Description

Helmerich & Payne (HP), a small-cap land driller in the oil & gas industry, recently completed the spin-off and merger of its exploration division as of October 1st. Originally highlighted by investor Michael Price in the Spring 2002 VIC interview, HP is now a pure-play driller -- with additional value, including an investment portfolio of publicly-traded stocks (about $2.50 per HP share, after-tax) and profitable Tulsa real estate operations (1,650 square feet). Despite superior equipment and operating characteristics, HP currently trades at a significant discount to its closest comparables based on after-tax cash flow, thus providing a cheap and defensive way to play the eventual recovery in the drilling cycle.

Industry Snapshot
The upturn in the drilling cycle has continued to be delayed, with rig counts holding steady this year despite higher oil & gas prices. The current U.S. rig count hovers at 830, compared to about 850 at the beginning of the year and roughly 1,000 one year ago. Utilizations and day-rates on rigs have remained depressed, holding back advancement in cash margins and earnings for the drillers. While typically E&P companies increase drilling after seeing higher commodity prices, they have been reluctant to follow through this time in the cycle due to more conservative postures which have largely disregarded near-term trends. Many customers have indicated they are focused on finalizing operating budgets toward year-end before committing to new rigs in the new year. Once drilling and rig counts pick up, the drillers should enjoy significant operating leverage, with higher utilization of their fleets along with higher day-rates, margins, and earnings.

Company overview
HP has clearly superior operating characteristics vs. competitors, with higher utilization rates and margins throughout the cycle. Currently, HP is able to run their conventional domestic land fleet at roughly 70% utilization, compared to below 50% for comparables. Daily cash margins for HP’s domestic land operations averaged $3,054 in the last quarter, compared to $2,450, $1,700 and $2,225 at other major domestic land drillers, Nabors Industries (NBR), Patterson-UTI Energy (PTEN) and Grey Wolf (GW), respectively.

While competitors have focused on consolidation for growth, HP has invested in new technology. HP’s newest rigs (FlexRig 3) are in high demand and are being put to work at almost 100% utilization, at a pace of 2 per month through the middle of next year. With the new rigs, the total fleet should reach about 130 rigs in 2003 from the current 113. While superior current utilization presumably means less leverage to the U.S. land drilling cycle for HP vs. comparables, HP will benefit from increased fleet size, significant increases in day-rates on their premium rigs and further upside through their international land rigs and offshore platforms, which are running at lower utilization rates than the domestic land rigs. Also, given the current industry environment, HP provides investors a more defensive way to play the eventual up-cycle.

Rig fleet (4Q/FY02) Rigs Utilization
U.S. land, conventional 29 72%
U.S. land, mobile & FlexRig 39 95%
Offshore platform 12 65%
International land 33 40%
Total 113 70%

Most of the international exposure is in South America, where HP has recently announced increased activity in Venezuela with 2 new rigs just contracted and 2 more likely before year-end. It is also worth noting that HP focuses on deeper drilling with almost half of its U.S. land fleet reaching over 30,000 feet. HP’s customers tend to be the major integrated oil companies and large independents.

Management Overview
W. H. Helmerich, III Chairman
Hans Helmerich President & CEO
Douglas Fears CFO
George S. Dotson President & COO, H&P International Drilling

Insider ownership (based on proxy)
W. H. Helmerich, III 1,991,485 4.0%
Hans Helmerich 617,311 1.2%
George S. Dotson 358,306 0.7%
Douglas E. Fears 109,659 0.2%
All Directors and Officers 3,403,483 6.7%

Financials
Management guidance
In September, before presenting at the Lehman Energy conference, HP provided updated guidance for fiscal 2003 (September), based on flat domestic land utilization levels and 10% higher average day-rates – which was then reiterated after their recent 4Q/FY02 earnings announcement.

FY2003
EPS $0.90-$1.00
EBITDA/share $3.20-$3.35

If utilization and day-rates are flat throughout FY2003, management expects EPS closer to $0.60, including EPS of only $0.07 for 1Q/FY03 due to the current soft operating environment. For comparison, analysts following HP show an EPS range of $0.65-$0.85 for FY2003. Using estimated D&A of $75 million for 2003, implies after-tax cash flow per share guidance for FY2003 of $2.40-$2.50, compared to the sell-side range of $2.10-$2.40. Calendarizing the FY2003 consensus estimates to December 2003, implies EPS and after-tax cash flow per share 40-50% higher due to the expected up-cycle effect on earnings later in calendar 2003.

Financial Leverage
HP has maintained a conservative balance sheet. With about $75 million of net debt, HP is funding their new generation technology capex program by increasing leverage. Of course, HP also owns an investment portfolio worth about $125 million after-tax currently. The portfolio has been partially liquidated opportunistically in recent quarters.

Valuation
The other major domestic land drillers, Nabors (NBR), Patterson-UTI (PTEN) and Grey Wolf (GW), are shown below for comparison with multiples on consensus earnings and after-tax cash flow. The other significant land driller, Unit Corporation (UNT), also has E&P operations and has been excluded for valuation purposes. Due to the cycle timing, adjusting HP’s fiscal year of September to a calendar year-end comparable to other drillers has a significant effect on relative valuation parameters. Adjusting for HP’s investment portfolio provides about $2.50 in value (after-tax) at current market prices, while no adjustment has been made for the profitable real estate holdings. HP currently trades at roughly the same stock price as at completion of the spin-off ($26) less than 2 months ago.

P/E P/E P/CF P/CF
Trading Multiples 2003 2004 2003 2004 Mkt.Cap
GW NM 12.7x 10.6x 5.9x $0.7b
NBR 27.2 15.8 12.5 9.4 $5.4b
PTEN 39.7 18.0 14.0 9.8 $2.2b
Average NM 15.5 12.4 8.4
Average (NBR & PTEN) 33.4 16.9 13.3 9.6
HP (fiscal year) 34.8 18.5 11.5 7.4 $1.3b
HP (calendar year) 23.4 18.5 9.7 7.4
HP (cal/investments) 21.3 16.8 8.8 6.7

While it can certainly be argued that HP deserves a discounted valuation multiple on short-term financial projections due to lower operating leverage (from higher current domestic utilization rates) and more international exposure, it could also argued that HP deserves a valuation premium due to its defensive nature and superior operating profile (consistently higher utilization, day-rates and margins based on premium equipment) combined with an increasing fleet size. HP also has a dividend yield (over 1%), compared to none for its closest comparables. Furthermore, with 2003 or 2004 likely to be a peak year after the 2002 trough, HP deserves a relative premium multiple on peak earnings due to the greater consistency of its cash flow through the cycle. While 2004 multiples are provided above, it should be noted that 2004 consensus estimates are based on a very limited sample since many analysts are waiting for visibility on 2003 before initiating 2004 estimates. In terms of sell-side coverage, CSFB follows HP, but the company is followed most closely by analysts at energy boutiques, including Howard Weil, Sanders Morris, Petrie Parkman, and Stifel Nicolaus.

Key Risks
*Continued delay in drilling cycle recovery
*Persistent relative valuation discount due to comparables’ higher perceived operating leverage and superior stock liquidity
*Exposure to South America

Catalyst

Catalysts
*Increased investor focus and valuation based on new pure-play status after completion of spin-off
*Upturn in drilling cycle
*Liquidation of stock portfolio (and potential monetization of real estate)