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Leverage Comes in Different Forms—Run From This One

One of the most beaten-down names in the entire oil services sector is Paragon Offshore (PGN-NYSE). A spinoff from the deepwater-focused Noble Corp (NE-NYSE), this “standard spec” offshore driller ended its first day of regular trading at $11 on August 4, 2014.

The stock has continued on an almost uninterrupted downward trend, hitting a low close of $1.12 back in March before rebounding to a recent price of $1.69. With around 85 million shares out, that puts Paragon’s remaining equity value at a sliver of total enterprise value, which includes roughly $2 billion of debt.

This is a highly leveraged security. As regular readers know, I like leverage in various forms. I love leverage to underlying results provided by a low share count, and I often seek leverage to commodity prices (but only when I think they’re headed higher!).

Given the challenged environment for offshore drilling at current prices, Paragon certainly offers the latter in spades. It’s why I recently took a look at the stock as a potentially cheap call option on higher oil prices.

What I initially saw at Paragon was operating leverage of a $1.7 billion revenue stream and $500 million of net income on a share count of only 87 million. Plus their Q1 15 financials showed almost double The Street’s estimates of cash flow. EBITDA margins are a healthy 35-40%.

Upon closer inspection however, the financial leverage here makes PGN a time bomb with a potentially short fuse. This company is in no position to ride out a multi-year downturn in the offshore drilling space. Given the very real possibility that this is what we’ll see unfold, I just can’t get comfortable that PGN equity holders will make it to the other side of the cycle with any money left in their pockets.

I really did try to find something to like here, but the negatives are just too plentiful:

  1. Asset quality is low, with an average age of ~35 years. This leads to elevated fleet maintenance spending well in excess of “maintenance capex” in order to meet customer upgrade requirements and extend rig service lives. Management estimated over $300 million in required and discretionary fleet maintenance spending back in September.  2015 capex guidance has been cut to $200 to $220 million, with as many expenses as possible being pushed out to 2016. That would be fine if 2016 cash flow were headed higher, but it’s more likely to be cut in half or worse.

 

  1. Debt levels are high at just over $2 billion—which is only 2.4x debt-to-cash-flow—with interest expense pegged at $125 to $130 million for the year.  But after fleet maintenance, interest expense, operating expenses, and taxes, there is not much free cash flow left over to deleverage the balance sheet, if any.

US brokerage firm Wells Fargo models PGN’s free cash flow falling from over $300 million this year to a negative number in both 2016 and 2017. If PGN can’t deleverage, and its cash flow collapses as expected, that risks putting the firm offside its debt covenants next year.

Moody’s downgraded PGN’s debt ratings on June 8th, warning that debt/EBITDA could push 5x by mid-2016. It also rates the firm’s liquidity as SGL-3 or “adequate,” which is the second-lowest rating for speculative-grade issuers. This indicates that PGN only has a modest cushion to meet its cash obligations over the next 12 months.

  1. There’s a large order book of jackups being delivered over the next few years. A portion of these uncontracted rigs, especially ones coming out of unproven Chinese shipyards, are unlikely to find work, but this supply imbalance should put additional pressure on rates and utilization for standard spec jackups.

The exception here would be certain niche jobs (gas drilling, workovers) that lower-quality rigs can cost-effectively provide in places like the North Sea.

  1. PGN has outsized exposure to Petrobras and PEMEX. The former is a basket case and the latter is in disarray. These are not great customers to be depending on for contract extensions and new awards right now.

In theory (i.e. according to the balance sheet) there is asset value in the rigs that more than covers the debt, but this is a terrible market to sell into, and I don’t know who would buy this iron when they could opportunistically buy brand new, uncontracted high-spec rigs that will be hitting the market at a steady pace.

I’m all for contrarian plays, but I see very little potential for near-term fundamental improvement in the offshore drilling space, making the PGN “call option” more likely than not to expire worthless. It just seems to me that this company needs a lot to break right in order to avoid a doughnut for the equity.

The case of peer Hercules Offshore (NASDAQ: HERO) is informative here. Hercules, another highly leveraged commodity jackup operator, had the rug pulled out from under it recently by Saudi Aramco, which cut three existing contracts to $67k per day from prior dayrates of $135-137k, $117-119k, and $116-118k, respectively. This action left HERO’s cash flow gutted. Two and a half weeks later, the company announced a debt restructuring that will leave existing shareholders with 3.1% of the restructured company’s stock, plus warrants. Ouch.

EDITORS NOTE–I’ve been putting a portion of my portfolio into investments that benefit from lower oil prices–and that stock is having a great day today.  Click here to start profiting like me.

 



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