UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

For the quarterly period ended September 30, 2014

OR

For the transition period from              to             

Commission File Number 001-34094

 

VANTAGE DRILLING COMPANY

(Exact name of Registrant as specified in its charter)

 

 

777 Post Oak Boulevard, Suite 800

Houston, TX 77056

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (281) 404-4700

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act). (Check one):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No   x

The number of Vantage Drilling Company ordinary shares outstanding as of October 23, 2014 is 307,792,075 shares.

 

 

 

 

 

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TABLE OF CONTENTS

 

 

 

 

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SAFE HARBOR STATEMENT

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements relate to our plans, goals, strategies, intent, beliefs and current expectations. These statements are expressed in good faith and based upon a reasonable basis when made, but there can be no assurance that these expectations will be achieved or accomplished. These forward-looking statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Items contemplating or making assumptions about our industry, business strategy, goals, expectations concerning our market position, future operations, margins, profitability, capital expenditures, liquidity and capital resources and other financial and operating information also constitute such forward-looking statements. You should not place undue reliance on these forward-looking statements. These forward-looking statements can be identified by the use of terms and phrases such as “believe,” “plan,” “intend,” “anticipate,” “target,” “estimate,” “expect” and the like, and/or future tense or conditional constructions (“will,” “may,” “could,” “should,” etc.). Our actual results could differ materially from those anticipated in these forward-looking statements. Among the factors that could cause actual results to differ materially are the risks and uncertainties associated with the following:

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Many of these factors are beyond our ability to control or predict. Any, or a combination of these factors, could materially affect our future financial condition or results of operations and the ultimate accuracy of the forward-looking statements. These forward-looking statements are not guarantees of our future performance, and our actual results and future developments may differ materially from those projected in the forward-looking statements. Management cautions against putting undue reliance on forward-looking statements or projecting any future results based on such statements or present or prior earnings levels.

In addition, each forward-looking statement speaks only as of the date of the particular statement, and we undertake no obligation to publicly update or revise any forward-looking statements. We may not update these forward-looking statements, even if our situation changes in the future. All forward-looking statements attributable to us are expressly qualified by these cautionary statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained from time to time in our filings with the Securities and Exchange Commission (the “SEC”), which may be obtained by contacting us or the SEC. These filings are also available through our website at www.vantagedrilling.com or through the SEC’s Electronic Data Gathering and Analysis Retrieval system (EDGAR) at www.sec.gov. The contents of our website are not part of this Quarterly Report.

Unless the context indicates otherwise, all references to “we,” “our” or “us” refer to Vantage Drilling Company and its consolidated subsidiaries.

 

 

 

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PART I—FINANCIAL INFORMATION

 

Item 1. Financial Statements

Vantage Drilling Company

Consolidated Balance Sheet

(In thousands, except par value information)

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

 

 

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Vantage Drilling Company

Consolidated Statement of Operations

(In thousands, except per share amounts)

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

 

 

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Vantage Drilling Company

Consolidated Statement of Cash Flows

(In thousands)

(Unaudited)

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

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VANTAGE DRILLING COMPANY

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

1. Organization and Recent Events

Vantage Drilling Company is a holding company organized under the laws of the Cayman Islands on November 14, 2007 with no significant operations or assets, other than its interests in its subsidiaries. Through our direct and indirect subsidiaries, Vantage Drilling Company is an international offshore drilling contractor for the oil and gas industry focused on operating a fleet of modern, high-specification mobile offshore drilling units (“MODUs”). Our operating fleet currently consists of four ultra-premium jackup rigs and three ultra-deepwater drillships. Our global fleet is currently located in India, Southeast Asia and West Africa.

In the first nine months of 2014, we repurchased in the open market $40.0 million of our 7.125% Senior Secured Notes (the “7.125% Senior Notes”) and $7.0 million of our 7.5% Senior Secured First Lien Notes (the “7.5% Senior Notes”).  In June 2014, we made an additional principal payment of $42.0 million on our $500 million Term Loan (the “2017 Term Loan”). In October 2014, we repurchased in the open market $5.0 million of our 7.125% Senior Notes, $12.4 million of our 7.5% Senior Notes and $13.4 million of our 7.875% Senior Convertible Notes (the “7.875% Convertible Notes”).

 

2. Basis of Presentation and Significant Accounting Policies

Basis of Consolidation: The accompanying interim consolidated financial information as of September 30, 2014 and for the three and nine months ended September 30, 2014 and 2013 has been prepared without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) and includes our accounts and those of our majority owned subsidiaries. All significant intercompany transactions and accounts have been eliminated. They reflect all adjustments which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the interim periods, on a basis consistent with the annual audited financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations, although we believe that the disclosures made are adequate to provide for fair presentation. The balance sheet at December 31, 2013 is derived from our December 31, 2013 audited financial statements. These interim financial statements should be read in conjunction with the financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013. The results of operations for the interim periods are not necessarily indicative of the operating results for the full fiscal year or any future periods. Certain previously reported amounts have been reclassified to conform to the current period presentation.

Cash and Cash Equivalents: Includes deposits with financial institutions as well as short-term money market instruments with maturities of three months or less when purchased.

Restricted Cash: Consists of cash and cash equivalents established as debt reserves and posted as collateral for bid tenders and performance bonds.

Inventory: Consists of materials, spare parts, consumables and related supplies for our drilling rigs and is carried at the lower of average cost or market.

Property and Equipment: Consists of the costs of our drilling rigs, furniture and fixtures, computer equipment and capitalized costs for computer software. Drilling rigs are depreciated on a component basis over estimated useful lives ranging from five to thirty-five years on a straight-line basis as of the date placed in service. Other assets are depreciated upon placement in service over estimated useful lives ranging from three to seven years on a straight-line basis. When assets are sold, retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and the gain or loss is recognized.

Interest costs and the amortization of debt financing costs related to the financings of our MODUs are capitalized as part of the cost while they are under construction and prior to the commencement of each vessel’s first contract. Total interest and amortization costs capitalized for assets under construction for the three and nine months ended September 30, 2014 were $1.3 million and $3.8 million, respectively. Total interest and amortization costs capitalized for assets under construction for the three and nine months ended September 30, 2013 were $9.5 million and $15.9 million, respectively. We evaluate the realization of property and equipment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment loss on our property and equipment exists when estimated undiscounted cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying amount. Any impairment loss recognized would represent the excess of the asset’s carrying value over the estimated fair value.

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Debt Financing Costs: Costs incurred with debt financings are deferred and amortized over the term of the related financing facility on a straight line basis which approximates the interest method.

Investment in Joint Venture: In November 2012, we acquired 41.9% of Sigma Drilling, Ltd. (“Sigma”), which had contracted to build an ultra-deepwater drillship, to be known as the Palladium Explorer, at STX Offshore & Shipbuilding Co. Ltd.’s (“STX”) shipyard in Korea. We are currently accounting for our interest in Sigma as an equity method investment. Accordingly, we recognize 41.9% of the profit or loss of Sigma as other income (expense) in our consolidated statement of operations with a corresponding adjustment to our investment in joint venture account. We capitalized interest on our investment in Sigma until September 2013 when STX suspended construction of the drillship. In January 2014, Sigma issued a termination notice to STX on the Palladium Explorer construction contract and Sigma terminated our construction management agreement. In July 2014, a reduction in Sigma’s capital was approved by the appropriate authorities and in August 2014, a distribution of $55.5 million was made to the remaining shareholders of Sigma, of which we received $23.3 million. See “Note 4. Construction Supervision and Operations Management Agreements.” During the three and nine-month periods ended September 30, 2014 and 2013, Sigma recognized losses from operations consisting primarily of general administrative expenses.

The change in our investment in joint venture account was composed of the following (in thousands):

 

 

Revenue: Revenue is recognized as services are performed based on contracted dayrates and the number of operating days during the period.

In connection with a customer contract, we may receive lump-sum fees for the mobilization of equipment and personnel or the demobilization of equipment and personnel upon completion. Mobilization fees received and costs incurred to mobilize a rig from one geographic market to another are deferred and recognized on a straight-line basis over the term of such contract, excluding any option periods. Costs incurred to mobilize a rig without a contract are expensed as incurred. Fees or lump-sum payments received for capital improvements to rigs are deferred and amortized to income over the term of the related drilling contract. The costs of such capital improvements are capitalized and depreciated over the useful lives of the assets. Upon completion of drilling contracts, any demobilization fees received are recorded as revenue. We record reimbursements from customers for rebillable costs and expenses as revenue and the related direct costs as operating expenses.

Rig and Equipment Certifications: We are required to obtain regulatory certifications to operate our drilling rigs and certain specified equipment and must maintain such certifications through periodic inspections and surveys. The costs associated with these certifications, including drydock costs, are deferred and amortized over the corresponding certification periods.

Income Taxes: Income taxes are provided for based upon the tax laws and rates in effect in the countries in which operations are conducted and income is earned. Deferred income tax assets and liabilities are computed for differences between the financial statement basis and tax basis of assets and liabilities that will result in future taxable or deductible amounts and are based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred income tax assets to the amount expected to be realized. We recognize interest and penalties related to income taxes as a component of income tax expense.

Earnings per Share: Basic earnings (loss) per share are based on the weighted average number of ordinary shares outstanding during the applicable period. Diluted earnings (loss) per share are computed based on the weighted average number of ordinary shares and ordinary share equivalents outstanding in the applicable period, as if all potentially dilutive securities were converted into ordinary shares (using the treasury stock method).

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The following is a reconciliation of the number of shares used for the basic and diluted earnings (loss) per share (“EPS”) computations:

 

The following is a reconciliation of the number of shares excluded from diluted EPS computations:

 

The warrants and share options are anti-dilutive as the exercise or conversion price of such securities exceeded the average market price of our shares for the applicable periods. The ordinary shares issuable for the convertible notes, if converted, are excluded as the effect of including convertible debt and the related adjustments to income under the “if-converted” method of computing diluted earnings per share is anti-dilutive for the applicable periods.

Concentration of Credit Risk: Financial instruments that potentially subject us to a significant concentration of credit risk consist primarily of cash and cash equivalents, restricted cash and accounts receivable. We maintain deposits in federally insured financial institutions in excess of federally insured limits. We monitor the credit ratings and our concentration of risk with these financial institutions on a continuing basis to safeguard our cash deposits. Some of our restricted cash is invested in certificates of deposit. We have a limited number of key customers, who are primarily large international oil and gas operators, national oil companies and other international oil and gas companies. Our contracts provide for monthly billings as services are performed and we monitor compliance with contract payment terms on an ongoing basis. Outstanding receivables beyond payment terms are promptly investigated and discussed with the specific customer. We did not have an allowance for doubtful accounts as of September 30, 2014 or December 31, 2013.

Share-Based Compensation: We account for share-based compensation using the fair value method as prescribed under U.S. GAAP. Restricted share grants are valued based on the market price of our ordinary shares on the date of grant and the fair value attributable to share options is calculated based on the Black-Scholes option pricing model. The fair values are amortized to expense over the requisite service period which is generally equivalent to the time required to vest the share options and share grants. We recognized approximately $2.3 million and $1.8 million of share-based compensation expense for the three months ended September 30, 2014 and 2013, respectively. For the nine months ended September 30, 2014 and 2013, we recognized approximately $6.5 million and $5.4 million, respectively, of share-based compensation expense.

Use of Estimates: The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. While management believes current estimates are appropriate and reasonable, actual results could differ from those estimates.

Fair Value of Financial Instruments: The fair value of our short-term financial assets and liabilities approximates the carrying amounts represented in the balance sheet principally due to the short-term nature or floating rate nature of these instruments. At September 30, 2014, the fair value of the 5.50% Convertible Senior Notes (the “5.50% Convertible Notes”), 7.125% Senior Notes, the 7.5% Senior Notes and the 7.875% Convertible Notes was approximately $86.0 million, $649.5 million, $1.1 billion and $54.9 million, respectively, based on quoted market prices, a Level 1 measurement.

Derivative Financial Instruments: We may use derivative financial instruments to reduce our exposure to various market risks, primarily interest rate risk. We have documented policies and procedures to monitor and control the use of derivatives. We do not

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engage in derivative transactions for speculative or trading purposes. At September 30, 2014 and December 31, 2013, we had no outstanding derivative instruments.

Recent Accounting Standards: In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers. The ASU will supersede most of the existing revenue recognition requirements in U.S. GAAP, including industry-specific guidance. The ASU is based on the principle that revenue is recognized when an entity transfers promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The new standard also requires significant additional disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The ASU is effective for annual reporting periods beginning after December 15, 2016, and interim periods within those years, using either a full or a modified retrospective application approach. We are beginning the process of evaluating the impact the pronouncement will have on our consolidated financial statements and related disclosures.

 

3. Transactions with F3 Capital and Affiliates

F3 Capital Note

In connection with the acquisition of the Platinum Explorer, we issued a promissory note to F3 Capital (the “F3 Capital Note”). The F3 Capital Note accrues interest at 5% per annum and matures in January 2018. If we do not repay the F3 Capital Note on its scheduled maturity date or upon the occurrence of certain customary default provisions, the interest rate on any amounts outstanding under the F3 Capital Note will rise to 10% per annum. The F3 Capital Note contains a preemptive right covenant that provides F3 Capital with the right to purchase a pro-rata portion of any equity or convertible debt that we offer at a price per share less than the contingent conversion price of the F3 Capital Note so long as the F3 Capital Note is outstanding.

In August 2012, F3 Capital elected to apply $6.5 million aggregate principal amount of the F3 Capital Note as consideration for an equivalent amount of 7.875% Convertible Notes. We did not receive any cash proceeds from this direct placement.

We originally valued the F3 Capital Note based on our weighed average cost of capital which resulted in a discounted present value of $27.8 million. As of September 30, 2014, if we were to value the F3 Capital Note at our current weighted average cost of capital, the current discounted present value would be approximately $33.7 million, a Level 3 measurement. In July 2013, F3 Capital delivered formal notice to us that it believes we breached the F3 Capital Note. Among its claims, F3 Capital alleged that we failed to use commercially reasonable efforts to obtain shareholder approval for the issuance of shares upon the conversion of the F3 Capital Note. In connection with its claims, F3 Capital may attempt to accelerate the maturity of the F3 Capital Note in an amount totaling approximately $63.0 million of principal and interest, plus F3 Capital’s claims for penalties and additional interest in excess of $35.0 million. We believe we have met our obligations under the F3 Capital Note to use commercially reasonable efforts to obtain shareholder approvals, and instituted an action for declaratory relief in the English High Court for purposes of obtaining a judicial determination on F3 Capital’s claims. We intend to vigorously defend our position. In recognition that the standards of what constitutes commercially reasonable efforts may be subject to interpretation, there can be no assurances that the court will agree with our interpretation.

Lawsuit

On August 21, 2012, we filed a lawsuit against Mr. Hsin-Chi Su, a former member of our Board of Directors and the owner of F3 Capital, our largest shareholder, asserting breach of fiduciary duties, fraud, fraudulent inducement and negligent misrepresentation, and unjust enrichment based on Mr. Su’s conduct in his dealings with the Company both immediately prior to and during his tenure as one of our directors. The lawsuit, styled Vantage Drilling Company vs. Hsin-Chi Su a/k/a Nobu Su, is currently pending in the 270^th Judicial District Court of Harris County, Texas. In the lawsuit, we are seeking to recover actual and punitive damages as well as other relief, in each case, relating to our past transactions with Mr. Su and F3 Capital, including our joint venture with Mandarin Drilling Corporation, an entity formerly owned and controlled by Mr. Su, our acquisition of the Platinum Explorer from Mandarin Drilling Corporation and the financing thereof, and the acquisition of the Titanium Explorer. In conjunction with the pending lawsuit, on June 20, 2014, we received notice that Mr. Su had filed a countersuit against the Company and certain of the Company's current and former officers and directors. The countersuit alleges fraud, breach of fiduciary duty and theft by the Company and certain of its current and former officers and directors in the Company's dealings with Mr. Su. Further, the countersuit alleges that the Company has wrongfully obtained an injunction against Mr. Su. In his countersuit, Mr. Su asks that the Company recover nothing in its suit against Mr. Su and seeks actual damages of at least $8 billion, exemplary damages, attorneys' fees and other relief. We intend to vigorously defend against the charges made in the countersuit and pursue our claims, but we can provide no assurance as to the outcome of this legal action.

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Drillship Construction Supervision Agreement

We had a construction supervision agreement with an affiliate of F3 Capital that entitled us to payments for supervising the construction of Hull 3608, an ultra-deepwater drillship. In November 2009, pursuant to the terms of the construction supervision agreement, the affiliate of F3 Capital cancelled the agreement. Management fee revenue of approximately $3.0 million for construction services rendered by us in 2009 prior to the suspension and cancellation has not been paid as of September 30, 2014, and remains currently due and payable. We have issued demand letters regarding payment of the overdue amount.

 

4. Construction Supervision and Operations Management Agreements

In September 2013, we signed an agreement to supervise and manage the construction of two ultra-deepwater drillships for a third party. We receive management fees and reimbursable costs during the construction phase of the two drillships, subject to a maximum amount for each drillship.

In connection with our November 2012 investment of $31 million for a 41.9% ownership interest in Sigma, we entered into an agreement to supervise and manage the construction of the Palladium Explorer. Pursuant to the terms of the construction management agreement, we were entitled to a fixed monthly management fee during the expected thirty-six month construction period for the vessel. Following the receipt of notice in September 2013 that STX was suspending construction of the Palladium Explorer, Sigma terminated our construction management agreement in January 2014. In May 2014, we reached an agreement with Sigma regarding amounts owed to us under the construction management agreement, which resulted in payment to us of $4.0 million, including a $3.0 million termination fee. The remaining $1.7 million outstanding will be received on the earlier of the receipt of any further monies from STX or one year from the date of the agreement. In July 2014, a reduction in Sigma’s capital was approved by the appropriate authorities and in August 2014, a distribution of $55.5 million was made to the shareholders of Sigma, of which we received $23.3 million. While we continue to believe we will recover substantially all of our remaining investment, there can be no assurance that we will receive payments equal to the current amount of our investment in Sigma and the amount due under the construction management agreement.

In October 2012, we reached an understanding with a contractor in Mexico to manage the construction and operations of a newbuild jackup rig. The contractor subsequently acquired a second jackup rig and ordered two additional rigs, and awarded us construction management contracts for each of the four rigs. Effective September 30, 2013, the contractor assumed construction management responsibilities for the third and fourth rigs, however, we continued to receive our management fees until mid-November. We managed the operations of the first two rigs in Mexico until May 31, 2014 when we transitioned the rig operations to the contractor. In connection therewith, we are receiving a termination fee of $2.75 million, payable in six equal monthly installments beginning June 30, 2014 and have received four payments thus far.

In July 2010, we signed an agreement to supervise and manage the construction and marketing of the ultra-deepwater drillship the Dalian Developer. In September 2013, the agreement was modified and notice was given to us that the contract would terminate in six months. The agreement terminated in March 2014 and we have no further obligations with regard to the Dalian Developer.

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5. Debt

Our debt was composed of the following:

 

 

 7.5% Senior Notes and $500 Million 2017 Term Loan

In October 2012, Offshore Group Investment Limited, one of our wholly-owned subsidiaries (“OGIL”), issued $1.150 billion in aggregate principal amount of 7.5% Senior Notes under an indenture. The 7.5% Senior Notes were issued at par and are fully and unconditionally guaranteed, on a senior secured basis, by us and certain of our subsidiaries. The 7.5% Senior Notes mature on November 1, 2019, and bear interest from the date of their issuance at the rate of 7.5% per year. Interest on outstanding 7.5% Senior Notes is payable semi-annually in arrears, commencing on May 1, 2013. Interest is computed on the basis of a 360-day year comprised of twelve 30-day months.

Concurrently with the closing of the 7.5% Senior Notes, we entered into the 2017 Term Loan. The 2017 Term Loan was issued at 98% of the face value and initially had an interest rate of LIBOR plus 5%, with a LIBOR floor of 1.25%. The 2017 Term Loan has scheduled debt maturities, payable quarterly, of 5% in the first year and 10% in subsequent years with final maturity on October 25, 2017. The original issue discount, reported as a direct deduction from the face amount of the 2017 Term Loan, will be recognized over the life of the 2017 Term Loan using the effective interest rate method. The 2017 Term Loan is secured on a senior secured basis by us and certain of our subsidiaries.

In November 2013, the 2017 Term Loan was amended to modify the applicable interest rates to: (i) decrease the adjusted LIBOR margin from 5.0% to 4.0% per annum, (ii) decrease the LIBOR floor from 1.25% to 1.0% per annum and (iii) decrease the ABR margin from 4.0% to 3.0%. The amendment also reflected a decrease in the principal amount due from $500 million to $475 million as a result of us making scheduled principal repayments under the original note.

The net proceeds from the above described financings, after fees and expenses, of approximately $1.6 billion were used (i) to pay the total consideration and accrued and unpaid interest on a concurrent tender offer of $1.0 billion of OGIL’s existing debt and related consent solicitation, (ii) for general corporate purposes, including the funding of the final construction payment for the Tungsten Explorer drillship and (iii) to pay fees and expenses related to both of the financings, consent solicitation and related transactions.

In June 2014, we made an additional principal payment of $42.0 million on the 2017 Term Loan. In connection with this payment, we recognized a non-cash charge of approximately $1.4 million related to the write-off of deferred financing costs and original issuance discount on the debt.  

In September 2014, we repurchased in the open market, and subsequently cancelled, $7.0 million of the 7.5% Senior Notes. In connection with this transaction, we recognized a non-cash gain of approximately $74,000 related to the early extinguishment of the debt.

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7.125% Senior Notes and $350 Million 2019 Term Loan

In March 2013, OGIL issued $775.0 million in aggregate principal amount of 7.125% Senior Notes under an indenture. The 7.125% Senior Notes were issued at par and are fully and unconditionally guaranteed, on a senior secured basis, by us and certain of our subsidiaries. The 7.125% Senior Notes mature on April 1, 2023, and bear interest from the date of their issuance at the rate of 7.125% per year. Interest on outstanding 7.125% Senior Notes is payable semi-annually in arrears, commencing on October 1, 2013. Interest is computed on the basis of a 360-day year comprised of twelve 30-day months.

Additionally during March 2013, we entered into the $350 million 2019 Term Loan (the “2019 Term Loan”). The 2019 Term Loan was issued at 98.5% of the face value and bears interest at LIBOR plus 4.5%, with a LIBOR floor of 1.25%. The 2019 Term Loan has annual scheduled debt maturities of 1% of the original principal amount that are payable quarterly commencing in June 2013. The maturity date of the 2019 Term Loan is March 28, 2019. The original issue discount, reported as a direct deduction from the face amount of the 2019 Term Loan, will be recognized over the life of the 2019 Term Loan using the effective interest rate method. The 2019 Term Loan is secured on a senior secured basis by us and certain of our subsidiaries.

The net proceeds, after fees and expenses, from the 7.125% Senior Notes and the 2019 Term Loan of approximately $1.1 billion were used to retire approximately $1.0 billion of OGIL’s existing debt for total consideration of approximately $1.1 billion, including $92.3 million paid for the early redemption and consent fees and $18.2 million for accrued and unpaid interest. The balance of the proceeds was used for payment of transaction expenses and general corporate purposes.

In February 2014, we repurchased in the open market, and subsequently cancelled, $6.0 million of the 7.125% Senior Notes. In connection with this transaction, we recognized a non-cash charge of approximately $106,000 related to the early extinguishment of the debt. In May 2014, we repurchased, and subsequently cancelled, an additional $1.5 million of the 7.125% Senior Notes and recognized a non-cash charge of approximately $10,600 related to the early extinguishment of the debt. In the three months ending September 30, 2014, we repurchased, and subsequently cancelled, an additional $32.5 million of the 7.125% Senior Notes and recognized a non-cash gain of approximately $977,000 related to the early extinguishment of the debt.

5.50% Senior Convertible Notes

In July 2013, we issued $100 million aggregate principal amount of 5.50% Convertible Notes under an indenture. The 5.50% Convertible Notes will mature on July 15, 2043, unless earlier converted, redeemed or repurchased, and bear interest at a rate of 5.50% per annum, payable semi-annually in arrears on January 15 and July 15 of each year, commencing on January 15, 2014. The 5.50% Convertible Notes are our senior, unsecured obligations, and rank senior in right of payment to all of our existing and future subordinated indebtedness and equal in right of payment with any of our other existing and future senior unsecured indebtedness, including our 7.875% Convertible Notes. The 5.50% Convertible Notes are structurally subordinated to all debt and other liabilities of our subsidiaries and are effectively junior to our secured debt to the extent of the value of the assets securing such debt. The net proceeds, after fees and expenses, of approximately $96.5 million were used to fund the initial payment of $59.5 million under the Cobalt Explorer construction contract and the remainder was used for general corporate purposes.

The 5.50% Convertible Notes are convertible into our ordinary shares, cash or a combination of ordinary shares and cash, at our election, based upon an initial conversion rate of 418.6289 ordinary shares per $1,000 principal amount of 5.50% Convertible Notes (equivalent to an initial conversion price of approximately $2.39 per ordinary share). In addition, for conversions by holders after July 15, 2013 and prior to July 15, 2016, converting holders are entitled to a conversion make-whole payment upon conversion.

The 5.50% Convertible Notes contain an embedded conversion option related to the cash settlement provisions and under U.S. GAAP is required to be separated into liability and equity components. We evaluated the 5.50% Convertible Notes based on the market terms of new, nonconvertible debt issuances made by companies with similar credit ratings, adjusting for the unsecured nature of the 5.50% Convertible Notes. Based on this evaluation, we determined that the fair value of the 5.50% Convertible Notes absent the conversion feature was approximately $88.3 million at issuance. The difference between the par value of the 5.50% Convertible Notes and the fair value at date of issuance is recorded as equity and as a discount to the face amount of the 5.50% Convertible Notes and is being amortized to interest expense over the expected life using the effective interest rate method.

The 5.50% Convertible Notes are subject to redemption at our option on or after July 15, 2016 and before July 15, 2018 if the volume weighted average price of our ordinary shares is greater than or equal to 150% of the applicable conversion price for at least 20 trading days during any 30 consecutive trading day period ending within five trading days prior to the notice of redemption. In addition, we may redeem the 5.50% Convertible Notes at any time on and after July 15, 2018. In each case, the redemption purchase price is equal to 100% of the principal amount of the 5.50% Convertible Notes being redeemed, plus accrued and unpaid interest to, but excluding, the redemption date.

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The 5.50% Convertible Notes are subject to repurchase by us at the option of holders of the 5.50% Convertible Notes on July 15, 2016 and on July 15, 2018 for cash at a price equal to 100% of the principal amount of the 5.50% Convertible Notes being repurchased, plus accrued and unpaid interest to, but excluding, the repurchase date.

7.875% Senior Convertible Notes

In August 2012, we issued $56.5 million aggregate principal amount of 7.875% Convertible Notes under an indenture. The 7.875% Convertible Notes will mature on September 1, 2042, unless earlier converted, repurchased or redeemed, and bear interest at a rate of 7.875% per annum, payable semiannually, in arrears, on March 1 and September 1 of each year, commencing on March 1, 2013. The 7.875% Convertible Notes are our senior unsecured obligation and rank equal in payment with our other senior unsecured debt but are structurally subordinated to the debt of our subsidiaries as the 7.875% Convertible Notes are not guaranteed by any of our subsidiaries. We issued $6.5 million of the 7.875% Convertible Notes to F3 Capital. The net proceeds, after fees and expenses, of approximately $48.3 million were used to fund capital expenditures and working capital needs, and for general corporate purposes.

The 7.875% Convertible Notes are convertible into our ordinary shares, or a combination of cash and ordinary shares, if any, at our election, based upon an initial conversion rate of 476.1905 ordinary shares per $1,000 principal amount of 7.875% Convertible Notes (equivalent to an initial conversion price of approximately $2.10 per ordinary share). Holders of the 7.875% Convertible Notes may voluntarily elect to convert all, or any portion, of their holdings at any time. In addition, for any conversions prior to September 1, 2017, holders will be entitled to a make-whole payment upon conversion.

Due to the embedded conversion option related to the cash settlement provisions, we evaluated the 7.875% Convertible Notes based on the market terms of new, nonconvertible debt issuances made by companies with similar credit ratings, adjusting for the unsecured nature of the 7.875% Convertible Notes. Based on this evaluation, we determined that the fair value of the 7.875% Convertible Notes absent the conversion feature was approximately $53.6 million at issuance. The difference between the par value and the fair value at date of issuance of the 7.875% Convertible Notes was recorded as equity and as a debt discount, and is being amortized to interest expense over the expected life of the 7.875% Convertible Notes using the effective interest rate method.

The 7.875% Convertible Notes are subject to redemption at our option on or after September 1, 2015 and before September 1, 2017 if the volume weighted average price of our ordinary shares is greater than or equal to 125% of the applicable conversion price for at least 20 trading days during any 30 consecutive trading day period. Further, the 7.875% Convertible Notes are subject to mandatory conversion at our option on or before September 1, 2015 if the volume weighted average price of our ordinary shares is greater than or equal to 150% of the applicable conversion price for at least 20 trading days during any 30 consecutive trading day period. In each case, the redemption purchase price is equal to 100% of the principal amount of the 5.50% Convertible Notes being redeemed, plus accrued and unpaid interest to, but excluding, the redemption date.

Credit Agreement

In June 2012, we entered into a secured revolving credit agreement (the “Credit Agreement”) to provide us with advances and letters of credit up to an aggregate principal amount of $25.0 million. In March 2013, in connection with the issuance of the 7.125% Senior Notes and the 2019 Term Loan, we amended the Credit Agreement to increase the aggregate principal amount to $200.0 million, of which $32.0 million is reserved for letters of credit. The Credit Agreement will now mature on April 25, 2017. Advances under the Credit Agreement bear interest at the adjusted base rate (as defined in the Credit Agreement) plus a margin of 2.50% or LIBOR plus a margin of 3.50%, at our option. We may prepay outstanding advances subject to certain prepayment minimums at any time.

The Credit Agreement includes customary covenants and events of default, including covenants that, among other things, restrict the granting of liens on certain assets, restrict the incurrence of indebtedness and the conveyance of and modification to vessels and require us to maintain certain financial ratios and provide periodic financial reports. Advances under the Credit Agreement are secured by a lien on certain of our assets, which are substantially similar to those assets pledged in connection with the 7.125% Senior Notes, the 7.5% Senior Notes, the 2017 Term Loan and the 2019 Term Loan. We believe we were in compliance with all financial covenants of the Credit Agreement at September 30, 2014. As of September 30, 2014, we had issued letters of credit for $21.5 million under the Credit Agreement.

 

6. Shareholders’ Equity

Preferred Shares

We have 10,000,000 authorized preferred shares, par value $0.001 per share. As of September 30, 2014, no preferred shares were issued and outstanding.

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Ordinary Shares

We have 500,000,000 authorized ordinary shares, par value $0.001 per share. Under our 2007 Long-Term Incentive Plan (the “LTIP”), we may issue a maximum of 45 million ordinary shares. During the nine months ended September 30, 2014, we granted to employees and directors 4,321,289 time-vested restricted shares and 1,978,542 performance unit awards under our LTIP. Time-vested restricted share awards issued to employees vest ratably over four years, while awards to directors vest one year from date of grant. Performance unit awards vest over a three-year period based on the level of attainment of pre-determined criteria; upon vesting, each performance unit award may be converted to ordinary shares at a ratio ranging from 0 to 1.5. The value of the 2014 time-vested restricted share awards and performance units is amortized to expense over the respective vesting period based on the fair value of the awards at the grant dates, which was approximately $11.7 million, based on an average share price of $1.86 per share. For purposes of calculating the grant date fair value of the performance units, the target conversion ratio of one ordinary share for one performance unit was used. In the nine months ended September 30, 2014, 2,836,634 of previously granted time-vested restricted share awards and 668,550 performance units, including 96,176 additional shares issued pursuant to achievement of pre-determined criteria, vested. Additionally, in the nine months ended September 30 2014, we issued 125,971 shares, valued at approximately $230,000, to directors in lieu of cash for directors’ fees.

 

7. Income Taxes

We are a Cayman Islands entity. The Cayman Islands does not impose corporate income taxes. Consequently, we have provided income taxes based on the tax laws and rates in effect in the countries in which operations are conducted, or in which we and our subsidiaries are considered resident for income tax purposes. We operate in multiple countries under different legal forms. As a result, we are subject to the jurisdiction of numerous domestic and foreign tax authorities, as well as to tax agreements and treaties among these governments. Our operations in these different jurisdictions are taxed on various bases, including (i) actual income before taxes, (ii) deemed profits (which are generally determined by applying a tax rate to revenues rather than profits) and (iii) withholding taxes based on revenue. Determination of taxable income in any jurisdiction requires the interpretation of the related tax laws and regulations and the use of estimates and assumptions regarding significant future events, such as the amount, timing and character of deductions, permissible revenue recognition methods under the tax law and the sources and character of income and tax credits. Changes in tax laws, regulations, agreements and treaties, foreign currency exchange restrictions or our level of operations or profitability in each tax jurisdiction could have an impact on the amount of income taxes that we provide during any given year.

We account for income taxes pursuant to ASC 740, Accounting for Income Taxes, which requires recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. We provide for deferred taxes on temporary differences between the financial statements and tax bases of assets and liabilities using the enacted tax rates which are expected to apply to taxable income when the temporary differences are expected to reverse. Deferred tax assets are also provided for certain tax credit carryforwards. A valuation allowance is established to reduce deferred tax assets when it is more likely than not that some portion or all of the deferred tax asset will not be realized.

In certain jurisdictions we are taxed under preferential tax regimes, which may require our compliance with specified requirements to sustain the tax benefits. We believe we are in compliance with the specified requirements and will continue to make all reasonable efforts to comply; however, our ability to meet the requirements of the preferential tax regimes may be affected by changes in laws, our business operations and other factors affecting our company and industry, many of which are beyond our control.

Our periodic tax returns are subject to examination by taxing authorities in the jurisdictions in which we operate in accordance with the normal statutes of limitations in the applicable jurisdiction. These examinations may result in assessments of additional taxes that are resolved with the authorities or through the courts. Resolution of these matters involves uncertainties and there are no assurances as to the outcome. Our tax years 2008 and forward remain open to examination in many of our jurisdictions and we are currently involved in several tax examinations in jurisdictions where we are operating or have previously operated. As information becomes available during the course of these examinations, we may increase or decrease our estimates of tax assessments and accruals.

 

8. Commitments and Contingencies

We are subject to litigation, claims and disputes in the ordinary course of business, some of which may not be covered by insurance. There is an inherent risk in any litigation or dispute and no assurance can be given as to the outcome of any claims. We do not believe the ultimate resolution of any existing litigation, claims or disputes will have a material adverse effect on our financial position, results of operations or cash flows.

On August 21, 2012, we filed a lawsuit against Mr. Hsin-Chi Su, a former member of our Board of Directors and the owner of F3 Capital, our largest shareholder, asserting breach of fiduciary duties, fraud, fraudulent inducement and negligent misrepresentation, and unjust enrichment based on Mr. Su’s conduct in his dealings with the Company both immediately prior to, and during his tenure

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as one of our directors. In June 2014, Mr. Su filed a countersuit against us and certain of our current and former officers and directors. See above under “Note 3. Transactions with F3 Capital and Affiliates—Lawsuit” for additional information.

We enter into operating leases in the normal course of business for office space, housing, vehicles and specified operating equipment. Some of these leases contain renewal options which would cause our future cash payments to change if we exercised those renewal options.

 

9. Supplemental Financial Information

 

Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets consisted of the following:

 

Property and Equipment, net

Property and equipment, net consisted of the following:

 

Other Assets

Other assets consisted of the following:

 

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Accrued Liabilities

Accrued liabilities consisted of the following:

 

Other Long-Term Liabilities

Other long-term liabilities consisted of the following:

 

10. Business Segment and Significant Customer Information

We aggregate our contract drilling operations into one reportable segment even though we provide contract drilling services with different types of MODUs, including jackup rigs and drillships, and in different geographic regions. Our operations are dependent on the global oil and gas industry and our MODUs are relocated based on demand for our services and customer requirements. Our customers consist primarily of large international oil and gas companies, national or government-controlled oil and gas companies and other international exploration and production companies. We also provide construction supervision and operations management services for drilling units owned by others.

For 2014 and 2013, the majority of our revenue was from countries outside of the United States. Consequently, we are exposed to the risk of changes in economic, political and social conditions inherent in foreign operations. Four customers accounted for approximately 32%, 24%, 18% and 11% of consolidated revenue for the three months ended September 30, 2014. For the nine months ended September 30, 2014, four customers accounted for 23%, 21%, 20% and 15% of consolidated revenue. Three customers accounted for 31%, 30 % and 10% of consolidated revenue for the three months ended September 30, 2013. For the nine months ended September 30, 2013, three customers accounted for 32%, 26% and 11% of consolidated revenue.

 

11. Supplemental Condensed Consolidating Financial Information

The 7.125% Senior Notes and 7.5% Senior Notes were issued under separate indentures and are fully and unconditionally guaranteed, jointly and severally, on a senior secured basis by us and certain of our subsidiaries (the “Subsidiary Guarantors”). Our other subsidiaries have not guaranteed or pledged assets to secure the 7.125% Senior Notes or the 7.5% Senior Notes (collectively, the “Non-Guarantors”).

The following tables present the condensed consolidating financial information as of September 30, 2014 and 2013 and for the three and nine months ended September 30, 2014 and 2013 of (i) Vantage Drilling Company (the “Parent”), (ii) OGIL, (iii) the Subsidiary Guarantors, (iv) the Non-Guarantors and (v) consolidating and elimination entries representing adjustments to eliminate (a) investments in our subsidiaries and (b) intercompany transactions.

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The financial information reflects all adjustments which are, in management’s opinion, necessary for a fair presentation of the financial position as of September 30, 2014 and 2013 and results of operations for the three and nine months ended September 30, 2014 and 2013, respectively.

Condensed Consolidating Balance Sheet (in thousands)

 

 

Condensed Consolidating Statement of Operations (in thousands)

Condensed Consolidating Statement of Operations (in thousands)

 

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Condensed Consolidating Statement of Cash Flows (in thousands)

 

 

Condensed Consolidating Balance Sheet (in thousands)

 

 

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Condensed Consolidating Statement of Operations (in thousands)

Condensed Consolidating Statement of Operations (in thousands)

 

 

Condensed Consolidating Statement of Cash Flows (in thousands)

 

 

 

 

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion is intended to assist you in understanding our financial position at September 30, 2014 and our results of operations for the three and nine months ended September 30, 2014 and 2013. The discussion should be read in conjunction with the financial statements and notes thereto, included in our Annual Report on Form 10-K for the year ended December 31, 2013. The results of operations for the interim periods are not necessarily indicative of the operating results for the full fiscal year or any future periods. Certain previously reported amounts have been reclassified to conform to the current year presentation.

Overview

We are an international offshore drilling company focused on operating a fleet of modern, high specification drilling units. Our principal business is to contract drilling units, related equipment and work crews, primarily on a dayrate basis to drill oil and natural gas wells for our customers. We also provide construction supervision services for, and will operate and manage, drilling units owned by others. Through our fleet of drilling units we provide offshore contract drilling services to major, national and independent oil and natural gas companies, focused primarily on international markets.

The following table sets forth certain information concerning our offshore drilling fleet.

 

Business Outlook

Expectations about future oil and natural gas prices have historically been a key driver of demand for our services. In a series of estimate revisions, the International Energy Agency now estimates that demand growth for 2014 will increase by approximately 700,000 barrels per day or 0.8% which is a significant reduction from the demand growth estimate of 1.3 million barrels per day or 1.4% estimated in the prior quarter. The driver of the revised estimates has been a perceived economic slowdown in China and Europe.  These estimate revisions have resulted in a steep decline in oil prices and increased the uncertainty around short-term drilling programs.

Our customers continue to favor newer, more technically capable rigs over older, less efficient rigs. However, during periods with a high rate of newbuild deliveries, competitors may significantly reduce the rates for the older, less efficient rigs in order to induce customers to contract their rigs. This tends to put downward pressure on dayrates for modern, high-specification assets as well, as the owners of those units reduce rates to be more competitive. The order book for jackups currently indicates that 10 additional jackups are scheduled for delivery through the end of 2014 with another 64 jackups scheduled for delivery in 2015. The order book for ultra deepwater floaters, including drillships and semisubmersibles, indicates that 12 additional floaters are scheduled for delivery in 2014 with another 28 floaters scheduled for delivery in 2015. We believe that all of the newbuild rigs will ultimately be contracted as either replacements for older rigs or through market expansion to meet growing demand. However, in the near-term, a few competitors are facing the possibility of having newly built rigs delivered without contracts, which in turn is resulting in drastic price cutting in such cases and is putting significant pressure on current dayrate benchmarks. We believe that these conditions will persist into 2015.

An additional factor that impacts our ability to contract our drilling rigs is geopolitical risk.  Geopolitical risk in parts of the Middle East, North Africa and West Africa has reduced access to these markets in recent years, leading to supply disruption. Additionally, international sanctions against Russia has reduced access for us and our competitors to this market, creating additional competition from rigs that otherwise would have been working in Russia.  The timing and magnitude of incremental oil production

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from these regions potentially becoming available to the world market has made it difficult for our customers to estimate the total oil supply and related impact on world oil prices. Additionally, the possibility of easing international sanctions against Iran could increase oil supply from the Middle East. In response to political pressure to support social agendas and promote localization of the workforce and production spending, countries in West Africa and Latin America have adopted additional local spending requirements and taxes on oil and gas producing activities, which has increased the costs of developing these oil and gas reserves. As a result, some exploration and production projects in these countries have been delayed while the new regulations and contracting requirements are evaluated.

We believe that we are well positioned for these market changes as our fleet has significant backlog for 2014 and 2015. We believe that our marketing efforts and current customer mix is also reflective of these trends as we have long-term relationships with national oil companies that have drilling programs which are expected to be less impacted by short-term volatility in the market. A summary of our backlog coverage of days contracted and related revenue is as follows:

 

 

Results of Operations

The first two of our jackup rigs began operations under their initial contracts in February and August 2009, respectively. Our third and fourth jackup rigs commenced operations in January and March 2010, respectively. Our first drillship, the Platinum Explorer, commenced operations in December 2010. Our second drillship, the Titanium Explorer, commenced operations in December 2012. Our third drillship, the Tungsten Explorer, commenced operations in September 2013.

The following table sets forth selected contract drilling operational information for the periods indicated:

 

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The following table is an analysis of our operating results for the three and nine months ended September 30, 2014 and 2013, respectively.

 

Revenue: Total revenue increased 18% and contract drilling revenue increased 19% in the three months ended September 30, 2014 as compared to the three months ended September 30, 2013. The increase in drilling revenue was primarily due to the commencement of operations of the Tungsten Explorer in September 2013, which added $36.1 million of revenue.

Jackup utilization for the three months ended September 30, 2014 increased 27.8% compared to the prior year period. Jackup utilization in the prior year was lower due to days out of service following the early termination of the Sapphire Driller contract in May 2013. Deepwater utilization for the three months ended September 30, 2014 decreased approximately 22% compared to the prior year due to the mobilization of the Tungsten Explorer to West Africa during the current quarter.

Management fees and reimbursable revenue for the three months ended September 30, 2014 were $1.9 million and $15.9 million, respectively, as compared to $3.9 million and $13.1 million in the prior year period. The decrease in management fees was primarily due to the termination of the operations management contract of two jackups in Mexico. The increase in reimbursable revenue was primarily due to higher reimbursables on the Tungsten Explorer.

Total revenue for the nine months ended September 30, 2014 increased 34% as compared to the nine months ended September 30, 2013 and contract drilling revenue increased 34% in the first nine months of 2014 as compared to the same period in 2013. The increase in drilling revenue was primarily due to the commencement of operations of the Tungsten Explorer in September 2013, which added $124.3 million of revenue, and to improved utilization of the Sapphire Driller in 2014, which contributed additional revenues of $19.2 million.

Jackup utilization for the nine months ended September 30, 2014 increased 12.8% compared to the prior year due to the early termination of the Sapphire Driller contract in May 2013. Deepwater utilization for the nine months ended September 30, 2014 decreased approximately 10% compared to the prior year due to the mobilization of the Tungsten Explorer to West Africa during the current period.

Management fees and reimbursable revenue increased in the nine months ended September 30, 2014 compared to the prior year primarily due to having multiple construction management services projects in 2014 and to managing the operations of two jackups for a contractor in Mexico during the first part of 2014.

Operating costs: Operating costs for the three months ended September 30, 2014 increased 32% compared to the three months ended September 30, 2013, due primarily to incremental operating costs on the Tungsten Explorer of approximately $22.0 million

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(resulting from a full quarter in service) and to increased costs of approximately $5.7 million on the Titanium Explorer, primarily due to the relocation of the rig from the U.S. Gulf of Mexico to West Africa.

Operating costs for the nine months ended September 30, 2014 increased 31% compared to the nine months ended September 30, 2013, due primarily to incremental operating costs on the Tungsten Explorer of approximately $52.5 million and to increased costs of approximately $16.2 million on the Titanium Explorer primarily due to relocation to West Africa.

General and administrative expenses: Increases in general and administrative expenses for both the three and nine-month periods ended September 30, 2014 as compared to the three and nine-month periods ended September 30, 2013 were primarily due to increased legal fees related to ongoing litigation.

Depreciation expense: The increase in depreciation expense for the three and nine-month periods ended September 30, 2014 as compared to the same periods of 2013 were primarily due to the addition of the Tungsten Explorer to our operating fleet in September 2013.

Interest expense and other financing charges: Interest expense and other financing charges for the three and nine-month periods ended September 30, 2014 increased over the same period in 2013 primarily because we had less capitalized interest in 2014 compared to 2013. We were capitalizing interest in 2013 on the Tungsten Explorer, until it commenced operations in September 2013.

We capitalized $1.3 million and $3.8 million of interest and amortization costs in the three and nine-month periods ended September 30, 2014, respectively. We capitalized $9.8 million and $17.6 million of interest and amortization costs, respectively, in the three and nine-month periods ended September 30, 2013. The reduction in capitalized interest was due to the Tungsten Explorer commencing operations in September 2013.

Gain (loss) on extinguishment of debt: During the three months ending September 30, 2014, we repurchased in the open market, at a discount to face value, $32.5 million of our 7.125% Senior Notes and $7.0 million of our 7.5% Senior Notes and recognized gains of $1.5 million and $177,000, respectively, which were partially offset by the write-off of deferred financing costs of $618,000.

In the nine-month period ending September 30, 2014, we repurchased in the open market, at a discount to face value, $40.0 million of our 7.125% Senior Notes and $7.0 million of our 7.5% Senior Notes and recognized gains of $1.5 million and $177,000, respectively. The gains were partially offset by the write-off of deferred financing costs of $751,000. In connection with an additional principal payment of $42.0 million in June 2014 on the 2017 Term Loan, we recognized a loss of $1.4 million resulting from the write-off of deferred financing costs of $820,000 and original debt issuance discount of $576,000.

In the nine-month period ended September 30, 2013, in connection with the early retirement of the remaining $1.0 billion of our 11.5% Senior Notes, we recognized a loss of $98.3 million resulting from the payment of early redemption fees and consent fees of $92.3 million and the write-off of deferred financing costs of $24.0 million, which were offset by the early recognition of debt issuance premium of $18.0 million.

Income tax expense: Income tax expense was $8.3 million and $36.0 million, respectively, for the three and nine-month periods ended September 30, 2014, as compared to $4.1 million and $16.8 million, respectively, for the comparable periods in 2013. Our income taxes are generally dependent upon the results of our operations and the local income taxes in the jurisdictions in which we operate. The increase in taxes during the three and nine-month periods of 2014 was primarily due to tax expense related to the Tungsten Explorer, which was not in operation in the comparable periods of 2013, an increase in non-deductible expenses and an increase in income in jurisdictions with high statutory rates or jurisdictions where we are taxed on a deemed profit basis. In some jurisdictions we do not pay taxes or receive benefits for certain income and expense items, including interest expense and loss on extinguishment of debt.

Liquidity and Capital Resources

As of September 30, 2014 we had working capital of approximately $143.7 million, including approximately $81.3 million of cash available for general corporate purposes. Additionally we have posted $6.6 million cash as collateral for bid tenders and performance bonds. We have approximately $249.3 million in available liquidity, including our available cash and $168.0 million available under our Credit Agreement. Under our Credit Agreement $32.0 million is reserved for letters of credit. As of September 30, 2014, we had issued letters of credit of $21.5 million.

Over the next twelve months, we are forecasting expenditures of approximately $239.8 million for principal (excluding voluntary prepayments) and interest payments on our outstanding debt, including scheduled maturities of $53.5 million on our long-term debt. For the remainder of 2014, we anticipate spending approximately $12.6 million on capital expenditures, including $7.0

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million on sustaining capital expenditures and our fleet capital spares program and $5.6 million on the Cobalt Explorer. In January 2015, we have the second milestone shipyard payment of $59.5 million due on the Cobalt Explorer. The third, and final, milestone payment is due upon delivery, which is currently expected to be in the fourth quarter of 2015, or later. Additionally, we are currently forecasting spending an additional $64.7 million on capital expenditures, including the Cobalt Explorer, and fleet capital spares in the first nine months of 2015. These amounts do not include any capitalized interest related to the Cobalt Explorer construction project. We expect to fund these expenditures from our available working capital, cash flow from operations and advances under the Credit Agreement, if necessary.

In the next twelve months, we will be evaluating financing alternatives for the remaining shipyard funding commitments for the Cobalt Explorer. We are currently pursuing drilling contracts for the Cobalt Explorer, and the timing and extent of any such contracts is a significant factor that will affect our financing alternatives, which will have a significant impact on our liquidity position in 2015.

As of September 30, 2014, our long-term debt was composed of the following:

 

During 2014, we have made several open market repurchases of our outstanding debt issuances and an additional principal payment on our 2017 Term Loan. The following table summarizes our debt payments, both scheduled and discretionary, through October 10, 2014 (in thousands).

We are subject to litigation, claims and disputes in the ordinary course of business, some of which may not be covered by insurance. There is an inherent risk in any litigation or dispute and no assurance can be given as to the outcome of any claims. We do not believe the ultimate resolution of any existing litigation, claims or disputes will have a material adverse effect on our financial position, results of operations or cash flows.

We enter into operating leases in the normal course of business for office space, housing, vehicles and specified operating equipment. Some of these leases contain options which would cause our future cash payments to change if we exercised those options.

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Critical Accounting Policies and Accounting Estimates

The preparation of financial statements and related disclosures in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. While management believes current estimates are appropriate and reasonable, actual results could materially differ from those estimates. We have identified the policies below as critical to our business operations and the understanding of our financial operations.

Property and Equipment: Our long-lived assets, primarily consisting of the values of our drilling rigs, are the most significant amount of our total assets. We make judgments with regard to the carrying value of these assets, including amounts capitalized, componentization, depreciation and amortization methods, salvage values and estimated useful lives. We capitalize interest costs related to the financings of our drilling rigs while they are under construction and prior to the commencement of each vessel’s first contract, which has increased the carrying value of the drilling rigs. Our weighted average cost of capital, which is the key component used in our calculation of capitalized interest, is directly impacted by the volatility in the global financial and credit markets. The completion of a construction project has an impact on the amount of interest expense that is prospectively recognized in our results of operations. Total interest and amortization costs capitalized for assets under construction for the three and nine months ended September 30, 2014 were $1.3 million and $3.8 million, respectively. Total interest and amortization costs capitalized for the three and nine months ended September 30, 2013 were $9.5 million and $15.9 million, respectively.

We evaluate the realization of property and equipment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment loss on our property and equipment exists when estimated undiscounted cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying amount. Any impairment loss recognized would be computed as the excess of the asset’s carrying value over the estimated discounted cash flows. Estimates of future cash flows require us to make long-term forecasts of our future revenues and operating costs with regard to the assets subject to review. Our business, including the utilization rates and dayrates we receive for our drilling rigs, depends on the level of our customers’ expenditures for oil and natural gas exploration, development and production expenditures. Oil and natural gas prices and customers’ expectations of potential changes in these prices, the general outlook for worldwide economic growth, political and social stability in the major oil and natural gas producing basins of the world, availability of credit and changes in governmental laws and regulations, among many other factors, significantly affect our customers’ levels of expenditures. Sustained declines in oil and natural gas prices, worldwide rig counts and utilization, reduced access to credit markets and any other significant adverse economic news could require us to evaluate the realization of our drilling rigs.

Debt Financing Costs: Costs incurred with debt financings are deferred and amortized over the term of the related financing facility.

Revenue: Revenue is recognized as services are performed based on contracted dayrates and the number of operating days during the period.

In connection with a customer contract, we may receive lump-sum fees for the mobilization of equipment and personnel. Mobilization fees and costs incurred to mobilize a rig from one geographic market to another are deferred and recognized on a straight-line basis over the term of such contract, excluding any option periods. Costs incurred to mobilize a rig without a contract are expensed as incurred. Fees or lump-sum payments received for capital improvements to rigs are deferred and amortized to income over the term of the related drilling contract. The costs of such capital improvements are capitalized and depreciated over the useful lives of the assets. Deferred revenue under drilling contracts was $75.0 million and $39.4 million at September 30, 2014 and December 31, 2013, respectively. Deferred revenue is included in either accrued liabilities or other long-term liabilities in our consolidated balance sheet, based upon the initial term of the related drilling contract.

We record reimbursements from customers for rebillable costs and expenses as revenue and the related direct costs as operating expenses.

Rig and Equipment Certifications: We are required to obtain regulatory certifications to operate our drilling rigs and certain specified equipment and must maintain such certifications through periodic inspections and surveys. The costs associated with these certifications, including drydock costs, are deferred and amortized over the corresponding certification periods.

Income Taxes: Income taxes have been provided based upon the tax laws and rates in effect in the countries in which operations are conducted and income is earned. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax basis of assets and liabilities that will result in future taxable or deductible amounts and are based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred income tax assets to the amount expected to be realized. We recognize interest and penalties related to income taxes in income tax expense.

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Share-Based Compensation: We account for share-based compensation using the fair value method as prescribed under U.S. GAAP. Restricted share grants are valued based on the market price of our ordinary shares on the date of grant and the fair value attributable to share options is calculated based on the Black-Scholes option pricing model. The fair values are amortized to expense over the service period which is equivalent to the time required to vest the share options and share grants.

Use of Estimates: The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. While management believes current estimates are appropriate and reasonable, actual results could differ from those estimates.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our rigs operate in various international locations and thus are sometimes subject to foreign exchange risk. We may from time to time also be exposed to certain commodity price risk, equity price risk and risks related to other market driven rates or prices. The risks associated with foreign exchange rates, commodity prices and equity prices have not been significant in the first nine months of 2014 as all of our drilling contracts thus far have been denominated in U.S. dollars. We do not enter into derivatives or other financial instruments for trading or speculative purposes.

Interest Rate Risk: As of September 30, 2014, we had $718.9 million of variable rate debt, net of discount of $8.8 million, outstanding. In October 2012, we entered into the 2017 Term Loan which bears interest at LIBOR plus 4%, with a LIBOR floor of 1.0%. The 2017 Term Loan has scheduled debt maturities, payable quarterly, of 5% of the original principal amount in the first year and 10% in subsequent years with final maturity in October 2017. In March 2013, we entered into the 2019 Term Loan. The 2019 Term Loan bears interest at LIBOR plus 4.5%, with a LIBOR floor of 1.25%. The 2019 Term Loan has annual scheduled debt maturities of 1% of the original principal amount that are payable quarterly commencing in June 2013. The maturity date of the 2019 Term Loan is March 28, 2019. Increases in the LIBOR rate would impact the amount of interest that we are required to pay on the term loans. For every 1% increase in LIBOR above the LIBOR floor, we would be subject to an increase in interest expense of $7.3 million per annum based on September 30, 2014 outstanding principal amounts. As of September 30, 2014, the 1-year LIBOR rate was 0.55% which means the LIBOR floor is triggered and the current interest rates on the 2017 Term Loan and the 2019 Term Loan would be approximately 5.0% and 5.75%, respectively, or approximately $39.0 million per year in interest expense. We have not entered into any interest rate hedges or swaps with regard to either of the term loans.

Foreign Currency Exchange Rate Risk. As we operate in international areas, we are exposed to foreign exchange risk. Our primary foreign exchange risk management strategy involves structuring customer contracts to provide for payment in both U.S. dollars, which is our functional currency, and local currency. The payment portion denominated in local currency is based on anticipated local currency requirements over the contract term. Due to various factors, including customer acceptance, local banking laws, other statutory requirements, local currency convertibility and the impact of inflation on local costs, actual foreign exchange needs may vary from those anticipated in the customer contracts, resulting in partial exposure to foreign exchange risk. Fluctuations in foreign currencies have not had a material impact on our overall results. If we find ourselves in situations where payments of local currency do not equal local currency requirements, foreign exchange derivative instruments, specifically foreign exchange forward contracts, or spot purchases, may be used to mitigate foreign currency risk. A foreign exchange forward contract obligates us to exchange predetermined amounts of specified foreign currencies at specified exchange rates on specified dates or to make an equivalent U.S. dollar payment equal to the value of such exchange. We do not enter into derivative transactions for speculative purposes. As of September 30, 2014, we did not have any open foreign exchange derivative contracts or material foreign currency exposure risk.

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Item 4. Controls and Procedures

Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified by the SEC rules and forms.

We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, such officers have concluded that the design and operation of these disclosure controls and procedures were effective as of September 30, 2014 to provide reasonable assurance that information required to be disclosed on our reports filed or submitted under the Exchange Act was (1) accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and (2) recorded, summarized and reported within the time periods specified in the SEC’s rules and forms.

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) during the most recent fiscal quarter that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

 

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PART II—OTHER INFORMATION

 

Item 6. Exhibits

 

 

 

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

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