We believe Helix Energy Solutions (HLX) is a unique, underfollowed vehicle to gain exposure to growing deepwater oil and gas activity, trading at a substantial discount to peers, and with several years of 20%+ growth ahead.

At $23, you get to buy at the same price where the CEO acquired $1mm just days ago, and potential for appreciation to $41 in the next two years (77% higher).

Business Description

HLX underwent a major reorganization in early 2013 where it shed several business lines, leaving it a more focused company with 3 main segments:

• Well Intervention: represents 57% of 2014E sales and 48% of EBIT. The company operates 4 deepwater well intervention rigs. These vessels are niche offshore rigs, used for maintenance, enhancement, or plugging of deepwater wells. The rigs are leased to E&P operators at a particular dayrate (currently in the $275k-350kpd range)

• Robotics (46% of revenues, 37% of EBIT). The company operates Remote Operated Vehicles (ROVs) that perform underwater vessel support and other deepwater tasks. 75% of segment sales are to oil and gas customers, the balance being renewable energy and others.

• Production Facilities (10% of revenues, 15% of EBIT). The least sexy of the 3 segments, HLX owns interests in 3 floating production platforms, that provide $60mm in EBITDA/yr. This is a cash-cow business that requires little attention and even less investment.

Thesis

• Well Intervention will be the main growth engine through the addition of new rigs to the fleet. The Helix 534 will enter service late in Q4 2013, with the Q5000 scheduled for 1H 2015 and the Q7000 in 2H2016. Each new vessel costs $400-500mm and contributes $80-100mm, so the company essentially buys growth at under 5x EBITDA.

• There is multi-year growth path in the Well Intervention market, given it’s a small niche with less than 20 well intervention rigs currently in operation worldwide. There is an emerging shortage as it’s too small a niche for the SDRLs of the world to pursue (limited supply), coupled with booming demand driven by increasing deepwater well count (most wells need intervention 5 years after starting production). This tightness is increasingly reflected in pricing: the latest rates booked on the backlog are 20% higher than in the past 2-3 years, according to management.

• With a hugely under-levered balance sheet (0.2x net debt/EBITDA), the question is why is HLX not building more rigs when it keeps talking about undersupply in the market.  We believe management is excessively conservative because of HLX’s prior history, when the company was over levered and operated in lumpier businesses. Hence, the company is taking it one step at a time and will likely only order its next rig once it contracts out the Q7000 for a few years.

• The Robotics segment will also benefit from increasing offshore activity, and HLX will keep adding a net 5 ROVs/yr to its existing fleet of 54. This should contribute an additional $6mm in EBITDA growth each year.

• Production Facilities is a business the company likes as it’s a “check in the mail” type of business, but it insists it’d be open to selling it if it receives an attractive offer. Were this to happen, we expect management to invest the cash into a new Well Intervention rig.

• Trading patterns suggest the business is still misunderstood post-reorganization. The company disposed of its oil and gas production and offshore construction businesses, ridding itself of lumpy quarter-to-quarter volatility and focusing on high-growth, high-return niches with more visibility and barriers to entry. Nevertheless, HLX still trades at a much higher beta than offshore drillers or oil equipment peers, in spite of the fact that all of 2014’s well intervention activity is in the backlog, and most of 2015 is also committed. We believe HLX still doesn’t get credit for this, and might re-rate as the company delivers predictably and dispels fears about volatility in quarterly results.

• HLX is underfollowed by the sell-side, and in our opinion is largely unknown to many energy and generalist investors. In spite of respectable average trading volume ($27mm/day), the company is only covered by 6 sell-side analysts. Offshore-oriented services and equipment stocks such as DRQ, OII or FTI have anywhere from 13 to over 30 sell-side analysts covering them. Even FI, which just IPO'd and is much less liquidly traded, has 9 analysts following it. Puzzingly, even energy specialists like TPH or Howard Weil don't follow HLX. There is a substantial premium currently being paid for offshore-levered names, and if HLX can raise its profile, we believe the company could be rewarded with a much higher multiple than its current 7x or even the 8x we suggest is fair. The fact that growth prospects for names like FTI, DRQ and certainly CAM appear to be under review, suggests increasing scarcity value to offshore-driven names that can deliver consistent, medium-term growth (OII being a good example).

• We like the management team. They're good allocators of capital - if anything, too cautious given the buoyant prospects for the business. The CEO, Owen Kratz, owns nearly $120mm in stock and sent a good signal buying $1mm on Oct 25 when the stock dipped to $23 after Q3 earnings.

Valuation

We believe HLX deserves a higher multiple than the 7.2x 14E EV/EBITDA it’s currently trading at (management guided to a 2013 exit rate, including the new Helix 534 rig, of $350mm EBITDA), based on comparing its valuation to its peers segment by segment:

• There are no public pure-play peers in the deepwater Well Intervention arena (Island Offshore is the #2 player but is private), but we think offshore drillers with modern, hi-spec fleets such as ORIG or PACD are good comps. Thus, we value Well Intervention at 7.0x 2014 EV/EBITDA

• To value Robotics, we take OII, the leader in ROV services, which trades at 10.6x 2014 EV/EBITDA. You could argue that the implied multiple for ROVs should be even higher, given that 60% of OII’s business (Products, Projects) deserves a lower multiple, but we will assign 10.6x to HLX’s Robotics business just to be conservative.

• Production Facilities: we assign a 5.5x EV/EBITDA multiple given zero-growth but small capex needs. If this business were sold to an MLP, valuation would likely be meaningfully higher.

The resulting implied multiple for HLX is 8.1x EV/EBITDA, or nearly a full turn above prior levels. Again, this is being conservative about the Robotics and Production Facilities multiple.

Even more important than the potential multiple expansion, the earnings growth story is real and highly visible through the delivery of 3 new Well Intervention vessels plus 5 ROVs/year. We believe by 2016 when the Q7000 is delivered, the company will be delivering an EBITDA run-rate of $550mm/yr, from a current base of $300mm. Applying an 8.1x multiple to that earnings power would result in a $41 target price, 77% higher than today’s level. It’s probably reasonable to expect HLX to reach this target price 2 years from now as it successfully delivers the Helix 534 and the Q5000. Note that assuming $300mm capex in 2014 and 2015, HLX should be roughly cash-flow neutral after capex (if not slightly positive) for both years, so net debt stays about where it is and all value generated goes to equity holders.

Risks

• One concern that often comes up is the potential for aging drilling rigs to compete directly with HLX’s well intervention rigs. We are not overly concerned by this, as drilling rigs already work on 70-80% of rigs that need intervention. The trend is actually the opposite – customers are switching to specialized rigs such as HLX’s that can perform the task quicker and more efficiently. The H534 rig is actually an old Transocean drilling rig, but HLX spent nearly $100mm to adapt it to well intervention needs.

• A collapse in oil prices and/or a dramatic downturn in offshore spending would obviously affect HLX, particularly the ROV business which is shorter-cycle than Well Intervention. We don’t take a view on the sustainability of oil prices at these levels, but deepwater spending seems almost certain to keep increasing over the next couple of years. For those uneasy about this macro risk, it might be attractive to pair HLX vs. a short position in an offshore driller – many of them trade in the mid-6x EBITDA and in our opinion the earnings estimates they're based on are likely to trend down from present levels.

• HLX is largely a fixed-cost business were profitability is driven by utilization. While ROV utilization is reasonably stable (with some seasonality in the Q4), those familiar with offshore drilling companies might fear HLX's Well Intervention rigs could be subject to similar out-of-control downtime issues that result in a slow bleed in earnings expectations as the year progresses. This is hardly the case for HLX, as regulatory requirements for certification and inspection are much lower than for drilling rigs (Well Intervention rigs have no BOP to inspect, for starters). Moreover, maintenance periods seem much shorter than for drilling rigs, and there is hardly any unplanned downtime at all.

• The announcement of additional newbuild rigs, particularly if it involves leveraging the balance sheet
• The sale of Production Facilities at an attractive price
• Announcement of contracting progress on the Q7000 rig.