Pacific Drilling (PACD): Earn 34% While You Wait To Quadruple Your Money

Pacific Drilling (PACD) owns seven drillships which it rents to large oil companies to drill deep ocean wells. The ships are typically rented for 6-18+ months for rates in the hundreds of thousands of dollars per day. These are large, complex, and expensive ships. Renting a ship includes a crew to operate it and its drilling equipment.

There are nine companies in the world that own and offer drillships for rent. Pacific Drilling is the smallest. Three of the nine companies are currently in bankruptcy (Valaris plc, Noble Drilling, and Diamond Offshore). Two are openly preparing for bankruptcy (Seadrill, Shelf Drilling). And one, Borr Drilling, just worked out a deal with its creditors to avert bankruptcy.

During the years when oil was over $100, the offshore drilling companies expanded too much. The COVID-19 pandemic has resulted in a dramatic drop in global oil demand and even more dramatic drop in demand for new offshore drilling. Excess supply of offshore drillships coupled with a dramatic drop in demand has led to falling prices and many idle ships. Currently, Pacific Drilling has only two ships under contract with a third contract starting in Q2 2021. The other four ships sit idle.

Valaris Plc, a much larger competitor that owns 13 drillships and 42 drilling platforms, released a presentation as part of its bankruptcy process. The presentation shows that global supply has decreased by 23% in the past 5 years to 101 drillships today with 60 currently under contract and the remaining 41 sitting idle. Since drillships can have a useful life of 40 years it will take some time before the market gets back to equilibrium. Valaris predicts that dayrates won't bottom until 2022 with an upward trend after that.

Despite the gloomy situation, Pacific Drilling is staying afloat - for now. When oil prices fell in 2015-2016 they had too much debt and in November 2017 filed for Chapter 11 bankruptcy protection. When they emerged from bankruptcy a year later they had reduced their debt by $3 billion and restructured their remaining debt into three classes:

1. $50 million Revolving Credit Facility due 4/1/23
2. $748 million 8.375% First Lien Notes due 10/1/23 (currently selling at 25)
3. $344 million 11%/12% Second Lien PIK Notes due 4/1/24 (currently selling at 28)

Interest on the Second Lien PIK Notes can be paid in cash at 11% or in "in-kind" with additional notes at 12%. The company gets to decide.

With $238 million cash on hand, the ability to pay interest on the Second Lien PIK Notes "in-kind", and no debt due until 2023, Pacific Drilling should be fine for the next year or so. As stated in their quarterly report on August 7th:

"We believe that our existing cash on hand will provide sufficient liquidity over the next 12 months to fund our cash needs."

However, there is a problem long term:

"Given current market conditions, we do not believe our current capital structure will be sustainable over the long term."

Pacific Drilling is in trouble. It is a small player in an industry that has overbuilt assets that have a 40-year lifespan. Most likely the company will be liquidated - either through an out-right purchase of the whole company, or a sale of its ships under bankruptcy protection. My prediction is the bankruptcy route.

How much are the seven drillships worth? It just so happens that we have expert appraisals from the bankruptcy proceedings in September 2018:

Are these appraisals still accurate? Probably. By 2018 the industry's over-supply problem was well understood. That's why these ships were so heavily discounted when appraised. For example, Pacific Meltem was built by Samsung Heavy Industries in South Korea and delivered in 2014 for $500 million. This appraisal in 2018 gives it a "high" value of $225 million and a "low" appraisal of $175 million - just 35% of its purchase price.

Of course, right now is not the best time to sell drillships. Fortunately, Pacific Drilling has enough cash to wait for a year or so to let the market to stabilize from the pandemic shock.

For argument's sake, let's use the lower value of $1,062 for the drillships. How much would you pay for these $1 billion in drillships?

Would you pay $146 million for seven drillships worth $1 billion? That is the current market value for Pacific Drilling. As remarkable as it may seem, for just $384 million you could buy $238 million in cash and seven drillships worth $1 billion.

But wait. It get's better! If we assume than Pacific Drilling goes into bankruptcy soon then you can get the ships for free. Bankruptcy law requires that senior debt get paid in full before junior debt receives any compensation. If the company were to be liquidated today then the $238 million in cash would be used to pay all $50 million in bank debt (the revolving credit facility) and the remaining $188 million would go to the First Lien Note holders. Currently priced at 25, the First Lien Notes are selling for $187 million. If we buy the First Lien Notes today at 25 then our entire investment would be covered by the cash on hand. And then we would get our share of the first $561 million of whatever the ships fetch on the open market.

But what if Pacific Drilling waits a year and then goes into bankruptcy and liquidates? If we purchase the First Lien Notes today at a price of 25 then we will collect sizable interest payments until the bankruptcy. For example, if we were to invest $25,000 to purchase $100,000 of the First Lien Notes we would collect $8,375 in interest (8.375% of the $100,000 face value), reducing our invested capital to $16,625. If the company liquidates for more than $800 million, we would get our whole $100,000 in face value - 4x our original investment.

The worst-case scenario would be the company burning all its cash and then the drillships get sold at fire-sale prices. Assuming it took a year, we'd collect $8,375 in interest and then the ships would have to sell for less than about $174 million before losing any of our investment.

In short, the First Lien Notes are a great investment. The margin-of-safety virtually guarantees a return of our investment and the profit potential is very large.