Energy

Expanded Purchase Recommendation: June 2014

 

The Turnaround Letter recommended this oil & gas turnaround stock in June 2014:

Hercules Offshore (HERO)

9 Greenway Plaza, Suite 2200

Houston, TX 77046

Phone: (713) 350-5100

Website: www.herculesoffshore.com

Investor Relations

Securities Exchange Commission Filings

History

Hercules’ stock was crushed back in 2008-09 when investors worried that the recession would push down oil prices and reduce drilling activity. At the same time that demand was weakening, a high level of drilling from previous years was leading to a surge in supply. At one point during 2009, oil and natural gas prices were nearly 77% and 86%, respectively, off their 2008 highs. An historic slowdown in exploration ensued. At one point during the summer, only 14 jackups were working in the entire U.S. Gulf of Mexico, a low not seen since the early days of the industry. Management responded by cutting operating costs, selling assets, issuing equity and debt and, importantly, worked preemptively with lenders to avoid breeching debt covenants. Hercules also benefited from management’s decision to have previously expanded internationally, as the international customer base was generally better capitalized; and they also benefitted operationally from their liftboats which generally support production activity that is not as closely tied to commodity pricing.

Then, just as the stock was beginning to recover and operating activity was on the rise, Hercules was again hit hard following the Macondo disaster in April 2010. The fact that there are substantive differences between shallow and deepwater drilling had little impact on regulators who rather arbitrarily mandated a defacto moratorium that included shallow water drilling, Hercules’ largest market.

While Hercules was able to avoid bankruptcy in the aftermath of the Macondo spill, some of its competitors were not, and Hercules was able to acquire assets cheaply and solidify its market leadership in the Gulf. In early 2011, Hercules agreed to purchase 20 U.S. Gulf of Mexico-located jackup rigs and related assets from Seahawk for $25 million and approximately 22.3 million shares of Hercules Offshore common stock; Seahawk needed the funds to pay off a debtor-in-possession loan which related to the company’s bankruptcy filing. Hercules’ management also capitalized on the opportunity to expand on the company’s international presence by investing $10 million in a newly formed company, Discovery Offshore S.A. that set out to construct two ultra high-specification jackup rigs capable of operating in harsh environments at water depths up to 400 feet and drill to 35,000 feet.

Turnaround Challenge/Opportunity

Things are finally beginning to look up for Hercules. Demand for drilling in the Gulf of Mexico is picking up again and dayrates for drilling platforms are increasing. Driven largely by higher dayrates, the average revenue per rig per day increased in the first quarter by over 36% to nearly $107,000; management has reported that while average dayrates are continuing to rise, they expect stable pricing in the near term as industry utilization of jackup rigs has remained near full utilization since the fourth quarter of 2011; most of Hercule’s rigs are under contract.

While contracting activity in early 2014 is off the pace of recent years, management believes there is a healthy balance between supply and demand in the Gulf of Mexico. Moreover, leasing activity for oil and gas tracts is also on the upswing which bodes well for future demand. Fieldwood Energy, one of the big end users of jackup rigs is likely to reengage following a combined $4 billion investment in shallow-water Gulf assets, some purchased from Apache and others from SandRidge Energy. Fieldwood’s CEO has argued that new technologies are opening up the opportunity for more Gulf discoveries.

Other activity in the Gulf includes Energy XXI’s–an independent oil and natural gas exploration and production company–$2.3 billion purchase of EPL Oil & Gas, a move that exemplifies industry participants commitment to the Gulf of Mexico. Hercules has a strong relationship with Energy XXI and is currently working four rigs in the West Delta Block for EPL.

Management also reports that at a recent lease sale showed a healthy increase in bidding on shallow water acreage; $56 million that was spent was more than double the prior sale. Seahawk–having emerged from bankruptcy due, in part, to Hercules buying some of its assets–bid on 131 blocks, up from 85. Apache, fresh from having sold a number of its assets to Fieldwood last year, returned as the high bidder on 17 shallow water tracts.

To be sure, on the supply side there are about 144 jackup rigs under construction or on order, with about 32 due to be delivered over the balance of 2014. Nine have been delivered since the beginning of last year, and management reports that the market has actually tightened. Many of the new rigs will operate in international markets; Hercules’ Gulf operations are somewhat sheltered from competitive inroads due to a number of factors that make it hard to reallocate rigs to the Gulf, including mobilization and insurance costs and expenses related to closely supporting shorebase operations. Events in Mexico–an end to a 75-year monopoly by the state will open up drilling to private companies–could release some existing assets into the U.S. Gulf, but so far that hasn’t happened and the owners of many of the rigs have large operations in West Africa and the Middle East.

Hercules itself has diversified internationally, expanding both its drilling platform and liftboat presence around the world. In fact, expanding the firm’s geographic footprint has been a fundamental element in management’s strategy, particularly in the Middle East, West Africa and Southeast Asia. As developing countries continue to grow, their demand for, and ability to pay for, oil and natural gas will no doubt rise.

Expansion of the firm’s international liftboat segment resulted both from transferring some assets from its domestic operations, the balance of which were sold in 2013, and from acquisitions. The majority of the firm’s liftboats operate offshore West Africa, a dependency that led to a small decline in quarterly operational performance for the international liftboat segment due to project delays in Nigeria and a heavy repair and maintenance schedule. The company’s Middle East liftboat segment remains strong, though it is much smaller.

Management pressed ahead with international jackup expansion in mid 2013 when it upped its investment in Discovery Offshore S.A. to 84%; they subsequently acquired all of the company that they helped start back in 2011 with a $10 million investment. As a result, its two main developments are now called Hercules Triumph and Hercules Resilience, two newly contracted high-specification rigs that bring strong operating margins. Both assets had little trouble landing their inaugural contracts; the Triumph in India at roughly $215,000/day and the Resilience in Southeast Asia at a day rate of about $162,000.

In May, Hercules entered into an agreement with Maersk Oil North Sea UK Limited for a new jackup rig to be owned and operated by Hercules. It is roughly a $420 million, five-year North-Sea contract that will provide Hercules the opportunity to establish a shorebase in the North Sea that will help in building out additional assets. It should also enhance management’s ability to market Triumph and Resilience, the firm’s other newly built ultra high-specification jackups. The Maersk deal raised Hercules’ revenue backlog to a record high $1.4 billion.

Hercules’ is regularly recognized as having a seasoned, well-respected management team. Since the collapsing markets in 2008, they’ve completed the bulk of a divestiture program whereby they sold older low-end and cold-staked assets (rigs not out on contract), they captured a leading position in the U.S. Gulf of Mexico by purchasing substantial assets from their largest competitor while it was in bankruptcy, they’ve expanded internationally with three advanced technology jackup rigs all while maintaining and even strengthening the balance sheet; there are currently no debt maturities until 2017.

Hercules could easily earn $0.50 per share this year and more next year. Nine times current earnings looks very cheap to us for the company that has such a dominant position in the Gulf of Mexico as well as growing international potential. One director who already owned over 2 million shares bought another 75,000 in March and April, and we like the institutional ownership; Dimensional Fund Advisors and BlackRock each own 8.3% and 5.9%, respectively, of the outstanding shares. We recommend buying Hercules up to 7.50.

Finance/Valuation

Price: 4.45

Market Capitalization: $715 million

Forward P/E = 7.80

Price/Sales = 0.77

Price/Book = 0.84

Total Debt/Equity = 1.53

        Forward Annual Dividend Rate = 0%

Hercules has come a long way since 2008 when its balance sheet showed a surge in debt at the same time that shareholder equity was cut more than in half, as was its cash balance. And while long-term debt is today higher than in 2008, management has refinanced Hercules’ debt obligations such that there are no debt maturities until 2017, and roughly three fourths of long-term obligations mature beyond five years and 80% maturing in 2021 or later. Cash has built back up and working capital is stronger than anytime since 2007. Operations have been profitable, and operating cash flows have recently covered capital expenditures. Furthermore, management has access to a $150 million revolving credit facility.

Products/Services

Hercules is a leading provider of shallow-water drilling and marine services to the oil and natural gas exploration and production industry globally. They provide these services to national oil and gas companies, major integrated energy companies and independent oil and natural gas operators. As of February 19, 2014, they owned a fleet of 38 jackup rigs, including Hercules Triumph (formerly Discovery Triumph) andHercules Resilience (formerly Discovery Resilience), 19 liftboat vessels and operated an additional five liftboat vessels owned by a third party. A diverse fleet is capable of providing services such as oil and gas exploration and development drilling, well service, platform inspection, maintenance and decommissioning operations in several key shallow-water provinces around the world.

As of February 19, 2014, Hercules’ business segments included the following:

Domestic Offshore — includes 28 jackup rigs in the U.S. Gulf of Mexico that can drill in maximum water depths ranging from 85 to 350 feet. Eighteen of the jackup rigs are either under contract or available for contracts and ten are cold stacked.

International Offshore — includes ten jackup rigs outside of the U.S. Gulf of Mexico. Three jackup rigs are contracted offshore in Saudi Arabia, two jackup rigs contracted offshore in India, one jackup rig contracted offshore in the Democratic Republic of Congo, one jackup rig contracted offshore in Angola and one jackup rig contracted offshore in Vietnam. In addition, they have one jackup rig cold stacked in Bahrain as well as one jackup rig cold stacked in Malaysia.

International Liftboats — includes 24 liftboats. Twenty are operating or available for contracts offshore West Africa, including five liftboats owned by a third party, one is cold stacked offshore West Africa and three are operating or available for contracts in the Middle East region.

Jackup Rigs

Jackup rigs are mobile, self-elevating drilling platforms equipped with legs that can be lowered to the ocean floor until a foundation is established to support the drilling platform. Once a foundation is established, the drilling platform is jacked further up the legs so that the platform is above the highest expected waves. The rig hull includes the drilling rig, jackup system, crew quarters, loading and unloading facilities, storage areas for bulk and liquid materials, helicopter landing deck and other related equipment.

Jackup rig legs may operate independently or have a lower hull referred to as a “mat” attached to the lower portion of the legs in order to provide a more stable foundation in soft bottom areas, similar to those encountered in certain of the shallow-water areas of the U.S. Gulf of Mexico. Mat-supported rigs generally are able to position themselves more quickly on the worksite and more easily move on and off location than independent leg rigs. Twenty-seven of Hercules’ jackup rigs are mat-supported and eleven are independent leg rigs.

Under most contracts, Hercules is paid a fixed daily rental rate called a “dayrate,” and they are required to pay all costs associated with their crews as well as the upkeep and insurance of the rig and equipment. Dayrate drilling contracts typically provide for higher rates while the unit is operating and lower rates or a lump sum payment for periods of mobilization or when operations are interrupted or restricted by equipment breakdowns, adverse weather conditions or other factors.

Liftboats

Liftboats are self-propelled, self-elevating vessels with a large open deck space, which provides a versatile, mobile and stable platform to support a broad range of offshore maintenance and construction services throughout the life of an oil or natural gas well. They are ideal working platforms providing support platform and pipeline inspection and maintenance tasks because of their ability to maneuver efficiently and support multiple activities at different working heights. Diving operations may be performed from liftboats in connection with underwater inspections and repair. In addition, liftboats provide an effective platform from which to perform well-servicing activities such as mechanical wireline, electrical wireline and coiled tubing operations. Technological advances, such as coiled tubing, allow more well-servicing procedures to be conducted from liftboats. Moreover, during both platform construction and removal, smaller platform components can be installed and removed more efficiently and at a lower cost using a liftboat crane and liftboat-based personnel than with a specialized construction barge or jackup rig. The length of the legs is the principal measure of capability for a liftboat, as it determines the maximum water depth in which the liftboat can operate. Liftboats are typically moved to a port during severe weather to avoid the winds and waves they would be exposed to in open water.

A liftboat contract generally is based on a flat dayrate for the vessel and crew. Liftboat dayrates are determined by prevailing market rates, vessel availability and historical rates paid by a specific customer. Under most of liftboat contracts, Hercules receives a variable rate for reimbursement of costs such as catering, fuel, oil, rental equipment, crane overtime and other items. Liftboat contracts generally are for shorter terms than are drilling contracts, although international liftboat contracts may have terms of greater than one year.

 

Management

Board of Directors

Management Team

John T. Rynd, Chief Executive Officer and President

Mr. Rynd was named Chief Executive Officer and President of Hercules Offshore in June 2008. In addition, he serves as a member of the Board of Directors for the Company. Mr. Rynd has served in various executive level positions since joining Hercules Offshore in September 2005.

Prior to joining the Company, Mr. Rynd spent 11 years with Noble Drilling Services, Inc., where he served in a variety of management roles, including Vice President Investor Relations and Vice President Marketing and Contracts. Mr. Rynd also served in various management roles at Chiles Offshore, culminating in Vice President of Marketing. His experience also encompasses 10 years of service for Rowan Companies Inc., where he served in various roles of increasing levels of responsibility on offshore rigs.

Mr. Rynd serves as Vice Chairman on the Board of Directors and the Executive Committee for National Ocean Industries Association (NOIA), the Executive Committee of the International Association of Drilling Contractors (IADC), the Board of Directors, Executive Committee and the Education Outreach Advisory Board for the Offshore Energy Center (OEC), the Board of Directors for Hornbeck Offshore, Inc. (HOS) – NYSE, and the Advisory Board for Spindletop International Charities. Mr. Rynd graduated from Texas A&M University with a Bachelor of Arts in Economics.

Consolidated Financial Statements

STATEMENTS OF CONSOLIDATED OPERATIONS

(In thousands, except per share amounts)

 

Year Ended December 31,

 

2013

 

2012

 

2011

Revenue

$

858,300

 

 

$

618,225

 

 

$

574,571

 

Costs and Expenses:

 

 

 

 

 

Operating Expenses

461,332

 

 

370,096

 

 

377,880

 

Asset Impairment

114,168

 

 

108,216

 

 

 

Depreciation and Amortization

151,943

 

 

142,329

 

 

149,477

 

General and Administrative

79,425

 

 

57,311

 

 

53,626

 

 

806,868

 

 

677,952

 

 

580,983

 

Operating Income (Loss)

51,432

 

 

(59,727

)

 

(6,412

)

Other Income (Expense):

 

 

 

 

 

Interest Expense

(73,248

)

 

(72,734

)

 

(72,086

)

Loss on Extinguishment of Debt

(29,295

)

 

(9,156

)

 

 

Gain on Equity Investment

14,876

 

 

 

 

 

Other, Net

(1,518

)

 

1,896

 

 

(3,934

)

Loss Before Income Taxes

(37,753

)

 

(139,721

)

 

(82,432

)

Income Tax Benefit

10,944

 

 

18,721

 

 

27,682

 

Loss from Continuing Operations

(26,809

)

 

(121,000

)

 

(54,750

)

Loss from Discontinued Operations, Net of Taxes

(41,308

)

 

(6,004

)

 

(21,378

)

Net Loss

(68,117

)

 

(127,004

)

 

(76,128

)

Loss attributable to Noncontrolling Interest

39

 

 

 

 

 

Net Loss attributable to Hercules Offshore, Inc.

$

(68,078

)

 

$

(127,004

)

 

$

(76,128

)

 

 

 

 

 

 

Net Loss attributable to Hercules Offshore, Inc. Per Share:

 

 

 

 

 

Basic and Diluted:

 

 

 

 

 

Loss from Continuing Operations

$

(0.17

)

 

$

(0.79

)

 

$

(0.42

)

Loss from Discontinued Operations

(0.26

)

 

(0.04

)

 

(0.16

)

Net Loss

$

(0.43

)

 

$

(0.83

)

 

$

(0.58

)

Basic and Diluted Weighted Average Shares Outstanding

159,501

 

 

153,722

 

 

130,474

 

 

CONSOLIDATED BALANCE SHEETS

(In thousands, except par value)

 

December 31,

 

2013

 

2012

ASSETS

 

Current Assets:

 

 

 

Cash and Cash Equivalents

$

198,406

 

 

$

259,193

 

Restricted Cash

 

 

2,027

 

Accounts Receivable, Net of Allowance for Doubtful Accounts of $891 and $788 as of December 31, 2013 and December 31, 2012, Respectively

220,139

 

 

167,936

 

Prepaids

20,395

 

 

16,135

 

Current Deferred Tax Asset

10,876

 

 

21,125

 

Other

17,363

 

 

12,191

 

 

467,179

 

 

478,607

 

Property and Equipment, Net

1,808,526

 

 

1,462,755

 

Equity Investment

 

 

38,191

 

Other Assets, Net

25,743

 

 

37,077

 

 

$

2,301,448

 

 

$

2,016,630

 

LIABILITIES AND EQUITY

 

 

 

Current Liabilities:

 

 

 

Short-term Debt and Current Portion of Long-term Debt

$

 

 

$

67,054

 

Accounts Payable

80,018

 

 

58,615

 

Accrued Liabilities

81,500

 

 

82,781

 

Interest Payable

33,067

 

 

17,367

 

Insurance Notes Payable

9,568

 

 

9,123

 

Other Current Liabilities

35,735

 

 

26,483

 

 

239,888

 

 

261,423

 

Long-term Debt, Net of Current Portion

1,210,676

 

 

798,013

 

Deferred Income Taxes

14,452

 

 

56,821

 

Other Liabilities

12,732

 

 

17,611

 

Commitments and Contingencies

 

 

 

Equity:

 

 

 

Common Stock, $0.01 Par Value; 300,000 Shares Authorized; 162,144 and 160,708 Shares Issued, Respectively; 159,761 and 158,628 Shares Outstanding, Respectively

1,621

 

 

1,607

 

Capital in Excess of Par Value

2,170,811

 

 

2,159,744

 

Treasury Stock, at Cost, 2,383 Shares and 2,080 Shares, Respectively

(55,165

)

 

(53,100

)

Retained Deficit

(1,293,567

)

 

(1,225,489

)

 

823,700

 

 

882,762

 

 

$

2,301,448

 

 

$

2,016,630

 

 

 

 

 

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