Paragon Offshore PLC (PGN) $6.22 September 2014 Investors who look backwards will like Paragon, a recently spun-off collection of oil drilling rigs from Noble Corp. Paragon screens well, enjoys plenty of backlog, and has initiated a dividend that would yield 8% at current prices. Digging deeper though, investors would see a company that will encounter a number of issues over the short-term that will cause declining cash flows and a potential suspension of the dividend. At current prices, I believe that Paragon offers more than 50% downside under base scenarios and the equity could go to zero if a surplus of rigs causes a downturn in rig rates to continue. There was a reason Noble spun-off these assets and loaded Paragon up with debt. Besides the longer term catalyst of lower rig rates and poor renewal economics, near-term technical selling from existing Noble shareholders and a dividend cut may cause investors to rush for the exits. Spin-Off of Assets from Noble Popularized by Joel Greenblatt in You Can Be a Stock Market Genius, spin-offs are the darling of the investment world these days. There are vehicles dedicated to spin-offs and popular investment sites routinely tout newly formed spin-offs. The mechanism is simple: often times a spin-off is ignored by most Wall Street analysts due to a different business, lack of a long-term track record, or small size relative to the parent. However, and I am sure Mr. Greenblatt will be the first to acknowledge this, each spin-off is different and a requisite analysis is key to each security. For every successful spin-off there could be a Tronox, which filed bankruptcy shortly after being spun-off from Kerr-McGee (now Anadarko Petroleum), who loaded the company up with environmental liabilities. While I do not believe Noble Corp is acting in a sinister manner, the company is clearly getting rid of undesirable assets and the liabilities that go along with them. Long investors of Paragon will note that CEO Randy Stilley is familiar with spin-offs. Mr. Stilley was also the CEO of Pride International spin-off Seahawk Drilling. It is worth noting that Seahawk filed for bankruptcy in 2011, two years after being spun-off. On August 1, 2014, Noble Corp completed the spin-off of Paragon Offshore, where Noble shareholders received 1 share of Paragon for every 3 shares of Noble they received. The basic outline of the spin can be seen in the table below. 1
Table 1. Paragon Offshore Spin Overview. Source: Company Filings, Presentations Jack-Ups Operating 33 Drillships Operating 4 Semi-submersibles Operating 2 Backlog (B) as of 6/30/2014 $2.3 Debt (M) $1,730 Cash $120 Shares Outstanding (M) 84.753 Current Market Cap (M) $623 Current Enterprise Value (M) $2,233 In a recent Barclay s conference, Paragon disclosed expectations for operating expenses and capital expenditures. Strangely, they did not mention revenue or EBITDA expectations in any of the slides. Using the Fleet Status Report, I was able to back into H2 revenue estimates (Appendix 1.). The table below shows my revenue estimates and calculates free cash flow (FCF) from Paragon s estimates. The bull estimate assumes that revenue includes all performance bonuses in Brazil. The bear estimate assumes that these performance bonuses are not met. Table 2. Second Half 2014 Income H2 Bull Estimate H2 Bear Estimate Revenue $886.0 $870.0 Operating Expense $453.0 $473.0 SG&A $30.0 $35.0 EBITDA $407.0 $362.0 Interest Expense $47.0 $53.0 Estimated Tax $72.5 $72.5 Capital Expenditures $200.0 $220.0 FCF $83.5 $16.5 Annualizing these figures we arrive at FCF ranges of $167-$33 million and annualized EBITDA of $814- $724 million. Compared to a market cap of $623 million and an enterprise value of $2.23 billion, the bull estimates look cheap. The figures above do not adjust for Noble s interest in the cash flows, since Noble spun-off the assets mid-quarter. If adjusted for the interest, FCF would be materially lower in H2. It may seem strange that Noble would spin-off such valuable (on a backwards looking basis) assets. Based on conference calls and presentations, it seems fairly likely that Noble simply wanted to get rid of these assets. For example: -In a June 2014 presentation Noble highlights that revenue is shifting from JU to Ultra deep water. The shift is dramatic. In 2009 50.2% of Noble s revenue was generated from standard jackups. In 2016 Noble estimates that only 4.1% of revenue will be generated from standard jackups. 2
-In the Q2 2014 conference call, Noble s management team stated In the absence of these transformative measures (the Paragon spin), our average fleet age would ve increased to 35 years by 2016. Conversely, the actions taken would ve allowed us to reduce the average fleet of our the average age of our fleet of (sp)13 years by 2016. Management goes on to elaborate on why their highspecification JU rigs are superior. There is clearly a goal to reduce the age of assets, increases contract committed rigs, lower capital expenditures, and focus on high-spec rigs. -Perhaps most notably, Noble tried to sell their lower spec (Paragon JU fleet) assets in 2012 but failed. When all else fails, spin the assets off to your shareholders, load the company up with debt and recoup the lost sale proceeds via debt. The last point raises an interesting question why would Noble have trouble selling their rigs? One possible answer lies in the age of the fleet and the required maintenance for aging rigs. Rig Maintenance Paragon has 39 rigs that are, on average, 34.5 years old, 19 have been rebuilt. David Williams, Noble Corp s CEO, mentioned in the Q1 2014 conference call that the rebuilt rigs were refurbished in midlife, implying an effective age of ~17 years for rebuilt rigs. Older rigs are more expensive to maintain and require steel renewal, equipment upgrades/replacement, new paint, and accommodation upgrades. These repairs are not cheap and typically range from $10-$30 million. With 19 of their rigs rebuilt, 20 rigs have yet to undergo a major refurbishment. Using a range of $10- $30 million/rig, a fleet wide refurbishment would cost anywhere from $200 to $600 million. Given the age of the rigs, a complete refurbishment would probably be in excess of $400 million, the mid-point to that estimate. The lack of rebuilds is surprising, especially given the age. Management is guiding for a capital expenditures of roughly $200 million. This will be a very difficult goal to hit given the number of rigs that need a major overhaul. The guidance also sharply diverges from H2 2014 capital expenditures of $200-$220 million. These costs, and the daily costs of operating the rigs, go up as the rigs age. This isn t good for Paragon unless rates start to rise faster than operating cost inflation. So what could rates do? Rig Rates Predicting worldwide trends is difficult, luckily for Paragon investors, I believe there are only three areas that matter: the North Sea, Brazil, and Mexico. Currently the most profitable region for Paragon is the North Sea, contributing 33% of EBITDA (roughly $126 million in H2 2014 by my calculations) via 7 JU s and 1 semisubmersible. The graphic on the next page shows the divergence between high spec rigs (Paragon has none) and standard spec rigs in the North Sea. It is clear that while rates have risen overall, high spec rigs have enjoyed a much greater rise in the past few years. I highlight this because the delta appears to be growing, while Paragon s maintenance costs should keep rising. 3
Another area of importance to Paragon is Brazil, home of 4 highly profitable Paragon drillships. Brazil has yet to renew a contract in the past year in the Campos Basin, according to management at Paragon in a recent conference call. Management admits they don t know what will happen in Brazil, but they believe it is likely that one of their floaters up for renewal will not be renewed. The table below shows my estimates and is based on information provided by Paragon in their presentations. I assumed an EBITDA margin of 30% for both rigs, which is below the EBITDA margin for Paragon s Brazilian fleet. Table 3. Brazil Rigs Income, all figures in thousands Authors Calculations Rig Dayrate Yearly Revenue Est. EBITDA DPDS1 $290 $109,105 $32,731 MSS2 $270 $101,580 $30,474 Graphic 1. North Sea Jack-Up Day Rates Source: 9/9/2014 Prospector Offshore Drilling IR presentation Discussions with management indicates that one rig, the DPDS1 will probably not be renewed and the MSS2 may be renewed. The loss of the DPDS1 would reduce EBITDA by $32.7M and the loss of both rigs would reduce EBITDA by $63.1 million. I believe that management is optimistic if they believe these drillships will be renewed at favorable terms, if at all. Paragon s former parent, Noble Corp, saw an 11% decrease to day rates for their 2011 built, high-spec drill ship, the Noble Bully II. If Brazil is lowering rates for new built higher-spec ships, what chance does Paragon have? The other issuing impact Paragon is the large backlog of rigs being built currently. Investors listening to any conference call hosted by oil drillers can appreciate the surplus of rigs currently being built. The slide on graphic 2, taken from Paragon s Energy Power Conference presentation shows the anticipated jackup deliveries, designs, and country of manufacture. 4
Management of Paragon is quick to tell you that this doesn t tell the full story and some of those rigs will never make it contracted status, especially since a number of them are being built in China. However, Credit Suisse notes The three leading Chinese yards are expected to deliver 47 jackup units, equivalent to Singapore yards and representing close to 32% of total jackup supply. Given the high quality rigs produced by leading Chinese yards (a fact admitted to by Paragon management at the Barclays conference) there are at least 94 jackups coming from quality, leading shipyards. Credit Suisse estimates utilization could sink to 81%. Another issue, not widely discussed, is asset impairments. Investors depend on NAV and price-to-book ratios to determine how inexpensive/expensive a stock is. This works great until the asset is found to be worth a lot less. If a number of newbuild ships come out of the yards and are sold for a significantly lower amount than initially planned for, asset impairments may occur. It seems illogical that Paragon could argue their aging fleet is worth more than brand new higher-spec rigs that just left the shipyard. Graphic 2. Jackup Delivery These newbuilds represent an enormous quantity of today s fleet which means they will either be replacing older, lower-spec, rigs, or simply sit idle. While it is tough to say with any accuracy or precision, 5
the actual results will probably be a combination of the two. Major drillers had the following comments to say about the jackup market. Graphic 3. Offshore Drillers Jackup Comments Drillers such as Ensco and Seadrill believe that the oversupply is a reality. However, they all believe their fleets are OK because 222 jackups are at least 30 years old and likely to be scrapped. This does not bode well for Paragon, owner of 34 rigs that are almost 35 years old. Ensco had the following to say in their Q2 2014 conference call about jackups and floater over 35 years old (emphasis added): Upon reaching 35 years of age, each of these rigs will be required to complete a regulatory survey in order to meet classification requirements, and significant capital expenditures may be required to keep these rigs certified, especially for jackups that have not been well maintained over their useful lives. These capital expenditures may prove cost prohibitive for many of these rigs, and we believe that these surveys could serve as a catalyst for jackup retirements. While the numbers I just gave you are for jackups that are at least 35 years of age, if we look at actual rig retirements over the past 3 years, the average age of the 36 jackups taken out of the global supply is 32 years. The global fleet of competitive floaters may experience similar phenomenon as approximately 60 floaters or 20% of the global fleet are at least 35 years of age. With customers preference for newer rigs that provide drilling efficiencies and with less capable floaters challenged to find contracts in the current 6
environment, many of these floaters may face extended periods of time without work. Drillers may look to reduce costs on older assets by stacking these rigs. The quotes above are not good news for Paragon, owners of an aging fleet and plenty of debt. In the face of a market oversupplied with rigs, there is only one way to increase cash flows purchase newer rigs. This will be difficult. Debt Drives Decisions During the spin-off, Noble gave Paragon more than $1.7 billion of debt, the tranches are shown below. Table 4. Paragon Debt Source: Company Presentation Notes Amount (M) Interest Maturity Secured Term Loan $650 L+2.75% 2021 Senior Unsecured Notes $500 6.75% 2022 Senior Unsecured Notes $580 7.25% 2024 This is a lot of debt, especially for an aging fleet. Management has stated that they may pay some debt debt, but this will not get the company away from a core problem they still have rigs that are lower spec and aging. Paragon will have difficulty acquiring new assets because new rigs are expensive. Of the 133 jackups being built right now, most have expected prices of $180-$220 million. At a $200 million per rig average, Paragon will need to take on another $140 million of debt if they finance 70% of the purchase. For now Paragon will need to depend on their free cash flow generation. The table shows my estimates for free cash flow generation in 2015. Table 5. 2015 Estimates Source: Authors calculations, Company guidance 2015 Estimate In Millions Bull Base Bear Revenue $1,574 $1,545 $1,452 Operating Expense $906 $926 $946 SG&A $60 $65 $70 EBITDA $608 $554 $436 Interest Expense $94 $100 $106 Estimated Tax $100 $110 $120 Capital Expenditures $300 $320 $350 FCF $114 $24 ($140) This has created an interesting point for both longs and shorts. In the S-1, Paragon stated We expect to pay a quarterly dividend on our ordinary shares. Initially, we expect that the amount of this dividend will be between approximately $20 million and $22.5 million in the aggregate per quarter, or between $80 million and $90 million in the aggregate on an annualized basis. 7
If the company pays out $85 million per year in dividends, that leaves $37 million of extra cash, enough for a rig per year even under the bullish scenario. The truth of lower cash flows seems more likely each day. On September 19, 2014 Paragon announced that a $0.50 annual ($0.125/share each quarter) dividend was being implemented. With 84.7 million shares outstanding, $42.35 million will be paid out in dividends. This should be shocking for bulls that were told just a few months ago that a dividend about twice the size waited for them. While it is impossible to say with any accuracy, I suspect many owners of Paragon were hoping for a large dividend. Beyond the dividend, the valuation is simply too high. Management of Paragon has stated that they would look to buy similar assets at roughly 3X EBITDA. If we assume that 2015 EBITDA will come in at my bull estimates of $616 million, a 3X multiple values the entire company at $1,848 million. Backing out the debt and adding cash of $73 million arrives at an equity value of $191 million, more than 60% below today s market cap of $527 million. And remember, this is my bull estimate. If the base calculation proves to be correct the downside could be much greater. Whether or not the company is valued on FCF or EBITDA, and even after applying generous multiples, there is little wiggle room for the company and plenty of downside for equity holders. With an equity value of $527 million, there is tremendous optimism in place for Paragon s shares and bulls must believe that contracts will be renewed at similar rates or higher. This seems to jar with the obvious fact that newer rigs are being built and Paragon has one of the oldest fleets in existence. Conclusion Paragon is a timely and compelling short given near-term catalysts and longer-term industry dynamics. At current prices around $7.00/share, bulls of Paragon believe that the company will continue to issue an attractive dividend and generate more than $150 million per year in FCF. This will prove to be very difficult as Paragon s rigs are, on average, more than 34 years old and are operating in an environment where numerous rigs are being constructed. As these newer, higher-spec rigs get finished downward price pressure on day rates will take place. This will suppress Paragon s cash flows and make the planned dividend unattainable. I believe that shares of Paragon offer a minimum of 60% downside, even under bullish forecasts for 2015, an unlikely event. There is a reason Noble spun-off these assets and loaded the company up with debt and it will not work out well for Paragon bulls. Bulls should be especially concerned about the dividend that was recently announced. Projecting a quarterly dividend of almost $0.25/share and then backing it down to $0.125/quarter in only six months is not a good sign and shows how little foresight management has into cash flows. 8
Appendix 1. Revenue Estimates Country Rig Dayrate($000) H2 Rev Estimate ($000) DPDS3 $347 $63,709 w/ Bonus Brazil DPDS2 $300 $59,241 w/ Bonus DPDS1 $290 $38,387 w/ Bonus MSS2 $270 $48,923 w/ Bonus M841 $112 $20,384 M842 $112 $19,040 M531 $112 $20,384 B301 $101 $17,473 L1116 $0 Available Mexico L1113 $101 $17,635 L1114 $90 $15,714 L781 $82 $14,432 M821 $69 $12,558 M824 $85 $14,705 M823 $85 $15,470 India MDS1 $151 $27,482 L1112 $55 $9,240 South East Asia L785 $120 $21,000 M1162 $135 $24,570 L784 $140 $25,480 L1111 $0 Available L1115 $111 $20,202 Middle East M1161 $0 Available L786 $0 Available M822 $0 Available B152 $95 $17,290 Dhabi II $89 $16,198 MSS1 $278 $50,596 B391 $154 $19,404 C20051 $176 $21,120 North Sea C20052 $180 $32,760 C461 $162 $29,484 C462 $168 $30,576 C463 $168 $30,576 HZ1 $168 $30,576 L782 $172 $31,304 West Africa L783 $145 $26,390 M825 $141 $19,176 M826 $136 $24,752 9
Average $150 $22,845 Total $5,100 $886,231 10