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Deep Water, Slick Profits

By Stewart Glickman We at Standard & Poor's Equity Research believe that oil-field-services outfit Hornbeck Offshore Services (HOS

; recent price, $25) is well positioned to benefit from a secular trend toward deepwater drilling in the U.S. Gulf of Mexico. In our view, Hornbeck possesses a technologically advanced fleet of offshore supply vessels (OSVs) that offers an attractive value proposition to oil and gas operators. Combined with what we view as an attractive valuation on intrinsic and relative measures, our recommendation on the stock is 5 STARS (strong buy).

Given its highly advanced fleet of vessels -- well-suited to work in THE deepwater Gulf of Mexico -- we anticipate that Hornbeck will outperform its oil-field-services peers. We believe that current day rates (the sum paid to a drilling contractor for each 24 hours of operation) in the OSV sector, while above historical averages, still fall below historical peak levels. And we think that, with utilization expected to remain high, further day-rate gains for the company's current fleet are achievable. In addition, ongoing capital expansion projects for the construction of new vessels with improved capabilities provide a potential catalyst for significant earnings growth starting in 2007, in our opinion.

LAUNCH PROGRAM. Deepwater drilling, despite generally higher costs due to the complex geology of deepwater hydrocarbon reserves, represents an important and substantial source of growth potential for the oil and gas industry. Within the U.S. Gulf of Mexico, a migration toward such deepwater drilling prospects has gone on for years, a trend we expect to continue. Those oil-field-services companies that can best provide the needed ancillary equipment and expertise to handle deepwater applications should, in our view, possess a competitive advantage.

In 1997, Hornbeck began a construction program of new-generation offshore supply vessels designed to meet the greater demands of complex well drilling, which typically occurs in deep waters. As of March, 2005, the company owned 25 OSVs, including 17 of proprietary design. Hornbeck believes that these vessels, which range from 200 feet to 265 feet, offer greater storage and off-loading capacity than conventional 180-foot OSVs, and also possess dynamic positioning capability, an important feature when safety requirements sometimes preclude an OSV from tying up directly to a rig installation.

The company estimates that the U.S.-flagged OSV fleet totals 386 vessels, of which approximately 65% are conventional 180-foot OSVs, with the remaining 35% new-generation OSVs. With an average vessel age of approximately 4 years, Hornbeck's fleet is substantially newer than conventional fleets (24 years of age, on average), many of which are currently mothballed due to lack of demand.

In addition to its fleet of OSVs, the company also operates a segment consisting of 14 oceangoing tugs and 14 oceangoing tank barges. These vessels transport refined petroleum products, mainly to and from ports in the northeastern U.S. and Puerto Rico. Hornbeck expects to add 4 more tank barges, for a total of 18, of which 6 will be double-hulled, by the end of 2005.

SHIPS COME IN. Based on monthly data between January, 1998, and March, 2005, for the OSV industry, we estimate that the historical average day rate for 200-foot-plus supply vessels is $8,100 per day, peaking in May, 2002 (at about $11,500 per day), and bottoming in June, 2004 ($5,000 per day). Since June, 2004, however, rates have risen in nine consecutive months, and stood at about $9,500 per day in March, 2005. While current rates imply a 15% premium to the historical average, we believe that high utilization (96% in March, 2005) suggests that further gains are achievable.

We also note that the most recently available day rates were still about 20% below peak levels. The company's average OSV day rate has historically been at a premium to the industry average, which we attribute to Hornbeck's greater percentage of high-specification vessels.

In early May, 2005, the company announced a new project to retrofit two sulfur tankers into U.S.-flagged 370-foot multipurpose supply vessels (MPSVs), at an expected capital cost of $55 million to $65 million. Hornbeck believes that the new vessels will offer nearly three times the storage capacity of its 265-foot OSVs (currently the largest in the fleet) and will enable oil and gas operators to use the vessel for a variety of applications that would otherwise require several different vessels.

BUOYANT SEGMENT. Based on continued high projections for oil and natural gas prices provided by Global Insight, an independent economic forecasting firm, and our view that deepwater Gulf of Mexico drilling demand will remain at high levels -- thereby boosting demand for ancillary oil-field services -- we project that the company will increase OSV segment revenues by approximately 37% in 2005.

We estimate average day rates to advance about 20%, and average utilization to rise to the mid-90% level, from approximately 88% in 2004. Operating margins in the OSV segment, which averaged 60.5% in 2004, broke the 65% mark in the first quarter of 2005. We see wider overall operating margins in 2005, albeit slightly below the first-quarter level. In 2006, we see segment revenue growth of about 13%.

In the tug and tank-barge segment, day rates reached a record high in the first quarter of 2005, approaching $13,200, with utilization reaching 85%, also high by historical measures. We see segment revenues advancing 13% in 2005, and a further 20% in 2006, given the expected addition of four new tank barges later in 2005. We see day rates in this segment staying relatively flat with first-quarter numbers, but with higher utilization.

NEW CONSTRUCTION. Although OSVs have historically represented about 57% of Hornbeck's revenue base in the two-year period of 2003 to 2004, they also represented about 72% of segment operating income during that period (and 82% in the first quarter of 2005). We expect the gradual trend toward a higher OSV proportion of operating income to continue, and estimate the OSV share to account for 80% in 2006 and 76% in 2006.

Overall, we expect revenue growth of approximately 27% in 2005, rising an additional 16% in 2006. We see EPS of $1.29 in 2005, and $1.60 in 2006, the latter estimate including 3 cents per share of stock option expense. For 2007 and beyond, we note that the company expects the planned construction of two new MPSVs to add approximately 25 cents to 35 cents of EPS.

Assuming the midpoint of the range, an incremental 30 cents per share on a (projected) base of $1.60 would represent a 19% earnings catalyst -- absent any other changes in fundamentals.

SLIGHT DISCOUNT. Our estimate of Standard & Poor's Core Earnings is $1.26 per share for 2005. This represents a 3-cents-per-share deduction from expected operating EPS for expensing of stock options, or a 2.3% divergence from operating results. We believe that this relatively low divergence suggests high earnings quality.

Given our view of the competitive advantage of new-generation OSVs in deepwater applications, we think that, in this regard, Hornbeck's fleet merits a modest premium to peers. However, at a 9.1 times multiple to estimated 2005 EBITDA (earnings before interest, taxes, depreciation, and amortization), Hornbeck is trading at a 4% discount to the peer group average of 9.5 times. Using a 10.5 times multiple, a slight premium to the group, implies a 12-month target price of $33 per share.

On a price-to-operating cash-flow basis, Hornbeck trades at an 8.2-times multiple, about 10% below the 9.1-times peer group average. Using an 11-times multiple on projected 2005 operating cash flows -- also a slight premium to the group -- yields a 12-month target price of $33 per share.

POISON PILL. Our intrinsic value estimation of $28 per share for Hornbeck stock results from calculating a sustainable growth rate for the company for the next 10 years, plus a terminal growth rate. We then discount the resulting free cash flows by the estimated weighted average cost of capital. Blending this estimate with the relative valuation metrics mentioned earlier yields a 12-month target price of $31 per share.

We believe that Hornbeck's corporate governance practices are generally sound. Independent outside directors represent a majority of the seats on the company's board. The audit committee and compensation committee are each composed solely of such outside directors. Directors serving more than three years have an equity component to their compensation. We have one notable criticism: that the company has a poison-pill provision, with no sunset, that it may exercise with an ownership position of 10%.

Risks to our recommendation and target price, in our view, include events that would cause substantial declines in oil and gas exploration and development and production activity, particularly in the U.S. Gulf of Mexico. Other dangers are an increase in unplanned dry-docking expenses, a reduction in domestic consumption of refined petroleum products, and the the potential for a rising supply of modern offshore supply vessels to compete with the company's fleet and hence suppress day-rate growth. Analyst Glickman follows shares of oil-field-services companies for Standard & Poor's Equity Research Services

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