[This was my application idea and while it was written a few weeks ago, the opportunity remains depite the recent rise.  For better printing results, on the print preview select landscape and shrink to fit at 70%.]

A Tribute to a Modern Day Hachiko

There is a little known company that makes its home in Calgary, Alberta Canada.  It is named after a Japanese dog breed and while I doubt anyone at the company was ever directly inspired by the famous akita Hachiko, the company clearly demonstrates a loyalty to several managing principles that is reminiscent of the loyalty of that devoted canine.  While I'll get to the money making part in due course, first the quick story of the dog.  

Hachiko, who now lies stuffed in the National Science Museum of Tokyo, became a national symbol of loyalty in Japan in the 1920's and 30's.  Upon the death of his owner, Hachiko devoutly returned to the Shibuya Train Station where he had met his owner each day before his death.  Hachiko didn't do this for just a few days.  He did it for nine years!  The now long-famous dog has since inspired a bronze statue, an annual ceremony, films and books.  Hachiko's story is a story of loyalty.

The story of AKITA Drilling Ltd. (TSX: AKT.A; OTCPK: AKTAF), on the other hand, is not only about loyalty but also making money.  The C$160 million company is named after that breed of dog to which Hachiko belonged, and has been listed in Toronto since its spin-off from ATCO Ltd. in the early-to-mid 1990's.  AKITA is an oil and gas drilling contractor that primarily conducts its business in western Canada.  While the company performs drilling operations for oil, heavy oil, and potash, the fortunes of the company are highly levered to natural gas.  The company, which operates wholly-owned and partner-owned rigs, owns 39 gross and 37.225 net drilling rigs.  The company has a wide-range of rigs and can service oil and gas companies seeking to drill at multiple depths and can provide horizontal and pad drilling.  While the majority of the company's rigs service western Canada, the company has serviced customers in the lower 48 and Alaska.  However, at the moment, these ancillary markets are a minor part of the company's business.

While there are many unique aspects to the company, the one that immediately jumps out at a potential investor is the company's balance sheet.  In atypical fashion, the company is debt free.  In an industry which freely borrows to support rig construction, that is rare.  In fact, when you look at the history of the company, the company reported positive net debt (i.e. more debt than cash) in only five quarters since the end of 1995.  That was in 2001 and early 2002 when the company last heavily invested in rig construction and at the time the heavy investments were secured by long-term contracts to utilize the new equipment.  I would argue, generally speaking, that the company has managed and continues to manage its balance sheet quite well for the industry in which it operates.

The company's management team, which has mostly been with the company since it was founded in the late 1970's, appears to be committed to operating in a somewhat counter cyclical manner.  As I mentioned, the last wave of rig construction took place starting in 2000, not when natural gas prices were pushing $13 per MmBtu.  Interestingly, the company currently believes now is another opportune time to be spending money and with its balance sheet is has the wherewithal to do so.  The balance sheet boasts nearly $60 million in cash and no debt.  

AKITA is in the process of converting many of their drilling rigs, mostly deeper though some shallow, to pad rigs.  Pad rigs are more mobile rigs which allow for an assembly line-like drilling of prospects.  Right now there is quite the demand for these rigs, which stands in stark contrast to the market for traditional rigs in western Canada.  In fact, the company just announced an agreement to build a new pad rig which I estimate will cost between $15 and $20 million.  The company has perhaps five or six more rigs that it could convert to pad rigs.  Each of these conversions costs approximately $5 to $6 million.  As you might imagine, having the ability to convert older rigs at an incremental cost of 1/3 the price of a new pad rig is potentially appealing to the market.  AKITA, which doesn't focus on IRR's on its assets, but instead focuses on payback periods, looks to secure most, if not all, conversions and new builds with long-term contracts.  It targets four or five year paybacks on new builds and slightly more aggressive targets on conversions (this would suggest at the low end perhaps an incremental $3 million in after-tax cash flows over the next five years from the recently announced deal).  I wouldn't be surprised to see the company continue to spend heavily on pad conversions.  The company has indicated that by the end of 2010 eleven rigs will have been converted to pads.  With one additional conversion in process and five or six more that could be converted, AKITA's fleet could be nearly 50% pad rigs in the not so distant future.  I think this is changing the outlook for the businesses, especially in this difficult operating environment.

The western Canada rig market currently has approximately 840 rigs.  This gives AKITA a rig market share of approximately 4%.  While this is not a large number, in the pad rig business the company is reportedly a much larger player.  Management at AKITA estimates the western Canada pad rig market to be in the 30's, which would suggest a market share in this business of approximately 30%.  

As you might imagine, the current market for drilling natural gas in Canada is not robust.  Below is a long-term picture of the active Canada rig count presented by Baker Hughes.  While 2010 has shown quite a recovery from 2009, the market remains far from its highs.

Baker Hughes Rig Count
Candaian Market
	2000	2001	2002	2003	2004	2005	2006	2007	2008	2009	2010
JAN	502	539	405	478	554	550	660	568	494	377	459
FEB	544	562	433	554	568	593	715	635	620	413	564
MAR	394	445	311	449	462	420	620	392	408	196	386
APR	146	217	121	151	153	183	198	101	106	74	123
MAY	189	238	114	150	187	247	240	107	135	72	147
JUN	301	302	205	308	265	293	408	210	266	125	229
JUL	308	319	266	398	351	450	553	349	435	175	350
AUG	319	325	235	404	353	545	482	343	449	178	387
SEP	314	317	250	348	273	497	446	351	435	208	347
OCT	353	304	220	394	372	541	431	338	446	244	398
NOV	362	266	281	412	447	600	432	371	417	277
DEC	410	264	348	417	440	575	456	360	361	313
AVG	345	342	266	372	369	458	470	344	381	221

The following natural gas price chart (www.tradingeconomics.com) provides, in addition to the credit disruptions of the last few years, a good explanation as to the current state of affairs in the drilling business.  

[Was not able to include chart, however the recent changes in natural gas pricing should be fairly well understood to this audience]

This environment has put extreme pressure on rig utilization in western Canada.  The accompanying table presents rig utilization for the industry and for AKITA.  It would appear that there are three primary conclusions that can be drawn.  First, industry wide utilization is far below the 10 year average.  Second, AKITA seems to outperform the industry in terms of utilization.  And, three, AKITA's opportunity in pad rigs, as reflected in the recent disclosure of the utilization of those particular rigs, seems intriguing.

AKITA Drilling Ltd.
Rig Utilization vs. Industry
					AKITA Detailed Utilization
	Year	AKITA	Industry		Conventional	Pad
	2010 YTD	36.5	31.9
	2009	31.1	24.8		23.7	59.5
	2008	42.2	41.7
	2007	40.9	37.0
	2006	56.6	55.1
	2005	59.3	58.8
	2004	52.2	52.9
	2003	54.7	53.1
	2002	46.8	39.2
	2001	56.9	53.0
	2000	60.0	55.2
	00 - 09 Avg	50.1	47.1

As you might next imagine, this state of affairs, especially given the high fixed costs of the business, has led to pricing issues.  The following set of tables shows what the last few years have looked like for AKITA.  Generally speaking, operating margin per operating day has been under a fair amount of pressure.  This is in spite of the fact, in AKITA's case, that the company has gradually been becoming more of a pad rig player where utilization and pricing has been much stronger.  

AKITA Drilling Ltd.							AKITA Drilling Ltd.
Revenue per Operating Day							Operating Margin Dollars per Operating Day
	2006	2007	2008	2009	2010			2006	2007	2008	2009	2010
Q1	$22,911	$24,661	$23,012	$24,923	$19,539		Q1	$9,984	$10,596	$9,746	$9,890	$6,788
Q2	$19,993	$23,412	$21,665	$29,604	$22,173		Q2	$8,880	$9,708	$7,346	$11,477	$7,455
Q3	$21,003	$20,755	$19,723	$21,018			Q3	$8,885	$6,834	$7,747	$6,061
Q4	$22,912	$22,595	$23,212	$21,840			Q4	NA	$9,390	$6,739	$7,713
AVG	$21,705	$22,856	$21,903	$24,346			AVG	$9,250	$9,132	$7,895	$8,785
AKITA Drilling Ltd.							AKITA Drilling Ltd.
Operating and Maintenance Costs per Operating Day							Operating Margin per Operating Day
	2006	2007	2008	2009	2010			2006	2007	2008	2009	2010
Q1	$12,927	$14,065	$13,266	$15,033	$12,751		Q1	43.58%	42.97%	42.35%	39.68%	34.74%
Q2	$11,113	$13,704	$14,319	$18,127	$14,718		Q2	44.42%	41.47%	33.91%	38.77%	33.62%
Q3	$12,118	$13,921	$11,976	$14,957			Q3	42.30%	32.93%	39.28%	28.84%
Q4	NA	$13,205	$16,473	$14,127			Q4	NA	41.56%	29.03%	35.32%
AVG	$12,053	$13,724	$14,009	$15,561			AVG	43.43%	39.73%	36.14%	35.65%	34.18%

Accounting Can Be Important

As with any capital intensive business, depreciation is a significant factor.  For instance, over the last ten years depreciation has represented, on average, 15.2% of AKITA's revenues and 17% of its total costs.  This makes the assumptions which drive depreciation quite important.  What is particularly interesting and illuminating when it comes to assessing management is that the company depreciates its rigs over 2,000 operating days (the company does also depreciate five rigs over 3,600 days).  According to my work, this is far faster than most drillers in the industry.  See the chart below for a sample of what the industry uses for depreciation rates.

AKITA Drilling Ltd
Comparable Company Depreciation Rates
	Company	Low	High	Method	Additional Notes
	Cathedral Energy Services Ltd.	4 yrs	10 yrs	declining balance
	Total Energy Services Inc.	5 yrs	15 yrs	straight line
	Ensign Energy Services Inc.	3,650 days		unit of production	on rigs
	Tuscany International Drilling Inc.	10 yrs		straight line
	Precision Drilling Corporation	5,000 days		unit of production
	Technicoil Corp.	2 yrs	15 yrs	straight line	more geared toward well servicing
	Nabors Industries Ltd.	4,900 days		unit of production	on rigs, not jack-ups
	Trinidad Drilling Ltd.	4,200 days		unit of production	on rigs only
	AKITA Drilling Ltd.	2,000 days	3,600 days	unit of production	just 5 of 37.225 net rigs at 3,600
	Xtreme Coil Drilling Corp.	5,000 days		unit of production	slightly different tech
	Savanna Energy Services Corp.	1,500 days	4,125 days	unit of production
	Helmerich & Payne Inc.	4 yrs	15 yrs	straight line	includes contract drilling equipment
	Patterson-UTI Energy Inc.	2 yrs	15 yrs	straight line	includes other equipment
	Unit Corp.	15 yrs		unit of production	rates starting at 15 yrs
	Rowan Companies Inc.	12 yrs	15 yrs	straight line
	Pioneer Drilling Co.	3 yrs	25 yrs		rigs and equipment
	Parker Drilling Co.	15 yrs	20 yrs		land drilling equipment
	Union Drilling, Inc.	2 yrs	12 yrs		includes related equipment
	Bronco Drilling Co. Inc.	3 yrs	15 yrs		includes related equipment

                                               
While it is certainly difficult to compare each of these companies, especially when several companies have chosen to use a different depreciation method than AKITA and several companies do little more than disclose a range for their entire rig segment (which often includes non-rig ancillary equipment which tends to be depreciated much faster), the table suggests AKITA depreciates its rigs far faster than many in the industry.  In fact, you could say that it depreciates its rigs nearly twice as fast, when operating, as many in the industry.  This obviously has a large impact on earnings.

Below is a chart showing net income, cash flow from operations and estimated free cash flow (excluding growth cap ex):

AKITA Drilling Ltd.
Cash Flow vs. Net Income
	Year	Net Income		CF From Operations	CF - NI	CF / NI		Cap Ex	CF - Cap Ex	CF / NI
	31-Dec-09	$8,380,000		$29,235,000	$20,855,000	3.49 x		($12,341,000)	$16,894,000	2.02 x
	31-Dec-08	$14,847,000		$19,367,000	$4,520,000	1.30 x		($19,567,000)	($200,000)	-0.01 x
	31-Dec-07	$20,752,000		$38,876,000	$18,124,000	1.87 x		($40,948,000)	($2,072,000)	-0.10 x
	31-Dec-06	$33,755,000		$61,152,000	$27,397,000	1.81 x		($49,698,000)	$11,454,000	0.34 x
	31-Dec-05	$29,264,000		$37,490,000	$8,226,000	1.28 x		($25,325,000)	$12,165,000	0.42 x
	31-Dec-04	$20,875,000		$25,663,000	$4,788,000	1.23 x		($15,308,000)	$10,355,000	0.50 x
	31-Dec-03	$18,822,000		$32,764,000	$13,942,000	1.74 x		($17,261,000)	$15,503,000	0.82 x
	31-Dec-02	$14,345,000		$25,335,000	$10,990,000	1.77 x		($5,831,000)	$19,504,000	1.36 x
	31-Dec-01	$17,889,000		$29,368,000	$11,479,000	1.64 x		($70,459,000)	($41,091,000)	-2.30 x
	31-Dec-00	$11,157,000		$14,745,000	$3,588,000	1.32 x		($34,649,000)	($19,904,000)	-1.78 x
	31-Dec-99	$5,211,000		$5,074,000	($137,000)	0.97 x		($7,670,000)	($2,596,000)	-0.50 x
	31-Dec-98	$12,907,000		$11,875,000	($1,032,000)	0.92 x		($7,832,000)	$4,043,000	0.31 x
	31-Dec-97	$11,363,000		$22,309,000	$10,946,000	1.96 x		($15,372,000)	$6,937,000	0.61 x
	31-Dec-96	$7,113,000		$8,144,000	$1,031,000	1.14 x		($3,760,000)	$4,384,000	0.62 x
	31-Dec-95	$6,053,000		$6,770,000	$717,000	1.12 x		($3,655,000)	$3,115,000	0.51 x
				Total	$135,434,000				$38,491,000
				15 Year Average	$9,028,933				$2,566,067
				5 Year Average	$15,824,400				$7,648,200

 

 

AKITA Drilling Ltd.
Cash Flow vs. Net Income
	Year	Yr End Rigs	Per Rig Maint Cap Ex	Maint Cap Ex	Est FCF	Est FCF - NI	Est FCF / NI
	31-Dec-09	39	$175,000	$6,825,000	$22,410,000	$14,030,000	2.67 x
	31-Dec-08	41	$169,750	$6,959,750	$12,407,250	($2,439,750)	0.84 x
	31-Dec-07	42	$164,658	$6,915,615	$31,960,385	$11,208,385	1.54 x
	31-Dec-06	40	$159,718	$6,388,711	$54,763,289	$21,008,289	1.62 x
	31-Dec-05	38	$154,926	$5,887,197	$31,602,803	$2,338,803	1.08 x
	31-Dec-04	37	$150,278	$5,560,303	$20,102,697	($772,303)	0.96 x
	31-Dec-03	36	$145,770	$5,247,724	$27,516,276	$8,694,276	1.46 x
	31-Dec-02	36	$141,397	$5,090,292	$20,244,708	$5,899,708	1.41 x
	31-Dec-01	36	$137,155	$4,937,583	$24,430,417	$6,541,417	1.37 x
	31-Dec-00	32	$133,040	$4,257,294	$10,487,706	($669,294)	0.94 x
	31-Dec-99	30	$129,049	$3,871,477	$1,202,523	($4,008,477)	0.23 x
	31-Dec-98	30	$125,178	$3,755,332	$8,119,668	($4,787,332)	0.63 x
	31-Dec-97	30	$121,422	$3,642,672	$18,666,328	$7,303,328	1.64 x
	31-Dec-96	28	$117,780	$3,297,833	$4,846,167	($2,266,833)	0.68 x
	31-Dec-95			$2,800,000	$3,970,000	($2,083,000)	0.66 x
				Total		$59,997,217
				15 Year Average		$3,999,814
				5 Year Average		$9,229,145

When you look at the difference between cash flows and net income and you contemplate the different accounting assumptions, perhaps AKITA is more profitable than it first appears.  The five year average cash flow from operations and more importantly FCF (excluding growth capital expenditures) significantly exceeds reported net income.  The company simply operates from the perspective that is should never have to write-down the value of its equipment.

In 2011 the company, as most Canadian companies are doing, is converting from Canadian GAAP to IFRS.  This could serve as a possible catalyst for a change in the manner in which the company records and depreciates its rigs.  The company recognizes the growing disparity between net income and cash flow.

Valuation

AKITA is currently trading at approximately 80% of tangible book value.  Given the company's aggressive depreciation rates, it is safe to assume that the tangible value of its assets is at least book value.  I think there is a case to be made that it is significantly more than stated book value.

In his 2009 shareholder letter, Mr. Ruud, the company's Chief Executive Officer noted:

"As well, the carrying value for the Company's fleet was only $142.2 Million ($3.7 Million per rig).  Although an evaluation of replacement cost for AKITA's fleet has not been performed, management is confident that the cost to replace the Company's fleet is significantly higher than its carrying value."

While it is somewhat tough to find exact comparables in an industry where it is all about the nature of a particular rig or fleet of rigs, a recent transaction provides at least some scope for Mr. Ruud's claims.  In May of this year, CanElson Drilling Inc. acquired Totem Drilling Ltd. which operated rigs in the south east of Saskatchewan.  The company's primary focus was on the Bakken play.  The fleet consisted of 5 double rigs with one additional rig on order and CanElson paid $40 million in cash and stock and assumed approximately $12 million in debt.  The implied price per rig was approximately $8.5 to $10 million, the implied P/BV was 2.0 x and the implied EV/EBITDA was 15.5 x.  Certainly rigs are different and certainly Totem was about to increase the size of its fleet by 20%, but the transaction at the very least provides a frame of reference.

While AKITA is certainly not a household name, it has in the past received its due share of respect in the marketplace.  The charts below show how AKITA has been valued in the past.  It is important to note, in my opinion, where it has traded in better operating environments.  

[chart could not be provided; while you can look it essentially shows that the company has traded between 1 x and 3.5 x in relation to TBV over its public history]

While it would be improper to suggest that the company could trade at the multiples it did in 2005 through 2007, it is important to realize that in a stronger operating environment this company has traded at significant premiums to book value.

It also is illustrative to look at where other drilling companies are trading.  Below is a chart for Canadian drillers and one for US drillers.  The US chart includes offshore drillers, which, while a somewhat different business, is provided for reference.

 

  

AKITA Drilling Ltd
Driller Comparables
Canada
16-Nov-10
Company	Ticker	Cap	Revenue	EBITDA	Debt	Cash	Debt/Equity	Debt/EBITDA	EBITDA Margin	P/TBV	EV/EBITDA
Cathedral Energy Services Ltd.	TSX: CET	$257	$136	$25	$49	$1	47.40%	2.64	18.33%	3.03	12.23
Total Energy Services Inc.	TSX: TOT	$346	$176	$48	$79	$0	41.83%	1.84	27.20%	1.85	8.88
Ensign Energy Services Inc.	TSX: ESI	$1,864	$1,230	$281	$138	$82	8.81%	0.12	22.87%	1.19	6.82
Tuscany International Drilling Inc.	TSX: TID	$239	$15	-$2	$51	$11	33.08%	NM	-16.09%	1.51	NM
Precision Drilling Corporation	TSX: PD	$2,066	$1,280	$383	$684	$209	26.13%	1.52	29.89%	1.21	7.30
Technicoil Corp.	TSX: TEC	$93	$78	$19	$0	$2	0.00%	1.39	24.08%	1.29	4.88
Nabors Industries Ltd.	NBR	$6,073	$3,695	$1,121	$4,509	$772	86.59%	2.59	30.33%	1.28	10.02
Trinidad Drilling Ltd.	TSX: TDG	$597	$609	$175	$574	$12	62.77%	2.97	28.68%	0.78	6.63
AKITA Drilling Ltd.	TSX: AKT.A	$159	$104	$25	$0	$59	0.00%	NM	23.67%	0.79	4.04
Xtreme Coil Drilling Corp.	TSX: XDC	$215	$89	$24	$35	$3	13.30%	0.88	26.32%	0.84	10.50
Savanna Energy Services Corp.	TSX: SVY	$456	$388	$67	$105	$6	13.39%	2.21	17.14%	0.59	8.35
Stoneham Drilling Trust	TSX: SDG.UN	$69	$92	$26	$53	$0	49.57%	4.29	28.12%	0.65	4.71
	Average	$1,036	$658	$182	$523	$96	31.91%	2.04	21.71%	1.25	7.67
	Median	$301	$156	$37	$66	$9	29.61%	2.02	25.20%	1.20	7.30
	Min	$69	$15	-$2	$0	$0	0.00%	0.12	-16.09%	0.59	4.04
	Max	$6,073	$3,695	$1,121	$4,509	$772	86.59%	4.29	30.33%	3.03	12.23

   

AKITA Drilling Ltd
Driller Comparables
United States
16-Nov-10
Company	Ticker	Cap	Revenue	EBITDA	Debt	Cash	Debt/Equity	Debt/EBITDA	EBITDA Margin	P/TBV	EV/EBITDA
Diamond Offshore Drilling Inc.	DO	$9,447	$3,373	$1,885	$1,496	$986	40.01%	0.32	55.88%	2.53	5.28
Royale Energy Inc.	ROYL	$21	$12	$3	$3	$3	23.75%	NM	22.95%	2.03	7.43
Helmerich & Payne Inc.	HP	$4,758	$1,875	$709	$360	$63	12.82%	0.42	37.83%	1.76	7.95
Transocean Ltd.	RIG	$21,106	$10,149	$4,731	$12,861	$4,668	61.14%	1.78	46.62%	1.65	6.19
Atwood Oceanics, Inc.	ATW	$2,276	$651	$359	$230	$181	16.79%	0.14	55.24%	1.75	6.86
Patterson-UTI Energy Inc.	PTEN	$3,090	$1,171	$398	$100	$74	4.69%	NM	33.97%	1.50	7.83
Noble Corp.	NE	$9,198	$3,104	$1,808	$2,762	$367	39.04%	0.00	58.26%	1.30	6.48
Unit Corp.	UNT	$1,918	$807	$399	$137	$1	8.14%	0.21	49.50%	1.19	5.14
Pride International Inc.	PDE	$2,066	$1,376	$375	$1,872	$640	42.00%	0.68	27.25%	1.25	7.30
Rowan Companies Inc.	RDC	$3,751	$1,760	$585	$1,684	$893	45.72%	0.32	33.23%	1.02	7.77
Pioneer Drilling Co.	PDC	$374	$420	$78	$283	$17	70.99%	2.98	18.62%	0.99	8.19
Parker Drilling Co.	PKD	$475	$662	$143	$469	$47	78.28%	2.05	21.61%	0.79	6.27
Union Drilling, Inc.	UDRL	$126	$175	$23	$38	$0	18.71%	0.26	13.32%	0.63	7.02
Vantage Drilling Company	VTG	$471	$232	$68	$1,100	$117	140.75%	13.39	29.38%	0.60	21.33
Bronco Drilling Co. Inc.	BRNC	$134	$111	$3	$8	$7	2.79%	3.77	2.67%	0.43	278.82
Hercules Offshore, Inc.	HERO	$310	$662	$124	$879	$135	93.94%	5.41	18.80%	0.33	8.48
Seahawk Drilling, Inc.	HAWK	$104	$97	($65)	$18	$41	4.71%	NM	-66.55%	0.27	NM
	Average	$3,507	$1,567	$684	$1,429	$485	41.43%	2.27	26.98%	1.18	24.90
	Median	$1,918	$662	$359	$360	$74	39.04%	0.55	29.38%	1.19	7.37
	Min	$21	$12	($65)	$3	$0	2.79%	0.00	-66.55%	0.27	5.14
	Max	$21,106	$10,149	$4,731	$12,861	$4,668	140.75%	13.39	58.26%	2.53	278.82

                                                                                            
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While it is difficult to make substantive relative value conclusions based on the survey presented, it might be fair to say at the very least that given AKITA's balance sheet and operating performance, the company is not overvalued relative to its peers.  In this author's opinion, given AKITA's depreciation decisions, balance sheet and operating performance, AKITA is in fact at a fair discount to its peers.

So at the end of the day what is AKITA worth and what rates of return could an investment at these prices produce?  At current prices AKITA is trading, net of cash, at approximately 21 times trailing-twelve-month earnings (earnings which I've suggested could be overburdened by excess depreciation charges).  To put that in perspective, the company is also trading at less than 3 times peak trailing-twelve-month net earnings which were achieved in June 2006.  In that year gas prices hit $14 per MmBtu and the company had one additional gross rig.

The exhibit below looks at several valuation scenarios based on replacement cost and long-term earnings.

  
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AKITA Drilling Ltd.
Valuation Possibilities
	By Replacement Cost / Rig
	Replacement Cost Est.			3,500,000		6,000,000		9,000,000
	Number of Net Rigs			37.225		37.225		37.225
	Total Replacement Cost			$130,287,500		$223,350,000		$335,025,000
	Net Cash			$60,000,000		$60,000,000		$60,000,000
	Total Replacement Cost			$190,287,500		$283,350,000		$395,025,000
	Shares Outstanding			18,040,513		18,040,513		18,040,513
	Total Replacement Cost per Share			$10.55		$15.71		$21.90
	By Multiple to Long-Term Earnings
	Multiple to Earnings			10.00 x		12.00 x		15.00 x
	10 Year Average Earnings ^			$19,723,000		$19,723,000		$19,723,000
	Earnings Value			$197,230,000		$236,676,000		$295,845,000
	Net Cash			$60,000,000		$60,000,000		$60,000,000
	Total Value			$257,230,000		$296,676,000		$355,845,000
	Shares Outstanding			18,040,513		18,040,513		18,040,513
	Total Value per Share			$14.26		$16.44		$19.72
	^ 10 Year Average Earnings includes the years 2001 through 2009 and the LTM as reported through Q3 2010

Presented below is are two exhibits that looks at return possibilities based on changes in book value and multiples to book value over the next five years.  The first extrapolates long-term book value growth into the future and the other provides a reduced book value growth rate to reflect a protracted poor drilling market.

AKITA Drilling Ltd.
Return Possibilities
				+ 1 YEAR	+ 2 YEAR	+ 3 YEAR	+ 4 YEAR	+ 5 YEAR
	Implied Future Book Value		$11.00	$11.55	$12.13	$12.73	$13.37	$14.04
	Reduceed Avg BV Growth			5.00%	5.00%	5.00%	5.00%	5.00%
	Multiple to BV			1.00 x	1.00 x	1.00 x	1.00 x	1.00 x
	Share Price		-$9.00	$11.55	$12.13	$12.73	$13.37	$14.04
	IRR			28%	16%	12%	10%	9%
	Multiple to BV			1.50 x	1.50 x	1.50 x	1.50 x	1.50 x
	Share Price		-$9.00	$17.33	$18.19	$19.10	$20.06	$21.06
	IRR			92%	42%	29%	22%	19%
	Multiple to BV			2.00 x	2.00 x	2.00 x	2.00 x	2.00 x
	Share Price		-$9.00	$34.65	$36.38	$38.20	$40.11	$42.12
	IRR			285%	101%	62%	45%	36%

Potential Risks

Investing in the common stock of a contract drilling company, even one trading at such a discount to replacement cost and book value is still not without its risks.  The following are a sample:

- The company is certainly levered to natural gas pricing.  Since the summer of 2007 the price for natural gas has declined considerably.  This has put pressure on exploration and development drilling, especially in traditional gas drilling.  A continued poor pricing environment for natural gas will not produce an ideal operating environment for the company.  Cash flows, while currently significantly positive, may face continued pressure.

- AKITA is a relatively small player, even in the western Canada drilling market.  As mentioned, the company has an approximate 4% share of the market.  Larger players like Nabors and Precision may get aggressive in a tough market looking to gain market share or push other players out of business.  At the very least they could "throw their weight around."

- Included in the rig fleet that AKITA maintains are several older rigs that the company admits are more marginable.  These rigs present concerns not only about the duration of cash flow particular to them, but also valuation metrics based on average rig market price or replacement cost.


Other Considerations

Ownership

AKITA is governed by a two class share structure.  The more liquid class of shares is the A shares, which carry no voting rights.  While the voting class B shares are traded, they are much less liquid and are controlled by Sentgraf Enterprises.  Sentgraf is controlled by Mr. Ronald Southern who is deputy chairman of the company.  In total Sentgraf owns a 32.73% economic interest in the company.  Mr. Southern is also the chairman and CEO of ATCO and its major shareholder.  Through Sentgraf he owns 31.66% of that $3.3 billion company.  

While there is certainly interested ownership on the board of directors, the company is clearly controlled by Mr. Southern.  Without any voting rights, shareholders are completely dependent on Mr. Southern for his stewardship of the company.  Mr. Southern is 79 years old and is the founder of ATCO, the former parent of AKITA.

Related Party Transaction

The company discloses a fairly sizable related party transaction.  Each year the company pays several hundred thousand dollars ($325,000 in 2009) as sponsorship and advertising to Spruce Meadows, which is controlled and founded by the Southern family.  Spruce Meadows hosts international horse jumping competitions and other events in Calgary.  While I don't condone such arrangements, given the status of the events and their importance to the area I am willing to tolerate it.  The company makes the case that while it may be pricy it does provide them an opportunity to entertain a great number of customers and potential customers.  

Dividend and Buyback

At current prices, the company shares yield approximately 3.1%.  The company has paid a dividend since 1996.  Given the current level of cash flows, there appears to be adequate capacity to continue to pay the dividend even in an environment of continued poor natural gas pricing.

The company does have a buyback authorization in place through a normal course issuer bid.  AKITA has a history of authorizing the buybacks, though rarely have they been utilized to their full extent.  In the second quarter of 2010 the company repurchased $1.3 million worth of shares, though conversations with management suggest this is not a priority at this time.

Commodity Pricing

It is perhaps foolhardy to predict where natural gas and oil prices will be in the future.  Given the developments in the US shale business over the last several years, perhaps the gas industry is in for a prolonged period of lower prices.  

Natural gas companies however do have to earn an economic return to justify their existence.  Of the individuals operating in that business that I respect, Ken Peak at Contango Oil & Gas is probably at the top.  In a late 2009 presentation entitled "The Big Lebowski and the Zen of E&P" he stated:

"I think the industry needs $6.00/mcfe to earn a 5-10% ROR"

While it is perhaps impossible to predict prices, it is not impossible to predict that the natural gas industry will at least need to generate a 5-10% rate of return.  If one believe in Mr. Peak's assessment, one might plausibly argue that over time natural gas prices will need to be at least $6.
Canadian Oil Sands Opportunity

Management at AKITA views the opportunity to supply rigs to the oil sands industry in Alberta, and potentially in Saskatchewan, as the most substantial prospect going forward.  While the company of course will not provide rigs for the mined extraction of bitumen, it will drill for the in-situ producers.  According to the Alberta Energy and Utilities Board (AEUB), 80% or more of all the recoverable oil in the sands will come from deposits which are too deep to be mined.  Several years ago AKITA's work for oil sands companies was just a few percent of its business.  Now it approaches 20%.  The future direction of the mix of business will certainly depend on the future of the gas business; however AKITA could become much more levered to oil over the course of the next several years.


Conclusion

Like Hachicko, AKITA ought to be known for its loyalty.  Of course, in this case it is the loyalty to a basic set of operating principles that, in this author's opinion, are prudent for a capital intensive, cyclical and at times unpredictable business.  The hallmark of those principles appears to be:

- An avoidance of significant levels of debt
- A focus on investing in assets when others are less willing and / or able
- A belief in conservative accounting
- A desire to build and upgrade assets when the asset's future use is secured by long-term contracts

The purchase of shares of AKITA Drilling Ltd. at recent prices appears to provide a significant risk / reward opportunity.  Given where the shares trade in relation to book value and potential replacement cost, there appears to be little downside.  With the company's ongoing investment in pad conversions and possible new construction, it would appear that the upside, particularly in an environment of higher-priced natural gas or sustained additional investment in the oil sands, is significant.





Disclosure:    I co-manage a partnership that owns shares in AKITA Drilling Ltd.  It may in the future buy or sell shares and it is under no obligation to update its activities.  Please do your own research.

- Possible change in accounting in 2011
- Any upturn in utilization has a huge impact on earnings
- Any acceleration of oil sands drilling