SeaDrill Ltd. (SDRL) has one of the highest dividend yields in the offshore drilling industry.
Source: Yahoo Finance - This table does not include SeaDrill's $0.20 special dividend that was paid on March 16, 2011.
Recently, there has been some doubt cast on the sustainability of SeaDrill’s dividend. I wanted to take a look to see if the company does have the financial strength to maintain that dividend for my own investment decisions. I hope that some of my readers can make use of this information as well.
SeaDrill paid out a total of $2.735 per share in regular and special dividends over the past four quarters. The company had an EPS of $2.73 during that same time period. Many financial sites list a trailing EPS of $2.61 for SeaDrill (or $2.69 after non-recurring items are removed). The $2.73 figure comes directly from the company’s 2010 annual report. For the purposes of this analysis, I am choosing to use this figure. These numbers give SeaDrill a payout ratio of 100.18%. If the payout ratio is over 100%, as it is in SeaDrill’s case, it could be a sign that a dividend is not sustainable and could be cut shortly. This is because the company is paying out more in dividends than it earns in income.
It is worth noting that SeaDrill’s net income of $1,171.6 million is higher than the $989.8 million that the company paid in dividends throughout the year. Net income is after both interest on the outstanding debt and taxes, so this number represents the amount of profit that is available to the shareholders. SeaDrill has $181.8 million in profit left over after sharing the net income with the stockholders through dividends. This works out to be a dividend payout rate of 84.5% of SeaDrill’s net income.
Net income and payout ratio are not always the best way to determine whether or not a company can afford to maintain its dividend. This is because net income is not an entirely accurate picture of a company’s cash generation ability. A company’s ability to generate cash is far more important than net income when determining how easily a firm can make its dividend payments or interest payments.
In the last four quarters, SeaDrill had an operating cash flow of $1,300.40 million. This is calculated by adding depreciation and amortization of $479.8 million onto the company’s net income of $1,171.6 million and then making a few other adjustments to determine how much cash the company’s business operations actually brought in. SeaDrill paid out $312.4 million in interest during the last four quarters. This leaves $988 million available from the operating cash flow. SeaDrill paid out a total of $989.8 million in dividends during the same four quarters, an amount that is slightly higher than cash flow from operations minus interest on the debt.
Free cash flow is defined as “the amount of cash that a company is able to generate after laying out the money required to maintain or expand its asset base,” (Source: Investopedia). Simply put, it is the cash that a company has available to distribute to stock and bond investors. Free cash flow is calculated by subtracting capital expenditures (CapEx) from the operating cash flow. I will admit, I expected SeaDrill’s dividends to exceed the free cash flow even before I performed the calculations. This expectation was because of the company’s business model. I will explain more about this model later in the article. SeaDrill had $2,367.4 million in capital expenditures in the last twelve month reporting period. This gives the company a free cash flow of -$1,067 million. Clearly, SeaDrill cannot pay any dividend at all, let alone such a massive one, based solely on free cash flow.
The trick lies in SeaDrill’s business model. SeaDrill is designed to pay out dividends to shareholders like most other companies controlled by John Fredriksen. SeaDrill does not finance capital expenditures from free cash flows. Instead, the company brings in outside money, primarily through the issuance of bonds, to finance the company’s capital investments. SeaDrill uses the cash flows that their capital expenditures (primarily used to obtain offshore rigs) generate to service the debt that was used to purchase them. The remaining cash after interest generated by these assets are available for other purposes, including dividends on common stock.
SeaDrill appears to be paying its dividends out of what remains from the operating cash flows after interest on the outstanding debt is paid. The company is paying out nearly all of this money in the form of dividends. Thus, SeaDrill’s dividend is highly susceptible to the results of the business. Should the company’s prospects or earnings decrease, it is likely that the company will also cut its dividend proportionally. Indeed, SeaDrill’s dividend has fluctuated over the years and even on a quarter by quarter basis. The company’s historical dividends can be found on SeaDrill’s web site.
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SeaDrill’s dividend is not sustainable in the traditional sense. Many companies pay a steady, or steadily increasing, amount every dividend payment period that management believes that their company can maintain in most economic conditions. SeaDrill does not follow that model. SeaDrill’s dividend is thus sustainable only for as long as the company can maintain its performance. This model does have a little more risk than the standard dividend distribution model, but it also has more reward. SeaDrill’s dividend will almost surely increase with any improvement in its performance.
Disclosure: I am long SDRL.