Seadrill: Cash Flow Doesn't Support Dividend

| About: Seadrill Limited (SDRL)


Seadrill reported quarterly earnings that bested estimates but also showed serious signs of weakness.

The company has no free cash flow, yet continues to increase the dividend, which it borrows to pay for.

Its backlog also shrunk and utilization fell as the market for rigs remains soft, which will challenge results for the foreseeable future.

Investors should avoid SDRL.

On Wednesday, Seadrill (NYSE:SDRL) reported quarterly earnings, and the market seemed to like the news with shares rising 2% in pre-market trading. The company's $1.44 billion in revenue beat estimates by $30 while its $788 million in EBITDA bested estimates by $48 million (all financial and operating data available here). Thanks to this beat, Seadrill raised its dividend by $0.02 to $1.00, despite suggesting last quarter that further dividend hikes were unlikely. Many investors love SDRL for its 10% dividend, but critical risks remain that investors should focus on.

First, the company continues to be highly levered. Due to the deconsolidation of Seadrill Partners (NYSE:SDLP), its debt balance did fall in the quarter to about $12.45 billion. Still, this amount exceeds in equity position of $10.7 billion. Over the foreseeable future, I expect its debt position increase, which has been the long term trend. After all, debt has nearly doubled since 2009. This is because Seadrill pays a hefty dividend without generating any free cash flow. In other words, it borrows to fund the dividend.

After the increase, the dividend costs $469 million per quarter. In this quarter, SDRL generated operating cash flow of $656 million. However, Seadrill is expanding aggressively and adding rigs in the hope of growing future cash flow. The company spent $722 million building new rigs, $20 million improving current vessels, and $342 million investing in associated company. Simply put, Seadrill is still free cash flow negative. Operating cash flow does not even cover cap-ex requirements at the current time. Seadrill has to borrow to fund some of its expansion and all of its dividend. In this sense, an increasing dividend is really negative for long-term holders as it increases the amount Seadrill has to borrow, increasing interest expense. To fund its dividend, Seadrill will be borrowing $1-$1.5 billion per year through 2016.

Now, Seadrill bulls counter that the current strategy is prudent because future cash flows will grow markedly as it adds new vessels. This is definitely a possibility, but this quarter offered bad news on the front. The company's backlog actually fell in the quarter from $20.2 billion to $18.8 billion. This backlog represents Seadrill's expansion opportunity, and it actually fell in the quarter. This suggests SDRL does not have as long of a growth runway as some believed as it eats into the backlog.

Moreover, there are signs that the deep-water rig market isn't robust enough to handle such a backlog. Seadrill's floaters had a utilization rate of 91% compared to 94% last quarter. On a pro forma consolidated basis, utilization was a disappointing 88%. Management also offered cautious guidance saying, "Currently, the market suffers from limited exploration drilling and delays in field developments from the major oil companies. The root cause of the muted activity level is the fact that many major oil companies are working in order to improve their cash generation. The outlook is further affected by sublets and by lower specification rigs trying to price themselves into a higher end market. The key question is when oil majors will resume tendering activity. To some degree, the decreased level of activity leads to further delays. Oil companies are trying to determine when dayrates will trough, thus are not compelled to sign contracts if they feel dayrates are still declining."

Now, there are signs the market has improved a bit in the month of May, but there is still clear weakness in the rig market. Companies like Exxon Mobil (NYSE:XOM) are cutting their cap-ex budget while others like ConocoPhillips (NYSE:COP) are focusing on onshore oil and gas. To this point, we are seeing tremendous energy production onshore in the U.S. thanks to shale gas and the Permian Basin. These phenomenon cut the demand for riskier offshore projects, cutting the dayrates for Seadrill's rigs. If the market stays soft, this backlog will not generate the cash flow growth that the bulls are hoping for.

There is no doubt that SDRL is a growth company as it increases its rig count, but investors should also focus on the cost of the growth. The company is free cash flow negative and will be for at least 3 years. As a consequence, its dividend is fully funded by debt, which worsens a highly levered balance sheet. If the offshore rig market dramatically improves, SDRL can grow out of its current problem, but there are signs the market will be weak, which undermines the company's growth strategy. Its dividend policy is dependent on access to low-cost debt. If this changes, a dividend cut is inevitable. I would continue to avoid SDRL, despite its seemingly juicy dividend.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.