Is Seadrill's Dividend Doomed?

Over the last eight years Seadrill (NYSE: SDRL  ) has been a dream stock for both income and growth investors. Since 2008 it has grown its dividend by 22.22% annually, which has resulted in Seadrill becoming one of the best performing stocks of the last several years. 

SDRL Total Return Price Chart
SDRL Total Return Price data by YCharts

The cause of Seadrill's hyper growth? A boom in offshore oil drilling that saw day rates for state-of-the-art drill ships climb as high as $653,000.

However, like every sector tied to the energy industry, prices are cyclical. Recently analysts have stated growing concerns about the industry's short-term pricing power, Seadrill's $14 billion debt load, and the sustainability of its dividend. Fool contributor Jason Hall has gone so far as to suggest it might be time to sell Seadrill, arguing that the combination of a 33% growth in the global drill ship fleet through 2015 (during market weakness) and its recent erratic debt offering threatens both Seadrill's balance sheet and dividend. 

Mr. Hall makes some very good arguments in his article, which I advise readers to consider. However, I must respectfully disagree with his overall conclusion by offering counterpoints to two of his main arguments.

Seadrill has 19 new rigs under construction, nine of which are to be delivered through 2015. A total of 68 drill ships are being delivered through 2015, which combined with oil companies delaying offshore projects could cause day rates to drop dramatically.

Thus far Seadrill has proven itself adept at obtaining continued high day rates despite market weakness. For example, in the second quarter Seadrill obtained four new contracts and one extension for five of its jackup drills worth $433 million. Two of those rigs, the West Ariel and West Mischief, saw day rate increases of 29% and 11% respectively. 

Also two of its drill ship newbuilds, the West Mira and West Neptune, recently secured new contracts with day rates of $590,000 and $570,000 respectively. This is far above the $450,000 level some analysts are worried is coming. 

Seadrill's debt: does it threaten the dividend?
Mr. Hall correctly pointed out that Seadrill's recent convertible debt offering would have been against shareholder's best interests. It would have resulted in a net increase in interest of $3 million annually, while resulting in 5% shareholder dilution and an extra $100 million/year in dividend expenses.

However, as another Fool contributor, Faisal Humayun pointed out, Seadrill's cash flows are more than sufficient to service its debts and pay its dividend.

Specifically, Humayun points out that Seadrill's last quarter saw adjusted EBITDA of $788 million and operating cash flows of $656 million. Its debt interest was $122 million, giving it an interest coverage ratio of 6.5.

Even assuming Seadrill had gone through with its shareholder-unfriendly debt offering, this would have resulted in a combined quarterly dividend/interest expense of just $617 million, well covered by its operating cash flows.

The fact that Seadrill cancelled its debt offering is also a good sign. Yes, it should never have offered such a bad deal, but it deserves credit for recognizing its mistake and not harming shareholders. But what about Seadrill's cash needs? Surely it needs that cash, or why make the offering? Well, Seadrill has three other sources of cash that can easily replace the aborted debt offering.

In the second quarter Seadrill sold 230 million shares of oil and gas service company SapuraKencana, for $300 million. It still owns 490 million shares worth $640 million.

Seadrill also owns 50% of Sevan Drilling and 40% of global oil services firm Archer; together these stakes are worth $260 million.

Next, Seadrill owns 70% of North Atlantic Drilling (NYSE: NADL  ) , one of its two MLPs. North Atlantic Drilling specializes in harsh environment drill ships and jackups and recently made a major deal with Russian oil giant Rosneft. The deal calls for Rosneft to take "a major equity stake" in North Atlantic Drilling in exchange for six to nine contracts with a 35 rig year guarantee.

If Rosneft's North Atlantic Drilling stake is 20% then Seadrill will receive $532 million from the deal and still own 50% of North Atlantic Drilling as well as all its incentive distribution rights.

Finally, Seadrill has its other MLP, Seadrill Partners (NYSE: SDLP  ) , as a cheap source of financing. For example it recently dropped down 51% of its stake in the drill ship West Auriga to Seadrill Partners for $1.24 billion. 

Seadrill has 34 total ultra-deepwater rigs to potentially drop down to both North Atlantic Drilling and Seadrill Partners. With EBITDA expected to grow 20% annually through 2016, Seadrill's dividend is secure and likely to continue growing.

Foolish takeaway
Seadrill and its 10.6% yield are safe and analysts are expecting Seadrill's dividend to grow by 6.7% annually over the next decade fueled by the offshore drilling megatrend (19% annual growth through 2035). Income investors hoping for high yield but faster dividend growth might want to consider North Atlantic Drilling, whose 9.2% yield and 7% expected dividend growth rate (likely higher due to the Rosneft deal) means it's likely to be a fantastic market outperformer over the long run. 

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Read/Post Comments (6) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 18, 2014, at 2:10 PM, Prudent1959 wrote:

    Seadrill is doomed. A dividend payout of this size will bankrupt the Company. Put options going into the next earnings period is the play.

  • Report this Comment On July 18, 2014, at 3:56 PM, AdamGalas wrote:

    While I disagree with your assessment of the company's prospects, your idea of using options to augment a position in Seadrill is intriguing.

  • Report this Comment On July 18, 2014, at 4:52 PM, awallejr wrote:

    I would be selling far dated puts, as I have as well as buying far dated calls. For Prudent to suggest SDRL will go bankrupt if it continues to pay its dividend shows he lacks understanding SDRL. I have ansered this a ton elsewhere, even the author of the article gave prudent the answer.

    I will again repeat it they can always sell rigs to SDLP or NADL and there is NOTHING wrong with selling rigs for a profit. ALL TYPES of leasing companies do this.

  • Report this Comment On July 24, 2014, at 11:26 PM, samuel2011 wrote:

    " major deal with Russian oil giant Rosneft"

    What affect will sanctions against Russia have

    on Seadrill ?

  • Report this Comment On July 26, 2014, at 1:29 AM, AdamGalas wrote:

    Sanctions are not very likely. The world needs Russian energy too much to pick an economic war over Ukraine.

    However, even if the Rosneft deal fell through, it still wouldn't threaten SeaDrill's dividend.

  • Report this Comment On July 28, 2014, at 9:29 AM, Heidikitty wrote:

    Would love to know more about the Huge deal with Rosneft and what leverage will Putin have in the deal?

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