- Company reports Q1/2020 results generally in line with expectations except for a massive $2.8 billion impairment charge mostly related to the decision to scrap a number of modern floaters.
- Valaris can't afford similar charges going forward as the company would otherwise violate debt covenants.
- Officially disclosed the engagement of restructuring advisors.
- Credit facility agent has reserved the right to assert that a material adverse effect has occurred which could result in lenders denying additional borrowings.
- Expect investors to be reluctant to provide new capital to the industry potentially resulting in a liquidation of the company. Investors should sell remaining positions and move on.
On Thursday, leading offshore driller Valaris released financial results for the first quarter 2020 which came in largely in line with expectations, except for a whopping $2.8 billion impairment charge, mostly related to the planned retirement of three modern drillships, four semi-submersibles and four jackup rigs and the decision to cold-stack nine additional rigs.
In fact, this is the first time an offshore driller commits to scrapping latest generation rigs.
The massive impairment charge has caused the company's debt-to-capitalization ratio to jump to 52.1% at the end of Q1 as disclosed in Friday's 10-Q filing with the SEC. While it would take another $1.7 billion in losses to exceed the 60% permitted under the terms of the company's revolving credit facility, additional impairment charges on modern rigs could easily cause Valaris to violate the covenant in the near future:
Our revolving credit facility requires compliance with covenants to maintain specified financial and guarantee coverage ratios, including a total debt to total capitalization ratio that is less than or equal to 60%. For the first quarter of 2020, we incurred impairments of $2.8 billion, and as of March 31, 2020, the total debt to total capitalization ratio was 52.1%. If activity levels of our customers remain at significantly depressed levels or further deteriorate, we could incur additional material impairments in future periods, which likely would result in our not being able to comply with such financial covenant. If we incur impairments or experience additional losses in the near future in excess of approximately $1.7 billion we would no longer be in compliance with such covenant.
If we exceed the total debt to total capitalization covenant in our credit facility, further borrowings under the credit facility would not be permitted, absent a waiver, and all outstanding borrowings would become immediately due and payable by actions of lenders holding a majority of the commitments under the credit facility. Any such acceleration would trigger a cross-acceleration event of default with respect to approximately $2.1 billion of our outstanding senior notes.
On the conference call, management also discussed a major change to its rig marketing approach:
We will not be keeping many rigs, particularly floating rigs available to pursue short-term work at near breakeven levels. That approach has more cash flow variability and was only successful at the rig level when high utilization was achieved. However, a nonworking available rig can be a material cash liability. Without meaningful cash flow being generated from our backlog and with our high cost of capital, we can no longer take the risk of keeping rigs available to pursue short-term work with a hopeful view on a near-term recovery.
In addition, the company officially disclosed having retained restructuring advisors to address its unsustainable debtload:
As we are taking rapid measures to address the financial impact of the challenging market conditions, we are also analyzing the cost to support our capital structure. With more than $6.5 billion of debt and an outstanding balance on our revolving credit facility, annual interest expense of approximately $400 million is our largest nonoperating cost by a wide margin. Therefore, we are evaluating various alternatives to address our capital structure and annual interest costs. To facilitate the evaluation of these alternatives, we are engaged in discussions with our creditors and their advisers around these alternatives, including, without limitation, a comprehensive debt restructuring, which may require a substantial conversion of our indebtedness to equity.
But the bad news doesn't stop here as the agent under the company's revolving credit facility has reserved the right to assert that a material adverse effect has occurred "based on changes in the oil market and certain company-specific operating incidents, including the drop of the blowout preventer stack off the VALARIS DS-8".
Should lenders indeed use this claim as a basis to deny further borrowings requests, Valaris would be left with cash on hand of $200 million at best as the terms of the credit facility preclude the company from drawings above this threshold.
With negative free cash flow of $230 million in Q1, Valaris would likely be out of funds within three months.
But even if lenders continue to permit additional drawings under the credit facility, the company will still face material difficulties to negotiate a comprehensive restructuring as simply equitizing the debt won't be sufficient given the company's massive cash burn.
Under current industry conditions, the restructured company won't be able to support any debt which would likely require new capital to be injected as equity.
The issue is already well-reflected in the company's bonds which mostly trade below 10% of face value.
Even if we assume annual cash burn being reduced to $350 million, in case of bankruptcy the company would likely require up to $1 billion of new capital for the bankruptcy court to confirm the plan of reorganization.
Depending on the amount ultimately drawn under the credit facility and the size of the required liquidity injection to successfully emerge from a potential bankruptcy, noteholders are apparently at risk of getting wiped out alongside equityholders as their claims are structurally junior to credit facility lenders.
At this point, there's apparently no viable path forward for Valaris as investors will be reluctant to commit new money to the industry for the time being.
As market conditions are unlikely to improve over the short- to medium-term, I do not expect Valaris to succeed in securing sufficient exit financing and would expect the company to be liquidated with its assets likely being sold for pennies on the dollar.
Regardless of what happens to the company, there's basically no hope left for common equityholders as even in case of successful debt restructuring, they would likely end up being wiped out.
With bankruptcy likely the ultimate outcome, investors should consider selling remaining positions or even outright shorting the shares as Valaris still carries a market capitalization of approximately $85 million.
That said, borrowing fees have already quintrupled over the past couple of weeks to about 22% p.a. at Interactive Brokers as of the time of this writing and might move even higher as evidenced by already bankrupt Whiting Petroleum (WLL) which has seen its stock rallying last week after shares became increasingly hard to borrow for shortsellers with fees now well exceeding 100% p.a.
Given this issue, investors should keep position sizes in close check and prepare to stomach some major volatility in the weeks and months ahead.
Expect Valaris to muddle along with additional draws under its credit facility for the time being with $1.3 billion still being available to the company at the end of Q1 but lenders might decide to pull the plug at any time now by asserting the above discussed "material adverse effect" on the company's business.
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This article was written by
I am mostly a trader engaging in both long and short bets intraday and occasionally over the short- to medium term. My historical focus has been mostly on tech stocks but over the past couple of years I have also started broad coverage of the offshore drilling and supply industry as well as the shipping industry in general (tankers, containers, drybulk). In addition, I am having a close eye on the still nascent fuel cell industry.
I am located in Germany and have worked quite some time as an auditor for PricewaterhouseCoopers before becoming a daytrader almost 20 years ago. During this time, I managed to successfully maneuver the burst of the dotcom bubble and the aftermath of the world trade center attacks as well as the subprime crisis.
Despite not being a native speaker, I always try to deliver high quality research to followers and the entire Seeking Alpha community.
Analyst’s 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.
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