Threat of Dilution Still Exists for Seadrill Ltd
Seadrill shares took a beating yesterday when the company announced the offering of $1 billion 2019 convertible bond. Together with this announcement, Seadrill made a voluntary incentive payment offer to convert the existing $650 million 3.375% 2017 convertible bond. If one word could explain investor fears over this news, this word would be "dilution."
The next day, Seadrill canceled its offering. The company stated that the drop in share price made conversion price unattractive. However, shareholder worries over future financing deals might have bothered Seadrill more than unattractive conversion prices.
Financial magic has its limits
Seadrill became a major player in offshore drilling with the help of leverage. Drilling companies tend to take on significant debt to finance building of expensive rigs, but Seadrill is certainly an outlier in this field. As a result, the company obtained a very fresh fleet with more rigs coming online in the next few years.
However, such strategy had a detrimental effect on the market, which became flooded with newbuild rigs. The constant flow of new rigs has kept dayrates from rising, especially for companies with older fleets like Diamond Offshore Drilling . Contrary to Diamond Offshore Drilling's conservative policy, which left it with an aging fleet, Seadrill was taking big risks and aggressively financed the building of new rigs.
Seadrill proved its mastery on the financing front, but the offering of additional convertible debt was a worrying sign, even as the issue was cancelled. Any future convertible bond issue would mean dilution. In addition, it is clear that the company wanted to limit its interest payments, because it was uncertain over the timing of market recovery. Seadrill's bonds were expected to have an annual coupon in the range of 2.00%-2.50%. The proposed use of convertible bond instead of ordinary debt issue highlighted pressure that the market downturn put on the company's cash flows.
There could be more such issues ahead
Seadrill intended to use the proceeds from this debt issue to fund the newbuild program and for general corporate purposes. Apart from funding new rigs, Seadrill has to fund its attractive dividend that yields more than 10%. Surely, Seadrill is on the radar of many income-oriented investors because of its high yield, and the sustainability of this dividend has been a popular topic.
My take is that Seadrill's dividend is dependent on the company's ability to refinance, and this ability will not be undermined in the near term. In the longer term, things could get uglier if the drilling market doesn't recover in 2016.
This recovery will depend on spending by big players, who try to curb rising costs in order to increase shareholder returns. The latest news on this front came from Total . Total stated that it would cut its costly drilling program if it didn't find anything substantial this year. Thus, Total will follow an industrywide trend of cutting on exploration spending.
Such news could signal that it could take longer for the drilling market to recover. In this case, the aforementioned Diamond Offshore Drilling has an advantage because of its stronger balance sheet. In turn, Seadrill needs a market recovery in 2016, because otherwise its financing costs will rise. The fact that drilling market will remain soft in 2015 is the current consensus, and this scenario is priced in financing costs for Seadrill. However, should the recovery take longer, Seadrill will face higher rates and will probably try one more time to issue convertible bonds, diluting existing shareholders.
Seadrill shares will face short-term pressure following the whole story, as it had a slight detrimental effect on investors' confidence. However, the company's shares will continue to receive support from income-oriented investors as long as there are no signs of a deeper downturn in the drilling market.
Looking for yield? Try these dividend monsters
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.
The article Threat of Dilution Still Exists for Seadrill Ltd originally appeared on Fool.com.Vladimir Zernov has no position in any stocks mentioned. The Motley Fool recommends Seadrill and Total (ADR). 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.
Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.