Borr Drilling… The Tesla of Offshore…

Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of  . Such units need to”rollover”their liabilities: (e.g. issue new debt to meet commitments on maturing debt)…

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.

Hyman Minsky

It is true that Tesla needed capital to build up its production capacity, especially given its promise to deliver hundreds of thousands of Tesla 3s in 2018, but it is also true that the best way to raise this capital for a company with negative earnings and cash flows and significant growth potential is to use equity, not debt. To the counter that this will cause dilution, it is better to have a diluted share in a much valuable company than a concentrated share of a defaulted entity.

Aswath Damodaran

Borr Drilling is a Rubin’s Vase, just like Tesla. Some see a visionary company accurately calling the end of the offshore down cycle. Others see the worst of the offshore boom with vast, unfunded, embedded leverage in to-be-delivered jack-ups with no work. One (Borr) has a charismatic Chairman while the other has an enigmatic CEO. Both are start-ups funded using vast amounts of debt, and both sail very close to the wind in financial terms. Without spectacular operational success and market growth they will also be terrible financial investments. The comments by the world-renowned valuation expert Aswath Damodaran on Tesla could virtually be repeated for Borr.

For the non-believers Borr is a play on a market recovery in shallow water drilling and operations that has been called too early and simply has no market pricing power or backlog to take on the quantum of new units they have committed to. Transocean and other deepwater drillers exited the shallow water market because just as in subsea there are far lower barriers to entry and therefore more firms compete lowering margins for everyone. The entire jack-up industry is racked by over capacity, has new buildings aplenty to be delivered, has seen the collapse of the shallow water US market (100% due to shale), and has had numerous competitors successfully complete restructurings or fund-raising that allow them to (continue to) operate at cash break-even at best. Direct comparison companies like Shelf, with a far longer operational history, are still losing money.

Don’t get me wrong Borr is a fundraising machine and executes a lot of things. In fact it is clearly part of the strategy: in an under-researched market it hires every conceivable investment bank thereby ensuring nearly all the research on it is positive. And thus the momentum continues… I take my hat off to the sheer outrageousness of the vision: To become a listed contrarian investment almost (bar say Tesla) without equal. This graph from the latest results shows what needs to happen for Borr to have any realistic chance of financial success:

BD Market Q2 2018.png

Activity is in offshore is clearly picking up, I am not denying that, not like 300% though? More of a modest  increase surely… But this graph, if it proves to be an accurate forecast, is amazing. Higher shallow water well investments, in fact almost double, 2010, when shale was far more marginal source of volume and smaller US independents were still doing shallow water work. Note as well how long it took these Final Investment Decisions to flow through to work with the 2008 approvals creating the 2013/14 project boom.

Even more amazing is that E&P companies are promising to sanction such an increase in this niche market without managing to drive up day rates in any of the assets that perform the work or adding substantially to the asset backlog of any asset owners in the space. The public prognostications of E&P company executives that they will not allow a cost explosion in the supply chain are running head-to-head with the investors and management who believe a boom must be coming.

I would be interested to know what sort of price and other assumptions are behind this forecast. As E&P companies don’t publish this data publicly graphs like this without the assumptions the “data” is based on actually useless because without knowing on that you are 100% reliant on quality of the forecast. In order to come up with this number Rystad have had to take actual (and assumed?) project sanctions and multiply them by an internally derived number on field development costs and assumed bidding levels of subcontractors etc. It is better than nothing but it’s all about the room for forecast error which is likely to be huge in something like this. The Gulf States and Asian regions shallow water spending is going up but the NOC’s don’t seem to have increased their CapEx budgets that much so where the money is coming from is an interesting question?

Plus markets are about demand and supply (the core Borr market is the  >350 segment). In 8 years a fleet of assets that lasts 30-35 years has doubled. 31% more (77 units out of 249) are on order and 99 our of 249 units are uncontracted! For this market to even equilibriate at a point where companies are earning their cost of capital requires an enormous move, yet alone make an unexpected gain.

KM August 2018 JU.png

Source: Kennedy Marr, August, 2018.

Borr with assets of $2.6bn, had $54m in the bank of unrestricted cash at the enf of Q2 2018, had an Operating Cash Deficit of $40m in the same period, and made a draw down of $30m on its revolving credit line of $200m, a short-term financing instrument that requires the company to have at least $50m in cash. It has 11 active jack-ups and 12 stacked with 11 to be delivered in the next 27 months. It can only be described as an enormously leveraged (financially and operationally) play on a large unforecasted surge in offshore demand.

BD FA P2.png

So if the market doesn’t grow massively in the next 27 months, or a vast array of the jack-up fleet is scrapped, Borr will have doubled their capacity in a market growing at a much slower rate, where all their competitors have excess capacity and the financial resources to compete on price, and roughly ~30% of the global fleet is still to be delivered. As a general rule firms in such situations, offering a near identical product as their competitors, with strong knowledgeable customers, in a market with widely known price statistics, are called price takers. And in all probability such firms are lucky to cover their cost of capital let alone earn the excess returns shareholders in ventures like these require. The market is fragmented and Borr simply does not have enough market share with 30 odd units to influence pricing.

All the new building are financed by the yards who had no other option but to provide non-takeout vendor financing to Borr. In all reality there were few other buyers. In every shipping and offshore cycle a key signal of excess credit is the unfinanced deliveries where yards and owners take on “take-out” risk (getting a commercial bank on board to pay the yard on delivery). I have no idea what rights Keppel and PPL have if Borr cannot come up with the money in 5 years post delivery, but it must surely involve the ability to wipe out the shareholders? Borr won’t have earned enough by then so if the market does not literally boom then shareholders are buying into a massive funding hole risk. This was a classic Minskian insight into the causes of financial instability (and see the article link above for the original source).

So it was a surprise when Borr announced yesterday they are buying back up to $20m of their shares, and then duly followed up today by stepping into the market today for $420k worth. Borr surely needs more long-term capital not less? Borr will literally have to dip into a short-term loan facility (the revolver) to finance purchasing its own shares when in the very near future it will have to raise significant sources of new funds to pay for its OpEx. This at a time when management say they are going to reactivate units stacked on risk?

The Borr Q2 18 EBITDA figure was $3.2m: they are spending 6x that buying back their own shares? There are very few reasons to do this. The obvious one is to make sure the share price doesn’t dip as you prepare for a major equity raise, potentiall related to a takeover (Borr own options on a listed driller). Only one of those options can solve Borr’s financial constraints as they simply cannot get enough jack-ups to work at rates sufficient to cover anything like their forecast expenditure (and the working capital takes a big hit every time they mobilise one). There will be a deal here. I suspect fundraising for a loss making jack-up firm is getting hard the longer the well-known (sic) offshore recovery takes to arrive and given the sheer scale of the company now getting meaningful percentage increases in capital size. Clearly this very short-term strategy is part of how the Board will deal with this.

Borr has enough asset value to cover this but just like Tesla it has loaded up on convertible debt instead of start-up equity. Returning to the equity market to cover basic OpEx given the scale of the company now is likely to be very expensive.

The other interesting dynamic here is what Schlumberger are going to do as a ~13% shareholder. Schlumberger bailed on Western Geco (seismic) earlier in the month in another clear signal of their intention to focus on shale. They have also pulled out of their Golar venture. Finding another credible shareholder on this scale will not be easy should they choose to leave.

The Borr investment case is based on the scrapping of over 100 units and the Rystad figures leading to over 2.8x increase in FID in their target market. All the people buying the shares are presumably informed financial buyers, some of whom may well just be taking a leveraged play on a dramatic increase in offshore work. There is clearly a market for such an investment.

But as I keep saying here if Borr, like everyone else in the offshore market, keeps raising money to keep capacity high and day rates low, then “the recovery” will by definition never arrive. Which is I admit not quite the same (one of the many?) problem(s) Tesla has at the moment but still bear some striking similarities from a financial perspective.

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