I am short Seadrill Partners LLC (NYSE: SDLP).  The common units are priced at $31.  I believe they could fall to
the mid-teens or worse.  The forward distribution yield is ~6.5% and the cost of borrow is ~2.4% at Interactive Brokers.

The units could trade up to ~$46 if I’m wrong.  But, in a scenario where it gets priced at $46 investors would make a ton
of money being long peer companies like Atwood Oceanics (NYSE: ATW) or Ensco (NYSE: ESV).

Therefore I think this makes a good pair trade against one of those companies.  As you will see, there is a large
valuation gap between SDLP and, say, Atwood.  The market will eventually have to reconcile that gap through an
upward repricing of Atwood or a downward repricing of SDLP.

I wrote this memo from the perspective of an SDLP short because I think it works on a standalone basis, and because
it’s a very interesting situation that says more about market inefficiencies than a writeup on Atwood as a long.

Business Overview
SDLP is an MLP that was established by John Fredriksen’s Seadrill Ltd. (NYSE: SDRL) for the purpose of owning
floating drilling rigs with long-term customer contracts (4-5 years) already in place.  The idea is 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 went
public in Oct-2012. 

SDLP currently owns full or partial interests in eight rigs; four semi-submersibles, three production rigs, and one
drillship.  They were all built within the last ~five years. 

Based on data as of the Q3’13 financial statements, the market cap is $1.3 billion.  There is $1.3 billion of debt
and $740 million of non-controlling interest.  It’s trading at 8.9x LTM EBITDA of $374 million and 4.7x tangible book
value of $6.60 per common unit.  Total debt/capital is 56% and LTM debt/EBITDA is 3.4x (excluding non-controlling
interest).

SDRL effectively owns 65% of the common units as well as the incentive distribution rights (IDRs).
They also own a non-controlling interest in many of SDLP’s rigs.


SDRL’s Angle
Using rough numbers, a newbuild drillship costs $600 million when you buy it directly from the shipyard.  If you’re
able to sign a customer contract at recently prevailing dayrates of $600,000 the NAV of the rig becomes $800 million.  
NAV would be higher than construction cost because those dayrates allow you to earn a return on capital in excess of
the cost of capital.

A drillship typically generates $125 million of EBITDA in this scenario.  The pure construction costs of $600 million imply a
valuation multiple of 4.8x EBITDA. 

If an operator turned around and sold the rig to another company for a price equal to the $800 million NAV right after
securing the contract, it would imply a valuation multiple of 6.4x EBITDA.

Note that the offshore C-corps traded at an average forward multiple of 6.2x over the five year period ending in 2012. 

SDRL’s playbook is 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.  Keep in mind
that’s 75% loan to value (LTV) – an incredibly high amount of leverage for such a cyclical and capital-intensive business.

It takes ~3 years for the shipyard to build the rig.  In the mean time, SDRL will procure 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 free cash flow – SDRL will sell a partial ownership interest in the rig to SDLP.

This is where things get interesting.

The implied valuation at which the rig gets dropped down into SDLP isn’t based on construction cost (4.8x EBITDA) or NAV
(6.4x EBITDA).  No, it gets dropped down at 9.5x EBITDA. 

A 9.5x multiple on $125 million of EBITDA implies a value of $1.2 billion, or 2x what it costs to build brand new. 
That’s a 50% premium to what it’s worth on an NAV basis.  The offshore C-corps traded at a 10% average discount
to NAV over the five year period ending in 2012.

$1.2 billion minus the $450 million of original debt leaves an implied residual equity value of $750 million.  If SDLP
took a 30% equity interest they would have to come up with $225 million (30% x $750 million), which they would raise
by issuing common units.  They would also assume a proportional amount of the rig’s debt.

Note that even though the implied purchase price of the rig is $1.2 billion only $675 million has been put into it
($450 million debt + $225 million equity).

So, in this scenario SDRL puts down $150 million of initial equity and gets back $225 million from SDLP for an ROI
of 50%, and they still get to receive 70% of the rig’s distributable cash flow. 

The SDLP common units they own just got diluted a bit because of the new issuance but they still own 100% of the IDRs.


What the bulls say
SDLP is paying a distribution of ~$2/unit on a forward basis for a current yield of 6.5%.  The distribution has great
certainty because over the 2014/2015/2016 time horizon SDLP already has 100%/95%/94% of its revenue locked in,
thanks to the long-term contracts on its rigs.  That is highly favorable compared with industry peers.  Atwood is the
next closest peer on this metric and they only have 98%/73%/49% of their revenue locked in.

Moreover, SDRL has four new additional floaters in the queue with long-term contracts that can be dropped down
over the next two years in order to drive SDLP’s distribution growth. Morgan Stanley is one of SDLP’s main promoters. 
They estimate the four floaters could support an increase in SDLP’s common distribution to $3/unit by YE2015.  A 6.5%
yield would imply a price of $46.

You’ve got 48% upside and you’re getting paid 6.5% while you wait.  That’s an attractive yield in this low interest
rate environment.

Yes, offshore drilling is a cyclical business, but SDLP has long-term contracts.  Yes, SDLP is highly levered, but
John Fredriksen is a genius and he has skin in the game.  SDRL owns $1.2 billion worth of SDLP common units
(38 million units x $31).  He would never let it blow up.


The bear case
SDLP’s existing fleet of eight rigs will be unable to support a common distribution starting in 2019 if the business
outlook that is currently being priced into the stocks of peer companies like Atwood were applied to SDLP’s rigs as
they rolled off their contracts.  In other words, the common distribution would have to be eliminated. 

Leading edge dayrates for modern deepwater floaters have fallen from >$600k to $550k, and are possibly on
their way to <$500k for new contracts.  SDLP’s leverage to this dynamic is massive.  Using rough numbers,
given daily opex of $200k, a 17% decline in dayrates from $600k to $500k would reduce a rig’s daily margin
by 25% from $400k to $300k.  Layer on fixed costs like maintenance capex and SG&A, plus the interest costs
associated with a large existing debt load of 3.5x EBITDA, and a 17% decline in dayrates would cause distributable c
ash flow to decline by 40%.

MLP investors have been seduced by SDLP’s 6.5% yield in a low interest rate environment and they have been
led to believe the distribution will grow over time.  These people are comfortable with traditional MLP assets
like pipelines that have toll road business models and stable cash flows, and believe SDLP is simply the next
evolution of the energy infrastructure playbook that worked so well for MLP investors over the last decade.

However, these investors are relative newcomers to the offshore drilling business – SDLP was the first offshore
MLP marketed to U.S. investors - and have little perspective on the industry’s volatility or economics.  They have
no idea what could happen to the cash flows of their company if its rigs were re-contracted based on the outlook
being priced into SDLP’s C-corp peers.

They also have no idea how badly they’re being fleeced by SDRL.

In what world does it make sense to pay $2 for something that can be bought for $1?  There is no reason SDLP
can’t buy their own drillships directly from a shipyard for $600 million.  The only reason to pay the kind of premium
associated with an implied price of $1.2 billion is so SDRL will absorb the risk of finding a contract during the 3 year
construction period.

How do we know the premium is excessive?  First, because we can calculate the NAVs of these rigs using verifiable
assumptions and the math shows they’re worth $800 million.  Find me an arm’s length transaction between
unaffiliated parties where a floater changed hands for $1.2 billion.  You can’t find one because nobody else is
crazy enough to pay those prices.

Second, Pacific Drilling (NYSE: PACD) is a deepwater pure play with a fleet of eight new drillships.  That company is
trading at an EV/rig of $534 million.

Moreover, SDLP is at the point in its IDR schedule where the next rig drop down will cause 50% of the incremental
distributions to flow to the IDR holders (i.e. SDRL).  Once the common distribution rises above $2.325/year (the bull
case has it going to $3/year by YE2015), the IDR holders get 50% of the incremental distributions. The forward
distribution is ~$2/year.  The next floater that gets dropped down will allow the common distribution to be
increased by ~$0.45/year, all else equal, thus triggering a 50% payout of the incremental cash flows to SDRL (the GP).

So, SDLP investors are going to pay crazy prices for the rigs needed to drive their future distribution growth, and
they’re going to give up half of their incremental cash flows to boot.

Let’s cast these economics into further relief.  Using Morgan Stanley’s model, and assuming these drop downs occur
when the IDR splits are at the 50% level, the four rigs identified as drop down candidates for the next two years will
generate ROEs for common unit holders of 5.1-5.3%.

A business must generate a return on equity in excess of its cost of equity in order to justify its economic existence. 
There is no earthly way a floater’s cost of equity is below 5.1%.

The underlying issue is that drilling rigs are unsuitable assets for a financing vehicle like an MLP.

Dogs and cats shouldn’t mate.  The drilling business is too cyclical to deliver the kinds of stable cash flows required
to support a full payout ratio through the cycle.  Ensco has a similar yield to SDLP of 5.8%, but their lack of leverage
and lower payout ratio (45% on 2014 consensus) means they can maintain the dividend even if dayrates fall 20%
and utilization falls 10%.  SDLP’s distribution would be completely wiped out if its existing fleet operated under those
assumptions.    

SDLP has temporarily been able to overcome that kind of cyclicality by starting life with a fleet of rigs that all have
long-term contracts in place that were priced at all-time high dayrates.  But eventually those contracts will get repriced,
upwards or downwards, and the company will begin lose its temporary immunity from the fluctuations of the industry.

The only way to postpone the day of reckoning is for SDRL to drop down more and more rigs with long-term contracts
in order to keep the weighted average contract term and weighted average dayrate of SDLP’s fleet from slipping. 

The governor on that type of behavior is the number of rigs with long-term contracts at peak dayrates that SDRL has
in inventory.  They have six by my count.  Recall that the bull case expects four by YE2015. 

Why don’t they just drop all six down and really juice the dividend?  I think SDRL would love to.  They have a
10% dividend yield to service on top of a 5.4x debt/EBITDA load, so they’ve got their own spinning plates in the
air they have to take care of.  The upstreamed cash from SDLP would definitely help.

The gating factor is the capital market’s appetite to absorb the borrowings and equity issuance SDLP would need. 
And as Morgan Stanley models it, SDLP’s capital requirements for the four dropdowns will represent a step-function
increase over the existing eight rigs because rather than buying a fractional interest in the rigs, SDLP would now be
buying a full interest in the rigs.

SDLP has to buy full ownership interests now because the next rig that gets dropped down will trigger a 50%
payout on incremental cash flows to the GP.  In order to overcome that value leakage to the GP and still grow the
common distribution at the same time, SDLP has to start taking full ownership of the rigs.

To highlight the magnitude of this step change, let’s look at the two rigs dropped down since Q3’13 - the West Leo
and West Sirius semi-submersibles.  The West Leo was dropped down at an implied value of $1.25 billion, but because
SDLP only took a 30% ownership stake, they only had to raise $714 million of external capital ($485 million debt + $229
million equity).  The West Sirius was dropped down at an implied value of $1.035 billion, but because SDLP only took a
51% ownership stake, they only had to raise $813 million of external capital ($585 million debt + $228 million equity).

That’s an average capital raise of $763 million per rig.

Going forward Morgan Stanley is modeling SDLP taking 100% ownership stakes in the four dropdowns.  Those rigs are
generating average EBITDA of $123 million.  They are modeling 10.5x multiples (I’m being serious) leading to an average purchase
price of $1.3 billion.  The average debt funding per rig is $644 million (recall that these things cost $600 million to build),
or $2.6 billion in total, leaving an average equity funding requirement of $643 million per rig, or $2.6 billion in total.

That’s an average capital raise of $1.3 billion per rig.

For the vision of a $3 common distribution to be realized, SDLP will have to double the unit count by issuing
60 million common units by the end of 2015, compared with the 58 million currently outstanding, and compared
with the 25 million they’ve issued in total since their formation.  Transocean is in the process of forming their own
MLP which will concurrently test the market’s appetite for this asset class in a falling dayrate environment.

The Morgan Stanley model assumes an average borrowing cost of 4.3% and equity issuance at prices of $37.67,
$41.67, $45.67 and $49.67 per unit.  In other words, it assumes a virtuous cycle where drop downs beget easier
access to capital, which begets further drop downs.

Bringing the discussion back around to the notion that cats and dogs shouldn’t mate, again, the only way for
SDLP to create “escape velocity” from the gravitational pull of industry fundamentals like falling dayrates and
falling utilization is to drop down more and more rigs in order to constantly dilute the impact of legacy rigs having
their dayrates marked to market as they roll off contract and/or experience lower utilization.

You can’t perform financial engineering where you pay 2x what something is worth unless you have a sucker
willing to fund it.  The money has to come out of somebody’s pocket.  The suckers in this case are the providers of
debt and equity capital to SDLP.  The absurdity of paying $1.2 billion for a rig that costs $600 million will be cast into
sharper relief as industry fundamentals are tested. 

The scheme starts to fall apart if the cost of capital rises.  What if lenders balk at receiving an interest rate of just
4.3% to lend an average of $644 million against rigs that cost $600 million to build?  What if MLP investors balk at
paying $1.2 billion for something that costs $600 million to build and then having to give up 50% of their cash flows? 

Heck, what if there’s simply an increase in the general level of interest rates?  If MLP investors demand a higher
distribution yield for the asset class in general and SDLP had to fund the $2.1 billion equity requirement for the four
dropdowns at the current price of $31 instead of $37.67, $41.67, $45.67 and $49.67, they would have to issue
83 million units instead of just 60 million. 

What if SDLP ends up paying 6.3% on their debt instead of 4.3%?  They’ll be at an EBITDA run rate of $1.2 billion
by Q4’15 with the economics of their existing contracts.  200 bps of higher interest expense on $4.4 billion worth
of debt will cost an extra $87 million, or 7% of their EBITDA.

Keep in mind this is a security that has never experienced a world without QE.

What about the bullish argument that Fredriksen won’t let it blow up because he has so much skin in the game? 
It’s true that SDRL owns $1.2 billion worth of SDLP units and participated in the latest secondary, but by my math
SDRL has already extracted $1.8 billion worth of net cash from SDLP.  Everything they get from this point forward is
gravy.  If they can drop down the four additional rigs they will net another $2.0 billion ($2.6 billion equity upstreamed
from SDLP minus the $600 million SDRL spent on down payments.  $600 million = $150 million down payments by
SDRL on four rigs.). 

SDRL just needs SDLP to survive long enough to execute the four drop downs.  After that they could almost care
less what happens from an economic perspective, as long as SDLP can service its debt.


The bull response
I have discussed how the existing fleet would be unable support a distribution if it experienced a 20% decline in
dayrates and a 10% decline in utilization.  But, that won’t happen until 2017.  That’s when the portion of SDLP’s future
revenue already under contract drops from 94% in 2016 to 66% in 2017, before falling to 26% in 2018 and 0% in 2019. 

Even if the existing fleet becomes unable to support a distribution, by that point SDRL will have dropped down
four more rigs, and the contracts associated with those incremental floaters will generate enough cash flow to
support an SDLP distribution of $2/common unit. 

Moreover, the long-term fundamentals for the industry are bright.  Offshore projects are economic down to $70
oil prices and Brent is at $105.  OPEC member states account for >40% of global oil production and most of their
governments (including Saudi) need >$80-100 oil to run a balanced budget.  40% of the world’s incremental
production will have to come from offshore.  Global upstream capital spending has more than doubled since 2005,
and so have oil prices, but global production of black oil remains stuck at ~75 mmbl/d.  Rising prices will be required
to incentivize future production efforts.

The bottom line is the short-term pain in the floater market isn’t due to structural demand pressure or falling
oil prices, it’s mainly due to temporary supply issues the industry created for itself.  There are 27 floaters
scheduled for delivery in 2014, 24 in 2015, 19 in 2016 but only 4 by 2017.  SDLP’s revenue coverage doesn’t
lapse until the pig is already through the python, and by that time the market will have tightened again.  SDLP
has enough contract coverage to give itself a bridge over troubled waters.


My response
I have only modeled a 20% decline in dayrates and a 10% decline in utilization for my downside case. 
That may prove to be optimistic.  There are potentially 30 older floaters (out of 300 globally) that need to
be cold stacked before the market can clear.  The owners of those 30 rigs won’t cold stack them without
a fight, and that means accepting lower and lower dayrates in a last gasp attempt to squeeze a few more
dollars out of them before they retire.

Markets are about expectations, and as those rigs fight for survival, the impact they have on leading edge
dayrates will have an impact on the industry’s cost of capital.  SDLP still has to raise a huge amount of money
to insulate itself from the industry’s current dynamics. 

Is it realistic to expect providers of equity capital to ignore the fact that they’re overpaying by 100% for new
dropdowns, and that they’re also giving up 50% of those incremental cash flows at the same time the value
of those rigs is falling on a mark to market basis?

Moreover, if you accept the premise that SDLP is a long because the market will eventually re-tighten and
allow them to maintain their economics on future contracts, then you need to mortgage your house and invest
it all in Atwood.

The upside on SDLP is $46 per unit ($3 distribution ÷ 6.5% yield = $46) plus interim distributions of $5 through
2015 per Morgan Stanley, for a total return of 70%.

The downside on SDLP could be 100% if you model a 40% peak to trough decline in dayrates and a 10% decline
in utilization because the financial and operating leverage is so great.  To exaggerate the point, S&P estimates
the eight existing rigs would have a value of $1.7 billion in a stressed recovery situation.  Those rigs are pledged
as collateral against $2.4 billion of debt.

The upside on Atwood is $8 of EPS in FY16.  A mid-cycle forward multiple of 11x would value the stock at $88,
for total upside of 89% vs. the current $46.50 share price.

The downside on Atwood under those conditions is $2.50 of EPS in FY16, even if their midwater floater called
the Hunter never works again after its contract rolls off this July.  An expanded multiple of 15x on $2.50 of EPS
would put the stock at $37.50, for downside of 19%.

Atwood doesn’t pay a dividend.  If you’re concerned about the negative carry on this pair trade you could use
Ensco for the long leg.  As mentioned earlier, It has a 5.8% yield and the dividend should be secure even with
a 20% decline in dayrates and a 10% decline in utilization.


Hedge Ratio
Ideally a pair trade would be long at most $2 of ATW for every $1 of SDLP shorted.  This is a simplistic way to
think about it…  Atwood’s NAV is $3.6 billion but its market cap is just $3.0 billion.  If it trades up to NAV it’ll make
$600 million for shareholders.  SDLP’s NAV is $600 million but its market cap is $1.8 billion (pro forma the recent
offering).  If it trades down to NAV it’ll lose $1.2 billion for shareholders.  In order to have the same amount of profit
opportunity relative to NAV on both legs of the pair trade you would have to be long $2 of ATW for every $1 of
SDLP you’re short (2 x $600 million = $1.2 billion). 

• The gravitational pull of market fundamentals that are already worsening
• Future attempts at raising external capital
• Retail investors come to their senses