The strategy behind the repurchase is to reduce the total outstanding number of shares after the recently announced notification of Call Option as informed in the press release on April 7, 2011, and subsequent anticipated conversion of the US $749.5 million 2012 convertible debt into equity.
On April 7, SeaDrill Ltd. (SDRL) announced its intention to redeem $1 billion of convertible bonds from an issue in 2007 (ISN NO 001 0395981). The loan agreement calls for SeaDrill to redeem the bonds in either cash or stock. If the bondholder chooses to convert those bonds into stock, then shares will be issued equal to the par value of the bond plus unpaid interest. The shares issued will be valued at $27.80 per share. At the time of the redemption announcement, the outstanding value of all the bonds that are being called is $749.5 million. Thus, if all the bondholders elect to convert their bonds to stock, SeaDrill will need to issue 26,960,431 new shares. The final settlement date of this conversion is May 10.
It can be difficult to determine just how many of these bond holders will choose to convert their bonds to equity. As of April 19, $400,000 of bonds was converted into 14,388 shares. SeaDrill stock closed at $34.65 per share on April 19. Thus, at a conversion price of $27.80, the bondholders could immediately sell the newly issued stock at $34.65, making a quick 24.64% profit. This is a substantial return in such a short time, so it seems reasonable to assume that a good many of the bondholders will convert their bonds into shares to capture these profits. Any of the bonds that are not converted into shares will be paid off at par value plus all accrued interest to the settlement date.
SeaDrill is attempting to limit the potential dilution that a large number of conversions could inflict on the current shareholders. On April 18, SeaDrill purchased 400,000 of its own shares in the public market at an average price of NOK 181.15. This is $33.35 at the April 19 exchange rate. SeaDrill’s own press release provides this as being their reason:
This repurchase of stock increased SeaDrill’s treasury stock holdings to 598,687 shares. Stock dilution, which occurs when a company increases its shares outstanding for whatever reason, is rarely desirable for investors. The reason for this is that, post-dilution, each share represents a smaller claim to the company’s revenues, profits, and assets than that same share did pre-dilution. This can reduce the earnings per share, which will reduce the share price if the P/E ratio stays constant. SeaDrill’s stock buyback shows that the company is at least cognizant of the potential for damage to its current investors and that the company is making an attempt to minimize the dilution that is inflicted on them.
SeaDrill had an average of 416.8 million shares outstanding during the final three months of 2010. If all the currently outstanding convertible bonds were converted to equity, the number of shares outstanding would increase to 443.76 million. The company earned $1,171.6 million in 2010. Zack's predicts earnings growth of 14.45% in 2011 over 2010 results. That would give full year 2011 earnings of $1,341.0 million, equating to post-dilution (post-conversion) full year earnings of 3.02 per share. That is a forward P/E of 11.47. This gives us a PEG ratio of 0.79. As I have indicated in prior articles, a PEG ratio below 1 indicates that a stock is underpriced relative to growth potential. In order for the stock to be fairly priced by this metric, it would need to have a price of $43.67. That price represents a 26% return from the current price, not including dividends.
It is worth noting too that this is the least optimistic assumption. That assumes that all the convertible bonds will be redeemed for equity and that there will be no share buybacks. Neither of those assumptions is likely. Most likely, there will not be full dilution or the company will buy back more shares. Either of these scenarios would make the stock cheaper than what it looks now.
It is also worth noting that my analysis above used the average number of shares outstanding from the final three months of 2010, which is the most recent financial statement. According to Zack’s, SeaDrill had 395.80 million shares outstanding at the close of 2010. Using that number in the analysis above would also show that the stock is even cheaper.
The bottom line is this: SeaDrill still looks cheap, even if the maximum number of shares are issued under the current Call Option that the company has taken in order to retire some debt. I intend to continue adding to my position in this company.
Disclosure: I am long SDRL.