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Posts Tagged ‘Seahawk Drilling (NASDAQ: HAWK)’

Longterm Investing has a series of posts examining several scenarios in Seahawk (HAWK) following the recent conference call (see my post archive for the background). In particular, Neil has examined the effect of CEO Randy Stilley’s proposal to take on debt to buy rigs, rather than buyback stock. Here’s the analysis:

It’s important to understand how the risk-reward profile of HAWK is modified as they take on debt. In their quarterly call they indicated a strong preference for adding debt and adding rigs.

I’ve considered three scenarios.

1. HAWK retains their current leverage and uses asset sales to pay for operations. These asset sales will be at scrap values, around $7M per rig.

2. HAWK takes on 110M of debt and 50M of new assets. These new assets are 3M cash flow positive each quarter after interest. All of HAWKs rigs, new and old are security for this debt. It replaces the existing credit line. This amount of debt is below the scrap value of existing rigs + new asset value.

3. Hawk takes on $150M of debt and 50M of new assets. Similarly,  these new assets are 3M cash flow positive each quarter after interest. All of HAWKs rigs, new and old are security for this debt. It replaces the existing credit line. This amount of debt is about the liquidation value of current rigs and new rigs, net of liabilities.

The “good case” is where HAWK continues their current cash burn, as modified in the scenarios above, until a point in time when rig market values return to December 2008 levels.

The company values under each scenario are shown below assuming a return to December 2008 values in that period. The value added and subtracted by debt are shown along with the 40M residual value under case 2.

image

See the post.

Long HAWK.

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Seahawk Drilling Inc (NASDAQ:HAWK) President and CEO Randy Stilley presented to the Barclays Capital CEO Energy-Power Conference on Thursday. I’ve been following HAWK closely (see the post archive here). It’s a deeply undervalued asset turnaround play with a bad case of seconditis. Once Stilley finds the person sticking the pins in the HAWK voodoo doll, HAWK should do fine. Here’s Stilley discussing HAWK’s current liquidation value (at around the 14:30 minute mark):

The other thing that is almost ridiculous to talk about in some ways, but if you think about the underlying asset values of the fleet, if you look at our current market cap less working capital, you end up with a value per rig of about $3-and-a-half million. We just had – within the last couple of months – a third party fleet value established that came out to $313 million, which is over $15 million per rig. And the book value of course is about $20 million per rig.

And the other way to think about that is, Hercules sold a less-capable mat. slot rig earlier this year for $5 million that had no drilling equipment on it, and it was a rig that had been stacked for 10 years. So, if you think about that, and you think about that we had rigs that have all worked with the past few years that are in better condition than that, it’s obvious that our rigs are worth more than $3 million. And if we were to just start cutting them up, you could, over time, sell the drilling equipment of a rig to generate $6 to $8 million in income by doing that. Now, I’m not saying we’re going to do that today, but we’re certainly going to think about it.

Here’s the relevant slide:

Listen to the Barclays Capital Presentation.

Long HAWK.

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Carl Icahn’s former lieutenant Mark Rachesky has opened a position in Seahawk Drilling Inc (NASDAQ:HAWK), a stock I’ve covered in some detail (see the post archive here). Rachesky holds the position in his investment vehicle, MHR Fund Management LLC. Rachesky’s most recent 13F filing indicates he picked up around 1.2M shares for around $11.4M, which implies an average purchase price of about $9.72 per share. According to Business Insider:

Rachesky, 49, spent six years working for Icahn, including serving as a senior investment officer and chief investment advisor for his last three years at Icahn Holding Corporation. He left Icahn in 1996 and opened his own New York-based firm, MHR Fund Management, for which he still serves as president.

Rachesky is perhaps best known for his position in Lions Gate:

He first took a 5.9% stake in Lionsgate in August 2005, but he boosted his ownership to 14.1% as of last July and has rapidly increased the size of his position over the past two months—at the same time Icahn enhanced his own stake—after Lionsgate reported its disastrous third-quarter earnings. Up until last week, Rachesky’s investment in Lionsgate was passive, meaning he didn’t seek to influence the company’s operations. But now he’s an active investor in the studio.

The $11.4M holding in HAWK represents around 0.8% of Rachesky’s $1.4B fund.

Hat tip JG.

Long HAWK.

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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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Further to my Seahawk Drilling, Inc. (NASDAQ:HAWK) liquidation value post, I set out below the slightly more optimistic valuation of HAWK’s rigs if they can be sold as operating rigs. Here is a guide to the second-hand market for rigs (click to enlarge):

I’ve combined it with the list of HAWK’s rigs and their operating status from the July 2 Drilling Fleet Status Report to calculate the approximate second-hand market value of HAWK’s rigs:


Assumptions

Although a handful of HAWK’s rigs were built prior to 1980, I’ve assumed that the recent upgrades make the rigs saleable in the second-hand market. There is no market value for the 300′ MC (mat cantilever). 250′ MCs sell for around half the market price of 250′ ICs, so I’ve assumed that 300′  MCs might sell for half the price of 300′ ICs, which is $60M. I’ve also assumed that most of the cold-stacked rigs can be made operational with little expense, as Randy Stiller indicated in the presentation to the Macquarie Securities Small and Mid-Cap Conference. Stiller mentioned that two rigs require significant cap ex to be returned to operational status, although it isn’t clear which two or what “significant” means in practice. I’ve assumed that the 80′ MC is saleable only for scrap at $5M.

Valuation

I calculated that HAWK was worth around $154M in the more dour liquidation scenario, assuming that the rig value was $230M. This valuation suggests HAWK could be worth another ~$150M in rig value if most of the rigs can be sold as operational, which implies a liquidation value around $300M or around $25 per share. The risks are the cash burn and the Mexican tax issue, both of which I’ll examine in detail at a later date.

Hat tip John.

[Full Disclosure: I hold 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.]

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Seahawk Drilling, Inc. (NASDAQ:HAWK), which I’ve posted about before, has taken a pounding over the last few days, down over 11% just yesterday to close at $9.61. It seems crazy to me. HAWK is cheap as a going concern, but with its market capitalization at $113M, it’s now at a hefty discount to its liquidation value. Here’s how I figure it:

Here’s a list of HAWK’s rigs and their operating status from the June 9 Drilling Fleet Status Report:

There are two possible liquidation values for HAWK rigs. In the slightly more optimistic scenario, HAWK’s rigs are sold off as operating rigs to other drillers in the Gulf of Mexico. In the other more dour scenario, some of HAWK’s rigs are sold for scrap. HAWK is trading at a discount to both values.

Rig resale values

In March and April this year, ENSCO Plc (NYSE:ESV) sold three 300′ ILC rigs from the same vintage as HAWK’s rigs for ~$48M a piece (see press releases here and here). These are clearly higher specification and therefore more valuable than HAWK’s rigs, but the sales do provide some insight into recent market conditions. Here’s a chart from HAWK’s presentation (.pdf) to the Macquarie Securities Small and Mid-Cap Conference on June 15 and 16 showing comparable sales since 2004:

When 300′ ILCs have sold in the past for ~$48M, rigs comparable to HAWK’s have sold for around $15M each. HAWK is presently trading as if its rigs are worth only $6M each. Retired rigs have sold recently for between $5M and more. Hercules Offshore, Inc.’s (NASDAQ:HERO) 31 December, 2009 10K is illustrative:

Additionally, the Company recently entered into an agreement to sell our retired jackups Hercules 191 and Hercules 255 for $5.0 million each.

In June 2009, the Company entered into an agreement to sell its Hercules 100 and Hercules 110 jackup drilling rigs for a total purchase price of $12.0 million. The Hercules 100 was classified as “retired” and was stacked in Sabine Pass, Texas, and the Hercules 110 was cold-stacked in Trinidad. The closing of the sale of the Hercules 100 and Hercules 110 occurred in August 2009 and the net proceeds of $11.8 million from the sale were used to repay a portion of the Company’s term loan facility. The Company realized approximately $26.9 million ($13.1 million, net of tax) of impairment charges related to the write-down of the Hercules 110 to fair value less costs to sell during the second quarter of 2009 (See Note 12). The financial information for the Hercules 100 has historically been reported as part of the Domestic Offshore Segment and the Hercules 110 financial information has been reported as part of the International Offshore Segment. In addition, the assets associated with the Hercules 100 and Hercules 110 are included in Assets Held for Sale on the Consolidated Balance Sheet at December 31, 2008.

During the second quarter of 2008, the Company sold Hercules 256 for gross proceeds of $8.5 million, which approximated the carrying value of this asset.

The rigs have a resale value well beyond the price implied by the company’s stock. Not convinced they can all be sold as operating rigs? How about as scrap?

Scrap value

In this audio of the presentation to the Macquarie Securities Small and Mid-Cap Conference, Randy Stilley, the President and CEO of HAWK, says in relation to the slide below, that the value of the scrap steel and equipment on HAWK’s rigs is worth roughly $8M to $9M each:

Randy Stilley (at about 21 minutes into the presentation):

This is something that is just kind of amazing in a way. If you look at the underlying asset value of our rigs: five million dollars. The scrap value of a jackup is about eight or nine [million dollars], and that’s assuming that you get almost nothing for the steel and you just start taking stuff off of there; mud pumps, engines, top drives, cranes, draw works. If you start adding all that up, that alone is worth more than our current asset values based on our equity.

Now you can also say, “Well, if they’re not working, they’re not worth much,” and we’re not likely to just start cutting them up for scrap, but I think that’s kind of an interesting reference point that you don’t want to forget about because we’re trading at a very low value today.

Conclusion

If the ten cold stacked rigs are worth $80M in scrap, and the ten other operating rigs are worth $150M ($15M each), HAWK has $230M in rig value. Add HAWK’s $88M in cash and receivables, and deduct HAWK’s $164M in total liabilities, and HAWK is worth $154M in the most dour liquidation scenario. With a market capitalization of $113m, HAWK is trading at a hefty discount to this value, and HAWK is too cheap. It’s burning cash, it’s got a chunky payable to Pride and some Mexican tax issues, but subliquidation value never materializes without hair.

Hat tip BB.

[Full Disclosure: I hold 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.]

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In his 2003 Annual Meeting, Mohnish Pabrai discussed his thesis for his investment in Frontline Ltd (USA) (NYSE:FRO). I see a number of parallels between HAWK now and FRO then. Here is an extract from the transcript:

Frontline (FRO) is company I’d like to talk about because it is an interesting datapoint on how I look at businesses. Frontline is in the crude oil shipping business. About 2 and half years ago if you asked me if I had any competency or knowledge of the crude oil shipping business, I would say that I knew nothing about the business or industry. In 2001, I was just looking at a list of companies that had high dividend yields. One of the screens I look at is companies with high dividend yields, which sometimes means some sort of overhang which is dropping the price below where it should be.

If I looked at Value Line today, I would probably find three or four companies that have a dividend yield of 10%-12%. In 2001 I noticed there were two companies with a dividend yield over 15%. Both were in the crude oil shipping business. One was called Knightsbridge (VLCCF). I wanted to understand why they had such a high dividend yield. So I spent about a month studying the crude oil shipping business.

When Knightsbridge was formed a few years ago, they ordered a few oil tankers from a Korean ship yard. Each of these VLCCs (Very large Crude Carrier) and Suezmaxes costs about $50-70 million a piece and it takes 2-3 years to build one. The day the tankers were delivered they had a long term lease with Shell Oil. The deal was that Shell would pay them a base lease rate (say $10,000 a day per tanker) regardless of whether they used them or not. On top of that, they paid them a percentage of the delta between a base rate and the spot price for VLCC rentals.

For example, if the spot price went to $30,000/day, they might collect $20,000 a day. If the spot was $50,000/day, they’d collect say $35,000/day etc. The way Knightsbridge was set up, at $10,000 a day; they were able to cover their principal and interest payments and had a small positive cash flow. As the rates went above $10,000, there was a larger positive cash flow and the company was set up to just dividend all the excess cash out to shareholders – which is marvelous. I wish all public companies did that.

When tanker rates go up dramatically, this company’s dividends goes through the roof. This happened in 2001 when tanker rates which are normally $20,000-$30,000 a day went to $80,000 a day. They were making astronomical profits at the time and the dividend yield went through the roof – but of course it was not durable or sustainable.

That’s why the stock didn’t jump up significantly. Then next week it could drop. It is a very volatile business. But I studied the business because I was just curious. But in investing, all knowledge is cumulative and makes the analytics much faster the next time around. At the time I studied Knightsbridge I also took a look at half a dozen other publicly traded pure plays in oil shipping.

Last year, we had an interesting situation take place with one of these oil shipping companies called Frontline (FRO). Frontline is a company that is the exact opposite business model of Knightsbridge. They have the largest oil tankers fleet in the world, amongst all the public companies. The entire fleet is on the spot market. There are very few long term leases. They ride the spot market on these tankers.

Because they ride the spot market on these tankers, there is no such thing as earnings forecasts or guidance. The company’s CEO himself doesn’t know tomorrow what the income will be quarter to quarter. This is great because whenever Wall Street gets confused, it means we can make money. This is a company that has widely gyrating earnings.

Oil tanker rates have varied historically between $6,000 a day to $80,000 a day. The company needs about $18,000 a day to break even. Once rates go below $18,000 a day, they are bleeding red ink. Once they go above $18,000, about $30,000-$35,000, they are making huge profits. In the third quarter of last year, oil tanker rates collapsed. There was a recession in the US, and a few other factors causing a drop in crude oil shipping volume. Rates went down to $6,000 a day. At $6,000 a day, Frontline is bleeding red ink badly. The stock appropriately went from $11 a share to about $3, in about 3 months.

If you spent some time studying Frontline, you would find that they have 60 or 70 ships, and while the rates had collapsed for daily rentals, the price per ship hadn’t changed much, dropping about 10% or 15%. There was a small drop in price per ship, but nowhere near the price the stock had dropped; the stock had dropped over 70%.

Slide 27

Frontline has a liquidation book value of about $16.50 per share, which means if they simply shut down the business sell all their ships, shareholders would get about $16 a share. If you take the collapsed ship price, you would still get $11 per share. If one could buy the entire business for $3/share, one could turn around the next day and sell the ships and clean up. While the stock was at $3, the company insiders were furiously buying shares.

When you looked at the numbers, they had plenty of cash. They could handle $6000/day rates for several months without a liquidity crunch. Also, if they sell a ship, they raise $60-70 million. The total annual interest payments are $150 million. If the income went to $0, they could sell a few ships a year and keep the company going.

In addition there is a feedback loop in the tanker market. There are two kinds of tankers. There double hull and single hull tankers. After the Exxon Valdez spill, all sorts of maritime regulations were instituted requiring all new tankers to be double hull after 2006 because they are less likely to spill oil. The entire Frontline fleet is double hull tankers.

But there’s a huge number of these single hull rust buckets built in the 1970s. If the double hull tanker spot rate is at $30,000 a day, the single hull tanker is at $20,000 a day. Oil that gets shipped from the Middle East to China or India, for example, is on single hull tankers. But Shell or Mobil, etc., will avoid leasing a single hull tanker because it is an enormous liability if they have a spill. The third world is nonchalant about importing oil on single hull tankers, and all the double hull tankers come to Europe and the West. But when rates go to $6,000 a day, the delta between single and double hull disappears.

The single hull tankers stop being rented because there’s no significant delta in the daily rate. Everyone shifts to double hull tankers at that point. The single hull tanker fleet goes to zero revenue in a $6,000 a day rate environment. When it goes to zero revenue, all these guys who own the single hull tankers get jittery; they can sell these tankers to the ship breakers and get a few million dollars instantly. They know that by 2006 their ability to rent them will decline substantially. There is a dramatic increase in scrapping rate for single hulled tankers whenever rates go down.

It takes four years to build a new tanker, so when demand comes back up again, inventory is very tight. There is a definitive cycle. When rates go as low as $6,000 and stays there for a few weeks the rise to astronomically high levels – say $60,000/day is very fast. With Frontline, for about seven or eight weeks, the rates stayed at under $10,000 a day and then spiked to $80,000 a day in Q402.

Slide 28

I started buying around here ($5.90). Again, not smart enough to buy at the very bottom. I bought on average price at a price of $5.90 per share, which is about half of the $11/$12 per share you would get in a liquidation. Now Frontline’s price is about $20 a share because tanker rates are at $60,000 a day – people are in a euphoric/greedy state. But once we got past $9, approaching $10, I started to unload of the shares. The whole thing happened in a very short time period – resulting in a very high annualized rate of return.

Slide 29

We had a 55% return on the Frontline investment and an annualized rate of return of 273%. Frontline is a good example of why I am hesitant to share ideas because we will see this again. Oil tanker rates will go down and at the last meeting a bunch of investors told me, “We are watching now.” The more people that are tuned in, once it gets to $8 or $9, the more the buying – reducing our gains. But that is an example of a Special Situation investment in a company with negative cash flow.

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Update: Links to Ben’s post have been fixed.

In September last year Ben Bortner provided a guest post on Seahawk Drilling (NASDAQ: HAWK). I said at the time that HAWK was not a typical Greenbackd stock, but it warranted consideration at a discount to Ben’s estimate of liquidation value. HAWK has been cut in half since Ben’s post for reasons unforeseeable at the time (see Ben’s excellent September post for the background) and it seems to be living in interesting times, which makes it a typical Greenbackd stock, to wit:

HAWK was cheapish before BP filled the Gulf of Mexico with oil and golf balls (to paraphrase Wyatt Cenac on The Daily Show, BP’s challenge now is to remove the impurities from the Gulf, namely the dead shrimp and the seawater). Prior to the spill, low natural gas prices and the credit crunch led to reduced fleet utilization and day rates that had hurt drillers in the Gulf of Mexico generally. Several problems specific to HAWK – a largish Mexican tax dispute and older jackup rigs in an environment where a slew of new rigs are in production – made it cheaper still. BP’s oil spill and the accompanying regulatory uncertainty have caused a perfect storm for HAWK, which may lead to a liquidity crisis. In short, that’s why I like it. The mere absence of bad luck should see this stock trade higher.

It looks very interesting at a big discount to liquidation value. At its $12 close yesterday HAWK has a market capitalization of $142M, which is 30% of its $443M or $36.6 per share in tangible book value as at March 31. It’s got $6.5M in debt and $73M in cash and short term investments. Cash burn is around $10M per quarter if demand for the rigs doesn’t pick up. The moratorium on drilling applies to deep-water drillers, and HAWK’s rigs are shallow water rigs, so permitting is not the reason for the cash burn – it’s insurance and overcapacity. That said, it seems that demand for HAWK’s rigs is improving.

On the other hand, here’s the bear case from August last year on HAWK’s prospects in less interesting times.

[Full Disclosure: I hold 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.]

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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:

Summary:

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.

Business:

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.

Industry:

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.

Management:

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.

Financial Position:

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.

HAWK 1

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.

Valuation:

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.

HAWK 2

* 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).

Risks:

– 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.

Catalysts:

– 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.

Disclosure:

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.]

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