PARAGON OFFSHORE PLC PGN S W
August 18, 2014 - 7:13pm EST by
Biffins
2014 2015
Price: 9.50 EPS $0.00 $0.00
Shares Out. (in M): 85 P/E 0.0x 0.0x
Market Cap (in $M): 803 P/FCF 0.0x 0.0x
Net Debt (in $M): 1,658 EBIT 0 0
TEV ($): 2,464 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • Offshore
  • Spin-Off
  • Oil and Gas
  • Highly Leveraged
  • Driller
  • Oil Services
  • dividend cut

Description

Price Target = 0.
 
Paragon Offshore is a recent spin-off from Noble Corp. In a collapsing rig environment Noble pulled off a stunning deal, somehow convincing credit holders to put $1.7b of debt on a fleet of 35 year old assets, cashed out, and chucked out this old crap that wouldn't have fetched that amount in a sale (and they tried). 
 
I met the management recently and was hoping to see a team who understands how dire the situation is. Instead management was quite sanguine and puzzled by the adverse share price reaction since listing. 
 
Paragon will do $800m or so in EBITDA this year. Mgmt told me they do $180m in regular maintenance capex to keep all rigs serviceable and another $120-130m or so in "project maintenance" capex where they take a few rigs into yards and try and upgrade them to extend life. They expect this to continue. So $300-310m in "maintenance capex" should continue. But maintenance in this case is a misnomer. Since even with this "maintenance" their fleet will rapidly deteriorate over the coming years. The 5 year yard survey's cost keeps increasing exponentially as you go past 30 years in rig life. Management freely admitted they needed to come up with some form of fleet renewal programme.
 
On top of this you add $100m or so of interest payments. And they said they will soon provide much more detail of their tax structure but they complained they got saddled with a very inefficient tax structure and we should expect $100-125m in taxes. This implies a very hefty tax rate for an offshore rig company. This results in about $275m of FCFs and management intends to pay out $90m in dividends since "Noble already told everyone that". Management said the 11% div yield will "open some eyes". When I told them that Seadrill trades at 11% div yield and that's with new assets, and that Awilco trades at 20% div yield with old assets, they said the US investor mindset is different from these Norwegian/UK companies and they will gobble it up.
 
So the math is pretty simple. Paragon has a fleet of an active fleet of 33 jackups (70% of 2015E revenues) and 6 floating rigs (30% of 2015E revenues), plus one jackup, two floaters, and one FPSO that are stacked. The company told me the 4 stacked rigs should be considered obsolete and will never start again. They have 1/3 EBITDA coming from floaters, 2/3 from Jackups. Both markets are under pressure. Geographically the 2 biggest markets are UK North Sea and Brazil and both are under pressure as well as Petrobras viciously pulls back on activity (Petrobras is PGN's largest customer with 40% of the backlog). And they have really old assets. Management seemed to admitted that activity was crashing and market was horrible but they still didn't feel they should be preserving cash or shoring things up. It was pretty clear they also had no view (or clue) as to if/when market would recover. Randy (CEO) looked especially out of his depth. At one point he said he was confident the debt on his balance sheet wasn't a problem since he was an oil bull. That's the plan to delever the company, higher oil prices! 
 
In JU market contract durations tend to be very short. Floaters can be better but theirs aren't particularly. PGN has 11 rigs in Mexico and 8 will be on spot by Apr 15, and remaning 3 by Apr 16. In UKNS 4 of 7 will run off contract by Feb 15 and remaining by Apr 16. Similarly for other regions. They have 4 floaters with Petrobras where NE had spent a considerable amount of money upgrading 2 very old rigs (DPDS2 and DPDS3). Unfortunately from the experience of upgraded 30-35 year old assets of Diamond Offshore and Fred Olsen Energy, we know that disaster awaits PGN. The old rigs do not behave like new assets nor command the dayrates or premium you would think after a considerable amount of money has been spent on them. Meanwhile the book value has been inflated by this upgrade. Still even considering that these 2 "upgraded" old rigs stay with PBR, we'll likely see lower dayrates negotiated when they roll off contracts in 2017. Worse still the 5 yr yard survey will likely be prohibitive again as we have seen with other drillers' 35 or 40 year yard surveys. PBR will likely release the other 2 rigs (DPDS1 and MSS2). Hence PGN will have both utilization and dayrates collapse as all these rigs roll off contract early next year. So they are poised to feel the full brunt of the leading edge dayrates collapsing. When I was asking management where dayrates and EBITDA would go, it seemed pretty much a given that thier EBITDA would come to $500-600m in next 1-2 years. This with management optimism that the quality of their fleet was better than others so they see a lower utilization fall and only get affected by dayrate collapse. A utilization impact on top would case even more dmg and EBITDA could go to $300m. How is this possile?
 
Currently the company experienced 90% utilization on JUs in 2013. And expects 79% or so in 2014. I expect this utilization to continue declining in coming years to 75% in 2015, 70% in 2016 an 65% in 2017. Dayrates should fall by 15% by 2016. The combined effect is a drop is revenues 30% or so. On floaters the company will see utilization in 2014 for 69% and this should collapse to 35-40% once the 2 older brazilian floaters are released and idled. Dayrates will decline less till 2017 are two floaters are on contract and only floater 5/6 find work. Even then revenues will halve. So revenues on floaters drop from $600m to about $300-350m by 2016. On JUs they collapse from $1.15b to $800m. Unfortunately costs don't come down as fast, especially if the rigs are still working. If anything the company complained about experiencing rapid cost inflation in Brazil and West Africa and Mexico, something other drillers have also complained about. So even as contract drilling revenues plummet from $1.75b in 2014 to $1.15b in 2015, contract drilling costs won't come down, and might even go up. Hence the 2014 drilling opex of $900m or so will remain (might even go up). And warm stacking or cold stacking the rigs to bring costs down would be a death-knell at this stage of the rigs as these 35 year old rigs will never be re-started. Subtract ongoing SGA of about $60m and the EBITDA, which in 2014 will be $1.75b - $900m - $60m SGA = approx $800m will collapse by 2016 to $1.15b - $900m - $60m SGA = $200m. You might think I am being drastic on. Even then lets say I am wrong in all these assumptions and EBITDA will still be atleast $500m by 2016. EVEN THEN you have the $300m or so of maint capex that they company expects to spend, $100m in interest payments, and still $100m or so in taxes to make FCFs of 0. 
 
The problem here is that this cycle when dayrates go lower for longer (or even going to cash breakeven) is that their rigs only have 5-10 years in lifespan remaining although they are hoping they will last longer beacuse of the "project" capex they are doing. Most of Paragon's current rigs won't make it to the other side of the cycle to see the recovery. And stacking them won't help either. This is alluded to by management who confirmed that the 2 floaters and 2 JUs currently stacked and mgmt confirmed that those rigs would never be activated and should be considered worthless. They also admitted that the massive amount Noble spent on upgrading their floaters DPDS2 and DPDS3 was mostly a waste of money as they are full of specs that are not in demand. They also admitted any rig cold-stacked at this stage would effectively be gone forever. Once we see utilizations drop off I expected the number of rigs they warm-stack and cold-stack will rise and never return. 
 
Meanwhile this company has $1.7b of debt. I am painting a picture that the $275m in FCFs this year are peak (and only half the year is remaining anyway), so $140m in FCFs for 2H 14, next year EBITDA goes to $650-700m to generate about $125-175m in FCF and then drops to $500m EBITDA or infact lower in 2016 to generate zero FCFs. And the FCFs never turn positive again due to life of assets and more rigs stacked that reduce earning power and can never be reactivated, and ever increasing maintenance capex and interest payments. Forget DCF. Just added these cashflows over next 18 months and the company is worth about $300m when current EV is $2.5b. DCF the negative FCFs to come from 2016 and the company is worth less than 0 EV although presumably it gets restructed by then. With $1.7b of debt, equity is zero and the debt is a good short. 
 
BTW this is base case. If market collapses quicker, I can see their EBITDA go to $200m in 2016 as i stated although the contract coverage helps a bit in 2015. Still the company goes into negative FCFs very quickly. The management already told me they are not concerned about all this situation since they have a $800m revolver that they can start tapping. Great!!. Also they said the Debt/EBITDA covenants of 3.0 only apply to senior debt and hence it's not an issue. Awesome! I expect to hear $90m of dividends to be announced shortly. Once this $90m, of the $300m in FCFs that I calculate they will generate over next 18 months, goes out of the window, then I can reduce remaining value to $210m for the $2.5b in EV. For those saying there is scrap value, forget it. There's not much steel here to scrap. For those saying there is sale value, NE tried and nobody would buy these assets.
  
Things Paragon could do to survive: Sell assets right now to some stupid Asian buyer, who can use them in some Asian country where Health and Safety are not issues, and hence to whom the rigs are still worth something. Hence PGN can get whatever they can for them before the market gets even worse. Cancel dividend and buyback as much of the debt as possible. Stop these "project capex" and stop investing more money into 35 year old assets to try and extend they life. Do a MASSIVE equity issue at this ridiculously inflated valuation and use it to pay down some debt as well as go buy some new assets. Meanwhile sell old assets to whoever would buy. 
 
Ofcourse the company will do none of this. They will dividend the little cash they can generate. 
 
I just thought i'd sense check what Jefferies, who initiated, had in their DCF valuation. First of all they used the entire 2014 EBITDA (why not?!) instead of the remaining half, and then reduce capex from 300 to $180m (management already told me to expect $300m annual spend), reduced SGA to $40m (why not? ) and they put an enormous about of value in Terminal Value after year 5 with a perputal growth rate of 2% (hahahah? 40 year old assets EBITDA growing at 2% per year). And they still have EBITDA collapsing to $500m despite optimistic assumptions. And all this nonsense just gets them to $11 per share value. Reality is value is 0.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Collapsing dayrtaes
Collapsing utilization
Collapsing credit covenants
More rigs stacked
Dividend announced and then rapidly cut
Expensive fleet renewal strategy
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    Description

    Price Target = 0.
     
    Paragon Offshore is a recent spin-off from Noble Corp. In a collapsing rig environment Noble pulled off a stunning deal, somehow convincing credit holders to put $1.7b of debt on a fleet of 35 year old assets, cashed out, and chucked out this old crap that wouldn't have fetched that amount in a sale (and they tried). 
     
    I met the management recently and was hoping to see a team who understands how dire the situation is. Instead management was quite sanguine and puzzled by the adverse share price reaction since listing. 
     
    Paragon will do $800m or so in EBITDA this year. Mgmt told me they do $180m in regular maintenance capex to keep all rigs serviceable and another $120-130m or so in "project maintenance" capex where they take a few rigs into yards and try and upgrade them to extend life. They expect this to continue. So $300-310m in "maintenance capex" should continue. But maintenance in this case is a misnomer. Since even with this "maintenance" their fleet will rapidly deteriorate over the coming years. The 5 year yard survey's cost keeps increasing exponentially as you go past 30 years in rig life. Management freely admitted they needed to come up with some form of fleet renewal programme.
     
    On top of this you add $100m or so of interest payments. And they said they will soon provide much more detail of their tax structure but they complained they got saddled with a very inefficient tax structure and we should expect $100-125m in taxes. This implies a very hefty tax rate for an offshore rig company. This results in about $275m of FCFs and management intends to pay out $90m in dividends since "Noble already told everyone that". Management said the 11% div yield will "open some eyes". When I told them that Seadrill trades at 11% div yield and that's with new assets, and that Awilco trades at 20% div yield with old assets, they said the US investor mindset is different from these Norwegian/UK companies and they will gobble it up.
     
    So the math is pretty simple. Paragon has a fleet of an active fleet of 33 jackups (70% of 2015E revenues) and 6 floating rigs (30% of 2015E revenues), plus one jackup, two floaters, and one FPSO that are stacked. The company told me the 4 stacked rigs should be considered obsolete and will never start again. They have 1/3 EBITDA coming from floaters, 2/3 from Jackups. Both markets are under pressure. Geographically the 2 biggest markets are UK North Sea and Brazil and both are under pressure as well as Petrobras viciously pulls back on activity (Petrobras is PGN's largest customer with 40% of the backlog). And they have really old assets. Management seemed to admitted that activity was crashing and market was horrible but they still didn't feel they should be preserving cash or shoring things up. It was pretty clear they also had no view (or clue) as to if/when market would recover. Randy (CEO) looked especially out of his depth. At one point he said he was confident the debt on his balance sheet wasn't a problem since he was an oil bull. That's the plan to delever the company, higher oil prices! 
     
    In JU market contract durations tend to be very short. Floaters can be better but theirs aren't particularly. PGN has 11 rigs in Mexico and 8 will be on spot by Apr 15, and remaning 3 by Apr 16. In UKNS 4 of 7 will run off contract by Feb 15 and remaining by Apr 16. Similarly for other regions. They have 4 floaters with Petrobras where NE had spent a considerable amount of money upgrading 2 very old rigs (DPDS2 and DPDS3). Unfortunately from the experience of upgraded 30-35 year old assets of Diamond Offshore and Fred Olsen Energy, we know that disaster awaits PGN. The old rigs do not behave like new assets nor command the dayrates or premium you would think after a considerable amount of money has been spent on them. Meanwhile the book value has been inflated by this upgrade. Still even considering that these 2 "upgraded" old rigs stay with PBR, we'll likely see lower dayrates negotiated when they roll off contracts in 2017. Worse still the 5 yr yard survey will likely be prohibitive again as we have seen with other drillers' 35 or 40 year yard surveys. PBR will likely release the other 2 rigs (DPDS1 and MSS2). Hence PGN will have both utilization and dayrates collapse as all these rigs roll off contract early next year. So they are poised to feel the full brunt of the leading edge dayrates collapsing. When I was asking management where dayrates and EBITDA would go, it seemed pretty much a given that thier EBITDA would come to $500-600m in next 1-2 years. This with management optimism that the quality of their fleet was better than others so they see a lower utilization fall and only get affected by dayrate collapse. A utilization impact on top would case even more dmg and EBITDA could go to $300m. How is this possile?
     
    Currently the company experienced 90% utilization on JUs in 2013. And expects 79% or so in 2014. I expect this utilization to continue declining in coming years to 75% in 2015, 70% in 2016 an 65% in 2017. Dayrates should fall by 15% by 2016. The combined effect is a drop is revenues 30% or so. On floaters the company will see utilization in 2014 for 69% and this should collapse to 35-40% once the 2 older brazilian floaters are released and idled. Dayrates will decline less till 2017 are two floaters are on contract and only floater 5/6 find work. Even then revenues will halve. So revenues on floaters drop from $600m to about $300-350m by 2016. On JUs they collapse from $1.15b to $800m. Unfortunately costs don't come down as fast, especially if the rigs are still working. If anything the company complained about experiencing rapid cost inflation in Brazil and West Africa and Mexico, something other drillers have also complained about. So even as contract drilling revenues plummet from $1.75b in 2014 to $1.15b in 2015, contract drilling costs won't come down, and might even go up. Hence the 2014 drilling opex of $900m or so will remain (might even go up). And warm stacking or cold stacking the rigs to bring costs down would be a death-knell at this stage of the rigs as these 35 year old rigs will never be re-started. Subtract ongoing SGA of about $60m and the EBITDA, which in 2014 will be $1.75b - $900m - $60m SGA = approx $800m will collapse by 2016 to $1.15b - $900m - $60m SGA = $200m. You might think I am being drastic on. Even then lets say I am wrong in all these assumptions and EBITDA will still be atleast $500m by 2016. EVEN THEN you have the $300m or so of maint capex that they company expects to spend, $100m in interest payments, and still $100m or so in taxes to make FCFs of 0. 
     
    The problem here is that this cycle when dayrates go lower for longer (or even going to cash breakeven) is that their rigs only have 5-10 years in lifespan remaining although they are hoping they will last longer beacuse of the "project" capex they are doing. Most of Paragon's current rigs won't make it to the other side of the cycle to see the recovery. And stacking them won't help either. This is alluded to by management who confirmed that the 2 floaters and 2 JUs currently stacked and mgmt confirmed that those rigs would never be activated and should be considered worthless. They also admitted that the massive amount Noble spent on upgrading their floaters DPDS2 and DPDS3 was mostly a waste of money as they are full of specs that are not in demand. They also admitted any rig cold-stacked at this stage would effectively be gone forever. Once we see utilizations drop off I expected the number of rigs they warm-stack and cold-stack will rise and never return. 
     
    Meanwhile this company has $1.7b of debt. I am painting a picture that the $275m in FCFs this year are peak (and only half the year is remaining anyway), so $140m in FCFs for 2H 14, next year EBITDA goes to $650-700m to generate about $125-175m in FCF and then drops to $500m EBITDA or infact lower in 2016 to generate zero FCFs. And the FCFs never turn positive again due to life of assets and more rigs stacked that reduce earning power and can never be reactivated, and ever increasing maintenance capex and interest payments. Forget DCF. Just added these cashflows over next 18 months and the company is worth about $300m when current EV is $2.5b. DCF the negative FCFs to come from 2016 and the company is worth less than 0 EV although presumably it gets restructed by then. With $1.7b of debt, equity is zero and the debt is a good short. 
     
    BTW this is base case. If market collapses quicker, I can see their EBITDA go to $200m in 2016 as i stated although the contract coverage helps a bit in 2015. Still the company goes into negative FCFs very quickly. The management already told me they are not concerned about all this situation since they have a $800m revolver that they can start tapping. Great!!. Also they said the Debt/EBITDA covenants of 3.0 only apply to senior debt and hence it's not an issue. Awesome! I expect to hear $90m of dividends to be announced shortly. Once this $90m, of the $300m in FCFs that I calculate they will generate over next 18 months, goes out of the window, then I can reduce remaining value to $210m for the $2.5b in EV. For those saying there is scrap value, forget it. There's not much steel here to scrap. For those saying there is sale value, NE tried and nobody would buy these assets.
      
    Things Paragon could do to survive: Sell assets right now to some stupid Asian buyer, who can use them in some Asian country where Health and Safety are not issues, and hence to whom the rigs are still worth something. Hence PGN can get whatever they can for them before the market gets even worse. Cancel dividend and buyback as much of the debt as possible. Stop these "project capex" and stop investing more money into 35 year old assets to try and extend they life. Do a MASSIVE equity issue at this ridiculously inflated valuation and use it to pay down some debt as well as go buy some new assets. Meanwhile sell old assets to whoever would buy. 
     
    Ofcourse the company will do none of this. They will dividend the little cash they can generate. 
     
    I just thought i'd sense check what Jefferies, who initiated, had in their DCF valuation. First of all they used the entire 2014 EBITDA (why not?!) instead of the remaining half, and then reduce capex from 300 to $180m (management already told me to expect $300m annual spend), reduced SGA to $40m (why not? ) and they put an enormous about of value in Terminal Value after year 5 with a perputal growth rate of 2% (hahahah? 40 year old assets EBITDA growing at 2% per year). And they still have EBITDA collapsing to $500m despite optimistic assumptions. And all this nonsense just gets them to $11 per share value. Reality is value is 0.
    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Collapsing dayrtaes
    Collapsing utilization
    Collapsing credit covenants
    More rigs stacked
    Dividend announced and then rapidly cut
    Expensive fleet renewal strategy
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