Many investors are optimistic to a fault. Because of that, they see a beaten-down stock as an opportunity to profit in a subsequent recovery. Unfortunately, not all companies do recover because some are in such deep financial distress that the only solution is a debt restructuring or highly dilutive stock offering, either of which could lead to permanent losses for investors. Three companies that appear headed for that fate are Cobalt International Energy (NYSE:CIE), Seadrill (NYSE:SDRL), and California Resources (NYSE:CRC).
Sinking to the bottom
Deepwater exploration and development company Cobalt International Energy is down nearly 99% from its all-time high. Some might see that and think that there can't be that much downside ahead. However, one look at its financial situation and it becomes apparent that this stock might not bottom out until it hits zero.
For example, Cobalt expects to reel in just $50 million in revenue this year. However, it plans to spend between $550 million to $650 million on oil and gas drilling activities. While the company did end last year with $956.5 million in cash, it's on pace to burn through more than half of that this year, which is obviously not sustainable.
Cobalt is working to address that problem by looking for a buyer for its assets in Angola. However, it faces a daunting task after a previous deal with Angola's national oil company fell through last year. That deal would have brought in $1.75 billion in much-needed cash to Cobalt's coffers. Now, it'll probably need to settle for much less given where oil prices are these days. Even if it did sell those assets for a decent price, it probably would also need to continue to raise outside capital to finance its development projects. That likely means it will need to dilute existing shareholders further by issuing stock at rock-bottom prices, which would weigh on the value of the company. Meanwhile, if it struggles to find a buyer for its Angola assets, it's possible that this stock could go all the way to zero given that Cobalt has $2.5 billion in long-term liabilities weighing it down.
A crushing weight of debt
Seadrill is another offshore-focused company in deep financial distress due to the oil market downturn, which caused its stock to crater 98% over the past three years. The company is currently working on a comprehensive restructuring plan to address its mountain of debt. However, the offshore driller issued a dire warning to investors earlier this month during an update on the process, noting that:
Based on stakeholder and new money investor feedback, as well as the Company's existing leverage, we currently believe that a comprehensive restructuring plan will require a substantial impairment or conversion of our bonds, as well as impairment, losses or substantial dilution for other stakeholders. As a result, the Company currently expects that shareholders are likely to receive minimal recovery for their existing shares. We expect the implementation of a comprehensive restructuring plan will likely involve schemes of arrangement or chapter 11 proceedings, and we are preparing accordingly.
I'm a long-suffering Seadrill shareholder myself, so this news is especially painful to read because it means the chances of my investment recovering are minimal. One reason I haven't sold is that I own shares in an IRA, so there's no tax-loss incentive to sell. Instead, I've decided to wait this one out to see if there's any recovery as opposed to wasting the commission to put this position out of its misery. That said, given the company's warning that this stock could go to zero, investors shouldn't buy in hopes of profiting from an eventual recovery in the offshore drilling market because it doesn't appear that Seadrill will be around to see that day.
Unsightly leverage metrics
While California Resources' financial situation isn't as dire as Seadrill's, the company still has an awful lot of debt, which is a big reason its stock is down more than 83% over the past few years. That said, it has made some progress on debt reduction, cutting it by nearly $1.5 billion last year, though it still has $5.3 billion of debt outstanding. Because of that, its credit metrics are atrocious. For example, debt to capitalization is 112% whereas a healthy financial ratio for an oil company is below 30%. Likewise, its debt-to-EBITDA ratio stood at 8.5 times at the end of last year while most oil companies try to keep that ratio below 3.0 times. Given its current expectations, the company doesn't see its leverage ratio heading back into the safe zone until 2019 and that's if oil averages $75 per barrel.
Because of its current debt level, nearly half of California Resources' projected EBITDA in 2017 will go toward interest and debt repayment as opposed to capital investments. That'll only improve slightly next year, assuming oil prices don't tank again. With so much of its cash flow going to creditors instead of capital investments, it hampers the company's ability to grow in a low oil price environment, which could cause the stock to underperform its peers. Meanwhile, if oil prices start dropping again, California Resources' stock would likely fall sharply under the weight of its debt.
It's possible that oil prices could rebound sharply, throwing these companies the lifeline they need to get their financials back on solid ground. However, that's a risky bet for investors because these stocks could easily continue to sink and might even go all the way to zero. That's why these stocks aren't worth the risk, in my opinion, especially when there are so many stronger oil companies that have a better chance at making investors money instead of losing it.
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