Giulio D. Iaconi's  Instablog

Hercules Offshore is a provider of shallow-water drilling and lift-boat services to the oil and natural gas exploration and production industry. The company is headquartered in Houston, Texas and employs roughly 3,100 employees.

In terms of financial strength, HERO’s EPS took a big hit in 2008, whereby the ($12.1)/share results damaged the stock from its previous highs. Book value per share also declined to 10.3/share, nearly 50% of the 2007 levels. The company’s liquidity, among others its current ratio, dropped from 2.2x to 1.7x, while the company continued to leverage itself to a 1.2x debt/equity ratio. So why in heaven’s name would I go long on this stock?

Well, when a company trades near or at liquidation value, there is likely one of two outcomes: bankruptcy or super potential for explosive turnaround gains. Jefferies & Company believes the company faces big challenges in the year ahead, but that the uncertainty is mostly priced in already and has the equity value trading below book value, despite management’s successful run at cutting costs and prorating the company’s size for today’s stringent environment.

Hercules not only shows signs of recovery, but is actively repurchasing its own convertible debt in an attempt to de-leverage in the face of the changing economy. It was able to repurchase $20 million worth of senior convertible notes for $6.1 million in cash, pretty much a 70% discount off par.

Hercules currently trades at about 10x TEV/EBITDA and 90% NAV, which compares to comparable companies trading at roughly 13x and 130%, respectively. This presents a somewhat small discount, but it is well-known that the majority of the offshore drilling service companies move in tandem when there is positive news. Within the specific sector however, I see only upside for Hercules, albeit risky nonetheless.

Hercules is also in early discussions with other parties with speculative newbuilds for management agreements similar to the Mosvold rig marketing and management agreement signed in February 2009.

There is likely some more downside risk to come to HERO after a little run alongside the bear market rally that ended shortly after May, but with the impending recovery and the rebound of oil in the medium to long-term, the company’s current positioning provides some sought-after potential for gains that might not be as attractive now, but may reap great rewards down the line.

The risks are numerous: A collapse in Gulf of Mexico drilling rig demand, whether by result of weaker natural gas prices or operators shifting geographic preferences, would be the primary risk to the downside.

Target price $10, 6-12 months, above average risk.

Transocean is a provider of offshore contract drilling services for oil and gas wells, across the world. Transocean's primary activity is to contract drilling rigs, related equipment and work crews to drill oil and gas wells. The company also specializes in other technical aspects such as offshore drilling with a particular focus on deepwater and harsh environment drilling services. Transocean principally uses three types of drilling rigs: drill ships, semi submersibles, and jackups. The company also operates drill rigs, tenders, a mobile offshore production unit and platform drilling rig.

So why Transocean? Well, to start, Transocean is a big player in the deepwater market, an offshore segment with big barriers to entry due to capital expenditure commitments needed, therefore providing excellent safety amongst oil-related securities. The major investment thesis is 4-fold: there’s major downturn protection, excellent upturn exposure, a really good cash position, and a potentially compelling valuation. All the above, in conjunction with a strong track record across all business segments, make this deepwater-centric driller one of the top picks within the sector.

Downturn Protection: Amongst most analysts, it has been shown quarter-to-quarter that one of the more compelling reasons to hold Transocean is its limited downside risk. Transocean's high contract coverage through 2010 represents a shield that should defend the bulk of its fleet from the worst, if not all, of the downturn in demand and pricing power across rig types.

The company also brings great upturn exposure to rising oil prices, and thanks to the ongoing reluctance of many of its clients to resume contracting 1+ years in advance, Transocean still has 48% of floater days available in 2011, representing meaningful EPS leverage to the next up cycle in floater-related demand that we expect to be well underway by that time. In 2012, 62% of floater days are uncommitted. This really all boils down to capacity and the ability for Transocean to capitalize on the potential for oil demand to rebound after a rather soft 2008 following oil’s rush pre-recession.

The company’s cash firepower was once badly bruised and often mocked, but Transocean has taken great strides in revitalizing its cash position, to the point where the company’s backlog and normalized free cash flow generation potential give the company a lot of breathing room. In a recent conference call, management reiterated Transocean’s strong liquidity position as the company currently has $1.3 billion in cash. Additionally, it holds a $2 billion credit facility which doesn’t mature for another four years and a $1.08 billion commercial paper backstop. In total, the company holds $2.2 billion in unused bank capacity and over $3.5 billion in liquidity. Most importantly, Transocean’s $35.8 billion revenue backlog still provides a stable, visible earnings stream as 95% of the contracted backlog is with investment grade companies. The company’s free cash flow backlog of $17.4 billion exceeds its debt level by $4 billion, which is close to management’s target of a $5 billion cushion.

The buyback program, given the uncertainty in the capital markets, is heavily favored over a dividend as a way to deliver value to shareholders due to the flexibility the buyback program provides in both dollar amount used and timing of share repurchases. The decision to refrain from paying out a cash dividend illustrates management’s leadership qualities and consciousness of current market conditions, a nice tell with regards to ensuring shareholder confidence in a good company.

Finally, out of the four dominating theses for investing in Transocean, the valuation of the company remains attractive by virtually every metric you can think about. With an enterprise value of approximately $37 billion, the stock is trading at 1.0x its backlog and 5.8x 2010E EBITDA. Transocean should trade between 95-105 based on a DCF model that forecasts up to 2013 and uses average FCF for terminal value estimation (based on 2002-2014 averages). While some analysts believe the current rally is short-lived and due for a big fallback once oil recovers back under $60/barrel, others have hinted that oil can continue to push up into the 80’s and even 90’s. The more and more oil pushes through such barriers, the less and less you’ll have to worry about Transocean’s viability and start enjoying the fruits of the oil being drilled.

As usual, risks that should be highlighted are the following: sustained weakness in customer economics, new-build program overruns, fairly high leverage, and cash return expectations. As always, commodity prices could also take a volatile tumble and erode at future profitability.

Agrium engages into retailing of agricultural products and services. It also produces and markets agricultural nutrients and supplies fertilizers in North America. Agrium operates through three segments: Retail, Wholesale and Advanced Technologies. The products that are produced and marketed by the company are nitrogen, phosphate, controlled-release fertilizers, micronutrients and potash. The materials produced by Agrium find applications in household products, mining explosives, pulp and paper, fiberboard, and aluminum. The markets served by the company’s products are specialty, international, industrial and agriculture.

CF Acquisition

Agrium has recently announced a hostile takeover bid for CF Industries, and in doing so, is showing the other commodities players in today’s markets it isn’t afraid to play with its cash in trying times. The CEO, Mike Wilson, is not afraid to ruffle feathers, and ying when the market yangs. In a recent Financial Post article, it was shown how nearly every Canadian resource company has continued to cut capital spending. Agrium on the other hand is attempting something the Canadian industry has not seen in a long time.

The proposal is quite ambitious, as the $3.6 billion offer for the nitrogen and phosphate fertilizer-centric CF Industries. Somehow, Agrium must make it clear to CF that its offer is better than acquiring Terra. Go figure. Get eaten up instead of eating someone else up. From a shareholder’s perspective, this is nuts for CF, but Agrium is showing that it won’t back down regardless of the amount of impediments showing their way. CF’s offer to Terra forced Agrium to act. Calgary-based Agrium has had its eye on CF for a number of years, and even held talks to buy it in 2005, when CF chose to go public instead.

Since then, Agrium has transformed itself into a fully integrated agricultural powerhouse through eight major acquisitions, including last year's US$2.7-billion purchase of UAP Holding Corporation, a deal which greatly enhanced the company's retail operations.

By adding CF to the mix, Agrium says it would gain even greater competitive advantages in the agriculture sector, in which it already stands alone as the one publicly traded company that covers the entire industry's value chain. "It matches our strategy and it broadens our scope both geographically and product-wise," Mr. Wilson said. "If someone's going to bet on the agriculture sector, they're going to take a long look at Agrium, because Agrium is the company that can cover all the segments." Long story short, if you love agriculture, maybe even more than oil, then Agrium is your choice. It’s the easy-bodied investor’s hedge fund equivalent for the entire sector; because the exposure is so rich and diversified you just can’t look away. Even Dan Carroll can’t let it go!

On the more specialized end, many people still keep asking: is Agrium's bold going to succeed? It’s gone up to about $90/share now. Some might say even a little expensive and perhaps counterproductive and perhaps value-eliminating.

Agrium's bid will also have to overcome regulatory hurdles, which a number of investors asked about on the company's conference call. Mr. Wilson said that the CF assets are complementary and there is very little overlap.

The cash portion of Agrium’s offer increased by about 14% to US$40 per CF share (was US$35); such that the new bid is US$40 per CF share + 1 AGU share. The current implied acquisition valuation for CF is about 5.9x 2010 estimated EBITDA (pre-synergies).

Given that Agrium expects synergies of US$150 million to be realized over three years, a post synergy valuation could be generously viewed as 4.8x on 2010 consensus EBITDA. On a conservative basis, Agrium could attain synergies of at least US$78 mm (i.e., SG&A expense and procurement), which would lower the implied acquisition valuation of CF at the current AGU bid to about 5.3x consensus 2010 EBITDA. As such, the revised higher bid is not out of line with the peer average.

Now also important to note with all this technical talk is that Agrium has sufficient cash resources and committed financing to fund the cash portion of the bid only. Unless Agrium is willing to substantially draw into its operating line or arrange further financing, there is unlikely to be much further room for an increase in the cash portion beyond the current US$40/share unless/until a friendly conclusion to the deal is achieved.

Agrium trades at roughly 5.5x 2010E EBITDA forecasts, which is slightly above CF at 5.2x and well above TRA, which is trading at 3.7x. However, a premium for AGU is reasonable versus its immediate peers given the fact that investors look favorably upon AGU’s retail business segment and its relative earnings stability over a full cycle.

Target price

At this time, I believe a price target of $60 to be conservative, with a potential upside going into 2010 and beyond of more than $70-80/share. Downside risk is associated with the potential pullback in commodity markets after the past three months of roaring bullish activity in the sector, but I would not discount Agrium to anywhere below $40/share.

You can also look at this valuation as being historically linked to that of Potash Corp, which usually trades at roughly 1-2% premiums on an EV/EBITDA basis. Therefore, such a valuation is further warranted if we were to look at the average analyst coverage for POT.

Key Risks to Target Price

Well, like any other key risk, you have the volatile commodity pricing exposure we spoke about earlier, but Agrium seems to take care of this via diversification. Another risk, of course, is weather, which really can’t be factored out of the equation by an active human involvement. Another key risk is the potential strengthening of the Canadian dollar vis-à-vis the USD, which is on a long road to potential devaluation, and which may eat away at potential EPS for future periods. We also have to consider integration risk that will be paramount when considering the potential fallback of the CF deal.

Conclusion

The CF acquisition is a commitment Agrium will not likely let go of, and this may pose potential threats to Agrium’s profitability. However, there’s nothing short of genius and bold management involved in the deal, and Agrium may soar to new heights in light of these pending changes. I firmly believe this company has the right exposure a medium-to-high risk investor is seeking in commodities, and may very well provide good upside on the 6-to-12 month period, but may also provide good benefits for the extra-long-term holder.

Disclosure: I hold AGU long in my stock portfolio on kaching. The portfolio is available for anyone to view or follow.