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.

Beginner's Guide To CQG Integrated Client Trading Platform: CQG Integrated Client Trading Platform is a robust trading platform that takes time to learn and to be able to take full advantage of its functionality.

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.

Related Articles
  1. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  2. Investing News

    Who Does Cheap Oil Benefit? See This Stock (DG)

    Cheap oil won't benefit most companies, but this retailer might buck that trend.
  3. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  4. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  5. Investing News

    Today's Sell-off: Are We in a Margin Liquidation?

    If we're in market liquidation, is it good news or bad news? That party depends on your timeframe.
  6. Investing News

    Bank Stocks: Time to Buy or Avoid? (WFC, JPM, C)

    Bank stocks have been pounded. Is this the right time to buy or should they be avoided?
  7. Stock Analysis

    Why the Bullish Are Turning Bearish

    Banks are reducing their targets for the S&P 500 for 2016. Here's why.
  8. Stock Analysis

    How to Find Quality Stocks Amid the Wreckage

    Finding companies with good earnings and hitting on all cylinders in this environment, although possible, is not easy.
  9. Stock Analysis

    The Top 5 Platinum Penny Stocks for 2016 (PLG, XPL)

    Examine five penny stocks in the platinum mining business that investors may wish to consider adding to their investment portfolios for 2016.
  10. Investing News

    What You Can Learn from Carl Icahn's Mistakes

    Carl Icahn has been a stellar performer in the investment world for decades, but following his lead these days could be dangerous.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
Trading Center