Description

Situation overview

How about yet another newly public energy-related company? Only this one went public via spac last year and has a material weakness in its internal controls! And it still pays a management fee to its private equity owner! And the stock has almost doubled in the last few months! While these things are all true, I believe Drilling Tools International Corporation offers a compelling risk/reward opportunity.

DTI rents and sells downhole and wellbore conditioning tools for drilling oil and gas wells. Why are these tools important? Because if there’s a problem with them, the rig operators might need to pull miles of drill string out of the ground, wasting expensive operating time. While this company has over 50% market share in its core business and serves some of the largest E&P and oilfield service companies as its customers, DTI is nonetheless a small and underfollowed stock with some recent acquisitions complicating its earnings picture.

The company consistently gains market share and is likely to strengthen its competitive position in an industry downturn. It generates gross margins in excess of 70% and EBITDA margins of 30%+, along with an average ROE over the last two years of nearly 20% and an average return on tangible capital of 23%. DTI is also in the process of expanding globally, and has been requested by its major global customers to do so. Read on, and see why else one might want to join the insiders who hold 70%+ of the stock.

Company and industry overview

Drilling Tools International Corporation (Nasdaq: DTI) rents and sells downhole and related oilfield tools and services to oil and gas drilling sites in North America, Europe, and the Middle East. About 90% of its revenue comes from the U.S. and roughly 80% of its revenue is rental related, with the remaining 20% of revenue related to product sales. The company employs 394 full-time employees and contractors including 29 sales professionals and operates out of 16 North America locations (covering all major basins) and seven international locations (Scotland, Germany, Middle East).

DTI divides its revenue into (i) “Directional Tools Rental”, 61% of 2023 revenue, renting bottom hole assembly tools such as drill collars, stabilizers, and sub-assemblies, (ii) “Wellbore Optimization Tools”, 17% of 2023 revenue, renting Drill-N-Ream, a wellbore conditioning tool and RotoSteer (DTI expects to add additional products in 2024 and beyond), (iii) “Premium Tools”, 19% of 2023 revenue, renting drill pipe, blowout preventers, and other drill string handling tools, and (iv) “Other”, 3% of 2023 revenue, inspection and machining solutions. These revenue divisions are mentioned only in company description material and DTI reports as a single operating segment.

DTI’s basic reason for existing is that drilling tools come in so many variations that it doesn’t make sense for the drilling companies to stock these tools themselves. Consider that DTI’s drilling fleet contains 65,000 tools at an average cost of $3,000 each. The most desirable tool could be different depending on geography, hole size and profile, or engineer preference. Getting the right tools to the right site is a logistics project that drillers are happy to outsource to DTI. In fact, the service that DTI provides is so valuable that the company earns consistent 70-75% gross margins and EBITDA margins above 30%. Further, DTI’s customer agreements provide for customers covering the cost of tools that are lost-in-hole or broken during use, covering nearly all maintenance capex. DTI converts about 90% of its EBITDA to cash flow. Lost tool revenue accounts for 60-70% of total product sale revenue (i.e. 12-14% of consolidated revenue).

While DTI is a small company by wall street standards, it is a major player in its segment. The company boasts a market share of over 50% within North American land drilling rigs, and is also a self-described market leader in the deep-water Gulf of Mexico. DTI has built an impressive blue-chip customer base (all of the following lists are “including but not limited to”): In 2023 diversified oilfield service companies accounted for ~50% of revenue and included Baker Hughes, Halliburton, Phoenix Energy, and SLB; E&P companies accounted for ~47% of revenue including ConocoPhillips, EOG Resources, Occidental, and Pioneer; the remaining 3% of revenue was from equipment manufacturers such as Liberty Lift and National Oilwell Varco. In order to do business with top-tier customers such as these, DTI enters into master service agreements that cover quality and safety requirements as well as specifying auditable work processes. These MSAs, of which DTI had 325 as of year-end, provide some amount of competitive moat (provided DTI continues to deliver high service levels) as they can be difficult and time-consuming to obtain. A blue-chip customer base can also mean customer concentration, and while DTI’s customer concentration isn’t extreme, it’s still a factor: In 2023, 39% of the company’s revenue came from its top three customers. DTI’s lease contracts charge by the day, month, or by the foot (drilled) and often have some level of minimum payment clause.

DTI currently has total debt including lease liabilities of $43.4mm, less $14.1mm of cash. All of my calculations assume that the Superior Drilling (“SDPI”) merger (discussed below) closes in Q424 and that all SDPI holders opt for stock consideration. As such, there is also $14.9mm of debt related to the SDPI merger, resulting in pro forma net debt of $44.2mm. DTI has 29.8mm shares outstanding plus another 1.7mm of options (treasury method) struck between $3 and $4 and 4.8mm shares to be issued to SDPI holders for total diluted pro forma shares of 36.3mm. At a stock price of $5.33, this results in a market cap of $193.5mm. Combine with DTI’s net debt and $1.1mm of equity investments for an enterprise value of $236.6mm. 2023 full year revenue was ~$152mm and EBITDA was ~$48mm.

How we got here

DTI’s predecessor entity was founded in Lafayette, LA in 1984 as Directional Rental. Over the course of 28 years the company did well as a tool rental provider serving the Gulf Coast area, eventually growing to three locations. In 2012 the company was acquired by Hicks Equity Partners and in 2013 current CEO Wayne Prejean was hired along with additional team members to put in place a long-term growth plan. The company states that today’s senior management team has been working together for over ten years.

I don’t love the idea of private equity fanboying, but the DTI deal appears to be private equity at its best. In twelve years the company has grown revenue from $35mm to $152mm, expanded to 23 locations including Europe and the Middle East, significantly expanded market share in both North America on-land and Gulf of Mexico offshore projects, and upgraded its customer base from primarily independent directional drilling providers to major oilfield service companies and global E&P operators (DTI states that revenue from E&P operators has increased from less than 10% in 2014 to over 47% in 2023 and the company believes it can exceed 50% while also maintaining a leading market position with major oilfield service companies). In addition, DTI has developed an order management and support portal (“COMPASS”) that tracks all fleet equipment and specifications, allowing (i) customers to order exactly the piece (out of 65,000 total available) they need and (ii) DTI to optimize the makeup and geography of its inventory (consider that annual lost tool replacement revenue is ~$20 million, representing about 10% of gross fleet PP&E, allowing DTI to meaningfully reshape its tool fleet each year to match customer needs). And all this without leaving the company an overleveraged mess!

In mid-2023 a spac called ROC Energy Acquisition Corp., whose major backers include Arch Energy Partners, Acadia Resources, Fifth Partners, Braeburn Capital Partners, and The Allar Company, merged with DTI (yes, I’m simplifying here - it wasn’t actually called DTI until after the merger) to bring it public. Prior to discussions with ROC, Hicks had been looking for growth capital in order to both purchase additional fleet tools and grow through acquisition. Through the course of the transaction, Hicks, DTI’s founders, the management team, and the spac sponsors all rolled all of their equity into the new company. The company has filed a prospectus for these backers to sell their shares from time to time, but it appears that they haven’t sold despite the lockup having expired. As of the April proxy statement, Hicks owned 53.5%, ROC owned 9.3%, CEO Wayne Prejean held 5.5%, and the president of the Directional Tool Rentals division owned 6.2%. These people have voted with their wallets.

While this management team has ably grown the business and generated returns for over a decade, they are clearly still getting their feet under them in the new context of being a public company. This is I believe the first time I’m recommending a company that clearly states that its disclosure controls and procedures are not effective and that it has a material weakness in its internal controls. I’m inclined to be sympathetic to DTI’s explanation that (i) they were previously a private company with limited accounting staff (and my guess is that Hicks wasn’t pushing for an IPO so they also weren’t holding the company to the strictest accounting standards) and (ii) the controls are not effective because DTI is still in the process of remediating the issues that came up in preparation for its 2022 audit. I realize I may regret this viewpoint, though (i) I also find some degree of mitigation in the fact that the audit letter finds DTI’s financials present fairly in all material respects (though it is certainly worth mentioning that the auditor is Weaver and Tidwell out of Oklahoma City rather than a better known name), and (ii) having looked through the company’s revisions, I don’t find them to merit disqualification of the company from investment. It’s worth noting that the correction of these issues may offer a positive upcoming catalyst. It is certainly something that requires monitoring however.

Following the close of the spac merger, DTI’s share price fell significantly from ~$10.50 to the mid-$4s and drifted down to ~$3 per share (and occasionally below) for the next nine months. I attribute this partially to not-unexpected spac post-merger behavior, but also to general investor nervousness about declining rig counts, and potentially some “sell the news” selling as DTI started to release earnings publicly (Q223)/have earnings conference calls (Q323)/etc. Although DTI missed its 2023 full-year guidance (possibly “newly public company”-related though also understandable because I don’t expect people to be able to forecast rig count changes), the stock price ran significantly from ~$3/share to the mid $5’s following the Q423 earnings announcement. This report had a number of positive news items (a few of which had already been shared in press releases but were reiterated on the call) including a stabilizing U.S. rig count, a clear example of DTI’s ability to take share and outperform rig count changes (flat yoy rental revenue vs a 20% yoy decline in rig count), statement that their strategy of targeting blue-chip customers was paying off in allowing the company to be on the acquiror side (and therefore safe as a vendor) of several 2023 energy industry mergers, an extended and expanded credit facility, and guidance for 2024 results that imply revenue growth of ~12% to ~22% and EBITDA growth of flat to up ~15%.

DTI also reiterated the closing of its acquisition of Deep Casing Tools, and the announcement of its acquisition of Superior Drilling Products, Inc. (“SDPI”). While I’ll say more about DTI’s M&A strategy below, both of these acquisitions appear to be highly complementary to DTI’s business and strategy. Deep Casing, purchased for approximately $21mm (I estimate 3.8x EBITDA), is based in the UK and designs and manufactures a range of products used in well construction, completion, and casing installation. The Deep Casing acquisition (i) is accretive to DTI earnings according to the company, (ii) gives DTI a stronger foothold to distribute its own products internationally (North Sea, Europe, Africa, and Middle East), and (iii) creates the opportunity for DTI to cross-sell Deep Casing’s products to North American customers. Similar to DTI, Deep Casing has strong relationships with major customers including Adnoc, Aramco, Pemex, Petronas, and Petrobras.

The SDPI acquisition similarly expands DTI’s product opportunity. DTI was a customer of SDPI’s Drill-N-Ream wellbore conditioning tool. Owning SDPI will allow DTI to accelerate international usage of the tool. DTI announced the deal price as ~$32.3mm (~2.8x EBITDA) in a combination of cash and stock. I’ll note here that unfortunately this deal was struck when DTI’s stock price was just above $3, meaning that in actuality DTI is paying more like 3.7x with the appreciation in DTI’s stock price. While it is tempting to call this a fumble on the management team’s part, the likelihood is that this deal is attractive to DTI even at a higher multiple due to the elimination of duplicative public company costs and the elimination of historical “intercompany charges” from DTI being a customer of SDPI. I estimate the value of the intercompany charges at about $6mm / year. It is worth mentioning that with these two acquisition DTI is expanding its patent portfolio by over 70 patents. Note that the Deep Casing results are included in DTI’s guidance and the SDPI results are not. My projections (discussed below) include both acquisitions.

Where we are now

So where does this sequence of events leave us? Is now the best time to buy DTI stock? Obviously five months ago was the best time, but now is still an excellent time! What we have with DTI is a small underfollowed stock. For those who are taking only a cursory look at it, it’s a sub-scale oilfield services company (yikes!) that, even worse, went public via spac (double yikes!). Investors who look a little closer are rewarded with a lack of internal controls, a few revisions to the financial statements, and a management that wants to grow through acquisition using stock as currency. All understandable reasons for this stock to reflect a discount to its potential.

It would be a shame, however, to get lost in these negatives, when on balance DTI offers excellent risk-reward. At a fundamental level, this company offers a valuable service (the right tool, on-time, in the right location, in good condition) to a major, blue-chip customer base. With rig rental day rates running in the tens of thousands of dollars, avoiding holdups in drilling provides a real, measurable roi to customers. Importantly, because customers pay DTI for lost or damaged tools, DTI can price competitively and transparently, without having to estimate a rate of tool loss.

DTI earns an attractive return on its asset base in exchange for the value it provides. My back-of-envelope unit economics analysis shows about a 20% IRR although this return relies on the tool replacement revenue (essentially buy a tool for $3,000, earn $606 per year in after-tax cash flow, and always end up with the same $3,000 tool at period end). The company uses a 5-10 year depreciable life for its tools. If a tool lasts five years with no replacement it’s a flat return (money back with no profits) and if it lasts ten years with no replacement, it generates a 15% IRR. This return is obviously dependent on estimating how much direct SG&A is required in order to rent out a tool, and this number could potentially improve over time.

On a consolidated basis, DTI’s results have also shown that its services merit a return on its capital. Gross margins averaged 73% for 2020 through 2023, and EBITDA margins averaged ~24%. That includes generating positive EBITDA in 2020 - a year when oilfield activity dropped precipitously. If we excluded 2020 and 2021, EBITDA margins for 2022-2023 averaged 33% and net income margin averaged 13%. Cash flow has bounced around in recent history due to fluctuations in working capital and meaningful capex for fleet expansion in 2023, but overall it is not an extremely working capital-intensive business and maintenance capex is, for the most part covered by lost tool revenue. I estimate normalized (leveraged) cash flow to be 13-15% of revenue. Does this all lead to attractive consolidated returns on owners’ capital? Yes. EBIT / TCE was ~22% in 2022 and ~24% in 2023 while ROE was 23% in 2022 and 16% in 2023. In both cases I forecast improvements of several percentage points over the next few years driven by SG&A leverage from increased scale.

What else is important to know about how DTI is situated? DTI’s focus on large, blue-chip customers has kept them on the acquiror side of much of the merger activity in the oilfield services industry, and has also insulated their business during “flights to quality” that may occur during difficult industry periods. This is borne out in looking at percentage changes in the company’s revenue vs changes in U.S. rig count. In five out of the last seven quarters, DTI’s rental revenue outperformed the rig count with an overall average quarterly outperformance for all seven quarters of just over five percent. For 2021 through 2023, average annual outperformance is nearly 12%. DTI also cites its exposure to a wide range of customers, regions, and operation types, as well as competitive market share gains as factors in its outperformance.

To summarize DTI’s overall strategy, they’re looking to (i) expand within their existing regions and customer base, (ii) expand their international business, (iii) expand by adopting and developing new tools and technologies, and (iv) do as much of (i), (ii), and (iii) as possible through accretive acquisitions. I’ll note that the Deep Casing acquisition appears to be a great example of this as it both allows for a new product to come to the U.S. market and provides a stronger physical footprint outside the U.S. for international expansion. DTI has been clear that they intend to be levered to the global low-cost production areas and not just the Permian.

Most of the time a company that has a strategy to grow through M&A is a cause for reflection and this is no different. That said, there are several compelling aspects to how they’ve laid out their M&A strategy. First, the company’s desire to grow through M&A is nothing new, and in fact was a problem that Hicks was working on (via looking for growth capital) prior to going public. The company has stated that it has had to pass on many transactions over the years due to capital constraints. Secondly, the company has been very consistent about (i) the target-rich environment that they see and (ii) their framework for evaluating potential transactions. Thirdly, the company appears to have good supervision.

Regarding the target-rich environment, DTI cites a very fragmented industry as well as (a) a number of products that they see in the market that need better distribution and would represent a beneficial transaction for both buyer and seller and (b) a set of private equity-backed companies that were formed when significant capital was flowing into the oilfield services sector but which now are “old” by private equity fund standards and are struggling to find exit capital. DTI’s M&A framework appears thoughtful, though I acknowledge that it is disciplined adherence to the framework that matters most. The company stated that acquisitions need to extend the company in some way, whether by bringing with them an attractive geographic expansion or an incubatable technology that will be additive to DTI’s current portfolio. Acquisitions must also be accretive and improve cash flow, and must involve products that will be meaningful to top-tier customers. As a quick note, DTI’s large customers have asked them to expand and serve them globally, so I expect the customer base to be on-board with this program (this sort of product-pull is yet another advantage of large blue-chip customers).

On the negative side, management has said that one of the planned outcomes of the M&A program is to issue shares, leading to a larger market cap, more float (and presumably a less sub-scale valuation), and reduce the ownership percentage of its largest shareholders. I’m certainly sympathetic to the fact that, other things being equal, a meaningfully larger company can get a higher multiple from the market and that, especially in a situation where large holders want to eventually exit, a larger float is better than a smaller one. However, this second objective around increasing share count could encourage management to drift from their framework.

That said the team does seem to say all the right things, including emphasizing their high returns on capital, their intention to maintain low leverage and generate significant cash flow, and the fact that looking at 500 acquisition opportunities has resulted in about five near-term priority targets. In addition, the management team is overseen by financial players holding over 60% of the company’s stock, and the management team itself owns over 11% of the company. Interests appear to be aligned.

Valuation and expected outcomes

Downside case

As with most energy-related companies, in a truly disastrous, protracted energy price/volume scenario (including a near-term, permanent, large-scale shift to clean energy technologies), DTI equity holders will see a significant impairment. As this is not the most capital-intensive business (EBITDA/Assets of ~30% with minimal maintenance capex), there is not significant downside protection from asset value. It is reasonable to expect, however that in many even severe downside scenarios, although stock price would be heavily depressed in the interim, DTI will be able to make it through to the other side. As stated above, the company has been EBITDA positive every single year for the past ten years, and, due to its size relative to smaller fragmented competitors and low leverage (0.6x pro forma EBITDA and 19x pro forma EBITDA/Interest), is likely to continue to outperform in all market conditions, including acquiring struggling competitors when the opportunity presents itself. It is important to keep in mind though that if management gets over its skis with acquisitions and leverage, this safety cushion could erode.

My downside case is as follows: U.S. rig count drops 10% and DTI doesn’t gain any share so core revenue drops 10% as well. SDPI revenue drops 10% and the Deep Casing acquisition contributes no revenue. Gross margins drop ten percentage points and the company cuts SG&A by 15% in order to conserve cash. However because SG&A from SDPI and Deep Casing have come online, this case still results in a ~$1mm increase in SG&A from Q124 annualized. I believe this is a conservative expression of DTI’s financials because (i) the company has consistently “taken share” in terms of revenue growth vs rig count in both up and down markets, and (ii) it implies a 64% gross margin on $166mm of revenue when DTI has historically generated 70% gross margins at under $100mm of revenue. This case results in a downside EBITDA of $35.6mm.

As I’ll discuss further below, there aren’t great direct comps to DTI, particularly with respect to rental business models. However of the 16 various oilfield services, construction equipment, and rental companies that I’ve cobbled together, EBITDA multiples range from 3.5x to 9x. I’ll take what I again think is a conservative multiple and say that in this depressed environment, investors put a 2.8x EBITDA multiple on DTI (despite the fact that during cyclical lows, multiples are often higher to compensate against the trough earnings). This results in a stock price decline of ~70% to $1.63 (~$100mm of EV less ~$43mm of debt net of cash and investments, over 34.6mm shares). Not good! However, because of DTI’s attractive cash flow characteristics, the company would still be generating $16mm of cash flow, resulting in a cash flow yield of nearly 30%, which is too high for a company with a manageable debt load (1.2x net debt / downside EBITDA. Note that DTI is still well within its debt covenants in this scenario) that is likely to strengthen its core operations during and after a downturn. And even if that valuation did persist, you’d be earning nearly a third of your market cap each year in cash. If investors instead demand a 16% cash flow yield, that implies a stock price of $2.93 or a 45% decline from current levels. This is still a significant mark-to-market loss, but more manageable and, assuming that management is still executing to plan, an excellent opportunity to add capital.

Base case

My base case valuation is pretty straightforward, though there are a few moving parts due to the recent changes in the business. In the U.S. I assume that the SDPI deal closes and contributes fully to DTI’s financials as of Q424 (possibly conservative as deal looks like it will close sooner) and I remove intercompany revenue and COGS. SDPI grows at 80% of mgmt. projections. I decline US rig count to 581 by the end of 2024 (vs current figure of 586), 570 for 2025, and 2% decline per year after that. I assume that DTI’s core tool revenue growth continues to outperform rig count changes by 3-5% per year. Product sales revenue grows in line with rental revenue and Deep Casing begins contributing $2mm of U.S. product sale revenue in 2025 (growing 30% annually from there). On the international side, in line with management’s posture that 2024 revenue growth will be higher than 2023, I have core international revenue growing 34% in 2024, 10% in 2025, and ~8% after that. Deep casing international sales revenue grows at 6%. The result of these pieces is that consolidated revenue in ’24, ’25, and ’26 is $170mm, $212mm, and $222mm, representing growth rates (including acquisitions) of 12%, 24%, and 5% (and ~5% thereafter).

For margins, I keep things generally consistent with history (though that may undervalue the COGS leverage DTI can get on a growing revenue base) resulting in fairly stable consolidated gross margins of ~75%. The company does earn a few points of SG&A leverage over a couple of years resulting in EBITDA for ’24, ’25, and ’26 of $50, $71, and $76 with EBITDA margins growing to 34% from 31.7% in 2023. With the bulk of capex being lost tool replacement cost, which is covered by lost tool revenue (I run about $4mm in expansion capex, which is consistent in prior years other than 2023 when they made a significant growth investment), cash flow for these years is $22mm, $27mm, and $33mm while net income grows from $19mm in 2024 to $38mm in 2026. My 2024 numbers come out to be in-line with the low end of management projections.

As I mentioned above, there are not great comps in terms of small, pure-play rental focused energy services companies. Heavily rental-weighted companies are in particularly short supply. I looked at a group that included small and large energy services companies, many of which had a focus on construction services, as well as general equipment rental companies (for the curious, SDPI, KLXE, WHD, BKR, URI, BOOM, OIS, RES, RNGR, XPRO, ESOA, GIFI, SND, NOV, HRI, HEES). General conclusions are as follows: DTI’s gross margins were more than double those of every company on the list except for SDPI and a couple of large equipment rental companies and EBITDA margins were higher than those of all except the large equipment rental companies. This speaks to the value of holding such a large fleet of cheap but individually specified tools. EV / EBITDA for this group ranges mostly from 3.5x to 9x.

I obviously don’t expect a recently public-via-spac energy services company with a sub-$200mm market cap to earn a valuation comparable to either a blue-chip equipment rental company (URI 8.2x EBITDA, 17x earnings, 2.4% cash flow yield) or a huge multinational diversified oilfield services company (BKR 9.8x EBITDA, 19x earnings, 6.3% cash flow yield). However 5x EBITDA for a company with EBITDA margins exceeding 30%, strong cash generation, and rapidly growing net income is too cheap. Even without a significant multiple rerating, DTI can deliver a very attractive return. At 6.5x 2026 EBITDA, EV is ~$494mm (less ~$43mm of debt net of cash and investments, resulting in a market cap of $450mm across 36.3mm shares) and DTI’s share price is $12.41 or a 133% increase from current levels. This implies a P/E of 11.9x, which may also be too low. At a 13x 2026E P/E, DTI is worth $13.54 or a 154% increase from current levels. On the other hand, the P/E of 11.9x implies a 2026E cash flow yield of 7.4%, which feels too tight (although with cash flow growth of 10%, which my base case model forecasts beyond 2026, it doesn’t take a very large yield to generate an attractive multi-year return). If we price DTI at an 11% cash flow yield, we arrive at a stock price of $8.34 or 57% upside, however this implies an EBITDA multiple of 4.6x, which again seems too low. Suffice it to say there is plenty of base case upside, and these figures don’t even include the additional cumulative cash flow of nearly $70mm ($1.92/share or 36% of current share price) that I forecast DTI to earn for Q224 through 2026.

High case

Although not nearly as important as the downside case or base case, let’s look quickly at a high case in order to get a more complete picture of the distribution of outcomes. Management has stated that its goal is to double or triple the size of the company in short order through acquisition. Although the purchase price for SDPI was less than 3x 2026E EBITDA I’ll assume that subsequent acquisitions are made at 4.5x EBITDA with 75% debt and 25% equity. DTI’s core EBITDA grows at the same rates as in the base case, and acquired EBITDA grows at 7% annually. By the end of 2026, the “double” case has reached EBITDA of $133mm which at 6.5x EBITDA is an EV of $862mm. Interim cash flow has resulted in debt paydown to ~$50mm of net debt and a total equity value of $812mm spread over 46.8mm pro forma shares. This implies a share price of $17.35 or 226% upside from current levels. The “triple” case results in a stock price of $19.82 or ~272% upside from current levels. Suffice it to say if anything even approaching this case occurs, returns will be excellent.

Key risks

--The obvious one is that the energy transition happens much more quickly and completely than it currently appears and hydrocarbon prices drop, taking hydrocarbon production with them. While I acknowledge that clean energy production can be cheaper than traditional energy sources, overall energy usage trends imply that hydrocarbons will be highly necessary for the foreseeable future. However, we should keep an eye on fusion reactor progress (really).

--The second obvious one is the M&A program. Whether it’s overpaying, acquiring low-margin/low-return companies, overleveraging the company, not integrating an acquiree well, or issuing too much dilutive stock, there are many ways for the management team to destroy value. As discussed above, the team at least has a sensible framework for transaction evaluation, as well as strong supervision and significant stock ownership. The company states that it has made six successful acquisitions since 2013.

--The company needs to correct its internal controls weakness. This seems very straightforward to fix (and understandable given its history) but merits attention if it isn’t taken care of relatively quickly.

--The company’s compensation program allows an additional 3% of shares to be issued each year to pay management. While the team seems focused on share value (and again has supervision), ten years of 3% dilution adds up. I’ll note that there are no spac warrants outstanding. It makes sense to mention here that DTI still pays a management fee to Hicks of ~$1mm/year. This is annoying.

--There is a reasonable amount of customer concentration and DTI is a small company. While DTI appears to be serving these customers well and getting financially rewarded for it (and receiving customer requests to expand globally), loss of a major customer would result in a meaningful impairment.

--In a fragmented industry with smaller players, periods of irrational pricing can occur. I would argue that a period of irrational pricing could help DTI’s competitive position given its likely stronger liquidity position and the fact that smaller players likely wouldn’t be competing for DTI’s largest customers. I would also expect that periods of irrational pricing would be short-lived as smaller players would disappear and it would be unlikely to see new capital come into the sector.

--One other interesting point about this business is the apparent risk pertaining to increasing drilling productivity and fewer drilling days needed for a given level of production. However, this doesn’t affect the overall value of the well, so (assuming rational competition of course) service providers should still have an argument to negotiate for equivalent compensation even if it is based on fewer days. Said another way, when the E&P companies are still making good money, they don’t need to capture 100% of the value of productivity increases for themselves.

Catalyst

--Continued growth results in fixed cost leverage and higher margins

--Accretive acquisitions add geographic and product breadth

--Potential market share gains to the extent more of DTI’s customers acquire non-customers

--Geographic cross-selling of current product portfolio (expansion of Deep Casing tools into North America and U.S. fleet into international markets)

--Potential acquisition of DTI by one of its customers. Would be margin accretive to the customer in the same way the SDPI transaction removes historical inter-company margin.

--Fixing the internal controls issues makes it more investor-friendly

--Potential short-term negative catalyst if a large holder starts unloading shares. This would be an attractive opportunity to upsize the position.