- Last week, Seadrill announced and then cancelled the issuance of convertible debt because of a 5% drop in the stock.
- Still, conversion is far from certain given a 23% premium and an overly aggressive dividend policy despite negative free cash flow and high leverage.
- Seadrill's dividend policy and focus on a 5% drop suggests near term stock return is too much of a focus.
- Lacking free cash flow and with high debt in a volatile business, investors should avoid Seadrill.
Last week was a volatile one for Seadrill (NYSE:SDRL), and management's decision making should also give investors some pause. While investors should want management to care about the stock price, it is generally bad for management to actively focus on moving the stock price. Instead, the focus should be on underlying operations and improving them, which over time should translate to a higher stock. If after time the market still fails to recognize fair value, programs like a stock buyback can be accretive. Still, every day to day fluctuation in a stock should not determine strategic corporate decisions as a focus on immediate stock returns can lead to poor long term strategic planning.
On July 8, Seadrill announced it would sell $1 billion in 2019 convertible bonds with a coupon of 2-2.5%. They would be convertible at a 30-35% premium over the average stock price that day (details available here). Concurrently, management wanted to redeem $650 million of 2017 convertible bonds. Offering stock and cash, holders of that bond would get 147 cents on the dollar, reflecting the value of the conversion right. Seadrill is extremely levered at roughly 4x Debt/EBITDA (financial and operating details available here). It also carries more debt than book equity, so from a financial stability standpoint, it makes sense to incentive some conversion and avoid refinancing headaches. Now in response to this potential dilution, shares fell about 5% on the session. It is worth noting that in the past three months, shares had rallied from $34 to $38, so SDRL shares were still not particularly low.
Nonetheless, Seadrill surprised financial markets on the following day by canceling the debt issuance, which also led to the cancellation of the 2017 bond redemption (details available here). Now, the company said that the issuance did not have a lack of demand, and I will take their word for it. Instead, management said the decline in the stock price no longer made the deal economical. However even with the stock down 5%, the conversion price would have been at least 23% above the close on July 7, before the offer was announced. This is not exactly an unfavorable term, especially given the company's aggressive dividend policy.
In the long run, stock returns tend to be in the 8-9% range, so SDRL's 10.6% dividend yield is a bit of a warning sign. In a sense, the market is suggesting that SDRL shares are likely to fall. Heck, they could fall 2% a year and still generate that 8% return. Of course, the market is often wrong, but for shares to reach the conversion price, investors would be getting a multi-year total return north of 15%, which is nothing to sneeze at. In other words, there is a high probability this bond would never convert even with the drop in the stock price.
The company's dividend policy also makes share price appreciation less likely. Seadrill is aggressively building new ultra-deep water rigs and as a consequence has been running free cash flow negative. On top of this, Seadrill's dividend is costing another $1.8 billion a year. Between this dividend and cap-ex, Seadrill needs to add at least $2 billion in debt per annum and likely will not generate free cash flow in excess of the dividend for 5 or more years. If rates are higher when debt is refinanced, it could be even later. While this dividend may be nice to receive, it results in increasing debt, which makes the company's financial situation more tenuous. Without free cash flow and increasing debt, this dividend could lead to a lower share price, especially if the rig market sees lower day rates because of new supply over the next three year.
With its high leverage and excessive dividend on equity, Seadrill should jump at the opportunity to sell debt at a less than 4% interest rate. Even with the fall in the share price resulting in a lower conversion rate, a 23% premium is nothing to sneeze at. If management thought it made sense on July 8, there was no reason to cancel it on July 9. Between this reversal and an ever increasing dividend despite the lack of free cash flow, it seems like Seadrill is more intent on managing the stock price than focusing on long term value creation. Seadrill's leverage and dividend policy is a warning sign and a dividend without corresponding free cash flow eventually is unsustainable. The best thing for Seadrill's operations would be a cut to the dividend, but given the likely near term stock reaction, management is unlikely to do that. This craziness around the bond issuance is a sign that investors should avoid SDRL and look for companies focused on long term operations and not daily price action.