Examining North Atlantic Drilling's Risk Of Bankruptcy

| About: North Atlantic (NADL)
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Summary

North Atlantic Drilling has one of the highest debt-to-equity ratios of any offshore drilling contractor.

The company has strong forward revenue and cash flow visibility.

The company's revenues and cash flows look likely to decline in 2015 which will leave it unable to finance all of its maturing debt with its cash flows.

North Atlantic Drilling does have several options available to it in the event that it is cut off from the credit market.

The company does have some significant risks due to its dependence on several key contracts with Russian oil giant Rosneft.

In a recent article that was published on Seeking Alpha PRO, I examined Seadrill Limited's (NYSE:SDRL) bankruptcy risk and determined that, while the company will likely face some challenges over the next few years, the risk that Seadrill will actually go bankrupt is rather low. In this article, I will take a look at another drilling company whose current share price indicates a relatively high concern about the risk of potential bankruptcy. That company is harsh-environment drilling specialist North Atlantic Drilling (NYSE:NADL).

One reason why North Atlantic Drilling seems to be considered at a very high risk of bankruptcy is that the company has a very high debt load. As of September 30, 2014, North Atlantic Drilling had $241.4 million in short-term debt (including $23.3 million owed to a related party) and $2.612 billion in long-term debt (also including debt owed to a related party). This gives the company a total debt load of $2.8534 billion compared to $937.6 million in shareowners' equity. This gives the company a total debt-to-equity ratio of 3.04, which is one of the highest ratios in the industry as shown here:

In order to understand whether or not North Atlantic Drilling can afford to maintain this debt load, it is important to understand how the offshore drilling industry works. Offshore drilling contractors such as North Atlantic Drilling generate their revenue by leasing their rigs under contracts with exploration and production companies who use these rigs to both explore for and develop oil resources located on the ocean floor. In exchange for this, the exploration and production company pays a contractually pre-determined rate to the rig owner, known as a dayrate, that generally does not vary over the contract term. In addition, these contracts are for extended periods of times, oftentimes several years in the case of North Atlantic Drilling's harsh-environment rigs. This provides tremendous visibility into the drilling contractor's forward revenues and cash flows.

That visibility is evident when looking at the current contract status of all of the rigs in North Atlantic Drilling's fleet:

Source: North Atlantic Drilling

As this chart shows, North Atlantic Drilling has one rig, the West Navigator, that is scheduled to go off contract in December of this year and then go to work for Russian oil giant Rosneft (OTC:RNFTF) in July of 2015. While North Atlantic Drilling has been searching for work for this rig to perform during these six months of inactivity, the company has thus far been unsuccessful. This will result in North Atlantic Drilling's cash flow dropping somewhat once this rig goes off contract this month. It is also uncertain what dayrate North Atlantic Drilling will be receiving under its contract with Rosneft, thus the company's cash flow may not return to its current levels even after the rig begins work on this contract. North Atlantic Drilling also looks likely to suffer further reductions in its cash flow next year when two semisubmersible rigs, the West Venture and West Phoenix, go off contract in July and September 2015 respectively. North Atlantic Drilling has not yet managed to secure replacement contracts for these rigs and as I stated in a recent article, the near-term economics for harsh-environment rigs are not promising. Thus, North Atlantic Drilling may have difficulty securing replacement contracts for these rigs in the near future. This will result in reductions in the company's cash flows once these rigs go off their respective contracts.

There is also some uncertainty about whether or not the West Navigator will actually begin work on the contract with Rosneft in July 2015 as currently scheduled. This uncertainty comes not only from the sanctions that the Western nations have imposed on Russia but also from the economics of extracting oil from the world's Arctic regions. North Atlantic Drilling's parent company Seadrill assembled this chart for its presentation at the Deutsche Bank Leveraged Finance Conference in October 2014 using data provided by the International Energy Agency and Morgan Stanley Equity Research that shows the costs of producing oil in various areas:

Source: Seadrill, International Energy Agency, Morgan Stanley Equity Research

As this chart shows, it costs an average of $75 per barrel to produce oil in the world's Arctic areas such as the one where the West Navigator is scheduled to work. As that is well above the current price of oil given oil's tremendous plunge, Rosneft may decide that it does not make financial sense to develop its Arctic resources at this time and thus postpone its development plans until the price of oil returns to its previous levels. However, as the chart shows, the costs of operating in the Arctic vary widely with some Arctic projects being economical even if the price of oil were to continue to fall to $40 per barrel. Rosneft itself has not stated what its own break-even point is on its Arctic projects but the company's CEO did state back in October that the company remains committed to its Arctic projects. It is worth noting though that the price of oil was considerably higher back in October than it is now so it is uncertain if his viewpoint has changed since then. It is a near certainty that Rosneft will develop these resources at some point, though. As North Atlantic Drilling points out in its third quarter earnings report, the company has only ten years to drill in its Arctic holdings or it risks losing its licenses to those offshore blocks. However, that does not mean that the company cannot temporarily postpone its drilling projects while it waits for more favorable economics. Unfortunately, as fellow Seeking Alpha contributor Vladimir Zernov states, Rosneft has now indicated that it may indeed postpone its drilling projects in the Arctic until 2018. This could certainly result in the contract not being executed as currently scheduled.

Thus, it appears certain that North Atlantic Drilling's revenue and, by extension, cash flow, will drop over the next year. Therefore, it is necessary to determine how far the company's cash flow can drop before it becomes unable to support its debt. In the third quarter of 2014, North Atlantic Drilling paid a total of $26.8 million in interest on its debt. This is relatively in line with the company's typical interest expense as North Atlantic Drilling paid a total of $77.6 million in interest during the first three quarters of 2014. Meanwhile, North Atlantic Drilling had an operational cash flow of $72.8 million in the third quarter of 2014 and $117.5 million in the first nine months of 2014. Thus, North Atlantic Drilling's interest expenses are approximately 66% of its operational cash flow (as the company's operational cash flow exhibited wide variation over the first three quarters of the year, this figure was calculated using the nine months numbers). It is worth noting, however, that interest on debt is considered a cost of operations and therefore the numbers provided for operational cash flow are after North Atlantic Drilling has already made the interest payments. Thus, North Atlantic Drilling does seem to have a fairly large margin (although much smaller than Seadrill's) to allow its operational cash flow to fall before the company becomes unable to support its debt.

Given that the company's cash flow is likely to decline over the next few years, it is important to determine how much its cash flow will go down. In order to determine that, we must first determine how much revenue each rig generates. This is easy to determine. The revenue that a rig generates is equal to its dayrate plus the amortization of the mobilization fee. However, since the mobilization fee is merely a reimbursement of the money that the drilling contractor spent to get the rig to its assigned location, it does not represent new money for the drilling contractor and so we will exclude it from the calculation. Thus, the revenue that each rig generates is equal to its dayrate and this number is shown in the chart above. We also need to know how much it costs to operate a rig. Unfortunately, North Atlantic Drilling has never provided a figure for this. But, one of North Atlantic Drilling's peer companies, Pacific Drilling (NYSE:PACD) has. In a presentation to investors given earlier this month, Pacific Drilling states that it costs approximately $175,500 per day to operate an ultra-deepwater drillship. That number is relatively in line with figures provided by North Atlantic Drilling's parent company Seadrill. Admittedly, these figures are for benign-environment rigs and not the harsh-environment rigs that North Atlantic Drilling operates but as the dayrates for harsh environment-capable ultra-deepwater rigs are relatively similar to the dayrates awarded to non-harsh environment ultra-deepwater rigs, we can assume that the costs of operating a harsh-environment ultra-deepwater rig are not significantly higher than for a benign-environment rig but there will naturally be some added costs caused by environmental conditions. Therefore, we will assume that it costs approximately $185,000 to operate one of these rigs. Finally, it is important to consider the impact of taxation. According to Pacific Drilling, taxes on a per rig basis average approximately 4% of revenue. This figure is in line with numbers provided by Seadrill and other offshore drilling contractors. Given this, we can determine the cash flow generated by each of the rigs that the company owns that will go off contract in the next two years.

However, this does not tell the whole story. As already mentioned, interest paid on debt is considered a cost of operations. Thus, in order to determine the operational cash flow from each rig, we need to know how much North Atlantic Drilling currently pays in interest on each of these rigs. Fortunately, North Atlantic Drilling's parent company Seadrill provides some insight into this. In a presentation at the Howard Weil 42nd Annual Energy Conference, Seadrill provided this chart that shows the breakeven costs of owning and operating an ultra-deepwater rig:

Source: Seadrill Ltd.

As this chart shows, Seadrill incurs approximately $49,000 per day in interest expenses on the debt that it took on to construct the UDW rig in question and an additional $58,000 per day in principal repayment on the same debt. If we assume that the same is true for North Atlantic Drilling then this allows us to expand upon the above chart:

Thus, at first glance, it appears that North Atlantic Drilling's operational cash flow will decline by approximately $24.35 million per quarter once the West Navigator goes off contract in December. However, it is actually more complicated than this as North Atlantic Drilling will still need to pay interest and principal on this rig. This amount works out to approximately $107,000 per day or approximately $9.6 million per quarter. Thus, North Atlantic Drilling could see its cash flow decline by approximately $33.95 million per quarter in the first quarter of 2015 should North Atlantic Drilling fail to secure a contract for it (which looks unlikely at this point). At least some of this cash flow will return once the West Navigator begins its work for Rosneft; however, as stated above, this may not occur until 2018. Thus, North Atlantic Drilling will likely need to find work for this rig in the interim, otherwise it could see its operational cash flow drop to approximately $38.85 million in the first quarter of next year. This works out to approximately $155.4 million per year.

A similar calculation can be performed for the West Venture and the West Phoenix, which come off of their respective contracts in July 2015 and September 2015 respectively. As the chart above shows, the West Venture looks to be generating approximately $8.89 million in operational cash flow every quarter and the West Phoenix appears to be generating approximately $11.8 million in operational cash flow. Naturally, North Atlantic Drilling will lose that cash flow should these rigs go off contract without securing replacement contracts. As with the West Navigator, however, North Atlantic Drilling will still need to make the principal and interest payments on these rigs. This works out to approximately $19.2 million per quarter per the charts above. Thus, should both of these rigs fail to secure new contracts, the total adverse impact to North Atlantic Drilling's operational cash flow could be approximately $39.9 million by the fourth quarter 2015. This could certainly be enough to reduce the company's operational cash flow to negative $1.05 million per quarter in the fourth quarter of next year.

In addition, North Atlantic Drilling has a significant amount of debt maturing in the next few years. Here is the company's debt maturation schedule going forward:

Source: North Atlantic Drilling

As this chart shows, North Atlantic Drilling has $218.1 million worth of debt maturing over the next year and $214.2 million worth of debt maturing over the following year. As both of these numbers are approximately equal to North Atlantic Drilling's current annualized operational cash flow, the company should be able to use its cash flow to pay off this debt as it matures. Indeed, doing this is the reason why North Atlantic Drilling recently suspended its dividend.

However, as already discussed, North Atlantic Drilling looks likely to have its operational cash flow decline going forward. Thus, it is certainly possible that the company will be unable to pay off all of its debt as it matures, particularly in 2016 should it fail to secure work for its three rigs that come off contract in 2015 and will need to use some other method to handle that portion of the debt that North Atlantic Drilling cannot pay off with its operational cash flow. The most likely method that the company will use is to roll over its debt. Fortunately, the company does appear to have the ability to accomplish this. This chart shows all of North Atlantic Drilling's outstanding credit facilities:

Source: North Atlantic Drilling

As this chart shows, the company currently has an outstanding credit facility for $2 billion against which it has only borrowed approximately $1.4 billion. These credit facilities can be either term loans or revolving credit facilities and it is not certain what this particular facility is. North Atlantic Drilling described the other credit facility in its third quarter earnings results press release thusly,

"In October 2013, SFL Linus Limited entered into a US$475 million secured term loan and revolving credit facility with a syndicate of banks to fund the acquisition of West Linus, which has been pledged as security. SFL Linus Ltd. drew down on the loan at the delivery date of the rig in February 2014. Subsequently, US$40 million was repaid on the facility by Ship Finance International Limited ("Ship Finance") on behalf of SF Linus Ltd through a short-term parent loan as per March 31, 2014 and redrawn again as per June 30, 2014."

Despite the description of this loan as a revolving credit facility, this facility sounds more like a traditional term loan. If we assume that the $2 billion facility is the same as this facility, which it likely is, then North Atlantic Drilling will be unable to roll over that portion of its debt that it cannot afford to repay as it matures into this credit facility. If, however, the $2 billion facility is a revolving credit facility then North Atlantic Drilling can simply borrow against this facility to repay that portion of its maturing debt as it comes due.

Even in the absence of this option, North Atlantic Drilling does have other options available to it. One strategy that the company has used in the past is to essentially sell drilling rigs to another of John Fredriksen's companies, Ship Finance (NYSE:SFL), and then continue to operate it while it slowly pays Ship Finance back for the rig. The company may be able to do this again and thus receive the cash that it needs to pay off its maturing debt.

Another tactic that North Atlantic Drilling may use to pay off that portion of its maturing debt that it cannot pay off with its operational cash flow is to obtain a shareholder loan from Seadrill or even Rosneft, as the Russian oil giant will be a large minority shareholder in North Atlantic Drilling once the two companies close their pending deal. There is precedent for such loans. According to the company's third quarter earnings report, North Atlantic Drilling has received an unsecured revolving line of credit from Seadrill for $85 million. Currently, the company has $0 drawn against this facility and the facility is scheduled to mature on January 30, 2015 but there is no particular reason why Seadrill could not provide a new credit facility once this one matures.

Perhaps the biggest challenge to the company's solvency looks to be coming in 2017. This is caused by the $1.122 billion worth of debt that the company has maturing in that year. It is difficult to see how North Atlantic Drilling will be able to pay off all of that debt without rolling a substantial portion of it over. However, as I have previously predicted (linked above), the drilling market will likely remain weak throughout 2016 and some of this weakness will continue throughout 2017, although there should be some early signs of strength in that year. If that results in the marine credit markets continuing to be tight then the company may encounter financial difficulties. It is my expectation, though, that the company will pay off some of this with its operational cash flow and be able to roll over the rest as the strengthening market may increase the willingness of lenders to lend and that North Atlantic Drilling's balance sheet will be much stronger by that point.

Another potential risk to the company's financial future comes from the aforementioned and already discussed deal with Rosneft. As the chart above shows, a significant number of North Atlantic Drilling's rigs are scheduled to go to work for Rosneft once their current contracts expire. In fact, $4.1 billion of the company's $6 billion, or 68.3%, in revenue backlog is due to its multiple contracts with the oil giant. If for whatever reason this deal should fail to materialize (both companies have until May to unilaterally cancel the contracts) then North Atlantic Drilling will need to find alternative work for its existing rigs (it will likely cancel the rigs under construction). This might prove difficult. Other than in the Arctic, the primary location where harsh environment-capable rigs are used is in the North Sea and the Norwegian Continental Shelf (although some rigs that formerly operated in the area have since left for other markets). As the company notes in its third quarter earnings report, these two markets are currently being heavily influenced by the major oil companies cutting capital expenditures in order to improve their free cash flows. For example, Norway's Statoil (NYSE:STO), one of the largest operators in the area, plans to decrease the number of floating rigs that it employs in the region from 16-17 last year to twelve in 2015. Depending on how long this area suffers from this weakness, it could result in the company having difficulty securing replacement contracts for its rigs should the Rosneft deal not work out.

In conclusion, North Atlantic Drilling appears to be in no short-term danger of bankruptcy, although there are some pending difficulties that could arise in 2016 and 2017 depending on the overall situation in the broader industry and the status of the pending deal with Rosneft. While I expect that the company will be able to weather the industry weakness without going bankrupt, there will be some difficulty ahead for the company.

Disclosure: The author is long NADL, SDRL, STO, SFL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.