Is Hercules Offshore Set to Jack Up Out of the Mud?

| About: Hercules Offshore (HERO)
A big part of the business of Hercules Offshore (NASDAQ:HERO), are “lift-boats” (not life-boats which is how one analyst I read described them). With sixty-five such boats, they have the largest fleet of that category in the world. They also have the 4th largest jack-up drilling fleet, although what has kept them alive is mainly the lift-boats.

A lift-boat is a peculiarly American contraption; it’s a small (for oilfields) self-propelled barge / workboat with three or four legs that are used mainly for maintenance of oilfield equipment in depths of water up to 150 feet.

So they potter around looking like some sort of mechanical spider and then they jack up the barge so that it is above the wave action and set to work doing repair work and maintenance, working as driving platforms, and for wire-line work.

One occupational hazard is if one of the legs (typically 36 inch or 48 inch steel pipes with a big foot on the end) gets stuck in the mud, and you can’t pull it out. Then you have to send divers down to do an amputation.

Hercules has been stuck in the mud since July 2008 when their share price started dropping from $38 all the way down to $1.1 in March 2009.

That drop was precipitated by the collapse in oil prices, which resulted in impairment of $950 million of goodwill following a re-valuation of assets right after what looked like a superbly mistimed highly leveraged expansion.

When the oil companies stopped spending that cut 30% off their revenues - and they have a lot of fixed costs, so the company was in a big hole and overleveraged to boot, and then they were in breach of their covenants.

They spent most of 2009 coming to an arrangement with their banks, which ties their hands but at least they are still breathing, and hanging on. After crawling back to $4.8 in May 2009, the share price has bounced around from $3 to $7 which according to some is pretty close to liquidation value - Friday it was $4.8.

Once you are stuck in the mud it's a long-slippery-climb back, but anyone who wanted to take a risky bet that they wouldn’t crash and burn in March 2009, would have done well. The main issue is that 85% of their fixed assets are tied up in equipment, and for the past year you'd have been lucky to sell that for scrap. I guess the banks probably figured it would be better to let them hang-on than risk a fire-sale.

Assuming that they have sorted out their finances for the moment, there may be some light at the end of the tunnel for HERO. For a start US rig counts have hit a 14 month high. Also, there is a growing consensus that the oil price is going to stay up, regardless of whether there is a solid recovery in USA and Europe.

Oil-service companies are very sensitive to sentiments about the price of oil, when that tanks it's cut-throat supply and demand, and the charter rates go through the floor, those are crawling back in the USA and have held up pretty well-considering, internationally.

They also made a sensible move to start deploying outside their back-yard into West Africa and recently into the Arabian Gulf which is ideal for lift boats, because water depth is hardly ever over 150 ft. Also, the bottom is mainly sand so you can generally avoid those painful amputations you get jacking up in Louisiana mud.

There is a lot of oil-field infrastructure that was neglected for years in the days of $20 oil that needs maintenance. Now there is a good reason to do that, and the oil-companies are flush with cash.

Most of the mainstream oil-service companies share-prices more than halved into March 2009; many have more that doubled on the bounce, so there aren’t many sure-fire bargains there.

Hercules broadly missed that bounce with all their other problems, so if indeed they have finally overcome the suction, they might be due for a bounce up to some place slightly above liquidation prices which could put that $4.8 up to $10 without too much trouble over the next year.

However, what they are worth is quite hard to work out - thanks to the vagaries of US GAAP. Which brings me back to my bug-bear which is valuation.

HERO's main assets are equipment "booked" at about $2 billion, but that's based on the cost of procuring those assets less depreciation straight-line over 15 years. That's great for a discussion with the tax-man, but it's not much use for anything else.

Mark-to-market "Fair Value" is a silly thing to work out in the middle of a slump (just as it's a silly thing to work out in the middle of a bubble), unless the decision is "shall we call the loans and put everything up for sale - today", which is a discussion that you have with your bank.

I noticed that the company said they worked out the "impairment of goodwill" by doing a DCF on estimates of future revenue - internally. Well, clearly they didn't do a very good job on that when they started piling on debt.

What I would like to see (if I was a significant investor - which I am not) would be a transparent disclosure of the Depreciated Replacement Cost of that equipment, which is what you would normally report (in these circumstances) if the valuation was being done according to International Valuation Standards. (Personally I'd like to see a third-party do that - it's not hard and it's not expensive either, although as far as I can see that is a concept that is almost unknown in American accounting circles).

(That's the cost of a new one built today using the latest technology multiplied by an estimate of the years left of service (taking into account the increase in maintenance and refurbishment costs as the thing gets older), divided by the total estimate of the years of service).

That way you would have an idea of the fundamental value of the company, which is currently a bit of a mystery, although I suspect that if they took the trouble to do that, they might find out that their company is worth more than is reflected in the share price.

Pity SEC doesn't require people to report that number - but then there are a lot of things that SEC does not require people to report.

Disclosure: Long HERO