Seadrill Will Emerge Like Venus From The Sea

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About: Seadrill Limited (New) (SDRL), Includes: SDLP
by: Ulrik Lehrskov-Schmidt
Summary

Seadrill is expected to announce a comprehensive restructuring of its capital structure before Friday, likely through Chapter 11.

The equity is a blind gamble now, but it's likely to be a fantastic investment when it emerges from bankruptcy.

The two key factors are earning power and the industry outlook for 2017-22.

Here I discuss my views on both.

Seadrill (NYSE:SDRL) is on the verge of a comprehensive restructuring of its capital structure and has warned that this is likely to include a Chapter 11 bankruptcy. With a very high likelihood (>95% in my estimate) this involves a prepackaged deal that has the backing of a large majority of the creditors (+85%), which will allow Seadrill to emerge from bankruptcy within months instead of years.

The interesting question is: Should you buy it then? I think the answer is probably "yes," and in this article I will offer some reasons why.

Equity Stubs - Power Mechanics at Work

First, let's look at the mechanics of post-bankruptcy companies to see why this might be an opportunity in the first place. Companies go bankrupt because they run out of liquidity.

We have no money

Some of these do so because their underlying business can't cover its own operating costs. Stay away from these "Walking Dead" types. They will emerge only to go under again in short order when their business fails to deliver.

The other category -- let's call them the "Unlucky Gamblers" -- got caught off guard by too much debt (or freak one-off events like lost lawsuits). Very often these are cyclical companies that just got the timing wrong. Sometimes very wrong. So the debt pulls them under. But in this case the restructuring actually has a healing effect: Maybe creditors take losses or maybe they just defer payment until later, but in any case, short-term liquidity is fixed and the company emerges with some sort of runway to get renewed momentum in its business.

Shareholders Start Afresh - From a Small Base

The unifying theme for both the Walking Dead and the Unlucky Gamblers is that their capital structures emerge from bankruptcy looking something like this:

Post Bankruptcy capital structure This is what's called an "equity stub," meaning that the equity value of the business is a tiny fraction of the (relatively) huge debt load that the underlying business has to carry -- simply because the creditors will want as large a piece of the future pie as their pre-bankruptcy claims can justify. If you are good at telling which companies are Walking Dead and which are Unlucky Gamblers, these equity stubs are a good way to get rich.

Why? Because any increase in enterprise value going forward is only going to increase the value of the equity while debt stays the same, as debt has no claim on the upside. With regard to the figure above, the blue line doesn't get any longer if the business starts to prosper, so any increase in total value has to come from an increase in equity -- which, because it starts at such a minimal value, will see a huge relative increase.

Enterprise Value increase goes straight to equity

Is Seadrill Just an Unlucky Gambler?

I think the answer to the above question is yes. (Some might say that "unlucky" is too nice a word and that "drunk on power and willing to risk every shareholder dollar to get bigger management bonuses" is a more apt description. OK, but investors took that gamble too when they threw in their chips. Had oil stayed at $150, I think those same investors would be throwing that same management a parade.)

Two things have to be true for this to be true as well:

  1. Offshore drilling as a whole has to have a future that allows at least a few companies to do well in the coming years.
  2. Seadrill has to have what it takes to be one of those companies.

Let's look at those two conditions in turn.

Offshore Drilling - My Best Guess for the Next Five Years

My thinking in this area has revolved around the following three key questions. Note that these are my conclusions and that I don't present them as fact -- there are pros and cons being weighed and the future is never clear:

Question 1: Will the world use an increasing amount of oil in the short term (five years)? My thinking here is that it will. The IEA predicts a 6.3% increase over five years from the 2016 level:

IEA oil demand forecast Source: IEA

The big oil companies seems to be in no panic either, with Shell's (NYSE:RDS.A) CEO being the most pessimistic, claiming that we have only 10 years of demand growth left. Many other analysts seem to think demand will peak in 2030 or later. Even if oil demand tops in 2030 at 110 million barrels a day, we'll still have decades of oil demand above current levels left. So far, so good.

Question 2: Will offshore drilling produce a portion of that oil roughly similar to its historic contribution? This question takes on almost religious proportions depending on who you choose to argue about it with, but to me it seems almost obvious that it will either stay at the current proportion or rise (as it has historically).

Why? If demand is still growing in five years and with further expected growth 10 years ahead -- plus the fact, we must assume, that what is currently being drilled is the easiest available oil -- then my thinking says that 1) offshore will grow along with overall demand growth, and 2) that as oil demand drops in a couple of decades due to the advance of electric vehicles and alternative energy sources, a larger relative proportion of the oil being produced will be produced offshore simply because that is where there's oil left at that point.

To sum up, we're going to pump it out of the sea because we already pumped out the stuff we found on land. Unless, of course, somebody came up with a whole new source of oil like, let's say, shale. The argument that shale will replace offshore is tempting and, I believe, false -- at least to a degree. It's simply not big enough at it's current 3 million barrels/day to replace the current 25-30 million barrels/day that offshore produces. And any argument that shale can double or triple in size will have to include an argument for why that can happen at stable, breakeven levels, and why similar cost reductions wouldn't also be achievable in offshore (which have achieved tremendous cost reductions these past two years).

Shale is here to stay -- and grow! No doubt about it. Will that "kill offshore"? Not even close. The two are not mutually exclusive, but will of course put mutual price pressure into the same global market.

Question 3: Will dayrates for offshore be high enough to enable some of the companies to have at least acceptable economics going forward?

Given that we've already established that offshore drilling will be needed, the question then becomes "how needed" -- and how the internal dynamics of rig supply and demand will unfold over the next few years. Now there is a huge oversupply of rigs due to the "ketchup effect" of arriving newbuilds to an already oversupplied market:

Offshore rig Count IHS
Source: IHS Markit RigBase

For drillships and semi-subs this oversupply is not going to get fixed by simply scrapping rigs. Even if every rig built before 1998 is scrapped, it would still not balance the market. What will help, however, is that despite the alluring simplicity of graphics like the one above drillships are not commodities: They are highly specialized assets and not all ships can do all jobs. Even among the ones that can, the economics will be quite different.

This variance in economic viability across assets that are seemingly similar is -- importantly -- both an aspect of the physical makeup of the asset itself (i.e., to what specification the rig is built, etc.), but also of the competency of the owner in terms of running the asset. High utilization is not only good for the rig owner, but also for the operator. Supply is, in other words, "lumpy," which gives rig owners some negotiation power in an otherwise impossible situation.

My prediction is that high spec assets that are run well will become increasingly sought after because those are the ones that gives oil majors the best economic output for a project overall. Conversely, the non-high spec assets (and this can be drillships even just a decade old) that are averagely run will find themselves far less competitive.

Over time -- and a relatively short period of time -- this splitting of the market will have a compound effect as the less competitive assets deteriorate without use. The economics of activating the rigs becomes a heavier burden on the bids in which they are involved. This will effectively decrease viable rig supply and consequently drive dayrates up, sooner or later. My bet is sometime within 12-18 months, if not sooner.

Borr Drilling said the following two weeks ago in its Q2 Board of Directors report:

Since the start of the year, marketed utilization for Independent Cantilever (IC) jack-up rigs that are less than 10 years old has improved by 3 percentage points to 72% today. During the same period marketed utilization for IC jack-ups older than 10 years has decreased 4 percentage points to 66%.

The market is splitting into new rigs vs. old rigs.

What About the Dayrates?

Take a look at this composition from Bassoe Offshore, the Norwegian-based global offshore advisory:

Rig Economics Source: Bassoe Offshore

It investigates the profitability of rigs in two scenarios: current dayrates and a possibly normalized dayrate environment, which Bassoe sees coming a few years out. Normalized means 350k for high spec drillships and 125k for jackups.

The "Payback Years" that you see at the bottom is the time it takes for these earnings to pay back the rig cost cash-on-cash, depending on whether you paid the full price of, let's say, $700M in construction cost or you got them on the cheap for $400M during the present downturn. Excluding interest. These Payback Years are roughly comparable to what you might call a P/E rate for rigs given current and proposed future dayrates. Roughly.

These future numbers from Bassoe makes sense to me as they are relatively good long-run averages adjusted for inflation. They sit at a level that allows rig owners a fair return on capital -- just enough to keep the capital in the game, but not enough to get anyone's mouths watering.

Seadrill - Normalized Earnings

I think that a restructured Seadrill will be a fierce competitor in the offshore drilling space, as their fleet is the youngest out there:

Fleet Age Source: Seadrill 2016 presentation

The graphic is a year old, so some selling and buying of assets has happened, but the overall picture of the sector is the same: Seadrill's fleet is by far the youngest, especially among the bigger drillers. Partly as a consequence, Seadrill -- together with Atwood Oceanics (NYSE:ATW) -- has had the highest utilization rates in the industry, routinely reporting 97%-99%. I think this is the single strongest argument for Seadrill going forward as their rigs will -- on an aggregate level -- be first in line when contracts are handed out.

To begin with (that is what's happening now), those contracts will only earn just about what it takes to keep the rig working and interest payments on the loan. But the very fact that they will be working is what will build their competitive edge for the contracts of 2018 and 2019.

Some Back-of-the-Napkin Math for Seadrill

If we reach those 350/125K dayrates and Seadrill manages to get 80% of its fleet working at that level (which is at the lower end of the long term average for the last 20 years), we'll see revenue of about $4.2B and EBITDA around half that at $1.9B, assuming warm stacking and active marketing of the non-working rigs. Assuming that all current $2B worth of bondholders are converted to equity in the coming restructuring, but the $7B bank debt stays intact and is joined by around $1B of new money from John Frederiksen in the form of some type of convertible bond or some such, then we're looking at a total of around $8B of interest bearing debt.

Seadrill has sub-4% rates on this debt, with +95% of it hedged against interest rate hikes, which makes $8 billion very manageable as long as it isn't maturing within two weeks (as is the case now with a $1B unsecured bond). 4% of $8B is only $320M a year, which means there is 6x coverage in this land of 350/125K dayrates. So, the bottom line is that Seadrill could very well see itself with around $800M of pre-tax income, free and clear, in a couple of years. And it could see a substantially higher cash flow, as the $800 annual depreciation charge isn't likely met with a similar need for new capex.

Bottom Line

OK, maybe your napkin scribblings look different. I know that mine are possible, but whether they are plausible or even probable is of course up to each and every investor to figure out. But the idea that Seadrill stands a good chance to be first among its peers if the industry recovery happens -- which I think it will -- is at least a possibility you should consider.

And if you think that it could happen, then you have to think how the market might value such an annual $800M pretax income with good coverage. 5x? 10x? 12x? Then, just compare that number with whatever the newly minted equity will be trading for in the market when Seadrill emerges from bankruptcy.

My bet is that the future of that company will be selling for cheap. Far below $1B. My other bet is that Seadrill, for all its flaws, was just an Unlucky Gambler and that it will reemerge as an industry leader with strong future earnings.

I'm readying some cash. You should consider that too.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SDRL over 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.

Additional disclosure: I'm long Seadrill Partners, a non-consolidated de facto subsidiary of Seadrill, with the same equity-stub structure as this article discusses. Also, I plan to take a position post-restructuring if equity value is as I predict. That isn't going to happen in the next 72 hours, so the disclosure above is to cover the non-bankruptcy scenario that is still, after all, in play.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.