UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number: 0-51582

 

HERCULES OFFSHORE, INC.

(Exact name of registrant as specified in its charter)

Delaware (State or other jurisdiction of incorporation or organization)		56-2542838 (I.R.S. Employer Identification No.)
9 Greenway Plaza, Suite 2200 Houston, Texas (Address of principal executive offices)		77046 (Zip code)

(713) 350-5100
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

     Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o (Do not check if a smaller reporting company)		Smaller reporting company o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.

Common Stock, par value $0.01 per share		Outstanding as of October 24, 2011 137,893,030

 

 

HERCULES OFFSHORE, INC.

INDEX

		Page No.
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010			3
Consolidated Statements of Operations for the three and nine months ended September 30, 2011 and 2010			4
Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and 2010			5
Consolidated Statements of Comprehensive Loss for the three and nine months ended September 30, 2011 and 2010			6
Notes to Unaudited Consolidated Financial Statements			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			28
Item 3. Quantitative and Qualitative Disclosures about Market Risk			51
Item 4. Controls and Procedures			52
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			52
Item 1A. Risk Factors			52
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			53
Item 6. Exhibits			54
Signatures			55
EX-31.1
EX-31.2
EX-32.1
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

HERCULES OFFSHORE, INC. AND SUBSIDIARIES

		September 30,				December 31,
		2011				2010
		(Unaudited)
ASSETS
Current Assets:
Cash and Cash Equivalents		$	127,274			$	136,666
Restricted Cash			13,604				11,128
Accounts Receivable, Net of Allowance for Doubtful Accounts of $12,867 and $29,798 as of September 30, 2011 and December 31, 2010, Respectively			163,780				143,796
Prepaids			23,651				17,142
Current Deferred Tax Asset			10,572				8,488
Other			16,906				11,794
			355,787				329,014
Property and Equipment, Net of Accumulated Depreciation of $605,997 and $516,565 as of September 30, 2011 and December 31, 2010, Respectively			1,631,661				1,634,542
Equity Investment			34,910				—
Other Assets, Net			31,667				31,753
		$	2,054,025			$	1,995,309
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Short-term Debt and Current Portion of Long-term Debt		$	4,768			$	4,924
Insurance Notes Payable			12,987				5,984
Accounts Payable			53,707				52,279
Accrued Liabilities			57,973				59,861
Interest Payable			18,585				6,974
Taxes Payable			6,231				—
Other Current Liabilities			20,942				16,716
			175,193				146,738
Long-term Debt, Net of Current Portion			838,012				853,166
Other Liabilities			21,869				6,716
Deferred Income Taxes			90,301				135,557
Commitments and Contingencies
Stockholders’ Equity:
Common Stock, $0.01 Par Value; 200,000 Shares Authorized; 139,789 and 116,336 Shares Issued, Respectively; 137,892 and 114,784 Shares Outstanding, Respectively			1,398				1,163
Capital in Excess of Par Value			2,056,428				1,924,659
Treasury Stock, at Cost, 1,897 Shares and 1,552 Shares, Respectively			(52,178	)			(50,333	)
Retained Deficit			(1,076,998	)			(1,022,357	)
			928,650				853,132
		$	2,054,025			$	1,995,309

The accompanying notes are an integral part of these financial statements.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
						(As Adjusted)								(As Adjusted)
Revenue		$	162,991			$	157,609			$	492,570			$	460,067
Costs and Expenses:
Operating Expenses			111,372				102,310				332,081				307,626
Depreciation and Amortization			43,895				44,982				128,699				140,382
General and Administrative			10,757				14,158				40,403				40,595
			166,024				161,450				501,183				488,603
Operating Loss			(3,033	)			(3,841	)			(8,613	)			(28,536	)
Other Income (Expense):
Interest Expense			(20,389	)			(20,752	)			(59,035	)			(62,437	)
Expense of Credit Agreement Fees			—				—				(455	)			—
Equity in Losses of Equity Investment			(34	)			—				(225	)			—
Other, Net			(1,561	)			(22	)			(2,583	)			3,144
Loss Before Income Taxes			(25,017	)			(24,615	)			(70,911	)			(87,829	)
Income Tax Benefit			7,973				8,478				25,921				38,267
Loss from Continuing Operations			(17,044	)			(16,137	)			(44,990	)			(49,562	)
Income (Loss) from Discontinued Operations, Net of Taxes			52				1,076				(9,651	)			(439	)
Net Loss		$	(16,992	)		$	(15,061	)		$	(54,641	)		$	(50,001	)
Basic Loss Per Share:
Loss from Continuing Operations		$	(0.12	)		$	(0.14	)		$	(0.35	)		$	(0.43	)
Income (Loss) from Discontinued Operations			—				0.01				(0.08	)			(0.01	)
Net Loss		$	(0.12	)		$	(0.13	)		$	(0.43	)		$	(0.44	)
Diluted Loss Per Share:
Loss from Continuing Operations		$	(0.12	)		$	(0.14	)		$	(0.35	)		$	(0.43	)
Income (Loss) from Discontinued Operations			—				0.01				(0.08	)			(0.01	)
Net Loss		$	(0.12	)		$	(0.13	)		$	(0.43	)		$	(0.44	)
Weighted Average Shares Outstanding:
Basic			137,887				114,774				128,000				114,742
Diluted			137,887				114,774				128,000				114,742

The accompanying notes are an integral part of these financial statements.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES

		Nine Months Ended September 30,
		2011				2010
Cash Flows from Operating Activities:
Net Loss		$	(54,641	)		$	(50,001	)
Adjustments to Reconcile Net Loss to Net Cash Provided by Operating Activities:
Depreciation and Amortization			130,355				144,758
Stock-Based Compensation Expense			3,898				2,799
Deferred Income Taxes			(47,458	)			(38,639	)
Provision (Benefit) for Doubtful Accounts Receivable			(12,240	)			80
Amortization of Deferred Financing Fees			2,877				2,493
Amortization of Original Issue Discount			3,305				3,041
Non-Cash Loss on Derivatives			3,065				1,987
(Gain) Loss on Disposal of Assets and Businesses, Net			5,495				(10,180	)
Other			(197	)			(381	)
(Increase) Decrease in Operating Assets -
Accounts Receivable			7,622				(10,841	)
Prepaid Expenses and Other			21,744				16,563
Increase (Decrease) in Operating Liabilities -
Accounts Payable			(9,013	)			(2,811	)
Insurance Notes Payable			(18,778	)			(15,036	)
Other Current Liabilities			13,260				(10,011	)
Other Liabilities			9,073				(14,141	)
Net Cash Provided by Operating Activities			58,367				19,680
Cash Flows from Investing Activities:
Acquisition of Seahawk Assets			(25,000	)			—
Additions of Property and Equipment			(33,508	)			(16,353	)
Deferred Drydocking Expenditures			(12,859	)			(10,972	)
Cash Paid for Equity Investment			(34,155	)			—
Proceeds from Sale of Assets and Businesses, Net			58,440				15,764
Increase in Restricted Cash			(2,476	)			(9,466	)
Net Cash Used in Investing Activities			(49,558	)			(21,027	)
Cash Flows from Financing Activities:
Long-term Debt Repayments			(18,615	)			(5,233	)
Payment of Debt Issuance Costs			(2,109	)			—
Other			2,523				396
Net Cash Used in Financing Activities			(18,201	)			(4,837	)
Net Decrease in Cash and Cash Equivalents			(9,392	)			(6,184	)
Cash and Cash Equivalents at Beginning of Period			136,666				140,828
Cash and Cash Equivalents at End of Period		$	127,274			$	134,644

The accompanying notes are an integral part of these financial statements.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
Net Loss		$	(16,992	)		$	(15,061	)		$	(54,641	)		$	(50,001	)
Other Comprehensive Income, Net of Taxes:
Changes Related to Hedge Transactions			—				1,762				—				5,773
Comprehensive Loss		$	(16,992	)		$	(13,299	)		$	(54,641	)		$	(44,228	)

The accompanying notes are an integral part of these financial statements.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES

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 and International Liftboats segments (See Note 12). At September 30, 2011, the Company owned a fleet of 49 jackup rigs, 17 barge rigs, two submersible rigs, one platform rig, and 60 liftboat vessels and operated an additional five liftboat vessels owned by a third party. The Company’s 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 May 2011, the Company completed the sale of substantially all of Delta Towing’s assets and certain liabilities (See Note 5). Accordingly, the Company has recast certain prior period financial information to reflect the results of operations of the Delta Towing assets as discontinued operations for all periods presented.

     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, accounts payable and certain contractual rights (“Seahawk Transaction”). On April 27, 2011, the Company completed the Seahawk Transaction (See Note 4).

     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 Company’s Consolidated Balance Sheet at September 30, 2011, Consolidated Statements of Operations and Consolidated Statements of Comprehensive Loss for the three and nine months ended September 30, 2011 and 2010, and Consolidated Statements of Cash Flows for the nine months ended September 30, 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 Company’s 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 Company’s Annual Report on Form 10-K, as amended on Form 8-K filed July 8, 2011. The results of operations for the three and nine months ended September 30, 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.

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 Company’s 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 continue 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 Company’s common stock or other securities as a result of these investigations.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

Recent Events

     On September 18, 2011, the Company was conducting a required annual spud can inspection on the Hercules 185 in protected waters offshore Angola. While conducting the inspection, it was determined that the spud can on the starboard leg had detached from the leg. While preparing the rig for heavy-lift transport to a shipyard in Pascagoula, Mississippi to conduct the spud can repairs, additional leg damage was identified. The additional damage must be repaired before the rig can be transported to the shipyard in Mississippi. The Company is currently in the process of repairing the additional leg damage and preparing the rig for the transport to Pascagoula, Mississippi. Until a full inspection of the rig is completed, it is impossible to determine the full extent of the damage, the scope and cost of the repairs necessary to return the rig to service and the anticipated time needed to complete the required repairs. However, the Company currently estimates that the rig will be out of service for approximately six months. During this period, the rig will be at zero dayrate pursuant to its contract with Cabinda Gulf Oil Company (“Cabinda Gulf”). The Company has discussed the expected downtime of the rig with Cabinda Gulf and Cabinda Gulf has indicated that it intends to accept the rig after the completion of the repairs and to continue the contract, although Cabinda Gulf may have the right to terminate the contract and be paid $1.0 million by the Company for liquidated damages. The Company expects to be insured for damage to the rig up to the insured value of $35.0 million, subject to a $3.5 million deductible and other customary limitations and exclusions. The Company has incurred approximately $2.0 million during the three months ended September 30, 2011 related to rig repairs, inspections and other costs, of which all or a portion of these costs will be applied to the deductible associated with this claim. In addition, the rig had a net book value of $52.3 million as of September 30, 2011.

     On September 30, 2011, the Starfish, a 140 class liftboat (the “Vessel”), was underway in the Gulf of Mexico in Ship Shoal Block 116 when it was hit by a series of waterspouts and capsized. The Vessel has been anchored and secured by a salvage company retained by the Company. The Company anticipates salvaging the Vessel when weather conditions are favorable. The Company’s underwriters have determined that the Vessel is considered to be a constructive total loss and, therefore, the Company will receive the full insured value of the Vessel, $2.5 million. The Company carries removal of wreck insurance adequately covering the salvage operation, subject to a $250,000 deductible. Additionally, the Company carries pollution insurance, subject to a $3 million deductible and other customary limitations. The Vessel had a net book value of $0.7 million.

Permanent Importation

     On May 16, 2011, the Company initiated the permanent importation of Rig 3, its platform rig under contract in Mexico, and related equipment and spares into Mexico, at a net cost of approximately $8 million. The net cost consists of a cash payment of approximately $13 million, including approximately $5 million of value added tax, which the Company expects to fully recover as provided by Mexican law.

Revenue Recognition

     Revenue generated from the Company’s 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. Additionally, the initial fair value of the warrants and 500,000 shares issued from Discovery Offshore have been recorded to deferred revenue to be amortized over 30 years, the estimated useful life of the two new-build Discovery Offshore rigs (See Note 3). Amounts related to deferred revenue, including revenue deferred related to the Company’s 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):

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
Revenue deferred		$	8,042			$	—			$	34,067			$	600
Expense deferred			5,729				—				9,227				—
Deferred Revenue recognized			6,712				4,892				17,487				15,114
Deferred Expense recognized			1,297				276				2,516				2,037

     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.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     The balances related to the Company’s Deferred Costs and Deferred Revenue are as follows (in thousands):

				As of				As of
		Balance Sheet		September 30,				December 31,
		Classification		2011				2010
Assets:
Deferred Expense-Current Portion		Other		$	8,342			$	1,824
Deferred Expense-Non-Current Portion		Other Assets, Net			3,365				3,172
Liabilities:
Deferred Revenue-Current Portion		Other Current Liabilities			14,637				12,628
Deferred Revenue-Non-Current Portion		Other Liabilities			14,571				—

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. During the nine months ended September 30, 2011, $14.0 million has been recorded as deferred revenue and $12.5 million was outstanding at September 30, 2011. The Company recognized $0.8 million and $1.5 million as revenue during the three and nine months ended September 30, 2011, respectively, under the percentage-of-completion method of accounting. Additionally, $0.7 million and $1.3 million in cost was recognized during the three and nine months ended September 30, 2011, respectively, under the percentage-of-completion method of accounting related to activities associated with the performance of contract obligations.

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 $12.9 million and $29.8 million at September 30, 2011 and December 31, 2010, respectively. The change in the Company’s allowance during the nine months ended September 30, 2011 related primarily to payments received from a customer in its International Offshore segment.

Other Assets

     Other assets consist of drydocking costs for marine vessels, a derivative asset, 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 September 30, 2011 and December 31, 2010, were $6.4 million and $5.9 million, respectively. Amortization expense for drydocking costs was $4.2 million and $12.1 million for the three and nine months ended September 30, 2011 and $3.0 million and $10.6 million for the three and nine months ended September 30, 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 September 30, 2011 and December 31, 2010 were $10.1 million and $11.4 million, respectively. Amortization expense for financing fees was $1.0 million and $2.9 million for the three and nine months ended September 30, 2011, respectively and $0.8 million and $2.5 million for the three and nine months ended September 30, 2010, respectively, and is included in Interest Expense on the Consolidated Statements of Operations.

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.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

Restricted Cash

     The Company’s restricted cash balance supports surety bonds related to the Company’s 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 Company’s 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 5.7 million and 6.5 million 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 and nine months ended September 30, 2011, respectively. Stock equivalents of 6.6 million and 6.2 million 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 and nine months ended September 30, 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 either the three and nine months ended September 30, 2011 and 2010, respectively, 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 any of these periods.

3. Equity Investment

     In January 2011, the Company made an initial investment of $10 million to purchase 5.0 million shares of a new entity incorporated in Luxembourg, Discovery Offshore S.A. (“Discovery Offshore”). Discovery Offshore has ordered two new-build ultra high specification harsh environment jackup drilling rigs (collectively the “Rigs” or individually “Rig”) and they hold options to purchase two additional rigs of the same specifications. Although these options were set to expire in late October 2011, Discovery Offshore is currently in discussions with the shipyard to extend the exercise date on these two options. 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. The Company has no other financial obligations or commitments with respect to the Rigs or its ownership in Discovery Offshore. Two of the Company’s officers are on the Board of Directors of Discovery Offshore.

     The Company’s total equity investment in Discovery Offshore was $34.9 million, or 28%, as of September 30, 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 totaling $24.2 million, or 12.9 million shares for the nine months ended September 30, 2011, which includes $12.3 million, or 7.5 million shares for the three months ended September 30, 2011, as well as the Company’s proportionate share of Discovery Offshore’s 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 was issued warrants to purchase up to 5.0 million additional shares of Discovery Offshore, additional compensation for its costs incurred and efforts expended in forming Discovery Offshore, that, if exercised, would be recorded as an increase in the Company’s equity investment in Discovery Offshore (See Notes 1, 7 and 8).

4. Business Combination

     On April 27, 2011, the Company completed its acquisition of 20 jackup rigs and related assets, accounts receivable, accounts payable and certain contractual rights from Seahawk for total consideration of approximately $150.3 million consisting of $25.0 million of cash and 22.1 million shares of Hercules common stock, net of a working capital adjustment. Seahawk operated a jackup rig business that provided contract drilling services to the oil and natural gas exploration and production industry in the Gulf of Mexico.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     The Seahawk Transaction expanded the Company’s jackup fleet and further strengthened the Company’s position as a leading shallow-water drilling provider. The fair value of the shares issued was determined using the closing price of the Company’s common stock of $5.68 on April 27, 2011. The results of Seahawk are included in the Company’s results from the date of acquisition.

     The Company accounted for this transaction as a business combination and accordingly the total consideration was allocated to Seahawk’s net tangible assets based on their estimated fair values. The Company is in the process of finalizing valuations of the property and equipment. Therefore, the valuations of property and equipment are preliminary and are subject to change upon the receipt and management’s review of the final valuations. In addition, certain of the Company’s tax positions are also being reviewed and the valuation of the Company’s deferred taxes are preliminary and are subject to change (See Note 11). The Company has recorded the accounts receivable at estimated fair value which does not include an allowance for doubtful accounts. Upon final valuation of net assets, the excess, if any, of the purchase price over the net assets will be recorded as goodwill, and conversely, if the purchase price is less than the fair value of the net assets, a gain from a bargain purchase will be recorded.

     The preliminary allocation of the consideration is as follows:

		April 27, 2011
		(In thousands)
		(Unaudited)
Accounts Receivable		$	15,366
Property and Equipment, Net			145,404
Total Assets			160,770
Accounts Payable			(10,441	)
Total Preliminary Purchase Price		$	150,329

     The following presents the consolidated financial information for the Company on a pro forma basis assuming the Seahawk Transaction had occurred as of the beginning of the periods presented. The historical financial information has been adjusted to give effect to pro forma items that are directly attributable to the acquisition, factually supportable and with respect to income, are expected to have a continuing impact on consolidated results. These items include adjustments to record the incremental depreciation expense related to the increase in fair value of the acquired assets, the elimination of amounts related to the operations of Seahawk that were not purchased in the transaction as well as the elimination of directly related transaction costs.

     The unaudited financial information set forth below has been compiled from historical financial statements and other information, but is not necessarily indicative of the results that actually would have been achieved had the transaction occurred on the dates indicated or that may be achieved in the future:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2011				2010				2011				2010
						(In millions, except per share amounts)
Revenue		$	163.0			$	176.2			$	526.0			$	519.0
Net Loss			(16.6	)			(35.2	)			(52.8	)			(80.4	)
Basic loss per share			(0.12	)			(0.26	)			(0.38	)			(0.59	)
Diluted loss per share			(0.12	)			(0.26	)			(0.38	)			(0.59	)

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     The amount of revenue and net income related to the net assets acquired from Seahawk included in the Company’s Consolidated Statements of Operations for the three and nine months ended September 30, 2011 is as follows (in millions):

		Three months				April 27, 2011
		ended				through
		September				September
		30, 2011				30, 2011
Revenue		$	24.8			$	42.0
Net income			1.1				2.7

     The Company incurred transaction costs in the amount of $0.5 million and $3.6 million for the three and nine months ended September 30, 2011 related to the Seahawk Transaction of which $0.5 million and $3.4 million in the same periods, respectively, are included in General and Administrative on the Consolidated Statements of Operations. The remaining $0.2 million in transaction costs are included in Operating Expenses on the Consolidated Statements of Operations for the nine months ended September 30, 2011.

5. Dispositions and Discontinued Operations

Dispositions

     From time to time the Company enters into agreements to sell assets. The following table provides information related to the sale of several of the Company’s assets during the nine months ended September 30, 2011 and 2010 (in thousands):

Rig		Segment		Period of Sale		Proceeds			Gain/(Loss)
2011:
Hercules 78		Domestic Offshore		May 2011		$	1,700		$	20
Various(a)		Delta Towing		May 2011			30,000			(13,359	)
Hercules 152		Domestic Offshore		July 2011			5,000			271
Hercules 190		Domestic Offshore		September 2011			2,000			1,440
Hercules 254		Domestic Offshore		September 2011			2,054			369
						$	40,754		$	(11,259	)
2010:
Various(b)		Inland		March 2010		$	2,200		$	1,753
Various(b)		Inland		April 2010			800			410
Hercules 191		Domestic Offshore		April 2010			5,000			3,067
Hercules 255		Domestic Offshore		September 2010			5,000			3,180
						$	13,000		$	8,410

Discontinued Operations

     In May 2011, the Company completed the sale of substantially all of Delta Towing’s 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 its Delta Towing business which was approximately $6 million at the date of sale. The results of operations of the Delta Towing segment are reflected in the Consolidated Statements of Operations for the three and nine months ended September 30, 2011 and 2010 as discontinued operations.

     Interest charges have been allocated to the discontinued operations of the Delta Towing segment in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 205-20, Discontinued Operations. The interest

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

was allocated based on a pro rata calculation of the net Delta Towing assets sold to the Company’s consolidated net assets. Interest allocated to discontinued operations was $0.8 million for the nine months ended September 30, 2011, and $0.6 million and $1.9 million for the three and nine months ended September 30, 2010, respectively.

     Operating results of the Delta Towing segment were as follows (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2011				2010				2011				2010
Revenue		$	—			$	10,875			$	9,822			$	25,161
Income (Loss) Before Income Taxes		$	84			$	1,800			$	(15,703	)		$	(733	)
Income Tax (Provision) Benefit			(32	)			(724	)			6,052				294
Income (Loss) from Discontinued Operations, Net of Taxes		$	52			$	1,076			$	(9,651	)		$	(439	)

     The carrying value of the assets included in the Delta Towing Sale are as follows:

		May 13,				December 31,
		2011				2010
		(In thousands)
Property and Equipment, Net and Related Assets		$	43,359			$	44,249

     The nine months ended September 30, 2011 includes a loss of $13.4 million, or $8.2 million net of taxes, in connection with the Delta Towing Sale.

6. Debt

     Debt is comprised of the following (in thousands):

		September 30,				December 31,
		2011				2010
Term Loan Facility, due July 2013		$	456,541			$	475,156
10.5% Senior Secured Notes, due October 2017			293,483				292,935
3.375% Convertible Senior Notes, due June 2038			89,245				86,488
7.375% Senior Notes, due April 2018			3,511				3,511
Total Debt			842,780				858,090
Less Short-term Debt and Current Portion of Long-term Debt			4,768				4,924
Total Long-term Debt, Net of Current Portion		$	838,012			$	853,166

     The unamortized discount of the 10.5% Senior Secured Notes and 7.375% Senior Notes is being amortized to interest expense over the life of the respective debt instrument. The unamortized discount of the 3.375% Convertible Senior Notes is being amortized to interest expense over their expected life which ends June 1, 2013.

						September 30, 2011												December 31, 2010
		Notional				Unamortized				Carrying				Notional				Unamortized				Carrying
Liability Component		Amount				Discount				Value				Amount				Discount				Value
						(in millions)												(in millions)
10.5% Senior Secured Notes, due October 2017		$	300.0			$	(6.5	)		$	293.5			$	300.0			$	(7.1	)		$	292.9
3.375% Convertible Senior Notes, due June 2038*			95.9				(6.7	)			89.2				95.9				(9.4	)			86.5
7.375% Senior Notes, due April 2018			3.5				—				3.5				3.5				—				3.5

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

		Three Months Ended September 30,
						2011																2010
		Coupon				Discount				Total				Effective				Coupon				Discount				Total				Effective
		Interest				Amortization				Interest				Rate				Interest				Amortization				Interest				Rate
		(in millions)																(in millions)
10.5% Senior Secured Notes, due October 2017		$	7.9			$	0.2			$	8.1				11.00	%		$	7.8			$	0.2			$	8.0				11.00	%
3.375% Convertible Senior Notes, due June 2038			0.9				0.9				1.8				7.93				0.8				0.9				1.7				7.93
7.375% Senior Notes, due April 2018			0.1				—				0.1				7.38				0.1				—				0.1				7.38

		Nine Months Ended September 30,
						2011																2010
		Coupon				Discount				Total				Effective				Coupon				Discount				Total				Effective
		Interest				Amortization				Interest				Rate				Interest				Amortization				Interest				Rate
		(in millions)																(in millions)
10.5% Senior Secured Notes, due October 2017		$	23.6			$	0.6			$	24.2				11.00	%		$	23.5			$	0.5			$	24.0				11.00	%
3.375% Convertible Senior Notes, due June 2038			2.5				2.7				5.2				7.93				2.4				2.6				5.0				7.93
7.375% Senior Notes, due April 2018			0.2				—				0.2				7.38				0.2				—				0.2				7.38

Senior Secured Credit Agreement

     The Company has a $596.5 million credit facility, consisting of a $456.5 million term loan facility and a $140.0 million revolving credit facility. The availability under the $140.0 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 interest rates on borrowings under the Credit Facility are 5.50% plus LIBOR for Eurodollar Loans and 4.50% plus the Alternate Base Rate for ABR Loans. The minimum LIBOR is 2.00% for Eurodollar Loans, or a minimum base rate of 3.00% with respect to ABR Loans. Under the credit agreement, as amended, which governs the credit facility (the “Credit Agreement”), the Company must among other things:

•

Maintain a total leverage ratio for any test period calculated as the ratio of consolidated indebtedness on the test date to consolidated EBITDA for the trailing twelve months, all as defined in the Credit Agreement according to the following schedule:

		Maximum Total
Test Date		Leverage Ratio
September 30, 2011			7.50 to 1.00
December 31, 2011			7.75 to 1.00
March 31, 2012			7.50 to 1.00
June 30, 2012			7.25 to 1.00
September 30, 2012			6.75 to 1.00
December 31, 2012			6.25 to 1.00
March 31, 2013			6.00 to 1.00
June 30, 2013			5.75 to 1.00

—

At September 30, 2011, the Company’s total leverage ratio was 5.03 to 1.00.

•

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 September 30, 2011, as calculated pursuant to the Credit Agreement, the Company’s total liquidity was $265.5 million.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

•

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 September 30, 2011, the Company’s fixed charge coverage ratio was 1.35 to 1.00.

•

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.

     The Company’s 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 Company’s 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 Company’s Credit Agreement.

     The Credit Agreement requires that the Company meet certain financial ratios and tests, which it met as of September 30, 2011. The Company’s 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 Company’s financial covenants, borrowings under the Company’s 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 Company’s 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. In addition to its scheduled payments, during the second quarter of 2011, the Company used a portion of the net proceeds from the sale of the Delta Towing assets to retire $15.0 million of the outstanding balance on the Company’s term loan facility.

     As of September 30, 2011, no amounts were outstanding and $1.8 million in standby letters of credit had been issued under the revolving credit facility, therefore the remaining availability under this revolving credit facility was $138.2 million. As of September 30, 2011, $456.5 million was outstanding on the term loan facility and the interest rate was 7.5%. The annualized effective rate of interest was 7.60% for the nine months ended September 30, 2011 after giving consideration to revolver fees.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     In connection with the amendment of the Credit Agreement in March 2011 (“2011 Credit Amendment”), the Company 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 Company’s 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.

10.5% Senior Secured Notes due 2017

     The 10.5% Senior Secured Notes are guaranteed by all of the Company’s existing and future restricted subsidiaries that incur or guarantee indebtedness under a credit facility, including the Company’s existing credit facility. The notes are secured by liens on all collateral that secures the Company’s 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 Company’s credit facility. Under the intercreditor agreement, the collateral agent for the lenders under the Company’s 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 Company’s secured indebtedness, other than these notes, does not exceed the lesser of $375.0 million and 15.0% of the Company’s 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 Company’s 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 the Company’s 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 Company’s 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 3.375% Convertible Senior Notes will be convertible under certain circumstances into shares of the Company’s 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 Company’s election, shares of Common Stock, cash or a combination of cash and shares of Common Stock. At September 30, 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.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     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 Company’s Common Stock.

Other debt

     In connection with the TODCO acquisition in July 2007, one of the Company’s 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

     The Company was issued warrants to purchase up to 5.0 million additional shares of Discovery Offshore stock at a strike price of 11.5 Norwegian Kroner (“NOK”) per share 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 September 30, 2011, for 30 consecutive trading days. 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 are recognized to other income (expense). 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 Company’s derivatives (in thousands):

September 30, 2011
Balance Sheet		Fair
Classification		Value
Derivatives:
Warrants		$	1,980
Other Assets, Net		$	1,980

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     The following table provides the effect of the Company’s derivatives on the Consolidated Statements of Operations (in thousands):

		Three Months Ended September 30,
				2011		2010						2011				2010
Derivatives		I.		II.						III.		IV.
Interest rate contracts		Interest Expense		$              —		$	(2,711	)		Interest Expense		$	—			$	(5	)
Warrants		N/A		—			—			Other Income (Expense)			(1,845	)			—

		Nine Months Ended September 30,
				2011		2010				2011		2010
Derivatives		I.		II.				III.		IV.
Interest rate contracts		Interest Expense		$           —		$(8,881)		Interest Expense		$              —		$(264)
Warrants		N/A		—		—		Other Income (Expense)		(3,065)		—

I.		Classification of Gain (Loss) Reclassified from Accumulated Other Comprehensive Income (Loss) into Income (Loss) (Effective Portion)
II.		Amount of Gain (Loss) Reclassified from Accumulated Other Comprehensive Income (Loss) into Income (Loss) (Effective Portion)
III.		Classification of Gain (Loss) Recognized in Income (Loss) on Derivative
IV.		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 Company’s 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.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     As of September 30, 2011 the fair value of the warrants issued by Discovery Offshore was $2.0 million. The fair value of the warrants was determined using a Monte Carlo simulation based on the following assumptions:

		September 30,
		2011
Strike Price (NOK)			11.50
Target Price (NOK)			23.00
Stock Value (NOK)			8.75
Expected Volatility (%)			50.0	%
Risk-Free Interest Rate (%)			0.96	%
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 September 30, 2011. 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 Company’s derivative asset measured at fair value on a recurring basis as of September 30, 2011 (in thousands):

Quoted Prices in

Total

Active Markets for

Fair Value

Identical Asset or

Significant Other

Significant

Measurement

Liability

Observable Inputs

Unobservable Inputs

September 30, 2011

(Level 1)

(Level 2)

(Level 3)

Warrants

$

1,980

$

—

$

1,980

$

—

     There were no derivative assets or liabilities outstanding at December 31, 2010.

     The following table represents the Company’s 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 and equipment was valued based on the discounted cash flows associated with the assets which included management’s estimate of sales proceeds less costs to sell.

     The carrying value and fair value of the Company’s equity investment in Discovery Offshore was $34.9 million and $27.4 million at September 30, 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 September 30, 2011.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

Fair Value of Financial Instruments

     The carrying amounts of the Company’s 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 Company’s 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 Company’s 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 Company’s long-term debt instruments:

		September 30, 2011								December 31, 2010
		Carrying				Fair				Carrying				Fair
		Value				Value				Value				Value
						(in millions)
Term Loan Facility, due July 2013		$	456.5			$	436.8			$	475.2			$	443.7
10.5% Senior Secured Notes, due October 2017			293.5				287.8				292.9				245.1
3.375% Convertible Senior Notes, due June 2038			89.2				81.5				86.5				69.1
7.375% Senior Notes, due April 2018			3.5				2.9				3.5				2.2

9. Long-Term Incentive Awards

Stock-based Compensation

     The Company’s 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 September 30, 2011, approximately 6.9 million shares were available for grant or award under the 2004 Plan, as amended in May 2011.

     During the nine months ended September 30, 2011, the Company granted 1.1 million time-based restricted stock awards with a weighted average grant-date fair value per share of $5.01. There were no stock options granted during the nine months ended September 30, 2011. The Company recognized $1.2 million and $3.9 million in stock-based compensation expense during the three and nine months ended September 30, 2011, respectively. The Company recognized $1.0 million and $2.8 million in stock-based compensation expense during the three and nine months ended September 30, 2010, respectively, which includes a reduction of $0.8 million and $2.8 million due to a change in the Company’s estimated forfeiture rate, respectively.

     On March 6, 2011, the Compensation Committee of the Company’s 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 479,183 shares. The fair value of these awards was based on the closing price of the Company’s stock on the date of grant.

     The unrecognized compensation cost related to the Company’s unvested stock options and restricted stock grants, including performance-based restricted stock grants as of September 30, 2011, was $1.2 million and $5.8 million, respectively, and is expected to be recognized over a weighted-average period of 0.8 years and 2.0 years, respectively.

Liability Retention Awards

     In December 2010, the Compensation Committee of the Company’s Board of Directors approved retention and incentive arrangements for the Company’s Chief Executive Officer, consisting of three separate awards.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     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 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 September 30, 2011, the Company’s liability related to these awards was $0.6 million and is included in Other Liabilities on the Consolidated Balance Sheets. Additionally, compensation expense of $0.6 million was recognized for the nine months ended September 30, 2011. The three months ended September 30, 2011 included a reduction to compensation expense of $0.1 million based on the fair value measurement at September 30, 2011. The unrecognized compensation cost related to these awards as of September 30, 2011 was $1.8 million and is expected to be recognized over a weighted-average period of 2.3 years.

     The first award is a Special Retention Agreement (the “Agreement”), which provides for a cash payment based on 500,000 shares of the Company’s 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 Company’s 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 September 30, 2011 using a Monte Carlo simulation based on the following weighted-average assumptions:

		September 30,
		2011
Dividend Yield			—
Expected Price Volatility			50	%
Risk-Free Interest Rate			0.3	%
Stock Price		$	2.91
Fair Value		$	0.74

     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 Company’s common stock at September 30, 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.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     The following summarizes investing activities relating to the Seahawk Transaction integrated into the Company’s operations for the period shown (in thousands):

		Nine Months
		Ended
		September 30, 2011
Fair Value of Assets		$	160,770
Common Stock Issuance			(125,329	)
Total Liabilities			(10,441	)
Cash Consideration		$	25,000

		Nine Months Ended September 30,
		2011				2010
		(In thousands)
Cash paid (received), net during the period for:
Interest		$	41,972			$	40,210
Income taxes			3,338				19,364

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 Company’s tax returns for 2005 through 2010 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 Company’s 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 Company’s Trinidadian tax returns are open for examination for the years 2005 through 2010.

     In January 2008, SENIAT, the national Venezuelan tax authority, 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 Company’s right to certain deductions and also claimed it did not remit withholding tax due on certain of these deductions. 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 2004—2007. 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.

     Effective April 27, 2011 the Company completed the Seahawk Transaction. The Company’s financial statements have been prepared assuming that this transaction should be characterized as a purchase of assets for income tax purposes. Seahawk is currently in a Chapter 11 proceeding in United States Bankruptcy Court. The resolution of the bankruptcy and future actions taken in the reorganization of Seahawk’s operations may require that the transaction is instead treated by the Company as a reorganization pursuant to IRC §368(a)(1)(G). Any resulting change, which is currently indeterminable, to the Company’s financial position would be reflected in its financial statements at that future date.

     As of September 30, 2011, the Company was in a net income tax payable position of $6.2 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.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

12. Segments

     The Company reports its business activities in five business segments: (1) Domestic Offshore, (2) International Offshore, (3) Inland, (4) Domestic Liftboats and (5) International Liftboats. The financial information of the Company’s discontinued operations is not included in the results of operations presented for the Company’s reporting segments (See Note 5). The Company eliminates inter-segment revenue and expenses, if any.

     The following describes the Company’s reporting segments as of September 30, 2011:

     Domestic Offshore — includes 41 jackup rigs and two submersible rigs in the U.S. Gulf of Mexico that can drill in maximum water depths ranging from 80 to 350 feet. Seventeen of the jackup rigs are either working on short-term contracts or available for contracts, one is in the shipyard and twenty-three are cold stacked. Both 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 contracted offshore in Saudi Arabia, one jackup rig contracted offshore in Vietnam, one jackup rig contracted offshore in India, one jackup rig contracted offshore in the Democratic Republic of Congo and one platform rig under contract in Mexico. The Company has one jackup rig contracted in Angola, however, it is currently preparing to be transported to a shipyard in Mississippi to undergo repairs and is estimated to be out of service for approximately six months. 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 a Construction Management Agreement and the Services Agreement with Discovery Offshore with respect to each of the Rigs (See Note 3).

     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-five are operating or available and six 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.

     The Company’s jackup rigs, submersible rigs and platform rigs are used primarily for exploration and development drilling in shallow waters. The Company’s 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.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     Information regarding reportable segments is as follows (in thousands):

		Three Months Ended September 30, 2011												Nine Months Ended September 30, 2011
						Income (Loss)				Depreciation								Income (Loss)				Depreciation
						from				&								from				&
		Revenue				Operations				Amortization				Revenue				Operations				Amortization
Domestic Offshore		$	60,246			$	(12,824	)		$	17,977			$	142,688			$	(55,121	)		$	49,920
International Offshore			48,965				12,946				12,913				196,131				63,827				39,469
Inland			8,124				923				3,310				21,251				(7,649	)			11,338
Domestic Liftboats			16,718				615				4,136				44,209				(844	)			11,637
International Liftboats			28,938				8,523				4,905				88,291				26,084				14,379
			162,991				10,183				43,241				492,570				26,297				126,743
Corporate			—				(13,216	)			654				—				(34,910	)			1,956
Total Company		$	162,991			$	(3,033	)		$	43,895			$	492,570			$	(8,613	)		$	128,699

		Three Months Ended September 30, 2010												Nine Months Ended September 30, 2010
						Income (Loss)				Depreciation								Income (Loss)				Depreciation
						from				&								from				&
		Revenue				Operations				Amortization				Revenue				Operations				Amortization
Domestic Offshore		$	25,058			$	(32,066	)		$	17,277			$	88,163			$	(82,712	)		$	50,986
International Offshore			74,429				26,893				14,404				221,364				73,616				43,808
Inland			5,745				(8,628	)			4,991				15,676				(21,663	)			18,736
Domestic Liftboats			24,612				9,424				3,314				53,950				9,851				11,182
International Liftboats			27,765				9,431				4,199				80,914				21,227				13,258
			157,609				5,054				44,185				460,067				319				137,970
Corporate			—				(8,895	)			797				—				(28,855	)			2,412
Total Company		$	157,609			$	(3,841	)		$	44,982			$	460,067			$	(28,536	)		$	140,382

		Total Assets
		September 30,				December 31,
		2011				2010
Domestic Offshore		$	891,593			$	772,950
International Offshore			740,054				712,988
Inland			121,283				136,229
Domestic Liftboats			84,064				86,013
International Liftboats			161,691				167,561
Delta Towing			2,605				56,631
Corporate			52,735				62,937
Total Company		$	2,054,025			$	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 September 30, 2011, management did not believe any accruals were necessary in accordance with FASB ASC 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.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     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 Company’s review of its internal records to date, the Company disputes the Company’s designation as a potentially responsible party and does not expect that 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 TODCO’s subsidiaries and certain subsidiaries of TODCO’s 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 plaintiff’s 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.

Shareholder Derivative Suits

     FCPA Litigation

     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 its 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 attorney’s fees.

     On October 19, 2011, the District Court sustained special exceptions filed by the Company and the other defendants (collectively “Defendants”). The special exceptions filed by the Defendants sought the dismissal of the action due to the plaintiff’s failure to plead sufficient facts giving rise to a cause of action. The District Court ordered the action will be dismissed with prejudice if the plaintiff fails to amend his petition by November 4, 2011 and plead sufficient facts giving rise to a cause of action against the Defendants.

     Say-on-Pay Litigation

     In June, two separate shareholder derivative actions were filed against the Company in response to the Company’s failure to receive a majority advisory vote in favor of its 2010 executive compensation. On June 8, 2011, the first action was filed in the District Court of Harris County, Texas, and on June 23, 2011, the second action was filed in the United States District Court for the District of Delaware. Subsequently, on July 21, 2011, the plaintiff in the Harris County action filed a concurrent action in the Federal District Court for the Southern District of Texas. Each action was ostensibly filed on behalf of and for the benefit of the Company, naming the Company as a nominal defendant and certain of its officers and directors, as well as its compensation consultant, as defendants alleging, among other claims, breach of fiduciary duty and unjust enrichment. The petitions allege that pay increases to the Company’s

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

executive officers in 2010 were unwarranted and violated Company policy. The plaintiffs in each matter seek damages, injunctive and/or equitable relief purportedly on behalf of the Company, certain corporate actions, and an award of their costs and attorney’s fees.

     The Company does not expect the ultimate outcome of any of these shareholder derivative 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 Company’s 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 management’s 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 Company’s insurance coverage. Management believes that claims and liabilities in excess of the amounts accrued are adequately insured. However, the Company’s 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 employer’s 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 Company’s primary marine package provides for hull and machinery coverage for substantially all of the Company’s 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 employer’s liability coverage for marine crew personal injury and death and certain operational liabilities, with primary coverage (or self-insured retention for maritime employer’s 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 charterer’s 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 Company’s 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 contractor’s extra expense policy with $25.0 million primary liability coverage 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, employer’s liability, auto liability and non-owned aircraft liability, with customary deductibles and coverage.

HERCULES OFFSHORE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
UNAUDITED

     The Company’s 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 Company’s 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 Company’s respective personnel and property, regardless of how the loss or damage to the personnel and property may be caused. The Company’s 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 customer’s 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 2011, in connection with the renewal of certain of its insurance policies, the Company entered into an agreement to finance a portion of its annual insurance premiums. Approximately $25.8 million was financed through this arrangement, of which $13.0 million was outstanding as of September 30, 2011. The interest rate on the note is 3.59% and it is scheduled to mature in March 2012.

Surety Bonds, Bank Guarantees and Unsecured Letters of Credit

     The Company had $17.6 million outstanding related to surety bonds at September 30, 2011. The surety bonds guarantee the Company’s 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 September 30, 2011.

Sales Tax Audits

     Certain of the Company’s 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, which is included in Accrued Liabilities on the Consolidated Balance Sheets, as of September 30, 2011 and December 31, 2010, respectively, while the Company provides additional information and responds to auditor requests.

14. Accounting Pronouncements

     In May 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”) which changes the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and disclosing information about fair value measurements. Some of the amendments clarify the FASB’s intent about the application of existing fair value measurement requirements while other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The amendments in this ASU are effective prospectively for interim and annual periods beginning after December 15, 2011, with no early adoption permitted. The Company does not expect the adoption of this standard to have a material impact on its consolidated financial statements.

     In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income (“ASU 2011-05”), which eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments in this standard require that an entity present the total of comprehensive income, the components of net income, and the components of other comprehensive income in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under either method, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. For public entities, the amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011 and are to be applied retrospectively, with early adoption permitted. The Company does not expect the adoption of this standard to have a material impact on its consolidated financial statements.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     The following discussion and analysis should be read in conjunction with the accompanying unaudited consolidated financial statements as of September 30, 2011 and for the three and nine months ended September 30, 2011 and September 30, 2010, included elsewhere herein, and with our Annual Report on Form 10-K for the year ended December 31, 2010, as amended on Form 8-K filed on July 8, 2011. 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, as amended on Form 8-K filed July 8, 2011, for the year ended December 31, 2010, Item 1A of Part II of our quarterly report on Form 10-Q, as amended on Form 8-K filed July 8, 2011, for the quarter ended March 31, 2011, Item 1A of Part II of our quarterly report on Form 10-Q for the quarter ended June 30, 2011 and Item 1A of Part II of this quarterly report 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. We own a fleet of 49 jackup rigs, 17 barge rigs, two submersible rigs, one platform rig 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.

Asset Purchase

     On April 27, 2011, we completed our acquisition of 20 jackup rigs and related assets, accounts receivable, accounts payable and certain contractual rights from Seahawk (“Seahawk Transaction”) for total consideration of approximately $150.3 million consisting of $25.0 million of cash and 22.1 million shares of Hercules common stock, net of a working capital adjustment. The fair value of the shares issued was determined using the closing price of our common stock of $5.68 on April 27, 2011. The results of Seahawk are included in our results from the date of acquisition.

Asset Disposition

     In May 2011, we completed the sale of substantially all of Delta Towing’s 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 approximately $6 million at the date of sale. The results of operations of the Delta Towing segment are reflected in the Consolidated Statements of Operations for the three and nine months ended September 30, 2011 and 2010 as discontinued operations.

Financial Statement Recast

     In connection with the Delta Towing sale, we have recast certain prior period financial information to reflect the results of operations of the Delta Towing assets as discontinued operations for all periods presented.

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. Although these options were set to expire in late October 2011, Discovery Offshore is currently in discussions with the shipyard to extend the exercise date on these two options.

     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 of 11.5 Norwegian Kroner per share 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 September 30, 2011, for 30 consecutive trading days. The warrants were issued to additionally compensate us for our costs incurred and efforts expended in 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 five business segments, which, as of October 26, 2011, included the following:

     Domestic Offshore — includes 41 jackup rigs and two submersible rigs in the U.S. Gulf of Mexico that can drill in maximum water depths ranging from 80 to 350 feet. Seventeen of the jackup rigs are either working on short-term contracts or available for contracts, one is in the shipyard and twenty-three are cold stacked. Both 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 contracted offshore in Saudi Arabia, one jackup rig contracted offshore in Vietnam, one jackup rig contracted offshore in India, one jackup rig contracted offshore in the Democratic Republic of Congo and one platform rig contracted offshore in Mexico. We have one jackup rig contracted in Angola, however, it is currently preparing to be transported to a shipyard in Mississippi to undergo repairs and is estimated to be out of service for approximately six months. In addition, we have one jackup rig warm stacked and one jackup rig cold stacked in Bahrain. In addition, to owning and operating our own rigs, we have the Construction Management Agreement and the Services Agreement with Discovery Offshore with respect to each of the Rigs.

     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-five are operating or available and six 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.

     In July 2011, we sold Hercules 152 for gross proceeds of $5.0 million. The financial information for Hercules 152 has been reported as part of the Domestic Offshore segment. In September 2011, we sold Hercules 190 and Hercules 254 for gross proceeds of $4.1 million. The financial information for Hercules 190 and Hercules 254 have been reported as part of the Domestic Offshore segment.

     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.

     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 October 26, 2011 totaled approximately $375.7 million for our executed contracts. Approximately $70.2 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 management agreements, 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.

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 continue 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 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.

Regulations

     The United States Coast Guard recently issued a Policy Letter that provides for more frequent inspections of foreign flagged Mobile Offshore Drilling Units (MODUs) that operate on the United States Outer Continental Shelf (OCS). The Coast Guard will make determinations to conduct more frequent inspections of foreign flagged MODUs in accordance with its newly-implemented Mobile Offshore Drilling Unit Safety and Environmental Protection Compliance Targeting Matrix. We may be subject to increased costs and potential downtime for certain of our rigs operating on the OCS if such rigs are determined by the Coast Guard to need additional oversight and inspection under this new Policy Letter.

     In addition to this new Coast Guard Policy Letter, the BOEMRE is also continuing to review whether it can directly regulate drilling contractors. To this point, the BOEMRE has only had jurisdiction over the operators of oil and gas properties, but has, in response to the Macondo well blowout in April 2010, been considering expanding its authority to include the regulation of drilling contractors. If the BOEMRE is granted such authority over drilling contractors, we could be subject to additional regulations with respect to our operations in the United States Gulf of Mexico, which may have an adverse effect on our business and results of operations.

Recent Events

     On September 18, 2011, we were conducting a required annual spud can inspection on the Hercules 185 in protected waters offshore Angola. While conducting the inspection, it was determined that the spud can on the starboard leg had detached from the leg. While preparing the rig for heavy-lift transport to a shipyard in Pascagoula, Mississippi to conduct the spud can repairs, additional leg damage was identified. The additional damage must be repaired before the rig can be transported to the shipyard in Mississippi. We are currently in the process of repairing the additional leg damage and preparing the rig for the transport to Pascagoula, Mississippi. Until a full inspection of the rig is completed, it is impossible to determine the full extent of the damage, the scope and cost of the repairs necessary to return the rig to service and the anticipated time needed to complete the required repairs. However, we currently estimate that the rig will be out of service for approximately six months. During this period, the rig will be at zero dayrate pursuant to its contract with Cabinda Gulf Oil Company (“Cabinda Gulf”). We have discussed the expected downtime of the rig with Cabinda Gulf and Cabinda Gulf has indicated that it intends to accept the rig after the completion of the repairs and to continue the contract, although Cabinda Gulf may have the right to terminate the contract and be paid $1.0 million by us for liquidated damages. We expect to be insured for damage to the rig up to the insured value of $35.0 million, subject to a $3.5 million deductible and other customary limitations and exclusions. We have incurred approximately $2.0 million during the three months ended September 30, 2011 related to rig repairs, inspections and other costs, of which all or a portion of these costs will be applied to the deductible associated with this claim. In addition, the rig had a net book value of $52.3 million as of September 30, 2011.

     On September 30, 2011, the Starfish, a 140 class liftboat (the “Vessel”), was underway in the Gulf of Mexico in Ship Shoal Block 116 when it was hit by a series of waterspouts and capsized. The Vessel has been anchored and secured by a salvage company retained by us. We anticipate salvaging the Vessel when weather conditions are favorable. Our underwriters have determined that the Vessel is considered to be a constructive total loss and, therefore, we will receive the full insured value of the Vessel, $2.5 million. We carry removal of wreck insurance adequately covering the salvage operation, subject to a $250,000 deductible. Additionally, we carry pollution insurance, subject to a $3 million deductible and other customary limitations. The Vessel had a net book value of $0.7 million.

RESULTS OF OPERATIONS

     On April 27, 2011, we completed the Seahawk Transaction. The results of Seahawk are included in our results from the date of acquisition which impacts the comparability of the 2011 periods with the corresponding 2010 periods.

     The following table sets forth financial information by operating segment and other selected information for the periods indicated:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2011				2010				2011				2010
						(Dollars in thousands)
						(As Adjusted)								(As Adjusted)
Domestic Offshore:
Number of rigs (as of end of period)			43				25				43				25
Revenue		$	60,246			$	25,058			$	142,688			$	88,163
Operating expenses			53,184				38,701				140,390				115,082
Depreciation and amortization expense			17,977				17,277				49,920				50,986
General and administrative expenses			1,909				1,146				7,499				4,807
Operating loss		$	(12,824	)		$	(32,066	)		$	(55,121	)		$	(82,712	)
International Offshore:
Number of rigs (as of end of period)			9				9				9				9
Revenue		$	48,965			$	74,429			$	196,131			$	221,364
Operating expenses			29,098				31,065				99,803				98,394
Depreciation and amortization expense			12,913				14,404				39,469				43,808
General and administrative expenses			(5,992	)			2,067				(6,968	)			5,546
Operating income		$	12,946			$	26,893			$	63,827			$	73,616
Inland:
Number of barges (as of end of period)			17				17				17				17
Revenue		$	8,124			$	5,745			$	21,251			$	15,676
Operating expenses			3,535				8,279				16,693				20,359
Depreciation and amortization expense			3,310				4,991				11,338				18,736
General and administrative expenses			356				1,103				869				(1,756	)
Operating income (loss)		$	923			$	(8,628	)		$	(7,649	)		$	(21,663	)
Domestic Liftboats:
Number of liftboats (as of end of period)			41				41				41				41
Revenue		$	16,718			$	24,612			$	44,209			$	53,950
Operating expenses			11,419				11,314				31,837				31,481
Depreciation and amortization expense			4,136				3,314				11,637				11,182
General and administrative expenses			548				560				1,579				1,436
Operating income (loss)		$	615			$	9,424			$	(844	)		$	9,851
International Liftboats:
Number of liftboats (as of end of period)			24				24				24				24
Revenue		$	28,938			$	27,765			$	88,291			$	80,914
Operating expenses			14,136				12,951				43,358				42,310
Depreciation and amortization expense			4,905				4,199				14,379				13,258
General and administrative expenses			1,374				1,184				4,470				4,119
Operating income		$	8,523			$	9,431			$	26,084			$	21,227