Paragon Offshore's Restructuring Agreement Trades Some Short-Term Gain For More Potential Long-Term Pain

| About: Paragon Offshore (PGNPQ)


Paragon Offshore announced a comprehensive restructuring in order to delever the company's balance sheet.

The changes will be implemented through a chapter 11-filing in mid-February.

Existing shareholders will continue to own 65% of the restructured company.

A substantial amount of debt remains on the balance sheet while liquidity after payments due to bondholders and banks looks rather tight.

While management did a great job preserving some short term value for their shareholders, it missed the chance to better position the company for a tough future.

Paragon Offshore (PGNPF) finally revealed some details of its long-awaited financial restructuring plan and, in fact, was able to land a major coup by preserving large parts of the company for its existing shareholders.

First and foremost, I have to admit that I have been BADLY WRONG about the ultimate outcome of this issue. I would like to offer a big "mea culpa" to each and everyone who constantly put his faith into the company and its management.

After the recent restructuring announcements of Hercules Offshore (NASDAQ:HERO) and Vantage Drilling (OTCPK:VTGDF) with little or even no recovery for existing shareholders I fully expected Paragon Offshore to go down the same road but management actually proved me wrong.

So let's now get into the details currently available:

  • Bondholders will exchange close to $1 bln in senior unsecured notes for $345 mln in cash and 35% of the equity of the restructured company. Should certain EBITDA targets be met in 2016 and 2017, the bondholders might receive another $50 mln in cash in aggregate.
  • Paragon Offshore will pay down $165 mln of the current revolving credit agreement that in exchange will be converted into a term loan with a modest LIBOR plus 4.5% interest rate but a $110 mln minimum liquidity covenant. In addition, the maturity date will be extended to 2021. The net leverage ratio and interest coverage covenants will be suspended for 2016 and 2017 but will be reintroduced in the first quarter of 2018.
  • The restructuring will reduce annual interest payments by close to $60 mln.
  • Existing shareholders will retain a 65% ownership in the restructured company.
  • Former parent Noble Corporation (NYSE:NE) will assume certain of Paragon's potential Mexican tax liabilities.

While the indebtedness under both outstanding high-yield bonds will be eliminated entirely, the company will still carry a substantial debt load of more than $1.5 bln after the restructuring consisting of:

  1. The old term loan facility with an outstanding balance of $640 mln at the end of September 2015 (interest rate 3.75%).
  2. The new term loan facility with an outstanding balance of $631 million after the agreed down payment (interest rate 5.5%).
  3. The outstanding $289 mln obligation in connection with the recent sale and leaseback transactions with SinoEnergy (interest rates of 5.2% and 7.5%).

In addition, the restructured company's available liquidity looks pretty tight after taking into account the $165 mln down payment on the former revolving credit facility and the $345 mln cash payment due to the former bondholders. Moreover, the company will have to maintain a $110 minimum liquidity covenant. In the restructuring FAQ section on its website the company is pointing to a "more than $750 mln cash balance" as of today. So subtracting the upcoming cash payments and the $110 million minimum liquidity covenant would leave Paragon Offshore with available liquidity of just a little over $130 mln after emerging from bankruptcy which I hardly view as adequate, given the size of the company and the current state of the industry.

Finally, the negotiated debt covenants suspension will reverse already in Q1/2018 which does not look appropriate given the company's very low contract coverage and the current weak industry environment which might persist even well beyond 2018.

As of today, Paragon Offshore has 19 (out of a total of 40) rigs working with 10 of them rolling off contract this year and another 6 in 2017. The remaining rigs will roll off contract in 2018.

Given the lower interest obligations, 2016 might actually see the restructured company generate some positive cash flows, but another $20 mln will have to be assigned to the former bondholders as there's little doubt that the 2016 EBITDA threshold set in the restructuring agreement will be met.

But, in 2017 the company will very likely start to burn sizable amounts of cash and this pattern will only accelerate going into 2018. So without a very substantial short-term recovery in oil prices and a subsequent material offshore exploration activity increase, Paragon Offshore looks poised for another restructuring in 2018 at the latest date - quite similar to Hercules Offshore. The difference is, that Hercules' restructuring negotiations took place with oil at above $60 while Paragon's management already knew about the much tougher than anticipated industry downturn and still decided to take the gamble.

So all in all, the company has managed to prevent their shareholders from getting wiped out for now but in return remains burdened with a substantial debt load and a seemingly very tight liquidity balance.

While I appreciate the outcome for the company's badly-stricken shareholders, I think the measures taken by the company aren't appropriate to ensure Paragon Offshore's viability after 2017.

After all, it might have been better to refrain from cash payments to the company's bondholders and instead hand them over a larger part of the company in order to preserve another $345 mln in liquidity.

In fact, the bondholders will be the major winners of this restructuring as they stand to pocket up to 40% of the bonds' face value in cash compared to market expectations in the mid-teens when judging by the latest bond prices. Furthermore, they will have some ongoing skin in the game through the new 35% equity stake.

Even the banks managed to get back some of their cash in the restructuring and moreover will not have to write off parts of their loan exposure to the company for now. In fact, their position has remained entirely intact which is a very rare outcome.

Lastly, equityholders are also big winners - at least for now - with 65% of the restructured company still being owned by them.

But, given the current and expected market conditions, the creditors and management will most likely find themselves back at the negotiating table at the end of 2017 at the latest date in order to hammer out another restructuring which then would require much deeper concessions from both sides.

For now, the restructuring agreement puts Paragon Offshore back in line with the weaker part of its peer group like for example Pacific Drilling (NYSE:PACD), Ocean Rig (NASDAQ:ORIG) and Seadrill (NYSE:SDRL) which all potentially face major debt restructurings in 2017.

So what kind of value can be assigned to the equity at this point ? At Friday's closing price of $0.34, the market cap of the restructured company stands at roughly $45 mln, but when including the remaining sizable debtload adjusted for the cash on hand Paragon Offshore's enterprise value actually calculates to more than $1.3 bln.

To put this into perspective, investors should take a look at the recently restructured Hercules Offshore which is actually trading at a NEGATIVE enterprise value with the company's current cash balance still eclipsing its debt. Granted, the business is burning sizeable amounts of cash, but the company in fact has a catalyst kicking in this year with the addition of a brand new jackup rig to its fleet that has a multi-year high margin contract with Maersk. In addition, management last week decided to explore strategic alternatives. Besides me, fellow contributor "Fun Trading" has also published an article on the issue that can be accessed here.

So, just like many of its peers, the company's shares can be best viewed as an option on a very material short-term oil price recovery with a corresponding substantial increase in offshore exploration activity. But even an uptick in demand would most likely not be accompanied by an increase in dayrates, given the industry's current unprecedented oversupply situation.

For interested investors I already expressed my views on the current and future situation of the offshore drilling industry in a detailed article at the beginning of the year. Given the abysmal prospects, I fully expect the company's announced measures to fall significantly short of the actual requirements resulting in just another round of restructuring actions roughly two years from now.

The company's remaining backlog at the end of FY15 calculates to roughly $1 bln with more than half of this work to be performed in the current fiscal year. With virtually no tendering activity currently in the market, there's little hope for material contract awards and while some minor extensions might still be in the cards, the expected dayrates will only cover the company's operating costs - if lucky. Actually, competitors like Seadrill already offer short-term contract drilling work BELOW their operational costs in order to avoid stacking expenses.

Frankly speaking, the company needs some kind of oil price miracle pretty soon in order to remain a viable business beyond the end of next year. At least, they are not alone in this as many of their industry peers will face the very same fate at that time.

Bottom line:

I have been badly wrong about the outcome of this long-awaited restructuring, but unfortunately management decided to trade a short-term gain for even more potential long-term pain, as they inexplicably agreed to advance more than half a billion dollar in much needed cash to banks and bondholders leaving the company with only a little over $130 mln in available liquidity which looks just enough to take Paragon Offshore through 2017. In addition, the company will continue to carry a hefty debtload of more than $1.5 bln with some temporarily suspended credit covenants being reintroduced in 2018.

So all in all, the agreement buys Paragon Offshore roughly two years of additional time but otherwise does very little to address the structural challenges of the company as debt remains still high and liquidity, in fact, is taking a major step backwards.

Without a short-term oil price miracle and a subsequent large uptick in offshore exploration, activity management and creditors will find themselves back at the negotiating table rather sooner than later and equityholders should not expect to get an equally sweet deal at that time.

Even from a valuation perspective the company does not look cheap here, given that the only already restructured peer available for comparison does currently trade at a negative enterprise value compared to more than $1.3 bln for Paragon Offshore.

For the time being the shares should be viewed as an option on a quick and very substantial oil price recovery but I would actually advice investors looking to take a long shot on oil to focus on a more direct exposure to the commodity and avoid the offshore drilling group as a whole as even in the case of higher oil prices this industry will continue to face serious structural issues like for example a heavily oversupplied rig market, an industry shift to shale oil and a general trend to de-emphasize deepwater exploration. The industry will most likely remain under pressure for many years to come with most of the damage still in front of us.

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.

Additional disclosure: As a daytrader I have actively traded the company's shares in the past and may consider to do so going forward.

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