Shares of offshore rig owner Seadrill (NYSE:SDRL) got hammered this week, falling more than 20%. The headline is that the company is slashing its dividend from $4 per share annually to nothing.
I can't say I'm surprised considering the fact that I said Seadrill should make exactly this move a month ago, but the market was certainly taken aback. While the market may not be happy, I think it's important to look at why this is a good move long-term.
Seadrill has billions in expenses it can't pay for
Any discussion of Seadrill has to start with the company's financial position. The company has $13.1 billion in long-term debt to just $917 million in cash on hand. What's worse is that debt is coming due in the next year and newbuilds have to be paid for as well.
In the next 12 months $1.7 billion in debt is coming due, and another $1.7 billion in the following year. Newbuilds will require installments of $1.6 billion in 2015 and $2.3 billion in 2016.
The cash on the balance sheet isn't enough to cover those commitments and even around $2 billion in cash flow each year won't pay for everything. If management would have committed to paying nearly $2 billion in a dividend annually going forward it would have been in a mad dash to add more debt to the balance sheet.
Investors may be disappointed in the dividend cut, but this is absolutely the right move for the long-term health of the company.
Seadrill's operations are better than most
Plunging oil prices have hurt everyone in the offshore drilling market, but Seadrill won't be as negatively affected as most companies. Seadrill Limited, the parent company, has a backlog over $18 billion, which is actually up slightly from late August. Seadrill Group's backlog is around $24 billion, also up slightly in the same time.
The reason backlog is growing in a low oil price environment is because of Seadrill's young drilling fleet. This makes Seadrill's rigs more desirable than competitors and the company can win contracts more easily than older rigs.
Just 9% of the floater fleet is even available next year and the average contract for floaters runs 37 months. The average jackup has a contract of 28 months.
Despite all of the negativity in the offshore drilling market, Seadrill did just report $461 million in operating income for the third quarter, bringing the first nine months of the year to $1.8 billion. Even if operating income remains flat next year the company will be able to de-leverage and add new rigs to the fleet, something it couldn't have done with a massive dividend.
Seadrill's future all comes down to oil
Shares of Seadrill have been crushed recently and this time is no different. But if oil prices recover, this year or next, the stock could double or triple in value. It isn't being widely reported, but when management dropped the dividend it also authorized a buyback program that could buy back 10% of the company's shares.
If it does that and the market recovers this stock could skyrocket. But a lot has to go right for that to happen and it's unknown if the market will play out as Seadrill hopes.
Travis Hoium manages an account that owns shares of Seadrill. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill. 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.