TEXT-S&P assigns prelim 'B' rating to Shelf Drilling; otlk stable

Tue Oct 9, 2012 7:47am EDT

Oct 09 -

Overview

-- On Sept. 10, 2012, Transocean Ltd. announced that it had agreed to sell 38 of its rigs to newly-formed oilfield services company Shelf Drilling Holdings Ltd. (Shelf Drilling).

-- We are assigning a preliminary 'B' rating to the Cayman Island-based Shelf Drilling.

-- The outlook reflects our expectation of supportive industry conditions and relatively stable credit metrics.

Rating Action

On Oct. 9, 2012, Standard & Poor's Ratings Services assigned a preliminary 'B' rating to Cayman Island-based oilfield services company Shelf Drilling Holdings Ltd. (Shelf Drilling). The outlook is stable.

At the same time, we assigned a preliminary issue rating of 'B+' and a recovery rating of '2' on the first-lien $75 million term loan facility.

We also assigned our 'B' preliminary issue rating on the $475 million senior secured notes and our recovery rating of '3.'

Rationale

The preliminary rating is based on initial information and is subject to the successful closing of the acquisition. The preliminary rating depends on:

-- The successful implementation of Shelf Drilling's funding structure, including appropriate commitments from the banks; and

-- Liquidity being assessed as "adequate" under Standard & Poor's criteria.

We aim to review the preliminary rating within 90 days.

The ratings on Shelf Drilling reflect our assessment of the business risk profile as "vulnerable," together with our view that the financial profile is "aggressive."

Our view of Shelf Drilling's financial risk profile is based on its leveraged cash-flow ratios. We forecast its funds from operations (FFO) to adjusted debt ratio will be around 13% in 2013 (under our criteria, we treat preferred equity as debt-like in calculating this ratio.) We consider Shelf Drilling's free operating cash flow (FOCF) generation to be modest, given its sizable capital expenditure, leading to modest deleveraging prospects. We assess it as having adequate liquidity, but a limited cushion if it does not adjust its capital expenditure in line with actual operating cash flows. Because the company is to be established as a spin-off, it also lacks audited financial information.

These risks factors are mitigated by some positive features. The company has moderate headline leverage (its debt to adjusted EBITDA ratio is around 3.5x-4.0x) and debt ratios are even less leveraged when we exclude the preferred equity. Additionally, we understand there are no financial maintenance covenants and the company has little meaningful debt amortization.

The "vulnerable" business risk profile is based on the lack of an established, operating business track record as a stand-alone entity and the company's participation in the competitive, fragmented, and capital-intensive oil and gas service industry. The "jack-up" segment it operates in has historically been even more volatile. The fleet of 38 rigs is relatively old, with an average time in service of 31 years. Oilfield service companies depend heavily on the investment decisions made by exploration and production companies, which in turn depend on the outlook for cyclical oil prices; as a result, day rates can be volatile through the cycle. Shelf Drilling's fleet has limited diversification by depth.

These constraints are partly mitigated by Shelf Drilling's sizable backlog of contracts, its sound market position as the number three jack-up driller in the world, its geographical diversification, and its management's significant industry experience.

Liquidity

We anticipate that Shelf Drilling's liquidity will be "adequate" under our criteria, reflecting our expectation that cash sources will cover cash needs by more than 1.2x during the next 15 months. However, we consider that there is a limited cushion and that a slight adverse variation from our base case in terms of operational performance or ability to curb capital expenditures would likely lead to a downward revision to the "less than adequate" category.

Our assessment of sources of liquidity over the coming 15 months, as of Sept. 1, 2012, includes:

-- Cash of about $255 million on hand, although at least $50 million of this may be tied to operations. In addition, the bulk of the opening cash balance is understood to be temporary, intended to be used to fund the exceptionally high working capital outflow in the first year; and

-- FFO of $160 million-$180 million to Dec. 31, 2013.

Our assessment of liquidity needs includes:

-- Scheduled debt maturities of less than $1 million a year;

-- Capital spending dedicated to maintenance purposes of close to $86 million, excluding the investment needed to restart the stacked rigs, for upgrade, or to prepare contracts to which management has not committed and therefore can be cut if the market conditions are not favorable.

-- One-off working capital outflow of about $180 million, because Transocean will collect and retain its existing receivables after the sale closes (offset by the high initial cash balance).

We consider it positive that Shelf Drilling will not have any financial maintenance covenants under its senior term loan.

Recovery analysis

The preliminary issue rating on the first-lien $75 million term loan facility is 'B+'. The recovery rating on the term loan is '2', indicating our expectation of substantial recovery (70%-90%) in the event of a payment default. The preliminary issue rating on the $475 million senior secured notes is 'B'. The recovery rating on the senior secured notes is '3', indicating our expectation of meaningful (50%-70%) recovery in the event of a payment default.

The recovery rating on the term loan will be primarily supported, as soon as the security is affected, by a first-lien security on at least 27 rigs and pledges of the equity of five restricted subsidiaries owning five of the company's 11 remaining rigs. The above-mentioned security will be required to be put in place within 90 days following the closing of the acquisition. The recovery rating on the senior secured notes is supported by a second-lien ranking on the same security package. However, it is constrained at the '3' level by substantial jurisdictional risk, as the rigs are located in many different jurisdictions through Africa, Asia, and the Middle East, and by the notes' contractual subordination to first ranking debt.

The 38 rigs are located in 12 different countries worldwide, primarily in Saudi Arabia, India, Egypt, and Thailand. We anticipate that enforcing these assets in case of a default could be challenging. The documentation for the credit facility allows for, in addition to the existing $75 million prior ranking term loan, an incremental term facility of $50 million that is subject to 3.25x total net leverage ratio, and additional second-lien debt that is subject to a 2.0x fixed-charge coverage ratio and 2.0x secured leverage ratio. The senior secured notes documentation includes restricted payments covenants, which provide restrictions on dividend payments that cannot exceed an income basket of 50% of consolidated net income, which starts to accumulate from the first quarter of the issuance of bonds.

In assigning recovery ratings according to our criteria, Standard & Poor's simulates a payment default scenario that incorporates a borrower's fundamental business risk and the financial risk inherent in the capital structure. We consider that the key risk Shelf Drilling faces concerns its ability to secure contracts on the rigs as existing ones expire. Furthermore, we believe the company has exposure to volatility in market rates as contracts come up for renewal, and has limited flexibility to reduce underlying operating costs without taking rigs out of operation. Given that most of the rigs are at least 30 years old, we expect relatively high maintenance capex. We assume these pressures would depress Shelf Drilling's utilization and day rates, revenue, and profitability, and lead to a payment default in 2014.

We believe Shelf Drilling would remain a going concern because of its good market position in the jack-up drilling rigs business pro forma the acquisition, its distinct operating activities, and the contract-based nature of its drilling activities, which provides short- to medium-term earnings visibility. Still, we have used a discrete asset valuation methodology to estimate the value of the company, given that we believe the company has an extensive asset base, and this method provides insight as to the company's likely value at default. We have estimated the stressed enterprise value of the company at default by stressing its assets at different levels according to their estimated value post-default. Given the volatility of the industry and the fleet age of these rigs (on average 30 years), we have estimated a stressed enterprise value of $618 million for Shelf Drilling at the point where the company would default.

From the gross enterprise value we deducted administrative costs and 50% of pension costs as priority liabilities. The net stressed enterprise value would be sufficient to provide substantial recovery (70%-90%) for the first-lien term loans of $129 million (which includes the incremental facility and six months prepetition interests), and meaningful recovery (50%-70%) for the second-lien senior secured notes of $496 million (including six months' prepetition interest). Numerically the coverage is high, but because of the jurisdictional risk and less than full asset security, we keep the recovery rating on the term loan at '2' and senior secured notes at '3'.

Outlook

The stable outlook reflects our expectation that industry conditions are becoming firmer after two weak years. Slightly higher day rates should allow Shelf Drilling to stabilize EBITDA, which has declined in recent years. We anticipate that the oil price will remain supportive for operators overall, despite the uncertain global environment. On a pro forma basis, we view a sustainable adjusted ratio of FFO to debt (including preferred equity) of 15%-20% as commensurate with the current ratings. We would expect this ratio to be 10%-15% at bottom of the cycle and above 20% at top of the cycle.

We could raise the ratings in the medium term, once Shelf Drilling has built an operating track record. If management can successfully contain costs, especially if Shelf Drilling can lock in higher average day-rates as the market strengthens, FFO to debt could rise sustainably to the "significant" category, that is, between 20% and 30%. Raising the ratings would also depend on the new owners pursuing supportive financial policies.

We could lower the ratings if we see FFO to debt of 12% or below on a sustainable basis or if day-rates or utilization levels fall. This could occur because new rigs are competing with Shelf Drilling's older rigs. That said, Shelf Drilling currently has an adequate contract line-up for the next 12-18 months. Falling day-rates remain a key risk factor, given the sensitivity of Shelf Drilling's cash flows and perceived limited liquidity cushion.

Related Criteria And Research

All articles listed below are available on RatingsDirect on the Global Credit Portal, unless otherwise stated.

-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008

-- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012

-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011

-- Hybrid Capital Handbook: September 2008 Edition, Sept. 15, 2008

-- Key Credit Factors: Global Criteria For Rating Oilfield Services And Equipment Companies, July 30, 2012

Ratings List

New Preliminary Rating

Shelf Drilling Holdings Ltd.

Corporate Credit Rating B/Stable/--

Senior Secured B+

Recovery Rating 2

Senior Secured B

Recovery Rating 3

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