Plenty of ink has been spilled here about the glory of spinoffs. Most recently, Jim Royal has become a vocal proponent of investing in these "special situations," and has added both Sabra Healthcare REIT (SBRA) and Madison Square Garden (MSG) to his Rising Stars portfolio. There are plenty more spinoffs in the pipeline, with Marathon Oil (MRO) looking to dump its downstream business, ITT seeking to close its conglomerate discount, and Northrop Grumman (NOC) prepping its shipbuilding unit for sale.
This is a proven hunting ground for value investors, as any reader of Joel Greenblatt's fabulous You Can Be a Stock Market Genius will attest. Some of the above situations should work out quite well for investors willing to pore over the SEC filings and separate the superficially ugly businesses from the just plain ugly ones. As we'll see below, some spinoffs are best left on the shelf.
A spinoff gets drilled
In late August 2009, jackup rig operator Seahawk Drilling (HAWK) was spun off from the increasingly deepwater-focused Pride International (PDE). On its second day of trading, I told investors that Seahawk was for the birds, and not a compelling investment opportunity. Less than 18 months later, Seahawk is selling its assets to Hercules Offshore (HERO) at fire-sale prices and pursuing a Chapter 11 bankruptcy filing.
Some events in Seahawk's brief life as a public company could not have been foreseen. First and foremost was the Macondo disaster in the Gulf of Mexico, which led to such a heavy-handed regulatory response that shallow-water permits became extremely hard to come by in the latter two-thirds of 2010. In its Friday afternoon press release announcing its asset sale, Seahawk called out the regulators for their role in the company's demise. I think that's entirely warranted, but there were other problems here, many of them interrelated:
- Low fleet quality: Seahawk's average rig age was 28 years at the time of its spinoff.
- Customer concentration risk: Mexico's Pemex accounted for 58% of revenue in 2008.
- Declining business: By February 2010, Seahawk had no remaining drilling operations in Mexico.
- Geographic concentration: With the Mexican revenue gone, Seahawk was solely operating in the U.S. Gulf of Mexico -- just in time for the catastrophic oil spill.
- Liabilities inherited from parent: Seahawk was stuck with significant tax assessments from the Mexican government, and is required to indemnify Pride for similar assessments for tax years prior to 2008.
That last bullet point appears to be the one that convinced Seahawk to go the Chapter 11 route. Investors long the stock made pretty strong arguments for these tax assessments being a nonissue, but it looks like they were wrong.
I was wrong, too. Not in my initial assessment, but in my subsequent warming to the stock as it declined in price. I looked ahead to "normalized" earning power, on the eve of an industry disaster that would prevent normalcy for a long time to come. I was right to downplay Seahawk's liquidation value, however, pointing out that "I don't see a natural buyer at non-fire-sale prices."
Hercules Offshore is arguably getting a good price here, at roughly $6 million per rig. If it secures antitrust approval, the firm will have the No.1 and No. 2 Gulf of Mexico jackup operations under one roof, with a combined 20 marketed rigs out of 45. That will consolidate the market considerably and may support higher dayrates.
At the end of the day, though, I have a hard time getting excited about the combination of these two fleets, especially in light of Hercules' formidable debt load. I would much rather place my bets on the proposed merger of Ensco (ESV) and Pride (PDE), which might just be a perfect pairing.
Disclosure: Author has no positions in companies mentioned.