Offshore oil and gas drilling companies currently support some impressive dividend yields. Indeed, the sector's biggest players, Seadrill (NYSE:SDRL), Transocean (NYSE:RIG), and Ensco (NYSE:ESV) offer yields of 11.1%, 5.4% and 5.9% respectively.
But how sustainable are these payouts? Many investors would be skeptical of dividend yields that are more than double the market average of around 2%, so yields Seadrill's yield could be considered to be highly suspect.
To find out how sustainable these payouts are, we can apply a 'stress test' to the historical income of these three drillers. While it is by no means a scientific measure of dividend sustainability, a stress test of this kind does give some sort of guidance to future trends.
I must reiterate that this test is only a guide and is by no means a forecast of dividend sustainability.
Putting together a benchmark
However, before we stress test these drillers' cash flows, we should work out how vigorous these tests will be.
The biggest concern for offshore drillers over the next year or so will be the excess capacity currently plaguing the market. With international oil and gas majors cutting back their exploration spending, the industry is likely to become a more competitive environment as multiple companies chase after one contract.
Further, it is widely believed by many offshore drilling industry analysts that the offshore drilling industry is about to enter a cyclical downturn. At present, analysts are currently predicting that the day rates for ultra-deepwater, or UDW, drilling units will drop by around 16%, to an average of $475,000 per day over the next few years, as a result of a 12 to 18 month industry slowdown.
So, with these figures in mind, a stress test based on a drop in net income of 20% would seem to be a bit on the safe side, but that is what we will work with.
Seadrill has the highest yield of the trio, so let's start analyzing this company first.
According to trailing-twelve-month cash flow figures supplied by market data company Morningstar, Seadrill generated $1.5 billion in cash from operations on net income of $2.5 billion during the last twelve month period.
Assuming all else remains equal, a 20% reduction in net income to $2 billion, would mean that Seadrill's cash flow from operations would be in the region of only $1 billion. This includes working capital movements during the year .
Once again, according to data from Morningstar, Seadrill's dividend payout cost the company a total of $1.6 billion during the past twelve months. Unfortunately, these figures indicate that Seadrill is going to struggle to cover its current dividend payout if the industry slows down as predicted.
Still, this stress test does not take into account other factors like asset sales, capital spending and the effects of working capital changes on cash flow, although the test is a handy guide.
Higher payout but is it worth it?
Transocean's board recently recommended a dividend hike to $3 per share per annum, a proposal to be put in front of shareholders at the next AGM. If this hike goes ahead, the company will have a dividend yield of around 7% when the new payout is approved
Applying the same metric to Transocean's finances, using data from Morningstar once again, we can see that during the past twelve months the company generated $1.9 billion in cash from operations, on a net income of $1.4 billion.
Factoring in a 20% reduction in net income and Transocean's cash generated from operations falls to $1.6. Transocean's dividend payout of $3 per share is likely to cost the company $1.1 billion, based on the fact there were 360 million shares in issue at the end of 2013.
With this being the case, it looks as if Transocean's dividend payout is well covered by operating cash flow, even after factoring in a 20% net income slump .
But the winner is
Last on the list is Ensco. However, Ensco's dividend analysis does not require as much work as that of Transocean and Seadrill as the company's payout appears to be well covered.
Indeed, Ensco reported a cash flow from operating activities of just under $2 billion during 2013. In comparison, the company's dividend payout for the period cost $526 million in total.
These figures show that Ensco's payout is covered slightly less than four times by cash from operations, an impressive coverage ratio. Actually, with a payout cover of around four times Ensco's dividend payout looks to be the most secure in this piece and able to withstand the slowdown encroaching on the industry.
So overall, as the dividend yields of the offshore drillers rise, while the industry heads toward a slowdown, investors are right to express concern over the level of these payouts.
Nevertheless, it would appear that Ensco's and Transocean's dividend payouts look to be secure with plenty of headroom to ride out the industry slowdown within being cut to conserve cash.
On the other hand, Seadrill's dividend payout could come under pressure if the offshore drilling market declines as much as is expected.
Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.