Don't Sweat Seadrill Partners' 61.4% Quarter-Over-Quarter Net Income Decline

| About: Seadrill Partners, (SDLP)


Seadrill Partners' net income fell by 61.4% in the first quarter compared to the previous one.

The reason for this decline has nothing to do with the company's operations.

This decline was due entirely to a write-down related to a hedging strategy that the company uses to manage its debt payments.

Seadrill Partners' cash flow was not impacted by this decline in net income and, in fact, the company's cash flow increased significantly quarter-over-quarter.

By this point, many investors likely know that Seadrill Partners' (NYSE:SDLP) latest earnings report showed a fairly significant quarter-over-quarter decline in net income. However, many may be less familiar with the reason for this decline. Fortunately, the reason for it is not something that has adversely impacted the company's financial standing, nor is it likely to be something that affects the partnership over a longer period of time. As such, it is not something that a longer-term investor or an investor that is focused primarily on income needs to worry about.

First, I would like to briefly discuss the situation that I was referring to in the introduction, as it will provide some background for the remainder of this article. In the first quarter of 2014, Seadrill Partners' revenue declined by 7.6% compared to the fourth quarter of 2013, due primarily to the need to repair equipment on two of its rigs (West Aquarius and West Capricorn), partially offset by the addition of the West Auriga to the company's fleet. However, Seadrill Partners' net income declined by an order of magnitude more, declining from $113.6 million in the fourth quarter, compared to $43.8 million in the first quarter. This is a 61.4% decline, clearly much more than the decline in revenue.

The primary reason for the company's outsized decline in net income compared to its revenue decline is a large unrealized loss in its portfolio of interest rate swaps. Like its parent company, Seadrill (NYSE:SDRL), Seadrill Partners uses a portfolio of interest rate swaps to manage its exposure to interest rates. Investopedia defines an interest rate swap as,

"An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap."

As you can see, Seadrill Partners uses this swap to ensure that the interest payments that it has to make to its creditors do not increase significantly.

This is necessary due to Seadrill Partners' relatively high debt load. At the end of the first quarter, Seadrill Partners had a total of $58.3 million in current interest-bearing debt, and an additional $2.1808 billion in long-term interest-bearing debt. The company also owes $800.8 million to related entities. This compares to $1.769 billion in shareholders' equity, giving the company a total debt-to-equity ratio of 1.72.

Source: Seadrill Partners

Seadrill Partners currently pays a relatively low interest rate to service this debt. In the first quarter, Seadrill Partners paid $28.6 million in interest, which works out to an average interest rate of 3.76% on its outstanding debt. This interest rate is not particularly difficult for the company to handle, as it represents just 17.5% of EBITDA. Unfortunately, Seadrill Partners did not provide a figure for its operating cash flow in its earnings report, as that or free cash flow would be a better figure to compare its interest payments to. However, this will suffice for our purposes here. If interest rates were to increase, though, then that would steadily increase the amount of money that the company has to pay to service this debt. This is true with either floating rate or fixed rate debt. Floating rate debt would have the interest payments increase at the beginning of each period, whether that be quarterly or annually or on some other schedule, while a fixed rate loan would see the interest paid when it matures and the company has to roll it over. If the company's interest payments were to increase significantly, such as in this scenario, then it could potentially threaten Seadrill Partners' distribution. The company's use of interest rate swaps is intended to prevent that from happening.

Interest rate swaps are just like any other investment in that they rise and fall in value. In the case of these instruments, the price is largely based on interest rates. As Seadrill Partners is using these securities to protect itself against a rise in interest rates, the value of the company's swaps will increase when interest rates rise and decrease when interest rates fall. This second situation is what happened during the first quarter and why Seadrill Partners' net income fell so much more than its revenue did.

Accounting rules require that the company make a mark-to-market adjustment on its income statement every quarter with regards to the value of these assets. Normally, the adjustment that Seadrill Partners has to make due to fluctuations in this portfolio is relatively small. For example, in the fourth quarter, the company had to increase its net income by $16.1 million due to a rise in the value of these assets. However, the adjustment that the company had to make in the first quarter was much more significant. Seadrill Partners had to write down the value of these swaps by $49.2 million in the quarter. This caused a significant decline in the company's quarter-over-quarter reported net income, as not only did it have to take a loss of $49.2 million, but it also did not get the benefit of the $16.1 million mark-to-market increase that it had in the fourth quarter. All-in-all then, the company's portfolio of interest rate swaps resulted in a quarter-over-quarter net income decline of $65.3 million.

It is important to keep in mind that these write-downs do not represent any actual cash leaving the business. This is because the losses that the company took in the first quarter due to declining interest rates are unrealized losses. Seadrill Partners did not actually sell any of the interest rate swaps that are now worth less money. Thus, should interest rates rise again, it could very well see its net income be positively affected by the then rising value of this portfolio (which Seadrill Partners would also have to mark-to-market).

As no actual cash left the business, Seadrill Partners' ability to pay its quarterly distribution was completely unaffected by this large decline in net income. Likewise, the company's cash flows were unaffected, and those ultimately have a much larger effect on the financial situation of a company than net income does. In the end, investors should not be worried about the 61.4% quarter-over-quarter decline in the company's net income. Instead, an investor should focus on the fact that Seadrill Partners' distributable cash flow increased by 41.6% quarter-over-quarter.

Disclosure: I am long SDRL. 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.

Additional disclosure: I have a business relationship with a registered investment advisor whose clients may have positions in any stocks mentioned. I am short covered call options on SDRL.