Herculean Effort at Hercules Offshore

Hercules Offshore (HERO) is a provider of shallow-water drilling and lift-boat services to the oil and natural gas exploration and production industry. The company is headquartered in Houston, Texas and employs roughly 3,100 employees.

In terms of financial strength, HERO’s EPS took a big hit in 2008, whereby the ($12.1)/share results damaged the stock from its previous highs. Book value per share also declined to 10.3/share, nearly 50% of the 2007 levels. The company’s liquidity, among others its current ratio, dropped from 2.2x to 1.7x, while the company continued to leverage itself to a 1.2x debt/equity ratio. So why in heaven’s name would I go long on this stock?

Well, when a company trades near or at liquidation value, there is likely one of two outcomes: bankruptcy or super potential for explosive turnaround gains. Jefferies & Company believes the company faces big challenges in the year ahead, but that the uncertainty is mostly priced in already and has the equity value trading below book value, despite management’s successful run at cutting costs and prorating the company’s size for today’s stringent environment.

Hercules not only shows signs of recovery, but is actively repurchasing its own convertible debt in an attempt to de-leverage in the face of the changing economy. It was able to repurchase $20 million worth of senior convertible notes for $6.1 million in cash, pretty much a 70% discount off par.

Hercules currently trades at about 10x TEV/EBITDA and 90% NAV, which compares to comparable companies trading at roughly 13x and 130%, respectively. This presents a somewhat small discount, but it is well-known that the majority of the offshore drilling service companies move in tandem when there is positive news. Within the specific sector however, I see only upside for Hercules, albeit risky nonetheless.

Hercules is also in early discussions with other parties with speculative newbuilds for management agreements similar to the Mosvold rig marketing and management agreement signed in February 2009.

There is likely some more downside risk to come to HERO after a little run alongside the bear market rally that ended shortly after May, but with the impending recovery and the rebound of oil in the medium to long-term, the company’s current positioning provides some sought-after potential for gains that might not be as attractive now, but may reap great rewards down the line.

The risks are numerous: A collapse in Gulf of Mexico drilling rig demand, whether by result of weaker natural gas prices or operators shifting geographic preferences, would be the primary risk to the downside.

Target price $10, 6-12 months, above average risk.

Comments

[DONE_SONZ:]

I would stick with the deepwater drillers if you want to be in the drillers.

Jun 25 11:21 AM

[one eye:]

If you want to make a couple of hundred %, you go with companies which not only Service the Deep Water drillers but have the ability to benefit substantially from the Geopolitical risks associated with other parts of the world. Additionally, as Mexico's Cantrell field is rapidly nearing exhaustion, More Drilling in the Gulf is likely.

Jun 25 11:39 AM

[SJD:]

I agree, so why not simply play OIH and get everything?

Jun 26 10:46 AM

[Shale Gas:]

What do you mean by exhaustion? Cantrell will probably continue to produce for generations. There are mature oil fields in North America that have produced for 100 years.

Jun 26 11:16 AM

[HerrHansa:]

Recent revenues might be propped up at Hercules Offshore (HERO) due to sales of some assets that were idled. Unfortunately that is not a sustainable strategy for them. They commented on this on their last earnings conference call, which I highly recommend anyone interested in this stock read prior to investing.

My opinion is that they are stacked too much in one geographic region, and they lack flexibility. As others suggested, I would bias deepwater drilling specialists, or companies involved in that, though like anything research is highly suggested.

Volume across many of the tanker companies, drillers, and smaller oil services companies was high today. I saw four of my holdings trade up on huge volumes. I wish I had a good explanation why, but so far all I have come across is more active program trading.

Jun 27 01:20 AM