Seadrill: Why A More Cautious Look Is Required

Seadrill (SDRL)

has around 16 semi-submersibles and around seven drillships under contract as of this year. The drillships and the semisubmersibles form Seadrill's fleet of floaters. I expect the company may face some headwinds in the coming quarters due to oil companies' reducing their capital expenditure in deepwater drilling. According to Seadrill's fleet status report, or FSR, among the total offshore rigs, the number of deepwater offshore rigs constitutes around 50%.

This leaves Seadrill exposed to fluctuation in the day rates in the deepwater offshore market. Deepwater exploration and production is one of the sources of energy and constitutes around 6% of the world's energy demand. However, drilling wells in deepwater is much costlier than drilling wells onshore. An oil well can cost around $100 million in deepwater areas. Capital expenditure by oil companies increased 13% last year, but profitability from exploration and production decreased. So oil companies are focusing on increasing their profitability by reducing the capital expenditure for offshore drilling. The decrease in capital expenditure in offshore drilling is expected to put pressure on the day rate of offshore rigs, this affecting Seadrill. One of the major sectors that can be negatively affected due to this change in focus of oil companies is deepwater offshore drilling. The following charts show the utilization and day rates trend of deepwater rig fleets across the world in the past few quarters: Source: IHS The mid-water depth semisubmersible day rates index as of November this year reduced 76 points, to 1066, while utilization was around 70%. Similar trends have been observed in the day rates of deepwater rigs. The IHS deepwater day rate index reduced two points, to 899, while fleet utilization was around 98%. The declining trend of day rates across the world might put downward pressure on the revenue of offshore drilling companies. As Seadrill has around half of its rig fleet for offshore drilling as floaters, it could also see a pressure on its day rates and could face pressure on its revenue in the coming quarters. Another major player in the offshore drilling market is Transocean (RIG). To strengthen its portfolio of offshore rigs, the company ordered five jack-up rigs at a cost of around $1.2 billion. The jack-up will be able to operate at a depth of around 400 feet, or ft. Currently the company has 12 jack-up rigs in operation. I believe the company is trying to balance the number of jack-ups and the number of floaters. The company has around 68 floaters in operation. This type of portfolio diversity will help decrease the price risks in different aspects of the offshore rig market. As of November this year, the company has a total backlog of around $29.8 billion. In a similar move to tap into the jack-up market, Ensco (ESV) ordered a premium harsh-environment jack-up rig. The company has one of the largest fleet of jack-up rigs and has around 49 premium jack-up rigs as well as around 28 floaters. The company has invested around $700 million in new premium jack-ups, which will be delivered at different times through 2016. The number of jack-ups suggest that Ensco is strengthening this segment with respect to its major competitors in the offshore rigs market. Will liquidity be an issue?

Year 2008 2009 2010 2011 2012
Short term debt ($ billions) 0.75 0.77 0.98 1.42 2.07
Long-term debt ($ billions) 6.69 6.62 8.61 8.57 8.70
Total Debt 7.44 7.39 9.59 9.99 10.77
Total Equity 2.63 4.18 5.40 5.98 5.50
Debt-to-Equity Ratio 2.83 1.77 1.78 1.67 1.95
Table: Debt-to-Equity Ratio The above table shows that Seadrill has been increasing its debt between 2009 and last year. The debt-to-equity ratio, or D/E, has also been increasing over the same time period. Is this level of debt and D/E ratio healthy for the company over the long run? Let's try to understand this from the point of view of the company's operations and the interest expense it has paid over the years.
Year 2008 2009 2010 2011 2012 TTM
Interest Expense ($ million) 130 228 312 295 340 397
EBIT ($ million) 30 1701 1643 1966 1777 3040
Interest Coverage Ratio 0.23 7.46 5.27 6.66 5.23 7.66
Table: Interest Coverage Ratio I can see from the above table that Seadrill's interest coverage ratio ranges between five and eight, except in 2008. As discussed in the debt-to-equity table, the company's D/E ratio has been rising due to its increasing debt. I expect the interest coverage ratio to fall during the coming quarters due to the rise in interest payments. Additionally, as I have discussed, the deepwater drilling market could face some headwinds in the coming quarters that could affect the day rates of Seadrill's floaters, which constitute around 50% of its operating offshore rigs. If there is downward pressure on the day rates for its fleet of floaters, then there could be a reduction in its operating income, which and could further decrease the interest coverage ratio. I believe Seadrill's debt level is currently high compared to its debt level in the last two years, which could weigh down its operating income in the coming quarters. Leads us to the dividend story Seadrill's operating income also impacts its dividend payments. One of the salient features of Seadrill's stock is the use of earnings for investment as well as paying dividends. The company's dividend yield has been around 7.90%. The table below shows the company's dividend growth and EPS growth over the past few years.
Year/Quarter 2009 2010 2011 2012
Dividend ($) 1.05 2.74 3.06 3.51
Dividend growth (%) 161 12 14.7
Earnings per share, or EPS (Basic) 3.16 2.73 3.05 2.37
EPS growth (%) -14 12 -22
Dividend Payout Ratio (%) 33 100 100.32 148
Table: Dividend and EPS The table shows that the company's dividend growth has been higher than its EPS growth in the discussed time period while the dividend payout ratio also increased over this period. So according to our discussion on the price environment of the deepwater drilling market, maintaining both dividend growth and EPS growth could prove to be a challenge for the company in the coming quarters. Watch out as the quarters come A significant portion of Seadrill's portfolio of offshore rigs is deepwater floaters. The rates of these floaters might face pressure, which could affect the revenue of the company. In addition to this, the company has built up a significant amount of debt that it has to repay. A pressure on day rates could put pressure on its operating income and could thus affect the company's debt paying capacity. In addition, the company might find it challenging to maintain EPS growth and dividend growth at the same time in such a constrained environment, given the pressure on its day rates.
By Rohit Gupta

Copyrighted 2016. Content published with author's permission.

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