Friday, September 19, 2014

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.

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.

  • 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


  1. You didn't delve into this, but one of PGN's big clients - PEMEX - has the ability to terminate all of its 10 contracts with PGN's jackups rigs without any termination penalties. This could wipe out a good portion of PGN's backlog, leaving them much more vulnerable to any problems. Any thoughts on that?

    1. Sure, that's a concern as well, fair point. Going back a few years in Noble's filings and it appears to have been a feature of the Pemex contracts for some time. A sharp decline in day rates could cause them to terminate early to renegotiate, but of the long list of potential concerns at Paragon, the early termination possibility seems further down the list.


    2. Good point - this was a great write-up, in fact. I agree with you that standard-spec jackup market looks incredibly (and irrationally) undervalued at the moment.

      Also interested in what you think about PGN's prospects versus other offshore drillers. You mentioned HERO having an EBTIDA multiple of 4.7X (which appears to have actually decreased to 4.12X as a result of huge price drops). By my estimates, if PGN were to lose Petrobras' contracts, it would be valued at 4.47X EBITDA. Granted that this is a conservative assumption, but combined with my unease over PGN's management and the incompetence of the spin-off execution, I'm not sure PGN is the right choice here.


    3. That's well said too, unease is a good word to describe management here, they seem very puzzled by the market reaction to the spin. I hope its genuine and not confusion/panic. A basket approach might be best with the offshore drillers, although Transocean interests me with the Icahn factor, capital allocation might finally improve there. Thanks for reading and good comments.

  2. I thought that the stock might bounce on dividend news but the exact opposite happened.. Any view on that? Also, bad managements can destroy value in the best of businesses. This Stilley character appears to stand out in his incompetence so far i.e. Seahawk bankruptcy, tax rate surprise, backing himself into corner with 80 to 90 mm dividend guidance etc. I am scratching my head..why not buy back stock and then issue the juicy dividend?

    1. No view on why the market didn't view the dividend more positively, but agree with you, I would have preferred a buyback instead of the dividend, they have better uses for the cash than I do.

      Incompetent management is a pretty significant risk, I was discussing Paragon with someone that got burned pretty badly in Seahawk. Had a similar, its too cheap to be trading at these multiples thesis and it ended up getting liquidated.

      BTW - hat tip to you, JBGL ended up being a far more profitable asset than I anticipated, looks like you were right and I was wrong on that one.

    2. Appreciate the compliment. At the time i didnt have much to go with other than a notion that if Einhorn was saddling the co with such high coupon, then the biz simply had to cover it and then a lot more. Otherwise it would have been a bad deal for every one involved. The stock goes ex on tuesday and it will be interesting to see how the stub and rights trade.

  3. Take a look at their pricing & utilization, then take a look at how many gen5 & 6 rigs are coming online circa 2015/16. There is no way they maintain the run-rate EBITDA they do today, and management is still paying dividend to shareholders instead of upgrading their rigs for the pending train wreck. They will have to cut dividend and will have no way paying back the debt. Props to NE, and I see this very likely to be a 0.

    1. I have trouble getting to a 0. The first debt maturity isn't until 2021, and then minimum annual cash requirements including the dividend is about $450MM ($42MM dividend, $100MM interest expense, $200MM maintenance capex, $100MM taxes). EBITDA is clearly going to drop from the current run-rate, no argument there, but is going to drop 40%? They also have some flexibility with the undrawn $800MM to pickup a small accretive acquisition or two. I think to get to a 0, you need to assume the worst in terms of oil prices, rig supply, and then probably some management fraud/incompetence thrown in there too.

    2. Zero is a possibility but a remote one at this point. I think minimum maintenance capex is $300M. They renewed a number of contracts per the last fleet status report and day rates stayed flat so decent data point but too early to call this one either way. Lets see if the four idle rigs in the Arabian Gulf get new contracts at acceptable day rates...the Pertobras rollovers in May and October are as good as dead.

      BTW, I think CEO Stilley is an idiot and I say this from a purely professional standpoint, nothing personal.

  4. I capitulated and sold Paragon, while I still don't see it as an immediate bankruptcy risk which the market is pricing in, the tax loss and mental space it was taking for a small position ultimately lead me to sell. I think Paragon could be part of an interesting bombed out oil basket type trade in early 2015.

  5. Any thoughts on Donald Smith & Co Inc. and their 10% position? And what if Stilley learned what not to do at Seahawk?

    1. No (intelligent) thoughts on Donald Smith & Co acquiring the 10% stake other than it doesn't take a whole lot when the market cap is down to ~$200MM. Stilley was the wildcard, I initially thought he got a bad reputation for what happened at Seahawk when a lot of that was outside of his control, but everything he's done at Paragon just seems like it's been a defensive/reactive move to counter the slide in the stock. I really dislike the Prospector acquisition, doesn't look cheap, poor timing ahead of an even deeper slide in crude prices, used up their best asset in the revolver. The hurdle for an acquisition is just too high when you're bonds are trading where they are unless you think you need scrap the entire fleet. I sold and I'm still staying away, but it will be interesting to revisit along the way. Thanks for the comment.