On March 11, 2014, Seadrill Partners (NYSE:SDLP) announced the acquisition of the West Auriga ultra-deepwater drillship from Seadrill (NYSE:SDRL). Seadrill Partners is a publicly-traded LLC that was set up as a partially-owned subsidiary of Seadrill in late 2012 as a vehicle to both increase the parent company's liquidity and provide a growing source of income to both Seadrill and the partnership's unitholders backed by long-term contracts. To this end, Seadrill Partners has the right, but not the obligation, to purchase any rig in Seadrill's fleet that obtains a contract of at least five years in length. Seadrill owned 53.2% of the outstanding units of Seadrill Partners as of the end of the first quarter 2014. The purchase of this rig is likely to result in an increase in Seadrill Partners' revenues and cash flow in the second quarter of 2014 compared to the first quarter. However, the company paid a hefty price for this earnings growth. The total purchase price of this rig was $1.24 billion, $443.1 million of which was debt that Seadrill owed on the rig and which was assumed by Seadrill Capricorn Holdings, the actual operating company that purchased the rig. In this article, we will examine whether or not Seadrill Partners overpaid for this rig.
The reason for the initial concern that Seadrill Partners may have overpaid comes from the fact that the West Auriga's implied purchase price of $1.24 billion was substantially more than what Seadrill paid to have the rig constructed. On April 11, 2011, Seadrill announced that it had placed an order with Samsung Heavy Industries in South Korea for the construction of an ultra-deepwater drillship. The company expected this rig to be delivered in the third quarter 2013. While Seadrill did not specifically state that this rig is the West Auriga, the rig's specifications and delivery date are identical. Thus, we can assume that this rig is either the West Auriga or, at the very least, should have the same construction price. The total price of the construction of this rig was $600 million. This is 48.4% of the price that Seadrill Partners paid for West Auriga.
However, there is much more to asset valuation than simply the cost to obtain the asset (or construct it in this case). This is because the cash flows from the asset also have a value. To determine the value of these cash flows, we will perform a present value calculation.
First, we need to determine the cash flows that the rig is likely to generate. To do this, we need to start by looking at the rig's contract. The West Auriga is currently under a long-term, seven-year contract with BP (NYSE:BP) that calls for the giant oil company to pay $565,000 per day to use the rig. This works out to $206.255 million per year assuming that the rig operates every single day, which is somewhat unrealistic. This is because in reality rigs need to be occasionally taken offline so that the owner can perform maintenance and other repairs on them. The rig is not paid for time that it spends undergoing these repairs. Thus, it is important to estimate the amount of downtime that the rig is likely to experience in order to accurately determine the amount of revenue that it is likely to generate. By looking through some of Seadrill's past contract announcements, we can see that Seadrill typically estimates that its rigs will experience downtime totaling 3% of its total time under contract. Presumably, Seadrill Partners would derive a similar estimate. However, the company's rigs do not generally achieve uptime figures that are that high. In the first quarter of 2014, Seadrill Partners achieved a total uptime of 82% fleetwide. However, this figure was adversely affected by major equipment failures on West Capricorn and West Aquarius. If the downtime from these figures is excluded, then the company's fleet achieved 98% uptime. However, that uptime figure in the most recent quarter (excluding major repairs) appears to be a fluke. In the fourth quarter of 2014, Seadrill Partners' fleet achieved uptime of 91%. For our valuation, we will take the average of these two figures and assume that West Auriga will achieve that uptime over the long term. This figure is 94.5%. This assumption about uptime brings the annual revenues generated by West Auriga down to $194.88 million.
Next, we have to estimate how much it will cost Seadrill Partners to operate the West Auriga. We will start by looking at figures provided by Seadrill. The company included this chart in a presentation that it gave at the Credit Suisse 2013 Energy Summit:
As this chart shows, Seadrill estimates that it costs $170,000 per day to operate an ultra-deepwater floating rig like the West Auriga. However, as I pointed out in a recent article, Seadrill has used this same chart in multiple industry presentations dating back several years. This cost estimate is also out of line with similar estimates provided by peer companies. For example, Pacific Drilling (NYSE:PACD) stated in a recent presentation that it costs approximately $200,000 per day to operate an ultra-deepwater floating rig. However, this estimate is higher than what it actually costs Pacific Drilling to operate one of its rigs. In the first quarter of 2014, Pacific Drilling reported that it actually had per rig operating costs of $183,800 per day. Thus, we can conclude that it costs $170,000 to $200,000 per day to operate an ultra-deepwater floating rig. Therefore, for the purposes of this analysis, we will assume that it costs $185,000 per day to operate a rig like the West Auriga as this is the average of the range. This works out to be approximately $63.8 million per year assuming the same rig uptime as what we assumed for the estimated revenues.
In order to determine the cash flows from this rig, we also need to estimate how much Seadrill Partners is going to have to pay in taxes. The chart provided by Seadrill above states that tax payments on a per rig basis average 4% of revenue. Unlike the operating expenses though, this estimate is in line with similar estimates made by the company's peers. In the case of the West Auriga then, this works out to $7.80 million per year.
From these three figures, we can estimate that the West Auriga will generate approximately $123.28 million per year in cash flow over the duration of the contract. At this point, it is important to note that the amount of revenue received by Seadrill Partners from this rig would be approximately half of that amount in the first year of the present value calculation. This is because the rig actually started on its seven-year contract in October 2013 but Seadrill Partners did not acquire the rig until March of 2014. Thus, we will assume that all revenues, operating expenses, taxes, and cash flows generated by the rig will be halved in the first year as Seadrill Partners only owned it for that proportional period of time.
Now, we can calculate the present value of these cash flows once we determine the discount rate that we will use. The value that is normally used for this is the risk-free rate as this effectively represents the rate of return that would be received if the money was simply put into an investment that has no risk as opposed to purchasing the asset (West Auriga in this case). The investment that is normally assumed to have no risk is U.S. Treasury bills, typically the 90-day Treasury bill that currently yields 0.04%. However, given the current state of U.S. Federal Government finances plus the fact that the Federal Reserve continues to purchase huge amounts of Treasury bills (taper notwithstanding), driving the rate down, I am not certain that this is truly representative of a market-based risk-free rate. For our purposes then, we will use an asset that is likely more representative of a true risk-free asset, the ten-year Norwegian government bond. This asset also has the advantage of being a long-term asset just like the West Auriga. The current yield on these bonds is 2.50%. Now that we have our discount rate, we can perform a present value calculation.
As the chart shows, the present value of the projected cash flows from West Auriga under the BP contract is approximately $722.62 million. While this is more than what it cost Seadrill to construct the rig, it is still less than the $1.24 billion that Seadrill Partners paid to acquire it.
This calculation would seem to imply that Seadrill Partners drastically overpaid for the West Auriga, but we are leaving out something that changes the value proposition significantly. This is that offshore drilling rigs are long-term assets with expected lifespans well in excess of seven years. The typical life expectancy of a rig like West Auriga is approximately forty years. Thus, we need to consider the value of the cash flows that West Auriga will deliver once the contract with BP has concluded. For example, if the rig secures a new comparable contract and thus continues to generate the same $123.28 million per year for an additional fourteen years after the current contract has expired then this brings the present value of the West Auriga's future cash flows up to $1.86 billion, clearly far more than what it paid to acquire the rig and at that point the rig would still have half of its useful life ahead of it. Seadrill Partners could also opt to sell the rig following the conclusion of the contract with BP and that would bring in some additional cash flow. As long as Seadrill Partners sold the rig for at least a present value of $517.38 million in 2020 (at least $615 million in future terms), then the purchase of the rig represents a good investment for the company. Therefore, in conclusion, while the purchase price of West Auriga was far too high for just the BP contract in isolation, when the future uses of the rig are considered then the price that Seadrill Partners paid looks quite reasonable.
Disclosure: The author is long SDRL, PACD, BP. 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. The author has a business relationship with a registered investment advisor whose clients may have positions in any stocks mentioned. The author is personally long Seadrill, Pacific Drilling, and BP. No entities directly controlled or managed by the author have any positions in any stocks mentioned.