Description

Enterprise Value on 9/30/05 balance sheet:
133 MM shares, diluted @ 14.25:
Market Cap:____1,895
Debt:____________440
Cash:____________104
EV:____________2,231
TTM EBITDA_______247___9.0x present EV/EBITDA
2006 EBITDA______367___6.1x present EV/forward EBITDA

1 year returns on a present investment may range from 44-60%.

Key Energy (KEGS) is the world’s largest rig based oil and natural gas well servicing company. It provides well servicing, fluid trucking, pressure pumping, and fishing and rental tools. KEGS has not filed its 2003 10-K or subsequent reports. The issues are historical, relating principally to a writedown of fixed assets, and do not affect current or future operations. The writedown will range from $165MM to 195MM, and will most likely come in towards the lower end of the range according to the company. Additional mainly non cash adjustments will be related to options expense (5-7MM), possible state & local taxes, reduction of environmental liabilities reserve, and increase of plugging and abandonment and auto liabilities. Cash is only significantly involved in the state and local tax item. 5MM was assessed in June of 2004 to be reallocated to earlier periods. The process has been drawn out as KEGS uncovered a severe lack of documentation due to the decentralized roll up operation it had been in the 90’s and early in this decade. Thus it kept finding further work necessary to put the appropriate audit trails and ongoing controls in place. As a result of the inability to file financials, KEGS was delisted from the NYSE in April of 2005, and now trades on the pink sheets.

With this baggage, what is the investment thesis? KEGS trades at a discount to oil services peers (presumably due to the restatement delays) and is achieving pricing power and organic growth in a much stronger operating environment due to the escalation of oil and gas prices to higher sustainable levels. This points to excellent operating results in 2006. The combination of completion of the restatement (likely in H1 06 I believe), and 33% YOY EBITDA growth in 2006 should both close the discount and further advance the stock for a very attractive combined 1 year return for present investors. The margin of safety lies with the present discount.

While full financials have not been available for two years, quarterly and even monthly operating, EBITDA, and balance sheet data are filed on form 8-K, for an EBITDA based analysis and valuation.

Negatives:
1) Not a free cash flow story; capital intensive, but funded out of operating flow.
2) Competitors adding rigs; KEGS expects net additions small as fleet is >20 years old.
3) Customers depend on commodity oil and gas price; high prices have raised activity of limited rig supply; some customers are seeking one and even a few two year contracts, suggesting their confidence in future commodity price levels.

Discount to market analysis:

A basket of oil services peers has an average TTM EV/EBITDA of 11.5x. The TTM EV/EBITDA for KEGS is 9.0, for a 22% discount to the peer group. The peer group is public oil services companies with market caps of 1.0B to 2.1B. It excludes seismic services and tube suppliers to look at direct well related services.

Within its specific well servicing business, KEGS has the #1 share of operating well servicing rigs at 32% (844/2659). Nabors Industries’ (NBR) well servicing segment is #2 with a 19% share. NBR is heavily involved in drilling as well, and is priced at an 11.5x TTM EV/EBITDA multiple. #3 Basic Energy Services is about to issue an IPO. Based on an annualized EBITDA from the 9 months of 2005 reported in its registration filing, the mid price for the equity issue will represent a 7.9x EV/EBITDA on a fully diluted basis. It should be noted that after the IPO, DLJ Merchant banking will own stock and warrants representing 51% of the outstanding share base (giving effect for warrant exercise). In addition, Basic emphasizes its decentralized operation, the situation that KEGS is working to correct! I believe this too is a discounted pricing.

KEGS is expanding its pressure pumping business by 37% of capacity for 2006. It presently is # 5 in this segment in the US. BJ Services (BJS) derives 89% of its segment income from pressure pumping (69% from the US and Mexico). BJS has a $12.2B EV, so is much larger, but is priced at a 15.6x TTM EV/EBITDA multiple.

Had KEGS had the 37% increased pressure pumping capacity in the TTM, I estimate EBITDA would be $19MM higher, or $266MM on 50MM greater revenue. If we lump the fishing and rental tool gross profits into the well services gross profits, we have (on an adjusted basis) an 82% well servicing business and 18% pressure pumping business. Averaging the NBR and BAS multiples, but giving 2/3 weight to NBR because of the BAS control issues, gives us a 10.3 multiple for the well service business; discounting the BJ Services multiple by 20% for size gives us a 12.5 multiple on the pressure pumping business. On a weighted basis, an arguably appropriate multiple for KEGS is 10.7x. This approach implies a 15% discount at present.

So KEGS appears discounted 15-22%, or could appreciate 18-28% on closing the discount.

2006 operating results:

KEGS is dependent on the capital expenditures of its oil and gas production customers which determines demand for KEGS’ services. In turn, those capital budgets depend on the perceived ongoing commodity prices for oil and gas themselves. I don’t pretend to know where these prices will be a year from now, but undoubtedly they will remain significantly above levels of just two years ago. KEGS’ customers clearly believe prices will remain above $40 for oil and $5 for gas and are operating accordingly. This has produced a sharp increase in demand giving the industry the ability to implement price increases during 2005. Demand pressures continue to increase and KEGS will implement further price hikes in Q1 06.

Specifically, a 10% price increase is slated for pressure pumping. Coupled with the 37% capacity increase, revenues and segment gross profits here will increase 62% and 68%. In the well services segment, rig rates will increase in the upper single to low double digits. This represents about half of the well services segment. Fluid services are more competitive, so for modeling I implemented a 4% across the board revenue hike. In addition, KEGS has ordered 30 new well service rigs with options for a larger order. Deliveries commence in Q4 ’05. KEGS will also remanufacture 60 existing rigs. Given the age of the fleet, KEGS is targeting net additions to its marketable rig base of 20-30. For modeling, I feed these in at 5 per quarter during 2006.

KEGS’ situation mirrors the industry. There are new rigs coming on for the first time in years. This raises the question of whether an oversupply situation will be created. KEGS’ view is that NET additions will not exceed increased demand. The industry fleet is easily 20-25 years old, and some rigs are probably ready to be scrapped. Further, KEGS customer demand has virtually eliminated the ability to maintain ‘swing rigs’ to substitute immediately in the event of a breakdown. Finally, wait times for rigs have lengthened and KEGS itself cannot take on new customers due to lack of rigs. The newer rigs will feed into this expanded market over time, and thus should not impair pricing. With some customers considering one year contracts, and even a few two year contracts to secure rig services, demand and customer concern over having needs met, is clearly high. Long term contracts have not been an historical feature of this industry.

Below is the model output for 2006 compared to recent history:

Valuation:
Year_____________2003_____2004_______2005est________2006est
Price/Share_____$12.28___$12.65______$14.35_________$14.35
EV_______________2,087____2,150_______2,245__________2,245
EBITDA_____________166______163_________275____________367
EV/EBITDA________12.6x____13.2x________8.2x___________6.1x
EBITDA margin____19.2%____16.6%_______23.4%__________26.6%
Revenue____________865______986_______1,184__________1,377
Cap Ex______________85_______81_________143____________185
PTFCF*/dil share_$0.23____$0.29_______$0.60__________$1.08
Price/PTFCF*_____52.7x____43.8x_______23.8x__________13.3x
*PTFCF is pre-tax free cash flow

This is not a free cash flow industry, yet given the potential for cash taxes to remain minimal in 2006, KEGS may well generate a reasonable, if not overwhelming, amount of free cash even given substantially higher cap ex. Analysis of reported cash balances and operating results show a high correlation between cash changes on the balance sheet and cash generated from operations after filtering out debt repayments and working capital changes. This implies low cash taxes at present, and with the writedowns and a pre-existing NOL, I would expect cash tax payments to be low in the year ahead. However for forward valuation purposes, I’ve conservatively left in full cash taxes based on a 35% provision.

So, what’s the upside?

Forward Valuation from $14.25:
2006 EBITDA___________________367_______367
EV/EBITDA multiple___________8.2x______9.0x___low in upper cycle
EV__________________________3,009_____3,303
Less net debt end of 2006**__-279______-279_assumes 83MM cash tax
End of 2006 market cap______2,730_____3,024
End of 2006 price__________$20.53____$22.74
1 year appreciation___________44%_______60%
* *based on 11/05 balances of 415 debt, 75 cash, and 2006 free cash generation of 61MM giving effect to 100% cash tax versus the provision

Catalyst

1) Restatement completion in H1 ’06
2) Record results for 2006