Description

This was my application idea and was written on a $2.25 stock price. I still think it's attractive at this level, but would note that I've seen it jump around alot and would not be surprised if it sold off. I have been surprised by the stock's reactions to earnings a few times and could see 4Q numbers causing additional selling pressures even though I am already expecting a weak 4Q. I'd been planning on adding a bit of detail, but since the stock's been running on me I wanted to get this up. I will do my best to answer questions quickly and thorougly.

Nasdaq: FES is an underappreciated microcap that benefits from secular tailwinds that has had cyclical pressures combined with high leverage cause its stock price to drop 63% YTD. It is trading like it has a high probability of going bankrupt which I do not consider likely. I believe the long-term secular trends in the oilfield services space to be a positive for the space and specifically for FES. I also believe that the high leverage in this case creates an attractive risk profile for an equity investor much like a long-dated call option that is already in the money. I think FES could easily trade at multiples of its current stock price as early as a year from now and in my bull case could see a 10-bagger over 3-4 years.

Overview:

Forbes Energy Services is an energy services company with two principal segments, Well Servicing and Fluid Handling. Energy services companies provide services to their customers, Exploration & Production companies or E&P companies, to facilitate the extraction of hydrocarbons. Energy services companies are often levered to the level of activity of E&P companies which tends to be driven by commodity pricing.

Well Servicing: This business is predominantly workover rigs which are used for all parts of the well cycle, but are focused on well maintenance and therefore slightly less beta to general E&P activity/commodity prices and more levered to overall well count. However, this does not hold up perfectly as their customers cash flows are still largely determined by commodity pricing and you still see a substantial correlation to activity levels/commodity prices. This business does have a significant amount of operating leverage, largely driven by the ability to do 24-hour work.

Fluid Handling: This business is comprised of trucks that transport salt water produced by hydraulic fracturing to salt water disposal wells and consequently is levered to drilling activity in particular drilling with high frac intensity which produces more salt water. This business has limited operating leverage, in large part because FES has used subcontractors to meet excess demand.

Coiled Tubing: These are units that can be used for a variety of well servicing activities but recently have been used primarily to complete wells so they are also levered to drilling activity. This business has high operating leverage due to crews effectively being a fixed cost. Note: FES purchased these assets recently and many are still yet to be delivered. They should all be operating by the end of the year.

Secular Trends:

The key to the secular trend here is the shale boom. The horizontal rig count is up 1900% over the last 10 years and over that period horizontal drilling as a % of the total has gone from 7% to 61%. This shift meant growth across the energy services sector. I expect this to continue as there have been many basins found economic in the US with many years of drilling inventory. I believe that the North American E&Ps will shift focus from exploratory mode into development mode allowing for materially more demand to be created as they focus on drilling more wells per year by doing things like pad drilling and improving frac efficiencies alongside the pad drilling.

Fluid Handling: This segment has grown with fraccing as it is effectively a derivative of fraccing. I believe has very significant tailwinds associated with drilling and completing more wells each year which will drive more demand for fluid handling.

Well Servicing: As mentioned above well servicing is levered to the existing well base so secular trends are less quick to take shape, but there are also secular trends here that are tailwinds for FES. Most well servicing rigs were built before the shale boom and are not capable of servicing horizontal shale wells. According to KEG, the largest well servicing company, less than 10% of the industry fleet is high horsepower/capable of servicing horizontal wells. 90% of FES’s fleet is capable of servicing horizontal wells and they have an average fleet age of just 5.5 years. As these wells grow as a percentage of the total well count high horsepower rigs will be in short supply. Another tailwind is that the shift to oil drilling will also increase demand for well servicing as these new oil wells will largely be on artificial lift which requires more maintenance work than the older wells.

Recent Cyclical Trends:

Declining natural gas prices caused by domestic undersupply caused a reduction in E&P cashflow and made a number of natural gas focused plays uneconomic. These two factors caused substantial reductions in demand for energy services in gas focused regions. On the other hand, strong oil prices and attractive economics in liquids basins has caused a dramatic pickup in activity in those basins. This resulted in the change in rig count composition – it is currently 77% oil vs 57% a year ago and 43% two years ago.

Over this period there has also been a change in aggregate rig count which grew dramatically in 2011 peaking just over 2,000 rigs. It is currently at 1,811 down 10% from that level. One of the drivers for the decline in rig count has been efficiency gains. For example, in some plays such as the Eagleford the time to drill a well has dropped from 30 days to 20 days.

Due to this shift towards liquids there was a huge migration of services equipment from gas basins to liquids basins which hurt both pricing and utilization across the board. This was the focus of Q1/Q2 this year. Things continued to deteriorate in late Q3 as many energy services companies have reported that their customers had exhausted their budgets for 2012 ahead of schedule due to increased drilling efficiencies.

I, roughly along with consensus, believe that Q4 will be the trough of this cycle and that customers will pick up spending in 2013 with new capital budgets. Anecdotally, I have heard some fraccing companies note that January is already full booked.

FES-specific Notes

FES’s fluid handling assets are predominantly based in the Eagleford, a play in South Texas that is levered to oil/liquids. Rig count in the Eagleford has held in above 200 rigs this year and I expect activity in that play to “outperform” general North American activity as that play is well understood and has strong economics. This provides FES with better downside protection than operators that operate in other basins. Note: While trucks are mobile between basins, FES benefits from owning many salt water disposal wells in Eagleford providing them a competitive advantage over their peers. These factors have allowed FES to hold utilization/margins better than their peers.

FES’s well servicing assets are predominantly split between the Permian and Eagleford. The Permian is an oil focused play in West Texas and has experienced growth this year. I expect it to continue to be a growth area. FES’s well servicing assets did not perform as well as their fluid handling assets recently, despite strong geographic position. I believe that was primarily due to drop offs in 24 hour work and I don’t expect the declines to continue.

FES-specific Outlook

The above cyclical trends caused FES’s 3Q12 EBITDA to drop to $19.2mm from $26.8mm sequentially. The company experienced declines in utilization in well servicing causing declines in both revenues and margins. Margins were especially hurt because they lost substantial amounts of 24 hour work allowing margins to drop over 800bps sequentially. They also experienced utilization declines in fluid handling which caused declines in revenues and margins, but the impact to margins was limited to under 200bps.

As mentioned above I am expecting 4Q to be the trough and have modeled $16mm in EBITDA based on continued deterioration in utilization and margins slightly offset by newly purchased assets, mainly coiled tubing units, coming online.

Next year I am expecting $85mm in EBITDA. I see Well Servicing margins normalizing to 20% (peaked at 27% dropped to 18%) with utilization ticking up slightly from Q4 levels. In Fluid Handling I also see utilization and margins up slightly from Q4 levels.

I expect interest expense of $28mm and the company has guided to $20mm in capex for next year. I also expect little to no cash taxes and that working capital uses should be limited as I don’t expect revenues to grow substantially. That gets me to $37mm in FCFE or 59% of the market cap.

While I am sure that capex and EBITDA will fluctuate over time based on the points of the cycle I think that the secular trends I discussed above will cause “normalized earnings” to grow considerably over the next 3-5 years. I would not be surprised if this company approaches $150mm in run-rate EBITDA by 2015. (That is based on margin improvement driven by stronger utilization coupled with organic growth capex, for reference they did $30mm of EBITDA in 4Q11 on a smaller asset base and 4Q is a seasonally weak quarter for FES.)

So…what’s it worth?

FES trades at .4x tangible book and I see it generating 57% FCF yield next year. I believe it trades this way in part because of its high leverage. I will explain below why I do not think this is an issue.

 I think the company can continue to earn $85mm of run rate EBITDA and view true maintenance capex as $30mm. Assuming $5mm for cash taxes on a run rate basis that gets me to FCFF of $50mm. Giving that FCFF a 10x multiple I get to a $500mm EV and using today’s capital structure that gets me to $8.65 a share, just shy of a 4-bagger.  Note that this valuation gives them no credit for potential to accrue additional value by buying shares (which I expect them to, will touch on that later).

FES and it’s comps (BAS, KEG, PES) are all trading around 4.0x EV/EBITDA on an LTM basis. I admit on that basis it does not seem particularly cheap. I would however point out that a 4.0x multiple on a business that is not in secular decline does not seem sustainable to me, so unless I am incorrect about the earnings trajectory of this set (lower from current levels, but not drastically lower) that these multiples must expand. I would expect them to expand when the market sees these businesses stabilizing and as the secular trends discussed above start to take hold.

Assuming that my analysis of the secular trends is correct and FES does get to what I view as my bull case in $150mm of EBITDA I would use a 6.0x multiple based on historic trading levels to value that and reach a valuation of $23.60 per share, over a 10 bagger in 3-4 year time frame.

One more valuation data point: HEK buys Powerfuels    

HEK primarily focuses on fluid handling, but has branded itself a environmental services company which allows it to trade at a 7.0x multiple while the rest of the space trades <4.0x. They recently acquired Powerfuels at a 3.5x LTM EBITDA, or so they have touted. Ignoring the fact that the stock price jumped over 30% after the acquisition (the acquisition was made predominantly with stock), Powerfuels had incredibly high LTM margins because its operations were in the Bakken a relatively undeveloped play were E&P companies were spending massively and the services market was undersupplied. I believe the run rate earnings at Powerfuels are materially lower than the LTM EBITDA purchased and that the true multiple of the acquisition is over 6.0x. As an aside, I do consider HEK to be overvalued and have noticed the short thesis posted on VIC recently. I will not delve into much detail here, but investors interested in hedging out some of the cyclical noise in this business could pair long FES/short HEK.

But…it’s going to go bankrupt before it gets good!?

This company trades at fraction of tangible book and the equity represents a tiny portion of the EV. I believe this is caused by equity investors discounting it because of how levered it looks. In my view, leverage helps the equity investor in FES. It allows one to capture substantially all of the upside of a company with an EV over $300mm with only $60mm at stake.  The weak covenants in the bonds along with the company’s liquidity make me think bankruptcy is unlikely.

Capital Structure/Covenant Summary:

FES has 300mm in debt. The bulk of this is a $280mm bond which has a 9% coupon and is due in 2019. The balance is combination of insurance notes and a small amount of equipment financing. FES also has a $75mm revolver which is currently undrawn. There also are 5.3mm common-share equivalent preferred shares that were issued in 09 when the company faced a liquidity issue. The bonds have no financial covenants and a $10mm RP carve-out which I believe to be fully available. Additionally, the revolving credit facility has no financial covenants until it is 80% drawn and it is currently undrawn. This means that if during a substantial downturn in the energy services market the company would not trigger any sort of default provided they could continue to service their debt. (Debt service is roughly $28mm per year). This fact combined with the substantial amount of liquidity the company enjoys makes me believe that a bankruptcy filing before the 2019 maturity is very unlikely. The RP capacity would allow the company to buy back 12% of the current market cap.

Management/Corporate Governance:

Corporate Governance: This area is likely the main reason not to own this stock. There are a substantial number of related party transactions that occur with entities owned by the Crisp and/or Forbes families. The company has made efforts to pull more of these assets into the company, but I don’t believe the related party transactions will stop. However, viewing the related party transactions, none of them seem egregious. (Please see note 9 of the most recent Q for a full breakdown). Additionally, perception of Forbes and Crisp amongst the energy services community is poor. Crisp also was implicated in a lawsuit by his former employer, Key Energy Services. You can read about it here: http://securities.stanford.edu/1031/KEG04-01/2005112_r01c_04082.pdf. The way I get comfortable with this is the Crisp and Forbes families combined own 35% of the equity in FES and they have been net buyers over the past 6 months.  I find it hard to imagine they would put their equity stakes at jeopardy unless the company was in materially more dire straits than it is now. Also, Mel Cooper, the CFO, does not appear to have interests in any of these related parties and has a substantial amount of stock options that vest at $9.16 per share.

Other risks:

-          I am incorrect about either the cyclical trends and this deterioration will continue and FES equity will continue to languish.

-          I am incorrect about the secular trends. Here I would be most concerned, not with the long-term growth, but with the potential for there to be a shift towards larger service companies picking up more of the market share and squeezing competitors like FES.

Catalyst