Paragon Offshore Report Sept 2014 Dichotomy Capital

1
Dichotomy Capital LLC info@dichotomycapital.com Scarsdale, NY

Dichotomy Capital LLC
Contrarian and Research Driven

Paragon Offshore PLC (PGN) $6.22 September 2014
Investors who look backwards will like Paragon, a recently spun-off collection of oil drilling rigs from
Noble Corp. Paragon screens well, enjoys plenty of backlog, and has initiated a dividend that would yield
8% at current prices. Digging deeper though, investors would see a company that will encounter a
number of issues over the short-term that will cause declining cash flows and a potential suspension of
the dividend.
At current prices, I believe that Paragon offers more than 50% downside under base scenarios and the
equity could go to zero if a surplus of rigs causes a downturn in rig rates to continue. There was a reason
Noble spun-off these assets and loaded Paragon up with debt. Besides the longer term catalyst of lower
rig rates and poor renewal economics, near-term technical selling from existing Noble shareholders and
a dividend cut may cause investors to rush for the exits.
Spin-Off of Assets from Noble
Popularized by Joel Greenblatt in You Can Be a Stock Market Genius, spin-offs are the darling of the
investment world these days. There are vehicles dedicated to spin-offs and popular investment sites
routinely tout newly formed spin-offs. The mechanism is simple: often times a spin-off is ignored by
most Wall Street analysts due to a different business, lack of a long-term track record, or small size
relative to the parent.
However, and I am sure Mr. Greenblatt will be the first to acknowledge this, each spin-off is different
and a requisite analysis is key to each security. For every successful spin-off there could be a Tronox,
which filed bankruptcy shortly after being spun-off from Kerr-McGee (now Anadarko Petroleum), who
loaded the company up with environmental liabilities. While I do not believe Noble Corp is acting in a
sinister manner, the company is clearly getting rid of undesirable assets and the liabilities that go along
with them. Long investors of Paragon will note that CEO Randy Stilley is familiar with spin-offs. Mr.
Stilley was also the CEO of Pride International spin-off Seahawk Drilling. It is worth noting that Seahawk
filed for bankruptcy in 2011, two years after being spun-off.
On August 1, 2014, Noble Corp completed the spin-off of Paragon Offshore, where Noble shareholders
received 1 share of Paragon for every 3 shares of Noble they received. The basic outline of the spin can
be seen in the table below.

2


Table 1. Paragon Offshore Spin Overview. Source: Company Filings, Presentations
Jack-Ups Operating 33
Drillships Operating 4
Semi-submersibles Operating 2
Backlog (B) as of 6/30/2014 $2.3
Debt (M) $1,730
Cash $120
Shares Outstanding (M) 84.753
Current Market Cap (M) $623
Current Enterprise Value (M) $2,233
In a recent Barclays conference, Paragon disclosed expectations for operating expenses and capital
expenditures. Strangely, they did not mention revenue or EBITDA expectations in any of the slides. Using
the Fleet Status Report, I was able to back into H2 revenue estimates (Appendix 1.). The table below
shows my revenue estimates and calculates free cash flow (FCF) from Paragons estimates. The bull
estimate assumes that revenue includes all performance bonuses in Brazil. The bear estimate assumes
that these performance bonuses are not met.
Table 2. Second Half 2014 Income

H2 Bull Estimate H2 Bear Estimate
Revenue $886.0 $870.0
Operating Expense $453.0 $473.0
SG&A $30.0 $35.0
EBITDA $407.0 $362.0
Interest Expense $47.0 $53.0
Estimated Tax $72.5 $72.5
Capital Expenditures $200.0 $220.0
FCF $83.5 $16.5
Annualizing these figures we arrive at FCF ranges of $167-$33 million and annualized EBITDA of $814-
$724 million. Compared to a market cap of $623 million and an enterprise value of $2.23 billion, the bull
estimates look cheap. The figures above do not adjust for Nobles interest in the cash flows, since Noble
spun-off the assets mid-quarter. If adjusted for the interest, FCF would be materially lower in H2. It may
seem strange that Noble would spin-off such valuable (on a backwards looking basis) assets. Based on
conference calls and presentations, it seems fairly likely that Noble simply wanted to get rid of these
assets. For example:
-In a June 2014 presentation Noble highlights that revenue is shifting from JU to Ultra deep water. The
shift is dramatic. In 2009 50.2% of Nobles revenue was generated from standard jackups. In 2016 Noble
estimates that only 4.1% of revenue will be generated from standard jackups.

3

-In the Q2 2014 conference call, Nobles management team stated In the absence of these
transformative measures (the Paragon spin), our average fleet age wouldve increased to 35 years by
2016. Conversely, the actions taken wouldve allowed us to reduce the average fleet of our the average
age of our fleet of (sp)13 years by 2016. Management goes on to elaborate on why their high-
specification JU rigs are superior. There is clearly a goal to reduce the age of assets, increases contract
committed rigs, lower capital expenditures, and focus on high-spec rigs.
-Perhaps most notably, Noble tried to sell their lower spec (Paragon JU fleet) assets in 2012 but failed.
When all else fails, spin the assets off to your shareholders, load the company up with debt and recoup
the lost sale proceeds via debt.
The last point raises an interesting question why would Noble have trouble selling their rigs? One
possible answer lies in the age of the fleet and the required maintenance for aging rigs.
Rig Maintenance
Paragon has 39 rigs that are, on average, 34.5 years old, 19 have been rebuilt. David Williams, Noble
Corps CEO, mentioned in the Q1 2014 conference call that the rebuilt rigs were refurbished in midlife,
implying an effective age of ~17 years for rebuilt rigs. Older rigs are more expensive to maintain and
require steel renewal, equipment upgrades/replacement, new paint, and accommodation upgrades.
These repairs are not cheap and typically range from $10-$30 million.
With 19 of their rigs rebuilt, 20 rigs have yet to undergo a major refurbishment. Using a range of $10-
$30 million/rig, a fleet wide refurbishment would cost anywhere from $200 to $600 million. Given the
age of the rigs, a complete refurbishment would probably be in excess of $400 million, the mid-point to
that estimate. The lack of rebuilds is surprising, especially given the age. Management is guiding for a
capital expenditures of roughly $200 million. This will be a very difficult goal to hit given the number of
rigs that need a major overhaul. The guidance also sharply diverges from H2 2014 capital expenditures
of $200-$220 million.
These costs, and the daily costs of operating the rigs, go up as the rigs age. This isnt good for Paragon
unless rates start to rise faster than operating cost inflation. So what could rates do?
Rig Rates
Predicting worldwide trends is difficult, luckily for Paragon investors, I believe there are only three areas
that matter: the North Sea, Brazil, and Mexico. Currently the most profitable region for Paragon is the
North Sea, contributing 33% of EBITDA (roughly $126 million in H2 2014 by my calculations) via 7 JUs
and 1 semisubmersible. The graphic on the next page shows the divergence between high spec rigs
(Paragon has none) and standard spec rigs in the North Sea.
It is clear that while rates have risen overall, high spec rigs have enjoyed a much greater rise in the past
few years. I highlight this because the delta appears to be growing, while Paragons maintenance costs
should keep rising.

4

Another area of importance to Paragon is Brazil, home of 4 highly profitable Paragon drillships. Brazil
has yet to renew a contract in the past year in the Campos Basin, according to management at Paragon
in a recent conference call. Management admits they dont know what will happen in Brazil, but they
believe it is likely that one of their floaters up for renewal will not be renewed. The table below shows
my estimates and is based on information provided by Paragon in their presentations. I assumed an
EBITDA margin of 30% for both rigs, which is below the EBITDA margin for Paragons Brazilian fleet.
Table 3. Brazil Rigs Income, all figures in thousands Authors Calculations
Rig Dayrate Yearly Revenue Est. EBITDA
DPDS1 $290 $109,105 $32,731
MSS2 $270 $101,580 $30,474
Graphic 1. North Sea Jack-Up Day Rates Source: 9/9/2014 Prospector Offshore Drilling IR presentation

Discussions with management indicates that one rig, the DPDS1 will probably not be renewed and the
MSS2 may be renewed. The loss of the DPDS1 would reduce EBITDA by $32.7M and the loss of both rigs
would reduce EBITDA by $63.1 million. I believe that management is optimistic if they believe these
drillships will be renewed at favorable terms, if at all. Paragons former parent, Noble Corp, saw an 11%
decrease to day rates for their 2011 built, high-spec drill ship, the Noble Bully II. If Brazil is lowering rates
for new built higher-spec ships, what chance does Paragon have?
The other issuing impact Paragon is the large backlog of rigs being built currently. Investors listening to
any conference call hosted by oil drillers can appreciate the surplus of rigs currently being built. The
slide on graphic 2, taken from Paragons Energy Power Conference presentation shows the anticipated
jackup deliveries, designs, and country of manufacture.

5

Management of Paragon is quick to tell you that this doesnt tell the full story and some of those rigs will
never make it contracted status, especially since a number of them are being built in China. However,
Credit Suisse notes The three leading Chinese yards are expected to deliver 47 jackup units, equivalent
to Singapore yards and representing close to 32% of total jackup supply. Given the high quality rigs
produced by leading Chinese yards (a fact admitted to by Paragon management at the Barclays
conference) there are at least 94 jackups coming from quality, leading shipyards. Credit Suisse estimates
utilization could sink to 81%.
Another issue, not widely discussed, is asset impairments. Investors depend on NAV and price-to-book
ratios to determine how inexpensive/expensive a stock is. This works great until the asset is found to be
worth a lot less. If a number of newbuild ships come out of the yards and are sold for a significantly
lower amount than initially planned for, asset impairments may occur. It seems illogical that Paragon
could argue their aging fleet is worth more than brand new higher-spec rigs that just left the shipyard.
Graphic 2. Jackup Delivery

These newbuilds represent an enormous quantity of todays fleet which means they will either be
replacing older, lower-spec, rigs, or simply sit idle. While it is tough to say with any accuracy or precision,

6

the actual results will probably be a combination of the two. Major drillers had the following comments
to say about the jackup market.
Graphic 3. Offshore Drillers Jackup Comments

Drillers such as Ensco and Seadrill believe that the oversupply is a reality. However, they all believe their
fleets are OK because 222 jackups are at least 30 years old and likely to be scrapped. This does not bode
well for Paragon, owner of 34 rigs that are almost 35 years old. Ensco had the following to say in their
Q2 2014 conference call about jackups and floater over 35 years old (emphasis added):
Upon reaching 35 years of age, each of these rigs will be required to complete a regulatory survey in
order to meet classification requirements, and significant capital expenditures may be required to keep
these rigs certified, especially for jackups that have not been well maintained over their useful lives.
These capital expenditures may prove cost prohibitive for many of these rigs, and we believe that these
surveys could serve as a catalyst for jackup retirements. While the numbers I just gave you are for
jackups that are at least 35 years of age, if we look at actual rig retirements over the past 3 years, the
average age of the 36 jackups taken out of the global supply is 32 years.
The global fleet of competitive floaters may experience similar phenomenon as approximately 60 floaters
or 20% of the global fleet are at least 35 years of age. With customers preference for newer rigs that
provide drilling efficiencies and with less capable floaters challenged to find contracts in the current

7

environment, many of these floaters may face extended periods of time without work. Drillers may
look to reduce costs on older assets by stacking these rigs.
The quotes above are not good news for Paragon, owners of an aging fleet and plenty of debt. In the
face of a market oversupplied with rigs, there is only one way to increase cash flows purchase newer
rigs. This will be difficult.
Debt Drives Decisions
During the spin-off, Noble gave Paragon more than $1.7 billion of debt, the tranches are shown below.
Table 4. Paragon Debt Source: Company Presentation
Notes Amount (M) Interest Maturity
Secured Term Loan $650 L+2.75% 2021
Senior Unsecured Notes $500 6.75% 2022
Senior Unsecured Notes $580 7.25% 2024
This is a lot of debt, especially for an aging fleet. Management has stated that they may pay some debt
debt, but this will not get the company away from a core problem they still have rigs that are lower
spec and aging. Paragon will have difficulty acquiring new assets because new rigs are expensive. Of the
133 jackups being built right now, most have expected prices of $180-$220 million. At a $200 million per
rig average, Paragon will need to take on another $140 million of debt if they finance 70% of the
purchase. For now Paragon will need to depend on their free cash flow generation. The table shows my
estimates for free cash flow generation in 2015.
Table 5. 2015 Estimates Source: Authors calculations, Company guidance

2015 Estimate
In Millions Bull Base Bear
Revenue $1,574 $1,545 $1,452
Operating Expense $906 $926 $946
SG&A $60 $65 $70
EBITDA $608 $554 $436
Interest Expense $94 $100 $106
Estimated Tax $100 $110 $120
Capital Expenditures $300 $320 $350
FCF $114 $24 ($140)
This has created an interesting point for both longs and shorts. In the S-1, Paragon stated We expect to
pay a quarterly dividend on our ordinary shares. Initially, we expect that the amount of this dividend will
be between approximately $20 million and $22.5 million in the aggregate per quarter, or between $80
million and $90 million in the aggregate on an annualized basis.

8

If the company pays out $85 million per year in dividends, that leaves $37 million of extra cash, enough
for a rig per year even under the bullish scenario. The truth of lower cash flows seems more likely each
day. On September 19, 2014 Paragon announced that a $0.50 annual ($0.125/share each quarter)
dividend was being implemented. With 84.7 million shares outstanding, $42.35 million will be paid out
in dividends. This should be shocking for bulls that were told just a few months ago that a dividend
about twice the size waited for them. While it is impossible to say with any accuracy, I suspect many
owners of Paragon were hoping for a large dividend.
Beyond the dividend, the valuation is simply too high. Management of Paragon has stated that they
would look to buy similar assets at roughly 3X EBITDA. If we assume that 2015 EBITDA will come in at my
bull estimates of $616 million, a 3X multiple values the entire company at $1,848 million. Backing out
the debt and adding cash of $73 million arrives at an equity value of $191 million, more than 60% below
todays market cap of $527 million. And remember, this is my bull estimate.
If the base calculation proves to be correct the downside could be much greater. Whether or not the
company is valued on FCF or EBITDA, and even after applying generous multiples, there is little wiggle
room for the company and plenty of downside for equity holders. With an equity value of $527 million,
there is tremendous optimism in place for Paragons shares and bulls must believe that contracts will be
renewed at similar rates or higher. This seems to jar with the obvious fact that newer rigs are being built
and Paragon has one of the oldest fleets in existence.
Conclusion
Paragon is a timely and compelling short given near-term catalysts and longer-term industry dynamics.
At current prices around $7.00/share, bulls of Paragon believe that the company will continue to issue
an attractive dividend and generate more than $150 million per year in FCF.
This will prove to be very difficult as Paragons rigs are, on average, more than 34 years old and are
operating in an environment where numerous rigs are being constructed. As these newer, higher-spec
rigs get finished downward price pressure on day rates will take place. This will suppress Paragons cash
flows and make the planned dividend unattainable. I believe that shares of Paragon offer a minimum of
60% downside, even under bullish forecasts for 2015, an unlikely event. There is a reason Noble spun-off
these assets and loaded the company up with debt and it will not work out well for Paragon bulls.
Bulls should be especially concerned about the dividend that was recently announced. Projecting a
quarterly dividend of almost $0.25/share and then backing it down to $0.125/quarter in only six months
is not a good sign and shows how little foresight management has into cash flows.

9

Appendix 1. Revenue Estimates
Country Rig Dayrate($000) H2 Rev Estimate ($000)

Brazil
DPDS3 $347 $63,709 w/ Bonus
DPDS2 $300 $59,241 w/ Bonus
DPDS1 $290 $38,387 w/ Bonus
MSS2 $270 $48,923 w/ Bonus
Mexico
M841 $112 $20,384

M842 $112 $19,040

M531 $112 $20,384

B301 $101 $17,473

L1116

$0 Available
L1113 $101 $17,635

L1114 $90 $15,714

L781 $82 $14,432

M821 $69 $12,558

M824 $85 $14,705

M823 $85 $15,470

India
MDS1 $151 $27,482

L1112 $55 $9,240

South East Asia L785 $120 $21,000

Middle East
M1162 $135 $24,570

L784 $140 $25,480

L1111

$0 Available
L1115 $111 $20,202

M1161

$0 Available
L786

$0 Available
M822

$0 Available
B152 $95 $17,290

Dhabi II $89 $16,198

North Sea
MSS1 $278 $50,596

B391 $154 $19,404

C20051 $176 $21,120

C20052 $180 $32,760

C461 $162 $29,484

C462 $168 $30,576

C463 $168 $30,576

HZ1 $168 $30,576

West Africa
L782 $172 $31,304

L783 $145 $26,390

M825 $141 $19,176

M826 $136 $24,752

10

Average $150 $22,845

Total $5,100 $886,231

Paragon Offshore Report Sept 2014 Dichotomy Capital

Hochgeladen von

Dokumentinformationen

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Paragon Offshore Report Sept 2014 Dichotomy Capital

Hochgeladen von

Copyright:

Verfügbare Formate

1

Dichotomy Capital LLC info@dichotomycapital.com Scarsdale, NY

Das könnte Ihnen auch gefallen