Description

Horizon Offshore (HOFF) is a small-cap late-cycle oil services company that recently completed a recapitalization amid strengthening industry fundamentals in the offshore construction business. HOFF trades at a cheap valuation - less than 10x P/E and about 5x EV/EBITDA - which reflects a substantial discount to comparable companies and understates the company’s improving vessel utilization, favorable pricing and expanding margins. Based on very-achievable company guidance this year and a valuation at the low-end for the group, the stock should trade closer to $30-$35/share – significant upside from the current $20/share price.

Last week, after recently being listed on NASDAQ, the company completed a stock offering of 8.5 million shares through Lehman (at $20.53), largely to allow residual bondholders to take profits in their new equity while raising about $40 million of additional cash to pay down debt. The stock weakened considerably into the equity offering and presents a compelling entry point now. The re-introduction of the company to the equity community after the recap and continuing removal of bondholder overhang should lead to a more reasonable valuation while fundamentals continue to improve in coming quarters. Helix Energy Solution’s pending carve-out IPO of their Cal-Dive services unit could also bring more investor focus to this booming sub-sector of the oil services industry.

Business description
Horizon Offshore, Inc. provides marine construction services for the offshore oil and gas, and other energy related industries in the United States, Gulf of Mexico, Latin America, Southeast Asia, and West Africa. Its marine construction services include 1) laying, burying or repairing marine pipelines; 2) providing hook-up and commissioning services; 3) installing production platforms and other structures; and 4) disassembling and salvaging production platforms, and other structures. The company’s fleet consists of 9 vessels – including the Texas Horizon which was purchased in February for $23 million. HOFF was incorporated in 1995 and is headquartered in Houston, Texas.

Background
HOFF experienced severe financial difficulties beginning in 2003 with collapsing margins due to the confluence of weak industry conditions, irrational pricing from a competitor (Torch Offshore) and 2 financial disputes – payment for extra work on a contract with Pemex and recovery of insurance claims for a vessel fire. In the past couple years, industry conditions for new marine construction have obviously improved as energy prices have strengthened while recent hurricanes have created extreme demand for repair work; competitor Torch has been liquidated in bankruptcy; the balance sheet has been solidified with the recap in late 2005; and the outstanding financial disputes should be resolved in the next few months, providing cash recoveries.

Recapitalization summary
During 2005, HOFF completed a two-step, recapitalization process that began in March 2005 and led to bondholders receiving the majority of HOFF equity. On March 31, 2005, HOFF closed $70 million of senior secured term loans with holders of the 16% and 18% subordinated secured notes due March 31, 2007. On June 10, 2005, HOFF completed a debt-for-equity exchange transaction with holders of all of subordinated notes. HOFF issued 2,400,001 shares of common stock and one million shares of Series B mandatorily convertible redeemable preferred stock, to the holders of subordinated notes in exchange for approximately $85 million of the approximately $110 million aggregate principal amount of outstanding subordinated notes at June 10, 2005 and all of the 1,400 outstanding shares of Series A redeemable participating preferred stock. During the fourth quarter of 2005, HOFF exchanged or converted all of the shares of Series B preferred stock into a total of 22,165,574 shares of common stock. On December 19, 2005, HOFF completed a private placement of 2,106,000 shares of common stock with several accredited investors at $9.50 per share, resulting in net proceeds of $18.8 million. During December 2005, HOFF exchanged $13.2 million in aggregate principal amount of 8% Subordinated Notes, resulting in the issuance of 1,395,272 shares of common stock. In April, the company effected a 1-for-25 reverse stock split. And HOFF just this last week conducted the equity offering of 8.5 million shares which included 6.5 million from selling shareholders. Net debt is down to a conservative 1.0x LTM EBITDA (which is only 0.5x EBITDA for the last quarter annualized).

Industry conditions
Demand for construction services is driven by the level of capital expenditures from E&P companies and usually lags exploratory drilling by at least 9 to 18 months. The robust offshore construction market is still experiencing significant demand for repair and salvage work from the 2005 hurricane season which could extend for the next 2 or 3 years – even without additional hurricanes this summer or beyond. The focus from customers right now is on availability of services with secondary regard for pricing – indicating that improving margins have yet to find a plateau. Business is so strong in the Gulf of Mexico that HOFF has been moving its international vessels into the Gulf from Asia and Africa. Also, HOFF has signed new contracts with Pemex as recently as February and has $180 million of Pemex contracts to be completed in 2006.

Competitors
The closest pure-play competitor among publicly-traded firms is Global Industries (GLBL). Other companies that compete with HOFF in related areas include McDermott (MDR) and Oceaneering (OII) as well as Helix (HELX) which also has significant E&P assets and is planning to carve-out their Cal-Dive services unit (the S1 has been filed).

Vessels
Max (tons) Max (inches)
Length (ft) Derrick Lift Pipelay Diameter
Pipelay/Pipebury
American Horizon 180 18
Lone Star Horizon 320 39
Brazos Horizon 210 18
Pecos Horizon 250 24
Pipebury
Canyon Horizon 330
Derrick
Atlantic Horizon 420 550
Pacific Horizon 350 1000
Derrick/Pipelay
Sea Horizon 360 1200 36
Diving Support / Pipelay
Texas Horizon 341 10

Financials
The first quarter saw EPS of $0.51 and EBITDA over $38 million on revenue of $130 million. Annualized, these results would put the company well into their guidance range.

The company’s guidance for 2006:
Revenue: $515 - $560 million
EBITDA: $135- $150 million
EPS: $1.98 - $2.30

Of course, the 1st quarter is seasonally weak (along with the 4th), so the company should have a solid opportunity to beat their guidance – even though the usually weak 1st quarter was admittedly stronger than normal due to good weather and backup of repair work from hurricane Katrina. Also, the Latin American operations operated at 0% gross margins for the 1st quarter while vessels moved into place for new contracts. Regionally, with HOFF vessels moving to the Gulf, future earnings should be driven by domestic and Latin American operations.

Second quarter guidance from management is for EPS of $0.56-$0.72 on EBITDA of $35-$40 million. The deleveraging effect should show improved EPS in relation to run-rate EBITDA levels.

Financials 2001 2002 2003 2004 2005
Revenue $272 $283 $270 $254 $325
Gross profit $35 $30 $7 $28 $57
EBITDA adjusted $33 $22 ($29) $18 $51

Revenue 2003 2004 2005 1Q/05 1Q/06
Domestic - GOM $94.1 $69.7 $180.2 $12.3 $73.1
Domestic - Other $107.6 $3.3 $0.0
Latin America $3.9 $58.2 $33.3 $0.3 $10.2
West Africa $16.2 $17.4 $76.8 $8.5 $42.7
SE Asia / Mediterranean $48.1 $105.6 $34.7 $16.2 $3.9
Other $0.4 $0.0 $0.0
Total $270.3 $254.2 $325.0 $37.3 $129.9

Gross profit
Domestic - GOM ($8.4) ($8.4) $49.0 ($1.2) $27.4
Domestic - Other $9.2 $1.8 $0.0
Latin America ($0.7) $11.5 $0.4 ($1.4) $0.0
West Africa ($1.4) $0.9 $7.9 $0.9 $8.6
SE Asia / Mediterranean $8.1 $22.0 ($0.5) $4.3 $2.4
Other ($0.3) $0.0 $0.0
Total $6.5 $27.8 $56.8 $2.6 $38.4

Gross margin
Domestic - GOM -8.9% -12.1% 27.2% -9.8% 37.5%
Domestic - Other 8.6% 54.5%
Latin America -17.9% 19.8% 1.2% -466.7% 0.0%
West Africa -8.6% 5.2% 10.3% 10.6% 20.1%
SE Asia / Mediterranean 16.8% 20.8% -1.4% 26.5% 61.5%
Other
Total 2.4% 10.9% 17.5% 7.0% 29.6%

Valuation
Comparable companies are trading about 15-20x P/E on 2006 earnings. At the low end of that range on $2.30 EPS, HOFF would reach over $30/share which would equate to about 7x EBITDA of $150 million. It should be noted that HELX trades at a discount to the group due to its sizable E&P business and its pending merger with Remington.

13.0x 14.0x 15.0x 16.0x 17.0x
$2.00 $26.00 $27.00 $28.00 $29.00 $30.00
$2.10 $27.30 $28.35 $29.40 $30.45 $31.50
EPS $2.20 $28.60 $29.70 $30.80 $31.90 $33.00
$2.30 $29.90 $31.05 $32.20 $33.35 $34.50
$2.40 $31.20 $32.40 $33.60 $34.80 $36.00

Capitalization
Price $20.20
Shares 32.375
Mkt.cap $654
Net debt $81
EV $735

Leverage LTM LQA
Debt/EBITDA 1.4 0.8
Net Debt/EBITDA (LTM) 0.9 0.5

EBITDA Implied multiples
2005A adj. $51 14.6
LTM (1Q) $89 8.3
LQA (1Q) $154 4.8
2006E -mgmt low $135 5.5
2006E -mgmt high $150 4.9

Comparables summary
GLBL MDR OII Average HELX
Price $15.97 $43.82 $41.44 $33.96
Mkt.Cap $1,843 $4,860 $2,242 $2,808
EV $1,804 $4,394 $2,383 $3,270

P/E
2005 31.9 39.8 35.4 35.7 17.0
2006 16.0 20.9 20.6 19.2 10.6
2007 13.3 16.9 17.6 15.9 9.4

EV/EBITDA
2005 17.5 16.8 12.5 15.6 9.5
2006 8.0 10.9 9.2 9.4 4.6
2007 6.2 8.9 8.2 7.8 3.7

Issues
Two outstanding disputes should be resolved soon and potentially provide tens of millions in cash settlement for HOFF. Due to an unpaid claim of $78 million for extra work performed for Pemex in 2003, HOFF carries a current claim of $18.5 million which is included in costs in excess of billings and is net of $33.1 million allowance for doubtful accounts. To date, HOFF has recovered $9.1 million from Pemex. The dispute is in arbitration and a decision is expected by the third quarter of 2006. Another claim of $28 million is being pursued in court, relating to lack of payment of fire insurance after the Gulf Horizon vessel suffered damage in 2004. A trial date was set in the English High Court for June 26, 2006.

Ownership
Below are the proforma ownership levels for the beneficial shareholders, who participated in the equity offering and together currently own over 40% of HOFF equity. The selling shareholders are subject to a 60-day lockup.

Shareholder Shares % total
Elliott Capital 6.4 19.6%
Highland Crusader 3.8 11.8%
Lloyd Miller & Trusts 3.2 10.0%
Subtotal 13.4 41.4%
Total 32.4 100.0%

Risks
*Energy exposure/cyclicality
*Disputes with Pemex contract and fire insurance
*Investigation of possible bribe in Latin America (for $35,000).
*Customer concentration
*Selling shareholder overhang

Catalyst

Catalysts
*Research coverage from underwriters (Lehman, Jefferies, Johnson Rice, and Oppenheimer).
*Resumption of investor relations activity (including conference calls for investors).
*HELX carve-out IPO of Cal-Dive unit to highlight bullish trends in sector.
*Resolution of fire insurance and Pemex contract disputes
*Hurricane season