Analysts Slash Outlook on Seadrill: What Investors Need to Know Now

By Markets Fool.com

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West Auriga Drill Ship Image courtesy of Seadrill.

Wall Street Analysts' track record of upgrading and downgrading stocks is pretty pathetic,and should be taken with a large grain of salt. On the other hand, when numerous analysts all pile on to downgrade a particular stock or industry, such as Seadrill and offshore drillers, it may be worth exploring their rationale in case they've truly uncovered something useful to long-term investors.

Let's take a look at what Wall Street analysts are saying about the outlook for Seadrill and its competitors to see what it might mean for your portfolio.

Analysts piling onto Seadrill and North Atlantic
According to analysts, things just keep getting worse for offshore drillers, and Seadrill and its subsidiary North Atlantic Drilling , in particular.

Morgan Stanley'sOle Slorer says that the industry is"fighting tooth and nail" to stay afloat as the combination of low oil prices and a glut of new ultra-deepwater--UDW-- rigs cause day rates to collapse. Regarding specific companies such as North Atlantic Drilling, Mr. Slorer isn't just bearish, he's downrightapocalyptic. In fact, he suspended coverage on North Atlantic entirely citing concerns about its ability to remain in business, even withenormous supportfrom its parent company, Seadrill.

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Why might Seadrill-- and by extension North Atlantic -- be in trouble? The answer may lay withCiti Group analysts. Theyrecently cut Seadrill to "sell"on concerns that utilization rates could fall another 20%, and day rates -- which have already plunged 40% in the last year -- might fall another 30%.

In such a harsh market environment, Citi believes Seadrill's debt covenants -- which require its ratio of net debt/EBITDAto remain at 4.5 or less -- could be breached in 2016, or even 2015 if further contracts get cancelled or renegotiated. That's because, according to Citi, 40% of Seadrill's fleet is uncontracted for 2016. That's not good given that the offshore drilling industry has experienced a massive drought of new contract announcements thus far in 2015.

Do they have a point?
While I typically ignore Wall Street analysts' specific "buy-sell-hold" recommendations because I view them as short-sighted attempts at market timing, I think such specific claims and concerns deserve to be investigated.

West Alpha Semi-submersible Image courtesy of Seadrill.

In terms of Seadrill's fleet, the company currently has, or has scheduled to be delivered by the end of 2016, 34 UDW and 33 jack-up and tender rigs. Of Seadrill's UDW rigs, 21 -- or 62% -- will need new contracts by 2016. For its jack-ups, that figure is 18, or 55%.

Given that SeadrillCFO Rune Magnus Lundetrae estimates that the breakeven day rate -- including debt servicing -- for UDW rigs is $400,000 per day, things may get very tough for Seadrill if Citi's worst-case scenario comes true -- deep waterday rates plunging to $245,000 from their current $350,000.

However I should point out that this low day rate projection includes deep water, as well as ultra deep-water rigs -- thus creating an inappropriately low estimate given that all of Seadrill's floaters are of the UDW variety. The current average market day rate for UDW drill ships and semi-submersibles are $520,000 and $436,000, respectfully, which is far higher than Citi's $350,000 per day assumption.

As a point of comparison -- and to show how much pain the company's cash flows are likely to feel in the coming quarters -- Seadrill's average day rates for its drill ships and semi-submersibles -- due to highly lucrative contracts signed years ago -- are $583,000 and $513,000, respectively.

In terms of Seadrill's jack-up fleet, the average market day rate has fallen to $180,000, 12% below the $204,000 that Seadrill's jack-upsare currently being paid due to older contracts.

Thus, Citi's specific concerns about Seadrill's ability to meet its debt obligations -- its enormous contract cliff and falling day rates -- appear to be valid. However, the current average market day rates for UDW rigs hasn't fallen nearly as much as this downgrade report indicates. Seadrill's future cash flows are certain to be negatively effected by lower future day rates but luckily its bankers have thus far proven to be very accommodating.

Short-term credit risk is overblown
Given that Seadrill's creditors have recently said they will defer loan installment payments until the industry recovers, I think it's likely that Seadrill's debt covenants will be renegotiated to allow Seadrill to continue operating -- and bailing out North Atlantic's debt -- without breaching its covenants. Even Citi's analyst agree that a short-term debt covenant waiver is likely, with their concern being for a longer-term debt covenant breach should the industry not recover within the next few years.

That is very possible given that UDW day rates are likely to keep falling, given that another 55 rigs are expected to be delivered in 2015, and already 25% of UDW rigs are without work.In fact, Seadrill's CFO recently said that UDW day rates may drop below $400,000, and not recover to that level until 2017.

Bottom line: Tough times ahead for Seadrill
Offshore drilling isn't likely to recover for a few years, and investors need to be extremely patient and aware of the risks facing companies such as Seadrill and North Atlantic Drilling. However, extremely negative reports from analysts can often be overly pessimistic, so investors need to be skeptical and do their own homework before basing selling decisions on them.

The article Analysts Slash Outlook on Seadrill: What Investors Need to Know Now originally appeared on Fool.com.

Adam Galasowns units in North Atlantic Drilling and leadsThe Grand Adventuredividend project, which owns North Atlantic Drilling and SeaDrill in several portfolios.The Motley Fool recommends 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.