Seadrill Limited (NYSE:SDRL), while sporting one of the youngest fleets in the industry, is hugely over-levered. By the middle of 2017 net debt/EBITDA will hit 7x, above their maximum level of 6.5x. They previously amended this so there is likely no room left. If sponsors don't contribute $1-2B in capital, the equity will need to be restructured. SDRL also has over $4B in capex due through 2019 and this includes 14 newbuilds that are being delivered.
Why does the opportunity exist? Value investors are focusing too heavily on P/NAV and historical trough multiples as a crutch, rather than the future earnings power of the company. Trailing multiples are distorted as they are based on peak day-rates, which have been in free-fall and will continue to decline unless supply is rapidly taken off the market. At current prices (just north of $3) the stock is trading at a mid-double digit forward EBITDA multiple.
At current day-rates, the majority of the industry is operating below cash break-even due to high expenses that will continue until drillers accelerate the process of cold-stacking and scrapping rigs. Seadrill is in a particularly bad place given a large newbuild queue of both floaters & jack-ups that will be unable to find profitable work at today's day-rates.
On top of a supply glut amongst offshore drillers, onshore drillers continue to reduce break-even costs and increase productivity. This serves to reduce the attractiveness of offshore drilling and extends the length of this down cycle.
A litany of catalysts exist to send both Seadrill lower, most of which are not priced in; more backlog cancellations in the vein of Petroleo Brasileiro Petrobras SA (NYSE:PBR), or potential for impairments and write-downs. If Seadrill avoids restructuring, they will have to issue dilutive equity to bridge a funding gap in 2017.
As incremental offshore data comes out and continues to surprise to the downside, SDRL will re-rate lower with the equity tranche of the most levered drillers (including RIG) could potentially be worthless. The most likely solution is a restructuring in 2017 where debt is termed out, covenants amended, and shareholders receive zero. If one is interested in expressing a bullish view then the distressed debt at 40 cents is a safer (albeit still risky) play with less volatility.