Paragon Offshore: Cigar Butt Spinoff

Paragon Offshore (PGN) is a 'standard specification' offshore rig business that was spun off of Noble Corporation (NE) and began trading on 8/1/2014, standard specification in the offshore industry means old and shallow water.  Noble initially attempted to conduct an IPO of the unit, but later scrapped that idea in favor of a rushed spinoff that ended up putting $1.6 billion in debt on Paragon, but immediately improved the optics of Noble's fleet.  Noble CEO David Williams said on a conference call to analysts that without the spinoff, Noble's fleet would have an average age of 35 years by 2016, now that it has shed the older equipment, the average age is 13 years.  

Paragon is once again, your classic spinoff of the 'bad asset' business to make the parent company appear more attractive.  In these situations we can often expect investors who receive shares in the spinoff to sell indiscriminately.  Since Paragon began trading it has basically been a falling knife, down more than 50% as it has suffered both from spinoff dump dynamics and poor timing as clouds have formed over the offshore drilling market.  

The offshore drilling market, especially the deepwater market, can be thought of as the marginal oil supply.  As the onshore/fracking market has increased oil supply, the result has been a pullback in the development of more expensive offshore oil and gas plays by the national and independent oil companies.  At the same time, many offshore rigs that were ordered in good times are scheduled to be delivered in the next 1-3 years just as the market softens creating an excess supply of rigs, particularly in the deepwater segment.  Day rates for jack-ups have stayed fairly steady, but there's some concern that oversupply in the deepwater market will force some high-specification floaters to move down market and compete in the standard-specification market (where Paragon primarily operates) driving down utilization and day rates there as well.  There are 139 (or an additional 30%) new build jack-ups scheduled to be delivered through 2017, however some of these might never make it to market as more than half are being built by speculative non-operating buyers.  The bull case rests on shallow water demand being there, and supply being more spread out than it currently appears.

Paragon's strategy is to be a low-cost, efficient provider focused on the shallow market.  Management claims to have the "best of the old rigs out there", a fleet of 34 jack-ups and 8 floaters.  The main concern around Paragon's assets is the age of their rigs, the average is over 35 years old.  However, some context, the majority of their rigs are jack-ups designed for shallow water, the average age of rigs in that market is more than 25 years old.  Yes, Paragon's rigs are on the older end, but it's generally unfair to compare the fleet to a modern deepwater driller like Seadrill (SDRL) whose EV/Rig ratio is many multiples of Paragon's.  Additionally, Noble spent approximately $1.8B on Paragon's fleet since the beginning of 2010, including $900MM on the floaters where much of the backlog is and all of which have been rebuilt since 2009.

There also seems to be some concern around Paragon's $2.3B backlog, much of it rolls off by mid-2015 potentially exposing the company to the worst of the oversupply situation.

However, key markets like Mexico have been opening up their energy markets, thereby potentially increasing drilling activity there (mostly shallow water gulf drilling), and Paragon's management has guided that the 4 jack-up rigs in the Middle East which are idle are expected to be operational in Q1 (which matches up with what other competitors are calling a hot market in the Middle East).  Another concern is around the 4 floaters which are currently contracted out to Petrobras (with 2-3x the typical jack-up day rate), Petrobras has 29 floaters coming online which could force out Paragon's older floater rigs when they come up for renewal.  But as mentioned earlier, Noble rebuilt each one of these in the past few years, and hopefully they'd be able to place them with new clients with only moderate downtime or expense.

Capital allocation is a bit of a question market with Paragon being such a recent spinoff.  In the initial prospectus, Paragon guided to a $80-90MM annual dividend, at the mid-point, the current yield would have been 14-15%.  Today they announced a $0.50 dividend on an annualized basis, which is roughly half the original guided amount, but still a 7% yield that should attract income based investors.  It also gives management more room to maneuver and address some of the market's concerns about their fleet.  Another option for excess free cash flow is buying back some of their debt in the open market, it's currently trading at a fairly significant discount (80-90) making any buybacks immediately accretive to the equity.  Paragon doesn't have any new builds in the pipeline, but they have stated in investor calls they'd be open to being a buyer of distressed rig assets as well if the industry does experience a downturn.

Valuation
Paragon is in deep value territory assuming you believe it can survive the current cycle.  With a current market capitalization of $575MM and net debt of $1.61B, Paragon has an enterprise value of $2.19B, analysts estimate 2015 EBITDA at $767MM giving PGN a EV/EBITDA multiple of just 2.9x which is basically unheard of in today's market.  Hercules Offshore (HERO) is Paragon's closest peer, operating a number of standard-spec jack-ups in the Gulf of Mexico, trades at 4.7x EBITDA even in this depressed market for offshore drillers.  On a P/E basis, Paragon is expected to earn $157MM in 2015, for a forward P/E of 3.66x.

Even if these estimates are too high, if you cut the $827MM in EBITDA for 2014 in half to $413MM it's still trading at just over 5x EBITDA.  So the market is pricing in the worst, half the rigs working and at lower rates.  Liquidity shouldn't be an immediate concern either as their first maturity is a $650MM term loan due in 2021, and then two tranches of senior unsecured debt due in 2022 and 2024.  They also have in place an undrawn $800MM revolving credit facility at LIBOR + 2.00% if needed.

Risks:

• Paragon's rigs are old, even if well maintained, many will likely need to be retired or rebuilt in the next several years; scrap value for jack-ups = $5MM, floaters = $10MM
• High effective tax rate (50%) in 2014 and early 2015 due to poorly executed/rushed spinoff; Noble skimped on a few corporate structure items that would have delayed the spinoff, tax rate should be in the mid-20s by 2016
• Half of Paragon's contracts come up by Q3 '15; modern-high specification rigs may move down market if deep water market is oversupplied and complete with Paragon's standard specification rigs, driving utilization and day rates lower
• Petrobras has 29 floaters coming online, but repeatedly delayed; Paragon's floaters may not get renewed or have significant downtime in the future as they find new projects; 18% of Paragon's EBITDA is to Petrobras
• CEO Randy Stilley was previously at a similar standard-spec spinoff Seahawk Drilling, which went bankrupt and was liquidated (assets were sold to HERO) after the BP Macondo disaster disrupted Gulf of Mexico drilling
• Offshore drilling is extremely cyclical; stocks in cyclical industries look the cheapest at the top

There seems to be a lot of fear and concern around the offshore drilling industry, I'm honestly a relative novice in this sector, only really deep diving into it in the last several weeks, so do your own research here.  It appears to me that Paragon could be a classic "cigar butt" trade, not one that will generate great returns over the long run, but it really needs to only survive long enough for the market to rebalance itself to be a satisfactory investment.  I initiated a starter position yesterday.

Disclosure: I own shares of PGN