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Rupert Hargreaves
Rupert Hargreaves
Articles (1234)  | Author's Website |

Investing Lessons: A Tale of 2 Drillers

The perfect example of why cash is king

March 06, 2017 | About:

I am a firm believer that taking on an overwhelming debt mountain is the single most destructive move for any business. In my view, cash is king and the more money a company has, the better. Seadrill Partners (SDRL) and Rowan Companies (NYSE:RDC) are two great examples of why I believe this is the case.

Four years ago, Seadrill and Rown had very different outlooks. Investors piled into Seadrill stock thinking the company’s rapid expansion would never end and the dividend yield, which at one point was as high as 10%, was fully funded from future cash flows.

Rowan, on the other hand, had adopted a much more cautious approach to business. The company had ordered just for new drillships, which it funded with a mix of both debt and cash. Management reluctantly introduced a 10 cents per share dividend, but only when the majority of this capital spending had been completed.

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The difference in investor sentiment surrounding the two companies after adopting the different strategies is evident in the price-book (P/B) ratio. From year-end 2011, Rowan’s P/B ratio averaged 0.8, while Seadrill’s traded as high as 3.1 times.

Lack of experience

Seadrill only became a public company in 2011. Its inexperience has clearly held it back. In comparison, Rowan has been around in one form or another for nine decades, so it knows how to weather industry downturns. It is fair to say that while Rowan has not completely escaped the offshore drilling industry downturn, the company’s experience has helped it stay afloat. In contrast, Seadrill is slipping under the waves.

The differing fortunes between Rowan and Seadrill since the oil price started to collapse in 2014 are nothing short of staggering. Both companies have suffered from industry price deflation, but while Seadrill had borrowed heavily to fund its fleet expansion, with borrowings tied to future cash flows from new drilling units, Rowan’s stronger balance sheet has helped it stay ahead of competitors.

Even though two of the company’s new ultra-deepwater drillships are now without contracts, and the other two drilling units have seen their day rates reduce from around $600,000 a day to $580,000 and $260,000, the company is still generating cash from its 19 other drilling units. What’s more, early cancellation charges have helped improve Rowan’s cash balance to around $1.3 billion, approximately 50% of gross long-term debt. Thanks to an aggressive cost-cutting plan by management, Rowan’s capital spending has fallen to $120 million per annum.

For some comparison, over the last two years, the company has reported net cash provided by operating activities of $900 million, offering plenty of headroom before it has to start eating into its cash balance to fund debt payment obligations.

Drowning in debt

Meanwhile, Seadrill is struggling to reach an agreement with its creditors. Over the past few years, the company borrowed billions to fund the expansion of its fleet. When drillship rates were high, this approach made sense as the company could tie drillship income to debt -- it was essentially borrowing on future cash flows. Now that these cash flows have disappeared, the whole tower of cards has collapsed.

At the end of February, management warned the company could be pushed into bankruptcy protection before May as it struggled to restructure $8.5 billion of debt. Seadrill, however, may be in an advantageous position as its lenders are reluctant to seize control of is drilling rigs -- for obvious reasons.

According to Seadrill’s third-quarter earnings report, the company has $3.1 billion of current long-term debt, with a further $6.7 billion of long-term debt matched against $1.3 billion of cash. Refinancing or paying off the $3.1 billion of debt due over the next 12 months is going to be a huge issue for the company as it cannot sell rigs to pay off the debt and cash reserves are dwindling.

Avoid debt

Seadrill made the fundamental mistake being dependent on capital markets. The company borrowed to fund the building of its drilling fleet. In order to refinance this borrowing, it requires the continued support of lenders. In a cyclical market, this support can vanish overnight.

With decades of experience behind it, Rowan is well aware of the oil industry’s instability and has protected itself by building a cash-rich balance sheet. It is unlikely the company will find itself depending on the kindness of capital markets anytime soon.

Disclosure: The author owns shares of Rowan Companies.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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