Seahawk Drilling: Former Value Trap Becoming an Actual Value

Sep.15.10 | About: Seahawk Drilling, (HAWKQ)

Click to enlargeSeahawk Drilling (NASDAQ:HAWK) has been an "on the radar" stock for me for several months as shares have been plummeting from a high of around $35 in September 2009 to a low of under $7 in late August. For a quick background, Seahawk was spun out of Pride International (NYSE:PDE) in 2009 and operates 20 jackup rigs in the Gulf of Mexico (of which 4 are currently working, 1 has a permit pending, 1 is cold stacked/in repairs and contracted for the remainder this year, 3 are actively available and 11 are cold stacked). These rigs are primarily used for shallow water drilling of natural gas in the US Gulf of Mexico (GoM).

While shares have recovered almost $1 of value since their recent lows based primarily on an initiating coverage report from Wells Fargo, Seahawk will likely continue to see headwinds in shallow water drilling in the Gulf of Mexico in the near/mid-term or until they are able to increase utilization (via higher demand for shallow-water gas drilling and/or an end to the deep-water moratorium) and/or execute possible asset sales. As I see it (as does Wells Fargo's analyst), these moves would help steer the company through these tough times to an eventual return to profit.

As I have been watching shares fall, I have been reading other pieces by value investors around the blogosphere arguing the value of the rigs based on scrap value or scrap + rig equipment to basically say, here is the floor for the shares because their equipment is worth more than this. In addition to the rig value, HAWK also has over $3.50/share of NET CASH (as of last reported 10Q).

Despite the valuation argument, a number of factors have been weighing on shares for the past several months:

1. Uncertainty about the GoM after the BP (NYSE:BP) disaster - Although this has effected all companies in the oil&gas drilling business that have operations in the GoM, HAWK already carried a fair amount of uncertainty due to the large number of rigs they have cold stacked, the age of their rigs and their quarterly cash burn ... all problems that are largely derived from the decline in utilization since 2008, when the GoM was running on all cylinders with oil and gas at record highs. While the moratorium on drilling does not effect shallow water drilling (all of Seahawk's rigs are shallow water), the resulting fallout and confusion within the BOEM has made it extremely slow to nearly impossible to get permits even for shallow water drilling, according to CEO, Randall Stiley.

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2. Quarterly cash burn has been running high, with no real end in sight given HAWK has only one of their rigs contracted past the end of October (Seahawk 3000) and even then, it's not certain as to when it will begin work given the fair amount of repairs to be done to make it ready for operation (HAWK draws credit line for repairs).

3. HAWK's shallow water day rates have not recovered and I'm not going to pretend to be an expert on all the reasons for this, but this is due to a number of things such as GoM rig overcapacity, the aforementioned moratorium, the age of HAWK's rigs as well as the abundance of gas reserves and drilling that is now going on onshore due to fracking the enormous finds of the barnett, haynesville, etc shale fields.

4. HAWK currently has a complicated tax issue with the Mexican authorities, a remnant of their time as a part of Pride International. The headline number for this liability is a whopping $229MM, which dwarfs the Company's cash on hand and would be burdensome even if they managed to sell several of their rigs with liberal valuation applied. However, the news may not be as bad it seems due to a tax sharing agreement between Pride and HAWK. (For a more fulsome explanation of this situation from a tax lawyer that certainly understands the situation better than I, see this article...)

I have stated these risks as a forewarning that there is some chance that if management cannot contract HAWK's rigs at a higher rate, sell certain assets and/or figure out a way to diversify the rig base by purchasing assets outside the GoM that would be immediately accretive to earnings and cash flow, there is further downside risk to shares.

However, at these levels, I believe it may be time to at least dip the toes in the name as the downside protection is notably more significant than it was just a few months ago when shares were trading at $10-12. I'm probably going to get some disagreement here despite the fact that mr. market seems to have proven this out, but I don't think HAWK's rigs are worth as much others think they are under the current scenario and I think they are worth even less in a liquidation scenario. While you can point to scrap value or equipment value as a floor valuation, there are much better places to get scrap steel than melting down a rig and there are much better places to get equipment than spending money to buy a rig for the equipment or pay to tear it off a rig.

$7-9MM may be a good fire-sale comp amount under a more normalized scenario, but we are far from normal right now and also talking about rigs that are either cold stacked and require repairs to get working and at very least we're talking about very old rigs with low desirability across the portfolio....I was told by one industry expert "there just aren't a lot of people that want their rigs in this environment" ... so, for conservatism sake, let's halve those numbers:

So, even at the low end of our conservative valuation, shares look to have upside potential of 23%! In another way of putting it, the market is valuing HAWK's rigs at a little less than $2.5MM per rig if the company were never to earn another dollar and ceased to operate. For comps, Hercules Offshore (NASDAQ:HERO) recently managed to sell 2 of its retired rigs, the Hercules 191 and Hercules 255, for $5MM each. Although the sale was negotiated at the end of 2009 when the 2010 economic outlook was notably more rosy than has played out today, the 191 sale is still notable because of the transaction closed in 2Q10 and was for a retired rig that had been cold-stacked for about 9 years and has a shallower depth capability than all but one of HAWK's rigs (the Seahawk 800).

So, as far as rigs go, it is pretty clear that HAWK's, even in a dire scenario are likely being grossly undervalued, a fact that should give comfort for downside protection. A second fact is that, despite not having a solid backlog going through the rest of the year after October, HAWK does have several rigs that are currently operating. Additionally, backlog for shallow water drills tends to be relatively short in nature and not necessarily planned many months or years in advance, so there is still decent likelihood that HAWK could get contracts for the remainder of the year lined up.

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Now with greater clarity on downside risks and protection via discounted rig valuation, let's look at a few further upside potential points:

1. Mexico's state owned oil company, PEMEX, recently announced an expanded budget for 2011 as well as a $1Bn loan from the U.S Imp-Exp Bank to be used primarily for shallow water drilling. Although it is unlikely HAWK will benefit from this spending directly due to PEMEX's reticence of using the mat jackup rigs that HAWK has, any shallow water contracts with other operators could take some of the competing capacity out of the US GoM by moving it to Mexico, which should help HAWK in the event of a drilling revival in the US GoM. Fair warning is that PEMEX is notoriously corrupt, inefficient and difficult to work with, so a lot of this spending may not come to fruition, but they have at least received a loan and indicated a desire to spend on production, which is a positive and will be even more so if it actually goes through in the next year.

2. HAWK has massive positive leverage in the event that they can survive this storm and return utilization to +50% and day rates improve to some degree. The below chart, provided by HAWK, details incremental EBITDA improvement given a starting point of average day rates of $40K with operating expenses of $26K.

With 16-18 rigs contracted back in 2008, HAWK was able to generate $300MM in EBITDA for the year. Assuming that the Company could even maintain half as many jackups with lower rates, HAWK could at least return to positive EBITDA and slow cash burn. Above this, operating leverage is significant.

3. Gulf certainty and/or a lift in the moratorium, either early or even by the current November 30 deadline, would be a big positive for HAWK and the drilling industry. If not lifted early, I believe shares might begin to run up in anticipation of the end of the ban and if lifted earlier than expected, you could see a substantial (albeit likely brief) pop in the shares as that load on their shoulders is at least lightened if not completely lifted.

Overall, at these levels, I believe that HAWK has a relatively attractive profile based on its discount asset valuation, cash on hand (albeit burning) and the eventual lift of the GoM moratorium. If management can make moves to shore up their cash burn through moves like asset sales or an acquisition of immediately accretive assets outside the GoM, I believe the thesis could play out faster.

Disclosure: Author long HAWK