TEXT-S&P rates Pacific Drilling corporate credit 'B'
Overview -- Luxembourg-based Pacific Drilling S.A. plans to issue $500 million of senior secured notes due 2017 through its subsidiary, Pacific Drilling V Ltd. (PD5). -- We are assigning our 'B' corporate credit rating to Pacific Drilling. We are assigning a 'B+' rating to Pacific Drilling V Ltd.'s proposed senior secured notes. -- The stable outlook reflects our expectation that the senior secured notes issue, along with a planned $1 billion credit facility, will fund the bulk of costs related to ongoing construction of additional ultra-deepwater drillships over the next two years. Rating Action On Nov. 12, 2012, Standard & Poor's Ratings Services assigned its 'B' long-term corporate credit rating to Luxembourg-based Pacific Drilling S.A. The outlook is stable. We also assigned our 'B+' issue-level rating to subsidiary PD5's planned $500 million senior secured notes due 2017. The recovery rating on the senior secured notes is '2', which indicates our expectations of substantial (70%-90%) recovery in the event of a payment default. Pacific Drilling will use proceeds of the senior secured notes to fund the construction of ultra-deepwater drillships. Rationale Our 'B' rating on Pacific Drilling reflects the company's "weak" business risk profile as a start-up oil and gas contract driller, and its "highly leveraged" financial risk profile. In assessing Pacific Drilling's business risk profile, we believe the company is disadvantaged by: -- Its lack of an extended track record:, it has only booked revenues since the second half of 2011; -- Its narrow asset base: all of its rigs are ultra-deepwater drillships, and only four drillships are currently operational; -- Its narrow customer base of only three customers. All of them are investment-grade global energy companies, however, with solid competitive positions in their upstream operations; -- Its high degree of exposure to country risk in Nigeria and Brazil; -- Its exposure to the operating risks of the ultra-deepwater drillship sector, including potential startup problems related to its new drillships, and liability exposure in the event of a spill (notwithstanding the protections afforded by indemnification agreements and insurance coverage); -- The potential that currently favorable supply/demand dynamics in the ultra-deepwater drillship segment could ultimately lead to the development of excess production capacity industrywide; and, -- A lack of transparency with respect to the financial condition of Pacific Drilling's founder and majority shareholder, privately held Quantum Pacific Group (unrated), and Quantum Pacific Group's long-range strategy with respect to its stake in Pacific Drilling. On the other hand, we believe that Pacific Drilling's business risk profile benefits from: -- The depth of industry experience among its top management group; -- Currently positive fundamentals of the ultra-deepwater drillship sector, including secular growth in demand and limited new capacity, which support favorable day rate trends and high capacity utilization industrywide; -- The advantages afforded by Pacific Drilling's highly modern fleet, which is concentrated in ultra-deepwater drilling, the contract drilling subsector with the most favorable near-term prospects presently; and, -- Pacific Drilling's demonstrated ability to secure customer contracts and drillship construction contracts on relatively favorable terms compared with market norms. In assessing Pacific Drilling's financial risk profile, we accounted for our expectation that credit protection measures will be very weak for at least the next two years. From 2012-2014, we expect negative free cash flow (that is, net cash provided by operating activities less cash flow used in investing activities) to total about $2 billion, assuming that there are incremental capital expenditures and debt-raising actions in 2013-2014 related to construction of additional drillships beyond those currently in operation or under construction. Based on our assumptions, definitions and adjustment methodology, we would expect gross debt-to-EBITDA to be very high at more than 8x in 2013, and debt-to-EBIDA could well be over 6x in 2014. Given these expectations, we believe that prefunding its investment requirements with the $500 million senior secured notes issuance and planning to establish a $1 billion credit facility would be supportive from a ratings perspective. We believe that Pacific Drilling's cash flow dynamics could improve markedly beyond the next two years, as the company places three additional drillships into operation and investment requirements subside. We recognize management's stated intention to target debt-to-debt plus equity of approximately 30%, compared with a peak level that could approximate 50%. However, we perceive the pace of future leverage reduction to be highly uncertain. Further new drillship development could slow the pace of deleveraging considerably. Liquidity We view Pacific Drilling's liquidity as "adequate," as this term is defined under our criteria. Notwithstanding our expectation of substantial negative free cash flow over the next two years, we assume that the company will prefund near-term investment requirements on relatively favorable terms through the two planned financings. In our broad consideration of Pacific Drilling's financial flexibility, we take account of the company's demonstrated ability to tap the capital markets for debt and equity funding. We also account for the potential that if, contrary to our current expectations, Pacific Drilling were to experience temporary liquidity problems, that Quantum Pacific Group could possibly extend extraordinary financial support, given its continuing large investment in Pacific Drilling. On the other hand, financial flexibility is limited by the fact that virtually all of Pacific Drilling's assets are encumbered. Also, financial covenants under different borrowing agreements could be problematic under certain adverse scenarios. Moreover, the average tenor of Pacific Drilling's term debt is relatively short, and there are substantial debt amortization requirements. Recovery analysis The issue rating on the $500 million senior secured notes is 'B+'. The recovery rating on the notes is '2', indicating our expectation of substantial (70%-90%) recovery in the event of a payment default. Pacific Drilling's British Virgin Island-based subsidiary, PD5, is the issuer of the notes. The recovery rating on the secured notes will be primarily supported by a pledge of the stock of PD5, a first priority security interest in the Khamsin drillship, once it is delivered and until the construction is complete, assignment of all of the issuer's rights under the Samsung construction contract. The secured notes are also supported by an unsecured parent guarantee at the Pacific Drilling level. Our simulated default scenario assumes a default in 2014 following a cyclical downturn, coupled with operating difficulties, start-up delays, or other disruptions that cause Pacific Drilling's vessels to experience downtime, which reduces cash flows for the idled vessels. We value the drillships at 70% of the $630 million expected cost of the recent drillships. Furthermore, we have assumed bankruptcy enforcement costs of 15% to reflect delays and increased costs that might result from the company's exposure to multiple jurisdictions in terms of the company's operations, creditors and the deployment of the company's assets. Nevertheless, actual enforcement costs could well be higher given the concentrated asset base (one drillship) comprising the collateral and the jurisdictional and legal complications that could arise in seizing the vessel. Under our analysis, the value of the collateral (approximately $375 million relating to the Khamsin drillship) represents slightly more than 70% of the $520 million (principal plus six months' interest) that we estimate would be due to the secured noteholders. Pacific Drilling's unsecured guarantee may represent an additional source of recovery for secured noteholders; to the extent Pacific Drilling's subsidiaries (other than PD5) have residual value after satisfaction of their respective debt obligations. The value at Pacific Drilling would be shared on a pari passu basis by the residual claims relating to the secured notes along with the other debt and guarantee related claims at Pacific Drilling. We expect approximately $445 million of value (includes $70 million from Pacific Drilling's guarantee) would be available to satisfy the claims relating to the senior secured notes, suggesting a recovery that is close to the high end of the 70%-90% range. Outlook We believe a stable rating outlook is warranted, given our expectation that there is less than a one in three chance of either an upgrade or downgrade occurring within the one-year time frame-the period our outlook considers. Still, if we come to expect that Pacific Drilling will achieve and maintain debt-to-EBITDA of less than 4x --possibly through a combination of successfully starting up its new drillships and demonstrating moderation in its growth trajectory--we could consider an upgrade. Conversely, if we come to expect that debt-to-EBITDA would remain at more than 5x beyond the next two years, we could consider a downgrade. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 Ratings List New Rating; Outlook Action Pacific Drilling S.A. Corporate credit B/Stable Pacific Drilling V Ltd. Senior secured B+ Recovery rating 2 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. 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