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Summary

  • During Q2-14, owners' equity improved $29.8M from previous quarter to $853.5M from $823.7M.
  • Second-quarter revenue improved to $242.9M from $211.4M compared to the same period in 2013.
  • Net Income was $6.6M, or $.04 per share, after a $5.3M write-off related to lift boat business.
  • Improving Gulf activity late in 2014.
  • Shares now over sold near 52-week lows and relative strength below 30. Market cap at $545M with mixed insider activity is well below book value of $853.2M.

Hercules Offshore (NASDAQ:HERO), a Delaware corporation headquartered in Houston, is an offshore operator of jack up rigs and lift boats. They lease and operate 36 jack up rigs and 24 lift boat vessels in various configurations around the globe through a large network of energy companies.

Their customers include:

  • Chevron
  • Maersk
  • Saudi Aramco
  • EPL
  • Arena
  • Cairn
  • Fieldwood
  • Castex
  • Walter Oil and Gas

Operational Performance:

During the 2nd quarter of 2014, Hercules generated $242.9M in revenue, up from $211.45M in the 2nd quarter of 2013. The company also reported positive EBITDA of $76M and net income of $6.6M during 2nd quarter, resulting in a positive EPS of .04/share. They wrote off $5.3M for an uncollectible debt related to their lift boat operations in Africa; however, after I spoke with the company, they assured me they were still going after collection action with the responsible customer. If they're successful in the litigation process, they will recognize this income in future quarters.

Hercules has seen a utilization decrease in both their domestic offshore (4%) and international operations (22%) mostly related to a failed business transaction in Angola on their HERC 267 rig (mentioned below) and downtime related to general rig and boat maintenance. In addition, the company noted that customer consolidation in the Gulf of Mexico has created a soft environment there since 2013; however, as customers consolidate and as prospects for new drilling locations grow, they expect renewed emphasis in the Gulf late in 2014, which they're well positioned to take advantage of.

As of July 23, 2014, their backlog was $1.2B, meaning they are currently under contract and will execute these future earnings.

In addition, the company has recently made a series of acquisitions and new business arrangements that will improve its operational results well into the future. These acquisitions include:

  • March 2013: Acquired Hercules 267 for $55M. This rig was supposed to go work in Angola; however, a contract dispute caused a lag in activity and was a driver in recent share declines. Management has this rig ready-stacked to operate and is seeking a customer to put it back to work. Day rates for this rig should be very attractive moving forward.
  • During March 2013, they acquired the lift boat "Bull Ray" for $42M. This is a very high demand vessel and was undergoing a survey during most of the second quarter. As it gets put back to work, look for it to lift average day rates for the Hercules lift boat business in the 3rd and 4th quarters of 2014.
  • In June 2013, they acquired Discovery Offshore Drilling. This move added two high spec rigs (Resilience and Triumph) to their lineup which are currently in service and operating in the Congo ($187K/Day) and India ($214K/Day), respectively.

The above transactions helped modernize their fleet toward more high-end specification rigs that can easily operate in more austere environments like the North Sea.

New Business:

In addition to the above acquisitions, the company recently signed a contract with Maersk at an attractive day rate of $225,000 per day for a 5-year period beginning in the 3rd quarter of 2016. Total contract amount for this business is $420M with an "all-in" delivery cost of $270M. The deal is projected to bring 235,000 barrels of oil to the market per day and could deliver up to 5% of all UK energy needs by 2020. This partnership opens the doors for business with other energy companies in the area and could help offset new rig supply (seen in Asia) as Hercules competes for business in this high growth region.

Share Price

HERO's share price has been rocked lately, trading at historic lows. As of Aug 1, 2014, relative strength was below 30, the stock hit a new 52-week low at $3.37 closing at $3.39 the same day, while market cap was $545M (with book value at $854M). This means that the current market price of the stock is $309M below net asset value, representing a unique opportunity to purchase a steady oil driller at an incredible discount. A fairly rare value play in this market...

Risk:

No investment thesis would be complete without acknowledging risks. While there's always the possibility of increased competition in the drilling business, day rates have yet to see a dramatic change; in fact, they've actually gone up over previous quarters. HERO management acknowledges the possibility of rate pressure and is keeping their eye on potential competition coming into the Gulf from Mexico proper, but for now, day rates are stable and steady. In addition, Hercules has a knack for securing big energy contracts, so I'd look for them to focus on rig utilization first and foremost, delay some of their CAPEX plans, and focus virtually all of their effort on EPS, paying down debt, and centering themselves on the bottom line. Of course we know that approximately a 100+ rigs are being built in the far east, but many are going to be put on the market for sale without a firm contract, putting great risk on the builders. These rigs could ultimately be put on the auction block for sale to the highest bidder or contracted by large energy companies like Chevron or Exxon through drillers like Hercules. In any case, they'll still need trained crews to operate them and will be competing against the older rig operators (like Hercules) whose rigs are almost fully capitalized and don't have any debt-related pressure against them (meaning they can be awfully competitive as the new rigs roll off the assembly line.) That said, I believe substantial competition from these newer rigs could be years in the making.

Insider Activity:

While I don't use insider activity exclusively to form investment decisions, it doesn't necessarily hurt to see what management is doing with their shares from time to time. People buy and sale shares all the time, but I tend to pay particular attention when they're buying big because this means they have faith in the business and expect operations to improve. Selling could mean either the company is souring or they have some personal issue they need to take care of. Looking at June to August 2014, the results were somewhat mixed. During this period we saw three interesting moves:

  • Jun 24, 2014: Thomas Bates purchased 20,000 shares at $3.9297/share.
  • Jun 27, 2014: Steven Webster purchased 50,000 shares at 3.9992/share.
  • Jun 30, 2014: Steven Webster purchased another 100,000 shares at $4.0251/share.
  • Aug 1, 2014: Noe William sold 75,000 shares at $3.5762/share.

In the above transactions, it would appear that the purchase transactions were made with "personal" money and wasn't part of a compensation package. I view these specific purchase transactions as being more significant than the sell transaction Mr. William initiated, because it looks like he sold stock grants which isn't nearly as significant as the June transactions where personal money was used to invest in the company.

Valuation:

If you just look at asset value, the company could be sold at their enterprise value in the $1.2B ($7.41/share) to the $1.6B ($9.88/share) range if another company came in to make a tender offer. If you just look at asset value, owners equity is $853M with 161,795,000 shares outstanding, which places "pure" equity value at $5.27/share. Since most of their rigs are currently under contract and executing against a $1.2B backlog, it would seem only reasonable to value the company at the $5-$6+ range. In addition, management improved both revenue and owners' equity from the same period last year. While there are some potential threats from increased competition, that competition will be years in the making, while Hercules quietly churns out profit and shores up their balance sheet.

Source: Hercules Offshore 10-Q and Conference Call for second quarter 2014. Form 4 filings in June and August 2014.

Disclosure: The author is long HERO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Hercules Offshore: Is It Time To Buy This Beaten-Down Offshore Driller?