We’re recommending a land drilling pair trade, long Patterson-UTI (PTEN) short Helmerich & Payne (HP). In the context of collapsing natural gas prices and concern over loosening supply/demand in the pressure pumping business in North America, PTEN stock has tanked on account of the lower quality of its rig fleet and its exposure to pressure pumping. HP has remained unscathed, opening a valuation disparity between the two companies that is unprecedented. While we recognize PTEN’s relative weaknesses, the market overreaction implies that we can buy PTEN’s drilling business at HP’s multiple and get the pressure pumping business (30% of PTEN’s EBITDA) for free. As this disparity becomes more apparent, we expect the valuation gap to close.   

Business overview

PTEN and HP are the #3 and #2 players in the US land drilling market, after market leader Nabors. Out of 2,000 land rigs currently active in the US, PTEN and HP are each operating ~230 active rigs (excludes idle rigs).

There are two key differences between PTEN and HP. As the chart below shows, nearly a third of PTEN’s sales and EBITDA come from pressure pumping, a business in which HP is not involved. Pressure pumping makes sand, proppant, fracking fluid and cement flow down the well, as part of the shale fracturing process. The Big 3 in this business are HAL, SLB and BHI, and there are many independents, given the low barriers to entry to this booming business.

% of 2012E EBITDA

The other key difference between PTEN and HP is the composition of their rig fleet. The shale oil/gas boom and the horizontal drilling process it involves have required more advanced and flexible land rigs, as the drilling process has become more sophisticated. It is fair to say that HP has been at the forefront of this trend, if not pioneering it, by designing and manufacturing hi-spec rigs that are best suited to horizontal and directional drilling. PTEN on the other hand has been more of a late comer: its deployment of hi-spec rigs is more recent, and it buys its rigs from NOV rather than designing/building themselves.

As a consequence of the above, HP’s existing fleet is arguably the most modern and capable in the industry: out of its fleet of 250 available rigs, nearly 230 are high-spec (AC drive, brand new SCR , or SCR with quick move capability). Demand for high-spec rigs is booming yet supply is still catching up, leading HP to hold industry-leading utilization rates above 90% in its US land fleet.

PTEN is rapidly modernizing its fleet, but still carries many legacy rigs that are ill-suited for horizontal drilling. Out of 300 available rigs, we would only consider about 100 “high-spec”. PTEN also owns 30 electric-powered rigs of decent capability, plus 170 mechanically-powered rigs that are at the bottom of the pyramid. PTEN’s fleet utilization rate is currently at around 74%, but this average comprises the top 100 rigs at over 90% utilization rate, while some of the oldest rig designs are below 40% utilization. PTEN has been retiring obsolete rigs or upgrading/retrofitting them when possible.

Note that there’s no standard industry definition of what a “hi-spec” rig is. Our definition comprises AC drive rigs, new SCRs with electronic drilling systems, and fast-moving SCRs. While an 1,500hp AC rig has a market value of $23mm and a conventional new SCR would cost you about $14mm, our “high-spec rigs” are all in high demand and over 90% utilized. Inferior rig types are typically worth under $7mm, and utilization rates drop as rig capabilities decrease. For reference, Goldman’s recent initiation report on the space does a nice job of describing the technicalities of the different rigs and maps out the fleets of both PTEN and HP.

As the hi-spec rig market has tightened, E&P companies have been increasingly willing to commit to 3+ year contract terms with pass-through clauses for most costs incurred (including labor, which accounts for 2/3rds of land drillers’ opex). Lower-capability rigs continue to operate mostly on a spot basis.

Valuation

HP has typically traded at a premium to PTEN over the past 5 years: on an EV/EBITDA basis, HP commanded an average 14% premium relative to PTEN.  Based on consensus numbers, with PTEN at 2.9x and HP at 5.0x CY12 EBITDA, the current 75% premium is at historical highs (see the link below for an EV/EBITDA graph of each stock).

http://tinypic.com/r/2v2vdy9/5

 Our bet is mostly on multiple convergence to historical levels rather than on big earnings surprises. We think this is reasonable considering that consensus has both companies growing EBITDA at a 21% rate in 2012. In our opinion, negative sentiment around PTEN’s pressure pumping business and older drilling rigs is so extreme that the market is ascribing zero or negative value to these profitable businesses.

If we trust consensus estimates to be accurate and we assume that the EV/EBITDA relative HP/PTEN premium returns to 14%, PTEN would have to trade up to 4.4x, implying 61% upside for PTEN and 30% over gross exposure for the trade. Alternatively, HP may converge to 3.3x and drop 37% from current levels, for an overall 18% return on the trade. We believe a 25% average target return is highly attractive for such a market-neutral trade, and we’re not even aiming for the stocks to trade at parity.

So what could go wrong that would justify the current valuation disparity? Admittedly, consensus numbers are not particularly pessimistic for PTEN, as they seem to expect no more than 200bps margin compression in pressure pumping and a stable legacy rig business. We’ve tried to figure out what type of scenarios would justify current valuation. A 14% HP/PTEN premium would imply PTEN trading at 4.4x 2012 EBITDA, which would in turn imply $758mm EBITDA in 2012. How do we get from consensus of $1,164mm EBITDA to $758mm? You really need to get creative here:

• Given that pressure pumping should bring in ~$340mm in segment EBITDA to PTEN, we would have to assume zero segment margins for a business that has reported 30+% margins in the past couple of years. Effectively, we would assign zero value to this business. And we’d still be over $50mm short in getting all the way down to $758mm EBITDA in 2012.
• If you’re more concerned about PTEN’s legacy rigs getting displaced out of the market, we believe these rigs bring no more than $250mm annually in segment EBITDA. Even assuming zero value for these rigs, this again falls way short from justifying PTEN’s current valuation.
• A combination of both scenarios: assuming zero earnings contribution from legacy rigs, pressure pumping margins would need to fall 2,000bps to get us to 4.4x EBITDA.

Of course, the above scenarios are very unlikely, particularly if unaccompanied by a serious impairment to HP’s business as well. All this goes to say that PTEN’s stock price reflects extreme levels of negativity that confer a very wide margin of safety to the trade.

Thesis         

• The boom in demand for pressure pumping services in the US has brought along huge increases in horsepower capacity (capacity has roughly doubled since 2008 and is expected to grow another 30% in 2012). Pricing in some of the dryer shale plays is already flattening, and everyone in the industry is concerned that margins have peaked. Trading multiples for pressure pumping-heavy service firms like HAL, BHI or RES have compressed substantially in anticipation of a cyclical top in the business. PTEN’s pressure pumping business represented 30% of overall earnings in 2011, and the company will grow its capacity 22% in 1H12, so it has shared the pain for being in this business. We don’t expect margins to expand from here nor do we expect a dramatic collapse. But assuming a draconian case of 10% lower pricing and 25% segment margins (down from 35% in 2011), the hit to EBITDA would be $122mm. This worst-case scenario would imply 2012 overall EBITDA just 10% below consensus for PTEN, which is something we’re very comfortable with given the valuation discount relative to HP.
• The market has been concerned by the impact of collapsing natural gas prices on the US rig count, and announcements by players like CHK or CNX curtailing gas drilling activity have confirmed this negative sentiment. PTEN is exposed to dry gas drilling, with over 50 rigs deployed in the Marcellus and Haynesville plays alone, plus other rigs drilling for gas in conventional formations. While PTEN might see utilization levels fall in the short-term, the main offsetting factor to lower gas drilling is the ongoing shift to drilling for oil and liquids. The number of rigs drilling for oil in the US overtook the number drilling for gas in early 2011, and the trend has only continued since then: most recently, 61% of US rigs for drilling for oil, up from 47% one year ago. If gas remains below $3/mmbtu, the gas rig count could probably fall by ~100 rigs from the current 777, but we’re quite confident that increased drilling for oil can fill that gap in 2012 (oil rig count grew by over 400 rigs in 2011).
• There is still plenty of opportunity for high-spec rigs to continue to capture market share: while horizontal and directional drilling already accounts for 70% of US land rig activity, AC drive rigs (the highest-end, of which HP owns 216 and PTEN 40) still only represent a quarter of active rigs. New capacity is being quickly added and replacing mechanical and certain SCR rigs but still manufacturing capacity for AC rigs is 150-200 new rigs/year, which we estimate should keep the AC market tight for at least 3 years. Moreover, PTEN’s fleet growth in this segment is higher relative to current fleet size than HP’s. By adding 30 AC newbuilds in 2012, PTEN will grow its “high-spec” fleet by about 30%, and its AC-drive fleet by 75%. HP on the other hand has capacity to build 4 rigs/month, which would allow it to grow its high-spec fleet by 21%.
• PTEN gets clearly penalized for holding legacy rigs that are hard to market in the current environment. However, this fact has largely played out already: utilization rates for PTEN “non-high spec” rigs are 68%, well below hi-spec around 95%, and this is after retiring 53 legacy rigs in 2H 11. Thus, we estimate that even though hi-spec rigs only account for a third of PTEN’s available fleet, they represent 55-60% of drilling EBIT. As the company adds to its hi-spec fleet (30 deliveries in 2012), hi-spec rigs should account for nearly 70% of drilling EBIT by late 2012.
• HP’s drilling backlog of $3.3bn is higher (about 123% of 2012 drilling revenues) than PTEN’s $1.7bn (about 86% of revenues). If the rig count were to collapse, HP would have a slightly larger revenue cushion than PTEN, however we feel 4 months’ worth of extra revenue hardly justify the massive valuation disparity. In fact, PTEN should progressively close this gap as its newbuild growth rate (mostly contracted on term contract basis) is relatively higher than HP’s.

Risks

• HP might be an interesting acquisition candidate for a larger oil service firm seeking to enter the US land drilling business. While expensive, it would allow for a cleaner integration as the acquirer would not have to bother retiring legacy rigs or dealing with side businesses as might be the case with a PTEN or a NBR. SLB, BHI and HAL have some exposure to international drilling but have thus far not shown an interest in US land drilling.

• We expect PTEN to announce term contracts with E&Ps for several of its 2012 newbuilds when it reports 4Q results on Feb 2^nd. Out of 30 newbuilds to be delivered in 2012, PTEN has only signed commitments for those delivered in 1Q (7-8 rigs). We believe there is some nervousness arising from the company’s comment in the 3Q call that signings had slowed somewhat. PTEN blamed this on E&Ps finalizing their drilling budgets, and we are confident that these hi-spec rigs will have no problem in finding demand.
• 3Q11 also saw some cost pressures arising from increasing labor and maintenance expenses ($1,100/rigday). The company sounded confident that some of this pressure would revert in the 4Q, and if the company delivers on that the stock should react positively. Note that labor costs account for as much as 2/3rds of opex, and most of those costs are contractually passed through to customers when the rig is operated on a term contract basis.