One of the hallmarks of a cyclical business is operating
leverage. When revenues explode, and your cost structure
remains relatively fixed, profitability kicks into overdrive.
When boom turns to bust, that leverage cuts just as hard in
the other direction, and losses pile up. Layering financial
leverage (i.e., debt) on top of this natural operating
leverage is often a recipe for disaster.
At the end of 2006, contract driller
Hercules Offshore 's (Nasdaq: HERO) long-term
debt totaled less than 20% of total capitalization. By the
end of 2008, this figure had run up beyond 50%. While less
spectacularly dumbthan the financial leverage employed by
Parker Drilling (NYSE: PKD) in past years,
this was still a big mistake.
If
Silgan Holdings (Nasdaq: SLGN) wants to run
its debt-to-cap up above 50%, that's fine by me. Given the
bottle-and-can maker's
steady, boring, beautifulbusiness, I know Silgan's good
for the interest payments, and isn't going to run afoul of
its loan covenants. An oil and gas driller has no business
running up this kind of debt load, especially when you're
talking about activity outside of the deepwater. At least out
there, where
Diamond Offshore (NYSE: DO) and
Pride International (NYSE: PDE) ply their
trade, five- to 10-year drilling engagements aren't uncommon
and can justify some amount of capital structure
rejiggering.
Other than a few fairly long-term engagements with the
likes of
Chevron (NYSE: CVX) in the Gulf of Mexico and
Murphy Oil (NYSE: MUR) in Malaysia, Hercules
lives pretty hand-to-mouth. When drilling activity dries up,
as it did in the third quarter, the driller's results are
startlingly bad. In the domestic offshore segment, operating
days fell 75% from the prior year, and revenue dropped 83%.
Inland barges fared even worse. International offshore
drilling held up pretty well, but overall company revenue was
roughly cut in half, and earnings from continuing operations
swung to a $32 million loss.
Hercules had over $950 million in total debt at the end of
the quarter. Catching what I believe is the tail end of a
monster junk bond rally, the firm recently sold $300
million of 2017 notes that were priced to yield 11%. This
will help pay down Hercules' term loan, thus buying the
company time to climb out of the hole it's drilled for itself
over the past few years.
If bidding activity continues to pick up in the Gulf of
Mexico, as it has since September, and the commodities
complex avoids another sharp downturn over the next two to
three years, Hercules could prove a rewarding speculation.
I'm not personally willing to take those odds, however.
Over 500
Motley Fool CAPSAll-Stars have rated Hercules Offshore to
outperform the market, so perhaps I'm missing the
liftboat here. What do
you think?
This article was originally published as
Is Hercules Ready to Dig Out of Its Debt Hole?on
Fool.com
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