S&P Assigns 'BB-/B' Rating to Seadrill Partners (SDLP)

Standard & Poor's Ratings Services said that it has assigned its 'BB-/B' long- and short-term corporate credit ratings to Marshall Islands-domiciled offshore drilling company Seadrill Partners LLC and its subsidiary, Seadrill Capricorn Holdings LLC. The outlook is stable.

At the same time, we assigned our 'BB' issue rating to the $100 million super senior revolving credit facility (RCF) due in 2019, co-issued by Seadrill Operating LP and Seadrill Capricorn Holdings LLC. The recovery rating is '2', indicating our expectation of substantial (70%-90%) recovery prospects for lenders in the event of a payment default.

We also assigned our 'BB-' issue rating to the increased $2.8 billion secured term loan B maturing in 2021, issued by Seadrill Operating LP and guaranteed by Seadrill Capricorn Holdings. The recovery rating is '3', indicating our expectation of meaningful (50%-70%) recovery prospects in the event of a payment default.

The ratings on Seadrill Partners reflect our assessment of the company's business risk profile as "fair" and its financial risk profile as "significant." Our business risk assessment recognizes Seadrill Partners' very modern, high specification fleet of contracted vessels with a revenue backlog of $5.7 billion. We also note that the contracts have relatively high day rates and an average length of nearly four years, with the earliest finishing in 2015. These provide medium-term visibility on revenues and also operating cash flow generation, as a result of cost escalation clauses. Rig utilization and profitability were weaker in first quarter 2014 than 2013, but we project that they should be solid for 2014 on average. We forecast free operating cash flow (FOCF) to be positive as a result of only modest capital expenditures on the modern vessels. We see the anticipated lack of new vessel building as positive for our ratings. Seadrill Partners is likely to avoid construction, start-up, initial contracting, and associated funding and liquidity risks, as these are largely borne by its parent, the large Bermuda-based offshore driller Seadrill Ltd. We assess Seadrill Partners as strategically important to Seadrill Ltd.

Under agreements with its majority owner Seadrill Ltd., Seadrill Partners is likely to continue to acquire rigs and fractional interests in rigs that already have contracts for more than five years. These so-called "drop downs" have been funded with a mix of new equity or unit interests in Seadrill Partners as well as secured debt, raised externally by Seadrill Ltd. and lent to Seadrill Partners' entities, including the borrowers. The proposed $1.0 billion term loan tap increase will refinance some of these facilities and other intercompany loans.

As a result of its growing asset base and cash generation, Seadrill Partners is expected to continue increasing distributions to its unitholders. The future balance between fleet expansion, leverage, and quarterly distributions will be important factors for our assessment of Seadrill Partners' financial policy. We note that proposed maintenance covenants would allow debt to EBITDA of up to 5x, closer to the leverage at Seadrill Ltd., although we do not project this in the near term for Seadrill Partners.

Another constraint for the ratings is the relative lack of diversification across the business, compared with Seadrill Ltd. and other large operators. Geographically, the vessels under current contracts are in three main regions. Operationally, there are four ultra-deepwater floaters, two drillships, and three tender barges, so more than a few days off day-rate for one or more vessels has a meaningful effect on performance. Also, although Seadrill Partners currently has indirect stakes in these nine vessels, Seadrill Ltd. has the remaining, material interests. Seadrill Ltd. has a 44% interest in collateral vessel West Capella, although the other borrowers have 100% interests in the rig-owning entities. We analytically consolidate Seadrill Partners and its controlled entities in line with the International Financial Reporting Standards accounts. We note the cross-default clauses between these entities, but also see Seadrill Partners' 30% interest in borrower Seadrill Operating LP and 51% interest in borrower Seadrill Capricorn Holdings LLC as a structural shortcoming, resulting in material dividend leakage to Seadrill Ltd.

In our view, Seadrill Partners' organizational complexity, including partial ownership of assets and consequent dividend leakage, is a relative weakness. In addition, credit metrics are at the weaker end of the range we consider commensurate with a "significant" financial risk profile. We reflect this assessment in our "comparable rating analysis" modifier, through which we apply a one-notch downward adjustment to the company's 'bb' anchor to result in the 'bb-' stand-alone credit profile.

Our base case assumes:

• A Brent oil price of $110 per barrel (/bbl) in 2014 and $105/bbl in 2015.
  
• Day rates as contracted and average utilization of over 90% in 2014 and 2015.
  
• EBITDA margins of more than 55%.
• 
  No modeled drop downs or acquisitions of interests in specific rigs. Although these activities are likely, we assume no resultant material net change in cash flow leverage measures.

Based on these assumptions, we arrive at the following credit measures:

• Adjusted funds from operations to debt of 20%-25% in 2014 and 2015.
  
• Adjusted debt to EBITDA of 3.4x-4.0x in 2014 and 2015.
  
• Positive FOCF, after maintenance capital investment and before distributions, of $300 million-$500 million in 2014 and 2015.

The stable outlook reflects our view that with the contracted revenues providing visibility on operating cash flow in 2014 and 2015 (at least), debt coverage measures should remain in line with a "significant" financial risk profile, as defined by our criteria. We forecast funds from operations (FFO) to debt to be more than 20% and we project discretionary cash flow (after modest capital investment and distributions) to be positive.

We do not see an upgrade as likely in the near term. We could raise the ratings, however, if funds from operations (FFO) to debt reaches more than 30% on a sustained basis and discretionary cash flow is at least breakeven. This could happen if operating performance is stronger than our base case assumes and the increased assets at Seadrill Partners are funded prudently.

We could consider a negative rating action if we observe a deterioration in operating performance, such that FFO to debt declines to below 20% on a sustained basis and debt to EBITDA increases to more than 4x. This would be exacerbated if utilization falls or if the predictability or profitability of operations weakens materially at Seadrill Partners or Seadrill Ltd.

Borderline metrics alone would not necessarily result in a downgrade if we consider that Seadrill Partners is establishing a solid operating track record and discretionary cash flow is positive. This reflects the strong cash conversion of EBITDA into free cash flow that we anticipate.

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