Thu 10/27/2022 15:03 PM
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Relevant Items:
Ensign Energy Debt Documents
Ensign Energy Covenants Tear Sheet and Debt Document Summaries

Ensign Energy Services Inc. provides oilfield services to the crude oil and natural gas industries in three main geographic operating regions: Canada, United States and international. Oilfield services include drilling and well servicing, oil sands coring, directional drilling, underbalanced and managed pressure drilling, and equipment rentals and transportation. The company is listed on the Toronto Stock Exchange under the ticker ESI and files in Canada, not with the Securities and Exchange Commission.

In this report, we discuss the company’s financial covenants and analyze capacity under its revolver agreement to prepay the unsecured 2024 notes, which can trigger a springing maturity of the revolver if they are not addressed by October 2023.

We conclude the following:
  • Financial covenants - As of June 30, the revolver’s net first lien leverage covenant contained virtually no room for financial decline, and because that covenant’s ratio test will step down later this year, it requires the company to deleverage.

    A 5.00x net leverage covenant will begin testing at the end of the first quarter of 2023, and as of June 30, the company exceeded that ratio (had it been tested). That covenant also requires deleveraging.

    Management said it expects EBITDA and related financial ratios to improve as EBITDA attributable to 2021 quarters rolls off from the LTM figure. But should that change, financial covenant compliance could become a more pressing issue.
  • Revolver springing maturity - The revolver generally requires the company to refinance the unsecured 2024 notes with unsecured pari debt.

    There is an asset-sale prepayment carve-out that can be used to prepay the 2024 notes with cash or revolver borrowings, but the carve-out is not expected to contain meaningful prepayment capacity. 

    The only other prepayment carve-out the revolver contains generally only permits unsecured-to-unsecured refinancings.
We have also published a covenants tear sheet for Ensign Energy, which includes detailed incurrence capacity estimates for each debt agreement and a debt document summary for the company’s unsecured 2024 notes.
Ensign Energy’s capital structure as of June 30 was as follows:

Financial Covenants

Ensign Energy’s revolver agreement contains four financial covenants:
  • A minimum EBITDA covenant (140 million Canadian dollars), which will terminate after the year-end 2022 testing date;
  • A 5.00x net total leverage covenant, which will begin testing at the end of first-quarter 2023;
  • A 3.25x net first lien leverage covenant, which will step down to 3x at year-end 2022; and
  • A 2.25x interest coverage covenant, which will step up to 2.5x at year-end 2022.

Each of the financial covenants are tested quarterly, and the leverage ratios are calculated with uncapped cash netting.

The current iteration of the revolver agreement is a December 2021 amendment and restatement, or A&R. Previously, a 2020 amendment terminated the 5.00x net total leverage covenant and replaced it with the EBITDA covenant. The 2021 A&R then amended the financial covenants to terminate the EBITDA covenant after year-end 2022 and at that time reinstate the 5.00x net total leverage, with net total leverage first being tested at the end of first-quarter 2023.

On recent earnings calls, management has been optimistic about the revolver’s financial covenants. On the May 9 earnings call, management emphasized that covenant EBITDA is expected to increase as EBITDA attributable to 2021 quarters rolls off from the LTM figure.
“Q: [A]t the end of the quarter, you’ve been in good standing with credit facility covenants, but fairly tight I would say on the [net first lien leverage] covenant. [Can] you just maybe talk about how you expect this to trend through the remainder of the year? I know both the debt and the EBITDA are going to be moving parts to that. But how wide do you - how wide of a margin do you expect to have on your covenants as the year progresses and you bring more rigs back into the field, but also face some reactivation costs?

“A: We’re definitely comfortable with what we have. If you look, I mean, Q2 of the prior year, EBITDA was CAD 45.6 million. If you kind of look at where consensus is, it’s - where that’s CAD 63.7 million for Q2 of 2022. So, you’re seeing a significant increase in activity and in EBITDA. So, the bank covenant is on a trailing 12. So, as we draw the lower quarters from 2021, you’ll see that covenant start to improve as we go out throughout the year. So, we definitely have enough room for it and don’t foresee any issues.

On the Aug. 5 earnings call, management stated that it expects to reduce revolver borrowings with operating cash.
“Q: [T]he year-to-date debt reduction of CAD 83 million is noted but the credit facility is practically fully drawn. Leverage ratios are still elevated. You bumped the capital program here, which makes sense given the outlook. I assume you’re also going to have to direct some cash towards working capital in the back half. But do you think we’ll see Ensign add a little breathing room on the line of credit in the near future or can you maybe just give us a sense of how you’re looking at capital allocation and debt reduction as we look ahead?
“A: Yeah, sure. So I think - I mean we see in the first half, we had about CAD 80 million worth of capital, of which now those rigs are going to be generating free cash flow going into Q3 and Q4. So I think we’ll see that liquidity on the facility continue to increase for the remainder of the year. So, when we look at our accounts receivables and everything like that, I think we’ll see more and more liquidity being added on to the balance sheet for the remainder of the year. Then I think that will continue to expand. We’ll definitely continue to expand into 2023. So, I think from operational cash flow, we’ll see continued deleveraging.”

Ensign is scheduled to release its third-quarter earnings and financials on Nov. 4.

Ensign discloses its financial ratios and covenant EBITDA under the revolver agreement.

The below table depicts the applicable quarterly financial covenant tests and related calculations. The two main takeaways from the table are the following:
  • Under the net total leverage covenant, Ensign must deleverage at least 0.30x by the end of first-quarter 2023, when that covenant is reinstated.
  • The net first lien leverage covenant contained only 0.03x of headroom as of June 30. That covenant’s test steps down by 0.25x at the end of this year and therefore also requires deleveraging.

Moreover, the net total leverage ratio can potentially be affected by fluctuations in currency exchange rates. The ratio is tested on a CAD basis, but the unsecured 2024 notes are USD. Therefore, fluctuations in exchange rates can potentially increase the amount of leverage the notes contribute to the net total leverage ratio, despite no change in the underlying obligation.

In addition to the above financial covenants, the revolver agreement also contains an anti-hoarding provision and a guarantor coverage covenant.

The anti-hoarding provision prohibits the loan parties from accumulating or otherwise maintaining cash or cash equivalents in any accounts maintained by loan parties, other than in the ordinary course of business, and the provision does not contain a dollar threshold. Under the anti-hoarding provision, revolver lenders can refuse to fund a borrowing if they reasonably determine that the advance would cause noncompliance with the anti-hoarding provision.

Because of the anti-hoarding provision, all of the company’s balance sheet cash is either cash of loan parties that is necessary to run the business or cash of nonguarantors. As of year-end 2018, nonguarantors accounted for 12% of consolidated revenue and 13% of consolidated assets (as disclosed by the notes’ offering memorandum).

The guarantor coverage covenant requires loan parties to directly own at least a certain percentage of the company’s consolidated total assets and receive or be entitled to at least a certain percentage of the company’s consolidated total revenue. The required percentage thresholds are redacted from the publicly filed version of the revolver agreement. Under the agreement, “Material Subsidiaries” are required to guarantee the revolver, and the “Material Subsidiary” definition also contains asset/revenue percentage provisions, also with redacted percentages. It is unknown whether the redacted percentages of the guarantor coverage covenant are more protective than the percentages of the Material Subsidiary definition (presumably, they are the same percentages).
Revolver Springing Maturity, Note Prepayment Restrictions

Although the revolver is scheduled to mature in November 2024, it is subject to a springing maturity to October 2023, six months before the unsecured 2024 notes mature in April 2024. Therefore, in the coming year, Ensign must also address the 2024 notes to avoid the springing maturity.

The revolver agreement contains a prepayment covenant, which applies to any repayment of the unsecured 2024 notes, including at their maturity. The covenant’s only carve-outs are a carve-out related to asset sale proceeds and a refinancing carve-out. The prepayment covenant does not contain a general dollar-capped prepayment basket (as it was removed by the 2021 A&R).
Asset-Sale Prepayment Basket

Capacity under the revolver’s asset-sale prepayment basket builds by one-third of net proceeds received by loan parties from “Permitted Dispositions” since the beginning of 2021. Basket usage is subject to a pro forma CAD 175 million liquidity requirement, and basket capacity is capped at an unknown amount.

Below, we discuss the asset-sale prepayment basket and estimate that the basket will likely contain insufficient capacity to fully prepay the $417.5 million of 2024 notes before the revolver’s October 2023 springing maturity.

The asset-sale prepayment basket permits revolver borrowings to be used to prepay the unsecured 2024 notes. The basket permits the company to use asset sale proceeds to, in the interim, repay revolver borrowings (or apply to any other transaction), without affecting any of the basket’s accrued capacity. Later, the revolver can be drawn on to finance a notes prepayment, using the basket’s accrued capacity. (The revolver’s use-of-proceeds provisions expressly permit revolver draws to be applied to repayment of the 2024 notes, subject to the prepayment covenant.)

The asset-sale prepayment basket’s pro forma liquidity requirement is likely CAD 175 million, and that requirement counts Ensign’s pro forma consolidated balance sheet cash and revolver availability.

Similar to the publicly filed version of the revolver agreement’s 2021 A&R, the revolver’s 2020 amendment was filed with many redacted terms. And, like the 2021 A&R, the 2020 amendment contained an asset-sale prepayment basket with a redacted liquidity requirement. The press release filed in connection with the 2020 amendment, however, disclosed various redacted terms, including that the 2020 amendment’s asset-sale prepayment basket contained a liquidity requirement of CAD 175 million. Therefore, it seems likely that the similar basket in the 2021 A&R contains a liquidity requirement of no less than CAD 175 million, considering that the 2021 A&R tightened various agreement terms in exchange for a maturity extension. As of June 30, Ensign’s liquidity was approximately CAD $67 million.

Because of the interplay between the basket’s pro forma liquidity requirement and the agreement’s anti-hoarding provision, the amount of balance sheet cash that could contribute toward the liquidity requirement is inherently capped at the amount of cash required to operate the company’s business. Therefore, use of the basket is conditioned on paying down a portion of the revolver balance.

The asset-sale prepayment basket is capped at an unknown amount. The basket applies to net proceeds of “Permitted Dispositions,” and the only relevant clause of the Permitted Dispositions definition is a general asset sale basket that permits fair-market-value dispositions to third parties and is capped per fiscal year at an unknown (redacted) amount. Because the size of the general asset sale basket is unknown, and because the asset-sale prepayment basket is sized at one-third of that amount, the size of the asset-sale prepayment basket is similarly unknown.

The asset-sale prepayment basket allows Ensign, in the context of a repurchase of 2024 notes, to capture the value of discounted repurchase prices. Under the basket, for discounted repurchases, the repurchase price counts against basket capacity not the principal amount (but for redemptions, the redemption price counts against basket capacity, including any related premium). The 2024 notes trade in the high 80s, and therefore this mechanic may not provide the company with a meaningful additional amount of prepayment capacity. (The notes are callable at 102.313% and become callable at par on April 15, 2023.)

As mentioned above, capacity under the asset-sale prepayment is limited to one-third of asset sale proceeds since the beginning of 2021. Although the company has completed some asset sales and expects to complete some additional sales, projected prepayment capacity under the basket is likely limited. We estimate that projected capacity under the asset-sale prepayment basket is not expected to be more than $30 million.

Ensign has completed a few asset sales since the beginning of 2021. Ensign’s cash flow statement for fiscal 2021 does not show a notable amount of divestiture proceeds, but during the first half of 2022, the company sold two cold-stacked drilling rigs located in Mexico for cash proceeds of $34 million and also sold a cold-stacked drilling rig from its U.S. operations. Therefore, as of June 30, the asset-sale prepayment basket contained accrued capacity of about $11.3 million, plus one-third of the net proceeds related to the sale of the U.S. rig (which was likely minimal, on the basis of second-quarter financials).

Ensign also projects that it will complete some additional limited sales. On its March 4 earnings call, management stated that it expected to apply proceeds of the Mexico rigs to revolver repayment, but, as stated above, that would not deplete related accrued capacity under the asset-sale prepayment basket. (The basket builds regardless of how the actual proceeds are used.)

Additionally, on the March 4 call, management stated that it had approximately $40 million of “redundant real estate” that it expected to monetize in the next 12 to 18 months. One-third of the net proceeds of such dispositions could further build the asset-sale prepayment basket by approximately $13.3 million, bringing total capacity under the basket to around $25 million.

Considering the asset-sale prepayment basket is expected to contain less than $30 million of accrued capacity, and considering usage of the basket is subject to a CAD 175 million pro forma liquidity requirement, the basket will likely contain insufficient capacity to fully prepay the $417.5 million of unsecured 2024 notes before the revolver’s October 2023 springing maturity.

Therefore, the company will likely need to rely, at least partially, on the prepayment covenant’s refinancing carve-out.
Prepayment Refinancing Carve-Out

The revolver agreement is governed by Canadian law and does not follow the typical formulations of a New York-governed credit agreement. Nevertheless, as would be expected, the prepayment carve-out for refinancings permits the unsecured 2024 notes to be refinanced with unsecured debt but generally not with secured debt and not with structurally senior debt.

The prepayment carve-out for refinancings permits the unsecured 2024 notes to be refinanced with debt incurred under the debt covenant’s general loan party debt basket, and that basket is the only debt carve-out the agreement contains for the loan parties to incur debt outside the revolver facility. The general loan party debt basket permits an uncapped amount of loan party debt, provided it matures at least six months after the revolver and subject to pro forma compliance with the financial covenants.

The revolver agreement generally does not permit the unsecured 2024 notes to be refinanced with non-revolver secured debt or structurally senior debt. There is a general lien basket, which could be paired with the general loan party debt basket, and there is no express restriction against refinancing the unsecured 2024 notes with secured debt, but the general lien basket does not permit blanket liens on a loan party’s assets and is likely sized at only CAD 25 million. (The basket size is redacted in the 2021 A&R, but in the 2020 third amendment it was sized at CAD $25 million.) As mentioned above, the agreement permits the 2024 notes to be refinanced with secured revolver borrowings but only if the asset-sale prepayment basket is used, which is unlikely to contain a meaningful amount of capacity. The debt covenant contains a carve-out for nonguarantor debt, but that carve-out cannot be paired with the prepayment refinancing carve-out.

Until March 31, 2023, if the net total leverage ratio of the preceding fiscal quarter exceeds 5.00x, any proceeds of second lien or unsecured loan party debt are required to be used to prepay the unsecured 2024 notes (or revolver borrowings). As shown in the table further above, as of June 30 net total leverage was 5.3x, and this ratio-based sweep is therefore operative at least until third-quarter financials are filed.

Other covenant conclusions are contained in our covenants tear sheet, including details about the revolver agreement’s lack of asset transfer capacity.
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