Greenbackd

I’ve recently run a few posts on Seahawk Drilling Inc (NASDAQ:HAWK) (see the post archive here). One of the major issues for HAWK is its Mexican tax dispute. It is a thorny, technical issue for which very few are adequately qualified to comment. Fortunately for holders of HAWK, I have found a practicing tax lawyer willing to provide some color to the matter. Andrew is an honors graduate of Harvard Law School currently practicing tax law in New York. He has over ten years of investment experience and is an avid reader of the value blogosphere and investment publications. His views are solely his own, do not constitute legal, tax or investment advice, and do not necessarily represent the views of any other person or organization.  Andrew welcomes comments and criticism and can be contacted at andrew48912 [at] gmail [dot] com.

Here’s Andrew’s take on HAWK:

Seahawk Drilling Inc. (HAWK) is a ~$100m company spun off from Pride International last year that has attracted considerable attention among value investors. HAWK’s business centers on renting out shallow-water jackup rigs, twelve of which are currently “cold-stacked” (inactive), to various drillers in the Gulf of Mexico and (when business is good) the Mexican coast.

Rather than analyze liquidation value, which Greenbackd did in multiple incisive posts, or discuss the company’s numerous challenges and opportunities, I examined tax issues discussed in HAWK’s recent filings. As a tax lawyer, I’m drawn to special situations involving complex tax issues.

Although there are tax issues with the CEO and directors’ stock compensation, and various tax assets and liabilities, these issues seem dwarfed by Mexican tax disputes.  Numerous posts have alluded to these disputes, but no one has tried to dig deeper (at least publicly) into how they may affect the company. I spent some time reading HAWK’s filings and exhibits in search of clues, and what I found surprised me.

Disputes with the Hacienda

HAWK’s most recent 10-Q states that the company is embroiled in several disputes with the Hacienda (the Mexican IRS), including:

a) Six disputes relating to tax years 2001 through 2003 totaling $97m.

b) Two disputes relating to tax years 2004 and 2006 totaling $42m.

c) Two Pride disputes relating to tax year 2003 totaling $5m, and

d) Several expected tax disputes for more recent years estimated to total $85m.

This represents estimated exposure of $229m, give or take foreign currency movements and any additional disputes.  $229m is a huge “scare” number, dwarfing the company’s reported cash of $48m as of 6/30 and ~$100m market cap, and so it seems likely to weigh on investor perceptions. But does it tell the whole story? I’m not so sure.

I have no special ability to predict the results of Mexican tax disputes,[1] and unfortunately the filings do not provide more guidance on the exact nature of the disputes, but there are more moving parts here. Before the spinoff, Pride and HAWK signed a Tax Sharing Agreement. The Agreement is included as an exhibit to the Form 10, and it addresses tax contests directly. More on that below.

The Tax Sharing Agreement

Under Section 2.1(b), Pride must compensate Seahawk for tax benefits allocated to Seahawk that Pride uses if such benefits arise from a pre-spin year and are used (a) to reduce Pride’s taxes in a post-spin year or (b) in the case of a tax contest or other dispute, to reduce Pride’s taxes in a pre-spin year. In a helpful move, the tax counsel set out an example of this compensation mechanic. This is great drafting, and I often wonder why more lawyers don’t do this.

The example says that if Seahawk has to pay Mexico as a result of a tax dispute attributable to the Seahawk business, Pride must amend its U.S. tax returns to the extent necessary to claim a foreign tax credit,[2] and must compensate Seahawk to the extent the credit is usable, either immediately if the credit can be used now or carried back, or, as it appears from the Agreement, in the future if the credit is used in a future year.

The foreign tax credit rules are very complex, and it’s not obvious whether the Mexican taxes at issue are creditable under U.S. law, or even if payments for a given year would generate tax credits that would be usable by Pride. However, the fact that Pride’s advisors chose to create a special provision for tax benefits attributable to tax contests and wrote an example to specifically illustrate this possibility as applied to a Mexican tax dispute is particularly striking. Agreements aren’t written in a vacuum – clients and lawyers discuss what should and shouldn’t be covered.

Why Things May Not Be As Bad As They Seem

Generally, foreign tax credits can be carried back one year and forward ten years (two and five for pre-2005 tax years), and refund claims must generally be made within ten years of the year to which the foreign tax payment relates.  If Pride can’t immediately use a credit, the present value of the credit is diminished, but this mechanism seems a potential way of mitigating the hit to HAWK of some of the Mexican judgments in a worst-case scenario.

In the absolute “best-case version” of this worst-case scenario, if credits were immediately usable by Pride and were allocated to Seahawk under the Agreement, requiring payments from Pride to Seahawk, payments to the Mexican tax authority for certain disputes could theoretically be “free” because the payments were offset one-to-one by immediately usable tax credits.[3] Moreover, the anticipation of needing to make a payment for which a compensating tax benefit payment by Pride may not arise until a future date could theoretically serve as a catalyst to dispose of less desirable rigs to provide interim liquidity. Such a sale could potentially generate taxable income to utilize tax benefits and put optimistic assessments of liquidation value to the ultimate test.

But what if HAWK wins?

Alternatively, there are scenarios in which the Mexican judgments could be a non-issue. HAWK could conceivably win some or all (as they appear to have done at a lower court in one dispute currently in appeals) of the cases. As another possibility, because the 10-K states that certain disputes are against subsidiaries that lack net assets or material operations, it appears conceivable that Mexico could be unable to collect in certain cases even if it does win (though query whether this could create politically-sensitive issues with respect to future rig business from state-owned Pemex).

With all these moving parts, it’s surprising that there is no direct discussion in HAWK’s filings that tax payments in the Mexican disputes could yield offsetting tax benefits. Rather, the 10-Q simply sets out the estimated maximum gross exposure without its connection to the Agreement, and only separately points out that the Agreement requires each party to reimburse the other in the event of a tax benefit arising from a tax dispute. I think it is unlikely that many people have taken the time to parse the interaction between the Agreement and the ongoing disputes, and I wonder if many investors are overweighting the disputes in their valuation of the company.

Conclusion

Taxes alone should (almost) never be the catalyst for an investment.  Without higher rig utilization, a favorable liquidation, or an asset sale, the cash burn could overwhelm the company, and potential tax benefits generally can’t save a firm if the underlying business model is unsustainable. HAWK is a highly risky play in a sea (or Gulf) of question marks, but one for which the risk may be justified by margin of safety and possibly significant upside, if one can stomach the volatility.

The author is currently long 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

[1] It should be noted that the most recent 10-Q of Hercules Offshore, a competitor of HAWK’s, reports that Hercules settled multiple Mexican tax disputes for approximately $10.8m. Although both Hercules’ and HAWK’s filings mention that the disputes involve Mexican tax deductions, the extent of any issue overlap is unclear.

[2] In general, and with considerable limitations, a U.S. taxpayer may claim a foreign tax credit for foreign taxes paid with respect to activities carried out in a foreign branch, and may claim an “indirect” foreign tax credit upon repatriation of earnings from a foreign subsidiary in which it holds sufficient ownership.

[3] It should be noted, however, that Pride reported $25.5m in foreign tax credits of its own on its last 10-K which begin to expire in 2017. Therefore, it is unclear whether any tax benefits would be immediately usable by Pride for the tax year in which the benefit ultimately relates, or even during the carryback or carryforward period allowed under U.S. tax law, but the fact that Pride does not record a valuation allowance against its existing U.S. deferred tax assets suggests that Pride expects future profitability to allow it to use its tax benefits at some point.

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