|Shares Out. (in M):||12||P/E||n/m||n/m|
|Market Cap (in $M):||360||P/FCF||n/m||n/m|
|Net Debt (in $M):||-55||EBIT||0||0|
HAWK is an attractively priced long-term call option on natural gas. The company is the second largest jackup rig operator in the Gulf of Mexico, with twenty offshore drilling rigs. It was recently spun-off from Pride's International ("PDE") so that PDE can focus on higher value and growing deep-water drilling and HAWK can focus on more mature shallow water drilling. Most of the company's mat-supported rigs are capable of operating in water depths of up to 200-250 feet and drilling to depths of 20,000 feet. Mat-rigs use a "mat hull" that connects the four legs in contrast to independent leg rigs, which (as the name implies) have four separately adjustable legs. Mat-rigs are well suited to flat ground, with a muddy bottom - a common situation in the Gulf. They are typically lower tech, easier to use, and less expensive than independent leg rigs. Most of the company's rigs operate off the coast in the U.S., and are natural gas driven. However, 25-35% of the company's rigs have historically operated in Mexico under contract to Pemex, and are driven more by oil (and Mexican government) dynamics.
The investment is interesting because the stock is trading near liquidation value and a little over 1x peak EBITDA. We believe that the stock is depressed principally by cyclical factors, with some spin-off related technical factors also contributing. The technical factors are straightforward: PDE is a mid/large-cap stock with a $5 billion market cap. HAWK is a relatively tiny company, with a $360MM market cap, and a 1:15 spin-ratio (e.g. existing shareholders are getting 1 share of HAWK for every 15 shares of PDE that they own). This has caused substantial pressure, as a high percentage of the shareholder base turns over. The cyclical factors are a combination of general factors related to natural gas, and specific factors related to the Gulf of Mexico. Cyclical pressures are likely to persist or worsen through the rest of 2009, but the company has brighter prospects a couple of years out.
Natural gas prices are extremely depressed, particularly at the front end of the curve (spot). Weak natural gas prices are driven by problems on both the supply and demand fronts. On the supply side, the industry is digesting large increases in U.S. production in 2007-8 from unconventional shale 'plays'. On the demand side, weak U.S. industry, which accounts for approximately 30% of demand, and lower power utilization, due to mild weather, are both contributing. Supply is starting to decline, as a lot of U.S. production - especially unconventional plays - has extremely high decline rates. It may be economic to continue producing at a flowing well at current prices, but it is often not economic to develop a new one. Supply declines with a lag. Demand is likely to remain below trend, but is starting to improve with auto builds and other parts of industry picking up. As a result of weak current conditions, but known reasons for improving conditions, the curve is in extreme contango, with spot prices near $3/mcf and 12 month prices at almost $6/mcf. There are limits on the ability to arbitrage this imbalance because natural gas storage is scarce relative to annual supply/demand and is currently bursting at the seams.
The Gulf of Mexico has its own dynamics that make current prospects worse for rigs than those for land drillers, but make mid-term prospects arguably better. Historically, the Gulf of Mexico has had a huge percentage of the world's shallow-water rigs. However, the Gulf is skewed towards natural gas and small wells. As oil prices increased over the past 5-6 years, rigs finally left the Gulf to international areas that were more oil-oriented. This is a positive development as it has helped fix the structural oversupply from building in the 1970s. The remaining rig operators in the Gulf have consolidated, with Hercules Offshore ("HERO") and HAWK accounting for a little over 50% of rigs in the market. Unfortunately, demand is volatile and tied to gas prices, which is exacerbated because E&P majors have been out of the Gulf for a long time as they focused on larger prospects. This has left small independent E&P companies that live hand to mouth. Subsequent to Katrina, these operators do not have access to business interruption insurance, which means that it is difficult to hedge because if a rig is knocked out, they would have a liability to the counterparty to deliver gas. This means that the Gulf is extremely sensitive to spot gas prices; more so than land prospects that can at least hedge using the curve.
The operating rig count has come down massively over the past 12 months, and is still coming down as rigs are "stacked". Management believes that the current operating level is purely maintenance, and that they don't even need exploration to pick-up in order to see a modest improvement in demand. However, management and industry analysts believe natural gas needs to return to $4.50-5/mcf to incent exploration and substantially improving demand. HAWK had EBITDA of $18MM in 1Q, $6MM in 2Q, and will have a modest loss in 2H09. The company is targeting being approximately cash-flow neutral by YE09 based on current operating conditions. We are currently estimating a cash burn of $1.5MM/qtr in early 2010. When demand picks up, the consolidated industry structure, and lack of new supply should allow for good pricing and utilization.
Market cap: $360MM
Estimated trough EBITDA Near zero
Estimated mid-cycle EBITDA $125MM
Estimated peak EBITDA $250MM
2006-8 avg. pro-forma EBITDA $230MM
Estimated sustainable cost savings vs. YE08 ~$50MM
(note: TBV excludes approximately $40MM of expected rig impairments as part of a fair value test associated with the spin-off. To the extent we are trying to understand historical cost or compare with other companies, we don't want to subject HAWK to a fair value test that other companies aren't experiencing.)
The valuation seems attractive, with the stock trading at 65% of TBV, near liquidation value, and at 1.3x peak EBITDA. While the closest competitor, Hercules Offshore ("HERO"), also trades at 65% of TBV, this is misleading for two reasons. First, HERO has been more acquisitive/expansionary and has a both younger, and higher carrying cost, fleet. Based on replacement cost, HAWK is cheaper than book value metrics suggest. Second, HERO has substantial leverage, and thus on an "unleveraged basis", it trades at over 80% of TBV. HAWK's balance sheet, with over $50MM of net cash, is important because it extends the life of our "call option" on natural gas pricing. We do not want to be correct about higher natural gas prices and their impact on driller earnings, only to have the value accrue to the new owners of a restructured company because we were "stopped out" at the bottom of the cycle. Downside for HAWK should be limited given the cheap valuation and strong balance sheet. If the company can trade at 4-5x mid-cycle EBITDA it is +50-85%, at 3-4x peak EBITDA it is +120-200%. Given that 12-month gas is at $6, and the company would quickly return to mid-cycle EBITDA at $6 gas, it seems like a mispriced security.
Under PDE, HAWK had a bloated cost structure that the current management team is addressing. We believe that this is a key part of both improving the over the cycle earnings power of the business, and preserving the value of the option by reducing near-term cash burn. The key cost buckets are:
Late 2008 Recently Target
Rig costs: High $30k's/day Low $30k's/day High $20k's/day
Mexico shore costs: ~$35MM/yr Similar pace $6MM/yr target
U.S. shore costs: $12MM/yr $6MM/yr Already hit
These should result in total shore-based savings of approximately $35MM annually. While some of these costs will return in a better market, the vast majority will not. In particular, Mexico was very overstaffed and used a high percentage of expensive expats workers. With regard to rig savings, some of these are pro-cyclical and are likely to either return when the cycle improves, or be passed along to customers. However, we estimate that about half of the rig cost savings are sustainable. For example, PDE spent ~$8k/day on rig maintenance vs. $2.5k/day at HERO or $4k/day at Noble Corp. Using $5k/day of sustainable rig savings, assuming 16 rigs operating at 80% utilization (so effectively 12.8 rigs on FY basis), would translate to $23MM of savings. If the company keeps 80% of its shore-based savings (mostly associated with Mexico), and this 50% of rig-based savings, the total sustainable cost saves are approximately $50MM.
Management is experienced, seems reasonable, and is highly incented to make the stock work-out well from the spin-off price. The CEO previously ran HERO, and knows the Gulf rig business very well. The scuttlebutt is that he was not happy about the leverage that was put on after the HERO/TODCO merger, and pushed PDE to have a strong balance sheet for HAWK. Management's compensation package is heavily stock-oriented, and the team will benefit from a low spin-off price. For example, as part of his compensation package, the CEO received a $4.8 million equity award at the time of the spin-off; half in stock and half in options. The stock price used for both components was based on the VWAP of the first trading day. The stock component is straightforward; a lower price is better in a linear way (e.g. at a $25 stock he gets ~100k shares at a $50 stock he would get ~50k shares). The options component is more nuanced. The $2.4 million of options are struck at the money and priced using a binomial method. What this means is that the payoff actually got exponentially better as the initial stock price moved lower. At a $50 stock, an "at the money" option might be valued at $20, so he would get 120k options. However, at a $25 stock, the similar "at the money" option would only be valued at $10 (even though in the real world it is worth more), and he would get 240k options. Between this award, and others, the top five members of management were granted approximately 450k RSUs and 350k options, which were struck at $25.95. The new COO came from Noble Corp. only three weeks ago, and we think that the attractive equity opportunity was part of the incentive.