Is Hercules Ready to Dig Out of Its Debt Hole?

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One of the hallmarks of a cyclical business is operating leverage. When revenues explode, and your cost structure remains relatively fixed, profitability kicks into overdrive. When boom turns to bust, that leverage cuts just as hard in the other direction, and losses pile up. Layering financial leverage (i.e., debt) on top of this natural operating leverage is often a recipe for disaster.

At the end of 2006, contract driller Hercules Offshore's (Nasdaq: HERO) long-term debt totaled less than 20% of total capitalization. By the end of 2008, this figure had run up beyond 50%. While less spectacularly dumb than the financial leverage employed by Parker Drilling (NYSE: PKD) in past years, this was still a big mistake.

If Silgan Holdings (Nasdaq: SLGN) wants to run its debt-to-cap up above 50%, that's fine by me. Given the bottle-and-can maker's steady, boring, beautiful business, I know Silgan's good for the interest payments, and isn't going to run afoul of its loan covenants. An oil and gas driller has no business running up this kind of debt load, especially when you're talking about activity outside of the deepwater. At least out there, where Diamond Offshore (NYSE: DO) and Pride International (NYSE: PDE) ply their trade, five- to 10-year drilling engagements aren't uncommon and can justify some amount of capital structure rejiggering.

Other than a few fairly long-term engagements with the likes of Chevron (NYSE: CVX) in the Gulf of Mexico and Murphy Oil (NYSE: MUR) in Malaysia, Hercules lives pretty hand-to-mouth. When drilling activity dries up, as it did in the third quarter, the driller's results are startlingly bad. In the domestic offshore segment, operating days fell 75% from the prior year, and revenue dropped 83%. Inland barges fared even worse. International offshore drilling held up pretty well, but overall company revenue was roughly cut in half, and earnings from continuing operations swung to a $32 million loss.

Hercules had over $950 million in total debt at the end of the quarter. Catching what I believe is the tail end of a monster junk bond rally, the firm recently sold $300 million of 2017 notes that were priced to yield 11%. This will help pay down Hercules' term loan, thus buying the company time to climb out of the hole it's drilled for itself over the past few years.

If bidding activity continues to pick up in the Gulf of Mexico, as it has since September, and the commodities complex avoids another sharp downturn over the next two to three years, Hercules could prove a rewarding speculation. I'm not personally willing to take those odds, however.

Over 500 Motley Fool CAPS All-Stars have rated Hercules Offshore to outperform the market, so perhaps I'm missing the liftboat here. What do you think?