I recently wrote about fresh details on Pacific Drilling's (NYSE:PACD) restructuring plan. As a reminder, Pacific Drilling is one of the most troubled drilling companies, suffering from poor backlog, upcoming maturities and exposure to the UDW segment of the offshore drilling market. Pacific Drilling creditors offered the company a debt-to-equity swap that would have left 2% of post-reorganization equity in current shareholders' hands. The news was refreshing to common shareholders as in the other case they were facing a complete wipeout, due to huge debt load and lack of any recovery prospects for the UDW segment.
Other ongoing restructurings involve Seadrill (NYSE:SDRL) and Ocean Rig (NASDAQ:ORIG). While the market capitalization of Ocean Rig fluctuates around $60-$70 million, Seadrill's capitalization stands above $700 million even after all the recent downside in the company's shares. Put simply, the stock market still expects that Seadrill shareholders will get something material in the restructuring.
Earlier this year, Seadrill made public its proposal to bondholders and bondholders' counter-proposal to the company. In my view, both proposals were out of touch with reality. So it was no surprise that the company indicated that material additional amendments to the terms of the proposed banks amendments were necessary to raise new capital and hopefully avoid entering Chapter 11 proceedings.
Just like in Pacific Drilling's case, Seadrill's problem (besides the worst downturn in the industry history) is debt. Everything is wrong about debt: wrong size, wrong maturity schedule. The offshore drilling industry will definitely find its place in textbooks on the risks of financing long-term projects with shorter-term debt.
Unfortunately for all stakeholders in Seadrill's case, the "kick the can down the road" solution simply does not work. Debt should be cut meaningfully to decrease interest payments and allow Seadrill to deal with newbuild deliveries and to navigate the severe industry downturn. Another main obstacle in Seadrill's restructuring is that the majority of debt is owed to banks, which are typically less inclined to debt/equity swaps than bondholders. Nevertheless, the debt should be cut for Seadrill to become a viable enterprise. Banks should get something if they agree to reduce their claims, and Seadrill has nothing to offer except equity.
That's where the Pacific Drilling restructuring may serve as a good example. Creditors offered to turn all debt into equity for a 98% stake in the company, leaving common shareholders with 2% of post-reorganization equity. The company will likely try to push creditors and negotiate a better deal for shareholders, leaving them with 3% to 4% of post-reorganization equity.
Let's look at how such a scenario will play out for Seadrill. Suppose that all debt is swapped into equity (I use debt at face value as of latest earnings report in this calculation). Assuming that common shareholders get 2% to 4% of post-reorganization equity, their stake will be valued at $200 million to $400 million. This implies significant downside to current valuation in the $700 million to $800 million range. Don't forget that Seadrill shares are highly volatile, so the company's valuation could easily return above $1 billion in a one-day move. In this case, potential downside will be even larger.
This calculation shows that if Seadrill follows Pacific Drilling steps, further downside should be expected in the near term. However, Seadrill's case is more complicated and we cannot just stop at looking at a debt/equity swap. First, the company indicated that it will need to raise about $1 billion of capital. Many believe that this capital will come from Seadrill's founder John Fredriksen. I would note that I take nothing for granted given the fact that the industry downturn is unprecedented.
Whatever the source of this capital, it could demand a share in the company. In all likelihood, many institutions will be willing to lend money to Seadrill if it was able to convert all debt into equity and emerge debt-free after the reorganization. However, this is a scenario that's quite likely to remain purely theoretical as banks have already proved in their previous proposal that they want money, rather than equity. In fact, they had to rely on extremely optimistic assumptions to plug in favorable bank amortization schedule. Also, Seadrill will have to deal with related companies North Atlantic Drilling (NYSE:NADL), which is likely to be reabsorbed by Seadrill, and Seadrill Partners (NYSE:SDLP), whose fate is not decided yet.
In my view, a simple debt/equity swap solution cannot be implemented in Seadrill's case. Pacific Drilling's case will likely be unique (if the company agrees to the creditors proposal), and other companies will negotiate other ways out of this deal. However, applying Pacific Drilling's case to Seadrill's situation is instructive as we can look at resulting valuations in a rather favorable deal. I have to reiterate that such a deal is favorable because shareholders stand to lose everything should Pacific Drilling or Seadrill file for Chapter 11 due to heavy debt load and absent any signs of recovery.
In order to have fundamental upside from current levels, Seadrill will have to negotiate a deal that will not wipe out shareholders completely, and at the same time cut the debt by a significant amount. Whether such a deal could be reached remains a big question. Seadrill is still a stock for active traders, and investors would be better off watching the story from the sidelines because the risk of losing the investment entirely is significant in this case. Recent news from Pacific Drilling highlights what is "significant dilution" for shareholders -- they'll be lucky to own a tiny percentage of the company after restructuring.
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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: I may trade any of the abovementioned stocks.
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