Hercules Offshore: HERO Has Some Flaws

On 6/26/07, I wrote an article on Hercules (HERO). In this article I stated that its upcoming merger with Todco placed the new company in an excellent position with shallow offshore drilling. I felt that in spite of the 30% short interest against the stock, it would prove to have increased pricing power and synergies that would allow very positive movement for the stock in the not too distant future.

Now on 8/7/07, I believe my assumptions were incorrect. A number of factors have occurred that have caused this change in my evaluation. The merger between Todco and Hercules was completed on July 11th, though the full impact of combined company will not be noted until the end of the fourth quarter of this year. In the meantime, the stock has had the short percentage increase from 30% to 40%. The stock itself has fallen from a high of approximately of 36 down to a low of approximately 26 and is presently just below 27. Its second quarter earnings were .72 cents a share, and excluding one time items were .74 cents a share. Analysts had forecast .67 cents a share. Analysts had forecast $98.1 million dollars in revenue and the company reported $99 million dollars.

On the earnings call, the main emphasis seemed to be explaining why there had been a lowering in the demand for their rigs, barges and lift boats. This was related they felt, to the dramatic drop in natural gas prices. These lowered natural gas prices were in turn due to increased production and record storage levels, as well as the fact that we are going forward into a shoulder season.

In addition, many of the companies who might have contracted with these rigs were waiting until the end of hurricane season to avoid costly production disruptions. The company officials explained that approximately 25% of their rigs were off-line and therefore not making any revenue. In addition, there were contract that they had going forward with Pemex which involved reconfiguring the rigs to allow for a larger number of workers on the rig. In addition, they spoke of the fact that many of the rigs had shorter contracts rather than the more desirable 2-5year contracts.

In speaking with the Investor Relation Department myself, I was able to verify the above information. In addition, they felt that since they have shallow-water rigs, they are most often associated with the production of natural gas. Therefore, a great deal of the demand for their equipment is associated with the price and supply of natural gas. Because of this, the day rates for their rigs has declined, unlike the large deep water rigs overseas, which have seen a sharp increase in demand and rates.

If one takes all of this into account including decreasing day-rates, between 65 and 70% utilization of the major equipment, significantly decreased costs for natural gas with an overabundance of supply and a shoulder season coming up, shorter than desirable contracts, hurricane season looming, and the expected and usual problems and complications associated with mergers; I now believe that while (HERO) Hercules is a good company with a reasonable long-term future, there is every reason to believe that it is unlikely to make a rapid recovery in the price of their stock.

The company believes that 2008 should be a better year with increased demand and increased utilization. While this is very possible, this means that one should expect relatively minimal changes in their earnings and revenue for their third and fourth quarters. Although this stock is inexpensively priced with a PE ratio of less than 10, I do not believe it is a buy at the present time. For those who are willing to have patience and take a longer view, it is a reasonable, if not ideal stock to own. There certainly are a number of variables that would need to fall into place in order to have a dramatic increase in this company’s valuation.

Disclosure: I have lightened my position in (HERO) Hercules, but still hold some long.

Comments

[C. Hendry]

Thanks for the update.

[Mischa]

David, Now that HERO has reported positive earnings in November and in December scored a drilling contract in India, are you more sanguine on the company?