Pacific Drilling Is Undervalued

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About: Pacific Drilling S.A. (PACD)
by: Vladimir Zernov
Summary

Pacific Drilling reports Q4 results and holds conference call.

I analyze the company's fresh-start accounting balance sheet.

Pacific Drilling's balance sheet numbers reflect reality. The difference between shareholders' equity and current market capitalization is substantial.

Low liquidity of the stock is the main problem that hurts potential upside at this point.

Pacific Drilling (PACD) has recently reported its fourth-quarter results, filed its annual report, and held its conference call. These reports are especially interesting since they come with fresh start accounting as the company has emerged from bankruptcy in November 2018. In this article, I want to discuss the company's current position, valuation, and key comments made during the earnings call. I won't focus on Q4 numbers, which can be easily accessed via the company's website and represent little interest for investors at this stage.

Balance sheet and valuation

Pacific Drilling's fresh start accounting provides a great opportunity to look at the balance sheet which is free of distortions that arise in the course of a company's operations. It is especially interesting to compare the balance sheet value of Pacific Drilling rigs with the independent estimates provided by Bassoe Offshore. Without further ado, let's look at both sides of the balance sheet, one by one.

Source: Pacific Drilling annual report

Pacific Drilling had $368 million of cash on the balance sheet at the end of 2018. It's a sufficient amount of liquidity to ensure the company's viability. The company valued its property and equipment at $1.9 billion, down from the previous value of $4.65 billion. Bassoe Offshore estimates that the value of Pacific Drilling's fleet is $1.77-1.96 billion, an average of $1.86 billion. Since Pacific Drilling's rigs are either drilling or warm-stacked (more on this in my recent article on the fleet status report), I believe that Bassoe's fleet value estimate is accurate - and so is the balance sheet value.

Source: Bassoe Offshore

I'd note two balance sheet lines - "receivable from unconsolidated subsidiaries" and "intangible asset". The receivable (which previously went under the "long-term receivable" line) is the company's claim related to construction of Zonda drillship. Two subsidiaries which hold Zonda filed a separate plan of reorganization and remain involved in arbitration with Samsung Heavy Industries, the maker of the drillship. At this time, the date of the ultimate arbitration ruling is not known, but the company expects decision within the next several months as per the annual report. Should the company prevail in arbitration and receive the cash proceeds from Samsung, it will have to use part of them to repurchase First Lien Notes (more on debt below). In case the court rules in favor of Samsung, subsidiaries holding Zonda will be liquidated, and Pacific Drilling will write off $205 million.

The intangible asset represents the value of Pacific Sharav contract, which is above current market rates. This value will be amortized as time goes by until the end of the rig's contract in August 2019.

Source: Pacific Drilling annual report

Pacific Drilling's debt consists of $747.4 million 8.375% First Lien Notes due 2023 and $291.9 million Second Lien PIK Notes due 2024. The company's guidance indicates 2019 interest expense at $95-98 million. Even in the current situation of low dayrates, the company's cash cushion, together with the positive cash flow provided by Pacific Sharav contract, ensures Pacific Drilling viability.

Given the fact that Pacific Drilling's balance sheet equipment value appears correct, the shareholders' equity value should be also close to reality. The biggest unknown is the Zonda arbitration, which, under the negative scenario, can cut shareholders' equity to ~$1.4 billion, which is still bigger than ~$1.1 billion valuation provided by the market right now.

Interesting comments made during the earnings call

Pacific Drilling is optimistic on dayrate upside in 2020:

"[…] projected utilization numbers along with our view on the future demand in the market reinforce our belief that we will see substantial day rate improvement starting early 2020".

Given this view in combination with the post-restructuring liquidity position, it's logical that Pacific Drilling wants to hold off its rigs to wait for better dayrates:

"We are focused on securing work with the Bora at increasing day rate levels for the remainder of 2019, while maintaining our optionality for the rest of the fleet for the expected market return in 2020 […] Our expectations for the sector are that fixtures will exceed $250,000 in the second half of 2020".

I share the view that drillship rates will gradually increase, especially for the top rigs. I'd also note that rates in the $250,000 area in the second half of 2020 - beginning of 2021 will be way below the optimistic projections that served as the basis of the recent Transocean (RIG) - Ocean Rig deal. Another thing to consider is that dayrates of $250,000 are most likely not sufficient enough to bring any of the cold stacked drillships back to life, further lengthening their cold stacked stay and increasing future reactivation costs.

On the topic of reactivation costs, Pacific Drilling stated that taking Pacific Khamsin from smart-stacked state to hot-stacked state will require investments of $15 million. Speaking about the other rigs in the fleet, Pacific Drilling estimates that it will take $10-20 million to bring them into the ready to work state. Given these numbers and the current liquidity numbers, I believe that Pacific Drilling's fleet will likely be able to survive - all seven rigs.

Another interesting comment from the Pacific Drilling earnings call was related to the labor inflation, a topic that has started to arise in offshore drilling-related discussions. Interestingly, the company sees no labor inflation at all. This is a good development for offshore drillers (and a disappointing news for workers, of course) which should be monitored closely as the market slowly heats up.

Conclusion

Pacific Drilling appears undervalued at this point, but certain factors may keep it from sustainable upside. The company's shares have low trading volume after restructuring, which keeps them out of radar for many players. Also, the company has to incur material interest expenses, which, in combination with the still weak backlog and current low dayrates, will lead to the decrease of cash position. Pacific Drilling would have easily captured a premium over current market capitalization in an M&A deal, but big players are out of ammo after Transocean - Ocean Rig and Ensco (ESV) - Rowan (RDC) deals, while Diamond Offshore (DO) continues with its conservative strategy, and Noble Corp. (NE) simply has no funds for such endeavor due to low cash cushion and high debt load.

The low trading volume is the biggest practical problem at his point, although patient investors willing to give this situation a shot may try to slowly establish a small position over time. Those searching for momentum will be better off waiting until more trading interest comes into the company's shares.

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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: I may trade any of the above-mentioned stocks.