How Safe Is This 10% Dividend?

In a surprise move, offshore driller Seadrill Limited (NYSE: SDRL  ) raised its dividend in the face of a difficult market for new contracts. The company even faced some operating issues during the first quarter, yet that didn't prevent solid earnings and cash flows from supporting the dividend.

At the time, investors couldn't grasp the 11% dividend considering the large debt load and 19 newbuilds under construction in a tough offshore drilling market. The stock has now rallied, and investors need to understand that the bifurcation of the market provides long-term stability for a company with limited rigs older than 10 years. Companies with older rigs like Transocean (NYSE: RIG  ) face a tougher road with limited contract coverage for 2015, so why is the market still allowing Seadrill to pay a high 10% dividend yield?

Generating cash  
Probably the biggest takeaway from the quarter for investors concerned about the dividend is that the company produced adjusted EBITDA of $788 million despite weak operations from some new floaters. The consolidated revenue that includes Seadrill Partners LLC (NYSE: SDLP  ) was slightly down from the fourth quarter at $1,436 million.

Seadrill produced $656 million of cash flow from operations that the company can utilize to help pay for newbuilds and the dividend. This number will improve with better operations going forward.

Disappointing operations
During the quarter, Seadrill operated 17 floaters and 24 jack-up rigs spread across multiple continents. The company had issues with the BOP on the West Pegasus and other operational issues on a few floaters that led to revenue efficiency of only 91% in the first quarter, down from 94% in the previous quarter. The jack-up segment continued to average an efficiency of 97% to match the previous quarter, but naturally the floaters are significantly more valuable to the financials.

Transocean hit a revenue efficiency of 95.7% in the first quarter, but those strong operations can't overcome a relatively low fleet utilization of only 78%. Again a sign that having the right rig is probably more important than the best operations.

Increased dividend
Any time a dividend exceeds 10%, the market assumes the payout isn't sustainable. In the case of Seadrill, the company actually increased the quarterly payout to $1.00 per quarter from $0.98. The dividend yield is now right around 10%, but the market doesn't exactly buy that the company can continue paying that sum. In comparison, both Transocean and Seadrill Partners have mandates to pay top dividend, but both stocks only pay dividend yields of around 6.5%.

With 469 million shares outstanding, the payout is equivalent to $469 million on a quarterly basis and only slightly less than the operating profit of $574 million on a consolidated basis. Of course, a key ingredient to the cash flow used to pay these dividends is the $170 million of depreciation expenses for rigs that mostly maintain values for extensive periods.

Considering Seadrill has $5.4 billion remaining to pay for newbuilds, some investors would undoubtedly prefer the driller use the dividend to pay for the new assets. The company prefers to use the debt markets to lock in attractive returns using low cost debt offset by long-term contracts. With a current backlog of roughly $20 billion following the signing of another long-term contract, the offshore driller isn't having any problems locking up debt at attractive rates.

Bottom line
Clearly Seadrill needs to tighten up operations in order to max out cash flow generation to more than cover the dividend payments, but the current stock price offering a roughly 10% dividend yield is extremely attractive. Especially considering the company will greatly expand the asset base into a more favorable market opening up toward 2016. With 66% of 2015 operating days already covered under contract prior to the recent deal, the market is worrying too much about a pause in the market and overlooking the long-term potential in the offshore market.

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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 June 26, 2014, at 4:49 PM, Heidikitty wrote:

    I read Fredriksen has a company that just went on the S@P if I read it correctly. If so which one was it?

  • Report this Comment On June 27, 2014, at 5:30 PM, awallejr wrote:

    Only reason why it is exceeding 10% is because of the shark attack knocking it down from a high of 48. The dividend is absolutely safe. People keep ignoring SDRL's relationship with SDLP. Should SDRL ever need to come up with some cash they sell a rig to SDLP and boom money in hand. Icahn is following this model now with RIG.

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Mark Holder

Mark has been writing for TMF since Dec. 2012 with a primary focus on taking advantage of opportunities provided by the market in the energy and tech sectors.

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