Investing

Andrew, the author of the excellent guest post on the HAWK - Mexican Tax Situation at Greenbackd asked for some clarification on my prior post regarding the recent sale of the Seahawk 2505. Specifically on why I was suggesting that the deferred tax shouldn't be counted in the liabilities. I realize that I had not clearly laid out my view on HAWK's balance sheet and how the non-rig assets and liabilities net out.

The short answer is that I had made some simplifying assumptions that vastly over-estimated the net liabilities. I had discounted much of the deferred tax liability but had not, in detail, worked out an accurate net asset/liability excluding rigs. I lay out the detailed and non-simplified answer below and find that the net liabilities are much smaller than the 30M number I had been using.

Deferred taxes, in HAWK's case, arise due to the timing differences between tax (IRS) based depreciation and financial reporting depreciation. In reality US corporations maintain two sets of books, one for the IRS and one for other stakeholders based on GAAP. Deferred tax assets and liabilities represent theses differences. If I purchase a rig for 10M and depreciate it in a straight line in my financial reports but use accelerated depreciation in my IRS filings then the "real" value versus the IRS value diverges. At year 5 it may be worth 7.5M in my financial reports but only 5M according to the IRS. If I was to then sell it for 7.5M (assuming that the financial reports accurately reflect asset values) then I would owe tax on the 2.5M difference as I had received a tax credit (effectively a credit) for the depreciation of the rig from 10M down to 5M. The notional tax I would owe on that 2.5M is a deferred tax liability. Also note that if in fact I only sold the rig for 5M then the actual tax liability would be zero even though I showed the liability in my accounts as 2.5M * 35% (assuming my tax rate is 35%).

So how does this apply to HAWK. Firstly they break out their deferred tax liability in their 2009 annual report as a 54.9M deferred tax asset and 114M deferred tax liability netting out to a 59M deferred tax liability. The asset side is primarily NOL and tax credit carry forwards (net of valuation allowances). The liability is entirely depreciation related. As outlined above, based on the different depreciation schedule used by the IRS and GAAP. Implicit in this liability is that original asset value minus liabilities is in fact fair value (if it wasn't then they would need to write down the asset value).

So the 59M deferred tax liability is entirely the result of more aggressive IRS based depreciation offset by tax losses and credits. We can quantify the difference between the IRS and GAAP based depreciation by dividing the net liability by the effective tax rate which is 59M divided by .35 which equals 169M. The rig value based on GAAP, net of GAAP depreciation, is 497M. Therefore the IRS value net of depreciation is 497-169 = 328M. The 328M is the same as the 5M is our simple example above. To the extent that our sale value is above 328M (5M) then we need to pay tax on that profit as we've already received a tax credit for the depreciation down to that level. However, if our sale value is only 328M (5m) then we owe no additional tax. 328M is around 16.5M per rig.

We now have a basis to assign a value to the deferred tax liability. If we think we'll receive more than 16.5M per rig then the liability kicks in. If we receive less than 16.5M per rig then the liability is zero.

The explanation above is based on the 2009 annual report because that breaks out the deferred tax assets and liabilities. The 2010 2Q 10Q does not. However, we can establish that over the 6 months in question the deferred tax liability has decreased by 21.6M. This is due to an increase in the deferred tax assets side of the ledger due to increased net operating losses. By the end of Q2 the total deferred tax liability was 39.6M. This means we can have rig values of 384M before the deferred tax liability kicks in. That is 19.2M per rig. If we work on 20M per rig, consistent with my prior post, then only 5.5M of the deferred tax liability would be incurred out of the 39.6M.

Below is an embedded google doc (I'm going to replace this with a more permanent image when I'm back to my regular PC).


This shows the 10Q balance sheet with adjustments. Liabilities are all at 100% aside from the deferred tax liability (as described above). On the asset side Cash and equivalents are at 100%. Trade receivables are at 85%, due from pride is at 100% because the due to pride is larger (on the liability side). Prepaid expenses relate entirely to the expected insurance payment for the Pride Wyoming and are more than offset by the accrued expenses also relating to the Pride Wyoming; As they a) are insurance payouts and b) offset on the liabilities side for the same reason, they've been marked at 100%. Other assets have been marked at 85% but they aren't really material if you disagree with the mark.

There is also a line on the liabilities side for Leases and Contractual Commitments. These are off balance sheet liabilities described in the 10-K. The Q2 10Q states that there are no material changes.

The bottom line is, excluding rig values, HAWK's net liabilities are only about 19M. As rig values fall or HAWK continues to make operating losses then the deferred tax liabilities are reduced by 35% of the operating loss/ capital loss until they reach zero and start to become an asset (a worthless asset in the even of a liquidation). From a headline $117M of liabilities plus 15M of off balance sheet liabilities, it's interesting to get down to a 19M net liability.

At the 400M rig value (20M per rig) I discussed in my prior post, less 19M of liabilities you have a share price of $32. At 16M per rig the net liabilities, excluding rigs, are around 13M for a price per share of $26.

This analysis ignores losses since the 2Q 10Q and also ignores liquidation expenses but they certainly don't change the indicative numbers. (In short the deferred tax liability would be zero, the net liabilities inclusive of liquidation charges might be 23M)

Part of the undervaluation in HAWK may be related to the difficulty in getting to that net liability/asset figure. After all if you take 8M per rig (scrap value) and subtract the headline liabilities and off balance sheet liabilities you're left with a $2.25 share price versus $11.55 if you use the correct net liability or $32 if you use the "correct" rig value as well.

Seahawk have entered a Memorandum of Understanding with Essar Oilfield Services India Ltd for the sale of the Seahawk 2505 for $14,550,000 plus some minor fees for training on the rig.

The sale is contingent upon Essar Oilfield Services winning tender MR/DS/MAT/CT/RIGS/CH/MAT-FLOATER/49(308)/2010 /P46JC10007.

Seahawk 2505 is Seahawk's 11th best rig of 20 according to my ranking criteria. It's close enough to call it the median rig. On that basis it's reasonable to multiply $14,550,000 by 20 to get a gross asset value of HAWK. To get the net assets we then need to subtract net liabilities, excluding rigs, of around 45M. This indicates net assets of 246M or $20.75 per share. This makes the same assumptions about liabilities made in previous posts (i.e. a liquidation so the deferred tax liability would not be realized).

The situation is actually better than this. The tender is for rigs in the PEL/ML ( Petroleum Exploration License/ Mining License) zone in India. Therefore Essar are going to incur costs in excess of $5M (based on generic mobilization costs mentioned by HAWK in their UBS presentation). Had the rig been in India it would have sold for at least $5M more. HAWK obviously don't want to sell their rigs to competitors in the US or Mexican GOM (and neither do HERO). They have created an opportunity to sell a rig that won't compete.

The deal is contingent on Essar winning the tender (which is interestingly only for a 150M mat supported jackup). If this happens then HAWK will get some much needed cash and will reduce their cash burn. If the deal fails then the offer highlights the true rig values in the current market. Based on HAWK's costs of 25k per day and a rig rate of 45k per day (current GOM rates), Essar would pay off the rig entirely during the 3 year contract, inclusive of mobilization costs. A 3 year payback is certainly indicative of a fair to cheap price, though I don't know what rate they are going to propose (their costs should be lower than HAWK's as they can use a foreign crew and will have lower insurance costs etc).

I suspect this announcement reduces the likelihood that HAWK are going to purchase a foreign rig package with debt.

Interestingly there may be opportunities for HAWK to relocate their mat supported rigs out of the GOM, albeit at a substantial cost. Finally, in a liquidation it shows that a median rig price of $20M for rigs sold to a local buyer (think a mixture of PEMEX and other GOM drillers) is possible. The deal price supports HAWK's claim that $20M per rig is supported by an independent appraisal from Basso for a net liquidation value of around $30 per share.