Pacific Drilling Joins The Debt Restructuring Party

| About: Pacific Drilling (PACD)

Summary

Company delivered a solid second quarter.

Early termination of the "Pacific Scirocco" was rescinded by Total in exchange for a slight dayrate reduction.

Management finally admits to the need of debt restructuring.

Investors should expect substantial dilution or even worse.

Despite the restructuring news, the stock will most likely continue to trade as a proxy on oil prices for the time being.

Note:

Pacific Drilling (NYSE:PACD) has been covered by me previously, so investors should view this article as an update to my earlier statements on the company.

Pacific Drilling just reported its second quarter 2016 results which came in substantially above expectations, mainly due to increased revenue efficiency and an one-time gain related to the buyback of some of the company's bonds during the quarter.

The company had more good news to offer as French supermajor Total (NYSE:TOT) rescinded its previous request to terminate the "Pacific Scirocco" and instead decided to put the rig back to work offshore Nigeria next month - after previously keeping the rig in stand-by mode for a couple of months - at a slightly reduced dayrate.

In combination with a 3.5% advance for the oil price and the low share count post reverse split, the news were good for a 40% jump in the stock price on Monday.

Unfortunately investors chose to overlook the most significant development as management during the conference call for the first time more or less openly admitted to an upcoming debt restructuring:

Consistent with Chris' earlier comments on our expectation of another 18 months to 24 months before the market offers the sort of rates necessary to earn attractive returns for our fleet, we are looking at a long-term solution to the capital structure with the intent to bridge us to the ultimate recovery in the market.

We are taking measures now to preserve and improve our balance sheet and liquidity flexibility, and our discussions today with the various stakeholders are of that nature. Ultimately, this means it may take some time to complete this process; and at this point, it is too early to provide further details.

While Pacific Drilling today owns the most advanced fleet of latest generation drillships in the entire industry, this achievement was only reached by accumulating roughly $3 bln in debt obligations over time that consist of the following tranches:

  1. $475 mln in 2017 Senior Secured Bonds
  2. $719 mln under the 2018 Senior Secured Term Loan B
  3. $285 mln under the 2018 Revolving Credit Facility
  4. $737 mln under the 2019 Senior Secured Credit Facility
  5. $750 mln in 2020 Senior Secured Notes

With cash on hand of $371 mln and just one drillship currently contracted beyond the second quarter of 2017, the company's capital structure looks clearly unsustainable here.

Pacific Drilling will already be the fifth US-exchange listed offshore drilling company to undergo a comprehensive debt restructuring following the footsteps of Hercules Offshore (OTCPK:HEROQ), Vantage Drilling (OTCPK:VTGDF), Paragon Offshore (OTCPK:PGNPQ) and Seadrill (NYSE:SDRL).

While Hercules Offshore - after having to file for bankruptcy a second time within 10 months - is now facing dissolution, Vantage Drilling has successfully restructured its debt by basically wiping out its former shareholders.

Paragon Offshore is still in the process of getting its recently revised reorganization plan approved in bankruptcy court but if successful, current shareholders will keep a respectable 53% of the equity.

Seadrill so far hasn't disclosed any details regarding the ongoing negotiations with its creditors but currently expects to present a solution until the end of the year. I already provided an outlook on potential outcomes in an article published earlier this year.

Given the very large debtload compared to the size and backlog coverage of Pacific Drilling, the odds of a favorable outcome for equityholders obviously don't look great at first glance but investors should note that the company is actually backed by Idan Ofer, a wealthy London-based Israeli business magnate who owns more than 70% of the company's outstanding shares.

But given the fact that his investment has already lost more than 90% over the last two years, there's actually not much left at stake for him currently.

So what options does Pacific Drilling have at this point?

Given the diverse debt structure with three different credit lines in combination with two bond issues, investors should prepare themselves for difficult and protracted negotiations due to the opposing interests of the creditors.

To address the December 2017 $475 mln bond maturity, the company could continue its recent debt repurchases or even make a public tender offer as liquidity would be sufficient, but already in 2018 the Senior Secured Term Loan B with a currently outstanding balance of $719 mln would be up for renewal, so solely focusing on the 2017 bonds for now and hoping for some kind of quick oil price miracle in the meantime does not look like a viable strategy here.

So Pacific Drilling will most likely have to come to terms with the majority of its creditors, including its group of banks.

Other than Paragon Offshore recently, Pacific Drilling won't be able to make substantial cash payments neither to its bondholders nor its banks under a potential restructuring support agreement, so as almost always the company's shareholders will most likely pay the price here.

Given the sheer size and structure of the debt, it seems hard to envision anything else but an almost total wipe out for current shareholders.

Now investors might point to the fact that Mr. Ofer would also be wiped out under this scenario, but he would most likely be better off to reclaim his stake by going after the company's outstanding bonds and later convert them into new equity but admittedly I do not know about his personal liquidity at this point.

Directionally Pacific Drilling should not only negotiate some major covenant and amortization holidays with regard to its bank debt, the company also needs a maturity extension potentially beyond 2020.

Looking at the $1.225 bln in outstanding bonds, the only viable path would be a debt-to-equity conversion at this point. With the 2017 bonds currently trading at 37% of face value and the 2020 notes at just 27%, bondholders are seemingly prepared for a major haircut anyway.

Should the company be able to come to terms with its banks and assuming the conversion of all outstanding bonds into new equity at 40% of face value, current shareholders would be diluted by roughly 80% - which I would actually view as already the best case scenario here.

I firmly expect the reorganization having to take place under chapter 11 given the sheer number of opposing creditors involved here.

Basically the only option for Pacific Drilling to avoid filing for bankruptcy would be Mr. Ofer stepping up to the plate and either directly injecting a significant amount of fresh capital (probably in the $500 mln ballpark) or making a discounted tender offer for the company's outstanding bonds while at the same time successfully renegotiating the bank loans. Personally, I view both scenarios as highly unlikely at this point as I do not expect Mr. Ofer to throw good money after the bad here.

So - absent a short term oil price miracle - Pacific Drilling looks destined for bankruptcy reorganization going forward.

Bottom line:

Pacific Drilling had a reasonably good quarter but this won't save the company from the need of undergoing a comprehensive debt restructuring within the next 12-18 months. Given the diverse capital structure, an out-of-court restructuring looks highly unlikely at this point and moreover I do not expect material support from the company's majority shareholder either.

Under a best case scenario, investors might face roughly 80% dilution but could very well end up with nothing or close to nothing.

Given the sheer number of opposing creditors involved here, investors should prepare for a protracted negotiation period.

Despite this gloomy outlook, investors shouldn't panic at this point as the company's stock - in tandem with most of its exchange-listed peers - has, to some extent, ceased to trade on individual fundamentals a couple of quarters ago. Today, offshore drilling stocks are basically being viewed as an option on oil prices. Alongside most of their peers, the company's shares will continue to be coupled to oil price movements and predominantly serve as a playground for traders and speculative retail investors for the foreseeable future as they have done for some time now.

More conservative investors would, of course, be well served to continue to avoid the industry as a whole until there will be at least some light at the end of the tunnel.

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.