Hercules Offshore: Getting to Know a Hero

For those of you following Hercules Offshore (HERO), you already know that they "provide shallow-water drilling and liftboat services to the oil and natural gas exploration and production industry in the U.S. Gulf of Mexico and internationally. Its liftboats provide a range of offshore support services, including platform maintenance, platform construction, well intervention, and decommissioning services. The company provides its services to integrated energy companies, and independent oil and natural gas operators. As of February 5, 2007, it owned a fleet of 9 jackup rigs and 64 liftboats. The company was founded in 2004 as Hercules Offshore, LLC and changed its name to Hercules Offshore, Inc. in 2005. Hercules Offshore, Inc. is based in Houston, Texas."

But let's take a deeper look at this small company to see if it is worthy of your investment dollars.

The above paragraph is all nice and dandy, but what the heck are jackup rigs and liftboats? A jackup rig is essentially a barge that is hauled out to the drilling spot, jacks down its four legs into the seabed, then lifts itself up out of the water, forming a platform for the drill rig:

A liftboat works the same way, but its' purpose is to drive out to a drilling operation to offer a work surface for repairs, construction, resupply, etc.

Both of these structures are capable of operating in waters up to around 250 ft deep. What you may not know is that just two months ago (July '07) HERO completed it's acquisition of TODCO. HERO has realized that more money is being made in the actual drilling, than in the servicing to the drillers. By acquiring TODCO, they increased their jackup rigs from 9 to 33. They only added one liftboat, for a total of 65. In addition to these, they acquired several more drilling platforms: 27 Barge Drilling Rigs, 9 Land Rigs, 3 Submersible Drilling Rigs, and 1 Platform Rig. They even added a towing service made up of 96 Marine Vessels and 60 barges. Barge drillers are used for shallower, calmer waters (mostly inland). The submersibles also operate in shallow water. Their "legs" are made of big inflatable pontoons. When they are over their drill site, the air is let out and the rig sits on the ocean floor. These have the advantage of being more mobile than a standard jackup rig. I should not have to explain what a land rig is, and a platform rig is the immobile rigs that can operate in deeper water:

HERO may be known as an oil "services" company, but don't fool yourself. With the TODCO acquisition, they made a bold statement that they are a true driller, with a servicing business on the side. When adding TODCO's 1st Half '07 revenue results to their own, over 75% of HERO's 2nd Half '07 Revenue can expect to come from drilling operations, and 25% from servicing. With the TODCO acquisition, they became the fourth largest global jackup rig operator (previously 12th), and the leading jackup rig operator in the Gulf of Mexico with almost twice as many as their nearest competitor, Ensco (ESV). They are now also the leader in Gulf Coast barge rigs by more than twice their nearest competitor, Parker Drilling, PKD. Finally, the TODCO purchase was a great diversification measure. Prior to TODCO, the majority of HERO's operations were based in the Hurricane-prone Gulf of Mexico. They now operate in ten different countries and five different continents. If all of this isn't eye-popping enough, let's drill down into the numbers:

1) PEG Ratio. Most people believe anything less than 1.0 is a good value BUY. Less than 0.5 is a "screaming" BUY. HERO currently sits with a PEG at 0.23.

2) Price performance. There are three ways to get a low PEG. Increasing earnings and increasing projected growth (good) and a falling stock price (bad). HERO's current price is above its' 50-day moving average which shows upward momentum.

3) Market cap. HERO is still priced at pre-TODCO levels. This is a good thing as too much market cap means less ability to run to higher prices. Granted, HERO needed to take on new credit to affect the TODCO merger, with the increased exposure to drilling, and the hefty price of oil, this will payoff sooner rather than later.

4) Profitability. With a 31% ROE and a 20% ROA, HERO's management has shown itself to be highly-efficient in managing the equity provided by shareholders as well as its' capital assets.

5) Total Debt to Equity. HERO's ratio is at 0.12, well below my 0.25 cutoff.

6) Estimated Sales Growth. My Yahoo screener shows HERO's estimated sales growth for THIS QUARTER to be 221%. That may seem high, but remember, they should have started receiving revenue from TODCO's assets starting in July. As I mentioned, TODCO was a BIG acquisition, and the added exposure to drilling should bring in massive revenues this quarter.

7) Insider Purchases. If you look past everything else I've mentioned, you cannot look past the recent insider purchases by senior officers at HERO. They have been loading up since the acquisition. If anybody knows the numbers and profitability of a company, it is the insiders. Seeing them put their own money on the company is the clincher for me. Although HERO has only traded since 2005, you can see on this chart that every time an insider makes a substantial purchase, it is followed by a price increase within the next 3-6 months:

Here's a more recent look at the last three months:

8) Common Sense Test: My final test. Despite all the beautiful numbers, I won't buy a stock based on a screen unless I truly believe it will outperform the market over the next 12 months. Let's take a look at the macroeconomic factors that will push this stock higher. The dollar has been on a long and steady decline. With the Fed lowering interest rates last week by 50 basis points, they have signaled that they are on a course to continue lowering rates over time. Lower interest rates diminish the strength of the dollar. A dropping dollar increases the value (in US dollars) of the price of oil. Add to this the current political and military picture in the Middle East, as well as the rapid growth in the demand of oil from China and India, and a constantly decreasing global oil reserve, and you have the recipe for what I see as $100-$150 dollar oil within 2-3 years. I realize that is a bold statement, but the US Dollar is in free fall. The mortgage crisis and tightening worldwide credit are contributing to the lower dollar. Even without the supply and demand problems, and without the Mideast conflict, the dropping dollar alone will continue to push the price of oil higher. So my common sense says that energy stocks, particularly drillers (which HERO clearly is now) will continue to be strong, despite the runup over the last few years.

Bottom Line

A strong stock, in a strong sector. HERO is a "no-brainer" for The Monthly Stock Portfolio.

Disclosure: Although profiled today, in accordance with my buying criteria, I will not be adding this to the portfolio until 1 October's opening price.

Comments

[Richie:]

!) Hero hasn't been above its 50 DMA (other than for one day last week) many weeks.

2) Hero's not a multinational, eventhough they offer their services all over the world --- so their revenues and profits are recorded in the dollar, which you correctly observe is in a state of collapse.

3) Much of the drilling by HERO is for Nat Gas. The markets perceive (rightly or wrongly) that we have a glut of Gas so Hero's rigs, boats and services will continue to operate at only about 70% of capacity --- well below the levels of a year ago.

I own a ton of HERO shares. I hope that there are other, stronger reasons to own it than those you have proposed. ie, The idea that oil will trade at a sustained price of $100 -$150 per barrel is off the wall. At that price, the economies of the world will be so far into recession (depression) that demand will totally collapse and so will the price!

2007 Sep 25 11:22 AM

[Matt Callow_:]

Thanks for the insightful comment.

1) On the day that I drafted up this article, HERO was above its' 50 DMA. Just barely, but the price trend was up and the 50 DMA line was moving down rapidly. I still see a good case for upward momentum here. I prefer to focus more on fundamental analysis than technical.

2) HERO is more multinational than they ever have been. With the TODCO purchase they have positioned themselves well in global waters. Even though they may receive dollars, the dayrates they receive have been moving up as the dollar falls and demand increases. I have no doubt that the revenue will be there at the end of the quarter.

3) I agree with you on this point. I figured about 75% utilization. If you look at the relationship between the price of oil to the price of natural gas, historically, it has been about 7 to 1. Right now, it sits at 10 to 1. Natural gas is currently undervalued. If you look at the prices on futures of natural gas, you can see that traders believe that the price of natural gas is going to rise over the next 6 months, filling in this gap back to 7 to 1.

I expected many comments about the $100-$150 oil call. Your's does not surprise me. Only time will tell. But keep in mind, as the dollar falls, the value of oil to the rest of the world falls as well, unless the price of oil goes up. Even if supply and demand remained stagnant (highly unlikely) oil would still rise in price if the dollar continued to fall. As I pointed out, demand rising, supply and dollar falling, oil will continue to go up.

2007 Sep 25 07:07 PM

[Richie:]

As to your last point ($100 - $150 oil), the US will certainly enter a sustained recession (especially given our other current problems). If we go into recession, the rest of the world will as well, as we are the world's buyer of last resort. Demand for all commodities from all countries will diminish. Oil, gold, copper, zinc etc. will drop dramatically in price. That will also discourage the ag sector and the production of ag sources of energy.

Today, this country is not in a position to live with oil at over $100. It won't happen, because we cannot afford to allow it to happen.

2007 Sep 26 10:02 AM

[Hero Owner:]

Hello Matt,

Can you please comment on how HERO's transition from oil services company to driller will affect the company's bottom line?

2007 Sep 27 09:30 PM

[Matt Callow_:]

In their Q207 earnings report, they stated that 48% of revenue came from drilling and 52% came from liftboats. At a recent Oil & Gas Conference, they presented a pie chart which showed where their revenue would have came from if combined with TODCOs assets for the First Half of 2007. TOTAL drilling accounted for 84% of revenues (my article incorrectly said 75%), Liftboats 9%, and the Delta Towing segment accounted for 8%. So you see why I make the claim that they are now a driller. So you have a drilling company that owns its own servicing fleet. Meaning, not only can they control their own liftboat utilization rate, they can pay wholesale costs for it as well, a HUGE advantage on the rest of the drillers. I don't think anyone knows what the bottomline will be, except the insiders maybe, and you know what they are doing.

2007 Sep 28 12:31 AM

[user 109578:]

Dayrates (the amount charged by a rig owner to an exploration company for the use of their rigs) for the type of jack-ups operated by HERO are falling - today they stand at $70-80k per day, but with the current oversupply of jack-ups in the Gulf of Mexico, these are expected to fall to $50-$60k.

Whereas most other jack-up operators (ie Rowan, Ensco, Pride, Noble) are able to mitigate this risk by moving their higher premium jack-ups into international waters (where day rates are higher), HERO's fleet can only operate in shallow water and, with the possible exception of being moved to Mexico, can't go anywhere.

Bottom line - HERO looks very good in valuation terms, but beware the threat to earnings posed by the company's exposure to the Gulf of Mexico and falling day rates.

2007 Sep 28 07:43 AM

[Matt Callow_:]

I'm not sure you read my last comment, or maybe you just disagree with it. HERO is not in the liftboat business anymore (my opinion). Revenue from liftboats will fall from 52% to 9%. That is a huge statement! They are a driller now with their own liftboat fleet. Day rates will not matter much as they will be using their own boats to service their own drilling rigs. They will have the lowest operating costs of any driller. If they do use their own boats to service their own drills, revenue from liftboats will fall even further, which is the right move for this company seeking to move into the more profitable drilling sector.

2007 Sep 28 06:25 PM

[user 109578:]

Matt - perhaps there's some confusion here but when HERO describes itself as a "driller", this means that the majority of the company's revenues come from the hiring out of jack-ups to E&P operators - it is the E&P companies that actually do the drilling, not HERO.

So, I certainly agree that following the TODCO acquistion, HERO is less dependent on liftboat revenues, but instead it is now largely dependent on revenues from hiring out its jack-up fleet. And it is the day rates at which the company hires out its jack-ups which are under threat (for the reasons I outlined above) - hence the threat to HERO's earnings.

2007 Oct 01 07:46 AM

[Mischa:]

Matt and others, Now that HERO has report November 07 earnings--above analyst estimates--why is the stock continuing to drift down? It does appear it may be stabilizing at $24 since they announced the India drilling deal. What are the prospects now?

2007 Dec 09 06:19 PM