Time to Swoop on This Offshore Driller?

Last August, I told you that Seahawk Drilling (Nasdaq: HAWK  ) was for the birds. So far, that's proven the correct call, as the stock has seriously underperformed offshore drilling peers like Rowan Companies (NYSE: RDC  ) , Ensco (NYSE: ESV  ) , and even Hercules Offshore (Nasdaq: HERO  ) . The shares have fallen by more than 20% during a period of market buoyancy that has lifted most boats.

I'm not here to gloat. I want to reassess my stance now that the shares have dropped by a meaningful amount. I went through a similar exercise recently with A-Power Energy Generation Systems. All things being equal, it makes sense to become more positive on a stock as the price falls. For a company like Seahawk Drilling, which has significant tangible asset value and zero debt, the business is obviously worth something. Our goal, as always, is to figure out what we would pay to own a piece of this business.

Seahawk leaves the nest
Seahawk came public last year as a spinoff from Pride International (NYSE: PDE  ) , a driller that's positioned itself as a deepwater-focused outfit. In a spinoff, all of the shares are distributed to existing shareholders of the former parent. Investors who've read their Greenblatt know that this can spell opportunity.

In the case of Pride and Seahawk, I would argue that most investors owned Pride for its deepwater fleet and care little about the jackup rig business that was transferred to Seahawk. Deepwater fundamentals look far stronger, especially once we get beyond the near-term bump in the global fleet. The jackup market is super-volatile, and may be experiencing a secular decline (as opposed to a merely cyclical one). Given the respective outlooks, you can hardly blame investors for dumping Seahawk shares.

At the time of the spinoff, some investors and analysts made a case for Seahawk based on this redheaded-stepchild effect. Were they wrong, or just too early? Now that shares have sold off a fair amount, let's take up the all-important question of valuation.

Fun with multiples
The price-to-earnings (P/E) ratio has a lot of fans, based on its simplicity. With a cyclical company like Seahawk, this ratio is particularly useless, so forget it. At a minimum, you want to try to ballpark a level of midcycle earning power (the cash earnings that Seahawk can generate in a "normal" year, if there is such a thing), and place a fairly low multiple on that, to compensate for extreme cyclicality.

Seahawk is currently at a low ebb in the cycle. Out of 20 rigs, only eight are contracted, and at pretty meager dayrates. The company was cash-flow negative in its first few months as an independent entity, and has warned that it may consume cash again in 2010 if things don't improve.

A rebound in natural gas prices would certainly get things moving in the right direction. If you believe that full-cycle drilling economics dictate $6 to $8 natural gas prices, as Chesapeake Energy (NYSE: CHK  ) has suggested, then there's certainly room for improvement in jackup rig utilization and contract drilling rates.

Assuming that Seahawk can achieve midcycle utilization and dayrates of 75% and $45,000, respectively, I would expect normalized earning power of around $30 million in annual after-tax operating cash flow. At 80% utilization and $65,000 per day, my estimate jumps to $84 million. It appears investors were pricing in the latter at the September highs of around $35 per share.

Taking the midpoint of these cash flow estimates and applying a multiple of five yields an intrinsic value estimate of around $24 per share. This estimate, which represents nearly 30% upside from today's price, is extraordinarily sensitive to utilization and rig rates. My confidence in its accuracy is low, but it's a starting point.

Is that the floor or the ceiling?
Investors looking for strong downside protection -- always a wise starting point -- definitely ought to consider a company's tangible asset value, or liquidation value. In Seahawk's case, the question is: How much cash could you expect to get for the rigs and other assets in an orderly liquidation?

In a recent presentation, Seahawk pegged its fleet value at $377 million, or $18.9 million per rig. Ensco recently sold two jackups for $95 million combined, but those were rated for 300 feet of water depth. Seahawk has only one such rig. On the other end of the spectrum, Hercules Offshore sold a pair of uncompetitive rigs last year for $12 million combined. Seahawk's average rig value no doubt lies somewhere in between.

Elsewhere in its presentation, Seahawk reported that 200-foot, mat-supported, cantilevered jackups are fetching around $21 million, while 250-foot, mat-supported, slot-type jackups (don't ask, it's boring) are going for $17 million. The company's fleet includes nine of the former and six of the latter, so that gets us to $291 million. Four of the remaining five rigs are more capable cantilevered rigs, while one is less so. Thus $377 million for the whole fleet seems like a reasonable figure. That translates to around $32 per share.

At present, Seahawk would seem to be worth more dead than alive. Of course, that's assuming that the company could sell its entire fleet at the drop of a hat. With larger peers like Transocean (NYSE: RIG  ) moving away from the shallow water, I don't see a natural buyer at non-fire-sale prices.

The Foolish bottom line
The idea of an immediate, orderly liquidation at the going rate strikes me as unrealistic. I prefer to stick with my $24/share cash flow-based estimate, and would probably demand a 40%-50% discount to that number, in order to give myself a nice big margin of safety.

Chesapeake Energy is a Motley Fool Inside Value choice. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his Motley Fool CAPS profile or follow his articles using Twitter or RSS. The Fool owns shares of Chesapeake Energy. The Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 08, 2010, at 5:04 PM, gugudada wrote:

    This is the most shameless attempt to make the author look knowledgeable and a follower of the value theory, but all he says is a whole lot of crap. Because:

    1- "the business is obviously worth something" - this is false. It may be obviously worth nothing. Just wait to see how much cash they consume at the end of the year. This destroys value.

    2 - Therefore, looking at the value of the company starting at the asset value is incorrect, because the company may have started with zero debt, but it is now consuming cash. And this means their assets may be unable to repay any dept the company generates.

    3 - You make absolutely meaningless assumptions. Rates of 45,000/day and 75% utilisation. Rates of 65,000/day and 80% utilisation... This is laughable. You would need utilisation rates very close to 100% to push rates up. This means that you may get the same daily rates at 75% or 80% utilisation. And the rates may very well be 25,000 for all you know! And if rates are this low, then utilisation may very well be close to 20%. YOU ARE PURELY GUESSING AND PROVIDING NOTHING USEFUL TO YOUR READERS.

    4 - You find, based on your meaningless assumptions, two different operating profits. It would have been good if you had explained how you got them. Anyway...

    5 - You then apply a multiplier of 5 to your operating profits to find two valuations for the company. You then divide this by the number of shares and proclaim that the value per share is 24 dollars... I HOPE PEOPLE SEE HOW MISLEADING THIS CRAP IS. JUST TRY USING SLIGHTLY DIFFERENT FIGURES AND YOU'LL GET VALUES RANGING FROM 10 to 80 DOLLARS.

    6 - Not happy with this nonsense, you then find it prudent to apply a 40 to 50% discount on your valuation! Why? BECAUSE YOUR VALUATION IS MEANINGLESS BECAUSE YOU ARE CLUELESS.

    7 - You try to pretend you are knowledgeable and therefore you use the words "intrinsic value" and "margin of safety". My friend, your 24 dollars per share are NOT "an intrinsic value". They are a price you have come up with, doing some back of the envelope maths (back of the envelope calculations are great, but only if your assumptions and methods are any good).

    8 - You say you "would probably demand a 40%-50% discount to that number [24 dollars per share], in order to give myself a nice big margin of safety". You use the words "margin of safety", as you did with "intrinsic value", to pretend you follow a certain investment approach. But no. You fail to do this and that's why you need to apply a 50% discount on your so called valuation. To be safe yourself, in case this company is something completely different. Something you really have shown you can't estimate.

    9 - AND THAT IS WHY YOU CAN'T RECOMMEND BUYING OR SELLING THIS COMPANY. YOU ASKED THE QUESTION IN THE TITLE. HOW ABOUT GIVING A SOLID ANSWER? YOU HAVEN'T GOT A CLUE!

  • Report this Comment On April 08, 2010, at 6:55 PM, XMFSmashy wrote:

    gugudada,

    You seem angry that I can't predict the future with great accuracy. Having followed the jackup market for the past three years, I know how volatile it is, and I know that I'm going to be wrong to some extent. Is my lack of omniscience that offensive? I know it's unusual for someone of even modest "pundit" stature in this business to acknowledge his limitations.

    As I noted, for a business with this much operating leverage, small changes in assumptions lead to huge swings in estimated value. That's why my confidence in the cash flow-based estimate is so low, and why I demand such a big discount in case I'm totally, woefully wrong.

    The $24/share figure is my best (albeit quick) estimate, given the current cost structure and based on a range of outcomes that I judge to be reasonably likely. I did not hold it out to be anything more than an estimate. It's one that I will review periodically. I hope the silent majority out there finds this useful.

    Cluelessly yours,

    TS

  • Report this Comment On April 08, 2010, at 10:00 PM, walt373 wrote:

    gugudada - why are you angry? this article was free. instead of attacking the author, why not provide us with your own insights?

  • Report this Comment On April 08, 2010, at 10:00 PM, walt373 wrote:

    gugudada - why are you angry? this article was free. instead of attacking the author, why not provide us with your own insights?

  • Report this Comment On April 09, 2010, at 2:43 AM, gugudada wrote:

    Dear TS and Walt373,

    What upsets me is not TS's inability to predict the future. Is the use of words such as "an intrinsic value". TS, there are not several "intrinsic values" from which you choose one. There is ONE intrinsic value and one may be, or not, able to estimate it.

    Valuation is, to some extent, a guess. One needs assumptions. The problem is that with bad assumptions, you are most likely to get wrong valuations.

    You say you have been following the market for three years, which I doubt. Or if you have, you must have been following it from a distance.

    For example, why would a client pay more, if the utilisation rate is at 80%, instead of 75%? The bargaining power of Seahawk (and of any other driller) is practically the same at these utilisations, so it wouldn't allow for prices to go up some 50%, as you assume.

    You basically made some calculations which have allowed you to come up with a "price", not "value". And you said that this price is 24, but then you suggest you would wanted it only at around 12.

    Now that the price is at 18, right in the middle, I'm sure the only thing you have given some of your readers is, as Walt373 said, an advice which is "free".

    But, Walt373, what's the use of "free" bad advice? Yes, it's better than free "paid" advice!

    Just try this: follow TS's "line of thought", until you reach his "price" of 24. It's easy, as I've written above. Then change daily rates and utilisations, just as a sensitivity test. For example, assume that the utilisation will be the same as today (some 40%). Then assume it's 20% (remember that some of their current contracts will soon expire).

    If Seahawk continues to operate at such low levels, they won't be worth 24 dollars, for sure!

    The truth is this company is an absolute gamble. Nobody can predict what this management is capable of, because we don't know what they are capable of. The company has just started and was given not one rig or two. It was given 20 of them! And 12 are not used. Just because one has a Ferrari, it doesn't mean one can drive it...

    Daily rates have been decreasing. With the excess drilling capacity, they will likely keep going down, as they turn to the much more effective deepwater drilling.

  • Report this Comment On April 09, 2010, at 5:15 AM, gugudada wrote:

    (sorry, my message was cut above)

    When Seahawk was created, Pride shareholders were paid 26 dollars per new Seahawk share. After the spin off, the price of Pride didn't change! Why did it not change? If Seahawk was as a profitable company, shouldn't the price of Pride have come down, as a result of future lower profits?

    Therefore, Pride "sold" assets and they have sold them at a price of 26 dollars a share. Seahawk claims their assets alone are worth 32 dollars. So why would have Pride sold for 26 the assets alone??

    So, Walt373, my insight is: Seahawk is not worth 24. Don't put your money into it, because it may very well vanish. For Seahawk to be worth 24, a lot of good things would have to happen, CONSISTENTLY. And for one to be confident of this, one has to give it time. At the moment, the company is losing money, as low margin rigs, most of them out of contract and the remaining with short term contracts. Why would you put your money into it?

    (by the way TS, you say we should "forget price-to-earnings", just because this is a cyclical company. Why is your price-to-operating profit be any better?)

    (and another "by the way"... you say that Seahawk is at "the low ebb in the cycle". How do you justify this? Just because their utilisation is at 40%? How do you know it won't go down even more? There is so much capacity for drilling!... And it's so much cheaper to go deepwater that you should assume, at least as a precautionary measure, that Seahawk is, in fact at "the high ebb in the cycle".)

  • Report this Comment On April 09, 2010, at 1:30 PM, XMFSmashy wrote:

    Thanks for the substantive additions to your criticism. Now I at least know where you are coming from, in terms of your point of view on the jackup market and Seahawk's value.

    I've written dozens of articles on the offshore drillers over the past three years. They're all searchable on this site. But you're right, I'm following it from a distance. I don't live on a rig offshore.

    Your premise is that the GoM jackup market may never improve. That is a possibility -- I myself suggested it may be in secular decline. (I do think the GoM shelf is a much more appropriate place for small to midsize independents to deploy capital than the deepwater, and will continue to offer opportunities to skilled operators, though).

    My valuation would probably be improved if I included a third scenario for a low case implying terminal decline and failure. If I did that, I wouldn't demand such a big discount to the resulting value estimate, as I would have shifted uncertainty as to the outlook into the estimate itself. The end result of the price I'd consider paying probably wouldn't change much.

  • Report this Comment On April 09, 2010, at 5:41 PM, gugudada wrote:

    Dear TS and Walt373,

    What upsets me is not TS's inability to predict the future. Is the use of words such as "an intrinsic value". TS, there are not several "intrinsic values" from which you choose one. There is ONE intrinsic value and one may be, or not, able to estimate it.

    Valuation is, to some extent, a guess. One needs assumptions. The problem is that with bad assumptions, you are most likely to get wrong valuations.

    You say you have been following the market for three years, which I doubt. Or if you have, you must have been following it from a distance.

    For example, why would a client pay more, if the utilisation rate is at 80%, instead of 75%? The bargaining power of Seahawk (and of any other driller) is practically the same at these utilisations, so it wouldn't allow for prices to go up some 50%, as you assume.

    You basically made some calculations which have allowed you to come up with a "price", not "value". And you said that this price is 24, but then you suggest you would wanted it only at around 12.

    Now that the price is at 18, right in the middle, I'm sure the only thing you have given some of your readers is, as Walt373 said, an advice which is "free".

    But, Walt373, what's the use of "free" bad advice? Yes, it's better than free "paid" advice!

    Just try this: follow TS's "line of thought", until you reach his "price" of 24. It's easy, as I've written above. Then change daily rates and utilisations, just as a sensitivity test. For example, assume that the utilisation will be the same as today (some 40%). Then assume it's 20% (remember that some of their current contracts will soon expire).

    If Seahawk continues to operate at such low levels, they won't be worth 24 dollars, for sure!

    The truth is this company is an absolute gamble. Nobody can predict what this management is capable of, because we don't know what they are capable of. The company has just started and was given not one rig or two. It was given 20 of them! And 12 are not used. Just because one has a Ferrari, it doesn't mean one can drive it...

    Daily rates have been decreasing. With the excess drilling capacity, they will likely keep going down, as they turn to the much more effective deepwater drilling.

  • Report this Comment On April 09, 2010, at 5:45 PM, gugudada wrote:

    Dear TS,

    When you're in a whole, stop digging!...

    If you included "a third scenario for a low case implying terminal decline and failure", you "wouldn't demand such a big discount to the resulting value estimate"? Why not??

    :) Oh dear...

    And the end result of the price you would "consider paying probably wouldn't change much"?? Really??

    Dear, oh dear...

    So you would pay 12 dollars for Hawk, no matter if it is a reasonably ok company or a terminal one?

    I'm sorry TS, you really must try harder.

    Good luck, anyway. See you.

  • Report this Comment On April 15, 2010, at 2:46 PM, hudsondusters wrote:

    Gugudada,

    Their may well be one "intrinsic" value, but good luck trying to divine what that is at any given time. There is absolutely no way to be sure what that is given the moving parts. I think you got replies which were much more polite than you deserved.

    Disclosure: I have no position at all in this company, never have.

  • Report this Comment On April 23, 2010, at 6:49 PM, gugudada wrote:

    wobatus,

    I said "There is ONE intrinsic value and one may be, or not, able to estimate it". So, we agree.

    You said "you got replies which were much more polite than you deserved". We disagree.

    I was not inpolite. I just made my case of TS's clueless opinion about HAWK. He seems to at least not totally disagree with me now. Look at what he's written about HAWK: "You can imagine how jackup-only contractors like Seahawk Drilling are faring".

    In http://www.fool.com/investing/general/2010/04/23/two-driller...

  • Report this Comment On April 06, 2011, at 7:35 AM, gugudada wrote:

    One year and a half ago, you said: "Sure, compared with Hercules Offshore (Nasdaq: HERO ) , Seahawk looks pretty good. "

    It's on http://www.fool.com/investing/general/2009/08/26/seahawk-dri...

    It's strange that Seahawk has filed for bankrupctcy. And that its assets are being bought by Hercules Offshore.

    You really don't have a clue about things, do you?

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