- The structure of the company gives it considerable financial flexibility which allows it to raise capital when needed.
- Refinancing of three rigs has shown Seadrill's strong relationship with lenders and the company has raised additional $350 million, which it wanted to raise from the bond issue.
- The conversion of debt will cause some dilution to the existing shareholders and increase the dividend obligation of the company.
There have been quite a lot of developments for Seadrill (NYSE:SDRL) over the last few days - the company decided to raise capital through debt offering and also offered to redeem the previously outstanding convertible bonds worth $650 million. However, the market did not respond positively to the news and the stock lost substantial value; as a result, Seadrill decided to withdraw the new bond offering and the offer to convert the debt into equity. However, on the following day, the company was able to refinance its three rigs and raise the extra $350 million that it wanted to get from the debt offering - this shows the strength of the company and the relationship it has with the lenders. The biggest reason for the adverse market reaction was already substantial debt of the company. You can read the details here.
Market's reaction will always be irrational to Seadrill's debt as the market just looks at a number, the level of outstanding debt of the company, ignoring a number of other factors. I have said this before that it is often misleading to look at the debt of a company in isolation - the cash flows, industry lifecycle and the market position of the company should also be considered. In Seadrill's case, these factors are in favor of the company. Again there have been calls for the investors to reconsider their position in Seadrill and the prospective investors have been warned - the same way these investors were being warned at the start of the year when the off-shore drilling sector was under pressure. However, the sector has made a strong recovery and the patient investors have been rewarded.
Seadrill investors need to understand the structure of the company and the level of financial flexibility it provides. I have talked about the financial flexibility of the company in the past but I will go into detail in this article. I will try to make it as simple as possible. The following image shows the company and its subsidiaries.
First of all, let's talk about Seadrill Partners (NYSE:SDLP) - it is a master limited partnership which was formed recently due to the increased investor interest in MLPs - the company believed that it will give Seadrill another outlet to raise capital, and it has proved to be a right decision. Seadrill can use Seadrill Partners in a number of ways. First, the company can raise capital through issuance of new units in order to expand. During the last quarter, Seadrill deconsolidated Seadrill Partners; as a result, the company will only report income (cash distributions) from Seadrill Partners - I explained this in detail here. The company can drop down/sell assets (as it did recently) to Seadrill Partners, maintaining a control over the assets and raising cash. Furthermore, the partnership can also raise debt separately to fund new assets or pay to its unitholders and without having an impact on the debt profile of the general partner. So, the formation of a master limited partnership has offered Seadrill a variety of options to raise capital - even if we assume that Seadrill loses credibility with the lenders, which I believe won't happen unless a catastrophe occurs; the company will be able to raise capital through other sources.
The biggest subsidiary for Seadrill is North Atlantic Drilling (NYSE:NADL) - the company registered on New York Stock Exchange at the start of the year. It has a fleet of 9 harsh environment rigs, and it mainly operates in the North Sea. Recently, the company has entered into an agreement with Rosneft to supply its rigs for off-shore and on-shore operations in Russia. In return, Rosneft will also buy a substantial stake in NADL. As I have said in my previous articles, this move might just be the start of a much bigger partnership and Seadrill will get more involved as Rosneft tries to exploit the reserves of East Barents and Kara Sea. Again, the IPO in the U.S. showed that NADL can be another tool for Seadrill to raise cash and expand its operations.
Archer Limited and Sevan Drilling are smaller investments for Seadrill compared to the other two mentioned above - Seadrill's stake in Archer and Sevan Drilling is worth about $365 million and $159 million, respectively, as of May 27, 2014. These subsidiaries further provide options to Seadrill to expand and grow as the debt profile of the parent company will not have a big impact on the ability of these subsidiaries to raise capital. Seadrill also has some other investments, the most prominent is its partnership with Sapura Kencana - these are minority stakes and do not give Seadrill control over the businesses.
As I mentioned in my previous article, the new bond issue and the conversion of the previous issue would have allowed the company to raise $350 million at a maximum additional cost of $3 million. Refinancing of three rigs has allowed the company to raise additional $350 million, and the company has separately offered to convert the $650 million bond issue. Lenders are likely to convert these bonds as the debt will be converted at a considerable discount. Furthermore, the bondholders will also get cash payment of $11,840 as the accrued interest for every $100,000 principal value.
The offer to convert the debt will cause some dilution and it might also cause the stock price to fall if the bondholders decide to take quick profit by selling their shares in the market. Furthermore, this will also increase the dividend obligation of the company and will likely increase the cost of capital for Seadrill as the cost of equity is higher for Seadrill than the debt. However, this was a necessary step as the company tries to manage its debt profile with a balance between its debt and equity, and at the same time, manage the cost of capital. Let's look at Seadrill's ability to meet this increased dividend obligation. Seadrill's quarterly cash dividend obligation is close to $460 million, and the company generates about $650 million in operating cash flows. Furthermore, the quarterly EBITDA of the company is close to $624 million; annual EBITDA is expected to reach $4 billion over the next two years. Keeping in mind the growth in EBITDA and operating cash flows of the company; I believe the target of $4 billion annual EBITDA is achievable and the cash flows will be enough to meet increased dividend obligation. Another factor to consider here is the newbuilds program - the company has about $5.4 billion in remaining payments for 19 rigs which will be delivered over the next few years. However, the company has decided not to order new rigs until the oil and gas sector starts to see increase in CapEx from the major oil companies. Cash reserves along with restricted cash and marketable securities were close to $2.2 billion at the end of the last quarter, and the addition $350 million from the refinancing will take this figure to over $2.5 billion.
I do not believe Seadrill will face any issue financing its newbuilds program. The company will continue to shuffle its debt as it tries to manage its debt profile and the cost and maturities of the outstanding debt. The interest rates are in favor of a debt heavy balance sheet and the debt should not pose any threat to the dividends or the stability of the company unless a major slowdown hits the sector, which is very unlikely. The geopolitical situation and the demand and supply factors indicate that the demand for off-shore drilling services will increase. Furthermore, the recent contract wins show that the demand for ultra-deep water rigs remains strong and the day rates will not fall. It is reasonable to assume that the company will be able to win contracts at an attractive rate for its newbuilds and existing rigs due to its strong relationships with oil and gas companies and newer fleet.
Seadrill remains a solid long-term investment and the renewed fears are again unfounded. The dividend of the company is under no threat and the fundamentals of the sector are still attractive. It is not a short-term investment - Seadrill is an income stock with a solid growth potential and it should be held for long term. Seadrill shareholders should ignore short-term price fluctuations and focus on the long term. The management will continue to make changes to its debt as they go towards the long-term bond issues; however, shareholders should not panic as these steps will enhance the debt position of the company and bring down the cost of capital.
Additional Disclosure: This article is for educational purposes only and it should not be taken as an investment recommendation. Investing in stock markets involves a number of risks and readers/investors are encouraged to do their own due diligence and familiarize themselves with the risks involved.