We continue our guest posts today with Seahawk Drilling (NASDAQ: HAWK), an idea from Ben Bortner. HAWK’s not a typical Greenbackd stock, but it warrants consideration at a discount to Ben’s estimate of liquidation value. It’s a recent spin-off (here is HAWK’s information statement from the spin-off). Ben sent this through before HAWK’s 8.14% run on Friday to close at $25.78 (it was trading at $23.30 when he submitted the post), which gives it a market capitalization of $300M. Ben is an undergraduate student at Western Washington University majoring in finance and accounting. He has over four years of investment experience and currently manages a portfolio that invests primarily in micro/small capitalization equities using a deep value/Graham & Dodd approach. After graduation (March 2010), Ben would like to pursue a career as an investment analyst at a firm practicing Graham & Dodd’s value investing principles. Ben can be contacted at BenBortner [at] gmail [dot] com:
Seahawk Drilling (NASDAQ: HAWK) is a compelling investment opportunity with very little risk of a permanent loss of capital. The company was recently spun-off from Pride International (NYSE: PDE) is a leading jack-up driller in the Gulf of Mexico (GOM). Seahawk is a cash generating machine with strong liquidity and no long-term debt. During 2009, the company will likely yield 13-19% of its market capitalization in cash flow and 6-11% in free cash flow (FCF). However, on a more normalized basis, Seahawk is likely to yield more than 65% of its current market capitalization in cash flow and 50% in FCF.
The company’s current market cap is approximately $270m ($23.3 x 11.6m shares outstanding). Based on first quarter results, and a schedule of current rig utilization and contracted dayrates provided by Investor Relations, we expect the company to earn $35-50m in cash from operations during 2009. However, based on results from the past three years, a return to more normalized natural gas prices could easily boost the company’s cash flow to more than $175m a year. A recovery in Seahawk’s cash flow would likely happen 1-2 years after a recovery in natural gas prices.
As a result of the spin-off, the share price of HAWK has experienced significant selling pressure from Pride shareholders who are not interested in Seahawk for whatever reason (difference in core business activities, cyclical recession within the industry, bylaws prohibiting ownership of small cap companies, index funds forced to sell non-index stocks, and etc.). The natural gas exploration and drilling industry is also suffering from a severe recession and has become extremely out-of-favor with investors. The combination of these factors has created a terrific opportunity for the value investor.
Seahawk provides contract drilling services to the oil and natural gas exploration and production industries. The company operates a fleet of mobile offshore drilling rigs, which consists of 20 mat-supported jack-up drilling rigs. The company’s fleet operates in water depths up to 300 feet and can drill up to 25,000 feet. Their fleet is the second largest fleet of jack-up rigs in the GOM. The company contracts with its customers on a dayrate basis to provide rigs, drilling crews, and to cover other maintenance and operating expenses. During 2008 the company benefited from high spot prices for oil and natural gas as well as a contraction in rig count within the GOM.
Seahawk’s rigs were built during the 1970s and 80s. However, the vast majority of these rigs have been upgraded within the past 10 years. Currently, as of 9/1/2009, only three of the company’s 20 rigs are under contract. The rest are either stacked or sitting idle. Since the company’s rigs are primarily used to drill for natural gas, the current depression-like prices for natural gas, swelling gas reserves, and weak economic environment have severely impacted the company’s operations.
The company previously operated as part of Pride’s GOM business but was spun off on August 24th. The vast majority of Pride’s GOM assets were spun off to the new company. It appears that the primary reason for the spin-off was that Pride wanted to exit the struggling shallow water drilling business in the GOM and increase its focus on the floating and deep water drilling segments where Pride “believes the best long-term growth prospects reside in the offshore industry.” The severe contraction in natural gas prices over the past year likely contributed to Pride’s desire to exit the industry as well.
The company’s focus on the GOM provides them with a competitive advantage. As a result of their localized focus, they have reduced mobilization costs and more flexible crew deployment than their competitors. Seahawk’s competitive advantage also derives from its specialized operational expertise regarding mat-supported jack-up rigs. As the low-cost service provider within the industry, Seahawk should benefit first from any recovery. According to Seahawk, the company is focusing its growth on available client opportunities in the GOM that will maintain or expand their market share, margin, and cash flow.
Demand for Seahawk’s services derives from its customer’s expectations of future natural gas prices. Currently, as a result of the depressed prices for natural gas and the inability of exploration companies to obtain financing, the drilling industry is experiencing the sharpest downturn in over 20 years. According to the company, as of August fourth there were only 18 jack-up rigs under contract in the GOM out of the market supply of 41.
Over recent years, rigs within the GOM have consistently been moved to international markets. Seahawk believes this shift is partially a result of the inability for many owners, especially the smaller owners, to pay increased insurance premiums. In many cases, owners have been unable to obtain insurance for the entire replacement cost of their new rigs. As a result, many owners have moved their rigs out of the GOM. The company believes that the inability of owners to obtain full windstorm damage coverage may continue indefinitely. As a result, they believe their competitors will continue to market their rigs in international markets, and, thus, the rig supply within the GOM should continue to decline. We believe Seahawk’s growing market share as a result of this shift, low mobilization costs, and flexible deployment, should give the company increasing pricing power within the GOM over time.
In recent years, production in established fields has begun to decline and there has been an increasing focus towards newer fields that are further offshore. While the company expects there will continue to be opportunities for its ten rigs with depth ratings of 200 feet or less, they expect demand for its ten rigs with water depth ratings of 250 feet and greater to be the main source of growth going forward.
There are currently seven jack-up rigs under construction in GOM ports, all of which are of higher specification than Seahawk’s rigs. These rigs could threaten Seahawk’s ability to obtain contracts within the 250 feet and greater segment. However, most new jack-up rigs built in the GOM in recent years have been relocated internationally due to the inability to obtain full insurance coverage within the GOM. The company expects this trend may continue indefinitely and should mitigate the effects of any new rigs.
The entire management team was hand-picked last fall in anticipation of the spin-off. The management team at Seahawk is highly qualified and was chosen for their experience growing newly public offshore drilling companies. In our opinion, the board members’ diverse backgrounds in natural gas, drilling, and engineering should also prove extremely valuable to Seahawk. We are confident that this team will successfully lead Seahawk out of these difficult times.
* Stephen Snider, Chairman of the Board: Mr. Snider is the Chief Executive Officer of Exterran Holdings, a global natural gas compression services company with annual revenues in excess of $3b.
* Randall Stilley, President and Chief Executive Officer: Mr. Stilley has served as President and CEO of Seahawk since September 2008. Prior to joining the company, he served in the same role at Hercules Offshore from October 2004 until June 2008. Hercules Offshore is another leading shallow-water drilling services provider in the GOM. During his tenure he took the company public, grew revenues from $31m to over $1.1b, cash from operations from ($6.5m) to $270m, and book value from $71m to $907m.
* Steven Manz, SVP and Chief Financial Officer: Mr. Manz has served in his role since October 2008. From January 2005 until September 2007, Mr. Manz acted as CFO and SVP of Corporate Development and Planning at Hercules Offshore under Mr. Stilley.
* Alex Cestero, SVP, General Counsel, and Chief Compliance Officer: Mr. Cestero has served in his role since October 2008. Prior to Seahawk, he served as General Counsel and Senior Counsel of Pride.
* Oscar German, SVP of Human Resources: Mr. German has served in his role since November 2008. Prior to Seahawk, he served as International Human Resource Director, Western Hemisphere for Pride. He has also served in senior human resource positions at Coca Cola and BHP Billliton.
Unfortunately, Pride did not historically break-out Seahawk’s operations from its GOM operations. Thus, we do not have any operating, balance sheet, or cash flow figures solely for Seahawk prior to 2008. In fact, we do not have any historical cash flow statements for Seahawk. Pride’s GOM business historically consisted of Seahawk’s 20 mat-supported jack-up rigs and five other types of rigs that were not spun off. As a result, Seahawk’s limited financial statements are presented on a pro forma basis. Thus, many of the numbers presented in the financial statements and in our analysis are estimates.
Seahawk’s latest financial statement is as of March 31, 2009. Per the master separation agreement, the company is targeting net working capital (NWC) of $85m upon separation. Of the $85m in NWC, the company expects to have $60-$70m in cash upon separation. The company will also have no long-term debt and an untapped $36m line of credit. The company currently has approximately $540m in plant, property, and equipment. However, they expect to record an impairment loss of $25-$45m as a result of the depressed market conditions. The company should have approximately $90m in long-term liabilities. Given this information, and assuming a $35m impairment to PP&E, Seahawk has a tangible book value of approximately $505m.
However, we believe the true book value of Seakhawk is understated. Of the company’s roughly $90m in long-term liabilities, $86.3m are deferred income taxes. The valuation of deferred income taxes is hotly debated among industry professionals. Deferred taxes are paid in the future but, under GAAP accounting, are not discounted. The present value of any deferred tax payments may be immaterial if they are not expected to be paid for years/decades, and, thus, are usually overvalued in our opinion. Also, for the net deferred taxes to be paid off, either (a) corporate capital expenditures must decline enough that the timing differences that created the account reverses and/or (b) the entity must remain profitable. In the case of Seahawk, no reversal in capital expenditures is evident. The timing gap has consistently expanded over recent years. Many argue (validly in our opinion), that it is unlikely a profitable entity would cease to reinvest capital for growth, and, thus, would likely never incur any deferred tax payments. If an entity ceased to reinvest capital, they are likely suffering losses, and, thus, not paying taxes anyway. Therefore, in our opinion, Seahawk’s deferred tax liability is certainly worth significantly less than the $86.3m carrying amount and may effectively be worth nothing. Based on this information, we believe that Seahawk’s book value is undervalued by roughly $40-$86.3m. We estimate that the company’s true book value as a going concern may be somewhere between $545-$591.3m. We believe including the entire deferred tax liability in the calculation of book value is only relevant if the company is not a going concern.
During 2008, Seahawk had revenue, EBITDA, and net income of $554m, $218m, and $103m, respectively. During the first quarter, the company had revenue, EBITDA, and net income of $90m, $18m, and $2.6m, respectively. During 2008 and Q1 2009 Seahawk had EBITDA margins of 39% and 20%, respectively. We expect the trend of declining margins to continue through the remainder of the year. Based on a schedule of rig activity and contract rates provided by the company, we expect the company to report Q2 revenue in the range of $42-45m (>50% decline sequentially). This, combined with declining margins and the expected impairment, charge should result in a significant net loss. However, the company should easily remain cash flow positive. In regards to the third quarter, based on the company’s current backlog, and assuming no new contracts within the quarter, the company could experience another 50% sequential decline in revenue to approximately $24m. Based on these revenue projections, we estimate that the company will be cash flow neutral during the third quarter, plus or minus $5m. We estimate that Seahawk will generate approximately $35-50m in cash from operations during 2009. The company’s ability to remain cash flow positive during such difficult periods is a testament to its strength and cash flow potential.
Estimating Seahawk’s historical cash flows is more difficult and requires quite a bit of imprecision. Pride’s GOM business generated cash flow of $240-$260 a year during 2006, 2007, and 2008. To estimate the cash from operations attributable to Seahawk during these years we used the following process (we realize that this process is not precise in anyway and will compensate with a large margin of safety in our purchase price). We calculated Seahawk’s NWC as a percentage of Pride’s GOM operation’s NWC at 3/31/09, which was 75%. We multiplied this percentage against the changes in Pride’s GOM operation’s NWC during each year to estimate Seahawk’s change in NWC. Next, we estimated Seahawk’s annual net income by multiplying the ratio of Seahawk’s 2008 net income to Pride’s GOM operation’s 2008 net income (67%) against the GOM operation’s net income during 2006 and 2007. Last, we estimated Seahawk’s annual depreciation by multiplying the ratio of Seahawk’s 2008 depreciation expense to Pride’s GOM operation’s 2008 depreciation expense (91%) against the GOM operation’s depreciation during 2006 and 2007. The estimation of Seahawk’s cash from operations is shown below.
We are relatively confident in our estimate of Seahawk’s 2008 cash from operations as most of the numbers were provided by the company. Given our 2008 estimate, our 2007 and 2006 estimates do not appear to be unreasonable and, considering the GOM operations as a whole, may actually be understated. Based on our estimates, Seahawk has averaged cash from operations of $176m a year over the past three years. If the price of natural gas recovers to the average levels between 2005 and 2008 ($6-$8), and demand for Seahawk’s rigs improves correspondingly, we believe the company can easily generate cash flow in the range of $175m. Based on past cycles, we estimate that a recovery in cash flow will lag a recovery in natural gas by 1-2 years. We believe the levels of cash flow achieved in 2006-2008 represent more “normal like” conditions for Seahawk than current conditions.
Seahawk plans to spend approximately $20m on capital expenditures (CAPEX) during 2009. This amount is almost entirely maintenance CAPEX. Given this projected spending level, and utilization rates for the year, Seahawk’s maintenance CAPEX in more “normal” years may be in the $40-50m range. Therefore, we estimate that Seahawk should generate $15-30m in FCF during 2009 and $125-135m at less depressed natural gas prices.
While we do wish we had better historical information, the lack of perfect information creates opportunity as other investors willing to do less work are likely to shy away from the company. If we can purchase the company at extremely attractive valuations relative to conservative financial estimates, we will have a large margin of safety and can be confident in our investment.
If the company were to be liquidated today, we believe it could be liquidated for roughly $280-290m. This represents a collection of the entire cash balance (~$65m), 85% of accounts receivable and other current assets (~$94m), 60% of book value for PP&E, less 100% of the current liabilities (~$90m), $10m in liquidation expenses, unrecorded contractual obligations of $21.4m, 60% of the deferred tax liability (you would only pay tax on the difference you were actually able to realize, ~$52m), and $4 in other long-term liabilities. Given that the company is trading below what we believe to be a conservative estimate of liquidation value and not burning any cash, we believe there is very little risk of a permanent loss of capital at current prices.
With a market cap of $270m, Seahawk is trading at less than 0.5x our estimates of its true book value and 2.6x 2008 earnings. Seahawk’s enterprise value is only 1.2x our estimates of normalized cash flows and 4.1-5.8x our estimated 2009 cash flow. These ratios seem to indicate that Seahawk is trading based on depressed 2009 cash flow levels. We believe this is indicative of Wall Street’s short-sightedness. While we view it as highly unlikely that $35m-$50m in cash from operations is the new norm, current prices still represent a reasonable investment with a 13%-19% cash flow yield and a 6-11% FCF yield (not to mention half of BV). However, a return to our estimates of normal cash flows represents a roughly 65% annual cash flow yield and a 46-50% FCF yield.
Another possible scenario is that both 2009 and 2008 cash flow levels are two opposite extremes and that Seahawk’s cash flows may never recover to 2008 levels. In this scenario, a recovery to the midpoint would still represent hefty cash flow and FCF yields of 38-40% and 20-25%, respectively. With high cash flow yields and a strong balance sheet with $65m in net cash, Seahawk is extremely attractive on an absolute basis.
While no two companies are the same, it is often useful to compare a company’s valuation to that of its closest competitors. Since a number of the firms in the offshore jack-up market have a significant amount of debt, and Seahawk does not, we compared the companies on the basis of enterprise values. Hercules is Seahawk’s closest competitor, and, at first glance, the second most attractive investment on a relative basis. However, Hercules and Seahawk have extremely different capital structures. Hercules has a long-term debt to equity ratio of 1.0x while Seahawk has no long-term debt; this ratio would be the equivalent of $500-$550m in long-term debt for Seahawk. Even more concerning is the fact that 92% of Hercules long-term debt is due within less than four years (July 2013) and the company is currently burning a significant amount of cash. Also, using the same estimated recovery ratios, our estimate of Hercules’ liquidation value is less than half of its current market value. Given this analysis, Seahawk is by far the cheapest company in the industry with the largest margin of safety.
* Estimates and adjustments taken from Thomson One Analytics
If the company were to simply trade at 1x our estimate of book value, that would represent upside potential of 100-120%. However, most of its peers trade at a premium to book value. We believe the company should trade at 5-7x our estimate of normalized cash flows and 1.5-2.0x book value, which would represent a price target of $75-$105 and upside potential of 225-350%. Given the current pessimism and difficulties surrounding the company, it may not reach these levels until 2011 or 2012. However, that would still represent an annualized return in excess of 50%. Potential returns such as these create a large margin of safety for the value investor. Our cash flow estimates could be as much as 100% too high and we could still realize a more than satisfactory return on our investment (20-30% annualized returns).
- PEMEX, Mexico’s national oil company owned and operated by the Mexican government, is Seahawk’s largest customer. During 2008, PEMEX represented 58% of Seahawk’s revenue. PEMEX’s demand for Seahawk’s drilling services is subject government approval and intervention. The loss of PEMEX as a customer could have a material adverse affect on Seahawk’s operations.
- A number of Seahawk’s customers, including PEMEX, have indicated an increasing shift towards rigs with water depth capabilities of 250 feet or greater. As a result, the company’s ability to contract out its 10 rigs with depth capabilities of 200 feet or less may be severely limited. If the company is unable to contract these rigs out, the carrying value of these rigs on the balance sheet may be overstated, and, thus, our estimate of tangible book value and liquidation value may be overstated.
- Demand for the company’s services is dependent on natural gas prices. It is possible natural gas prices may never recover, and, thus, demand for Seahawk’s services may never recover to pre-2009 levels.
- Currently, forced selling by investors, institutions, and index funds liquidating their newly acquired shares is exerting significant downward pressure on the stock. The dwindling downward volume indicates that this pressure is beginning to subside.
- Per discussions with Investor Relations, the company plans to release second quarter earnings on September 14th. The earnings release will be the first time management has held a conference call and released official results as a stand-alone entity. These factors should provide additional clarity and comfort to investors regarding the newly formed company.
- Upon completion of the spin-off, management was awarded over $7m in restricted stock and stock options. Mr. Stilley, CEO, was awarded $4.8m himself. Considering his annual salary is $625k, this award should provide a significant financial incentive for Mr. Stilley (and the rest of the management team) to drive increased shareholder value going forward. Mr. Stilley also has his reputation at stake. We suspect he would like to repeat his performance at Hercules.
- If natural gas prices were to rise from their depression-like lows, HAWK could experience a significant boost in demand for its services.
The analyst has an ownership interest in Seahawk Drilling.
The contents of this report is based on information that is thought to be reliable but is not gaurenteed to be accurate or complete. The author is neither certified nor licensed to give investment advice or analyze securities, nor do they claim to be. This report has been developed and published solely for illustrative purposes and is not an offer to buy or sell any of the aforementioned securities. The author does not sell investment research and is not a registered broker/dealer; this report is provided as a courtesy and has been created for personal research purposes only. This report is the sole property of the author and may not be reproduced, distributed, reprinted, cited, or used in any way without prior written consent from the author.
[Full Disclosure: We do not have a holding in HAWK. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]