Parker Drilling Company's Capex Flexibility And Robust Recovery Rate Warrant Better Market Spreads

| About: Parker Drilling (PKD)

Summary

Credit markets are exaggerating Parker Drilling’s credit risk by over 400bps.

Moreover, Moody’s is overstating PKD with their highly speculative, high-yield B3 credit rating.

Our fundamental analysis highlights that PKD has cash flows over operating obligations, a robust recovery rate, and capex flexibility.

These factors drive our much safer near cross-over HY1 (equivalent to Moody’s Ba2) credit rating.

Credit markets are grossly overstating Parker Drilling Company's (NYSE:PKD) credit risk with a CDS of 1,107bps and a cash bond YTW of 15.386%. Our fundamental analysis highlights a safer credit profile for PKD, considering the firm's cash flows that would exceed operating obligations. Moreover, their capex flexibility should allow them to free up liquidity, and their robust recovery rate should allow them access to credit markets. These drive our much safer Intrinsic CDS of 671bps and Intrinsic YTW of 7.856%.

Moody's is also overstating credit risk, viewing PKD as a highly speculative, high-yield B3 credit as opposed to our near cross-over HY1 (Ba2 using Moody's rating scale) credit rating for the firm.

Cash Flow Profile

Click to enlarge

We produced a Credit Cash Flow Prime chart for Parker Drilling Company, as we do for every company we evaluate. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Research's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.

The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.

If the company generates and has cash levels that are above their obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, they can allow assets to age a little longer, or they can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service their credit obligations?

PKD's cash flows would be sufficient to cover yearly operating obligations. Furthermore, the firm's sizable expected cash build would be sufficient to cover all obligations including debt maturities until 2020. However, they would need to refinance their 2022 debt headwall to avoid a liquidity crunch, as cash flows and cash on hand would fall short of servicing all obligations.

That said, PKD has significant capex flexibility arising from the operational nature of their business, allowing them to reduce capex costs to free up liquidity. Moreover, with a robust recovery rate of 198.7%, the firm should be able to access credit markets with limited issue. However, it is important to note that the firm's commodity-based business augments cash flow risk, elevating credit risk from the high potential for the variability of cash flows.

Management Incentives

Like most people, senior executives and board members do what they are paid to do. This is why PKD's Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Our Incentives Dictate Behavior™ analysis focuses on PKD's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.

PKD management's short-term compensation is based on EBITDA less capex, days sales outstanding, and individual performance, while their long-term compensation includes grants of restricted stock units (RSUs), phantom stock units based on relative TSR, and performance cash units based on relative ROCE.

The firm's EBITDA less capex metric incentivizes management to expand margins and drive growth, and at the same time, limit investment in capex, improving asset utilization as well. Meanwhile, the days sales outstanding metric focuses management on diminishing the length of time needed to collect their receivables, thereby improving liquidity and balance sheet position. Additionally, the ROCE metric incentivizes management to improve margins and asset utilization levels by controlling their capex and working capital spending. This combination of metrics is favorable for ROA' expansion, which would lead to greater cash flows available to service debt obligations.

Management Representations

We provide analyses of companies' statements on earnings calls, termed Earnings Call Forensics™. This analysis is meant to help assess a management team's confidence in their conference calls when discussing certain areas of the business such as operations, stability, strategies, their ability to manage business risks, and especially, their liquidity and solvency.

In the case of PKD, the analysis of their Q1 2016 earnings call highlights negative markers from management. Management appears concerned about their lower utilization rates and about continued margin compression. Additionally, they may be concerned about demand and pricing pressures in their international and Gulf of Mexico rentals.

Conclusion

Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. PKD's credit risk is being grossly overstated by credit markets and overstated by Moody's. Given PKD's cash flows over operating obligations, robust recovery rate, capex flexibility, and favorable management compensation framework, ratings are expected to improve while credit market spreads are expected to tighten once the company's fundamentals are recognized.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Melvin Yubal. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.