A Look Inside Seadrill's Debt

| About: Seadrill Limited (SDRL)
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In the comments to a recent article on Seadrill (SDRL), fellow Seeking Alpha contributor Steven Breazzano asked,

"I think using cheap debt to fund purchases of new drilling equipment and then securing long-term contracts is a decent strategy, albeit potentially risky (as anything with leverage can be). Is the debt fixed rate of floating? How much would rising interest rates hurt?"

I responded to his question,

"The debt is both fixed rate and floating. The company's debt consists mostly of bonds and bank loans. Here is a list of its currently outstanding bonds.

As you can see, the company has fixed rate, floating rate, and convertible bonds. The company also has bank debt and other debt (such as outstanding loans payable to an affiliated company, Ship Finance International).

Seadrill hedges its interest rate exposure through interest rate swap agreements in an attempt to prevent the problem that you seem to be predicting (basically, getting severely hurt by rising interest rates). Considering that, personally, I'd say that as long as rates don't skyrocket overnight then the company is probably fine. Its loans are denominated in both USD and NOK so the two countries to watch with regards to interest rates are Norway and the USA."

The most frequent concern about Seadrill that I hear from readers and investors is something about the company's leverage. For that reason, I wanted to take an indepth look at the company's debt and see what conclusions can be drawn from it.

Here are all of SeaDrill's outstanding bond issues:

The company's total bond debt is less than this chart would imply, though. As of March 31, 2012 (the latest quarter for which financial statements have been released), Seadrill had $588 million in outstanding bonds and another $549 million outstanding from the convertible bond issue. This gives the company a total of $1,137 million of total outstanding bond debt. As the chart above shows, most of this debt does not mature until 2015 or later. Another fairly large issue matures in February 2014. Of all the bond debt, only one comparatively small issue matures in the next twelve months. That would be the NOK 500,000,000 bond issue that matures on September 28 (ISIN NO 0010283799). NOK 500,000,000 is equivalent to approximately $82.2 million in U.S. dollars at the current exchange rate. SeaDrill's EBITDA in the first quarter alone was $592 million and operating cash flow for the quarter was $454 million. There have been no significant changes to SeaDrill's fundamentals since the first quarter that would put any doubts in my mind about the company's ability to generate similar results going forward. Thus, the maturation of the bond issue by itself does not appear to pose any problem.

Seadrill has also been financing its rapid expansion with bank debt. Here are all the bank credit facilities that the company has available to it as well as the amount owed under each facility as of March 31.

Source: Seadrill Q1 2012 Report

The amount outstanding under each individual facility generally decreased from the previous quarter. Of the twelve facilities, only two saw the amounts owed by Seadrill increase from the previous quarter. However, those two increased by enough to increase the amount of bank loan debt outstanding to $7,330 million from the previous quarter's $7,316 million. In addition to this bank debt, Seadrill owes a total of $1,361 million to Ship Finance International (SFL), another company that SeaDrill's chairman is involved with. This amount is less than the total amount outstanding under this credit facility at the end of the previous quarter. Seadrill owed $1,409 million to Ship Finance International at the end of the previous quarter. Seadrill also has $306 million outstanding under other credit facilities. This amount has increased from the previous quarter's $298 million outstanding. Seadrill thus had a total of $10,134 million in long-term debt outstanding at the end of the most recent quarter (this figure also includes the current portion of this debt). This is an increase from the $9,993 million of long-term debt that the company had at the end of the preceding quarter.

It is important to look at the dates that debt becomes due when evaluating a company's liabilities. SeaDrill's outstanding debt as of the close of the latest quarter is repayable as follows:

Source: Seadrill Q1 2012 Report

As this chart shows, the largest percentage of outstanding debt does mature until after 2016. By that time, Seadrill will likely be a much larger company than it is today, based on the company's growth rate and newbuild schedule. Seadrill is committed to achieving an annualized EBITDA of more than $3 billion once its newbuilds arrive in 2013. It has more newbuilds though that are expected to be delivered between 2013 and 2015. These should push its EBITDA up further. The company's management expects that Seadrill can generate at least $4 billion in annualized EBITDA by the end of 2015. This should provide some confidence in SeaDrill's ability to handle that debt coming due in 2016 or later.

Seadrill also has a fairly large tranche of debt coming due in 2013. This is admittedly harder to dismiss than the later maturity debt. I do not, however, believe that Seadrill will have any difficulty handling it. At the end of April, Seadrill stated that it had approximately $13.3 billion in revenue backlog. Since that time, Seadrill has also announced that it is in advanced discussion that would add approximately $1.16 billion in backlog to the total. The amount of backlog does continually decrease as the company earns the money but the total amount of contractual backlog is likely still around $13 billion. This will likely offer some comfort to creditors when the company tries to rollover some or all of this debt. Additionally, Seadrill has a strong asset base with regards to its modern fleet of offshore drilling rigs. An ultra-deepwater offshore rig costs approximately $600 million to build depending on the design. On May 4, Seadrill contracted with the Hyundai Samho Shipyard for the construction of a harsh environment semi-submersible rig at a cost of $650 million. Industry insiders have noted that there is a very limited number of building slots available at shipyards and so many drilling companies that wish to expand their respective fleets may not be able to. Given that, along with the modernity of SeaDrill's fleet and the very strong demand for offshore drilling rigs, SeaDrill's rigs are still very valuable and in demand from competitors looking to grow their own fleets. Thus, the company could meet this debt obligation through rig sales. This is not a move that I want to see the company take but it remains an option nonetheless. The company also has a much better option here, and that is the ability to use rigs as collateral to refinance this debt as it becomes due.

As might be expected, Seadrill has much more exposure to interest rate risk than many of its competitors. The company's management is well aware of this fact and for this reason the company uses interest rate swaps to hedge against this risk. These swaps have occasionally had dramatic effects on the company's earnings. For example, Seadrill took a $330 million loss in the third quarter of last year due to an adverse contribution to earnings from these instruments. The size of this writedown caused some to wonder if Seadrill is speculating in swaps much like an investment bank or hedge fund might. However, as I observed back in December, there is no evidence of this. Instead, these appear to be instruments designed to move inversely to interest rates. This is exactly what would be expected from an interest rate hedge. Furthermore, this was an entirely unrealized loss. Seadrill suffered no actual cash outflows from this position.

Disclosure: I am long SDRL.