Ultra-deepwater drilling specialist Pacific Drilling (PACD) announced its third quarter 2013 results on Wednesday, November 6, 2013. These results continue the trend of increasing revenue and net income that we have seen at several other offshore drillers recently. This trend is due to the firm industry fundamentals which I have written about several times recently, most notably here. Many readers may immediately note the large number of bearish articles that have been published recently regarding a weakening of the fundamentals of the offshore drilling industry. This is why I state that the fundamentals are firm. Several oil companies are re-examining and even reducing their development budgets due to cash flow problems. This reduction of development spending is leading to reduced demand for offshore drilling rigs than what the industry has seen for the past year or two. However, it appears that the reduction in demand is primarily affecting the market for older, non-premium rigs. The industry is seeing relatively steady demand for modern, sophisticated rigs like the ones that Pacific Drilling owns and operates. Additionally, these results also show Pacific Drilling's own growth story playing out. This growth is likely to continue in later quarters.
Before getting into the meat of this analysis, let's have a look at the highlights from the company's earnings report:
- The company reported net income of $30.3 million. This represents a 44% increase over the previous quarter's net income of $21 million.
- Pacific Drilling reported a stellar revenue efficiency of 96.9% in the quarter.
- The company incurred direct rig operating expenses of $163,400 per day. This is relatively in line with the previous quarter.
- Pacific Drilling generated an EBITDA of $96.9 million in the third quarter. This represents an increase of 13.3% over the previous quarter.
Readers will likely immediately notice the growth in both net income and EBITDA that the company reported. One reason for the company's increases in these profitability measures is the growth in revenue that the company experienced during the quarter. Pacific Drilling had total contract drilling revenue of $193.2 million in the third quarter, an increase of 9.28% over the $176.8 million that the company brought in during the second quarter. The primary reason for this increased revenue is the high revenue efficiency that Pacific Drilling achieved in the third quarter, particularly when compared to the second quarter. In the second quarter, the company had markedly lower revenue efficiency of only 90.2% compared to 96.9% in the third quarter. Revenue efficiency is a metric used by the offshore drilling industry as a way to express the percentage of the company's maximum potential revenue that the company actually brought in. This is necessary because offshore drilling contractors are only compensated for time that a rig actually spends working; the exploration and production companies that hire offshore drilling rigs do not pay for time that the rig spends out of operation such as time spent undergoing maintenance. Therefore, the company's higher revenue efficiency in this quarter compared to the last indicates that the company captured more of its theoretical maximum revenue given its current contracts than it did in the previous quarter. Unfortunately, there is a limit to how much an offshore drilling company can grow its revenue by increasing its revenue efficiency. This is because it is by definition impossible to increase revenue above the theoretical maximum given the company's current contracts. Pacific Drilling is, in fact, close to the maximum realistic revenue efficiency. This is because offshore drilling rigs are very complicated machines and these machines require regular maintenance in order to keep functioning. Therefore, some amount of downtime will always be required in order to perform this required maintenance. Pacific Drilling has historically maintained a revenue efficiency of 95%, a figure that puts the company in the very top tier of all the ultra-deepwater drillers. As this figure alone is very high relative to its peers, including other companies with similarly modern fleets, it is unlikely that the company will be able to increase this figure significantly going forward. Therefore, growth in revenues solely due to an increasing revenue efficiency is unlikely.
Fortunately, the company has other avenues for growth going forward. The most significant of these is the impending growth of its fleet. During the third quarter, Pacific Drilling had four ultra-deepwater rigs in operation with another four under construction. One of these four rigs that was under construction, Pacific Khamsin, was delivered to the company at the end of August. The rig immediately set sail for West Africa where it will begin work on its first contract around the beginning of December. The start-up of this new rig will have a significant positive effect on the company's fourth quarter earnings and an even larger positive effect on the company's first quarter 2014 results. According to Pacific Drilling's most recent fleet status report, the Pacific Khamsin has a contract dayrate of $660,000 and average daily contract revenue of $722,000 per day. The contract dayrate is most important in quantifying the actual likely impact of this rig on the company's results since the average contract backlog revenue includes items such as the mobilization fee and reimbursements for the contract preparation expenses that Pacific Drilling will be collecting. This money is thus merely a reimbursement of costs that Pacific Drilling has already incurred (or is currently incurring) that is amortized over the contract term, per standard industry practice. This money will show up as revenue on the company's income statement but it is not "new money" that the company did not have before in the way that dayrate would be.
In the company's most recent industry presentation, it estimates that it will have total per rig operating costs of $200,000 per day. This figure is significantly above the per rig direct operating costs that the company incurred in the third quarter but it is useful for our purposes because it provides sufficient headroom to include indirect costs such as onshore support costs and future cost inflation. Therefore, the rig's dayrate of $660,000 and its expected operating costs of $200,000 should result in the Pacific Khamsin increasing the company's EBITDA by approximately $460,000 every day that it is in operation. If we assume that the rig actually does begin operating on December 1, then it would increase Pacific Drilling's EBITDA by approximately $14.3 million in the fourth quarter compared to the third quarter assuming that it operates continually through the month of December. In reality, the rig is unlikely to have this much operating time during the month of December. This is because ultra-deepwater rigs tend to have much lower reliability during their first six months of operation than after this period. In the industry, this is referred to as the "break-in period." Thus, Pacific Khamsin will likely generate lower EBITDA than its theoretical maximum in both the fourth quarter of this year and the first two quarters of next year. The rig will still not be able to achieve its theoretical maximum revenue or EBITDA after the break-in period has ended as it will still experience downtime for repairs and maintenance just like any other rig. However, by the second half of next year, the rig should be fully broken in and be generating in excess of 90% of its maximum revenue and EBITDA just like the other rigs in Pacific Drilling's fleet.
Unfortunately, Pacific Drilling stated in its December 2013 fleet status report that the Nigerian authorities have been slow to issue the required drilling permit for the Pacific Khamsin to begin operations in Nigeria. Therefore, the company's revenue boost from this rig may be delayed until the first quarter of 2013, depending upon when the authorities issue the permit. The contract for the rig is for two years and so the rig will produce revenue and EBITDA at the calculated level for two years following the issue of this permit.
In conclusion, Pacific Drilling's third quarter results were outstanding and quite effectively show a company in the early stages of a rapid growth spurt. The company will be doubling the size of its operating fleet over the next few years, from four rigs to eight rigs and this will serve as the company's primary driver of growth. The addition of these fours rigs to the company's operating fleet will steadily grow its revenue and cash flow well into 2016. The company could thus be appealing to an investor looking to capitalize on this growth.