Hercules Offshore: Follow the Cash Flows

There are a lot of good buys among oil service companies right now as the market has hammered most of them due to the recessionary environment and the plunging oil prices we saw earlier in the year. Offshore oil related companies have been particularly hard hit, which makes it a particularly interesting sector to me.

From a macroeconomic perspective, I believe oil is going to hover around $60 - $80/gallon in the long-term, which will bring off-shore back into the fold. It might take a while for us to get in that range and stay there for a significant period of time, but the trend is that increasing difficulty of oil extraction is driving up costs.

One of my favorites right now amongst the offshore oil service companies is Hercules Offshore (HERO). Hercules provides shallow-water drilling and lifeboat services for oil and natural gas exploration in the Gulf of Mexico region.

My major reason for liking HERO is that I believe that (a) offshore's prospects are still relatively good in the long-run, (b) HERO is in better financial shape than similarly situated competitors, and (c) it appears to be currently priced below liquidation value at this point in time.

The Financials and the Bull Case

As of their most recent 10-Q filing, HERO's net tangible assets were worth $10.33 per share. Debt-to-value is moderately high at 64.1%, but that's not actually that high compared to other companies operating in this industry. HERO has relatively strong liquidity. Current ratio is 1.71 and quick ratio is 1.51. Add to that strong operating cash flows.

While HERO is currently losing money on their income statement, the cash flow picture is much better. For Q1 for FY '09, they had a loss per share of 5 cents, which actually doesn't seem that bad to me given the operating environment during the 1st Quarter.

What's really encouraging, though, is that HERO brought in 87 cents per share in operating cash flows and 51 cents per share in free cash flows. A substantial portion in the differential between earnings and cash flows can be attributed to depreciation and amortization charges, which are recurring non-cash items.

This might be one reason why the market is significantly underpricing this company, but as one of my accounting professor's at UNC used to preach, "you've got to follow the cash flows!"

The most surprising thing about HERO's first quarter performance is that it covered a period where oil prices were more suppressed than they have been in awhile. The logical conclusion is that demand for their services will increase as oil prices continue their inevitable long-term march up towards $70+/gallon.

At that point, offshore oil becomes more attractive and investors become more interested in companies like HERO. If HERO is only turning a minor earnings loss in one of the worst environments they'll ever see and is still significantly cash flow positive, that suggests good things to me.

Not only was HERO cash flow positive for the most recent quarter, they had positive operating cash flows for the past three fiscal years. However, their free cash flows were negative for most of that time as they, like most other companies in the oil service industry, took on debt to rapidly expand their operations. They have suffered with all the others, but under $5, I think the stock is a good buy --- but be aware that this is a volatile "high-risk" stock.

On the Other Hand ...

While I have given a moderately bullish outlook for oil, I would definitely consider the significant likelihood of a short-term retreat in prices. There's a strong case that rising inventory levels could put a hamper on prices.

This could, once again, send HERO's stock into a tailspin. This is why I emphasize that this is a "high-risk" stock and not something to touch if you are afraid of losing 50% of your investment over the next few months.

For me, this is a very long-term pick so I am willing to ride out any bumps and might increase my position if the price drops back down to the $2 - $3 range. For others with a lower risk tolerance, that might not be very ideal.

I'd also suggest that HERO's most recent earnings call is required reading for potential investors. It certainly provides a sobering near-term outlook for the industry. There are definitely reasons to be cautious with HERO.

All the same, my fundamental philosophy on commodity stock investing is to buy in when fear is at its greatest point and sell off during euphoria. While fear has subsided a little bit for HERO, the price when compared to the company's financials suggest that the market still has a frightened outlook for Hercules.

Valuation

After running a DCF analysis, my most probable valuation for HERO is around $23. Downside probable valuation is $15. Upside probable valuation is $32. Downside risk is $0 due to their moderately heavy debt load and their position within a risky/volatile industry. Upside potential might be around $45.

I initiated my position around $2.15 in my KaChing simulated portfolio. I also recently initiated a small position in HERO for my actual portfolio at $3.80. Due to the high risks, I would factor in a substantial discount to my probable valuation, but I believe this is a good long-term buy under $5 for investors with a well-diversified portfolio.

Disclosure: Long on HERO

Comments

[Roy Manning:]

Hello Honeycut - I hate to be critical but oil trades per barrel not per gallon. Most of your references are the price of oil not the price of gasoline which does trade per gallon. I know what I'm talking about since I used to trade crude oil futures (1000 barrels per contract). Otherwize your article looks really good. I will have to take a look at HERO. I recently made alot of money in the Chinese oil stock CNEH so I know there is alot of opportunity for profits with oil near $60 a barrel.

May 20 08:56 AM

[H.J. Huneycutt:]

Roy, my apologies on that. Bad habit on my part --- I often substitute "barrel" and "gallon" without thinking about it. I realize that oil trades per barrel. Wish I had caught that sooner.

May 20 09:10 AM

[The Hammer:]

This articles lacks some further needed research into the jackup market and the debt schedule going forward. This company has a poor JU fleet in comparison to RDC ESV or NE.
How many of their rigs stacked now? Were you aware of the speculative build in the JU market? Obviously if oil goes to $70 and holds demand for their services will improve and even the weakest of the bunch can perform well and survive.

May 20 03:32 PM

[ZZQUINCE:]

How do you explain HERO profit margin at -96% and return on equity at -73%?. RDC, ESV and NE have profit margin from +20% to +45% and return on equity +17% to +30%. Also, cash and debt are less encouraging than the other 3.

May 21 12:46 PM

[Spicer:]

On May 21 01:33 AM Freya wrote:

> Hammer: Its all relative. How much of HERO's earnings come from servicing
> RDC and its like?

Delta Towing's share of HERO's last years revenues was 5.2%. I'd say not much. Am I wrong?

> JU's may be important to you but everyone has a problem in this area.

HERO's rigs have the lowest rated water depth and HERO has the oldest fleet in the market. I think they have the lowest (rig)fleet utilization rate currently.

> Meanwhile what Rigs are operational or become operational will use
> the Logistic services that HERO provides.

I think they're more likely to use Tidewater's or Trico Marine's services.

May 21 01:48 PM

[LawMajor7:]

Really liked your article on HERO. What impressed me was the due diligence you undertook in not only presenting the potential positives about HERO, but also your caveat that it is in fact, an inherently risky stock- particularly with the forthcoming hurrican season on the immediate horizon. Anyhow, I bought HERO at $3.90 and my mom just closed a limit buy at $3.90 as well. Once more, thank you for your info.

May 21 06:18 PM

[one eye:]

You know, I've a Vested interest in Freya's recommendations. And I've done a DD on those which I'm either In or am Following.

Oh Hell, Read the Damn Annual. Do your Own Due Dilligence, 2008 Operating earnings per Share were $1.07 Before Non Cash write Downs which propelled the overall to a Negative $12.

Exclude the NON CASH write downs and then redo all of profit margins, ROI, etc Garbage.

Because it is Garbage which clouds the actuality.

May 22 11:35 AM

[one eye:]

LawMajor7, Major Hurricane in the Gulf?, Offshore Logistics...Great.

Expectation? 9-14 Named Hurricanes for this season.

May 22 11:38 AM

[Wisdom vs. ...:]

There is absolutely no fundamental reason for HERO's price to be this low; reminds me of when WFT's stock went down to $8, easy money. if the only way you know to evaluate a stock is the income statement, then you should not be investing on your own-- but please stay ignorant, the rest of us get to buy cheap stocks when you bail

Jun 01 05:41 PM