Seadrill: Dip Coming?

| About: Seadrill Limited (SDRL)
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Summary

Seadrill's stock price is highly correlated to the oil prices.

Debt profile of the company makes it difficult for Seadrill to take anymore risks.

Cash flows will not be enough to meet debt obligations.

New debt, if raised, will have strict covenants which will further put pressure on the profitability.

Seadrill (NYSE:SDRL) has again started to come under pressure due to the falling oil prices. The concerns about rising inventories and tepid global economic growth have again created a panic among the traders, and the oil prices are again showing weakness. Seadrill's stock price is highly correlated to the oil price and it starts to go down with the oil prices. Since the company's revenues are indirectly related to the oil price, the correlation is a bit surprising. Seadrill is not a seller of the commodity. However, this might be explained by the fact that the offshore drilling sector is costlier and investors believe these companies might be the first to face the consequences of a reduction in capital spending. As a result, the whole sector performs poorly if the oil prices are going down. Another explanation of Seadrill's strong correlation is the high levels of debt. A slight decline in oil prices spooks the investors and the doubts are raised about the ability of the company to survive in these harsh conditions.

Looking at some metrics in isolation can mislead the readers. For example, Seadrill's current EBITDA margin (Ratio of its EBITDA to total revenues) of 59% is better than the first quarter of last year as well as the previous quarter. However, this does not mean that the company has made more money or cash in the first quarter of the year. There has been some cost cutting measures but this should be kept in mind that these measures are always preventive in nature and allow the company some breathing space. However, the main drivers: revenue and order backlog, have been consistently declining. Most of the orders have either been revised downwards or cancelled. Oil and gas companies have realized that in order to achieve breakeven in low prices environment, capital should be invested in the onshore developments. Nevertheless, these factors have been present for quite some time and are not the cause of panic among the investors right now.

While analyzing Seadrill, one needs to keep in mind three key components: Debt, maturities of the debt, and the company's ability to meet these obligations. Almost everyone who follows the company knows that the debt levels are high. However, a large number of people do not understand the debt profile or the debt maturities and how it can impact the company. I look at the debt in a different way here which might help make it easier for some readers to understand. The image below shows the debt and changes in it during the last quarter. The data was taken from the first quarter earnings report.

Source

Most of Seadrill's debt is in the form of credit facilities. The company has drawn quite a large portion of its total allowed borrowing under these credit facilities. The third column shows how much of the each credit facility has been drawn. Some of these credit facilities are for its subsidiaries. However, as Seadrill owns majority stakes in these subsidiaries, the company consolidates the debt of its subsidiaries as well. I have marked those credit facilities red that have been used 60% or more. Although up to 40% of borrowing capacity is still available in these facilities, further borrowing usually results in considerable increase in costs. In some cases, the lending institutions also opt to tighten the covenants as the total leverage of the business increases. Some of these facilities are already at above 85% which makes them almost unusable further. There are only two facilities that are in the green or below 50%. There is still some room in these facilities. Only 3 facilities are in the range of 50-60%.

The credit market in this industry is extremely tight at the moment and the focus is on reducing the debt. The trend in these facilities shows that the company is trying to pay back some of the borrowed amount. Almost all the facilities are showing a decline during the first quarter. The last column shows the changes in the amount drawn during the first quarter. Seadrill has reduced its borrowing from credit facilities by almost 3% during the first three months of the year. However, the trend changes totally in the VIEs (Variable Interest Entities) as the facilities maintained by these VIEs have seen a considerable increase in the amount borrowed. All of these facilities are drawn more than 67% and the increase from December has been in double digits. So, the decrease in other facilities is being offset by an increase these three facilities, to some extent. Unsecured bonds have also gone up in the first three months. In total, the decrease in borrowing is about $64 million. This discussion and the above figure show that there is little room for the company to borrow further from these facilities. In desperate times, Seadrill might want to use them but it will not be a wise decision. This will cause the interest expense and the debt burden to rise, which will be hugely detrimental in the current industry dynamics.

Another thing to consider is the debt maturity profile. This breakdown is given in the quarterly and yearly reports.

More than 45% of the total debt is due in the next two years, over $4.7 billion. If the market conditions remain tight then the company will not be able to meet these payments from the internal sources. In addition to this, the credit markets for the industry will also remain difficult and there will be little opportunity to replace this debt with a new one. Even if this can be done, the terms will not be favorable. Banks will put stricter covenants and the interest rates will be high. If the company goes to the bonds market then the interest rate will need to be extremely attractive as these bonds will not get an investment grade rating. The third option is an equity issue which will be exceedingly damaging to the current shareholders. At current share price, an equity issue will not help the company.

Annual operating cash flows are around $1.5 billion, impressive in the current conditions but not enough to cover the debt repayments over the next two years. A substantial portion of these cash flows will also go towards new investments. So, the company will have to use a mix of these cash flows and new debt to replace the old debt. This is doable but involves a lot of risk, especially if the oil prices do not make a strong recovery over the next twelve months.

I am optimistic about the oil prices and believe that this downturn will be temporary and the prices will start to rise in 2017. However, oil producers might decide to stay away from offshore investments as these are costlier assets. We also need to keep in mind the deliveries of newbuilds. Seadrill cannot defer these deliveries for an indefinite period. These deliveries will create new problems in the form of idle machinery and increased costs. All these factors need to be considered while looking at Seadrill. I am still of the view that investors with lower risk tolerance should stay away and wait for the market conditions to improve. Investors with an appetite for risk can buy it in the hope of a turn around and a major upward move, or even a small rally if the oil prices make a recovery over the next few days. For the cautious investors, I think there are too many risks involved.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.