap-ex budgets away from riskier offshore projects, I do not expect a dramatic improvement in day rates. Seadrill's current dividend policy is therefore adding too much leverage to the balance sheet and will prove unsustainable over the next 18-24 months. While no cut is imminent, Seadrill's dividend is at risk over the medium. Given this risk, I would be hesitant to pay more than 8-9x earnings or $28-$30. At current prices, investors should sell and look elsewhere.