HOS is one of the more interesting reward / risk stories we've ever come across and believe HOS is a 2-4 bagger with significant downside protection.

To summarize, we believe that HOS will, through EBITDA generation and divestitures, be able to pay down most or all of their $700m net debt over the next several years. If HOS's enterprise value remains depressed at current levels, the stock is more than a double. If EBITDA grows to the mid-point of potential (or beyond) and multiples return to historic levels, the stock is more than a quadruple. While there is some near-term uncertainty, we believe the asset values and variable cost controls are adequate to limit downside to somewhere around $13-14 (or $5-6 of downside vs. $25-$70 of upside). Probability weighted the reward-to-risk looks even greater.

HOS is a deepwater oilfield services provider operating primarily in the Gulf of Mexico. HOS makes money by renting its vessels and crews to customers on a daily, weekly, monthly or multi-year basis to fulfill various tasks related to the exploration, production, maintenance and ultimate decommissioning of offshore oilfield operations.

HOS has spent the better part of a decade expanding its fleet of OSVs (offshore supply vessels) and MPSVs (multi-purpose support vessels) and capital expansion plans have recently come to an end with the completion of their OSV newbuild program #4 this quarter. An investor buying HOS today can buy a company with one of the youngest and most advanced fleets of deepwater offshore oilfield vessels in the world at a substantial discount to both the book value and replacement cost of the fleet.

This story is relatively simple: We believe that HOS can easily pay down their entire debt balance in the next four years through operating income and, to a lesser extent, sale of non-core assets. Since EV/MV = 2.4, this represents significant upside. What's more, this is the conservative case which uses the low end of HOS's EBITDA potential and low EV/EBITDA multiple. Downside risk is mitigated by significant asset value and HOS's ability, if need be, to bring vessel operating costs to near $0 within 24 hours mitigating cash burn concerns (existing vessels with contracts generate 50%+ EBITDA margins so HOS wouldn't simply go to cash breakeven).

An investor can acquire shares of HOS at these depressed levels because of the drilling moratorium in the Gulf of Mexico. While I could spend pages writing about what's going on and the potential outcomes, reading WSJ's dedicated online section can bring you up to speed in about 30 minutes. I'll summarize my key takeaways here:

1. In the last four years, Gulf royalties totaled $33.2b to local and Federal governments and this does not include the sale price of leases. The Gulf oilfield provides thousands of jobs, 85% of US offshore production and 1/3 of total US oil production.
2. An initial 6 month drilling moratorium was implemented just after BP's Macondo oil spill
3. HOS spearheaded a lawsuit against the Federal Gov't on the basis that Salazar (Secretary of the interior) didn't base the moratorium on anything factual. HOS won the case and the judge barred the moratorium
4. Salazar then threw out the original moratorium and implemented a new, very similar moratorium. HOS again sued saying that the new moratorium is the same as the old one. HOS has made two pieces of solid progress in this one so far: 1) the Feds asked that HOS's second case be thrown out and were rejected; 2) the Feds were trying to withhold 8k pages from plaintiffs and were just ordered to release this information.
5. Though the moratorium is still in effect, Bromwich (Head of BOEMRE and reports to Salazar) has mentioned on several occasions that: 1) his report and ensuing lifting of the moratorium could come before the November 30 deadline; 2) there haven't been any discussions about extending the moratorium
6. Officials and legislators from Louisiana, Texas and Alaska have filed suit against the Federal Gov't
7. When drilling does come back the playing field will likely be significantly altered: 1) Independents, which have pioneered a lot of the deepwater drilling, may be faced with new potential liabilities that will prohibit them from continued drilling in the Gulf; 2) permits and certifications will likely take far longer to obtain than in the past; 3) offsetting this will likely be the need for additional safety and standby vessels in the event of an emergency.
8. Though the moratorium has been in effect, service providers have not been as hard hit as expected because of the massive cleanup efforts which are winding down with the permanent closure of the Macondo well
9. Arizona senator Grijalva has been pushing for a capping and dismantling of unused and non-producing wells, mostly in an effort to create jobs during the drilling downtime. He was successful and last week Bromwich sent a notice to lessees that they'd have to cap 3,500 wells - the cost of this per well is anywhere b/t $300-500k and requires a lot of support labor and vessels (which is why the shares have run to where they're at today).
10. Even if the moratorium is lifted in November, it will likely be a quarter before things get back to a new normal meaning that drilling probably won't really ramp back up until 2Q11 or slightly later.

The net of all of this is that there may be 1-2 quarters of depressed revenue depending on when the well-cap program comes online. If it lasts too much longer, more drill rigs will leave the Gulf and we expect that HOS's vessels will go with them, further mitigating the risk of long-term cash burn and permanent loss of capital.

To better understand the significant value underlying this story, here is the financial framework:

Market Cap: $500m

Net Debt: $700m

Enterprise Value: $1.2b

Maintenance capex: $45m (guidance from management)

Expansion capex: $0 (guidance from management)

Cash debt service: $45m (total interest expense is higher but some of this is non-cash OID)

Cash taxes: $0 (HOS accelerated tax-basis depreciation on the fleet buildout and therefore will pay no cash taxes for several years)

Annual cash requirements = $90m (HOS's management actually guides $80-85m p.a.)

Put another way, any EBITDA over $90m is effectively free cash flow as there are no cash taxes, 40-45m in maintenance capex and $40-45m in cash interest.

Book value of upstream assets: $1.6b

Book value of downstream assets: $210m (currently held for sale)

Total Book Value of Assets (including corporate): $1.8b

Replacement value of Assets: >$2b

Earnings Power:

Revenue is straightforward:  average dayrate * average utilization * average # of vessels * days = revenue.

Upstream EBITDA margins are typically >60% before Corporate, >50% after corporate.

The following EBITDA figures (before stock-comp) are in respect of HOS's current fleet potential (straight from management):

2010 Trough Dayrates = $210m

2008 Peak Dayrates = $425m

The following analysis assumes a $225m average annual EBITDA representing 2010's low dayrates.

+$100m Cash Exiting '10

+$900m EBITDA = $225m * 4

+$110m Sale of Downstream Assets

-$360m = $90 * 4 for Maintenance Capex and Debt Service

=$750m Cash at end of year 4

-$750m Current Total Debt

=$0 Net debt at end of year 4

With $0 net debt at end of year 4, if EV stays the same (conservative), debt pay down will grow equity by $700m on top of a market value of $500m.

However there is significant upside:

$300m EBITDA (Mid-range of EBITDA potential)

8.0x EV/EBITDA (Mid-range of historical multiple)

$2.4b Enterprise Value. With no net debt at end of year 4, HOS's equity is worth $2.4bn / 27.2m shares = $88 vs. the current $19 share price. [Note that ~5m converts are struck at $48] This would be >4x the current share price.

HOS has 51 OSVs, 4 MPSVs and 9 tugs/barges. OSVs have been commanding dayrates at about $20,500 (before 1x bump up due to a special project). MPSVs, which are much larger and newer, command anywhere from $75k - >$200k day rates. We believe the OSVs alone could conservatively do $200m / year in EBITDA while the MPSVs, at a dayrate somewhere just north of $100k would conservatively add another $40-$50m EBITDA. In addition, their downstream business, during this historic low, generates $5-10m in EBITDA.

HOS's downstream business is for sale currently. This is a cyclical business and recently represents about 10% of overall revenue. High relative gasoline and crude inventories along the US' east coast, where HOS operates, has kept this business depressed. At the peak of the cycle, the downstream business does $40-50m of EBITDA. If an acquirer takes this business out at $100m (which we believe is so low that the company wouldn't even sell it) they'd be getting the assets for around 2x peak EBITDA. Even at $200m the acquisition would pay for itself in 3-5 years; sooner if the vessels are added to an existing larger fleet. Either way, to remain conservative, we use $100m cash proceeds from downstream divestiture.

What's the short story?

Business in the Gulf will drop to zero once cleanup work is done.

Not quite. HOS has contracts  on 46% of capacity for the remainder of 2010, and more than 1/3 of capacity is contracted for 2011. Meanwhile, the well-cap order could provide some support during the downtime in addition to cleanup efforts. Further, even if business drops significantly, HOS can warm- or cold-stack vessels in 24 hours bringing the daily opex from $7k-$11k / day to $500. Meanwhile, vessels that are still working are going to generate EBITDA margins >50%.

New requirements in the Gulf are going to severely impact the level of activity as independent operators will be unable to risk the new levels of liability.

No doubt independent operators are going to be impacted. We believe however, that the amount of additional support per rig will increase as safety requirements and emergency standby support will increase. Additionally, if activity falls off a cliff due to new requirements, HOS already has 8 vessels operating in Brazil and can send incremental vessels to foreign waters. What's more, if they send vessels to foreign waters and things pick back up in the Gulf, HOS is flagged in the US in line with the Jones Act and can bring the vessels home whereas foreign companies are unable to send vessels to the Gulf. (This could also provide support for an acquisition of the company by a larger player).

Dayrates during 2003 and 2004 (the last hard time for the industry) were much lower than 2010's dayrates.

That's true however, capital costs for ships and opex costs for crews have since increased significantly for the industry as a whole and have lead to a new level of dayrates over the past half-decade. Given the rapid growth in deepwater offshore drilling, vessel materials became difficult to source and prices skyrocketed. Meanwhile, skilled labor in the Gulf has significantly increased in cost as deepwater drilling and advancements in vessel technology (Dynamic Positioning, etc.) have increased the skill required. Further, it takes almost a decade for an employee to go from deck-hand to captain and as demand increases there's a shortage of skilled labor. If dayrates go down substantially, so too will crew wages.

To summarize, we believe that HOS will, through EBITDA generation and divestitures, be able to pay down most or all of their $700m net debt over the next several years. If HOS's enterprise value remains depressed at current levels, the stock is more than a double. If EBITDA grows to the mid-point of potential (or beyond) and multiples return to historic levels, the stock is more than a quadruple. While there is some near-term uncertainty, we believe the asset values and variable cost controls are adequate to limit downside to somewhere around $13-14 (or $5-6 of downside vs. $25-$70 of upside). Probability weighted the reward-to-risk looks even greater. 

1. Macondo well permanently capped on 9/19 - political momentum likely dies down substantially
2. Ensco's moratorium-related suit against the government, unrelated to the HOS's filing, has a key hearing on 9/22
3. Bromwich concluded his final fact-finding forum on 9/13. Will likely hear some positive progress on the Moratorium by 9/30
4. Plans for capping non-producing / abandoned wells due to BOEMRE by 10/15
5. Potential early lifting of the moratorium - otherwise it's scheduled to be lifted by 11/30
6. 4Q10 - HOS exits the year w/ $100m cash
7. 1Q/2Q11 - Gulf Drilling activity begins to ramp back up
8. 2Q/2H11 - Earnings power of HOS becomes apparent (especially new MPSVs w/ dayrates at $75k minimum)
9. Next 12 months - downstream assets sold for proceeds of >$100m