Description

 Seahawk Drilling (HAWK) $30.30 on 10-6-2009      Spinoff: August 24, 2009

Revolver- zero drawn, up to $36MM of availability only for Capex on existing rigs and 20% for the Mexico Tax Liability surety bonds.

Recommendation

We recommend a short of Seahawk Drilling (HAWK).  The company is facing terrible end market fundamentals as a result of being solely focused on the very high cost shallow water Gulf of Mexico offshore basin as well as many company specific issues and contingent liabilities that no sell-side analyst is discussing.  Despite the many issues discussed below, the stock is up over 40% since the spin. 

Description

HAWK was spun off from Pride International (PDE, $4.5BB market cap) on August 25^th; with Pride shareholders receiving 1/15 share of new HAWK.  HAWK leases and operates solely in the shallow water Gulf of Mexico for PEMEX on a contractual basis and a day rate basis for U.S. customers ( small independents). The shallow water Gulf of Mexico is an extremely mature natural gas production area and the most profitable areas have already been drilled. The decrease in demand for rigs has increased competitiveness in bidding contracts to supply rigs.

Why is it a short?

• 1) Fundamentals: The shallow water GOM is among the highest cost offshore basins in North America. Independent operators we've talked to said they need $6-7 to justify drilling new prospects in the gulf and this will be harder to achieve given the plethora of new shale plays with much lower cash costs. Spot prices remain well below economic levels and the forward strip through December 2010 remains below levels that would justify GOM drilling programs. HAWK's rigs are operating at a 30% utilization rate today on its way to 15-20% in November as its PEMEX rigs roll off contract.
• 2) Mexican Tax Liabilities: The Mexican government states that HAWK owes $120MM in back taxes from 2001-2004 and potentially another $150MM from 2005-2007. To put this in context, the entire market capitalization of $368MM and $270MM in Tax liabilities.
• 3) Imminent Dilutive Capital Raise: With respect to the 2001-2004 Mexican tax issue, PDE has posted a $50MM surety bond. HAWK must post a $70MM surety bond by the end of 2009. HAWK has already exhausted 15 of their 20 rigs as collateral for their secured revolving credit facility, and therefore will need to cash collateralize the remaining of the surety bond. In addition, HAWK will likely have to post a $150MM surety bond for the 2005-2007 Mexican tax claims when it is finalized in 2010. Given the lack of remaining collateral, the only way HAWK will be able to post bonding is through an equity raise. Management has indicated that their Mexican subsidiary will have to file bankruptcy if they lose their Mexican tax lawsuit. The week of September 21^st, HERO announced a secondary offering of 17.5M shares at $5 per share to shore up their balance sheet for corporate purposes after the bank eased their covenants since this summer.
• 4) Bad Assets: There is a good reason the smartest money in the space is trying to divest their GOM mat jackups (PDE divested, Seadrill has discussed spinning theirs off, RDC and ESV are cold stacking or moving to different geographies). Unlike RDC and ESV, HAWK's assets are old (avg age 29yrs) and can't work in other basins. The new finds in the GOM are in the deep water where mat jackups can't operate due to water depth. Pride kept their deep water and IDC GOM rigs which could operate at these depths.
• 5) Customer Concentration: Historically 60% of sales and roughly 80-90% of EBITDA comes from PEMEX. In Q2 PEMEX asked the Mexican government to increase their budget and was denied, and has recently released 3-4 rig contracts from both HERO and HAWK. HAWK's mgmt has stated that they expect to lose one of the four current contracts with PEMEX. Since the latest "Fleet Status Report", Seahawk is still in negotiations with PEMEX over the third working rig. According to HAWK, money is tight for PEMEX but PEMEX wants the rig to stay in Mexico. However, HAWK tends to leave out that PEMEX has to pay the multimillion dollar transportation cost to bring the Seahawk 2505 back to the US. Instead HAWK is paying 5 times the cash cost to idle the rig rather than forcing PEMEX to return a rig they don't intend to use. Furthermore, HERO has seen 40% sequential declines in day rates in newly renegotiated PEMEX contracts and HAWK is expected to follow suit. The bigger concern is that PEMEX has made a decisive move away from mat jackups to focus on Independent Leg Cantilever (IDC) rigs because of the mat jackups capabilities and the accident on the Usmacinta that killed 18 workers. Coincidentally NE and RDC have both stated that PEMEX has tendered 7 IDC rigs while 7 mat jackupsare rolling off contract. We think HAWK could lose all but one of their rigs contracted with PEMEX. The small independent contractors that work in the US GOM don't have the ability to hedge (production is sold at spot prices), and are witnessing less access to capital markets. Therefore, natural gas price volatility must stabilize before US GOM contractors will start production. Favorability has been observed from the small independents to derisk by being more involved with the onshore shale plays that have easier access to capital.
• 6) Pride Wyoming Liability: In addition HAWK may be responsible for collateral damage from when their Pride Wyoming jack up hit other infrastructure during hurricane Ike. We believe it is uncertain as to whether PDE's insurance will cover the losses associated with the damage, including loss of revenue. The owners have claimed damages of $148MM.
• 7) Bribery: The Company is subject to bribery accusations with the Mexican government. Although PDE has agreed to indemnify HAWK for its US FCPA penalties over $1MM, HAWK is fully liable for any fines levied on them by the Mexican government.
• 8) Irrational Competition: HAWK is primarily competing against Hercules (HERO) in the GOM. HERO is a levered company and has a $4k lower operating cost structure per rig per day than HAWK with virtually the same type of "commodity rigs". In order to stay solvent, HERO has bid very aggressively to levels slightly above their cash costs. HAWK has said HERO has underbid them by up to $10k/day and are stealing market share. HAWK has recently alluded to having to start bidding more aggressively to hold its market share. We believe this will be at or below their cash breakeven and much bigger losses based on all in costs.
• 9) Hurricane Risk: HAWK decided to forgo wind storm insurance citing high insurance premiums. We believe management is taking an unconscionable business risk in terms of self insuring a GOM fleet.
• 10) Management: Management is delusional at best with their recent statements that $4.50 gas prices would stimulate significant shallow water GOM drilling. We also question management's judgment given the FCPA violations, Mexico tax issues and recent decision to forgo insurance.
• 11) FCF Burn Rate: HAWK has guided to burning $10MM- $20MM if they have 3 rigs working in Mexico and 3 rigs working in the US GOM for the remainder of 2009. Currently they have 2 in Mexico and three in the US. They also stated at the Barclay's Energy Conference that they have $38-$42MM in one time charges coming due in 2H2009.
• 12) Sell Side Revisions: After Q2 earnings call, the sell-side analyst at Barclays revised the EPS for 2009 and 2010 to a -$2.95 from -$2.60 and to -$2.60 from -$2.35 respectively. Sell-side expectations are for 6 working rigs, no issues with contingent liabilities, very little pricing pressure, and no regards to the collateral backing the surety bonds due in 2009.

 Worth

 In a perpetual depressed gas price scenario, only 3 of the company's rigs would operate (15% utilization rate). In this case the company would be earning -$8.12EPS. NAV would be roughly $20/share based on the price assigned by Pride International's Insurance reimbursement value for the Pride Wyoming after being destroyed, compared to a rig sales consultant's valuation over the aged commodity rig class.

 Value

Fair Estimate: Represents a normalized GOM Jack-up rig market

NAV Fully Diluted Share                                            $22.82

Price (30.30)/NAV                                                   132.8%

 NAV Discount: Represents a depressed GOM Jack-up rig market.

NAV Fully Diluted Shares                                          $18.71

Price (30.30)/NAV                                                  162.0%

Catalyst

We have several different ways to win:

• 1. The company receives a negative judgment with respect to one of the contingent liabilities
• a. FCPA
• b. Lawsuits over damages from Pride Wyoming
• c. Mexican tax liabilities
• 2. Depressed natural gas prices keep utilization rates and day rates at today's levels causing wall street to cut estimates
• 3. Pricing pressure from competitors
• 4. PEMEX moves to IDCs in November

Risks

The market overlooks near and medium term end market weakness and values the company based on a major recovery in natural gas drilling in the GOM.  We believe this is unlikely given all the slated shale capacity.

Natural Gas

Current spot prices of $3.6/MMBtu are realizing pressure from net injections approaching storage capacity that is estimated at 3.5-3.9 Tcf. Natural gas spot prices have increased in the past few weeks, but the forward curves (which are what matter) haven't been influenced. During the week ending Oct 1, implied net injections were 64Bcf into underground storage. Working gas in underground storage was estimated at 3,589 billion cubic feet, which is 481Bcf above the 5 year average.

 The arduous task of locating the natural gas in the Gulf of Mexico has created a higher risk factor correlated toward the nat gas price to necessitate drilling. Let alone, Finding and Development costs are $4, and Cash Costs $2. This dictates a gas price of $6. Southwestern energy has assigned values as high as $8/MMBtu to maintain drilling for natural gas in the Gulf of Mexico.

Valuation

 Comps

                                                      Seahawk           ENSCO            Rowan           Hercules

Catalyst

Catalysts:

* Dilutive Capital Raise

* Mexican Tax Liabilities

* Pride Wyoming Liability

* PEMEX Moves to IDC rigs

* Deteriorating Fundamentals & Bad Assets

* FCPA fines

* Hurricane Risk

* Sellside analysts waking up