Offshore drilling giant Seadrill Ltd. (NYSE:SDRL) announced its first quarter 2014 results on Wednesday, May 28. These results were, to put it mildly, quite impressive and the company managed to perform admirably even given the drag that the deconsolidation of Seadrill Partners (NYSE:SDLP) imposed on Seadrill. Seadrill also noted that the long-term prospects for the offshore drilling market remains bright despite the near-term market challenges. I have discussed these market conditions several times in the past, most recently here. Fortunately, Seadrill is very well-positioned to ride out these near-term challenges and prosper as the strength returns to the market.
It is my usual practice to share the highlights from a company's earnings report before delving into the analysis of the results as it serves to provide background for the rest of the report. Therefore, without further adieu, here are the highlights from Seadrill's first quarter 2014 results:
- Seadrill reported total consolidated revenues of $1,221 million. This represents a decrease of 16.9% from the $1,469 million that the company reported in the fourth quarter of 2013.
- The company's reported operating profit increased significantly compared to the previous quarter, going from $568 million in the fourth quarter to $890 million in the first.
- Seadrill's net income increased substantially on a quarter-over-quarter basis; however, the first quarter of 2014 and the fourth quarter of 2013 were not directly comparable. Seadrill reported total net income of $3,064 million in the quarter. This works out to $6.54 per basic share and $6.23 per diluted share.
- Seadrill reported total first quarter EBITDA of $624 million. Seadrill's EBITDA in the fourth quarter of 2013 was $768 million.
- Seadrill once again raised its dividend and now pays $1.00 per share per quarter. This gives the stock a yield of 10.59% at the current level.
As stated in the introduction to this article, the primary reason why Seadrill saw its revenues fall compared to the previous quarter is that the company is no longer able to consolidate the earnings results from its subsidiary Seadrill Partners into its own. I discussed how the consolidation of the results from all of Seadrill's various majority-owned subsidiaries increased the numbers that Seadrill itself reports in an earlier article which is linked above. Now that Seadrill no longer has this benefit, its reported results would understandably be lower. If Seadrill had been able to consolidate the results from Seadrill Partners then its reported revenues would have been $1,436 million. While this still represents a decline from the previous quarter, it is nowhere near as steep. Seadrill also would have reported a significantly higher EBITDA had it been able to consolidate the results from Seadrill Partners. In this case, it would have reported an EBITDA of $788 million. This would have represented an increase compared to the previous quarter.
Perhaps somewhat unexpectedly, Seadrill's reported operating profit would have been lower had it consolidated the results from Seadrill Partners. If it had consolidated, then Seadrill would have reported an operating profit of $574 million in the first quarter of 2014. While this is still an increase over the $568 million that Seadrill reported in the fourth quarter, it is nowhere near as large of an increase as the figure that Seadrill actually reported. The reason for the higher operating profit on a non-consolidated basis is that Seadrill had a $440 million gain on the sale of the West Auriga ultra-deepwater rig to Seadrill Partners during the quarter. This would have been backed out of the reported results had Seadrill Partners been consolidated into the parent company's results. The total purchase price of this rig was $1.24 billion including the assumption of $443 million in debt by Seadrill Partners. Subtracting out this assumed debt results in Seadrill Partners providing Seadrill with total consideration of $797 million which is less than it cost Seadrill to build this rig. On November 11, 2010, Seadrill ordered two ultra-deepwater drillships from the Samsung Yard in South Korea at a purchase price of less than $600 million each. While Seadrill did not specifically state that the West Auriga was one of these rigs, the delivery date, specifications, and constructing shipyard are consistent with this conclusion. Therefore, it appears that Seadrill Partners may have overpaid for this rig, depending on the present value that is assigned to the rig's seven-year contract, which would ultimately prove beneficial for Seadrill (as the company is selling assets for more than they are worth and thus creating value) but not so much for Seadrill Partners, although the latter company does get the advantage of fairly consistent cash flows from this rig over a long period of time.
As already mentioned, Seadrill's reported first quarter net income was not directly comparable to the company's net income in the fourth quarter. This is also because of its deconsolidation of Seadrill Partners. In the first quarter, Seadrill reported a net financial gain of $2.239 billion compared to a loss of $286 million in the fourth quarter. This gain was applied directly to the company's net income and is not included in either Seadrill's revenue or in its operating profit. This is how the company's net income was actually higher than its revenues in the first quarter. There were three sources of income that provided this gain, although the deconsolidation of Seadrill Partners was by far the largest source. The company received $39 million in income from Seadrill Partners, presumably from distributions that Seadrill received from its 53.2% stake in the partnership, and $5 million in income from Archer Ltd. As neither of these companies is consolidated into Seadrill's results, the company has to recognize this income here instead of including it in its revenues and operating profits like it would if the three companies' results were consolidated. The remainder of this gain was due to the deconsolidation of Seadrill Partners. However, it is worth noting that Seadrill did not actually receive any inflow of cash from this deconsolidation so this is merely an accounting figure and is not money that Seadrill can actually go out and spend on new rigs, paying down its debt, or paying out dividends. However, Seadrill has, over the time that Seadrill Partners has been in existence, received cash from the company through the dropdowns of its rigs that it was able to put to use but which was not directly reported on the company's results. Seadrill will likely receive more money from future dropdowns, which will be partially used to pay down its debt and support the company's dividend. I discussed this in an analysis of Seadrill's fourth quarter results.
In the first quarter of 2014, both Seadrill Partners and North Atlantic Drilling (NYSE:NADL) saw their net incomes adversely affected by unrealized losses on interest rate swaps. I discussed this in a previous article in which I also stated that Seadrill itself also uses this instruments to protect itself against rising interest rates. Like the other two related companies, Seadrill reported an unrealized loss on these instruments in the first quarter. In this case however, it was a relatively small unrealized loss of $37 million and another $49 million on interest rate swaps located in variable interest entities and other subsidiaries excluding Seadrill Partners and North Atlantic Drilling. The reason that Seadrill's net income did not fall along with the other two companies is that the already discussed $2.339 billion reported gain from the deconsolidation of Seadrill Partners along with the income that Seadrill received from both Archer and Seadrill Partners was more than sufficient to cancel out this reported unrealized loss. As in the case of Seadrill Partners, the losses that the company suffered here are not something that investors need to worry about.
Long time followers of Seadrill are likely aware that the company strives to maintain high utilization rates, meaning that its rigs experience very little downtime and come closer to generating the maximum amount of revenue possible given its current contracts than many of its peers. The company has historically been successful at achieving this but the most recent quarter was an exception. Seadrill had disappointing results in this area in the most recent quarter which was the other reason why the company's revenues declined on a quarter-over-quarter basis. In the first quarter, Seadrill's ultra-deepwater fleet achieved an economic utilization rate of 91% compared to 94% in the previous quarter. The reason for the decline is that Seadrill had equipment failures on two rigs, West Pegasus and West Phoenix, as well as needed to upgrade the West Alpha. It is worth noting that the West Phoenix and West Alpha are technically owned by North Atlantic Drilling , but since North Atlantic Drilling's results are consolidated into Seadrill's, the downtime that was experienced on these rigs would still impact Seadrill's reported top line. As a result of this downtime, these rigs did not generate as much revenue for the companies in the first quarter as they did in the fourth. This is because offshore drilling rigs are not compensated for time that they do not spend in operation, as was the case with these rigs in the first quarter.
The Seadrill family of companies as a whole had relatively poor performance in this area during the first quarter. Two rigs owned by Seadrill Partners, West Aquarius and West Capricorn, also experienced significant amounts of downtime during the quarter. Combined with North Atlantic Drilling's West Phoenix and West Alpha and Seadrill's West Pegasus, the companies' fleets experienced a total of 149 rig days of downtime during the quarter. This means that Seadrill or one of its subsidiaries did not earn anywhere near as much revenue as could have been earned. This understandably disappointed management as it was below the standards that the company has set for itself.
Management is committed to improving this situation as the company has historically done whenever it experiences a quarter in which it sees high downtime. If management succeeds and addresses the problems that led to this downtime then the company should see higher revenues going forward as its rigs will spend more time operating and less time receiving repairs. Admittedly, there is only so much that can be done to prevent the equipment failures that were responsible for some of this downtime in the first quarter. In this case, the company was fortunate that it had spare parts on nearby rigs that the rig crews were able to use to repair the failed part instead of having to order a new part and experience the delays and expense that would likely occur if the part had to be ordered from a vendor. If these parts were not readily available then the downtime would have been much worse. Management has identified some areas for improvement however, so it is still likely that the company's economic utilization rate will improve going forward.
Another opportunity for forward growth presented itself just after the earnings announcement. On June 2, Seadrill announced that it has secured a five-year contract with Total (NYSE:TOT) for the use of its new rig, West Jupiter. This rig is currently under construction and is not expected to be finished until August 2014. Upon the completion of its construction, the rig will travel to Nigeria where it will begin work on this contract at either the end of the third quarter or the beginning of the fourth. The West Jupiter will generate a maximum of $1.1 billion over the length of this contract which works out to be approximately $602,700 per day. Unfortunately, this figure includes the mobilization fee which is merely a reimbursement of Seadrill's costs of getting the rig into position and ready to work. As it is a reimbursement of money that Seadrill already had and had to spend on Total's behalf, it does not truly represent new money coming into the firm. However, because the mobilization fee is amortized over the full term of the contract, the rig's impact on the company's top line revenue should be around that figure. This rig will prove to be accretive to Seadrill's revenue and cash flow once it begins operating because it will be earning money where previously it was earning none.
In Seadrill's fourth quarter 2013 earnings press release the company's management stated that it would be freezing the dividend at $0.98 per share per quarter in order to strengthen the company's balance sheet. I discussed this in my previous analysis of Seadrill that is linked above. Therefore, it is somewhat interesting that management appears to have changed its mind and raised the dividend again. Management said nothing about this prior dividend freeze in its first quarter announcement other than to say that the Board of Directors believes that the higher dividend is sustainable. Following the fourth quarter though, the same individuals stated that the company would likely be able to pay a growing dividend but that doing so did not make a whole lot of sense. It thus appears that the company's management changed its mind about that statement. Regardless, this higher dividend does show the company's commitment to provide a significant cash return to investors. This is a trait that has been present among all the companies in the Seadrill family in recent years (except for Sevan Drilling and Archer) and among many of the other companies controlled by Cypriot billionaire John Fredriksen.
Disclosure: The author is long SDRL, NADL. 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. My shares of North Atlantic Drilling are the Norwegian OTC shares, not the NYSE-traded ones. I am short covered call options on SDRL. I have a business relationship with a registered investment advisor whose clients may have positions in any stocks mentioned.