Hercules Offshore Seeing Better Days In The Gulf

By Stephen D. Simpson, CFA | February 11, 2013 AAA

The energy exploration and production business in the Gulf of Mexico has finally gotten back to something closer to normal, and that's good news for Hercules Offshore (Nasdaq:HERO). While the company's relatively low-spec rigs do limit the company's earnings potential (and the multiple investors should pay), it's also true that a rising tide lifts all boats and that the company is seeing improving day rates and contract lengths. Investors should be cautious about the run-up in energy services stocks, but Hercules could yet be a name worth following.

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Improving Conditions Drive Better Results
With day rates and utilization on the upswing, Hercules is seeing better operating conditions and has returned to profitability.

Excluding a $10-million payment from the state-sponsored Angola Drilling, Hercules saw revenue improve 18% from last year and 4% from the third quarter. Growth was particularly strong in the company's domestic operations, where offshore drilling revenue improved 22%, inland drilling revenue improved 17%, and liftboat revenue improved 60%. While international liftboat revenue grew 22%, international drilling revenue decreased slightly (3%) after netting out that payment.

With higher revenue and better fleet utilization, Hercules Offshore has returned to profitability. EBITDA improved 14% on a sequential basis, while operating income reversed a year-ago and quarter-ago loss to over $21 million. The company did see higher operating expenses, though, and net operating performance was basically in line with expectation.

SEE: Understanding The Income Statement

Day Rates Improving, and Rigs Coming Off the Stacks
While Hercules reported that domestic offshore rig utilization actually slipped a bit this quarter (down about 4% to 81.3%), revenue per rig improved 29%. Better still, the count of cold-stacked rigs declined by five to 12 rigs, and the company has started to reactivate rigs - something that just five or six months ago bearish analysts were saying wouldn't happen.

This good news is being powered by a recovery in drilling activity in the Gulf of Mexico - Hercules' key operating area. While Hercules has a relatively old and low-spec fleet, the reality is that there are only so many rigs to go around. So while companies like Transocean (NYSE:RIG) and Ensco (NYSE:ESV) can command better rates for their newer rigs, the higher demand still filters down to Hercules, and rates for the 200-MC and 250-MC rigs have been steadily above $90,000 per day. In fact, Hercules has reported secured a day rate above $100,000 from Apache (NYSE:APA) for a rig, and operators are increasingly talking about longer-term contracts.

But Don't Assume the Good Times Will Last
Investors would do well to remember that we may be early in an upswing in the Gulf of Mexico, but the good times won't last. (They never have and they never will.) So U.S. regulators are skittish about drilling in the Gulf that the failure of bolts on some General Electric (NYSE:GE) blowout preventers stopped drilling for about one-third of the rigs in the Gulf. What's more, whenever day rates start moving up, fleet operators start ordering new rigs and the supply ultimately pushes prices down again.

Remember, too, that Hercules runs itself a little differently than most. For most of its life, Hercules has been content to purchase second-hand rigs from the likes of Transcoean when those larger firms wish to upgrade their fleets. Over the years, there has been a growing bifurcation between the rates and demand for high-spec and low-spec equipment, and Hercules risks getting the short end of the stick if operators' desire for oil over gas continues to push exploration into deeper waters and to deeper drilling depths.

SEE: Oil And Gas Industry Primer

The Bottom Line
Hercules Offshore has clearly rebounded strongly from the bottom of the cycle, and I wouldn't underestimate the potential for this upswing to set new records before settling down again. That would create a lot of opportunity for Hercules to make money and for the stock to benefit from upgraded expectations.

Even so, I'm not sure how much of a bargain these shares are. Offshore drillers can trade at seven to eight times forward 12-month EBITDA, and even higher, but I'm not sure that the operator of low-spec shallow-water rigs should get that same premium. As such, I'm inclined to give Hercules a six times multiple, which suggests a target around $8 - still above today's price, but not by a large margin.

If investors are sold on the recovery in the Gulf, Hercules is a credible play. At the same time, I would at least consider names like Hornbeck Offshore (NYSE:HOS), Bristow Group (NYSE:BRS) and GulfMark Offshore (NYSE:GLF). These are not jack-up rig companies, but rather supply and service companies that have meaningful operators in the Gulf and could benefit from the overall trend in increased activity.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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