Description
My sincere apologies in advance: I submitted this idea on January 26th as my application. I recognize it's now of limited value as my thesis has largely played out. However, I thought I would post it in hopes it may be of interest to some, as well as serve as a forum for anyone interested in discussing Seahawk's bankruptcy proceedings.
Abstract
Seahawk Drilling (HAWK), with a market capitalization of $88m, book value of $380m, and total liabilities of $124m has become a popular deep value pick with a seeming high margin of safety. I believe this view is mistaken and Seahawk equity holders are likely to experience significant losses.
A summary of my argument is as follows:
- The market has fallen for the "time portal" fallacy: only Seahawk's current position and the future realization of value are being considered - no attention has been paid to the path Seahawk must take before any value may be realized
- This path contains significant constraints that are not well understood by the market and which preclude beneficial outcomes for shareholders
Company Overview
Seahawk Drilling owns 20 jackup rigs that provide shallow water drilling services in the Gulf of Mexico. Seahawk was spun-off from Pride International on August 24, 2009. Due to extremely challenging market conditions, primarily due to increased regulation following the Deepwater blowout and low natural gas prices, Seahawk has experienced large losses, with net income of -$22.3m, -$19.7m, and -$32.1m in Q1, Q2, and Q3 of 2010, respectively.
The "Time Portal" Fallacy
Given recent financial performance, valuing Seahawk in a liquidation scenario seems to make sense. Using a variety of assumptions, many parties have proposed a fair equity price based on the estimated liquidation value of Seahawk's rigs and subtracting for liabilities and cash burn. However, I believe this type of analysis suffers from the "Time Portal" fallacy and ignores the critical path between Seahawk's present state and any future date when value may be realized.
As of the Q3 quarterly report (Sept 30th), Seahawk had $41.4m in cash and $11.5m remaining on a $36m revolving credit facility. During the earnings call, management provided guidance for Q4 cash burn of $25m (which includes $15m in repairs to the Seahawk 3000). Based on this guidance, and assuming Seahawk draws down on the remaining facility, Seahawk will have $27.9m in cash as of the start of 2011. During the Q3 call, management also acknowledged its liquidity constraints and stated they had retained Simmons & Co to seek strategic alternatives.
The Difficult Road Forward
There are significant limitations to the alternatives Seahawk can pursue. As part of the spin-off from Pride, Seahawk signed a tax sharing agreement that had several stipulations. From the 2010 Proxy:
The tax sharing agreement requires that neither we (Seahawk) nor any of our subsidiaries take or fail to take any action that would be inconsistent with or prohibit the spin-off and certain related transactions from qualifying under Sections 355 and/or 368... Such actions include but are not limited to any of the following actions within the two-year period following the effective time of the spin-off:
- (i) selling all or substantially all of the assets that constitute our mat-supported jackup rig business to any person
- (ii) transferring any of our or any of our affiliates' assets in certain transactions described in Section 368(a)(1) of the Code to another entity
- (iii) transferring all or substantially all of the assets that constitute our mat-supported jackup rig business in a transaction described in Sections 351 or 721 of the Code
- (iv) issuing stock of us or any affiliate (or any instrument that is convertible or exchangeable into any such stock) except in certain cases relating to employee compensation
Per these restrictions, Seahawk is unable to sell substantial assets, itself in entirety, or issue stock for two years from the spin-off. Two years following the spin-off will be late August 2011.
What Can Seahawk Do?
In the absence of the above options, Seahawk can meet its short-term liquidity needs in two ways: 1) sell assets or 2) raise debt.
Seahawk has done an admirable job selling assets. In March 2010, they sold 10 cementing units ($9M), in September, surplus equipment ($900k). However, a conditional arrangement to sell the Seahawk 2505 to Essar Oilfield Services India for $14.6m fell through in January after Essar was unable to obtain a permit for the rig (the condition of the sale). I believe this may be a grave sign: if there are no private market buyers for rigs at even a fraction of book value, Seahawk is unlikely to meet its liquidity needs from the sale of non-rig assets alone.
This leaves the second option of raising debt. Let us first examine Seahawk's existing credit situation:
Seahawk existing revolving facility is backed by nearly all of its assets: "The Revolving Credit Facility is secured by 15 of our rigs, including the Seahawk 2505, and substantially all of our other assets, including our accounts receivable, spare parts, and certain cash and cash equivalents" (Q3 10-Q). This facility contains several covenants:
The Revolving Credit Facility contains a number of covenants restricting, among other things... sales of assets... [it] also requires us to maintain certain minimum ratios with respect to our financial condition, including current assets to current liabilities, liquidation value of the collateralized rigs, tangible net worth, and adjusted earnings before interest, tax, depreciation and amortization and fixed charges (Q3 10-Q).
I do not know the complete and specific terms of the covenants, but each investor presentation contains a slide that provides some insight:
- Financial covenants
- Fixed charge coverage - 2.0x EBITDA; not applied when liquidity > $25m
- Minimum Net Worth of $320 million
- Minimum Working Capital Ratio - 1.2x
- Minimum Security Maintenance Ratio - 3.0x
Based on the above criteria, I believe it is possible that Seahawk is very close (if not currently) in breach of some conditions of its debt covenant. It is open to speculation whether this may jeopardize Seahawk's ability to draw down on the remaining $11.5m of the facility, accelerating Seahawk's decline.
Given Seahawk's dire financial position, its challenges in reaching near-term profitability (regulatory challenges, natural gas prices, excess rig capacity, etc), and the questionable value of its rigs given the dearth of private market buyers, I believe it is unreasonable to expect Seahawk to be able to raise a sufficient amount of debt to retire its existing facility and provide additional working capital on terms that will not significantly impair current equity holders.
The "Narrow Framing" of a Seahawk Liquidation
In the event Seahawk breaches its covenants and creditors seek to recoup their money, I believe shareholders will suffer losses. Several analyses have imputed a value for each rig, deducted liabilities, and arrived at a liquidation value. I believe this is a mistake. What is the liquidation value of one of Seahawk's rigs? $5m or so, many posit. That seems fair. What is the value of the 6th Seahawk rig sold at liquidation, in a market rife with overcapacity, where significant expenditure may be required before the rig can be used? That is a very different question.
Risks
A significant, sustained pickup in the market for shallow water rigs (i.e. regulatory constraints are relaxed, natural gas prices increase, etc) improves Seahawk's results to the point where liquidity constraints are relaxed.
Seahawk manages some type of workaround with Pride on the Tax Sharing Agreement (I believe that this is more likely with respect to an equity raise than a total sale of the firm). This may still be an adverse outcome for existing shareholders.
Catalyst
Near-term liquidity constraints.
Potential accelerants: breach of debt covenant, adverse ruling from the Hacienda tax case, adverse ruling on $14.5m Pride claim.