It has been a crazy few weeks for Seadrill (NYSE:SDRL) as management has made and then backtracked on financing decisions. I first wrote of these happenings a week ago (article available here), when Seadrill launched a new convertible bond, offered to repurchase existing converts, then rescinded these offers the next day because the stock fell 5%. At the time, I was critical of management's decision to let a one-day stock reaction interfere with longer-term financial planning. On Friday July 18, Seadrill complicated things further by offering, once again, to repurchase some of its existing convertible bonds (press release available here).
According to the press release, SDRL will give bondholders 3,612 shares of Seadrill and $11,840 in cash for each $100,000 in principal. While the share exchange is unchanged, this offer includes an addition $1,375 in cash, so it is superior to the previous offer. Seadrill's rationale for this new and better offer is that some bondholders shorted SDRL shares once accepting the conversion to lock in the conversion rate. The next day, when the offerings were pulled, SDRL stock rallied, leaving these bondholders with a loss. This reversal is a sign of how management's previous reversal had unintended consequences. Rather than annoy its bondholders, which could slightly hinder Seadrill's ability to issue new debt, it now has to make amends and give a better offer.
Assuming a 90% conversion rate, which is probably about right as over 60% pre-committed to the deal, the increased cash offering will cost about $8 million, not a bad price to maintain good relations with the debt market. While I have been unhappy with management's inconsistency and backtracking, I do think the right decision was probably made in the end. Seadrill carries a ton of debt, with a debt/EBITDA ratio of 4x (financial and operating data available here). Seadrill also operates in an industry that tends to be very cyclical, as economic activity is a key factor in oil prices, which determines the cap-ex budgets of oil companies. This, in turn, determines day rates for Seadrill's ultra-deepwater rigs.
While a stable business like a regulated utility can carry a lot of debt, Seadrill should carry less debt, probably closer to 2x debt/EBITDA, given the cyclical nature of offshore drilling. As such, I want to see it de-lever whenever possible. Now, on the other hand, this decision is also cash flow-negative. Dividend payments on these shares will exceed $85 million, when the coupon these bonds carried only cost $22 million. Interest expense is also tax-deductible, unlike dividend payments. Of course, Seadrill can always cut the dividend when things get bad while interest is unchanging.
At the end of the day, I think SDRL stock is over-priced because the dividend is unsustainable, making it wise to convert debt to equity. Seadrill is running free cash flow-negative, and its dividend costs another $1.8 billion annually. As such, Seadrill will not be generating free cash flow in excess of the dividend for at least 5 years. This means that Seadrill will have to continue issuing debt to meet its growth and dividend targets or actually cut the dividend, should interest rates become uneconomical. At this point, there is no credible path to pay down debt because of the outsized dividend and growth cap-ex budget. This will leave the company with excess leverage and susceptibility to any economic downturn.
In the end, it was a crazy process, but Seadrill made the right decision to de-lever the balance sheet by exchanging debt for equity. If I were management, I would consider making other offers to convert debt to right-size the balance sheet, and when possible, refinance existing debt with lower coupon convertible debt to minimize interest expense. Equity investors should recognize that Seadrill's debt balance makes it a riskier investment, and further equity dilution may be necessary to cut the outsized debt balance. Seadrill's dividend is a false sign of health without corresponding free cash flow. Continue to avoid SDRL.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.