On Tuesday, November 22, 2016, offshore drilling giant Seadrill Ltd. (NYSE:SDRL) announced its third-quarter 2016 results. These results certainly show that the sustained weakness in oil prices and the oversupply of offshore drilling rigs have taken their toll on the company. With that said, the worst aspect of these results appears to be attributable to Seadrill's sister company, Seadrill Partners (NYSE:SDLP), and not directly to Seadrill itself, which will be discussed in a later article. Seadrill's results individually were still quite disappointing, however.
As my long-time readers are no doubt aware, it is my usual practice to share the highlights from a company's earnings results before performing an analysis of those results. This serves to provide background for the remainder of the article and serves to provide a framework for the resultant analysis. Therefore, here are the highlights from Seadrill's third-quarter 2016 results:
- Seadrill reported total revenue of $743 million in the third quarter 2016. This compares quite unfavorably to the $985 million that the company brought in during the third quarter of last year.
- The company reported an operating income of $247 million in the quarter, resulting in a substantial 185% increase over the $291 million operating loss that it incurred in the prior year quarter.
- Seadrill reported an economic utilization rate of 95%, in line with most historical quarters.
- EBITDA was $441 million, a decline of 19% over the prior year quarter.
- The company reported a disappointing net loss of $656 million in the third quarter.
The first highlight that nearly any reader is likely to note is the company's large net loss during the third quarter. In fact, this net loss by itself represents almost a third of the company's market cap at the current stock price. However, this is not necessarily as bad as it first seems. This is because this loss is entirely due to impairment charges. According to accounting rules, when the value of one of a company's investments declines in value and is unlikely to recover its value in the near term, that company is required to reduce the value of that asset as reported on its balance sheet. In order to adjust for this, it must then take a corresponding loss to net income. That is what Seadrill was required to do in the third quarter. Due to the continuing weakness at Seadrill Partners, the management determined that the latter company's previous value is unlikely to return in the near future and so it wrote down the value of its still substantial holdings in Seadrill Partners. Therefore, Seadrill took an impairment charge of $806 million in the quarter related to this investment.
The remainder of the total $882 million in impairment charges that Seadrill took during the quarter is due to its investment in SeaMex, which has suffered the same fate as its investment in Seadrill Partners, only to a much smaller magnitude. It is worth noting, if these one-time charges are backed out, then Seadrill would have earned a profit of $226 million in the third quarter. It is also important to note that these are non-cash charges. No money directly left the company as a result of these charges. However, should Seadrill sell these assets, then it will be locking in a loss.
A second disappointment in this report was the high number of idle rigs. During the third quarter, five rigs (West Orion, West Phoenix, West Alpha, West Pegasus, and Sevan Driller) all went off contract, adversely impacting revenue. In addition, two of the company's AOD rigs were given extended contracts in exchange for dayrate reductions. These things are all likely to negatively impact the company's revenues going forward. This will be partially offset by the fact that two of Seadrill's rigs, West Eclipse and West Vigilant, began work on newly awarded contracts, but these two rigs will be unable to make up for the loss of revenue from the others.
One major concern that investors have had with Seadrill, particularly following the overall industry decline, has been the company's substantial debt load. Fortunately, Seadrill has been making progress at tackling this problem. As of the end of the third quarter, it had total net interest bearing debt of $8.948 billion. This represents a 2% improvement over the $9.114 billion of net debt that it had as of the end of the second-quarter 2016. It also represents an even more significant 12% improvement over the $10.178 billion of net debt that the company had at the end of the third quarter of 2015. Thus, Seadrill is certainly making progress at solving its debt woes. However, as this debt load is still 4.76 times the company's current market cap of $1.88 billion and represents a debt-to-equity ratio of 0.97, it clearly still has a ways to go.
Interestingly, Seadrill has somewhat increased its confidence in the future of the industry, although this is rather cautious optimism at the moment. According to Seadrill CEO Per Wullf:
"The offshore drilling market continues to be challenging however we are seeing an improvement in the level of bidding activity. Most of the new work is for short-term contract at or near cash flow breakeven levels, and 2017 is expected to remain challenging. However, we expect the market to gradually improve as costs have been reset across the value chain and more drilling activity will be needed to avoid accelerated production declines."
This is certainly not the narrative that investors have been hearing from the media and from analysts, many of whom seem quite convinced that the offshore drilling industry will never return. While it is certainly true that Mr. Wullf's statement cannot be interpreted to mean that the industry has regained any semblance of its former glory, he does have reason to be optimistic. For example, during the fourth-quarter 2016, Seadrill has already secured two new contracts for West Phoenix and West Saturn. Granted, these are both short-term contracts and both have comparatively low dayrates, at least compared to the highly profitable contracts that ultra-deepwater rigs were being awarded a few years ago, but they still represent an improvement over the previous situation in the marketplace.
In addition to improving its balance sheet, Seadrill also made progress in delaying delivery of newbuild rigs. This was one of the options that I mentioned in previous articles that Seadrill may use to improve its finances in the face of the industry weakness. This was a concern in the eyes of many investors because of the way that newly constructed rigs are financed. When an offshore drilling company wishes to purchase a new rig, it will typically pay the shipyard 20% of the estimated cost of constructing the rig upfront. When the rig is complete, the shipyard will deliver the rig to the contractor, which then pays the remaining 80% of the construction cost.
As with many other contractors, Seadrill ordered a substantial number of new rigs during the industry boom that lasted from approximately 2010 until 2013. Due to the time required to construct a new drilling rig (often two to three years), the concern was that Seadrill would have a large number of newly constructed rigs coming online just as the industry was facing a large surplus of available rigs. This would cause the company to have to take on additional and substantial quantities of new debt when it may not have been able to secure contracts to pay for this debt.
However, Seadrill's management has been taking steps to address this problem. The most significant of which is the aforementioned delaying deliveries. Essentially, Seadrill enters into an agreement with a shipyard that is constructing one of its rigs. The shipyard then agrees to deliver the completed rig at a later date than what was originally scheduled. This puts off the date at which Seadrill would have to pay for the completed rig and gives it additional time to get its financial house in order.
Seadrill has, in fact, had great success in this and has managed to delay delivery of several of its rigs over the past few years and it continued with that success in the latest quarter. During October, the company's subsidiary, North Atlantic Drilling (NYSE:NADL), announced an agreement with the Jurong Shipyard to extend the delivery date of the West Rigel rig until January 2017. If no contract is secured by the rig, then it will be jointly owned by North Atlantic Drilling and Jurong in lieu of final payment. Another of the company's subsidiaries, Sevan Drilling (OTCPK:SDRNF), also managed to delay the delivery of its newbuild rig from the COSCO Shipyard until April 2017. In addition, it managed to get the final installment due on the rig reduced by 5%.
In conclusion, Seadrill's results certainly reflect the industry weakness in a much stronger way than what they have done in the past. In the same vein, they also show a company that is likely to make it through this weakness, particularly if management is right and the industry is showing signs of improvement. However, it is far too early to draw this conclusion at this time and it may be best for potential investors to remain at the sidelines for now until stronger conclusions can be drawn either way.
Disclosure: I am/we are long SDRL, SDRNF, NADL.
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.
Additional disclosure: Our position in Sevan Drilling consists of the Oslo-traded shares, not the American pink sheets
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.