Attached files
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8-K - FORM 8-K - HERCULES OFFSHORE, INC. | h83106e8vk.htm |
EX-23.1 - EX-23.1 - HERCULES OFFSHORE, INC. | h83106exv23w1.htm |
EX-99.1 - EX-99.1 - HERCULES OFFSHORE, INC. | h83106exv99w1.htm |
Exhibit 99.2
As
further discussed in Note 1 to our unaudited consolidated financial statements, in May 2011, we
completed the sale of substantially all of Delta Towings assets and certain liabilities. As a
result of this sale, we have recast certain information included in
our unaudited consolidated financial
statements as of and for the three months ended March 31, 2011.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
March 31, | December 31, | |||||||
2011 | 2010 | |||||||
(Unaudited) | ||||||||
ASSETS |
||||||||
Current Assets: |
||||||||
Cash and Cash Equivalents |
$ | 162,966 | $ | 136,666 | ||||
Restricted Cash |
11,129 | 11,128 | ||||||
Accounts Receivable, Net of Allowance for Doubtful Accounts of $22,228 and
$29,798 as of March 31, 2011 and December 31, 2010, Respectively |
157,684 | 143,796 | ||||||
Prepaids |
8,033 | 17,142 | ||||||
Current Deferred Tax Asset |
8,488 | 8,488 | ||||||
Other |
8,311 | 11,794 | ||||||
356,611 | 329,014 | |||||||
Property and Equipment, Net |
1,603,521 | 1,634,542 | ||||||
Equity Investment |
18,254 | | ||||||
Other Assets, Net |
38,304 | 31,753 | ||||||
$ | 2,016,690 | $ | 1,995,309 | |||||
LIABILITIES AND STOCKHOLDERS EQUITY |
||||||||
Current Liabilities: |
||||||||
Short-term Debt and Current Portion of Long-term Debt |
$ | 4,924 | $ | 4,924 | ||||
Insurance Notes Payable |
736 | 5,984 | ||||||
Accounts Payable |
60,176 | 52,279 | ||||||
Accrued Liabilities |
62,071 | 59,861 | ||||||
Interest Payable |
24,003 | 6,974 | ||||||
Taxes Payable |
9,559 | | ||||||
Other Current Liabilities |
19,520 | 16,716 | ||||||
180,989 | 146,738 | |||||||
Long-term Debt, Net of Current Portion |
854,255 | 853,166 | ||||||
Other Liabilities |
24,117 | 6,716 | ||||||
Deferred Income Taxes |
118,294 | 135,557 | ||||||
Commitments and Contingencies |
||||||||
Stockholders Equity: |
||||||||
Common Stock, $0.01 Par Value; 200,000 Shares Authorized; 116,738 and 116,336 Shares
Issued, Respectively; 115,106 and 114,784 Shares Outstanding, Respectively |
1,167 | 1,163 | ||||||
Capital in Excess of Par Value |
1,925,115 | 1,924,659 | ||||||
Treasury Stock, at Cost, 1,632 Shares and 1,552 Shares, Respectively |
(50,671 | ) | (50,333 | ) | ||||
Retained Deficit |
(1,036,576 | ) | (1,022,357 | ) | ||||
839,035 | 853,132 | |||||||
$ | 2,016,690 | $ | 1,995,309 | |||||
The accompanying notes are an integral part of these financial statements.
1
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(As Adjusted (Note 1))
(In thousands, except per share data)
(Unaudited)
CONSOLIDATED STATEMENTS OF OPERATIONS
(As Adjusted (Note 1))
(In thousands, except per share data)
(Unaudited)
Three Months Ended March 31, | ||||||||
2011 | 2010 | |||||||
Revenue |
$ | 159,378 | $ | 144,560 | ||||
Costs and Expenses: |
||||||||
Operating Expenses |
106,381 | 103,364 | ||||||
Depreciation and Amortization |
41,793 | 48,664 | ||||||
General and Administrative |
12,826 | 11,935 | ||||||
161,000 | 163,963 | |||||||
Operating Loss |
(1,622 | ) | (19,403 | ) | ||||
Other Income (Expense): |
||||||||
Interest Expense |
(18,506 | ) | (21,065 | ) | ||||
Expense of Credit Agreement Fees |
(455 | ) | | |||||
Equity in Losses of Equity Investment |
(55 | ) | | |||||
Other, Net |
316 | (16 | ) | |||||
Loss Before Income Taxes |
(20,322 | ) | (40,484 | ) | ||||
Income Tax Benefit |
6,679 | 25,493 | ||||||
Loss from Continuing Operations |
(13,643 | ) | (14,991 | ) | ||||
Loss from
Discontinued Operations,
Net of Taxes |
(576 | ) | (965 | ) | ||||
Net Loss |
$ | (14,219 | ) | $ | (15,956 | ) | ||
Basic Loss Per Share: |
||||||||
Loss from Continuing Operations |
$ | (0.12 | ) | $ | (0.13 | ) | ||
Loss from
Discontinued Operations |
| (0.01 | ) | |||||
Net Loss |
$ | (0.12 | ) | $ | (0.14 | ) | ||
Diluted Loss Per Share: |
||||||||
Loss from Continuing Operations |
$ | (0.12 | ) | $ | (0.13 | ) | ||
Loss from
Discontinued Operations |
| (0.01 | ) | |||||
Net Loss |
$ | (0.12 | ) | $ | (0.14 | ) | ||
Weighted Average Shares Outstanding: |
||||||||
Basic |
114,906 | 114,696 | ||||||
Diluted |
114,906 | 114,696 |
The accompanying notes are an integral part of these financial statements.
2
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Three Months Ended March 31, | ||||||||
2011 | 2010 | |||||||
Cash Flows from Operating Activities: |
||||||||
Net Loss |
$ | (14,219 | ) | $ | (15,956 | ) | ||
Adjustments to Reconcile Net Loss to Net Cash Provided by Operating Activities: |
||||||||
Depreciation and Amortization |
42,911 | 50,254 | ||||||
Stock-Based Compensation Expense |
1,158 | 156 | ||||||
Deferred Income Taxes |
(18,027 | ) | (22,657 | ) | ||||
Benefit for Doubtful Accounts Receivable |
(5,021 | ) | (1,472 | ) | ||||
Amortization of Deferred Financing Fees |
874 | 873 | ||||||
Amortization of Original Issue Discount |
1,089 | 1,002 | ||||||
Equity in Losses of Equity Investment |
55 | | ||||||
Non-Cash (Gain) Loss on Derivatives |
(155 | ) | 3,561 | |||||
Gain on Disposal of Assets |
(702 | ) | (3,013 | ) | ||||
Expense of Credit Agreement Fees |
455 | | ||||||
Excess Tax Benefit from Stock-Based Arrangements |
(117 | ) | (374 | ) | ||||
(Increase) Decrease in Operating Assets - |
||||||||
Accounts Receivable |
(8,867 | ) | (1,062 | ) | ||||
Prepaid Expenses and Other |
21,673 | 10,397 | ||||||
Increase (Decrease) in Operating Liabilities - |
||||||||
Accounts Payable |
571 | (4,077 | ) | |||||
Insurance Notes Payable |
(5,248 | ) | (4,724 | ) | ||||
Other Current Liabilities |
21,221 | (7,733 | ) | |||||
Other Liabilities |
11,461 | (4,843 | ) | |||||
Net Cash Provided by Operating Activities |
49,112 | 332 | ||||||
Cash Flows from Investing Activities: |
||||||||
Additions of Property and Equipment |
(10,277 | ) | (4,546 | ) | ||||
Deferred Drydocking Expenditures |
(4,124 | ) | (4,396 | ) | ||||
Cash Paid for Equity Investment |
(10,000 | ) | | |||||
Proceeds from Sale of Assets, Net |
3,421 | 3,616 | ||||||
Increase in Restricted Cash |
(1 | ) | (3,370 | ) | ||||
Net Cash Used in Investing Activities |
(20,981 | ) | (8,696 | ) | ||||
Cash Flows from Financing Activities: |
||||||||
Long-term Debt Repayments |
| (2,050 | ) | |||||
Excess Tax Benefit from Stock-Based Arrangements |
117 | 374 | ||||||
Payment of Debt Issuance Costs |
(2,109 | ) | | |||||
Other |
161 | 9 | ||||||
Net Cash Used in Financing Activities |
(1,831 | ) | (1,667 | ) | ||||
Net Increase (Decrease) in Cash and Cash Equivalents |
26,300 | (10,031 | ) | |||||
Cash and Cash Equivalents at Beginning of Period |
136,666 | 140,828 | ||||||
Cash and Cash Equivalents at End of Period |
$ | 162,966 | $ | 130,797 | ||||
The accompanying notes are an integral part of these financial statements.
3
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
(Unaudited)
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
(Unaudited)
Three Months Ended March 31, | ||||||||
2011 | 2010 | |||||||
Net Loss |
$ | (14,219 | ) | $ | (15,956 | ) | ||
Other Comprehensive Income, Net of Taxes: |
||||||||
Changes Related to Hedge Transactions |
| 2,079 | ||||||
Comprehensive Loss |
$ | (14,219 | ) | $ | (13,877 | ) | ||
The accompanying notes are an integral part of these financial statements.
4
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
UNAUDITED
(As Adjusted (Note 1))
1. General
Hercules Offshore, Inc., a Delaware corporation, and its majority owned subsidiaries (the
Company) provide shallow-water drilling and marine services to the oil and natural gas
exploration and production industry globally through its Domestic Offshore, International Offshore,
Inland, Domestic Liftboats, International Liftboats and Delta Towing segments (See Note 12). At
March 31, 2011, the Company owned a fleet of 30 jackup rigs, 17 barge rigs, three submersible rigs,
one platform rig, a fleet of marine support vessels operated through Delta Towing, a wholly owned
subsidiary, and 60 liftboat vessels and operated an additional five liftboat vessels owned by a
third party. The Companys diverse fleet is capable of providing services such as oil and gas
exploration and development drilling, well service, platform inspection, maintenance and
decommissioning operations in several key shallow water provinces around the world.
In February 2011, the Company entered into an asset purchase agreement (the Asset Purchase
Agreement) with Seahawk Drilling, Inc. and certain of its subsidiaries (Seahawk), pursuant to
which Seahawk agreed to sell the Company 20 jackup rigs and related assets, accounts receivable,
cash and certain liabilities. On April 27, 2011, the Company completed the Seahawk asset purchase
(See Note 4). Including the assets acquired in the Seahawk transaction, the Company owns a fleet of
50 jackup rigs, 17 barge rigs, three submersible rigs, one platform rig, a fleet of marine support
vessels operated through Delta Towing, a wholly owned subsidiary, and 60 liftboat vessels and
operated an additional five liftboat vessels owned by a third party.
The consolidated financial statements of the Company are unaudited; however, they include all
adjustments of a normal recurring nature which, in the opinion of management, are necessary to
present fairly the Companys Consolidated Balance Sheet at March 31, 2011 and the Companys
Consolidated Statements of Operations, Consolidated Statements of Cash Flows and Consolidated
Statements of Comprehensive Loss for the three months ended March 31, 2011 and 2010. Although the
Company believes the disclosures in these financial statements are adequate to make the interim
information presented not misleading, certain information relating to the Companys organization
and footnote disclosures normally included in financial statements prepared in accordance with U.S.
generally accepted accounting principles have been condensed or omitted in this Form 10-Q pursuant
to Securities and Exchange Commission rules and regulations. These financial statements should be
read in conjunction with the audited consolidated financial statements for the year ended December
31, 2010 and the notes thereto included in the Companys Annual Report on Form 10-K. The results of
operations for the three months ended March 31, 2011 are not necessarily indicative of the results
expected for the full year.
The preparation of financial statements in conformity with U.S. generally accepted accounting
principles requires management to make estimates and assumptions that affect the reported amounts
of assets and liabilities and disclosures of contingent assets and liabilities at the date of the
financial statements, as well as the reported amounts of revenue and expenses during the reporting
period. On an ongoing basis, the Company evaluates its estimates, including those related to bad
debts, investments, derivatives, property and equipment, income taxes, insurance,
percentage-of-completion, employment benefits and contingent liabilities. The Company bases its
estimates on historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from other sources.
Actual results could differ from those estimates.
Recast of Financial Information for Discontinued Operations
In May 2011, the Company completed the sale of substantially all of Delta Towings assets and
certain liabilities for aggregate consideration of $30 million in cash (the Delta Towing Sale)
and recognized a loss on the sale of approximately $13 million.
The Company retained the working capital of the Delta Towing business, which was
valued at approximately $6 million at the date of sale. As a result of the Delta Towing
Sale, we have recast certain information to classify the results of operations of the Delta Towing
assets as discontinued operations, including the Consolidated Statements of Operations and related
information in Notes 5, 8 and 12 for all periods presented.
Investigations
On April 4, 2011, the Company received a subpoena issued by the Securities and Exchange
Commission (SEC) requesting the delivery of certain documents to the SEC in connection with its
investigation into possible violations of the securities laws, including possible violations of the
Foreign Corrupt Practices Act (FCPA) in certain international jurisdictions where the Company
conducts operations. The Company was also notified by the Department of Justice (DOJ) on April 5,
2011, that certain of the Companys activities are under review by the DOJ.
The Company, through the Audit Committee of the Board of Directors, has engaged an outside law
firm with significant experience in FCPA-related matters to conduct an internal review, and intends
to cooperate with the SEC and DOJ in their investigations. At this time, it is not possible to
predict the outcome of the investigations, the expenses the Company will incur
5
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
associated with these matters, or the impact on the price of the Companys common stock or other
securities as a result of these investigations.
Investment
In January 2011, the Company paid $10 million to purchase 5.0 million shares, an initial
investment in approximately eight percent of the total outstanding equity of a new entity
incorporated in Luxembourg, Discovery Offshore S.A. (Discovery Offshore), which investment was
used by Discovery Offshore towards funding the down payments on two new-build ultra high
specification harsh environment jackup drilling rigs (collectively the Rigs or individually
Rig) (See Note 3). The Rigs, Keppel FELS Super A design, are being constructed by Keppel FELS
in its Singapore shipyard and have a maximum water depth rating of 400 feet, two million pound hook
load capacity and are capable of drilling up to 35,000 feet deep. The two Rigs are expected to be
delivered in the second and fourth quarter of 2013, respectively. Discovery Offshore also holds
options to purchase two additional rigs of the same specifications, which must be exercised by the
third and fourth quarter of 2011, with delivery dates expected in the second and fourth quarter of
2014, respectively.
The Company also executed a construction management agreement (the Construction Management
Agreement) and a services agreement (the Services Agreement) with Discovery Offshore with
respect to each of the Rigs. Under the Construction Management Agreements, the Company will plan,
supervise and manage the construction and commissioning of the Rigs in exchange for a fixed fee of
$7.0 million per Rig, which the Company received in February 2011. Pursuant to the terms of the
Services Agreements, the Company will market, manage, crew and operate the Rigs and any other rigs
that Discovery Offshore subsequently acquires or controls, in exchange for a fixed daily fee of
$6,000 per Rig plus five percent of Rig-based EBITDA (EBITDA excluding SG&A expense) generated per
day per Rig, which commences once the Rigs are completed and operating. Under the Services
Agreements, Discovery Offshore will be responsible for operational and capital expenses for the
Rigs. The Company is entitled to a minimum fee of $5 million per Rig in the event Discovery
Offshore terminates a Services Agreement in the absence of a breach of contract by Hercules
Offshore.
In addition to the $10 million investment, the Company received 500,000 additional shares
worth $1.0 million to cover its costs incurred and efforts expended in forming Discovery Offshore.
The Company was issued warrants to purchase up to 5.0 million additional shares of Discovery
Offshore stock at a strike price equivalent to $2.00 which is exercisable in the event that the
Discovery Offshore stock price reaches an average equal to or higher than 23 Norwegian Kroner per
share, which approximated $4.00 per share as of March 31, 2011, for 30 consecutive trading days.
The warrants were issued to additionally compensate the Company for its costs incurred and efforts
expended in forming Discovery Offshore. The warrants are being accounted for as a derivative
instrument (See Notes 7 and 8). The initial fair value of the warrants and the 500,000 additional
shares have been recorded to deferred revenue to be amortized over 30 years, the useful life of the
Rigs. The Company has no other financial obligations or commitments with respect to the Rigs or its
ownership in Discovery Offshore. Two of the Companys officers are on the Board of Directors of
Discovery Offshore.
Other Agreements
In January 2011, the Company entered into an agreement with China Oilfield Services Limited
(COSL) whereby it will market and operate a Friede & Goldman JU2000E jackup drilling rig with a
maximum water depth of 400 feet. The agreement is limited to a specified opportunity in Angola.
In March, 2011, at the Companys request, the parties agreed to terminate, without the payment
of a termination fee, the management agreement with First Energy Bank B.S.C. (MENAdrill) with
respect to Hull 110.
Revenue Recognition
Revenue generated from the Companys contracts is recognized as services are performed, as
long as collectability is reasonably assured. For certain contracts, the Company may receive
lump-sum fees for the mobilization of equipment and personnel. Mobilization fees received and costs
incurred to mobilize a rig from one market to another under contracts longer than ninety days are
recognized as services are performed over the term of the related drilling contract. Amounts
related to deferred revenue, including
revenue deferred related to the Companys construction management agreements with Discovery
Offshore as well as the warrants and 500,000 additional shares received from Discovery Offshore,
and deferred expenses are summarized below (in thousands):
6
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
Three Months Ended March 31, | ||||||||
2011 | 2010 | |||||||
Revenue deferred |
$ | 24,533 | $ | 600 | ||||
Expense deferred |
1,349 | | ||||||
Deferred Revenue recognized |
5,232 | 4,927 | ||||||
Deferred Expense recognized |
586 | 1,001 |
For certain contracts, the Company may receive fees from its customers for capital
improvements to its rigs. Such fees are deferred and recognized as services are performed over the
term of the related contract. The Company capitalizes such capital improvements and depreciates
them over the useful life of the asset.
The balances related to the Companys Deferred Costs and Deferred Revenue are as follows (in
thousands):
As of | As of | |||||||||
Balance Sheet | March 31, | December 31, | ||||||||
Classification | 2011 | 2010 | ||||||||
Assets: |
||||||||||
Deferred Expense-Current Portion |
Other | $ | 2,141 | $ | 1,824 | |||||
Deferred Expense-Non-Current Portion |
Other Assets, Net | 3,618 | 3,172 | |||||||
Liabilities: |
||||||||||
Deferred Revenue-Current Portion |
Other Current Liabilities | 15,002 | 12,628 | |||||||
Deferred Revenue-Non-Current Portion |
Other Liabilities | 16,927 | |
Percentage-of-Completion
The Company is using the percentage-of-completion method of accounting for its revenue and
related costs associated with its construction management agreements with Discovery Offshore,
combining the construction management agreements, based on a cost-to-cost method. Any revisions in
revenue, cost or the progress towards completion, will be treated as a change in accounting
estimate and will be accounted for using the cumulative catch-up method. As of March 31, 2011,
$14.0 million has been recorded as a deferred revenue liability; however, no deferred cost asset
has been recorded. There was no revenue or cost recognized during the three months ended March,
31, 2011 under the percentage-of-completion method of accounting as there were no activities
associated with the performance of contract obligations during the current quarter.
Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable are stated at the historical carrying amount net of write-offs and
allowance for doubtful accounts. Management of the Company monitors the accounts receivable from
its customers for any collectability issues. An allowance for doubtful accounts is established
based on reviews of individual customer accounts, recent loss experience, current economic
conditions, and other pertinent factors. Accounts deemed uncollectible are charged to the
allowance. The Company had an allowance of $22.2 million and $29.8 million at March 31, 2011 and
December 31, 2010, respectively. The change in the Companys allowance during the three months
ended March 31, 2011 related primarily to a payment received from a customer in its International
Offshore segment.
Other Assets
Other assets consist of drydocking costs for marine vessels, a derivative asset, other
intangible assets, deferred income taxes, deferred operating expenses, financing fees, investments
and deposits. Drydocking costs are capitalized at cost and amortized on the straight-line method
over a period of 12 months. Drydocking costs, net of accumulated amortization, at March 31, 2011
and December 31, 2010, were $6.4 million and $5.9 million, respectively. Amortization expense for
drydocking costs was $3.7 million and $4.2 million for the three months ended March 31, 2011 and
2010, respectively.
Financing fees are deferred and amortized over the life of the applicable debt instrument.
However, in the event of an early repayment of debt or certain debt amendments, the related
unamortized deferred financing fees are expensed in connection with the repayment or amendment (See
Note 6). Unamortized deferred financing fees at March 31, 2011 and December 31, 2010 were $12.2
million and $11.4 million, respectively. Amortization expense for financing fees was $0.9 million
for both the three months ended March 31, 2011 and 2010, and is included in Interest Expense on the
Consolidated Statements of Operations.
7
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand, demand deposits with banks and all highly
liquid investments with original maturities of three months or less.
Restricted Cash
At both March 31, 2011 and December 31, 2010, the Company had restricted cash of $11.1 million
to support surety bonds related to the Companys Mexico and U.S. operations.
2. Earnings Per Share
The Company calculates basic earnings per share by dividing net income by the weighted average
number of shares outstanding. Diluted earnings per share is computed by dividing net income by the
weighted average number of shares outstanding during the period as adjusted for the dilutive effect
of the Companys stock option and restricted stock awards. The effect of stock option and
restricted stock awards is not included in the computation for periods in which a net loss occurs,
because to do so would be anti-dilutive. Stock equivalents of 6,813,234 and 5,384,189 were
anti-dilutive and are excluded from the calculation of the dilutive effect of stock equivalents for
the diluted earnings per share calculations for the three months ended March 31, 2011 and 2010,
respectively. There were no stock equivalents to exclude from the calculation of the dilutive
effect of stock equivalents for the diluted earnings per share calculations for the three months
ended March 31, 2011 and 2010 related to the assumed conversion of the 3.375% Convertible Senior
Notes under the if-converted method as there was no excess of conversion value over face value in
either of these periods.
3. Equity Investment
The Companys total equity investment in Discovery Offshore was $18.3 million, or 13% as of
March 31, 2011, which includes the initial cash investment of $10.0 million, additional equity
interest of $1.0 million related to 500,000 Discovery Offshore shares awarded to the Company for
reimbursement of costs incurred and efforts expended in forming Discovery Offshore, additional
purchases of Discovery Offshore shares on the open market totalling $7.3 million or 3,203,700
shares (amount was not cash settled until April 2011) as well as the Companys proportionate share
of Discovery Offshores losses. This investment is being accounted for using the equity method of
accounting as the Company has the ability to exert significant influence, but not control, over
operating and financial policies. The Company has warrants issued from Discovery Offshore that, if
exercised, would be recorded as an increase in the Companys equity investment in Discovery
Offshore (See Notes 1, 7, 8 and 10).
4. Asset Purchase
On April 27, 2011, the Company completed its acquisition of 20 jackup rigs and related assets,
accounts receivable, cash and certain liabilities from Seahawk for total consideration of
approximately $151.8 million consisting of $25.0 million of cash and 22.3 million Hercules common
shares. The fair value of the shares issued was determined using the closing price of the Companys
stock of $5.68 on April 27, 2011.
5. Dispositions and Discontinued Operations
In November 2010, the Company entered into an agreement to sell its retired jackups Hercules
190 and Hercules 254 for a total of $4.0 million for both jackups, which is expected to close in
the second quarter of 2011. In March 2011, the Company entered into an agreement to sell its
submersible rig Hercules 78 for $1.8 million, which is expected to close in the second quarter of
2011. The financial information for Hercules 190, Hercules 254 and Hercules 78 has been reported as
part of the Domestic Offshore segment.
In April 2011, the Company entered into an agreement to sell its jackup Hercules 152 for a
purchase price of $5.0 million.
The Company completed the sale of 3 barges in March 2010 for total gross proceeds of $2.2
million, resulting in a gain of $1.8 million.
In May 2011, the Company sold substantially all of the assets and certain liabilities of its
Delta Towing segment (See Note 1). The results of operations of the Delta Towing segment are
reflected in the Consolidated Statements of Operations for the three months ended March 31, 2011
and 2010 as discontinued operations.
Interest charges have been allocated to the discontinued operations of the Delta Towing
segment in accordance with FASB Codification Topic 205-20, Discontinued Operations. The interest
was allocated based on a pro rata calculation of the net Delta
8
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
Towing assets sold to the Companys
consolidated net assets. Interest allocated to discontinued operations was $0.5 million and $0.7
million for the three months ended March 31, 2011 and 2010, respectively.
Operating results of the Delta Towing segment were as follows (in thousands):
Three Months Ended March 31, | ||||||||
2011 | 2010 | |||||||
Revenue |
$ | 6,868 | $ | 6,289 | ||||
Loss Before Income Taxes |
$ | (964 | ) | $ | (1,613 | ) | ||
Income Tax Benefit |
388 | 648 | ||||||
Loss from Discontinued Operations, Net of Taxes |
$ | (576 | ) | $ | (965 | ) | ||
6. Debt
Debt is comprised of the following (in thousands):
March 31, | December 31, | |||||||
2011 | 2010 | |||||||
Term Loan Facility, due July 2013 |
$ | 475,156 | $ | 475,156 | ||||
10.5% Senior Secured Notes, due October 2017 |
293,113 | 292,935 | ||||||
3.375% Convertible Senior Notes, due June 2038 |
87,399 | 86,488 | ||||||
7.375% Senior Notes, due April 2018 |
3,511 | 3,511 | ||||||
Total Debt |
859,179 | 858,090 | ||||||
Less Short-term Debt and Current Portion of
Long-term Debt |
4,924 | 4,924 | ||||||
Total Long-term Debt, Net of Current Portion |
$ | 854,255 | $ | 853,166 | ||||
Senior secured Credit Agreement
At December 31, 2010, the Company had outstanding a $650.2 million credit facility, consisting
of a $475.2 million term loan and a $175.0 million revolving credit facility which is governed by
the credit agreement (Credit Agreement), as amended.
Prior to the March 2011 Credit Amendment, the interest rates on borrowings under the Credit
Facility were 4.00% plus LIBOR for Eurodollar Loans and 3.00% plus the Alternate Base Rate for ABR
Loans, based on the principal amount of the term loans outstanding during the period. A minimum
LIBOR rate of 2.00% for Eurodollar Loans, or a minimum base rate of 3.00% with respect to ABR
Loans, apply to all borrowings under the Credit Facility. The commitment fee on the revolving
credit facility was 1.00% and the letter of credit fee with respect to the undrawn amount of each
letter of credit issued under the revolving credit facility was 4.00% per annum.
The availability under the $175.0 million revolving credit facility must be used for working
capital, capital expenditures and other general corporate purposes and cannot be used to prepay the
term loan. The Company is required to maintain a minimum level of liquidity, measured as the amount
of unrestricted cash and cash equivalents on hand and availability under the revolving credit
facility, of (i) $75.0 million during calendar year 2011 and (ii) $50.0 million thereafter. As of
March 31, 2011, as calculated pursuant to the
Credit Agreement, the Companys total liquidity was $290.8 million.
In addition, the Company is required to maintain a minimum fixed charge coverage ratio
according to the following schedule:
Fixed Charge | ||||||||||||
Period | Coverage Ratio | |||||||||||
July 1, 2009 |
| December 31, 2011 | 1.00 to 1.00 | |||||||||
January 1, 2012 |
| March 31, 2012 | 1.05 to 1.00 | |||||||||
April 1, 2012 |
| June 30, 2012 | 1.10 to 1.00 | |||||||||
July 1, 2012 and thereafter |
1.15 to 1.00 |
9
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
- | The consolidated fixed charge coverage ratio for any test period is defined as the sum of consolidated EBITDA for the test period plus an amount that may be added for the purpose of calculating the ratio for such test period, not to exceed $130.0 million in total during the term of the credit facility, to consolidated fixed charges for the test period adjusted by an amount not to exceed $110.0 million during the term of the credit facility to be deducted from capital expenditures, all as defined in the Credit Agreement. As of March 31, 2011, the Companys fixed charge coverage ratio was 1.76 to 1.00. |
| In addition, the Company is required to make mandatory prepayments of debt outstanding under the Credit Agreement with 50% of excess cash flow as defined in the Credit Agreement for the fiscal years ending December 31, 2011 and 2012, and with proceeds from: |
- | unsecured debt issuances, with the exception of refinancing; | ||
- | secured debt issuances; | ||
- | casualty events not used to repair damaged property; | ||
- | sales of assets in excess of $25 million annually; and | ||
- | unless the Company has achieved a specified leverage ratio, 50% of proceeds from equity issuances, excluding those for permitted acquisitions or to meet the minimum liquidity requirements. |
March 2011 Credit Amendment
On March 3, 2011, the Company amended its Credit Agreement (2011 Credit Amendment) to, among
other things:
- | Allow for the use of cash to purchase assets from Seahawk, to the extent set forth in the Companys previously disclosed Asset Purchase Agreement with Seahawk; | ||
- | Exempt the pro forma treatment of historical results from the Seahawk assets with respect to the calculation of the financial covenants in the Credit Agreement; | ||
- | Increase the Companys investment basket to $50 million from $25 million; and | ||
- | Revise the covenant threshold levels of the Total Leverage Ratio, as defined in the Credit Agreement, to the following schedule: |
Amended Total | ||||||||
Test Date | Previous Total Leverage Ratio | Leverage Ratio | ||||||
March 31, 2011 |
7.00 to 1.00 | No Change | ||||||
June 30, 2011 |
6.75 to 1.00 | No Change | ||||||
September 30, 2011 |
6.00 to 1.00 | 7.50 to 1.00 | ||||||
December 31, 2011 |
5.50 to 1.00 | 7.75 to 1.00 | ||||||
March 31, 2012 |
5.25 to 1.00 | 7.50 to 1.00 | ||||||
June 30, 2012 |
5.00 to 1.00 | 7.25 to 1.00 | ||||||
September 30, 2012 |
4.75 to 1.00 | 6.75 to 1.00 | ||||||
December 31, 2012 |
4.50 to 1.00 | 6.25 to 1.00 | ||||||
March 31, 2013 |
4.25 to 1.00 | 6.00 to 1.00 | ||||||
June 30, 2013 |
4.00 to 1.00 | 5.75 to 1.00 |
- | At March 31, 2011, the Companys total leverage ratio was 4.69 to 1.00. |
Further, the interest rates on borrowings under the Credit Facility were increased to 5.50%
plus LIBOR for Eurodollar Loans and 4.50% plus the Alternate Base Rate for ABR Loans. The minimum
LIBOR of 2.00% for Eurodollar Loans, or a minimum base rate of 3.00% with respect to ABR Loans,
remains. In addition, total commitments on the revolving credit facility, which is currently
unfunded, were reduced to $140.0 million from $175.0 million.
10
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
The Company also agreed to pay consenting lenders an upfront fee of 0.25% on their commitment,
or approximately $1.4 million. Including agent bank fees and expenses the Companys total cost was
approximately $2.0 million. The Company recognized a pretax charge of $0.5 million, $0.3 million
net of tax, related to the write off of certain unamortized issuance costs and the expense of
certain fees in connection with the 2011 Credit Amendment.
Other Terms and Conditions
The Companys obligations under the Credit Agreement are secured by liens on a majority of its
vessels and substantially all of its other personal property. Substantially all of the Companys
domestic subsidiaries, and several of its international subsidiaries, guarantee the obligations
under the Credit Agreement and have granted similar liens on the majority of their vessels and
substantially all of their other personal property.
Other covenants contained in the Credit Agreement restrict, among other things, asset
dispositions, mergers and acquisitions, dividends, stock repurchases and redemptions, other
restricted payments, debt issuances, liens, investments, convertible notes repurchases and
affiliate transactions. The Credit Agreement also contains a provision under which an event of
default on any other indebtedness exceeding $25.0 million would be considered an event of default
under the Companys Credit Agreement.
The Credit Agreement requires that the Company meet certain financial ratios and tests, which
it met as of March 31, 2011. The Companys failure to comply with such covenants would result in
an event of default under the Credit Agreement. Additionally, in order to maintain compliance with
the Companys financial covenants, borrowings under the Companys revolving credit facility may be
limited to an amount less than the full amount of remaining availability after outstanding letters
of credit. An event of default could prevent the Company from borrowing under the revolving credit
facility, which would in turn have a material adverse effect on the Companys available liquidity.
Furthermore, an event of default could result in the Company having to immediately repay all
amounts outstanding under the credit facility, the 10.5% Senior Secured Notes and the 3.375%
Convertible Senior Notes and in the foreclosure of liens on its assets.
Other than the required prepayments as outlined previously, the principal amount of the term
loan amortizes in equal quarterly installments of approximately $1.2 million, with the balance due
on July 11, 2013. All borrowings under the revolving credit facility mature on July 11, 2012.
Interest payments on both the revolving and term loan facility are due at least on a quarterly
basis and in certain instances, more frequently.
As of March 31, 2011, no amounts were outstanding and $12.2 million in standby letters of
credit had been issued under the revolving credit facility, therefore the remaining availability
under this revolving credit facility was $127.8 million. As of March 31, 2011, $475.2 million was
outstanding on the term loan facility and the interest rate was 7.5%. The annualized effective rate
of interest was 6.89% for the three months ended March 31, 2011 after giving consideration to
revolver fees.
10.5% senior secured notes due 2017
The notional amount of the 10.5% Senior Secured Notes, its unamortized discount and its net
carrying amount was $300.0 million, $6.9 million and $293.1 million, respectively, as of March 31,
2011 and $300.0 million, $7.1 million and $292.9 million, respectively, as of December 31, 2010.
The unamortized discount is being amortized to interest expense over the life of the 10.5% Senior
Secured Notes which ends in October 2017. During the three months ended March 31, 2011, the
Company recognized $8.1 million, $5.2 million, net of tax, in interest expense, or $0.05 per
diluted share, at an effective rate of 11%, of which $7.9 million related to the coupon rate of
10.5% and $0.2 million related to discount amortization. During the three months ended March 31,
2010, the Company recognized $8.0 million, $5.2 million, net of tax, in interest expense, or $0.05
per diluted share, at an effective rate of 11%, of which $7.9 million related to the coupon rate of
10.5% and $0.1 million related to discount amortization.
The notes are guaranteed by all of the Companys existing and future restricted subsidiaries
that incur or guarantee indebtedness under a credit facility, including the Companys existing
credit facility. The notes are secured by liens on all collateral that secures the Companys
obligations under its secured credit facility, subject to limited exceptions. The liens securing
the notes share on an equal
and ratable first priority basis with liens securing the Companys credit facility. Under the
intercreditor agreement, the collateral agent for the lenders under the Companys secured credit
facility is generally entitled to sole control of all decisions and actions.
All the liens securing the notes may be released if the Companys secured indebtedness, other
than these notes, does not exceed the lesser of $375.0 million and 15.0% of the Companys
consolidated tangible assets. The Company refers to such a release as a collateral suspension.
If a collateral suspension is in effect, the notes and the guarantees will be unsecured, and will
effectively rank junior to the Companys secured indebtedness to the extent of the value of the
collateral securing such indebtedness. If, after any such
11
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
release of liens on collateral, the
aggregate principal amount of the Companys secured indebtedness, other than these notes, exceeds
the greater of $375.0 million and 15.0% of its consolidated tangible assets, as defined in the
indenture, then the collateral obligations of the Company and guarantors will be reinstated and
must be complied with within 30 days of such event.
The indenture governing the notes contains covenants that, among other things, limit the
Companys ability and the ability of its restricted subsidiaries to:
| incur additional indebtedness or issue certain preferred stock; | ||
| pay dividends or make other distributions; | ||
| make other restricted payments or investments; | ||
| sell assets; | ||
| create liens; | ||
| enter into agreements that restrict dividends and other payments by restricted subsidiaries; | ||
| engage in transactions with its affiliates; and | ||
| consolidate, merge or transfer all or substantially all of its assets. |
The indenture governing the notes also contains a provision under which an event of default by
the Company or by any restricted subsidiary on any other indebtedness exceeding $25.0 million would
be considered an event of default under the indenture if such default: a) is caused by failure to
pay the principal at final maturity, or b) results in the acceleration of such indebtedness prior
to maturity.
3.375% convertible senior notes due 2038
The carrying amount of the equity component of the 3.375% Convertible Senior Notes was $30.1
million at both March 31, 2011 and December 31, 2010. The principal amount of the liability
component of the 3.375% Convertible Senior Notes, its unamortized discount and its net carrying
amount was $95.9 million, $8.5 million and $87.4 million, respectively, as of March 31, 2011 and
$95.9 million, $9.4 million and $86.5 million, respectively, as of December 31, 2010. The
unamortized discount is being amortized to interest expense over the expected life of the 3.375%
Convertible Senior Notes which ends June 1, 2013. During the three months ended March 31, 2011,
the Company recognized $1.7 million, $1.1 million, net of tax, in interest expense, or $0.01 per
diluted share, at an effective rate of 7.93%, of which $0.8 million related to the coupon rate of
3.375% and $0.9 million related to discount amortization. During the three months ended March 31,
2010, the Company recognized $1.7 million, $1.1 million, net of tax, in interest expense, or $0.01
per diluted share, at an effective rate of 7.93%, of which $0.9 million related to the coupon rate
of 3.375% and $0.8 million related to discount amortization.
The notes will be convertible under certain circumstances into shares of the Companys common
stock (Common Stock) at an initial conversion rate of 19.9695 shares of Common Stock per $1,000
principal amount of notes, which is equal to an initial conversion price of approximately $50.08
per share. Upon conversion of a note, a holder will receive, at the Companys election, shares of
Common Stock, cash or a combination of cash and shares of Common Stock. At March 31, 2011, the
number of conversion shares potentially issuable in relation to the 3.375% Convertible Senior Notes
was 1.9 million.
The indenture governing the 3.375% Convertible Senior Notes contains a provision under which
an event of default by the Company or by any subsidiary on any other indebtedness exceeding $25.0
million would be considered an event of default under the indenture if such default: a) is caused
by failure to pay the principal at final maturity, or b) results in the acceleration of such
indebtedness prior to maturity.
The Company determined that upon maturity or redemption it has the intent and ability to
settle the principal amount of its 3.375% Convertible Senior Notes in cash, and any additional
conversion consideration spread (the excess of conversion value over face value) in shares of the
Companys Common Stock.
Other debt
In connection with the TODCO acquisition in July 2007, one of the Companys domestic
subsidiaries assumed approximately $3.5 million of 7.375% Senior Notes due in April 2018. There are
no financial or operating covenants associated with these notes.
7. Derivative Instruments and Hedging
The Company is required to recognize all of its derivative instruments as either assets or
liabilities in the statement of financial position at fair value. The accounting for changes in
the fair value of a derivative instrument depends on whether it has been
12
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
designated and qualifies
as part of a hedging relationship and further, on the type of hedging relationship. For those
derivative instruments that are designated and qualify as hedging instruments, a company must
designate the hedging instrument, based upon the exposure being hedged, as a fair value hedge, cash
flow hedge, or a hedge of a net investment in a foreign operation.
The Company periodically uses derivative instruments to manage its exposure to interest rate
risk, including interest rate swap agreements to effectively fix the interest rate on variable rate
debt and interest rate collars to limit the interest rate range on variable rate debt. These hedge
transactions have historically been accounted for as cash flow hedges.
For derivative instruments that are designated and qualify as a cash flow hedge, the effective
portion of the gain or loss on the derivative instrument is reported as a component of other
comprehensive income and reclassified into earnings in the same line item associated with the
forecasted transaction and in the period or periods during which the hedged transaction affects
earnings. The effective portion of the derivative instruments hedging the exposure to variability
in expected future cash flows due to changes in interest rates is reclassified into interest
expense. The remaining gain or loss on the derivative instrument in excess of the cumulative change
in the present value of future cash flows of the hedged item, if any, or hedged components excluded
from the assessment of effectiveness, is recognized in interest expense.
The Company currently has no interest rate derivatives outstanding. On October 1, 2010, the
Companys zero cost LIBOR collar, entered into in July 2007, was settled per the agreement with a
cash payment of $3.4 million. This zero cost LIBOR collar was on $300.0 million of term loan
principal with a final settlement date of October 1, 2010 with a ceiling of 5.75% and a floor of
4.99%. The counterparty paid the Company in any quarter that actual LIBOR reset above 5.75% and the
Company paid the counterparty in any quarter that actual LIBOR reset below 4.99%. The terms and
settlement dates of the collar matched those of the term loan through July 27, 2009, the date of
the 2009 Credit Amendment.
As a result of the inclusion of a LIBOR floor in the Credit Agreement, the Company determined,
as of July 27, 2009 and on an ongoing basis, that the interest rate collar would not be highly
effective in achieving offsetting changes in cash flows attributable to the hedged interest rate
risk during the period that the hedge was designated. As such, the Company discontinued cash flow
hedge accounting for the interest rate collar as of July 27, 2009. Because cash flow hedge
accounting was not applied to this instrument, changes in fair value related to the interest rate
collar subsequent to July 27, 2009 were recorded in earnings. As a result of discontinuing the cash
flow hedging relationship, the Company recognized a decrease in fair value of $0.4 million related
to the hedge ineffectiveness of its interest rate collar as Interest Expense in its Consolidated
Statements of Operations for the three months ended March 31, 2010.
The Company was issued warrants to purchase up to 5.0 million additional shares of Discovery
Offshore stock at a strike price equivalent to $2.00 which is exercisable in the event that the
Discovery Offshore stock price reaches an average equal to or higher than 23 Norwegian Kroner per
share, which approximated $4.00 per share as of March 31, 2011, for 30 consecutive trading days
(See Note 1). The warrants are being accounted for as a derivative instrument as the underlying
security is readily convertible to cash. Subsequent changes in the fair value of the warrants is
recognized to other income (expense). If the warrants become exercisable and the Company exercises
those warrants, the settlement would be recorded as an increase in the Companys equity investment
in Discovery Offshore. The fair value of the Discovery Offshore warrants was determined using a
Monte Carlo simulation (See Note 8).
The following table provides the fair values of the Companys derivatives (in thousands):
March 31, 2011 | ||||
Balance Sheet | Fair | |||
Classification | Value | |||
Derivatives: |
||||
Warrants: |
||||
Other Assets, Net |
$ | 5,215 | ||
13
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
The following table provides the effect of the Companys derivatives on the Consolidated
Statements of Operations (in thousands):
Three Months Ended March 31, | ||||||||||||||||||||||||||||||
2011 | 2010 | 2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||||||
Derivatives | I. | II. | III. | IV. | V. | |||||||||||||||||||||||||
Interest rate contracts(a) |
$ | | $ | | Interest Expense | $ | | $ | (3,198 | ) | Interest Expense | $ | | $ | (363 | ) | ||||||||||||||
Warrants |
$ | | $ | | N/A | $ | | $ | | Revenue | $ | 31 | $ | | ||||||||||||||||
Warrants |
$ | | $ | | N/A | $ | | $ | | Other Income | $ | 155 | $ | |
(a) | These interest rate contracts were designated as cash flow hedges through July 27, 2009. | ||
I. | Amount of Gain (Loss), Net of Taxes Recognized in Other Comprehensive Income (Loss) on Derivative (Effective Portion) | ||
II. | Classification of Gain (Loss) Reclassified from Accumulated Other Comprehensive Income (Loss) into Income (Loss) (Effective Portion) | ||
III. | Amount of Gain (Loss) Reclassified from Accumulated Other Comprehensive Income (Loss) into Income (Loss) (Effective Portion) | ||
IV. | Classification of Gain (Loss) Recognized in Income (Loss) on Derivative | ||
V. | Amount of Gain (Loss) Recognized in Income (Loss) on Derivative |
8. Fair Value Measurements
FASB ASC Topic 820-10, Fair Value Measurements and Disclosures (ASC Topic 820-10) defines
fair value, establishes a framework for measuring fair value under generally accepted accounting
principles and expands disclosures about fair value measurements; however, it does not require any
new fair value measurements, rather, its application is made pursuant to other accounting
pronouncements that require or permit fair value measurements.
Fair value measurements are generally based upon observable and unobservable inputs.
Observable inputs reflect market data obtained from independent sources, while unobservable inputs
reflect the Companys view of market assumptions in the absence of observable market information.
The Company utilizes valuation techniques that maximize the use of observable inputs and minimize
the use of unobservable inputs. ASC Topic 820-10 includes a fair value hierarchy that is intended
to increase consistency and comparability in fair value measurements and related disclosures. The
fair value hierarchy consists of the following three levels:
Level 1
|
- | Inputs are quoted prices in active markets for identical assets or liabilities. | ||
Level 2
|
- | Inputs are quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable and market-corroborated inputs which are derived principally from or corroborated by observable market data. | ||
Level 3
|
- | Inputs are derived from valuation techniques in which one or more significant inputs or value drivers are unobservable. |
As of January 1, 2010, the Company adopted the FASB Accounting Standards Update (ASU) No.
2010-06, Improving Disclosures about Fair Value Measurements (ASU 2010-06) which requires
additional disclosures about the various classes of assets and liabilities measured at fair value,
the valuation techniques and inputs used, the activity in Level 3 fair value measurements and the
transfers between Levels 1, 2, and 3. The requirement for disclosures about purchases, sales,
issuances and settlements in the roll forward of activity in Level 3 fair value measurements are
effective for interim and annual reporting periods beginning after December 15, 2010 and were
adopted by the Company on January 1, 2011 (See Note 14).
As of March 31, 2011 the fair value of the Companys warrants was in an asset position in the
amount of $5.2 million. The fair value of the warrants was determined using a Monte Carlo
simulation based on the following assumptions:
14
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
March 31, | ||||
2011 | ||||
Strike Price (USD) |
$ | 2.00 | ||
Target Price (USD) |
$ | 4.12 | ||
Stock Value (USD) |
$ | 2.30 | ||
Expected Volatility (%) |
50.0 | % | ||
Risk-free Interest Rate (%) |
2.13 | % | ||
Expected Life of Warrants (years) |
5.0 | |||
Number of Warrants |
5,000,000 |
The Company used the historical volatility of companies similar to that of Discovery Offshore
to estimate volatility. The risk-free interest rate assumption was based on observed interest rates
consistent with the approximate life of the warrants. The stock price represents the closing stock
price of Discovery Offshore stock at March 31, 2011, converted to U.S. Dollars. The strike price,
target price, expected life and number of warrants are all contractual based on the terms of the
warrant agreement.
The following table represents the Companys derivative asset measured at fair value on a
recurring basis as of March 31, 2011 (in thousands):
Quoted Prices in | ||||||||||||||||
Total | Active Markets for | |||||||||||||||
Fair Value | Identical Asset or | Significant Other | Significant | |||||||||||||
Measurement | Liability | Observable Inputs | Unobservable Inputs | |||||||||||||
March 31, 2011 | (Level 1) | (Level 2) | (Level 3) | |||||||||||||
Warrants |
$ | 5,215 | $ | | $ | 5,215 | $ | |
There were no derivative assets or liabilities outstanding at December 31, 2010.
The following table represents the Companys assets measured at fair value on a non-recurring
basis for which an impairment measurement was made as of December 31, 2010 (in thousands):
Total | Quoted Prices in | Significant | ||||||||||||||||||
Fair Value | Active Markets for | Other | Significant | |||||||||||||||||
Measurement | Identical Asset or | Observable | Unobservable | |||||||||||||||||
December 31, | Liability | Inputs | Inputs | Total | ||||||||||||||||
2010 | (Level 1) | (Level 2) | (Level 3) | Gain (Loss) | ||||||||||||||||
Property and Equipment, Net |
$ | 27,848 | $ | | $ | | $ | 27,848 | $ | (125,136 | ) |
The Company incurred $125.1 million ($81.3 million, net of tax) in impairment of property and
equipment charges related to certain of its assets of which
$2.4 million ($1.5 million, net of tax)
related to the discontinued operations of its Delta Towing segment. The property, plant and
equipment was valued based on the discounted cash flows associated with the assets which included
managements estimate of sales proceeds less costs to sell.
The carrying value and fair value of the Companys equity investment in Discovery Offshore was
$18.3 million and $20.0 million at March 31, 2011, respectively. The fair value was calculated
using the closing price of Discovery Offshore shares converted to U.S. dollars using the exchange
rate at March 31, 2011.
15
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
Fair Value of Financial Instruments
The carrying amounts of the Companys financial instruments, which include cash and cash
equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities,
approximate fair values because of the short-term nature of the instruments.
The fair value of the Companys 3.375% Convertible Senior Notes, 10.5% Senior Secured Notes
and term loan facility is estimated based on quoted prices in active markets. The fair value of the
Companys 7.375% Senior Notes is estimated based on discounted cash flows using inputs from quoted
prices in active markets for similar debt instruments. The following table provides the carrying
value and fair value of the Companys long-term debt instruments:
March 31, 2011 | December 31, 2010 | |||||||||||||||
Carrying | Fair | Carrying | Fair | |||||||||||||
Value | Value | Value | Value | |||||||||||||
(in millions) | ||||||||||||||||
Term Loan Facility, due July 2013 |
$ | 475.2 | $ | 469.1 | $ | 475.2 | $ | 443.7 | ||||||||
10.5% Senior Secured Notes, due October 2017 |
293.1 | 307.7 | 292.9 | 245.1 | ||||||||||||
3.375% Convertible Senior Notes, due June
2038 |
87.4 | 90.9 | 86.5 | 69.1 | ||||||||||||
7.375% Senior Notes, due April 2018 |
3.5 | 3.0 | 3.5 | 2.2 |
9. Long-Term Incentive Awards
Stock-based Compensation
The Companys 2004 Long-Term Incentive Plan (the 2004 Plan) provides for the granting of
stock options, restricted stock, performance stock awards and other stock-based awards to selected
employees and non-employee directors of the Company. At March 31, 2011, approximately 0.9 million
shares were available for grant or award under the 2004 Plan.
During the three months ended March 31, 2011, the Company granted 988,549 time-based
restricted stock awards with a weighted average grant-date fair value per share of $4.89. There
were no stock options granted during the three months ended March 31, 2011. The Company recognized
$1.2 million in stock-based compensation expense during the three months ended March 31, 2011. The
Company recognized $0.2 million in stock-based compensation expense during the three months ended
March 31, 2010 which includes a reduction of $1.8 million due to a change in the Companys
estimated forfeiture rate.
On March 6, 2011, the Compensation Committee of the Companys Board of Directors approved
equity grants for certain of its executive officers which consisted of a time-based vesting
restricted stock award and a performance based restricted stock award . The grants vest one-third
per year on each of the first three anniversaries of the grant date; however, the vesting of the
performance grant is contingent upon meeting the established consolidated safety and EBITDA metrics
at a weighting of 50% each, with vesting prorated between threshold, target and maximum levels.
Threshold, target and maximum performance objectives have been established for each metric, with
the officer vesting 33% more shares at the maximum level, 33% less shares at the threshold level,
with vesting pro rated between levels, and no shares will be issued with respect to a particular
metric if the threshold performance objective is not met with respect to such metric. The target
number of performance-based restricted stock issuable under this award if conditions for vesting
are met is 507,509 shares. The fair value of these awards was based on the closing price of the
Companys stock on the date of grant.
The unrecognized compensation cost related to the Companys unvested stock options and
restricted stock grants, including performance-based restricted stock grants as of March 31, 2011
was $2.1 million and $7.8 million, respectively, and is expected to be recognized over a
weighted-average period of 1.2 years and 2.4 years, respectively.
Liability Retention Awards
In December 2010, the Compensation Committee of the Companys Board of Directors approved
retention and incentive arrangements for the Companys Chief Executive Officer, consisting of three
separate awards.
Vesting under each award is conditioned upon continuous employment with the Company from the
date of grant until the earlier of a specified vesting date or a change in control of the Company.
Subject to the satisfaction of all vesting requirements, awards are payable in cash based on the
product of the number of shares of Common Stock specified in the award, the percentage of that
number
16
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
of shares that vest under the award and the average price of the Common Stock for the 90 days
prior to the date of vesting (Average Share Price).
The grant date of each of the three awards is January 1, 2011. Vesting of any award and the
amount payable under any vested award do not affect vesting or the amount payable under any of the
other awards. Subject to vesting, all awards are payable in cash within thirty days of vesting. No
shares of common stock are issuable under any of the awards. These awards are accounted for under
stock-compensation principles of accounting as liability instruments. The fair value of these
awards is remeasured based on the awards estimated fair value at the end of each reporting period
and will be recorded to expense over the vesting period. At March 31, 2011, the Companys liability
related to these awards was $0.3 million and is included in Other Liabilities on the Consolidated
Balance Sheets. Additionally, compensation expense of $0.3 million was recognized for the three
months ended March 31, 2011.
The first award is a Special Retention Agreement (the Agreement), which provides for a cash
payment based on 500,000 shares of the Companys common stock, subject to vesting. Upon
satisfaction of vesting requirements, 100% of the amount under the Agreement becomes vested on
December 31, 2013 and the payout will equal the product of 500,000 and the lesser of the Average
Share Price and $10.00. If all of the requirements necessary for vesting of this award are not met,
no amounts become vested and no amount is payable. The fair value of this award is based on the
average price of the Common Stock for the 90 days prior to the end of the quarter or date of
vesting.
The second and third awards are performance awards under the 2004 Plan (Performance Awards).
Each Performance Award provides for a cash payment, subject to vesting, based on 250,000 shares of
the Companys common stock. Upon satisfaction of vesting requirements, 100% of the first
Performance Award will vest on December 31, 2013, and 100% of the second Performance Award will
vest on March 31, 2014. Under each Performance Award, vesting is subject to the further requirement
that the Average Share Price is at least $5.00. Subject to the satisfaction of the vesting
requirements, the payout of each Performance Award shall be equal to the product of (1) 250,000,
(2) the Average Share Price or $10.00, whichever is less, divided by $10.00, and (3) the lesser of
the Average Share Price or $10.00. If the requirements necessary for vesting of a Performance Award
are met, the amount payable in cash under each of the Performance Awards shall be not less than
$625,000 and not more than $2,500,000. The fair value of these awards was determined at March 31,
2011 using a Monte Carlo simulation based on the following assumptions:
March 31, | ||||
2011 | ||||
Dividend Yield |
| |||
Expected Price Volatility |
50 | % | ||
Risk-Free Interest Rate |
1.3 | % | ||
Stock Price |
$ | 6.61 | ||
Fair Value |
$ | 3.32 |
The Company used the historical volatility of its common stock to estimate volatility.
The dividend yield assumption was based on historical and anticipated dividend payouts. The
risk-free interest rate assumption was based on observed interest rates consistent with the
approximate vesting period. The stock price represents the closing price of the Companys common
stock at March 31, 2011.
10. Supplemental Cash Flow Information
The Company had non-cash investing activities related to its equity investment in Discovery
Offshore as 500,000 shares of Discovery Offshore valued at $1.0 million were received by the
Company as reimbursement for costs incurred and efforts expended in forming Discovery offshore. In
addition, the Company purchased 3,203,700 shares of Discovery Offshore for $7.3 million which were
not cash settled until April 2011.
17
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
Three Months Ended March 31, | ||||||||
2011 | 2010 | |||||||
(In thousands) | ||||||||
Cash paid (received), net during the period for: |
||||||||
Interest |
$ | 41 | $ | 60 | ||||
Income taxes |
(4,199 | ) | 11,321 |
11. Income Tax
The Company, directly or through its subsidiaries, files income tax returns in the United
States, and multiple state and foreign jurisdictions. The Companys tax returns for 2005 through
2009 remain open for examination by the taxing authorities in the respective jurisdictions where
those returns were filed. Although, the Company believes that its estimates are reasonable, the
final outcome in the event that the Company is subjected to an audit could be different from that
which is reflected in its historical income tax provision and accruals. Such differences could have
a material effect on the Companys income tax provision and net income in the period in which such
determination is made. In addition, certain tax returns filed by TODCO and its subsidiaries are
open for years prior to 2004, however TODCO tax obligations from periods prior to its initial
public offering in 2004 are indemnified by Transocean under the tax sharing agreement, except for
the Trinidad and Tobago jurisdiction. The Companys Trinidadian tax returns are open for
examination for the years 2005 through 2009.
In December 2002, TODCO received an assessment from SENIAT, the national Venezuelan tax
authority, relating to calendar years 1998 through 2001. After a series of partial payments and
appeals, in July 2009, the Company settled the remaining tax and interest portion of the
assessment. Residual penalties of $0.8 million (based on the official exchange rate at March 31,
2011) remain in dispute. The Company, as successor to TODCO, is fully indemnified by TODCOs former
parent, Transocean Ltd. for this issue. The Company does not expect the ultimate resolution of this
assessment and settlement to have a material impact on its consolidated financial statements. In
January 2008, SENIAT commenced an audit for the 2003 calendar year, which was completed in the
fourth quarter of 2008. The Company has not yet received any proposed adjustments from SENIAT for
that year.
In March 2007, a subsidiary of the Company received an assessment from the Mexican tax
authorities related to its operations for the 2004 tax year. This assessment contested the
Companys right to certain deductions and also claimed it did not remit withholding tax due on
certain of these deductions. In accordance with local statutory requirements, the Company provided
a surety bond for an amount equal to approximately $13 million, which was released in July 2010, to
contest these assessments. In 2008, the Mexican tax authorities commenced an audit for the 2005 tax
year. During 2010, the Company effectively reached a compromise settlement of all issues for
20042007. The Company paid $11.6 million and reversed (i) previously provided reserves and (ii)
an associated tax benefit in the year ended December 31, 2010 which totaled $5.8 million, of which
the initial impact for the three months ended March 31, 2010 was $6.2 million.
As of March 31, 2011, the Company was in a net income tax payable position of $9.6 million
which is included in Taxes Payable on the Consolidated Balance Sheets and as of December 31, 2010,
the Company was in a net income tax receivable position of $5.6 million which is included in Other
on the Consolidated Balance Sheets.
12. Segments
The Company reports its business activities in six business segments: (1) Domestic Offshore,
(2) International Offshore, (3) Inland, (4) Domestic Liftboats, (5) International Liftboats and (6)
Delta Towing. The Company eliminates inter-segment revenue and expenses, if any.
The following describes the Companys reporting segments as of March 31, 2011:
Domestic Offshore includes 22 jackup rigs and three submersible rigs in the U.S. Gulf of
Mexico that can drill in maximum water depths ranging from 85 to 350 feet. Ten of the jackup rigs
are either working on short-term contracts or available for contracts, one is in the shipyard and
eleven are cold-stacked. All three submersibles are cold-stacked.
International Offshore includes eight jackup rigs and one platform rig outside of the U.S.
Gulf of Mexico. The Company has two jackup rigs working offshore in each of India and Saudi Arabia,
one jackup rig contracted offshore in Malaysia, one jackup rig contracted in Angola and one
platform rig under contract in Mexico. The Company has one jackup rig warm-stacked and one jackup
rig cold-stacked in Bahrain. In addition, to owning and operating its own rigs, the Company has an
agreement with COSL to market and operate a jackup rig in Angola. Further, the Company has the
Construction Management Agreement and the Services Agreement
18
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
with Discovery Offshore with respect
to each of the Rigs. (See Note 1). There was no revenue or expense associated with the COSL
agreement, nor the Construction Management Agreement and Services Agreement with Discovery Offshore
during the three months ended March 31, 2011.
Inland includes a fleet of six conventional and eleven posted barge rigs that operate
inland in marshes, rivers, lakes and shallow bay or coastal waterways along the U.S. Gulf Coast.
Three of the inland barges are either operating on short-term contracts or available and fourteen
are cold-stacked.
Domestic Liftboats includes 41 liftboats in the U.S. Gulf of Mexico. Thirty-eight are
operating or available and three are cold-stacked.
International Liftboats includes 24 liftboats. Twenty-one are operating or available for
contracts offshore West Africa, including five liftboats owned by a third party, one is
cold-stacked offshore West Africa and two are operating or available for contracts in the Middle
East region.
Delta Towing the Companys Delta Towing business operates a fleet of 29 inland tugs,
10 offshore tugs, 34 crew boats, 46 deck barges, 16 shale barges and five spud barges along and in
the U.S. Gulf of Mexico and from time to time along the Southeastern coast and in Mexico. Of these
vessels, 24 crew boats, 11 inland tugs, three offshore tugs, one deck barge and one spud barge are
cold-stacked, and the remaining are working, being repaired or available for contracts.
The Companys jackup rigs, submersible rigs and platform rigs are used primarily for
exploration and development drilling in shallow waters. The Companys liftboats are self-propelled,
self-elevating vessels with a large open deck space, which provides a versatile, mobile and stable
platform to support a broad range of offshore maintenance and construction services throughout the
life of an oil or natural gas well.
In May 2011, the Company sold substantially all of the assets and certain liabilities of its
Delta Towing segment (See Notes 1 and 5). The Company has recast the financial information in this
footnote as it relates to the Consolidated Statements of Operations to exclude the discontinued
operations of its Delta Towing segment.
19
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
Information regarding reportable segments is as follows (in thousands):
Three Months Ended March 31, 2011 | ||||||||||||
Income (Loss) | Depreciation & | |||||||||||
Revenue | from Operations | Amortization | ||||||||||
Domestic Offshore |
$ | 33,799 | $ | (25,130 | ) | $ | 15,082 | |||||
International Offshore |
77,119 | 32,674 | 13,300 | |||||||||
Inland |
5,502 | (6,379 | ) | 4,621 | ||||||||
Domestic Liftboats |
10,631 | (3,369 | ) | 3,641 | ||||||||
International Liftboats |
32,327 | 11,601 | 4,498 | |||||||||
159,378 | 9,397 | 41,142 | ||||||||||
Corporate |
| (11,019 | ) | 651 | ||||||||
Total Company |
$ | 159,378 | $ | (1,622 | ) | $ | 41,793 | |||||
Three Months Ended March 31, 2010 | ||||||||||||
Income (Loss) | Depreciation & | |||||||||||
Revenue | from Operations | Amortization | ||||||||||
Domestic Offshore |
$ | 28,962 | $ | (30,126 | ) | $ | 16,539 | |||||
International Offshore |
73,442 | 22,486 | 14,931 | |||||||||
Inland |
4,751 | (5,307 | ) | 7,506 | ||||||||
Domestic Liftboats |
11,443 | (2,566 | ) | 4,200 | ||||||||
International Liftboats |
25,962 | 5,303 | 4,691 | |||||||||
144,560 | (10,210 | ) | 47,867 | |||||||||
Corporate |
| (9,193 | ) | 797 | ||||||||
Total Company |
$ | 144,560 | $ | (19,403 | ) | $ | 48,664 | |||||
Total Assets | ||||||||||||
March 31, | December 31, | |||||||||||
2011 | 2010 | |||||||||||
Domestic Offshore |
$ | 785,683 | $ | 772,950 | ||||||||
International Offshore |
743,054 | 712,988 | ||||||||||
Inland |
127,933 | 136,229 | ||||||||||
Domestic Liftboats |
80,823 | 86,013 | ||||||||||
International Liftboats |
168,079 | 167,561 | ||||||||||
Delta Towing |
53,312 | 56,631 | ||||||||||
Corporate |
57,806 | 62,937 | ||||||||||
Total Company |
$ | 2,016,690 | $ | 1,995,309 | ||||||||
13. Commitments and Contingencies
Legal Proceedings
The Company is involved in various claims and lawsuits in the normal course of business. As of
March 31, 2011, management did not believe any accruals were necessary in accordance with FASB
Codification Topic 450-20, Contingencies Loss Contingencies.
In connection with the July 2007 acquisition of TODCO, the Company assumed certain material
legal proceedings from TODCO and its subsidiaries.
In October 2001, TODCO was notified by the U.S. Environmental Protection Agency (EPA)
that the EPA had identified a subsidiary of TODCO as a potentially responsible party under CERCLA
in connection with the Palmer Barge Line superfund site located in Port Arthur, Jefferson County,
Texas. Based upon the information provided by the EPA and the Companys review of its internal
records to date, the Company disputes the Companys designation as a potentially responsible party
and does not expect that
20
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
the ultimate outcome of this case will have a material adverse effect on
its consolidated results of operations, financial position or cash flows. The Company continues to
monitor this matter.
Robert E. Aaron et al. vs. Phillips 66 Company et al. Circuit Court, Second Judicial District,
Jones County, Mississippi. This is the case name used to refer to several cases that have been
filed in the Circuit Courts of the State of Mississippi involving 768 persons that allege personal
injury or whose heirs claim their deaths arose out of asbestos exposure in the course of their
employment by the defendants between 1965 and 2002. The complaints name as defendants, among
others, certain of TODCOs subsidiaries and certain subsidiaries of TODCOs former parent to whom
TODCO may owe indemnity, and other unaffiliated defendant companies, including companies that
allegedly manufactured drilling related products containing asbestos that are the subject of the
complaints. The number of unaffiliated defendant companies involved in each complaint ranges from
approximately 20 to 70. The complaints allege that the defendant drilling contractors used
asbestos-containing products in offshore drilling operations, land based drilling operations and in
drilling structures, drilling rigs, vessels and other equipment and assert claims based on, among
other things, negligence and strict liability, and claims authorized under the Jones Act. The
plaintiffs seek, among other things, awards of unspecified compensatory and punitive damages. All
of these cases were assigned to a special master who has approved a form of questionnaire to be
completed by plaintiffs so that claims made would be properly served against specific defendants.
Approximately 700 questionnaires were returned and the remaining plaintiffs, who did not submit a
questionnaire reply, have had their suits dismissed without prejudice. Of the respondents,
approximately 100 shared periods of employment by TODCO and its former parent which could lead to
claims against either company, even though many of these plaintiffs did not state in their
questionnaire answers that the employment actually involved exposure to asbestos. After providing
the questionnaire, each plaintiff was further required to file a separate and individual amended
complaint naming only those defendants against whom they had a direct claim as identified in the
questionnaire answers. Defendants not identified in the amended complaints were dismissed from the
plaintiffs litigation. To date, three plaintiffs named TODCO as a defendant in their amended
complaints. It is possible that some of the plaintiffs who have filed amended complaints and have
not named TODCO as a defendant may attempt to add TODCO as a defendant in the future when case
discovery begins and greater attention is given to each individual plaintiffs employment
background. The Company has not determined which entity would be responsible for such claims under
the Master Separation Agreement between TODCO and its former parent. More than three years has
passed since the court ordered that amended complaints be filed by each individual plaintiff, and
the original complaints. No additional plaintiffs have attempted to name TODCO as a defendant and
such actions may now be time-barred. The Company intends
to defend vigorously and does not expect the ultimate outcome of these lawsuits to have a
material adverse effect on its consolidated results of operations, financial position or cash
flows.
The Company and its subsidiaries are involved in a number of other lawsuits, all of which have
arisen in the ordinary course of business. The Company does not believe that ultimate liability, if
any, resulting from any such other pending litigation will have a material adverse effect on its
business or consolidated financial statements.
The Company cannot predict with certainty the outcome or effect of any of the litigation
matters specifically described above or of any other pending litigation. There can be no assurance
that the Companys belief or expectations as to the outcome or effect of any lawsuit or other
litigation matter will prove correct, and the eventual outcome of these matters could materially
differ from managements current estimates.
Insurance
The Company is self-insured for the deductible portion of its insurance coverage. Management
believes adequate accruals have been made on known and estimated exposures up to the deductible
portion of the Companys insurance coverage. Management believes that claims and liabilities in
excess of the amounts accrued are adequately insured. However, the Companys insurance is subject
to exclusions and limitations, and there is no assurance that such coverage will adequately protect
the Company against liability from all potential consequences. In addition, there is no assurance
of renewal or the ability to obtain coverage acceptable to the Company.
The Company maintains insurance coverage that includes coverage for physical damage, third
party liability, workers compensation and employers liability, general liability, vessel
pollution and other coverages.
As of March 31, 2011, the Companys primary marine package provides for hull and machinery
coverage for substantially all of the Companys rigs and liftboats up to a scheduled value of each
asset. The total maximum amount of coverage for these assets is $2.1 billion. The marine package
includes protection and indemnity and maritime employers liability coverage for marine crew
personal injury and death and certain operational liabilities, with primary coverage (or
self-insured retention for maritime employers liability coverage) of $5.0 million per occurrence
with excess liability coverage up to $200.0 million. The marine package policy also includes
coverage for personal injury and death of third-parties with primary and excess coverage of $25
million per occurrence with additional excess liability coverage up to $200 million, subject to a
$250,000 per-occurrence deductible. The marine package also provides
21
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
coverage for cargo and
charterers legal liability. The marine package includes limitations for coverage for losses caused
in U.S. Gulf of Mexico named windstorms, including an annual aggregate limit of liability of $100.0
million for property damage and removal of wreck liability coverage. The Company also procured an
additional $75.0 million excess policy for removal of wreck and certain third-party liabilities
incurred in U.S. Gulf of Mexico named windstorms. Deductibles for events that are not caused by a
U.S. Gulf of Mexico named windstorm are 12.5% of the insured drilling rig values per occurrence,
subject to a minimum of $1.0 million, and $1.0 million per occurrence for liftboats. The deductible
for drilling rigs and liftboats in a U.S. Gulf of Mexico named windstorm event is $25.0 million.
Vessel pollution is covered under a Water Quality Insurance Syndicate policy (WQIS Policy)
providing limits as required by applicable law, including the Oil Pollution Act of 1990. The WQIS
Policy covers pollution emanating from the Companys vessels and drilling rigs, with primary limits
of $5 million (inclusive of a $3.0 million per-occurrence deductible) and excess liability coverage
up to $200 million.
Control-of-well events generally include an unintended flow from the well that cannot be
contained by equipment on site (e.g., a blow-out preventer), by increasing the weight of the
drilling fluid or that does not naturally close itself off through what is typically described as
bridging over. The Company carries a contractors extra expense policy with $50 million primary
covering liability for well control costs, expenses incurred to redrill wild or lost wells and
pollution, with excess liability coverage up to $200 million for pollution liability that is
covered in the primary policy. The policies are subject to exclusions, limitations, deductibles,
self-insured retention and other conditions. In addition to the marine package, the Company has
separate policies providing coverage for onshore foreign and domestic general liability, employers
liability, auto liability and non-owned aircraft liability, with customary deductibles and coverage
as well as a separate underlying marine package for its Delta Towing business.
The Companys drilling contracts provide for varying levels of indemnification from its
customers and in most cases, may require the Company to indemnify its customers for certain
liabilities. Under the Companys drilling contracts, liability with respect to personnel and
property is customarily assigned on a knock-for-knock basis, which means that the Company and its
customers assume liability for the Companys respective personnel and property, regardless of how
the loss or damage to the personnel and property may be caused. The Companys customers typically
assume responsibility for and agree to indemnify the Company from any
loss or liability resulting from pollution or contamination, including clean-up and removal
and third-party damages arising from operations under the contract and originating below the
surface of the water, including as a result of blow-outs or cratering of the well (Blowout
Liability). The customers assumption for Blowout Liability may, in certain circumstances, be
limited or could be determined to be unenforceable in the event of the gross negligence, willful
misconduct or other egregious conduct of the Company. The Company generally indemnifies the
customer for the consequences of spills of industrial waste or other liquids originating solely
above the surface of the water and emanating from its rigs or vessels.
In 2010, in connection with the renewal of certain of its insurance policies, the Company
entered into agreements to finance a portion of its annual insurance premiums. Approximately $25.9
million was financed through these arrangements, of which $0.7 million and $6.0 million was
outstanding as of March 31, 2011 and December 31, 2010, respectively. The interest rate on the
$24.1 million note was 3.79% and it was fully paid as of March 31, 2011. The interest rate on the
$1.8 million note is 3.54% and the note is scheduled to mature in July 2011.
In April 2011, the Company completed its annual renewal and revised its insurance coverage to
include the assets from the Seahawk asset purchase (See Note 15).
Surety Bonds, Bank Guarantees and Unsecured Letters of Credit
The Company had $11.2 million outstanding related to surety bonds at March 31, 2011. The
surety bonds guarantee the Companys performance as it relates to its drilling contracts and other
obligations in various jurisdictions. These obligations could be called at any time prior to the
expiration dates. The obligations that are the subject of the surety bonds are geographically
concentrated in Mexico and the U.S.
The Company had $1.0 million in unsecured bank guarantees and a $0.1 million unsecured letter
of credit outstanding at March 31, 2011.
Sales Tax Audits
Certain of the Companys legal entities obtained in the TODCO acquisition are under audit by
various taxing authorities for several prior-year periods. These audits are ongoing and the Company
is working to resolve all relevant issues, however, the Company has accrued approximately $5.9
million as of March 31, 2011 while the Company provides additional information and responds to
auditor requests.
22
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
14. Accounting Pronouncements
In December 2010, the FASB issued ASU No. 2010-29, Disclosure of Supplementary Pro Forma
Information for Business Combinations (ASU 2010-29), which amends and clarifies the acquisition
date that should be used for reporting the pro forma financial disclosures in Topic 805 when
comparative financial statements are presented. It also requires a description of the nature and
amount of material, nonrecurring pro forma adjustments that are directly attributable to the
business combination. ASU 2010-29 is effective prospectively for business combinations for which
the acquisition date is on or after the beginning of the first annual reporting period beginning on
or after December 15, 2010 with early adoption permitted. The Company has adopted this standard
with no material impact on its consolidated financial statements as it only amends required
disclosures. The Company will comply with the provisions of this update for its Seahawk asset
purchase which closed April 27, 2011 (See Notes 4 and 15).
In January 2010, the FASB issued ASU 2010-06 which requires additional disclosures about the
various classes of assets and liabilities measured at fair value, the valuation techniques and
inputs used, the activity in Level 3 fair value measurements and the transfers between Levels 1, 2,
and 3. The disclosures are effective for interim and annual reporting periods beginning after
December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in
the roll forward of activity in Level 3 fair value measurements, which are effective for interim
and annual reporting periods beginning after December 15, 2010. The Company adopted the required
portions of ASU 2010-06 as of January 1, 2010 with no material impact to its consolidated financial
statements and adopted the remaining portions on January 1, 2011 with no material impact on its
consolidated financial statements (See Note 8).
15. Subsequent Events
Investigations
On April 4, 2011, the Company received a subpoena issued by the Securities and Exchange
Commission (SEC) requesting the delivery of certain documents to the SEC in connection with its
investigation into possible violations of the securities laws, including possible violations of the
Foreign Corrupt Practices Act (FCPA) in certain international jurisdictions where the Company
conducts operations. The Company was also notified by the Department of Justice (DOJ) on April 5,
2011, that certain of the Companys activities are under review by the DOJ.
The Company, through the Audit Committee of the Board of Directors, has engaged an outside law
firm with significant experience in FCPA-related matters to conduct an internal review, and intends
to cooperate with the SEC and DOJ in their investigations. At this time, it is not possible to
predict the outcome of the investigations, the expenses the Company will incur associated with
these matters, or the impact on the price of the Companys common stock or other securities as a
result of these investigations.
Shareholder Derivative Suit
On April 27, 2011, a shareholder derivative action was filed in the District Court of Harris
County, Texas, allegedly on behalf of and for the benefit of the Company, naming the Company as a
nominal defendant and certain of our officers and directors as defendants alleging, among other
claims, breach of fiduciary duty, abuse of control, waste of corporate assets, and unjust
enrichment. The petition alleges that the individual defendants allowed the Company to violate the
U.S. Foreign Corrupt Practices Act (FCPA) and failed to maintain internal controls and accounting
systems for compliance with the FCPA. Plaintiffs seek damages, restitution and injunctive and/or
equitable relief purportedly on behalf of the Company, certain corporate actions, and an award of
their costs and attorneys fees.
Asset Purchase
On April 27, 2011, the Company completed the Seahawk asset purchase. (See Note 4).
Insurance Renewal
The Company is self-insured for the deductible portion of its insurance coverage. Management
believes adequate accruals have been made on known and estimated exposures up to the deductible
portion of the Companys insurance coverage. Management believes that claims and liabilities in
excess of the amounts accrued are adequately insured. However, the Companys insurance is subject
to exclusions and limitations, and there is no assurance that such coverage will adequately protect
the Company against liability from all potential consequences. In addition, there is no assurance
of renewal or the ability to obtain coverage acceptable to the Company.
23
HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
UNAUDITED
(As Adjusted (Note 1))
The Company maintains insurance coverage that includes coverage for physical damage, third
party liability, workers compensation and employers liability, general liability, vessel
pollution and other coverages.
In April 2011, the Company completed the annual renewal of all of its key insurance policies.
The Companys primary marine package provides for hull and machinery coverage for substantially all
of the Companys rigs and liftboats up to a scheduled value of each asset. The total maximum amount
of coverage for these assets is $1.6 billion, including the newly acquired Seahawk units. The
marine package includes protection and indemnity and maritime employers liability coverage for
marine crew personal injury and death and certain operational liabilities, with primary coverage
(or self-insured retention for maritime employers liability coverage) of $5.0 million per
occurrence with excess liability coverage up to $200.0 million. The marine package policy also
includes coverage for personal injury and death of third-parties with primary and excess coverage
of $25 million per occurrence with additional excess liability coverage up to $200 million, subject
to a $250,000 per-occurrence deductible. The marine package also provides coverage for cargo and
charterers legal liability. The marine package includes limitations for coverage for losses caused
in U.S. Gulf of Mexico named windstorms, including an annual aggregate limit of liability of $75.0
million for property damage and removal of wreck liability coverage. The Company also procured an
additional $75.0 million excess policy for removal of wreck and certain third-party liabilities
incurred in U.S. Gulf of Mexico named windstorms. Deductibles for events that are not caused by a
U.S. Gulf of Mexico named windstorm are 12.5% of the insured drilling rig values per occurrence,
subject to a minimum of $1.0 million, and $1.0 million
per occurrence for liftboats. The deductible for drilling rigs and liftboats in a U.S. Gulf of
Mexico named windstorm event is $25.0 million. Vessel pollution is covered under a Water Quality
Insurance Syndicate policy (WQIS Policy) providing limits as required by applicable law,
including the Oil Pollution Act of 1990. The WQIS Policy covers pollution emanating from the
Companys vessels and drilling rigs, with primary limits of $5 million (inclusive of a $3.0 million
per-occurrence deductible) and excess liability coverage up to $200 million.
Control-of-well events generally include an unintended flow from the well that cannot be
contained by equipment on site (e.g., a blow-out preventer), by increasing the weight of the
drilling fluid or that does not naturally close itself off through what is typically described as
bridging over. The Company carries a contractors extra expense policy with $25.0 million primary
covering liability for well control costs, expenses incurred to redrill wild or lost wells and
pollution, with excess liability coverage up to $200 million for pollution liability that is
covered in the primary policy. The policies are subject to exclusions, limitations, deductibles,
self-insured retention and other conditions. In addition to the marine package, the Company has
separate policies providing coverage for onshore foreign and domestic general liability, employers
liability, auto liability and non-owned aircraft liability, with customary deductibles and coverage
as well as a separate underlying marine package for its Delta Towing business.
The Companys drilling contracts provide for varying levels of indemnification from its
customers and in most cases, may require the Company to indemnify its customers for certain
liabilities. Under the Companys drilling contracts, liability with respect to personnel and
property is customarily assigned on a knock-for-knock basis, which means that the Company and its
customers assume liability for the Companys respective personnel and property, regardless of how
the loss or damage to the personnel and property may be caused. The Companys customers typically
assume responsibility for and agree to indemnify the Company from any loss or liability resulting
from pollution or contamination, including clean-up and removal and third-party damages arising
from operations under the contract and originating below the surface of the water, including as a
result of blow-outs or cratering of the well (Blowout Liability). The customers assumption for
Blowout Liability may, in certain circumstances, be limited or could be determined to be
unenforceable in the event of the gross negligence, willful misconduct or other egregious conduct
of the Company. The Company generally indemnifies the customer for the consequences of spills of
industrial waste or other liquids originating solely above the surface of the water and emanating
from its rigs or vessels.
24
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
As
further discussed in Note 1 to our unaudited consolidated financial statements, in May 2011, we
completed the sale of substantially all of Delta Towings assets and certain liabilities. As a
result of this sale, we have recast certain information included in
our unaudited consolidated financial
statements as of and for the three months ended March 31, 2011.
The following discussion and analysis should be read in conjunction with the accompanying
unaudited consolidated financial statements as of March 31, 2011 and for the three months ended
March 31, 2011 and 2010, included elsewhere herein, and with our Annual Report on Form 10-K for the
year ended December 31, 2010. The following information contains forward-looking statements. Please
read Forward-Looking Statements below for a discussion of certain limitations inherent in such
statements. Please also read Risk Factors in Item 1A of our Annual Report on Form 10-K for the
year ended December 31, 2010 for a discussion of certain risks facing our company.
OVERVIEW
We are a leading provider of shallow-water drilling and marine services to the oil and natural
gas exploration and production industry globally. We provide these services to national oil and gas
companies, major integrated energy companies and independent oil and natural gas operators. In
February 2011, we entered into an asset purchase agreement (the Asset Purchase Agreement) with
Seahawk Drilling, Inc. and certain of its subsidiaries (Seahawk), pursuant to which Seahawk
agreed to sell us 20 jackup rigs and related assets, accounts receivable, cash and certain
liabilities. On April 27, 2011, we completed the Seahawk asset purchase (See Part I, Item 2.
Managements Discussion and Analysis of Financial Condition and Results of Operation Recent
Developments). Including the assets acquired in the Seahawk transaction, we own a fleet of 50
jackup rigs, 17 barge rigs, three submersible rigs, one platform rig, a fleet of marine support
vessels operated through Delta Towing, a wholly owned subsidiary, and 60 liftboat vessels and
operate an additional five liftboat vessels owned by a third party. Our diverse fleet is capable of
providing services such as oil and gas exploration and development drilling, well service, platform
inspection, maintenance and decommissioning operations in several key shallow water provinces
around the world.
Investment
In January 2011, we paid $10 million to purchase 5.0 million shares, an initial investment in
approximately eight percent of the total outstanding equity of a new entity incorporated in
Luxembourg, Discovery Offshore S.A. (Discovery Offshore), which investment was used by Discovery
Offshore towards funding the down payments on two new-build ultra high specification harsh
environment jackup drilling rigs (collectively the Rigs or individually Rig). The Rigs, Keppel
FELS Super A design, are being constructed by Keppel FELS in its Singapore shipyard and have a
maximum water depth rating of 400 feet, two million pound hook load capacity, and are capable of
drilling up to 35,000 feet deep. The two Rigs are expected to be delivered in the second and fourth
quarter of 2013, respectively. Discovery Offshore also holds options to purchase two additional
rigs of the same specifications, which must be exercised by the third and fourth quarter of 2011,
with delivery dates expected in the second and fourth quarter of 2014, respectively.
We also executed a construction management agreement (the Construction Management Agreement)
and a services agreement (the Services Agreement) with Discovery Offshore with respect to each of
the Rigs. Under the Construction Management Agreements, we will plan, supervise and manage the
construction and commissioning of the Rigs in exchange for a fixed fee of $7.0 million per Rig,
which we received in February 2011. Pursuant to the terms of the Services Agreements, we will
market, manage, crew and operate the Rigs and any other rigs that Discovery Offshore subsequently
acquires or controls, in exchange for a fixed daily fee of $6,000 per Rig plus five percent of
Rig-based EBITDA (EBITDA excluding SG&A expense) generated per day per Rig, which commences once
the Rigs are completed and operating. Under the Services Agreements, Discovery Offshore will be
responsible for operational and capital expenses for the Rigs. We are entitled to a minimum fee of
$5 million per Rig in the event Discovery Offshore terminates a Services Agreement in the absence
of a breach of contract by Hercules Offshore.
In addition to the $10 million investment, we received 500,000 additional shares worth $1.0
million to cover our costs incurred and efforts expended in forming Discovery Offshore. We were
issued warrants to purchase up to 5.0 million additional shares of Discovery Offshore stock at a
strike price equivalent to $2.00 which is exercisable in the event that the Discovery Offshore
stock price reaches an average equal to or higher than 23 Norwegian Kroner per share, which
approximated $4.00 per share as of March 31, 2011, for 30 consecutive trading days. The warrants
were issued to additionally compensate us for our costs incurred and efforts expended in
25
forming Discovery Offshore. The warrants are being accounted for as a derivative instrument.
The initial fair value of the warrants and the 500,000 additional shares have been recorded to
deferred revenue to be amortized over 30 years, the useful life of the Rigs. We have no other
financial obligations or commitments with respect to the Rigs or our ownership in Discovery
Offshore. Two of our officers are on the Board of Directors of Discovery Offshore.
We report our business activities in six business segments, which, as of April 27, 2011,
included the following:
Domestic Offshore includes 42 jackup rigs and three submersible rigs in the U.S. Gulf of
Mexico that can drill in maximum water depths ranging from 80 to 350 feet. Fifteen of the jackup
rigs are either working on short-term contracts or available for contracts, three are in the
shipyard and 24 are cold-stacked. All three submersibles are cold-stacked.
International Offshore includes eight jackup rigs and one platform rig outside of the U.S.
Gulf of Mexico. We have two jackup rigs working offshore in each of India and Saudi Arabia, one
jackup rig contracted offshore in Malaysia, one jackup rig contracted in Angola and one platform
rig under contract in Mexico. In addition, we have one jackup rig warm-stacked and one jackup rig
cold-stacked in Bahrain.
Inland includes a fleet of six conventional and eleven posted barge rigs that operate
inland in marshes, rivers, lakes and shallow bay or coastal waterways along the U.S. Gulf Coast.
Three of our inland barges are either operating on short-term contracts or available and fourteen
are cold-stacked.
Domestic Liftboats includes 41 liftboats in the U.S. Gulf of Mexico. Thirty-six are
operating or available and five are cold-stacked.
International Liftboats includes 24 liftboats. Twenty-one are operating or
available for contracts offshore West Africa, including five liftboats owned by a third party, one
is cold-stacked offshore West Africa and two are operating or available for contracts in the Middle
East region.
Delta Towing our Delta Towing business operates a fleet of 29 inland tugs, 10 offshore
tugs, 34 crew boats, 46 deck barges, 16 shale barges and five spud barges along and in the U.S.
Gulf of Mexico and from time to time along the Southeastern coast and in Mexico. Of these vessels,
24 crew boats, 11 inland tugs, three offshore tugs, one deck barge and one spud barge are
cold-stacked, and the remaining are working, being repaired or available for contracts.
In May 2011, we completed the sale of substantially all of Delta Towings assets and certain
liabilities for aggregate consideration of $30 million in cash (the Delta Towing Sale) and
recognized a loss on the sale of approximately $13 million. We
retained the working capital of our Delta Towing business, which was
valued at approximately $6 million at the date of sale. As a result of the Delta Towing Sale,
we have recast certain information to classify the results of operations of the Delta Towing assets
as discontinued operations.
In November 2010, we entered into an agreement to sell our retired jackups Hercules 190 and
Hercules 254 for a total of $4.0 million for both jackups, which is expected to close in the second
quarter of 2011. In March 2011, we entered into an agreement to sell our submersible rig Hercules
78 for $1.8 million, which is expected to close in the second quarter of 2011. The financial
information for Hercules 190, Hercules 254 and Hercules 78 has been reported as part of the
Domestic Offshore segment.
In April 2011, we entered into an agreement to sell our jackup Hercules 152 for a purchase
price of $5.0 million.
In January 2011, we entered into an agreement with China Oilfield Services Limited (COSL)
whereby we will market and operate a Friede & Goldman JU2000E jackup drilling rig with a maximum
water depth of 400 feet. The agreement is limited to a specified opportunity in Angola.
In March, 2011, at our request, the parties agreed to terminate, without the payment of a
termination fee, the management agreement with First Energy Bank B.S.C. (MENAdrill) with respect
to Hull 110.
Our jackup and submersible rigs and our barge rigs are used primarily for exploration and
development drilling in shallow waters. Under most of our contracts, we are paid a fixed daily
rental rate called a dayrate, and we are required to pay all costs associated with our own crews
as well as the upkeep and insurance of the rig and equipment.
26
Our liftboats are self-propelled, self-elevating vessels with a large open deck space which
provides a versatile, mobile and stable platform to support a broad range of offshore maintenance
and construction services throughout the life of an oil or natural gas well. Under most of our
liftboat contracts, we are paid a fixed dayrate for the rental of the vessel, which typically
includes the costs of a small crew of four to eight employees, and we also receive a variable rate
for reimbursement of other operating costs such as catering, fuel, rental equipment and other
items.
Our revenue is affected primarily by dayrates, fleet utilization, the number and type of units
in our fleet and mobilization fees received from our customers. Utilization and dayrates, in turn,
are influenced principally by the demand for rig and liftboat services from the exploration and
production sectors of the oil and natural gas industry. Our contracts in the U.S. Gulf of Mexico
tend to be short-term in nature and are heavily influenced by changes in the supply of units
relative to the fluctuating expenditures for both drilling and production activity. Our
international drilling contracts and some of our liftboat contracts in West Africa are longer term
in nature.
Our backlog at April 27, 2011 totaled approximately $211.6 million for our executed contracts,
including those related to assets purchased from Seahawk. Approximately $165.7 million of this
backlog is expected to be realized during the remainder of 2011. We calculate our backlog, or
future contracted revenue, as the contract dayrate multiplied by the number of days remaining on
the contract, assuming full utilization. Backlog excludes revenue for mobilization, demobilization,
contract preparation and customer reimbursables. The amount of actual revenue earned and the actual
periods during which revenue is earned will be different than the backlog disclosed or expected due
to various factors. Downtime due to various operational factors, including unscheduled repairs,
maintenance, weather and other factors (some of which are beyond our control), may result in lower
dayrates than the full contractual operating dayrate. In some of the contracts, our customer has
the right to terminate the contract without penalty and in certain instances, with little or no
notice.
Our operating costs are primarily a function of fleet configuration and utilization levels.
The most significant direct operating costs for our Domestic Offshore, International Offshore and
Inland segments are wages paid to crews, maintenance and repairs to the rigs, and insurance. These
costs do not vary significantly whether the rig is operating under contract or idle, unless we
believe that the rig is unlikely to work for a prolonged period of time, in which case we may
decide to cold-stack or warm-stack the rig. Cold-stacking is a common term used to describe a
rig that is expected to be idle for a protracted period and typically for which routine maintenance
is suspended and the crews are either redeployed or laid-off. When a rig is cold-stacked, operating
expenses for the rig are significantly reduced because the crew is smaller and maintenance
activities are suspended. Placing rigs in service that have been cold-stacked typically requires a
lengthy reactivation project that can involve significant expenditures and potentially additional
regulatory review, particularly if the rig has been cold-stacked for a long period of time.
Warm-stacking is a term used for a rig expected to be idle for a period of time that is not as
prolonged as is the case with a cold-stacked rig. Maintenance is continued for warm-stacked rigs.
Crews are reduced but a small crew is retained. Warm-stacked rigs generally can be reactivated in
three to four weeks.
The most significant costs for our Domestic Liftboats and International Liftboats segments are
the wages paid to crews and the amortization of regulatory drydocking costs. Unlike our Domestic
Offshore, International Offshore and Inland segments, a significant portion of the expenses
incurred with operating each liftboat are paid for or reimbursed by the customer under contractual
terms and prices. This includes catering, fuel, oil, rental equipment, crane overtime and other
items. We record reimbursements from customers as revenue and the related expenses as operating
costs. Our liftboats are required to undergo regulatory inspections every year and to be drydocked
two times every five years; the drydocking expenses and length of time in drydock vary depending on
the condition of the vessel. All costs associated with regulatory inspections, including related
drydocking costs, are deferred and amortized over a period of twelve months.
RECENT DEVELOPMENTS
Investigations
On April 4, 2011, we received a subpoena issued by the Securities and Exchange Commission
(SEC) requesting the delivery of certain documents to the SEC in connection with its
investigation into possible violations of the securities laws, including possible violations of the
Foreign Corrupt Practices Act (FCPA) in certain international jurisdictions where we conduct
operations. We were also notified by the Department of Justice (DOJ) on April 5, 2011, that
certain of our activities are under review by the DOJ.
We, through the Audit Committee of the Board of Directors, have engaged an outside law firm
with significant experience in FCPA-related matters to conduct an internal review, and intend to
cooperate with the SEC and DOJ in their investigations. At this
27
time, it is not possible to predict the outcome of the investigations, the expenses we will
incur associated with these matters, or the impact on the price of our common stock or other
securities as a result of these investigations.
Asset Purchase
On April 27, 2011, we completed our acquisition of 20 jackup rigs and related assets, accounts
receivable, cash and certain liabilities from Seahawk for total consideration of approximately
$151.8 million consisting of $25.0 million of cash and 22.3 million Hercules common shares. The
fair value of the shares issued was determined using the closing price of our stock of $5.68 on
April 27, 2011.
Insurance Renewal
We are self-insured for the deductible portion of our insurance coverage. We believe adequate
accruals have been made on known and estimated exposures up to the deductible portion of our
insurance coverage. We believe that claims and liabilities in excess of the amounts accrued are
adequately insured. However, our insurance is subject to exclusions and limitations, and there is
no assurance that such coverage will adequately protect us against liability from all potential
consequences. In addition, there is no assurance of renewal or the ability to obtain coverage
acceptable to us.
We maintain insurance coverage that includes coverage for physical damage, third party
liability, workers compensation and employers liability, general liability, vessel pollution and
other coverages.
In April 2011, we completed the annual renewal of all of our key insurance policies. Our
primary marine package provides for hull and machinery coverage for substantially all of our rigs
and liftboats up to a scheduled value of each asset. The total maximum amount of coverage for these
assets is $1.6 billion, including the newly acquired Seahawk units. The marine package includes
protection and indemnity and maritime employers liability coverage for marine crew personal injury
and death and certain operational liabilities, with primary coverage (or self-insured retention for
maritime employers liability coverage) of $5.0 million per occurrence with excess liability
coverage up to $200.0 million. The marine package policy also includes coverage for personal injury
and death of third-parties with primary and excess coverage of $25 million per occurrence with
additional excess liability coverage up to $200 million, subject to a $250,000 per-occurrence
deductible. The marine package also provides coverage for cargo and charterers legal liability.
The marine package includes limitations for coverage for losses caused in U.S. Gulf of Mexico named
windstorms, including an annual aggregate limit of liability of $75.0 million for property damage
and removal of wreck liability coverage. We also procured an additional $75.0 million excess policy
for removal of wreck and certain third-party liabilities incurred in U.S. Gulf of Mexico named
windstorms. Deductibles for events that are not caused by a U.S. Gulf of Mexico named windstorm are
12.5% of the insured drilling rig values per occurrence, subject to a minimum of $1.0 million, and
$1.0 million per occurrence for liftboats. The deductible for drilling rigs and liftboats in a U.S.
Gulf of Mexico named windstorm event is $25.0 million. Vessel pollution is covered under a Water
Quality Insurance Syndicate policy (WQIS Policy) providing limits as required by applicable law,
including the Oil Pollution Act of 1990. The WQIS Policy covers pollution emanating from our
vessels and drilling rigs, with primary limits of $5 million (inclusive of a $3.0 million
per-occurrence deductible) and excess liability coverage up to $200 million.
28
Control-of-well events generally include an unintended flow from the well that cannot be
contained by equipment on site (e.g., a blow-out preventer), by increasing the weight of the
drilling fluid or that does not naturally close itself off through what is typically described as
bridging over. We carry a contractors extra expense policy with $25.0 million primary covering
liability for well control costs, expenses incurred to redrill wild or lost wells and pollution,
with excess liability coverage up to $200 million for pollution liability that is covered in the
primary policy. The policies are subject to exclusions, limitations, deductibles, self-insured
retention and other conditions. In addition to the marine package, we have separate policies
providing coverage for onshore foreign and domestic general liability, employers liability, auto
liability and non-owned aircraft liability, with customary deductibles and coverage as well as a
separate underlying marine package for our Delta Towing business.
Our drilling contracts provide for varying levels of indemnification from our customers and in
most cases, may require us to indemnify our customers for certain liabilities. Under our drilling
contracts, liability with respect to personnel and property is customarily assigned on a
knock-for-knock basis, which means that we and our customers assume liability for our respective
personnel and property, regardless of how the loss or damage to the personnel and property may be
caused. Our customers typically assume responsibility for and agree to indemnify us from any loss
or liability resulting from pollution or contamination, including clean-up and removal and
third-party damages arising from operations under the contract and originating below the surface of
the water, including as a result of blow-outs or cratering of the well (Blowout Liability). The
customers assumption for Blowout Liability may, in certain circumstances, be limited or could be
determined to be unenforceable in the event of the gross negligence,
willful misconduct or other egregious conduct of us. We generally indemnify the customer for
the consequences of spills of industrial waste or other liquids originating solely above the
surface of the water and emanating from our rigs or vessels.
29
RESULTS OF OPERATIONS
The following table sets forth financial information by operating segment and other selected
information for the periods indicated:
Three Months Ended | ||||||||
March 31 | ||||||||
2011 | 2010 | |||||||
(Dollars in thousands) | ||||||||
Domestic Offshore: |
||||||||
Number of rigs (as of end of period) |
25 | 25 | ||||||
Revenue |
$ | 33,799 | $ | 28,962 | ||||
Operating expenses |
41,002 | 39,152 | ||||||
Depreciation and amortization expense |
15,082 | 16,539 | ||||||
General and administrative expenses |
2,845 | 3,397 | ||||||
Operating loss |
$ | (25,130 | ) | $ | (30,126 | ) | ||
International Offshore: |
||||||||
Number of rigs (as of end of period) |
9 | 9 | ||||||
Revenue |
$ | 77,119 | $ | 73,442 | ||||
Operating expenses |
33,828 | 34,719 | ||||||
Depreciation and amortization expense |
13,300 | 14,931 | ||||||
General and administrative expenses |
(2,683 | ) | 1,306 | |||||
Operating income |
$ | 32,674 | $ | 22,486 | ||||
Inland: |
||||||||
Number of barges (as of end of period) |
17 | 17 | ||||||
Revenue |
$ | 5,502 | $ | 4,751 | ||||
Operating expenses |
7,030 | 5,717 | ||||||
Depreciation and amortization expense |
4,621 | 7,506 | ||||||
General and administrative expenses |
230 | (3,165 | ) | |||||
Operating loss |
$ | (6,379 | ) | $ | (5,307 | ) | ||
Domestic Liftboats: |
||||||||
Number of liftboats (as of end of period) |
41 | 41 | ||||||
Revenue |
$ | 10,631 | $ | 11,443 | ||||
Operating expenses |
9,864 | 9,314 | ||||||
Depreciation and amortization expense |
3,641 | 4,200 | ||||||
General and administrative expenses |
495 | 495 | ||||||
Operating loss |
$ | (3,369 | ) | $ | (2,566 | ) | ||
International Liftboats: |
||||||||
Number of liftboats (as of end of period) |
24 | 24 | ||||||
Revenue |
$ | 32,327 | $ | 25,962 | ||||
Operating expenses |
14,657 | 14,462 | ||||||
Depreciation and amortization expense |
4,498 | 4,691 | ||||||
General and administrative expenses |
1,571 | 1,506 | ||||||
Operating income |
$ | 11,601 | $ | 5,303 | ||||
30
Three Months Ended | ||||||||
March 31, | ||||||||
2011 | 2010 | |||||||
(Dollars in thousands) | ||||||||
Total Company: |
||||||||
Revenue |
$ | 159,378 | $ | 144,560 | ||||
Operating expenses |
106,381 | 103,364 | ||||||
Depreciation and amortization |
41,793 | 48,664 | ||||||
General and administrative |
12,826 | 11,935 | ||||||
Operating loss |
(1,622 | ) | (19,403 | ) | ||||
Interest expense |
(18,506 | ) | (21,065 | ) | ||||
Expense of credit agreement fees |
(455 | ) | | |||||
Equity in losses of equity investment |
(55 | ) | | |||||
Other, net |
316 | (16 | ) | |||||
Loss before income taxes |
(20,322 | ) | (40,484 | ) | ||||
Income tax benefit |
6,679 | 25,493 | ||||||
Loss from continuing operations |
(13,643 | ) | (14,991 | ) | ||||
Loss from
discontinued operations, net of taxes |
(576 | ) | (965 | ) | ||||
Net loss |
$ | (14,219 | ) | $ | (15,956 | ) | ||
The following table sets forth selected operational data by operating segment for the period indicated:
Three Months Ended March 31, 2011 | ||||||||||||||||||||
Average | ||||||||||||||||||||
Average | Operating | |||||||||||||||||||
Operating | Available | Revenue | Expense | |||||||||||||||||
Days | Days | Utilization (1) | per Day (2) | per Day (3) | ||||||||||||||||
Domestic Offshore |
788 | 990 | 79.6 | % | $ | 42,892 | $ | 41,416 | ||||||||||||
International Offshore |
582 | 720 | 80.8 | % | 132,507 | 46,983 | ||||||||||||||
Inland |
205 | 270 | 75.9 | % | 26,839 | 26,037 | ||||||||||||||
Domestic Liftboats |
1,330 | 3,420 | 38.9 | % | 7,993 | 2,884 | ||||||||||||||
International Liftboats |
1,395 | 2,070 | 67.4 | % | 23,173 | 7,081 |
Three Months Ended March 31, 2010 | ||||||||||||||||||||
Average | ||||||||||||||||||||
Average | Operating | |||||||||||||||||||
Operating | Available | Revenue | Expense | |||||||||||||||||
Days | Days | Utilization (1) | per Day (2) | per Day (3) | ||||||||||||||||
Domestic Offshore |
823 | 990 | 83.1 | % | $ | 35,191 | $ | 39,547 | ||||||||||||
International Offshore |
527 | 869 | 60.6 | % | 139,359 | 39,953 | ||||||||||||||
Inland |
240 | 270 | 88.9 | % | 19,796 | 21,174 | ||||||||||||||
Domestic Liftboats |
1,727 | 3,420 | 50.5 | % | 6,626 | 2,723 | ||||||||||||||
International Liftboats |
1,174 | 2,160 | 54.4 | % | 22,114 | 6,695 |
(1) | Utilization is defined as the total number of days our rigs or liftboats, as applicable, were under contract, known as operating days, in the period as a percentage of the total number of available days in the period. Days during which our rigs and liftboats were undergoing major refurbishments, upgrades or construction, and days during which our rigs and liftboats are cold-stacked, are not counted as available days. Days during which our liftboats are in the shipyard undergoing drydocking or inspection are considered available days for the purposes of calculating utilization. | |
(2) | Average revenue per rig or liftboat per day is defined as revenue earned by our rigs or liftboats, as applicable, in the period divided by the total number of operating days for our rigs or liftboats, as applicable, in the period. | |
(3) | Average operating expense per rig or liftboat per day is defined as operating expenses, excluding depreciation and amortization, incurred by our rigs or liftboats, as applicable, in the period divided by the total number of available days in the period. We use available days to calculate average operating expense per rig or liftboat per day rather than operating days, which are used to calculate average revenue per rig or liftboat per day, because we incur operating expenses on our rigs and liftboats even when |
31
they are not under contract and earning a dayrate. In addition, the operating expenses we incur on our rigs and liftboats per day when they are not under contract are typically lower than the per day expenses we incur when they are under contract. |
For the Three Months Ended March 31, 2011 and 2010
Revenue
Consolidated. Total revenue for the three-month period ended March 31, 2011 (the Current
Quarter) was $159.4 million compared with $144.6 million for the three-month period ended March
31, 2010 (the Comparable Quarter), an increase of $14.8 million, or 10%. This increase is further
described below.
Domestic Offshore. Revenue for our Domestic Offshore segment was $33.8 million for the Current
Quarter compared with $29.0 million for the Comparable Quarter, an increase of $4.8 million, or
17%. This increase resulted primarily from an increase in average dayrates, which contributed to an
approximate $6 million increase in revenue. Partially offsetting this increase is a decline in
operating days to 788 days during the Current Quarter from 823 days during the Comparable Quarter
which contributed to an approximate $2 million decrease during the Current Quarter as compared to
the Comparable Quarter.
International Offshore. Revenue for our International Offshore segment was $77.1 million for
the Current Quarter compared with $73.4 million for the Comparable Quarter, an increase of $3.7
million, or 5% primarily related to Hercules 185 operating under a new contract in the Current
Quarter compared to not meeting revenue recognition criteria in the Comparable Quarter.
Inland. Revenue for our Inland segment was $5.5 million for the Current Quarter compared with
$4.8 million for the Comparable Quarter, an increase of $0.8 million, or 16%. This increase was
driven by a 36% increase in average dayrates which contributed to an approximate $2 million
increase to revenue in the Current Quarter as compared to the Comparable Quarter. Partially
offsetting this increase, operating days decreased to 205 in the Current Quarter as Compared to 240
in the Comparable Quarter which contributed to an approximate $1 million decrease in revenue.
Domestic Liftboats. Revenue from our Domestic Liftboats segment was $10.6 million for the
Current Quarter compared with $11.4 million in the Comparable Quarter, a decrease of $0.8 million,
or 7%. This decrease resulted primarily from a 23% decline in operating days, which contributed to
an approximate $3 million decrease in revenue. This decrease was partially offset by an increase
in average revenue per liftboat per day to $7,993 in the Current Quarter compared with $6,626 in
the Comparable Quarter, which contributed to an approximate $2 million increase in revenue.
International Liftboats. Revenue for our International Liftboats segment was $32.3 million for
the Current Quarter compared with $26.0 million in the Comparable Quarter, an increase of $6.4
million, or 25%. This increase resulted primarily from an increase in operating days during the
Current Quarter to 1,395 days from 1,174 days in the Comparable Quarter, which contributed to an
approximate $5 million increase in revenue.
Operating Expenses
Consolidated. Total operating expenses for the Current Quarter were $106.4 million compared
with $103.4 million in the Comparable Quarter, an increase of $3.0 million, or 3%. This increase is
further described below.
Domestic Offshore. Operating expenses for our Domestic Offshore segment were $41.0 million in
the Current Quarter compared with $39.2 million in the Comparable Quarter, an increase of $1.9
million, or 5%. The increase was driven by an increase in workers compensation expenses of $4.6
million offset by a decrease in equipment rentals of $2.0 million in the Current Quarter as
compared to the Comparable Quarter. Average operating expenses per rig per day were $41,416 in the
Current Quarter compared with $39,547 in the Comparable Quarter.
International Offshore. Operating expenses for our International Offshore segment were $33.8
million in the Current Quarter compared with $34.7 million in the Comparable Quarter, a decrease of
$0.9 million, or 3%. Hercules 205 was transferred to the Domestic Offshore segment during the first
quarter of 2010 which contributed to a $3.2 million decrease, Platform 3 was preparing for a
contract a portion of the Comparable Quarter which contributed to a $1.1 million decrease in the
Current Quarter and Hercules 156 was cold stacked in December 2010 which contributed to a $0.6 million decrease. These
decreases were partially offset by i) Hercules 185 operating under a new contract in the Current
Quarter compared to being on stand-by in the Comparable Quarter which contributed to a $1.3 million
increase, ii) costs to prepare Hercules 170 for contract during the Current Quarter contributed to
a $1.7 million increase and iii) an increase in workers compensation expenses of $1.3 million
overall during the Current Quarter. Average operating expenses per rig per day were $46,983 in the
Current Quarter compared with $39,953 in the Comparable Quarter.
32
Inland. Operating expenses for our Inland segment were $7.0 million in the Current Quarter
compared with $5.7 million in the Comparable Quarter, an increase of $1.3 million, or 23%. This
increase is primarily due to a $1.8 million gain in the Comparable Quarter for the sale of three
barges partially offset by a $0.4 million decrease in property taxes in the Current Quarter as
compared to the Comparable Quarter due to decreases in assessed values. Average operating expenses
per rig per day were $26,037 in the Current Quarter compared with $21,174 in the Comparable
Quarter.
Domestic Liftboats. Operating expenses for our Domestic Liftboats segment were $9.9 million in
the Current Quarter compared with $9.3 million in the Comparable Quarter, an increase of $0.6
million, or 6%. This increase is primarily due to an increase in labor and burden of $0.4 million
and an accrual for an insurance deductible of $0.3 million in the Current Quarter as well as the
Comparable Quarter including a favorable adjustment to property taxes of $0.2 million. These
increases are partially offset by a $0.3 million reduction in repairs and maintenance expenses in
the Current Quarter as compared to the Comparable Quarter. Available days were flat in the Current
Quarter as compared to the Comparable Quarter. Average operating expenses per vessel per day were
slightly higher at $2,884 in the Current Quarter compared with $2,723 in the Comparable Quarter.
International Liftboats. Operating expenses for our International Liftboats segment were $14.7
million for the Current Quarter compared with $14.5 million in the Comparable Quarter, an increase
of $0.2 million, or 1%. Available days decreased slightly to 2,070 in the Current Quarter from
2,160 in the Comparable Quarter.
Depreciation and Amortization
Depreciation and amortization expense in the Current Quarter was $41.8 million compared with
$48.7 million in the Comparable Quarter, a decrease of $6.9 million, or 14%. This decrease resulted
primarily from reduced depreciation in the Current Quarter of approximately $7 million due to asset
sales, fully depreciated assets as well as asset impairments recorded in the fourth quarter of
2010, partially offset by an approximate $1 million increase in depreciation in the Current Quarter
due to capital additions.
General and Administrative Expenses
General and administrative expenses in the Current Quarter were $12.8 million compared with
$11.9 million in the Comparable Quarter, an increase of $0.9 million, or 7%. The increase is
related to i) an approximate $1 million increase in the Current Quarter in labor and burden costs
partially due to the impact of a revision of our estimated forfeiture rate for stock-based
compensation during the Comparable Quarter of $1.8 million, partially offset by a decrease in the
Current Quarter as compared to the Comparable Quarter for bonus and base salary of $0.8 million,
ii) an approximate $0.2 million increase in software and licensing fees in the Current Quarter as
compared to the Comparable Quarter and iii) an approximate $3 million increase in legal and
professional service fees in the Current Quarter of which approximately $2 million related to the
Seahawk asset purchase. These increases are largely offset by a $3.6 million reduction in bad debt
expense in the Current Quarter as compared to the Comparable Quarter.
Interest Expense
Interest expense in the Current Quarter was $18.5 million compared with $21.1 million in the
Comparable Quarter, a decrease of $2.6 million, or 12%. This decrease was related primarily to the
impact of our interest rate collar outstanding in the Comparable Quarter.
Expense of Credit Agreement Fees
During the Current Quarter, we amended our credit agreement (the Credit Agreement) In doing
so, we recorded the write-off of certain deferred debt issuance costs and expensed certain fees
directly related to these activities totaling $0.5 million.
Income Tax Benefit
Our income tax benefit was $6.7 million on a pre-tax loss of $20.3 million, for an effective
rate of 32.9%, during the Current Quarter, compared to a benefit of $25.5 million on a pre-tax loss
of $40.5 million, for an effective rate of 63.0%, for the Comparable Quarter. The effective tax
rate in the Current Quarter decreased as compared to the Comparable Quarter due to mix of earnings
(losses) from different jurisdictions as well as the prior year benefit of $6.2 million related to
the effective compromise settlement with the Mexican tax authorities on certain tax liabilities.
Discontinued Operations
We had a loss from our discontinued Delta Towing operations of $0.6 million during the Current
Quarter compared to a loss from our discontinued Delta Towing operations of $1.0 million during the
Comparable Quarter, a decrease of $0.4 million or 40%. The decrease is primarily related to an
increase in revenue of $0.6 million, or 9%.
33
Non-GAAP Financial Measures
Regulation G, General Rules Regarding Disclosure of Non-GAAP Financial Measures and other SEC
regulations define and prescribe the conditions for use of certain Non-Generally Accepted
Accounting Principles (Non-GAAP) financial measures. We use various Non-GAAP financial measures
such as adjusted operating income (loss), adjusted net income (loss), adjusted diluted earnings
(loss) per share, EBITDA and Adjusted EBITDA. EBITDA is defined as net income plus interest
expense, income taxes, depreciation and amortization. We believe that in addition to GAAP based
financial information, Non-GAAP amounts are meaningful disclosures for the following reasons: (i)
each are components of the measures used by our board of directors and management team to evaluate
and analyze our operating performance and historical trends, (ii) each are components of the
measures used by our management team to make day-to-day operating decisions, (iii) the Credit
Agreement contains covenants that require us to maintain a total leverage ratio and a consolidated
fixed charge coverage ratio, which contain Non-GAAP adjustments as components, (iv) each are
components of the measures used by our management to facilitate internal comparisons to
competitors results and the shallow-water drilling and marine services industry in general, (v)
results excluding certain costs and expenses provide useful information for the understanding of
the ongoing operations without the impact of significant special items, and (vi) the payment of
certain bonuses to members of our management is contingent upon, among other things, the
satisfaction by the Company of financial targets, which may contain Non-GAAP measures as
components. We acknowledge that there are limitations when using Non-GAAP measures. The measures
below are not recognized terms under GAAP and do not purport to be an alternative to net income as
a measure of operating performance or to cash flows from operating activities as a measure of
liquidity. EBITDA and Adjusted EBITDA are not intended to be a measure of free cash flow for
managements discretionary use, as it does not consider certain cash requirements such as tax
payments and debt service requirements. In addition, the EBITDA and Adjusted EBITDA amounts
presented in the following table should not be used for covenant compliance purposes as these
amounts could differ materially from the amounts ultimately calculated under our Credit Agreement.
Because all companies do not use identical calculations, the amounts below may not be comparable
to other similarly titled measures of other companies.
34
The following table presents a reconciliation of the GAAP financial measure to the
corresponding adjusted financial measure (in thousands):
For the Three Months | ||||||||
Ended March 31, | ||||||||
2011 | 2010 | |||||||
Loss from
Continuing Operations |
$ | (13,643 | ) | $ | (14,991 | ) | ||
Interest expense |
18,506 | 21,065 | ||||||
Income tax benefit |
(6,679 | ) | (25,493 | ) | ||||
Depreciation and amortization |
41,793 | 48,664 | ||||||
EBITDA |
39,977 | 29,245 | ||||||
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are those that are important to our results of operations,
financial condition and cash flows and require managements most difficult, subjective or complex
judgments. Different amounts would be reported under alternative assumptions. We have evaluated the
accounting policies used in the preparation of the unaudited consolidated financial statements and
related notes appearing elsewhere in this quarterly report. We apply those accounting policies that
we believe best reflect the underlying business and economic events, consistent with accounting
principles generally accepted in the United States. We believe that our policies are generally
consistent with those used by other companies in our industry. We base our estimates on historical
experience and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources. Actual results could
differ from those estimates.
We periodically update the estimates used in the preparation of the financial statements based
on our latest assessment of the current and projected business and general economic environment.
During recent periods, there has been substantial volatility and a decline in gas prices. This
decline may adversely impact the business of our customers, and in turn our business. This could
result in changes to estimates used in preparing our financial statements, including the assessment
of certain of our assets for impairment.
We believe that our more critical accounting policies include those related to property and
equipment, equity investments, derivatives, revenue recognition, percentage-of-completion, income
tax, allowance for doubtful accounts, deferred charges, stock-based compensation and cash and cash
equivalents. Inherent in such policies are certain key assumptions and estimates. For additional
information regarding our critical accounting policies, please read Managements Discussion and
Analysis of Financial Condition and Results of OperationsCritical Accounting Policies in Item 7
of our Annual Report on Form 10-K for the year ended December 31, 2010 and Item 1 of Part I of this
Quarterly Report on Form 10-Q.
35
LIQUIDITY AND CAPITAL RESOURCES
Sources and Uses of Cash
Sources and uses of cash for the three-month period ended March 31, 2011 are as follows (in
millions):
Net Cash Provided by Operating Activities |
$ | 49.1 | ||
Net Cash Provided by (Used in) Investing Activities: |
||||
Additions of Property and Equipment |
(10.3 | ) | ||
Deferred Drydocking Expenditures |
(4.1 | ) | ||
Cash Paid for Equity Investment |
(10.0 | ) | ||
Proceeds from Sale of Assets, Net |
3.4 | |||
Total |
(21.0 | ) | ||
Net Cash Provided by (Used in) Financing Activities: |
||||
Payment of Debt Issuance Costs |
(2.1 | ) | ||
Excess Tax Benefits from Stock-Based Arrangements |
0.1 | |||
Other |
0.2 | |||
Total |
(1.8 | ) | ||
Net Increase in Cash and Cash Equivalents |
$ | 26.3 | ||
Asset Purchase
On April 27, 2011, we completed our acquisition of 20 jackup rigs and related assets, accounts
receivable, cash and certain liabilities from Seahawk for total consideration of approximately
$151.8 million consisting of $25.0 million of cash and 22.3 million Hercules common shares. The
fair value of the shares issued was determined using the closing price of our stock of $5.68 on
April 27, 2011.
Equity Investment and Derivative Asset
Our total equity investment in Discovery Offshore was $18.3 million, or 13% as of March 31,
2011, which includes the initial cash investment of $10.0 million, additional equity interest of
$1.0 million related to 500,000 Discovery Offshore shares awarded to us for reimbursement of costs
incurred and efforts expended in forming Discovery Offshore, additional purchases of Discovery
Offshore shares on the open market totalling $7.3 million or 3,203,700 shares (amount was not cash
settled until April 2011) as well as our proportionate share of Discovery Offshores losses. This
investment is being accounted for using the equity method of accounting as we have the ability to
exert significant influence, but not control, over operating and financial policies. We have
warrants issued from Discovery Offshore that are being accounted for as a derivative asset equal to
$5.2 million as of March 31, 2011 that, if exercised, would be recorded as an increase our equity
investment in Discovery Offshore. The initial fair value of the warrants of $5.0 million as well as
the $1.0 million related to the 500,000 additional shares have been recorded as deferred revenue to
be amortized over 30 years, the useful life of the two Discovery Offshore rigs, of which thirty-one
thousand dollars was recognized as of March 31, 2011. Subsequent changes in the fair value of the
warrants is recognized to other income (expense). We recognized $0.2 million to other income
related to the change in the fair value of the warrants during the three months ended March 31,
2011.
Percentage-of-Completion
We are using the percentage-of-completion method of accounting for our revenue and related
costs associated with our construction management agreements with Discovery Offshore, combining the
construction management agreements, based on a cost-to-cost method. Any revisions in revenue, cost
or the progress towards completion, will be treated as a change in accounting estimate
36
and will be
accounted for using the cumulative catch-up method. As of March 31, 2011, $14.0 million has been
recorded as a deferred revenue liability; however, no deferred cost asset has been recorded. There
was no revenue or cost recognized during the three months ended March, 31, 2011 under the
percentage-of-completion method of accounting as there were no activities associated with the
performance of contract obligations during the current quarter.
Sources of Liquidity and Financing Arrangements
Our liquidity is comprised of cash on hand, cash from operations and availability under our
revolving credit facility. We also maintain a shelf registration statement covering the future
issuance from time to time of various types of securities, including debt and equity securities. If
we issue any debt securities off the shelf or otherwise incur debt, we would generally be required
to allocate the proceeds of such debt to repay or refinance existing debt. We currently believe we
will have adequate liquidity to meet the minimum liquidity requirement under our Credit Agreement
that governs our $475.2 million term loan and $140.0 million revolving credit facility and to fund
our operations. However, to the extent we do not generate sufficient cash from operations we may
need to raise additional funds through debt, equity offerings or the sale of assets. Furthermore,
we may need to raise additional funds through debt or equity offerings or asset sales to meet
certain covenants under the Credit Agreement, to refinance existing debt or for general corporate
purposes. In July 2012, our $140.0 million revolving credit facility matures. To the extent we are
unsuccessful in extending the maturity or entering into a new revolving credit facility, our
liquidity would be negatively impacted. In June 2013, we may be required to settle our 3.375%
Convertible Senior Notes. As of March 31, 2011, the notional amount of these notes outstanding was
$95.9 million. Additionally, our term loan matures in July 2013 and currently requires a balloon
payment of $464.1 million at maturity. We intend to meet these obligations through one or more of
the following: cash flow from operations, asset sales, debt refinancing and future debt or equity
offerings.
Our Credit Agreement imposes various affirmative and negative covenants, including
requirements to meet certain financial ratios and tests, which we currently meet. Our failure to
comply with such covenants would result in an event of default under the Credit Agreement.
Additionally, in order to maintain compliance with our financial covenants, borrowings under our
revolving credit facility may be limited to an amount less than the full amount of remaining
availability after outstanding letters of credit. An event of default could prevent us from
borrowing under the revolving credit facility, which would in turn have a material adverse effect
on our available liquidity. Furthermore, an event of default could result in us having to
immediately repay all amounts outstanding under the term loan facility, the revolving credit
facility, our 10.5% Senior Secured Notes and our 3.375% Convertible Senior Notes and in the
foreclosure of liens on our assets.
Cash Requirements and Contractual Obligations
Debt
Our current debt structure is used to fund our business operations.
At December 31, 2010, we had outstanding a $650.2 million credit facility consisting of a
$475.2 million term loan and a $175.0 million revolving credit facility which is governed by the
credit agreement (Credit Agreement), as amended.
Prior to the March 2011 Credit Amendment, the interest rates on borrowings under the Credit
Facility were 4.00% plus LIBOR for Eurodollar Loans and 3.00% plus the Alternate Base Rate for ABR
Loans, based on the principal amount of the term loans outstanding during the period. A minimum
LIBOR rate of 2.00% for Eurodollar Loans, or a minimum base rate of 3.00% with respect to ABR
Loans, apply to all borrowings under the Credit Facility. The commitment fee on the revolving
credit facility was 1.00% and the letter of credit fee with respect to the undrawn amount of each
letter of credit issued under the revolving credit facility was 4.00% per annum.
The availability under the $175.0 million revolving credit facility must be used for working
capital, capital expenditures and other general corporate purposes and cannot be used to prepay the
term loan. We are required to maintain a minimum level of liquidity, measured as the amount of
unrestricted cash and cash equivalents on hand and availability under the revolving credit
facility, of (i) $75.0 million during calendar year 2011 and (ii) $50.0 million thereafter. As of
March 31, 2011, as calculated pursuant to our Credit Agreement, our total liquidity was $290.8
million.
37
In addition, we are required to maintain a minimum fixed charge coverage ratio according to
the following schedule:
Fixed Charge | ||||||
Period | Coverage Ratio | |||||
July 1, 2009 |
| December 31, 2011 | 1.00 to 1.00 | |||
January 1, 2012 |
| March 31, 2012 | 1.05 to 1.00 | |||
April 1, 2012 |
| June 30, 2012 | 1.10 to 1.00 | |||
July 1, 2012 and thereafter |
1.15 to 1.00 |
- | The consolidated fixed charge coverage ratio for any test period is defined as the sum of consolidated EBITDA for the test period plus an amount that may be added for the purpose of calculating the ratio for such test period, not to exceed $130.0 million in total during the term of the credit facility, to consolidated fixed charges for the test period adjusted by an amount not to exceed $110.0 million during the term of the credit facility to be deducted from capital expenditures, all as defined in the Credit Agreement. As of March 31, 2011, our fixed charge coverage ratio was 1.76 to 1.00. |
| In addition, we are required to make mandatory prepayments of debt outstanding under the Credit Agreement with 50% of excess cash flow as defined in the Credit Agreement for the fiscal years ending December 31, 2011 and 2012, and with proceeds from: |
- | unsecured debt issuances, with the exception of refinancing; | ||
- | secured debt issuances; | ||
- | casualty events not used to repair damaged property; | ||
- | sales of assets in excess of $25 million annually; and | ||
- | unless we have achieved a specified leverage ratio, 50% of proceeds from equity issuances, excluding those for permitted acquisitions or to meet the minimum liquidity requirements. |
March 2011 Credit Amendment
On March 3, 2011, we amended our Credit Agreement (2011 Credit Amendment) to, among other
things:
- | Allow for the use of cash to purchase assets from Seahawk, to the extent set forth in our previously disclosed Asset Purchase Agreement with Seahawk; | ||
- | Exempt the pro forma treatment of historical results from the Seahawk assets with respect to the calculation of the financial covenants in the Credit Agreement; | ||
- | Increase our investment basket to $50 million from $25 million; and | ||
- | Revise the covenant threshold levels of the Total Leverage Ratio, as defined in the Credit Agreement, to the following schedule: |
38
Amended Total | ||||
Test Date | Previous Total Leverage Ratio | Leverage Ratio | ||
March 31, 2011 |
7.00 to 1.00 | No Change | ||
June 30, 2011 |
6.75 to 1.00 | No Change | ||
September 30, 2011 |
6.00 to 1.00 | 7.50 to 1.00 | ||
December 31, 2011 |
5.50 to 1.00 | 7.75 to 1.00 | ||
March 31, 2012 |
5.25 to 1.00 | 7.50 to 1.00 | ||
June 30, 2012 |
5.00 to 1.00 | 7.25 to 1.00 | ||
September 30, 2012 |
4.75 to 1.00 | 6.75 to 1.00 | ||
December 31, 2012 |
4.50 to 1.00 | 6.25 to 1.00 | ||
March 31, 2013 |
4.25 to 1.00 | 6.00 to 1.00 | ||
June 30, 2013 |
4.00 to 1.00 | 5.75 to 1.00 |
- | At March 31, 2011, our total leverage ratio was 4.69 to 1.00. |
Further, the interest rates on borrowings under the Credit Facility were increased to 5.50%
plus LIBOR for Eurodollar Loans and 4.50% plus the Alternate Base Rate for ABR Loans. The minimum
LIBOR of 2.00% for Eurodollar Loans, or a minimum base rate of 3.00% with respect to ABR Loans,
remains. In addition, total commitments on the revolving credit facility, which is currently
unfunded, were reduced to $140.0 million from $175.0 million.
We also agreed to pay consenting lenders an upfront fee of 0.25% on their commitment, or
approximately $1.4 million. Including agent bank fees and expenses our total cost was approximately
$2.0 million. We recognized a pretax charge of $0.5 million, $0.3 million net of tax, related to
the write off of certain unamortized issuance costs and the expense of certain fees in connection
with the 2011 Credit Amendment.
As of March 31, 2011, the credit facility consisted of a $475.2 million term loan which
matures on July 11, 2013 and a $140.0 million revolving credit facility that matures on July 11,
2012, under which the remaining availability was $127.8 million as $12.2 million in standby letters
of credit had been issued under it. Other than the required prepayments as outlined previously, the
principal amount of the term loan amortizes in equal quarterly installments of approximately $1.2
million, with the balance due on July 11, 2013. Interest payments on both the revolving and term
loan facility are due at least on a quarterly basis and in certain instances, more frequently. As
of March 31, 2011, $475.2 million was outstanding on the term loan facility and the interest rate
was 7.5%. The annualized effective interest rate was 6.89% for the three months ended March 31,
2011 after giving consideration to revolver fees.
Other covenants contained in the Credit Agreement restrict, among other things, asset
dispositions, mergers and acquisitions, dividends, stock repurchases and redemptions, other
restricted payments, debt issuances, liens, investments, convertible notes repurchases and
affiliate transactions. The Credit Agreement also contains a provision under which an event of
default on any other indebtedness exceeding $25.0 million would be considered an event of default
under our Credit Agreement.
In July 2007, we entered into a zero cost LIBOR collar on $300.0 million of term loan
principal with a final settlement date of October 1, 2010 (which was settled on October 1, 2010 per
the agreement with a cash payment of $3.4 million) with a ceiling of 5.75% and a floor of 4.99%.
The counterparty paid us in any quarter that actual LIBOR reset above 5.75% and we paid the
counterparty in any quarter that actual LIBOR resets below 4.99%. The terms and settlement dates of
the collar matched those of the term loan through July 27, 2009, the date of the 2009 Credit
Amendment.
As a result of the inclusion of a LIBOR floor in the Credit Agreement, we determined, as of
July 27, 2009 and on an ongoing basis, that the interest rate collar (which settled on October 1,
2010) would not be highly effective in achieving offsetting changes in cash flows attributable to
the hedged interest rate risk during the period that the hedge was designated. As such, we
discontinued cash flow hedge accounting for the interest rate collar as of July 27, 2009. Because
cash flow hedge accounting was not applied to this instrument, changes in fair value related to the
interest rate collar subsequent to July 27, 2009 were recorded in earnings. As a result of
discontinuing the cash flow hedging relationship, we recognized a decrease in fair value of $0.4
million related to the hedge ineffectiveness of our interest rate collar as Interest Expense in our
Consolidated Statements of Operations for the three months ended March 31, 2010. We had a net
unrealized gain on hedge transactions of $2.1 million, net of tax of $1.1 million for the three
months ended March 31, 2010. Overall, our interest expense was increased by $3.6 million during the
three months ended March 31, 2010, as a result of our interest rate derivative instruments. We did
not recognize a gain or loss due to hedge ineffectiveness in the Consolidated Statements of
Operations for the three months ended March 31, 2011 as the interest rate collars final settlement
occurred on October 1, 2010.
39
On October 20, 2009, we completed an offering of $300.0 million of senior secured notes at a
coupon rate of 10.5% (10.5% Senior Secured Notes) with a maturity in October 2017. The interest
on the 10.5% Senior Secured Notes is payable in cash semi-annually in arrears on April 15 and
October 15 of each year, to holders of record at the close of business on April 1 or October 1.
Interest on the notes will be computed on the basis of a 360-day year of twelve 30-day months. The
notes were sold at 97.383% of their face amount to yield 11.0% and were recorded at their
discounted amount, with the discount to be amortized over the life of the notes. As of March 31,
2011, $300.0 million notional amount of the 10.5% Senior Secured Notes was outstanding.
The notes are guaranteed by all of our existing and future restricted subsidiaries that incur
or guarantee indebtedness under a credit facility, including our existing credit facility. The
notes are secured by liens on all collateral that secures our obligations under our secured credit
facility, subject to limited exceptions. The liens securing the notes share on an equal and ratable
first priority basis with liens securing our credit facility. Under the intercreditor agreement,
the collateral agent for the lenders under our secured credit facility is generally entitled to
sole control of all decisions and actions.
All the liens securing the notes may be released if our secured indebtedness, other than these
notes, does not exceed the lesser of $375.0 million and 15.0% of our consolidated tangible assets.
We refer to such a release as a collateral suspension. If a collateral suspension is in effect,
the notes and the guarantees will be unsecured, and will effectively rank junior to our secured
indebtedness to the extent of the value of the collateral securing such indebtedness. If, after
any such release of liens on collateral, the aggregate principal amount of our secured
indebtedness, other than these notes, exceeds the greater of $375.0 million and 15.0% of our
consolidated tangible assets, as defined in the indenture, then the collateral obligations of the
Company and guarantors will be reinstated and must be complied with within 30 days of such event.
The indenture governing the notes contains covenants that, among other things, limit our
ability and the ability of our restricted subsidiaries to:
| incur additional indebtedness or issue certain preferred stock; | ||
| pay dividends or make other distributions; | ||
| make other restricted payments or investments; | ||
| sell assets; | ||
| create liens; | ||
| enter into agreements that restrict dividends and other payments by restricted subsidiaries; | ||
| engage in transactions with our affiliates; and | ||
| consolidate, merge or transfer all or substantially all of our assets. |
The indenture governing the notes also contains a provision under which an event of default by
us or by any restricted subsidiary on any other indebtedness exceeding $25.0 million would be
considered an event of default under the indenture if such default: a) is caused by failure to pay
the principal at final maturity, or b) results in the acceleration of such indebtedness prior to
maturity.
On June 3, 2008, we completed an offering of $250.0 million convertible senior notes at a
coupon rate of 3.375% (3.375% Convertible Senior Notes) with a maturity in June 2038. As of March
31, 2011, $95.9 million notional amount of the $250.0 million 3.375% Convertible Senior Notes was
outstanding. The net carrying amount of the 3.375% Convertible Senior Notes was $87.4 million at
March 31, 2011.
The interest on the 3.375% Convertible Senior Notes is payable in cash semi-annually in
arrears, on June 1 and December 1 of each year until June 1, 2013, after which the principal will
accrete at an annual yield to maturity of 3.375% per year. We will also pay contingent interest
during any six-month interest period commencing June 1, 2013, for which the trading price of these
notes for a specified period of time equals or exceeds 120% of their accreted principal amount. The
notes will be convertible under certain circumstances into shares of our common stock (Common
Stock) at an initial conversion rate of 19.9695 shares of Common Stock per $1,000 principal amount
of notes, which is equal to an initial conversion price of approximately $50.08 per share. Upon
conversion of a note, a holder will receive, at our election, shares of Common Stock, cash or a
combination of cash and shares of Common Stock. At March 31, 2011, the number of conversion shares
potentially issuable in relation to our 3.375% Convertible Senior Notes was 1.9 million. We may
redeem the notes at our option beginning June 6, 2013, and holders of the notes will have the right
to require us to repurchase the notes on June 1, 2013 and certain dates thereafter or on the
occurrence of a fundamental change.
The indenture governing the 3.375% Convertible Senior Notes contains a provision under which
an event of default by us or by any subsidiary on any other indebtedness exceeding $25.0 million
would be considered an event of default under the indenture if such default: a) is caused by
failure to pay the principal at final maturity, or b) results in the acceleration of such
indebtedness prior to maturity.
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We determined that upon maturity or redemption, we have the intent and ability to settle the
principal amount of our 3.375% Convertible Senior Notes in cash, and any additional conversion
consideration spread (the excess of conversion value over face value) in shares of our Common
Stock.
The fair value of our 3.375% Convertible Senior Notes, 10.5% Senior Secured Notes and term
loan facility is estimated based on quoted prices in active markets. The fair value of our 7.375%
Senior Notes is estimated based on discounted cash flows using inputs from quoted prices in active
markets for similar debt instruments. The following table provides the carrying value and fair
value of our long-term debt instruments:
March 31, 2011 | December 31, 2010 | |||||||||||||||
Carrying | Fair | Carrying | Fair | |||||||||||||
Value | Value | Value | Value | |||||||||||||
(in millions) | ||||||||||||||||
Term Loan Facility, due July 2013 |
$ | 475.2 | $ | 469.1 | $ | 475.2 | $ | 443.7 | ||||||||
10.5% Senior Secured Notes, due October 2017 |
293.1 | 307.7 | 292.9 | 245.1 | ||||||||||||
3.375% Convertible Senior Notes, due June 2038 |
87.4 | 90.9 | 86.5 | 69.1 | ||||||||||||
7.375% Senior Notes, due April 2018 |
3.5 | 3.0 | 3.5 | 2.2 |
We maintain insurance coverage that includes coverage for physical damage, third party
liability, workers compensation and employers liability, general liability, vessel pollution and
other coverages.
As of March 31, 2011, our primary marine package provides for hull and machinery coverage for
substantially all of our rigs and liftboats up to a scheduled value of each asset. The total
maximum amount of coverage for these assets is $2.1 billion. The marine package includes protection
and indemnity and maritime employers liability coverage for marine crew personal injury and death
and certain operational liabilities, with primary coverage (or self-insured retention for maritime
employers liability coverage) of $5.0 million per occurrence with excess liability coverage up to
$200.0 million. The marine package policy also includes coverage for personal injury and death of
third-parties with primary and excess coverage of $25 million per occurrence with additional excess
liability coverage up to $200 million, subject to a $250,000 per-occurrence deductible. The marine
package also provides coverage for cargo and charterers legal liability. The marine package
includes limitations for coverage for losses caused in U.S. Gulf of Mexico named windstorms,
including an annual aggregate limit of liability of $100.0 million for property damage and removal
of wreck liability coverage. We also procured an additional $75.0 million excess policy for removal
of wreck and certain third-party liabilities incurred in U.S. Gulf of Mexico named windstorms.
Deductibles for events that are not caused by a U.S. Gulf of Mexico named windstorm are 12.5% of
the insured drilling rig values per occurrence, subject to a minimum of $1.0 million, and $1.0
million per occurrence for liftboats. The deductible for drilling rigs and liftboats in a U.S. Gulf
of Mexico named windstorm event is $25.0 million. Vessel pollution is covered under a Water Quality
Insurance Syndicate policy (WQIS Policy) providing limits as required by applicable law,
including the Oil Pollution Act of 1990. The WQIS Policy covers pollution emanating from our
vessels and drilling rigs, with primary limits of $5 million (inclusive of a $3.0 million
per-occurrence deductible) and excess liability coverage up to $200 million.
Control-of-well events generally include an unintended flow from the well that cannot be
contained by equipment on site (e.g., a blow-out preventer), by increasing the weight of the
drilling fluid or that does not naturally close itself off through what is typically described as
bridging over. We carry a contractors extra expense policy with $50 million primary covering
liability for well control costs, expenses incurred to redrill wild or lost wells and pollution,
with excess liability coverage up to $200 million for pollution liability that is covered in the
primary policy. The policies are subject to exclusions, limitations, deductibles, self-insured
retention and other conditions. In addition to the marine package, we have separate policies
providing coverage for onshore foreign and domestic general liability, employers liability, auto
liability and non-owned aircraft liability, with customary deductibles and coverage as well as a
separate underlying marine package for our Delta Towing business.
Our drilling contracts provide for varying levels of indemnification from our customers and in
most cases, may require us to indemnify our customers for certain liabilities. Under our drilling
contracts, liability with respect to personnel and property is customarily assigned on a
knock-for-knock basis, which means that we and our customers assume liability for our respective
personnel and property, regardless of how the loss or damage to the personnel and property may be
caused. Our customers typically assume responsibility for and agree to indemnify us from any loss
or liability resulting from pollution or contamination, including clean-up and removal and
third-party damages arising from operations under the contract and originating below the surface of
the water, including as a result of blow-outs or cratering of the well (Blowout Liability). The
customers assumption for Blowout Liability may, in certain circumstances, be limited or could be
determined to be unenforceable in the event of the gross negligence, willful misconduct or other egregious conduct of us. We generally indemnify the customer for
the consequences of spills of industrial waste or other liquids originating solely above the
surface of the water and emanating from our rigs or vessels.
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In 2010, in connection with the renewal of certain of our insurance policies, we entered into
agreements to finance a portion of our annual insurance premiums. Approximately $25.9 million was
financed through these arrangements, of which $0.7 million and $6.0 million was outstanding at
March 31, 2011 and December 31, 2010, respectively. The interest rate on the $24.1 million note was
3.79% and it was fully paid as of March 31, 2011. The interest rate on the $1.8 million note is
3.54% and the note is scheduled to mature in July 2011.
We are self-insured for the deductible portion of our insurance coverage. Management believes
adequate accruals have been made on known and estimated exposures up to the deductible portion of
our insurance coverage. Management believes that claims and liabilities in excess of the amounts
accrued are adequately insured. However, our insurance is subject to exclusions and limitations,
and there is no assurance that such coverage will adequately protect us against liability from all
potential consequences. In addition, there is no assurance of renewal or the ability to obtain
coverage acceptable to us.
In April 2011, we completed our annual renewal and revised our insurance coverage to include
the assets from the Seahawk asset purchase (See Part I, Item 2. Managements Discussion and
Analysis of Financial Condition and Results of Operation Recent Developments).
Capital Expenditures
We expect to spend approximately $55 million on capital expenditures and drydocking during the
remainder of 2011, which includes our preliminary estimate of expenditures related to the recently
acquired Seahawk jackup rigs. Planned capital expenditures are generally maintenance and regulatory
in nature and do not include refurbishment or upgrades to our rigs, liftboats, and other marine
vessels. Should we elect to reactivate cold stacked rigs or upgrade and refurbish selected rigs or
liftboats, our capital expenditures may increase. Reactivations, upgrades and refurbishments are
subject to our discretion and will depend on our view of market conditions and our cash flows.
Costs associated with refurbishment or upgrade activities which substantially extend the
useful life or operating capabilities of the asset are capitalized. Refurbishment entails replacing
or rebuilding the operating equipment. An upgrade entails increasing the operating capabilities of
a rig or liftboat. This can be accomplished by a number of means, including adding new or higher
specification equipment to the unit, increasing the water depth capabilities or increasing the
capacity of the living quarters, or a combination of each.
We are required to inspect and drydock our liftboats on a periodic basis to meet U.S. Coast
Guard requirements. The amount of expenditures is impacted by a number of factors, including, among
others, our ongoing maintenance expenditures, adverse weather, changes in regulatory requirements
and operating conditions. In addition, from time to time we agree to perform modifications to our
rigs and liftboats as part of a contract with a customer. When market conditions allow, we attempt
to recover these costs as part of the contract cash flow.
From time to time, we may review possible acquisitions of rigs, liftboats or businesses, joint
ventures, mergers or other business combinations, and we may have outstanding from time to time
bids to acquire certain assets from other companies. We may not, however, be successful in our
acquisition efforts. We are generally restricted by our Credit Agreement from making acquisitions
for cash consideration, except to the extent the acquisition is funded by an issuance of our stock
or cash proceeds from the issuance of stock (with the exception of the Seahawk asset purchase), or
unless we are in compliance with more restrictive financial covenants than what we are normally
required to meet in each respective period as defined in the 2011 Credit Amendment. If we acquire
additional assets, we would expect that the ongoing capital expenditures for our company as a whole
would increase in order to maintain our equipment in a competitive condition.
Our ability to fund capital expenditures would be adversely affected if conditions deteriorate
in our business.
Off-Balance Sheet Arrangements
Guarantees
Our obligations under the credit facility and 10.5% Senior Secured Notes are secured by liens
on a majority of our vessels and substantially all of our other personal property. Substantially
all of our domestic subsidiaries, and several of our international subsidiaries, guarantee the
obligations under the credit facility and 10.5% Senior Secured Notes and have granted similar liens
on the majority of their vessels and substantially all of their other personal property.
42
Bank Guarantees, Letters of Credit, and Surety Bonds
We execute bank guarantees, letters of credit and surety bonds in the normal course of
business. While these obligations are not normally called, these obligations could be called by
the beneficiaries at any time before the expiration date should we breach certain contractual or
payment obligations. As of March 31, 2011, we had $24.4 million of bank guarantees, letters of
credit and surety bonds outstanding, consisting of $1.0 million in unsecured bank guarantees, a
$0.1 million unsecured outstanding letter of credit, $12.2 million in standby letters of credit
outstanding under our revolver and $11.2 million outstanding in surety bonds that guarantee our
performance as it relates to our drilling contracts and other obligations in Mexico and the U.S. If
the beneficiaries called the bank guarantees, letters of credit and surety bonds, the called amount
would become an on-balance sheet liability, and we would be required to settle the liability with
cash on hand or through borrowings under our available line of credit. As of March 31, 2011, we
have restricted cash of $11.1 million to support surety bonds related to our Mexico and U.S.
operations.
Contractual Obligations
Our contractual obligations and commitments principally include obligations associated with
our outstanding indebtedness, certain income tax liabilities, surety bonds, letters of credit,
future minimum operating lease obligations, purchase commitments and management compensation
obligations. During the first three months of 2011, there were no material changes outside the
ordinary course of business in the specified contractual obligations.
For additional information about our contractual obligations as of December 31, 2010, see
Managements Discussion and Analysis of Financial Condition and Results of Operations Liquidity
and Capital Resources Contractual Obligations in Item 7 of our Annual Report on Form 10-K for
the year ended December 31, 2010.
Accounting Pronouncements
See Note 14 to our condensed consolidated financial statements included elsewhere in this
report.
FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
All statements, other than statements of historical fact, included in this quarterly report that
address outlook, activities, events or developments that we expect, project, believe or anticipate
will or may occur in the future are forward-looking statements. These include such matters as:
| our levels of indebtedness, covenant compliance and access to capital under current market conditions; | ||
| our ability to enter into new contracts for our rigs and liftboats and future utilization rates and dayrates for the units; | ||
| our ability to renew or extend our long-term international contracts, or enter into new contracts, at current dayrates when such contracts expire; | ||
| demand for our rigs and our liftboats; | ||
| activity levels of our customers and their expectations of future energy prices and ability to obtain drilling permits; | ||
| sufficiency and availability of funds for required capital expenditures, working capital and debt service; | ||
| levels of reserves for accounts receivable; | ||
| success of our cost cutting measures and plans to dispose of certain assets; | ||
| expected completion times for our refurbishment and upgrade projects; | ||
| our plans to increase international operations; | ||
| expected useful lives of our rigs and liftboats; | ||
| future capital expenditures and refurbishment, reactivation, transportation, repair and upgrade costs; |
43
| our ability to effectively reactivate rigs that we have stacked; | ||
| liabilities and restrictions under coastwise and other laws of the United States and regulations protecting the environment; | ||
| expected outcomes of litigation, investigations, claims and disputes and their expected effects on our financial condition and results of operations; and | ||
| expectations regarding offshore drilling activity and dayrates, market conditions, demand for our rigs and liftboats, our earnings, operating revenue, operating and maintenance expense, insurance coverage, insurance expense and deductibles, interest expense, debt levels and other matters with regard to outlook. |
We have based these statements on our assumptions and analyses in light of our experience and
perception of historical trends, current conditions, expected future developments and other factors
we believe are appropriate in the circumstances. Forward-looking statements by their nature involve
substantial risks and uncertainties that could significantly affect expected results, and actual
future results could differ materially from those described in such statements. Although it is not
possible to identify all factors, we continue to face many risks and uncertainties. Among the
factors that could cause actual future results to differ materially are the risks and uncertainties
described under Risk Factors in Item 1A of our Annual Report on Form 10-K for the year ended
December 31, 2010, and Item 1A of Part II of this quarterly report and the following:
| the ability of our customers in the U.S. Gulf of Mexico to obtain drilling permits; | ||
| oil and natural gas prices and industry expectations about future prices; | ||
| levels of oil and gas exploration and production spending; | ||
| demand for and supply of offshore drilling rigs and liftboats; | ||
| our ability to enter into and the terms of future contracts; | ||
| the worldwide military and political environment, uncertainty or instability resulting from an escalation or additional outbreak of armed hostilities or other crises in the Middle East, North Africa, West Africa and other oil and natural gas producing regions or acts of terrorism or piracy; | ||
| the impact of governmental laws and regulations, including new laws and regulations in the U.S. Gulf of Mexico arising out of the Macondo well blowout incident; | ||
| the adequacy and costs of sources of credit and liquidity; | ||
| uncertainties relating to the level of activity in offshore oil and natural gas exploration, development and production; | ||
| competition and market conditions in the contract drilling and liftboat industries; | ||
| the availability of skilled personnel in view of recent reductions in our personnel; | ||
| labor relations and work stoppages, particularly in the West African and Mexican labor environments; | ||
| operating hazards such as hurricanes, severe weather and seas, fires, cratering, blowouts, war, terrorism and cancellation or unavailability of insurance coverage or insufficient coverage; | ||
| the effect of litigation, investigations and contingencies; and | ||
| our inability to achieve our plans or carry out our strategy. |
Many of these factors are beyond our ability to control or predict. Any of these factors, or a
combination of these factors, could materially affect our future financial condition or results of
operations and the ultimate accuracy of the forward-looking statements. These forward-looking
statements are not guarantees of our future performance, and our actual results and future
developments may differ materially from those projected in the forward-looking statements.
Management cautions against putting undue reliance on forward-looking statements or projecting any
future results based on such statements or present or prior earnings levels. In addition,
44
each forward-looking statement speaks only as of the date of the particular statement, and we undertake
no obligation to publicly update or revise any forward-looking statements except as required by
applicable law.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are currently exposed to market risk from changes in interest rates. From time to time, we
may enter into derivative financial instrument transactions to manage or reduce our market risk,
but we do not enter into derivative transactions for speculative purposes. A discussion of our
market risk exposure in financial instruments follows.
Interest Rate Exposure
We are subject to interest rate risk on our fixed-interest and variable-interest rate
borrowings. Variable rate debt, where the interest rate fluctuates periodically, exposes us to
short-term changes in market interest rates. Fixed rate debt, where the interest rate is fixed over
the life of the instrument, exposes us to changes in market interest rates reflected in the fair
value of the debt and to the risk that we may need to refinance maturing debt with new debt at a
higher rate.
As of March 31, 2011, the long-term borrowings that were outstanding subject to fixed interest
rate risk consisted of the 7.375% Senior Notes due April 2018, the 3.375% Convertible Senior Notes
due June 2038 and the 10.5% Senior Secured Notes due October 2017 with a carrying amount of $3.5
million, $87.4 million and $293.1 million, respectively.
As of March 31, 2011, the interest rate for the $475.2 million outstanding under the term loan
was 7.5%. If the interest rate averaged 1% more for 2011 than the rates as of March 31, 2011,
annual interest expense would increase by approximately $4.8 million. This sensitivity analysis
assumes there are no changes in our financial structure and excludes the impact of our interest
rate derivatives, if any.
The fair value of our 3.375% Convertible Senior Notes, 10.5% Senior Secured Notes and term
loan facility is estimated based on quoted prices in active markets. The fair value of our 7.375%
Senior Notes is estimated based on discounted cash flows using inputs from quoted prices in active
markets for similar debt instruments. The following table provides the carrying value and fair
value of our long-term debt instruments:
March 31, 2011 | December 31, 2010 | |||||||||||||||
Carrying | Fair | Carrying | Fair | |||||||||||||
Value | Value | Value | Value | |||||||||||||
(in millions) | ||||||||||||||||
Term Loan Facility, due July 2013 |
$ | 475.2 | $ | 469.1 | $ | 475.2 | $ | 443.7 | ||||||||
10.5% Senior Secured Notes, due October 2017 |
293.1 | 307.7 | 292.9 | 245.1 | ||||||||||||
3.375% Convertible Senior Notes, due June 2038 |
87.4 | 90.9 | 86.5 | 69.1 | ||||||||||||
7.375% Senior Notes, due April 2018 |
3.5 | 3.0 | 3.5 | 2.2 |
Fair Value of Warrants and Derivative Asset
At March 31, 2011, the fair value of derivative instruments was $5.2 million. We estimate the
fair value of these instruments using a Monte Carlo simulation which takes into account a variety
of factors including the strike price, the target price, the stock value, the expected volatility,
the risk-free interest rate, the expected life of warrants, and the number of warrants. We are
required to revalue this asset each quarter. We believe that the assumption that has the greatest
impact on the determination of fair value is the closing price of Discovery Offshores stock. The
following table illustrates the potential effect on the fair value of the derivative asset from
changes in the assumptions made:
Increase/(Decrease) | ||||
(In thousands) | ||||
25% increase in stock price |
$ | 2,385 | ||
50% increase in stock price |
4,960 | |||
10% increase in assumed volatility |
860 | |||
25% decrease in stock price |
(2,130 | ) | ||
50% decrease in stock price |
(3,860 | ) | ||
10% decrease in assumed volatility |
(970 | ) |
45