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JakilaTheHun (99.92)

Hercules Offshore: Follow the Cash Flows



May 20, 2009 – Comments (8) | RELATED TICKERS: HERO.DL

There are a lot of good buys among oil service companies right now as the market has hammered most of them due to the recessionary environment and the plunging oil prices we saw earlier in the year. Offshore oil related companies have been particularly hard hit, which makes it a particularly interesting sector to me.

From a macroeconomic perspective, I believe oil is going to hover around $60 - $80/barrel in the long-term, which will bring off-shore back into the fold. It might take a while for us to get in that range and stay there for a significant period of time, but the trend is that increasing difficulty of oil extraction is driving up costs.

One of my favorites right now amongst the offshore oil service companies is Hercules Offshore (HERO). Hercules provides shallow-water drilling and lifeboat services for oil and natural gas exploration in the Gulf of Mexico region.

My major reason for liking HERO is that I believe that (a) offshore's prospects are still relatively good in the long-run, (b) HERO is in better financial shape than similarly situated competitors, and (c) it appears to be currently priced below liquidation value at this point in time.

The Financials and the Bull Case

As of their most recent 10-Q filing, HERO's net tangible assets were worth $10.33 per share. Debt-to-value is moderately high at 64.1%, but that's not actually that high compared to other companies operating in this industry. HERO has relatively strong liquidity. Current ratio is 1.71 and quick ratio is 1.51. Add to that strong operating cash flows.

While HERO is currently losing money on their income statement, the cash flow picture is much better. For Q1 for FY '09, they had a loss per share of 5 cents, which actually doesn't seem that bad to me given the operating environment during the 1st Quarter.

What's really encouraging, though, is that HERO brought in 87 cents per share in operating cash flows and 51 cents per share in free cash flows. A substantial portion in the differential between earnings and cash flows can be attributed to depreciation and amortization charges, which are recurring non-cash items.

This might be one reason why the market is significantly underpricing this company, but as one of my accounting professor's at UNC used to preach, "you've got to follow the cash flows!"

The most surprising thing about HERO's first quarter performance is that it covered a period where oil prices were more suppressed than they have been in awhile. The logical conclusion is that demand for their services will increase as oil prices continue their inevitable long-term march up towards $70+/barrel.

At that point, offshore oil becomes more attractive and investors become more interested in companies like HERO. If HERO is only turning a minor earnings loss in one of the worst environments they'll ever see and is still significantly cash flow positive, that suggests good things to me.

Not only was HERO cash flow positive for the most recent quarter, they had positive operating cash flows for the past three fiscal years. However, their free cash flows were negative for most of that time as they, like most other companies in the oil service industry, took on debt to rapidly expand their operations. They have suffered with all the others, but under $5, I think the stock is a good buy --- but be aware that this is a volatile "high-risk" stock.

On the Other Hand ...

While I have given a moderately bullish outlook for oil, I would definitely consider the significant likelihood of a short-term retreat in prices. There's a strong case that rising inventory levels could put a hamper on prices.

This could, once again, send HERO's stock into a tailspin. This is why I emphasize that this is a "high-risk" stock and not something to touch if you are afraid of losing 50% of your investment over the next few months.

For me, this is a very long-term pick so I am willing to ride out any bumps and might increase my position if the price drops back down to the $2 - $3 range. For others with a lower risk tolerance, that might not be very ideal.

I'd also suggest that HERO's most recent earnings call is required reading for potential investors. It certainly provides a sobering near-term outlook for the industry. There are definitely reasons to be cautious with HERO.

All the same, my fundamental philosophy on commodity stock investing is to buy in when fear is at its greatest point and sell off during euphoria. While fear has subsided a little bit for HERO, the price when compared to the company's financials suggest that the market still has a frightened outlook for Hercules.


After running a DCF analysis, my most probable valuation for HERO is around $23. Downside probable valuation is $15. Upside probable valuation is $32. Downside risk is $0 due to their moderately heavy debt load and their position within a risky/volatile industry. Upside potential might be around $45.

I green thumbed Hercules at $1.78 here on CAPS.  I recently initiated a small position in HERO for my actual portfolio at $3.80. Due to the high risks, I would factor in a substantial discount to my probable valuation, but I believe this is a good long-term buy under $5 for investors with a well-diversified portfolio.

Disclosure: Long on HERO

8 Comments – Post Your Own

#1) On May 20, 2009 at 10:39 AM, BigFatBEAR (28.28) wrote:

Great write-up! This is what CAPS needs more of.

MLG also had some good thoughts on oil rigs a while ago - if you haven't already seen em, read here and here.

...Reading back through those, I see where you asked MLG about HERO. He said:

"Only took a glance at HERO, but they do shallow water witch should see more pain than deepwater and for some reason their current earning are hurting badly.  Perhaps they don't have good contracts on their rigs, but they are priced cheaply.  Should post a bigger rebound than other drillers because of cheap price if they can survive when oil rises again."

Now MAY be that time, but personally I am liking NE's margins and chances for survival right now more than HERO. Though to be fair, since it has been beaten down so much, HERO seems more high-risk and high-reward. But NE has a div, which becomes important to me for long-term investments.

Anyway, those are my 2 cents. Thanks again for your's.


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#2) On May 20, 2009 at 10:59 AM, jmt587 (99.42) wrote:

I heard yesterday that oil supplies are higher than they've ever been, and land-based storage is nearly full and bursting at the seams, to the point that many countries / companies, etc. that own oil are putting it into super tankers and just parking them in strategic places to wait out the glut and then release them when supplies are down and prices are higher.  Have you heard that?

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#3) On May 20, 2009 at 11:29 AM, MattH42004 (28.15) wrote:

"Great write-up! This is what CAPS needs more of"

Agreed. Jakila, your write-ups have become some of the best stuff on this entire site. The fact that these blogs can't even get 10 recs on average while useless, mind-numbing garbage gets 2x and 3x that amount is a testament to the overall decline of the Fool. At least IMO, but I've only been here a little over six months so I might not be the best judge. Anyway, keep up the good work, you'll always get a rec from me.

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#4) On May 20, 2009 at 11:34 AM, MattH42004 (28.15) wrote:

Owe, and to keep this on subject, I agree with you on HERO. I jumped the gun a little and got in at about 4.50 on CAPS. After the initial landslide the pick is back close to even. In the long run I'm not too worried, I would say about 80/20 that it ends up green.

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#5) On May 20, 2009 at 1:38 PM, JakilaTheHun (99.92) wrote:


MLG did do an excellent analysis on a lot of the drillers.  I'd actually love to read more of his thoughts.  I understand the financial picture much better than I understand the business picture in the oil services industry, so I like reading people who are very knowledgeable on that side. 

I'll often play some stocks where I have a "blind-side" so to speak on the basis that I (a) don't establish quite as large of a position on them and (b) diversify well.  But my basic thought here is that HERO is run well enough so that as long as oil hits that critical $70/barrel level again, the stock should appreciate quite handsomely. 

I'll have to look into NE a bit more.  I remember taking a quick glance at them after reading MLG, but never really reached any conclusions. 

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#6) On May 20, 2009 at 1:41 PM, JakilaTheHun (99.92) wrote:


I think you should read the entire article ;)

Not that I don't blame you for skimming.  Sometimes my write-ups get lengthy.  I mentioned precisely that issue in the "On the Other Hand ..." section.

Short-term, HERO might be due for a retreat since it'll probably trade with a correlation to the price of oil.  Long-term, I think it's still offer very favorable risk-reward prospects even if it might offer slighty more favorable prospects if oil falls back down towards $50/brl 

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#7) On May 20, 2009 at 1:42 PM, JakilaTheHun (99.92) wrote:


Thanks for the kind words.  I'd agree with your assessment --- it may very well be due for a retreat, but long-term, probably about 80/20 shot in my mind that it's still a good investment anywhere under $5.

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#8) On May 21, 2009 at 7:37 AM, translator999 (99.93) wrote:

MattH, I agree with you wholeheartedly.

Jakila, your blogs and analyses are, indeed, some of the best here imo.  Again, thank you for taking the time. Your work is appreciated. Cannot understand why you are not getting 50, 60, etc. recs. The only conclusion I can come to is that most people are here for reasons other than investing (which, given that this is an investment website, doesn't make all that much sense).

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