Shares of Seadrill (NYSE:SDRL) have been sliding over the past few months, primarily on concerns about the company's debt exposure in the face of a possible decline in rig day rates. In particular, many investors are worried about Seadrill's dividend and high debt load relative to the company's peers. In a previous article I gave some thoughts about Seadrill's dividend. In this article I will take a closer look at Seadrill's debt. Seadrill's debt is a bit more complicated than that of other drillers such as Ensco. I will try to concisely explain Seadrill's situation while comparing the company to its peers.
Data from Morningstar
With debt at nearly nine times operating cash flow, Seadrill is significantly more leveraged than Transocean (NYSE:RIG) or Ensco (NYSE:ESV) are. Seadrill's relatively high leverage is, I believe, a major reason why the stock has suffered over the last six months. For example, since September, Seadrill shares have declined by 28.7%, while Ensco and Transocean have declined by 9.3% and 12.5%, respectively. Spooked by this leverage ratio, many are opting to pick up shares of Ensco instead of Seadrill, despite the latter's much steeper decline.
As a debt manager, Seadrill is quite a bit more flexible than, say, Ensco. Unlike Ensco, Seadrill takes out not only bonds but also 'facilities' which are often tied to individual rigs in Seadrill's fleet and are based either on LIBOR or NIBOR (the N stands for Norway).
While these facilities do have variable rates, Seadrill buys protection most of them, and does so in the form of rate swaps. In fact, of the $10.18 billion of facilities which Seadrill owes, $9.78 billion is covered by an interest rate swap.
Of Seadrill's $3.18 billion in bonds, one security is due in 2014, one in 2015, three in 2017 and two more in 2020. So, the company's bonds are fairly short term, and therefore will need to be dealt with when they come due but also carry fairly low rates. The weighted average cost of debt, of bonds alone, is 4.78%. This compares with 2.75% for Ensco despite similar bond horizons. As you can see, the market has given Seadrill a higher cost of bonds, and the reason for this is that Seadrill is more highly leveraged than Ensco is.
Of Seadrill's $13 billion plus in debt, a majority of that is not due until 2017 or later. About $1.4 billion in debt will come due this year. Judging from the fact that Seadrill spends virtually all of its cash flow on dividends, Seadrill will likely have to refinance this debt and and roll the due date back to another time. Two other options would be a corporate equity offering or an equity offering from Seadrill Partners, the company's new master limited partnership vehicle.
In September of 2012 Seadrill Partners did its initial public offering. The purpose of this MLP is to provide an alternative funding vehicle for Seadrill the corporation. For example, the corporation can raise funds by issuing equity which comes at a yield lower than that of the corporate shares. For example, Seadrill partners yields 5.85% while corporate shares of Seadrill yield 11.5%. That wide 'spread' in per-share cash flow obligations is what management is looking to exploit. The tax exempt status of partnership income could allow for a tax-equivalent yield similar to that of the corporate shares, but on an absolute basis would yield much less.
Courtesy of Investor Relations
The partnership will be able to steadily grow cash flow by receiving drop downs from Seadrill. In doing so, Seadrill will be able to raise funds through the issuance of new units, and Seadrill Partners will be able to grow its distributable cash flow. By next year, management expects the MLP to comprise of 15% of Seadrill's total debt structure.
Clearly, the market is nervous about Seadrill's indebtedness. I propose we look at the big picture for a moment. Management's decision to take on relatively more debt was a fairly recent one, and I believe that decision was a reaction to two very important market forces.
- Rising offshore energy activity, and in particular a rising demand for deepwater and ultra deepwater rigs. This is amplified by the Macondo disaster in 2010, which has resulted in a greater demand of safer, state-of-the-art rigs. Seadrill has responded to this demand by borrowing to obtain the youngest fleet among its large-cap peers.
- Historically low interest rates. Seadrill borrowed when it was cheap, and when demand for new ships were high.
When put into this kind of perspective, one can better understand why Seadrill took on so much debt. Taking out relatively more debt than its peers was indeed a bold move, but the reward will be immense if it all works out. On the other side of that coin, though, Seadrill would be the first major lessor to be 'caught swimming naked' in the event of a substantial and sustained drop in day rates, which some believe will occur.
Overall, Seadrill's choice was a calculated risk, but one that I believe is more likely than not to work out. As an operator Seadrill is the best of breed among large rig lessors, with the youngest and most deepwater-oriented fleet. Therefore, I believe that the decline in Seadrill's share price, not only on a relative basis but also on an absolute one, represents a great value opportunity here.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.