As a younger investor, I am extremely interested in many of the smaller  companies because of their potential for extremely high returns.  Obviously these returns come with much higher risks, but for young investors it is generally more prudent to take these types of risks when you have your whole life ahead of you and you are not trying to save. Hercules Offshore (HERO: 6.63, +0.31 (+4.91%)) is a company that fits this description perfectly due to their outstanding fundamentals and growth prospects as well as their track record of success.

Background

Hercules Offshore is an offshore driller, a company that performs the drilling services in order to extract resources from the bottom of the ocean for other companies.  Hercules focuses on shallow water drilling projects for the most part, although they do have some deepwater projects.  Hercules is also the largest liftboat provider and inland barge driller in the entire world.  Below you can find a geographical breakdown of their areas of operation:

• U.S. Gulf of Mexico - 24 Jackups, 3 Submersibles, 45 Liftboats
• U.S. Gulf Coast - 27 Inland Barges
• Mexico - 2 Jackups, 1 Platform Rig
• Trinidad - 1 Jackup
• West Africa - 2 Jackups, 18 Liftboats
• Middle East - 3 Jackups, 2 Liftboats
• India - 2 Jackups
• Malaysia - 1 Jackup
• Total - 35 Jackups, 65 Liftboats, 27 Inland Barges, 3 Submersibles, 1 Platform Rig

As you can see Hercules is extremely diverse geographically while still having a heavy focus on domestic operations.  The exposure to West Africa, an area where we have seen a multitude of new deepwater discoveries, is extremely appealing.  Hercules’ business model is mostly focused on shallow water business when concerning exploration and production, but their servicing vessels can be utilized in deepwater projects.

Fundamentals

Hercules presents an extremely attractive play for value investors, and through the fundamentals it is easy to see that the stock price is extremely depressed.  I would heavily bet that valuations will not stay at these low levels for long into the future.  Whether this means appreciation of the stock price or deterioration of the current fundamentals I am not sure, but I would imagine there is a greater likelihood that it would be the former although it could be a combination of both options.  Some of these fundamentals below are so staggering that they seem to be unreal in the grand scheme of things.  Most times when you encounter numbers like these the company is either going out of business or will not trade at these depressed levels for any extended period of time.  The price to book value and cash per share are both very impressive:

• Market Capitalization: $530.39M
• Trailing P/E: 6.32x
• 2008E P/E: 5.85x
• 2009E P/E: 3.77x
• Price to Book: 0.32x
• Cash Per Share: $1.20
• EV/EBITBA: 4.44x
• Operating Margin: 18.52%
• Profit Margin: 7.87%

Growth Potential

Contrary to popular belief, Hercules’ business is not greatly affected by commodity prices in the short or intermediate run.  Because they are mostly serviced based they don’t have to only concern themselves with commodity prices.  Of course over the long run it is better for Hercules if crude oil and natural gas prices are higher, but temporary dips in these prices will not destroy their business.  Hercules signs contracts that can last up to a few years in length and because these contracts are binding barring a customer default the revenues and backlog are guaranteed.  Over the course of FY2009, Hercules internal projections expect the follow demand increases for jackup rigs:

• Central America: +2 Jackups
• South America: +3 Jackups
• North Sea/Western Europe: +6 Jackups
• Mediterranean/Black Sea: +1 Jackups
• West Africa: +6 Jackups
• Middle East: +19 Jackups
• Australia/New Zealand: +2 Jackups
• Worldwide Demand: +35 Jackups

Hercules will not be able to fill out anywhere close to all of this demand, and in a way it doesn’t matter if they do fill out any of this demand.  The key is that the supply and demand metrics of jackup supply will become tighter worldwide which will in turn drive up day rates.  Even if Hercules puts no new rigs out for use during 2009 they can still bring in higher revenues and profits from increasing day rates.

According to their most recent investor report on Hercules’ site, the company plans to have 3 jackup rigs and 1 liftboat back into operation that had no accretion towards revenues in Q2 2008.  Beyond this, Hercules should be able to expand their margins from the most current quarters financial results as they capture a large market share on the service side of their business dude to increasing demand going into the future.

Conclusion

Services stocks have been hammered this year, as shown by Hercules’ stock declining over 75% year to date.  These fundamental levels can’t last forever and through industry consolidation during the short term we will be able to again gain long term growth potential.  Hercules’ financial statements seem to be very solvent and bankruptcy does not seem like a likely scenario.  The dwindling supply of easily accessible oil on land will cause the future to be bright for service stocks, especially those companies focused in projects that do not require extremely high crude oil prices such as Hercules.

- Charles W. Petredis

Disclosure: None.