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.
Period until HAWK goes bankrupt
Value if recovery occurs just before bankruptcy
Value if recovery at 8 Quarters
Value if recovery at 16 Quarters
Case 1 (no debt)
Hawk keeps selling rigs until they have no rigs left to sell or liabilities exceed net assets
Case 2 (Medium Debt)
HAWK is liquidated by lenders but the liquidation yields more cash than the lenders had security because HAWK did not take on the absolute maximum amount of debt.
Case 3 (Maximum Debt)
HAWK is liquidated by lenders and there is no residual because HAWK borrowed against the full, scrap, value of the rigs.
By taking on debt instead of scrapping rigs a large potential return is maintained at the expense of the time in which that return can occur.
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.
The degree to which debt will be a good or bad idea will depend on the covenants, the total debt load and the purpose for which they can use that debt. To the extent that HAWK can take on 150M of debt with few covenants (because their security is money good) and for general working capital, then I don’t mind the risk reward trade-off. To the extent that HAWK take on less than the maximum debt then there will be a residual value in the event of a bankruptcy. That residual value could easily be half of the current share price which will not be available if HAWK is allowed to liquidate their last rig (in reality their last few rigs because they have liabilities if not long term debt). With debt You sacrifice the last 1.5 years of potential turnaround for up to 3 times your upside.
Hercules offshore has had similar, albeit much smaller, tax issues with Mexico. In March 2007 HERO received a tax assessment from the Mexican government for the 2004 tax year. The Mexican government then commenced an audit for 2005. This related to deductions and remittance of withholding tax for these deductions. HERO reserved 17M for the tax assessment and posted a bond for 13.2M. They settled for 10.8M. HAWK’s total assessment is for 93M plus $5M as a result of indemnifying PRIDE. Furthermore HAWK believes that the Mexican authorities could level a further 100M using the same methodology for other tax years. HAWK is being much more aggressive than HERO, especially as they have essentially no assets in Mexico. In this quarter HAWK have reduced their future exposure to the Mexican tax issue by 10M out of the 93M. It seems unlikely that HAWK will get any meaningful work in Mexico after likely walking away from their tax liability. However, demand in the Mexican GOM will divert vessels from the US GOM, tightening supply there.
There is a fantastic analysis of the tax issue at http://greenbackd.com/2010/08/10/guest-post-seahawk-drilling-inc-nasdaqhawk-and-the-hacienda . The possibility that paying the IRS ends up paying the Mexican authorities rather than HAWK is at least intriguing.
The tax issues relate to work for PEMEX. They are a major source of revenues for the Mexican government and the only way they are even going to sustain current, much lower, production is through substantial capital investment. There are currently about 50 rigs marketed and 70 or so including cold stacked in the US GOM. Demand was for about 90 from 2002-05. Maybe 70 since 2005 until the drop off in early 09. The commodity jackup demand has been almost constant at around 55 until early 09. As premium rigs abandon the GOM, never to return then demand will be met by commodity rigs or rates that are sufficiently high to lure the premium rigs back. If demand for commodity rigs stays at 55 with 10 of the 70 supplied off to PEMEX then HAWK will be running 18 rigs. If there is small additional demand from the lost premium rigs then HAWK easily gets to 100% utilization. That assumes HERO can bring their cold stacked rigs back online. Some of them apparently require a lot of Capex.
I have heard concern that PEMEX will lay off their jackup rigs and look to upgrade. The truth is that there are only 2 matt supported jackups in Mexican GOM so worst case they are a few percent addition to the US GOM commodity fleet. To the extent that PEMEX can add matt supported jackups then they’ll be getting more bang for their E&P buck.
On a different note I had a discussion on seekingalpha regarding the suitability of HAWK’s rigs and whether or not they would be the last to get contracts because their rigs were less desirable.
Comparison of HAWK and HERO GOM Fleet:
Having listened to the Hercules Offshore (HERO) and Seahawk (HAWK) quarterly calls there is some interesting information on the current state of offshore and potential minor changes to the HAWK thesis both positive and negative. This should be ready in conjunction with my original analysis on HAWK .
Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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