In an article written on April 30, fellow Fool Rupert Hargreaves raised some concerns associated with Seadrill (NYSE: SDRL ) and the company's dividend policy. The article included this comment from a Wells Fargo analyst:
It has long been our analysis that [Seadrill's] aggressive dividend policy has never been funded solely by the operations of its high-quality fleet, but instead has been funded through the sale of i) equity and convertible debt ii) equity in sponsored "child" entities ([North Atlantic Drilling (NADL), Seadrill Partners (SDLP)]), and iii) the outright sale of rigs ... As long as [Seadrill] could sell these assets and equity for premium prices, it could sustain a high dividend ... asset values are slipping, we think [Seadrill] may fail to secure the sales prices and external financing required to sustain its current dividend.
The author went on to cite that dividends well exceed free cash flow and are causing a large shortfall. While at first glance this may look alarming, when you dig deeper into Seadrill's operations, it becomes apparent that the company is in a transitory phase. Seadrill has engaged in an ambitious plan to provide the most modern fleet in the market. Once Seadrill finishes or even pauses its rig-building program, its finances will look very different from how they look now.
While Hargreaves certainly wasn't wrong in stating the facts, I believe that a 'bigger picture' view will better convey my point about Seadrill's transition.
The above two charts, I believe, give an accurate 'big picture' view of Seadrill's finances over the last five years. Look first at the left-hand chart. Operating cash flow, or OCF in the chart, has consistently been higher than the company's dividend payments.
Adequate operating cash flow, however, is no guarantee of a safe dividend. Ideally, dividends should be paid from free cash flow, which is operating cash flow less capital expenditures. Free cash flow, therefore, represents the company's cash flow minus the spending allocated into growing the business. The chart on the right hand side above represents operating cash flow and capital expenditures. Since 2010, Seadrill has outspent its own cash flow, meaning that it has had negative free cash flow for most of these years.
This capital spending, however, is to build a larger, newer, more ultra deepwater-oriented fleet, including ships such as the West Auriga shown above. After the Maconodo accident in 2010, operators have preferred to lease newer rigs with updated safety specifications. Furthermore, the majority of offshore discoveries have been at depths greater than 7,500 feet below sea level, or at 'ultra-deepwater' depths.
Therefore, it makes sense for Seadrill to be building a new, deepwater fleet, which operators will pay a premium for. The results already speak for themselves too: Seadrill's floater utilization rate is near 100% and is consistently higher than that of its peers.
By focusing on just one metric it's easy to take things out of context. Yes, Seadrill has negative free cash flow and is paying a large dividend. But looking at things holistically, this situation is a concern only if you don't believe that Seadrill's new build program will not pay off.
I believe that it will, and I would argue that it already is. There's no doubt that Seadrill's strategy of taking out debt to ambitiously build deepwater ships is a bold one, but it is a move that is grounded in solid thinking. In other words, Seadrill is a calculated risk.
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