In the offshore drilling industry, one of the most anticipated results is from Seadrill (SDRL, Financial) as investors and traders await the next move from the struggling company.
With Seadrill reporting its first quarter results recently, there are several points worth discussing that will determine the trend for the stock in the foreseeable future.
I will start with a few comments on the industry before discussing the company’s credit perspective. A single comment from the company’s first-quarter results puts the industry outlook into perspective – “Major oil companies continue to cut activity levels for 2016 and 2017 and appear to have more rig capacity already under contract than they require, severely affecting new demand and leading to contract renegotiations and terminations.”
There are several conclusions from this crisp management comment:
- Industry conditions will remain challenging through 2016 and potentially through 2017. Late in 2015 and going into 2016, offshore drillers expected improvement in market conditions in 2017. However, as industry depression continues, the challenges will magnify for Seadrill (especially from a credit perspective).
- Significant demand-supply imbalance exists in the industry. While Seadrill has delayed rig deliveries in 2016, potential rig deliveries in 2017 can also remain without contract.
- Contract renegotiations will eventually translate into lower day rates and I see EBITDA margin compression coming in the remainder of 2016 and 2017. The key issue here is how it will impact covenants, and Seadrill does not have significant headroom buffer if EBITDA significantly worsens in the next 12 to 24 months.
With industry level challenges, Seadrill is certain to face issues related to the company’s credit health in the coming quarters. The extension in payment of certain credit facilities is a relief for the near term, but reduction in debt is the key positive trigger in debt payment. Seadrill has reduced total debt from $12.3 billion in first quarter 2015 to $10.7 billion in the first quarter of 2016 with net debt currently at $9.6 billion. However, if industry conditions remain weak for the next 12 to 24 months (very likely), further reduction in debt is critical.
Seadrill has already issued EBITDA guidance for the second quarter, and this factor is discounted in the stock with likely EBITDA of $510 million. While the front-end loaded order backlog will ensure that EBITDA is strong enough for comfortable debt servicing, the markets will focus on how soon the industry recovers.
Also from the industry perspective, oil might have recovered from January lows, but the current levels are certainly not enough to ensure that offshore industry conditions improve. Even if oil continues to trend higher and sustains at higher levels, EBITDA margin compression is unlikely to reverse any time soon.
Seadrill is likely to service debt smoothly in the coming quarters, but the market concern is beyond debt servicing and cash from existing backlog. The stock will be interesting for exposure only when there is further debt reduction, sustained oil price recovery and clarity on the extent of EBITDA margin compression likely in the coming 12 to 24 months.
Disclosure: No positions in the stock.
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