As woes for the energy industry continue, Seadrill (SDRL, Financial) is in a serious bear grip. In the last six months, the stock has slumped by 70%, and the selling has been relentless.
Is Seadrill well positioned to survive very challenging industry conditions through 2016? The company’s leverage has been the talking point and the key factor that has accelerated the stock decline. Can Seadrill manage to service debt and fund new rig deliveries through 2016?
Coming straight to the balance sheet, Seadrill had debt of $11 billion as of Sept. 30, 2015 and net debt of $10 billion for the same period. Further, the company’s debt to capitalization was 54% and debt to EBITDA (2015 annualized) was 4.6 for the same period. If industry conditions were favorable, these numbers would not have been a concern. However, with dwindling new orders, challenging market conditions, increasing idle rigs and prospects of meaningfully lower day rates for new contracts implies that leverage is significant.
Going forward, as EBITDA declines and as leverage continues to increase on new rig deliveries, the debt covenant headroom will diminish, and that’s the key concern for markets. The company’s EBITDA and cash flow potential for 2016 will provide clarity on the company’s survival.
Seadrill has provided total backlog estimate of approximately $3.2 billion for 4Q15 and 2016. For 3Q15, Seadrill reported EBITDA margin of 55%, and the company’s EBITDA cash conversion for the first nine months of 2015 has been 79%. Therefore, $3.2 billion in order backlog for the next 15 months (4Q15 and 2016) would imply EBITDA and operating cash flow of $1.8 billion and $1.4 billion respectively. With $420 million to $450 million in annual interest expense, debt servicing will still be smooth through 2016. Therefore, Seadrill is unlikely to default on debt even if the company’s covenant headroom shrinks during the year.
However, these are the concerns in the next 12 to 24 months:
- For the next 24 months (September 2015 to September 2017) Seadrill has $4.5 billion in debt maturity, and this implies significant debt refinancing pressure. Even if refinancing does not turn out to be a big hurdle, the company’s debt servicing cost will increase meaningfully in the next 12 to 24 months.
- As of Sept. 30, 2015, Seadrill still has 14 new rigs for delivery in the next 12 to 24 months, and the company has $3.9 billion in remaining installments for these rigs. If all the rigs are delivered, the company’s leverage will increase further. Seadrill is trying to delay rig delivery and cancel a few new rig deliveries. Markets will be watching the outcome closely.
- The company’s order backlog for 2016 is still decent, but the other backlog for 2017 is approximately $1.8 billion. If industry recovery is slow in 2017, the order backlog addition will not be meaningful. Further, as several contracts expire in 2016 and 2017, idle rigs will increase or new contracts will be at significantly lower day rates. Significant EBITDA margin contraction can be expected in 2017, and markets are discounting this factor.
With these concerns, I would still refrain from buying a meaningful long-term position in Seadrill. However, the correction is overdone in the near term, and there is likely to be a short-term relief rally for the stock. It is important to note that beaten-down sectors provide excellent trading opportunities, and Seadrill is interesting from a one- to two-month perspective.
Seadrill has a strong relationship with banks, and that is an important factor in challenging times. In May 2015, the company was successful in amending several debt covenants, and further relaxation in covenants can be expected if the company’s credit metrics worsen. Further, it is also important to note that the book value of the company’s drilling units as of Sept. 30, 2015 was $15.0 billion, and this implies net debt-to-asset value of 67%, providing debt holders with some asset cushion.
Seadrill has been a value creator in good times, and all hope is still not lost for the stock. Seadrill will survive 2016; if the industry conditions start improving in 2017, Seadrill will see gradual revival.
Disclosure: No positions in the stock.
