The market appears to have overreacted to today's announcement by Seadrill (NYSE:SDRL) that it is issuing a $1 billion convertible bond offering. The senior, unsecured bonds, which will have a five-year maturity and yield 2.0%-2.5%, are convertible at a 30%-35% premium over the volume weighed July 8 stock price (SDRL press release).
As I wrote in June (Large Gains For Ensco...), I am bullish on the underwater drill sector and believe SDRL, Ensco (NYSE:ESV), Noble Energy (NYSE:NE) and Transocean (NYSE:RIG) have positive outlooks based on geo-political shifts. Today's 5% drop in SDRL represents an opportunity to acquire a potential outperformer for less.
A refresher in corporate financial theory tells us that a company should be indifferent to debt or equity financing.
From an equity holder perspective, the issuance of a bond is a claim on corporate assets and cash flow that is satisfied before that of the stock. In this case, assuming the mid-point of the yield, the annual cost will be $22.5 million. By comparison, the annual dividend costs $1.876 billion ($4/share; 469 million shares outstanding at March 31, 2014) - in other words, the annual cost of the bond is 1.2% of the dividend. To provide some perspective on these numbers, first-quarter 2014 net income was $3.09 billion.
Debt Pricing is Very Attractive
The proposed cost of financing is also relatively cheap at an adjusted cost of 2.6% (coupon + value of conversion rights). The details are summarized below.
The annual coupon is 2.3% (at the mid-point). The conversion option allows bond holders to exchange their bonds for SDRL shares at a 30% premium (low end of range), or approximately $49.08 ($37.75 x 130%), and is worth about $0.73/share (using the Black Scholes Option Pricing Model- BSOPM; for you finance geeks, the other assumptions were: volatility of 23.4%, 10.1% dividend yield, $37.50 stock price at issuance and 1.66% five-year risk-free rate). The conversion option is valued at about $14.9 million ($0.73 x $1 billion / $49.08) over the five-year life of the bond. Assuming the bond is not called and using straight division ($14.9 million / 5 years = $3.0 million / $1 billion), the annual cost of the convert feature is 0.3%, bringing the net cost of the debt offering to about 2.6%. Assuming pricing at par, SDRL is borrowing for less than 1% over Treasuries.
What About Dilution?
Assuming all shares are converted, the maximum new shares related to the convertible bond would be 20.4 million, or 4.3% of the current outstanding shares. Remember, SDRL would have been paid $1 billion, or $49.08/share, so the issuance would be the equivalent of a secondary offering at a nice premium to today's price.
What Does the Offering Signal?
The non-math part of the deal is the only negative. The SDRL press release states the proceeds will be used to "fund the newbuild program and for general corporate purposes." The reality is SDRL needs outside funding to complete its ambitious rig acquisition (new build) program and to fund its dividend. In the first quarter of 2014, SDRL completed three bond offerings, so to a certain extent, this is business as usual. In a normalized environment, when the aggressive drill acquisition program is complete, it is reasonable to assume the dividend will be paid from operating cash flow.
SDRL announced the issuance of medium-term debt, taking advantage of today's very attractive rates. Cash cost is approximately 2.3%, and "all-in" costs are about 2.6%, less than 1% above US Treasuries.
This is business as usual for SDRL, which completed three debt offerings in the first quarter of 2014.
Potential dilution is a little over 4%, but would only occur if the stock appreciated 30% (or 25% over the pre-announcement price).
Today's market drop is an overreaction on a day when the market was jittery.
Disclosure: The author is long SDRL, RIG, NE. 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.