The Defensive Investor

About the Author The Defensive Investor

Implements the principles of defensive investing in the contrarian spirit set forth by Benjamin Graham in The Intelligent Investor.

Paragon Offshore PLC (PGN): Impressive 2015 Guidance Underscores Bull Thesis

It has been a bumpy ride (to say the least) for investors in Paragon Offshore PLC (NYSE:PGN) since my last report. The company reported their August fleet report on August 10 and their 2015 Q2 results on August 12.

The call included surprisingly detailed guidance for 2015 and disclosed a contract dispute with Petrobras over the drillships DPDS 2 and DPDS 3, the two highest dayrate rigs in Paragon’s fleet.

2015 Guidance underscores Bull Thesis

In terms of updating the models after the Q2 earnings call and August fleet report, the company gave fairly detailed guidance for 2015. If we compare this full year guidance with the 1st half results, we see that the investment thesis is playing out as expected operationally.

Paragon Offshore 2015 Q1 2015 Q2   2015 Guidance 2015 H2
  $ millions $ millions   $ millions $ millions
Revenues 430.6 393.2 cons> 1520.0 696.2
Cash operating costs 250.7 221.4   790.0 317.9
G&A 15.4 13.7   57.5 28.4
EBITDA 164.5 158.1   672.5 349.9
Capex 50.7 62.4   195.0 81.9
Interest 30.2 29.0   124.2 65.0
Taxes 6.6 -18.5   0.0 11.9
FCF 77.0 85.2   353.3 191.1

Note that FCF in the 2nd half will be higher than in the 1st half. That is possible because of cost control. The company has aggressively cold stacked idle rigs at the end of Q2, dramatically reducing cash operating costs. Cold stacking rigs has also led to slashed capex. Capex is guided to $195 million down from roughly $300 million last year.

The aggressive drop in cash operating and capex expenditures validates the fundamental thesis underlying the PGN long position – that the company can scale its cost structure to the size of its business, staying cash flow positive even in extreme market scenarios.

Petrobras Drillship Contracts

On the call, management announced that Petrobras is contesting some of the backlog on their drillships DPDS2 and DPDS3. There is little I can add other than what was discussed on the call. My expectation would be that Paragon and Petrobras are able to negotiate a settlement, but I am simply eliminating the disputed period from the contracted backlog, assuming that these contracts are terminated early and not renewed.

Obviously that is a hit on 2016 and 2017, but, surprisingly not an unmanageable one.

Updated Forecasts for 2015 and 2016

In the following forecasts for 2015 and 2016, I have included the impact of a full loss of the DPDS2 & 3 contracts for the disputed period.

$millions 2015 2016
Revenue $1,512 $988
Cash Cost $790 $424
SGA $60 $60
EBITDA $662 $504
Net Interest $122 $105
Tax $0 $0
Capex $194 $135
FCF $346 $265

As you can see, the company remains firmly cash flow positive and should remain able to repurchase debt.

Commentary on Supply/Demand in Jackup market

Before talking about supply, it is very important to know that customers usually put only a modest advance down when they order a rig. 95% of the money is due upon delivery of the rig. As a result it is very cheap to order a rig for its option value and the order can be delayed or transferred to someone else without even losing the deposit (as Paragon has done themselves with Prospector 6&7). The real commitment comes with taking delivery.

At the beginning of this year, roughly 55 jackups were scheduled to be delivered in 2015. To date, 15 have actually been delivered (the rest delayed) and of those, 10 were already under contract. What this tells me is that very few operators are actually taking delivery of uncontracted rigs.

Of the 122 (or so) rigs still on the order books over the next 3 years, only 10 have contracts. The other 112 do not have contracts. I think it is clear that, delivery/payment for of the vast majority of these will be delayed indefinitely until conditions (dayrates) improve. If they took delivery of these rigs and tried to contract them in the current environment, they would probably not cover their interest costs.

Nobody would do that. So they need the higher dayrates at least as much than Paragon does. And in an environment of improved dayrates, Paragon wouldn’t have a problem.

In addition, almost none of the new supply are standard jackups of the type Paragon has, they are premium and high spec jackups that are really designed to be deployed in places where you would not typically use a standard jackup anyway. Premium jackups are capable of drilling in deeper waters than standard jackups, high spec is designed for deeper water and use in harsh conditions like the North Sea. This is why they are priced at premiums to standard spec jackups, but I don’t think that they would offer any particular advantage over a standard jackup where one is already working.

So, in my view, the problem of supply is essentially a self correcting one, particularly since the bulk of this problematic supply has not even been built yet.

Summary of Debt Outstanding and Covenants

People are constantly claiming on SA that Paragon is about to violate their covenants. I don’t see how. So, I wanted to lay out my analysis of the debt situation in the hopes of seeing where the differences lie. The company has a very small market cap compared to a fairly large amount of debt outstanding, as summarized below.

Outstanding Debt Schedule Q2 2015

$ millions notes
Revolver due 2019 (Libor + 2%) 365.0 secured, with financial covenants
Term Loan due 2021 (Libor + 2.75%) 642.3 secured, no financial covenants
6.75% Senior Notes due 2022 456.5 unsecured, no financial covenants
7.25% Senior Notes due 2024 527.0 unsecured, no financial covenants
Total Debt 1990.8  
Cash 112.4 Not including $292 mil proceeds from sales leaseback in July
Net Debt 1878.4  
Net Debt/FCF 5.4  
Net Debt/EBITDA 2.8  

The only financial covenants are the ones on the revolver: Net Debt to EBITDA < 4 and Interest Coverage (EBITDA to Interest Expense) > 3

According to my model, which has the company using free cash flow to retire debt at par (conservative because much of the debt structure is heavily discounted) the credit metrics deteriorate slightly in 2016, but remain well ahead of the covenants.

2015 YE 2016 YE
Net Debt 1716 1489
Net Debt/EBITDA 2.6 3.0
EBITDA/Interest 5.4 4.8

Net Debt to EBITDA remains well below 4 and EBITDA/Interest stays well above 3 the whole way.

However, the covenants need not even be an issue because, with the proceeds of the sale leaseback transaction and excess cash already on the balance sheet, the company could pay off the revolver by the end of Q3. $437 million should be available for debt paydown by then versus $365 million remaining on the revolver.

$ millions

Q2 Balance Sheet Cash $112
Sale/Leaseback Proceeds $292
Q3 FCF $90
Operating Cash Needed (2014 Q4) -$57
Q3 Debt Paydown Available $437


To me this is a nonissue. There is no accounting issue here, it is simply a matter of share price. Paragon could easily go back over $1 with a simple reverse split.

What about the long run?

By the end of 2016, all the lucrative floater contracts have lapsed and the rapid decline in FCF ought to stabilize somewhat. Without a recovery in oil, I see them running at $160-$180 mil FCF in 2017.

  1. Even without the significant recovery in oil that I expect, I think that Paragon is still likely a cheap stock with attractively priced debt. Their jackups are used in the cheaper parts of the supply curve and will likely continue to find work, albeit at lower rates.
  1. The market has continuously underestimated Paragon. At the beginning of the year, in a ratings downgrade, Moody’s estimated the company would do $130 million in FCF for the year. In fact the company exceeded this estimate in the first half and guidance suggests $350 million in FCF for the year. What people continually fail to realize about Paragon is how low the fixed costs actually are. With SG&A at 4% and Interest at 9% of Revenues, Paragon can stay cash flow positive for a long time.
  1. Paragon could survive with low oil prices, but it won’t have to. Oil cannot stay at $40/barrel for an extended period of time (three more years) simply because so much of the new supply (like NAM shale) comes with a high decline rate and must be replaced with new wells drilled by ongoing capex (which cannot be justified at current price levels). With the rig count having dropped precipitously last year, production will start to fall as well. By this time next year the impact of reduced capex budgets will be felt and the supply curve will do its work. Production will weaken and the price will move higher.
  1. When the price of oil recovers, so will drilling and exploration budgets and Paragon’s revenues will recover. This may take a couple years but my analysis suggests that Paragon will be able to survive for several years without any significant restructuring. Company needs only to start repurchasing their discounted debt on the open market.

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