The most recent earnings announcement by Seadrill (NYSE:SDRL) caused a mini panic among its investors and some investors thought the predictions about the slowdown in the sector are becoming true. As a result, the stock lost some value; however, as the initial panic faded, the stock started to climb up again, and it is again close to the levels it traded on before the earnings release. So, did the market realize that the slowdown was temporary? I believe so.
The market was eagerly awaiting the results due to the fear created by some analysts about the long-term prospects of the off-shore drilling market - as the management said that they were expecting a slowdown in the short term, the market assumed that all the fears about the sector were true and off-shore drillers are doomed. However, that was never the case. There were a lot of positives in the earnings release, and I will talk about some points in this article.
Understanding the Utilization Rate
Utilization rate is a very important metric for off-shore drillers - utilization rate can also give an idea about the current and the future prospects of the industry as well as economy. Utilization rate shows what percentage of the total fleet is being utilized - for Seadrill, these rates are very high. First of all, let's talk about the floaters - Seadrill has 23 floaters and for the floaters the utilization rate remained stable at 94% during the fourth quarter. For the jack-up fleet, the utilization rate even showed an improvement - for the fourth quarter, the utilization rate in the jack-up fleet went to 98% from 97%. And finally, the tender rig fleet saw its utilization rate come down to 95% from 98%.
Now, utilization rates above 90% show an incredible strength in the sector as well as economy. Utilization rates in the region of 90-100% are only seen when the current and the future prospects of the drilling sector are bright. This also means that the oil prices are likely to remain strong, which has allowed the oil companies to keep the drilling activities on the higher side. As long as the utilization rate remains high, the day rates will remain strong. A falling utilization rate means the rigs are sitting idle, which can force the off-shore drillers in accepting lower day rates. However, as the utilization rates remain high, the negotiation position of the drillers will remain strong and the day rates will not take a hit. My personal stance on the future oil prices is bullish and I believe the oil prices will remain strong due to the global economic recovery.
A very important factor to consider for Seadrill investors is the capital structure and how the management can play with it. As I have mentioned in my previous articles, the establishment of subsidiaries and the limited partnership, Seadrill Partners (NYSE:SDLP), has given Seadrill a lot of financial flexibility. When we look at Seadrill's debt in isolation, it certainly spooks a lot of people. However, in order for Seadrill's debt to become an issue for the company; a lot will need to change. An example of Seadrill using its subsidiary for financial flexibly is the North Atlantic Drilling (NYSE:NADL) - recently, NADL has been listed on the U.S. stock market - the company raised $125 million, out of which, Seadrill contributed $25 million. At the same time, NADL raised $600 million from the U.S. bond market at 6.25%.
The proceeds from the issue were used to repay $500 million, 7.75% bond held by Seadrill, which was due in 2018. The transaction serves dual purpose: first, it saves 150 basis points for NADL and decreases its interest expense. Second, it gives cash to Seadrill - it's true that Seadrill will lose some income in the form of interest; however, as Seadrill is not in the business of loaning money, it should not have an impact on the business of the company. The transaction shows how the company is focusing on creating a group of small, strong, independent companies that can contribute to the future cash flows of the company. For NADL, it is important to understand that the company only operates in the North Sea and Seadrill will keep it that way. It has small fleet of harsh-environment rigs. Further expansion for NADL will also happen in the North Sea as Seadrill is working on expanding its reach to Russia.
Let's now talk a little about Seadrill Partners. Seadrill has been using Seadrill partners to drop down its assets for cash - SDLP has been financing these drop downs through equity and debt. The drop downs allow Seadrill to enhance its balance sheet while maintaining the control of the assets as it holds the majority shares as the general partner of the Partnership. As a result, majority of the cash generated by SDLP will return to Seadrill in the form of cash distributions. The drop downs are expected to increase in the future. The main reason is that the company wants to make its balance sheet attractive. An important point in the earnings announcement was the company's decision to not complete the ratings procedure before March 14. The company believes that by delaying the ratings procedure they can achieve a higher rating. As a result, drop downs will increase over the next twelve months, along with a further increase in the order backlog. The decision to not invest further in capex is understandable as the better cash reserves will certainly have a positive impact on the ratings procedure.
The Issue of the Dividends
Despite an increase of 3 cents in quarterly dividends, there have been doubts about the dividend stability of the company. As I have said this before, the dividends of the company are under no threat. In fact, the shareholders should be very pleased by what the management has planned. We are unlikely to see much growth in dividends over the next twelve months due to the weak market, which should allow the company to preserve some cash as the cash flows will continue to increase. Further, 20% of the cash flows from the drop downs to SDLP will be kept in a fund for future dividends, and 80% of the proceeds will be used to reduce the debt. So, we should see a decline in the debt over the next twelve months as there will be more drop downs.
If the market picks up in 2015, according to the expectations, shareholders can expect a considerable increase in dividends. However, even more important is the fact that the company will be reducing its debt. Moreover, EBITDA and cash flows will continue to grow for the company as the management has clearly stated that the growth in earnings will be above 20%. At the moment, EBITDA is about $2.8 billion for the company - if we keep the 20% growth rate constant for two years, we will have about $4.1 billion in EBITDA at the end of 2015, which is in line with the management's target. Furthermore, the company is paying about 76% of its operating cash flows in dividends. As the dividends are unlikely to grow over the next twelve months, the payout ratio is expected to come down substantially.
The growth in operating cash flows was about 6.6% during the last year. If the growth in operating cash flows remains constant, the payout ratio will be close to 71%. Cash dividends for the year are at just under 46% of EBITDA. By the end of 2014, Seadrill will have substantial cash at hand in my opinion. The company will have the option to substantially decrease the debt or increase the distribution to shareholders. In my opinion, we will see some decrease in the leverage for Seadrill and the cash distributions will increase from 2015.
Let's take the worst case scenario - assuming that there is a dividend cut of about 50% (I do not think this will ever happen, but let's just assume for the sake of argument), Seadrill will still have a dividend yield of over 5% in case of no fall in the stock price, and even higher yield if there is a fall in price following the dividend cut. Let me say it again, I do not expect a dividend cut as the company has already started to shift the strategy a little in order to decrease the leverage. The only way there will be a dividend cut is if there is a mega event such as a recession, or any other incident hitting the overall off-shore drilling industry (I am talking about an incident like the Gulf of Mexico). The fear of oversupply is a little overblown in my opinion, as I have stated in my previous articles.