Description

I’m writing to recommend the purchase of Shelf Drilling’s 8.25% Senior Unsecured Notes due 2/15/2025 at the current price of 91.  This is a yield to maturity of 14% but I expect the notes to be refinanced on or around its par call date of 2/15/2024 which would be a yield of 24%.

It should be noted that I also own the Shelf 8.875% 1^st Lien Notes due 11/15/2024 as I view these notes as extremely low risk.  These notes trade around par for an attractive 9% yield as a quasi cash-substitute.  It is these 1^st Lien notes which will force the hand of the company to refinance the entire stack (both notes) in early 2024.  It would be a covenant breach under both notes if the company receives a “going concern” notice in its financial statements which it would undoubtedly receive if it does not refinance the 1^st Lien notes prior to its requirement to publish its annual financial statements in March 2024.  Not only would new lenders (or existing noteholders) be unwilling to provide new capital (or roll existing) with a maturity beyond a slug of debt due about a year and a half later, it wouldn’t make any sense for the company to even bother refinancing only the 1^st Liens when they will be in same situation with the unsecureds ~8 months later.  The company has also acknowledged as much on its latest earnings calls.

In the highly unlikely event the company is unable to refinance the entire capital structure, you are creating a stable, highly contracted driller with $2.8B of backlog for less than 3x EBITDA (see analysis below).  While a restructuring is never the desired result in an investment like this one, it would not be such a bad outcome as the ultimate IRR, albeit longer with more uncertainty, would likely be higher than in a refinancing scenario.

Company Description

Shelf Drilling is a pure play jack-up rig contractor with 36 jack-ups (35 currently under contract).  It was created in 2012 by the current CEO David Mullen with the backing of 3 middle-market private equity firms (Castle Harlan, CHAMP Private Equity, and Lime Rock Partners) by acquiring 37 jack-ups from Transocean for $1.05 billion.    

As anyone who has followed the rig space (or oil & gas in general) knows, this transaction looked smart for the first few years but took a severe turn for the worse around 2015.  It’s actually pretty impressive Shelf has managed to avoid bankruptcy during the armageddon years of 2015-2020 for the space, a feat few drillers can claim.  Through numerous capital markets transactions, many of which we were involved, Shelf has survived and made it to the other side to a currently robust jack-up market.

Current Capital Structure:

$310                     8.875% 1^st Lien Notes due 11/15/2024

$900                     8.25% Sr Unsecured Notes due 2/15/2025

$1,210                 Total Debt

$81                        Cash

$1,129                 Net Debt

$436                     Market Cap

$1,565                 Enterprise Value

Shelf also acquired 5 premium jack-up rigs (included in the 36 rig fleet number in the introduction) from Noble in October 2022 for $375mm.  The estimated build cost of these 5 rigs is $1.6 billion.  Shelf created a new subsidiary called Shelf Drilling North Sea (“SDNS”) to complete the acquisition.  Shelf Drilling Holdings, Ltd. (“SDHL”, the issuer of the notes listed above) contributed $120mm of cash, SDNS raised $80mm in an IPO, and SDNS issued $250mm of secured notes to complete the transaction.  The $75mm ($450mm raised less the $375mm acquisition price) less transaction costs and start-up related capex remain on SDNS’s balance sheet for working capital.  Thus, SDHL owns 60% of SDNS with the remaining 40% publicly traded.

Shelf consolidates SDHL and SDNS in its financial reporting but I prefer to view the companies separately as SDNS debt has no recourse to SDHL.  The $81mm of cash listed in the capital structure above represents cash at SDHL only.

Market Environment

As previously mentioned, it had been tough environment for drillers for many years but the environment has slowly been improving in the 2020s.  Total active supply of jack-ups in April 2014 were 453 which stands at 427 as of May 2023.  So there has been a decrease of net 26 rigs over the past 9 years.  As highlighted by the Noble transaction, dayrates and rig values are still nowhere near newbuild economics.  This is also while demand for jack-ups continues to increase.  The market is as tight as it has been since 2014 with global utilization above 90%.  New contracts are reflecting the tightness.  Shelf has doubled its backlog since 2020 from $1.4 billion to $2.8 billion as of the last quarter.

Shelf’s average dayrate across its fleet last quarter was $70k, however, this is increasing fast as old contracts expire and new contracts commence.  The following are Shelf’s contract awards in 2023:

Shelf also announced two monster 5 year contracts in the Middle East, both at rates above $100k/day, late last year for Harvey Ward and Shelf Drilling Victory.  Excluding SDNS, Shelf indicates it generates $550mm of EBITDA at current spot rates at only 85% utilization.

Valuation

Shelf provided 2023E EBITDA guidance of $310-345mm.  Consensus EBITDA for 2023 and 2024 is $323mm and $481mm, respectively.  This is consolidated for SDHL and SDNS.  Consensus EBITDA for SDNS for 2023 and 2024 is $22mm and $69mm, respectively, so this implies SDHL consensus of $301mm and $412mm, respectively. 

Despite a vast majority of the rigs under long-term contracts, assumptions around pricing and timing of a handful of rigs can swing one’s estimate of full year EBITDA significantly.  For example, a rig may generate $2.5mm of EBITDA per month under contract and burn $1.5mm per month off contract, a swing of $4mm in cash flow per month.  A seamless contract extension versus needing to move a rig to a new location with say 6 months between contracts could be a $24mm ($4mm * 6 months) delta in EBITDA for a single rig, depending on assumptions.

There aren’t many assumptions needed to get to around $300mm of EBITDA this year for SDHL.  At 91 on the notes, we create the tranche for $819mm behind $310mm of secured debt.  The current market cap of SDNS is $257mm of which SDHL owns 60%, or $154mm.  SDHL currently has $81mm of cash and should generate about $120mm this year for total cash of about $200mm at year-end.  Thus, you create SDHL at an enterprise value of about $755mm through the notes:

$310                     Secured Debt

$819                     Mkt Value of Unsecured Notes

($154)                  Mkt Value of SDHL’s equity in SDNS

($200)                  Cash

$755                     Enterprise Value

At $300mm of EBITDA, we create SDHL at 2.5x through the notes.  At $400mm of consensus 2024 EBITDA, it is less than 2.0x.  If capital markets completely freeze at the end of the year and unsecureds end up owning this company, I believe the ultimate result would be better than the 24% IRR we are expecting from a refi.

In summary, I expect this to be about a 9-month hold with a 24% IRR.  If the notes cannot be refinanced, this should be a relatively clean restructuring with a small amount of secured debt (relative to the EV) senior to the unsecured notes.  The highly contracted position of the fleet coupled with a tight and improving global jack-up market makes me feel more than comfortable creating the company through the unsecured notes if they cannot be refinanced.

Catalyst

Refi