We witnessed some interesting price movement in Seadrill (NYSE:SDRL) yesterday - the stock started to fall as the news came before the market open that the company was going to raise $1 billion in convertible bonds, and it went down 5% for the day.
The reaction was not surprising as the market has always been a bit "panicky" when it comes to Seadrill's debt levels, and the addition of $1 billion to its current outstanding debt sent a number of negative signals. First of all, the statement clearly said the company intended to use the proceeds to fund the newbuild program and for general corporate purposes. This gave rise to the fear that the future cash flows of the company were under threat and it was not able to meet its cash needs for the newbuild program - an important point to note here: Seadrill has mostly financed its newbuild program through outside cash sources, mainly revolving credit facilities. Seadrill's financial dealings have been opportune in the past, and the company has exploited the record low interest rates to collect an extremely efficient fleet of modern sixth-generation ultra-deep water rigs.
The statement had an extremely important part about the future conversion price - Seadrill was offering to convert the debt into shares at 30-35% premium to the closing price on July 8, 2014. The company was expecting to have the future conversion price somewhere between $50-55, in my opinion. However, the stock price movement prompted the company to cancel the bond issue as it would have resulted in a conversion price below $50 even at 35% premium. Seadrill stated that the transaction was an opportunity rather than a requirement and the company will have about $1.5 billion in cash by the end of the month.
The transaction is not going to happen; however, would it have been that bad a decision that it warranted a 5% fall in the stock price? Let's see which opportunity the company is talking about. The initial statement had two parts: the first part was about the new bond issue and the second part was about the offer to redeem a previous bond issue worth $650 million. The image below shows the unsecured and convertible debt of the company and it was taken from the first-quarter earnings report.
The converted bonds, which were offered to be converted to shares, were issued at 3.375%. Let's assume that all the bond holders decided to convert their bonds to shares, this would have shaved about $22 million in interest payments from the expenses of the company. At the same time, the conversion would have resulted in some dilution for the current shareholders. On the other hand, the new bond issue was being offered at 2-2.5% coupon rate, which means even at 2.5%, the interest expense would have been $25 million - so the company was adding about $350 million to its cash reserves at additional cost of just $3 million per year. This does not look like a bad deal to me. Not to mention that the $350 million was going to be spent on the acquisition of new equipment, which continues to give solid profit margin.
I have highlighted this in my previous articles that I expect Seadrill to slowly go towards long-term debt and we will see more bond issues in the future. At the same time, we will likely see a reduction in the revolving credit facilities. However, as long as Seadrill is able to raise cash at a low cost; it will continue to do so. The stock has gained about 4% in pre-market trading and I expect it to again breach the $40 barrier soon. In my previous article, I explained why I expect Seadrill to continue to trade above $40. Unfortunately, my article coincided with an overall fall in the market and the announcement about the bond issue. However, my long-term argument about the stock remains, and I believe it will continue to move higher as the fundamentals of the industry are strong.
Yesterday's price movement and the announcements have given an opportunity to the believers of Seadrill, and it has further strengthened the belief of its long-term investors that the management is making the right moves. There is no sense in making an opportune transaction if the opportunity evaporates. The management decided to cancel the bond issue in order to safeguard the price of the stock against further negative sentiment. It was the right decision as the conversion price would have been low and it would have resulted in considerable dilution at a discount going forward. In my opinion, yesterday's fall in price has given an opportunity to its long-term investors.
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