Company: Seadrill Limited (NYSE: SDRL)
Written: January 2017
Authors position: No current position
Overview of Investment Thesis
- Current Backlog is not enough to support future debt maturity
- SDRL recently announced that it expects to conclude restructuring negotiations by the end of April 2017.
- Current shareholders are likely to face substantial dilution
- SDRL consolidated balance sheet does not reflect the companies true leverage
- SDRL poor transparency and complexity in its accounting is highly concerning
Ever since February 2016, I’ve been taking advantage of the deep value opportunities presented in the offshore drilling segment by, among others, going long ATW, ESV, RDC and FOE. While my long-term view on the offshore drillers remains bullish, SDRL is not my first choice. If a company’s accounting is too complex for you to understand, then the problem is probably not with you, it’s with the company. Berkshire Hathaway places their investment ideas into one of three baskets; a ‘Yes’, ‘No’ or ‘Too hard’. Anything that’s too hard to understand goes into the ‘Too hard basket’ and everyone moves on. SDRL has fascinated me for quite some time, and even though I’ve done my due diligence, SDRL goes straight into my ‘Too Hard’ basket. I would argue that there are much more preferable companies to long in the offshore drilling segment. There might even be merit to buy puts in SDRL &/or SDLP.
Rigged for Success
It’s well known that SDRL is one of the riskiest players in the sector because of its high leverage compared to its peers. I would go even further with this argument and claim that most people underestimate the amount of financial engineering that has taken place in SDRL over the last years. The truth is that SDRL’s consolidated balance sheet significantly understates the true financial leverage of the business.
Consolidated & Equity Method of Accounting
If a firm has significant influence (>20 percent) over the activities of the investee, but owns no more than 50 percent of the capital stock, then the firm would apply the equity method. If it holds more than 50 percent of the common stock of the company, then the investing corporation would apply the consolidation method.
Under the equity method, the investment account is adjusted for the investor’s proportionate share of the investee’s income. Under the consolidation, the investor eliminates the investments account and replaces it with the assets and the liabilities of the investee. An important relationship exists between the equity method and consolidation, namely that the investor company will have exactly the same net income, whether it employs the equity method or whether it consolidates the statements. This is however not true for the balance sheet, as the equity method understates the financial leverage of the enterprise. The lower leverage level occurs because the equity method in essence nets the debts of the subsidiary with its assets in the parent’s investment account. Whatever measure of financial leverage is considered, the equity method presents results that look better than the consolidated numbers.
Because of this manager are incentivized to argue that the mother company owns less than 51 percent of its highly leverage investees, which would result in a more attractive consolidated balance sheet. Even if it would be more appropriate to utilize the consolidated method while the mother company, for example, owns 49 percent of the investee, this is not the case due to that SFAS No 94 requires consolidation only when the parent company owns more than 50 percent of the investee. The difficulty of this position is that it is patently unfair to the readers of the financial statements and does not reflect the substance of what is going on.
As we can see SDRL have 5 subsidiaries (<51%) which are deconsolidated from the balance sheet and accounted for with the equity method. One interesting point is that the mother company has the lowest leverage ratio compared to all other subsidiaries and investees that I manage to find a balance sheet for. A second interesting point is that SDLP makes up approximately 1/3 of SDRL’s total assets, but is still not consolidated. To understand SDRL’s true balance sheet the best solution would be to adjust the consolidated balance sheet by consolidating the investees of interest. As I’m not an accountant and as I lack some key information to complete this exercise, I will leave this adjustment to the reader. Instead, I will look at each of SDRL’s investees buy their own, which will provide us with more insight of SDRL true debt profile.
SDLP is a form of a master limited partnership (MLP) established by SDRL for the purpose of owning floating drilling rigs with long-term customer contracts already in place. The idea was that long-term contracts will provide the entity with enough cash flow visibility to employ a full distribution payout strategy through the cycle, and therefore allow SDRL to raise growth capital from income-focused investors. SDLP currently owns full or partial interests in eight rigs; four semi-submersibles (10K feet) and four drillship (10-12K feet). They were all built within approximately the last 7 years.
SDRL’s playbook was to initiate a newbuild order with a shipyard and fund the construction cost by borrowing ~$450 million (from a credit facility dedicated to, and secured by, the specific rig) and putting down ~$150 million of equity. This would result in a 75% loan to value (LTV), which is a very high amount of leverage for such a cyclical and capital-intensive business. It takes approximately 3 years for the shipyard to build a rig. In the meantime, SDRL produces a long-term customer contract so the rig is ready to start making money after it leaves the yard. At some point after the rig begins working for the customer – i.e. begins generating positive cash flow – SDRL sells a partial ownership interest in the rig to SDLP.
Morgan Stanley was one of SDLP’s main promoter as the idea looked attractive before the oil crash. The reasoning for the MLP structure was that, SDLP is highly levered, but John Fredriksen is a genius and he has skin in the game. The underlying issue, however, is that drilling rigs are unsuitable assets for a financing vehicle like an MLP. SDLP was the first offshore MLP marketed to U.S. investors – which had little perspective on the industry’s volatility or economics. Lowered day rates and/or terminations of contracts would be devastating for SDLP as the company is currently relying on a small number of rigs (Aquarius, Leo, Auriga, Vela and Polaris) which all enjoy significantly higher day rates compared to the industry average. Notice that during October a notice of Force Majeure (frees both parties from liability or obligation when an extraordinary event take place) was received from Tullow for the Leo drilling contract effective October 3, 2016. The Company has disputed Tullow’s claim for Force Majeure.
Summarizing SDLP is stacked with debt, and some of that debt is not reflected in SDRL’s balance sheet. SDRL deconsolidated SDLP in early 2014. I would argue that this was made to delever it owns balance sheet despite still controlling the company . I expect the debt to asset ratio (66%) to trend upward for SDLP as future impairments will eroad the asset and equity base.
SDRL is needed to provide certain guarantees on behalf of SDLP. These should not be overlooked and are as follows.
- Guarantees in favor of customers, which guarantee the performance of the SDLP’s drilling units, totaled $280 million as at September 30, 2016 (December 31, 2015: $370 million).
- Guarantees in favor of banks provided on behalf of SDLP’s totaled $640 million as at September 30, 2016 and correspond to the outstanding credit facilities relating to the Polaris and Vela (December 31, 2015: $698 million).
- Guarantees in favor of suppliers provided on behalf of SDLP, relating to custom guarantees in Nigeria, totaled $2 million as at September 30, 2016 (December 31, 2015: $86 million).
As with SDLP, ARCHER is a public company (trades on OSLO). ARCHER makes up around 5 percent of SDRL assets, which makes it less relevant to discuss. Notice however that its debt to asset ratio is around astonishing 93 percent (partly due to accumulated deficit in equity). ARCHER has negative adjusted CFO (-$15.1M) for the 9 months of 2016. The majority of ARCHER’s debt is available under a revolving credit facility. As of September 30, 2016, a total of $625 million was drawn under the revolving facility. SDRL has granted on-demand guarantees of $250 million in favour of the lenders under the revolving facility and the lenders of the overdraft facilities, securing ARCHER’s obligations under these facilities. The revolving facility contains certain financial covenants, including, 12 months rolling EBITDA of $30 million and a net interest bearing debt to 12 months rolling EBITDA that should not exceed 3,75x. As of September 30, 2016, the Company is in compliance with all covenants as agreed with its lenders. I project that ARCHER will be in breach of the covenants in mid 2017. As the trend in the industry at the moment is to restructure covenants this might not be that relevant however.
Seabras Sapura Participacoes SA and Seabras Sapura Holdco Ltd, along with their wholly owned subsidiaries, are together referred to as Seabras Sapura. Seabras Sapura are joint ventures that construct, own and operate pipe-laying service vessels in Brazil and are owned 50% by the Company and 50% by SapuraKencana. The amount guaranteed as of September 30, 2016 was $378 million (December 31, 2015: $256 million).
During the year ended December 31, 2014, the Company entered into a joint venture agreement with an investment fund controlled by Fintech Advisory Inc. (“Fintech”), for the purpose of owning and managing certain jack-up drilling units (Oberon, Intrepid, Defender, Courageous and Titania) located in Mexico under contract with Pemex. SeaMex, which was previously owned 100 percent by SDRL, was deconsolidated from SDRL financial statements on March 10, 2015. SDRL have provided a $250 million seller’s credit to SeaMex and owns $162 millions in consideration receivables ($412M in total, ~3.5% of SDRL debt)
Ship Finance is a related party of the Company through which SDRL have entered into sale and leaseback agreements for three drilling units. The West Taurus, West Hercules and West Linus. Each of the units had been sold by the Company to single purpose subsidiaries of Ship Finance and simultaneously leased back by the Company on bareboat charter contracts for a term of 15 years. The Company has several options to repurchase the units during the charter periods, and obligations to purchase the assets at the end of the 15 year lease period. SDRL has determined that the Ship Finance subsidiaries, which own the units, are VIEs, and that the SDRL is the primary beneficiary of the risks and rewards connected with the ownership of the units and the charter contracts. Accordingly, these VIEs are fully consolidated in the company’s consolidated financial statements, meaning the debt is incorporated in the consolidated balance sheet.
While SDRL are not, directly or indirectly, obligated to repay the borrowings under this facility, a breach of one or more of the covenants contained in this credit facility will have a material adverse effect. SDRL is the charter guarantor under these facilities. The main financial covenants contained in the variable interest entities are as follows:
- Ship Finance must maintain cash and cash equivalents of at least $25 million.
- Ship Finance must maintain positive working capital.
- Ship Finance must have a ratio of total liabilities to total assets of at least 0.8 to 1.0 at the end of each quarter.
- The Company’s covenants under the bank loans also apply
Drowning in Debt
As we now realize, taking a look at SDRL balance sheet is insufficient to determine the risk profile of the company. Studying SDRL’s debt maturity provides a more consistent view what’s really going on. The first diagram shows SDRL’s debt maturity, up until 2020. As we can see $3,176M is due in 2017. The second diagram shows that SDRL also has $2,361M due in new builds for 2017. Assuming no deferral of new builds and ignoring the potential debt restructuring, SDRL is due for ~$7,500M as net working assets are at negative $1,986M. This is around 6.5x as high as forecasted adjusted CFO ($1,169M) for 2017, which means that debt restructuring is axiomatic. Given the material amount of debt and shipyard payments, the logical question for investors is what form the restructuring will take and what the impact will be on equity.
The consensus is that the restructuring will be announced by April 2017 (material payments related to the Sevan Developer and West Eminence are due in that month). I will make, in my opinion, very conservative assumptions as I’m bearish for the stock. The first assumption I will make is that all of the new builds ($2,361M) will be deferred. That leaves SDRL with -$1,986M in net working assets and $3176M of debt due in 2017 (~$5,150M in total). The second assumption I will make is that 65 percent of the $3,176M in due will be rolled over. That leaves ~$1,100M in debt and -$1,986M in net working assets (~$3,000M in total). Let’s assume SDRL will make $1,200M in CFO for the year and that whole amount goes to paying off debt. That leaves the company with $1,800M left. Now let’s assume that SDRL will issue equity at $2.50/share. To cover $1,800M, SDRL than have to issue 720 shares. To put this into context, SDRL has 504 million shares outstanding today. All this dilution might not me instant, because SDRL might use derivatives like warrents etc, but I see no scenario where shareholders won’t be significantly diluted. Remember also that 2018 will have the exact same problems, as CFO is expected to be lower, while debt maturity is at $2,371M and new builds at $1,191M for 2018.
As the future value of the drillers is very binary: either they go bankrupt or they become long term winners, their risk-reward profile is very simple to estimate. What makes the offshore drillers an attractive deep value opportunity is that the possibility of survival can create return around 5-10x. This means the investment can still be advantageous if the investor is risk neutral and estimates below ~80% of bankruptcy (ignoring restructuring etc.). If, however, restructuring and significant dilution takes place, the long term return of ~5-10x will be destroyed. I therefore advise the long term investor to avoid SDRL.