Description
PHI (formerly called Petroleum Helicopters) is a long investment idea that will profit from the growth story of increasing and sustained deepwater drilling in the Gulf of Mexico, where it has a 90% market share and long-term relationships with virtually all major integrated oil companies. Due to the growth expected, the stock currently trades around 3.7x estimated 2007 EBITDA, a considerable discount to its peers (Bristow Group, Seacor, CHC Helicopter, and Air Methods) at 7.3x, using current prices and UBS estimates from November 2006. More importantly, PHI is trading at a discount to our calculation of “intrinsic value” at $51 as derived from a DCF (drivers/assumptions are noted below).
Outstanding shares (dual-class): 15.3m
Equity value: $507m
Enterprise value: $546m
2007E EBITDA: $146m (our estimate; IBES at $120m)
2008E EBITDA: $169m (our estimate)
Overview
PHI Inc provides helicopter transportation services in four different segments. The two primary segments are Domestic Oil and Gas (60% of revenues, 81% of EBITDA), serving exploration companies in the Gulf of Mexico, and Air Medical (31% of revenues, 10% of EBITDA), which provides medical transportation services via helicopter. PHI also has a small International business segment and provides helicopter repair and maintenance services to customers.
As of November 9, 2006, PHI operated 235 aircraft, 150 of which are dedicated to the oil and gas operations, and 67 of which are dedicated to the air medical operations. The remaining aircraft are used in its International business segment.
In September 2001, Al Gonsoulin, the Chairman of the Board and Chief Executive Officer, acquired approximately 52% of the voting common stock from the founder’s family. It is important to note that Gonsoulin is a “money maker” as demonstrated by past investments in energy-related services, including Sea Mar and McDermott International. Since September 2001, the company has made significant operational enhancements in their business, including substantial investments in facilities, the refurbishment of the fleet, the implementation of a significant cost reduction program, computer systems and software upgrades, and the raising of $115M in the June 2005 and $158M in April 2006 equity offerings to partially finance a significant expansion of the fleet.
Although this plan has resulted in depressed levels of free cash flow due to the significant amount of capital expenditures needed for both growth and restructuring, I believe the operational leverage now in place will lead to significant free cash flow generation over the next several years. PHI’s current investment initiative in newer and larger helicopters will allow PHI to continue the price increases and mix shift toward the higher margin deepwater business.
I’ll discuss the two main businesses in some detail and then show from a valuation perspective the potential upside and downside of the stock.
Domestic oil and gas
The business is set to grow based on the investment in new aircraft which can capitalize on high market share in a growing market. The deepwater in the Gulf of Mexico is a region that will see oilfield activity for the foreseeable future because of the recent oil discoveries there and the considerable time and resources required to extract the oil. Helicopter services are a late-cycle phenomenon in that they benefit from the already discovered oil in the region. By having a near-monopoly on the deepwater transportation segment, PHI will be able to service the additional demand without dropping utilization levels by adding capacity gradually over the next 5 quarters.
Demand outlook:
Customers include major integrated oil companies and independent exploration and production companies. The company believes they are the sole outsourced provider of helicopter transportation services to three of the five largest producers of oil and gas in the Gulf of Mexico, including Shell and BP, who rank #1 and #2 in GoM 2005 production.
Since PHI began targeting the Gulf of Mexico in 2003 because of the increasing demand for helicopter services and deep relationships with many of the primary producers there, the number of fixed and floating production facilities installed has increased significantly. This has led to a substantial increase in the demand for long distance transportation of personnel and cargo (tools, equipment) by helicopter. Currently 31 deepwater production platforms are in service or under development, and an additional 13 platforms and facilities have been identified for development between 2006 and 2011 in the Gulf of Mexico. This will create increased demand for transportation services in the region.
Total flight hours increased for the nine months ending September 30, 2006 compared with that time period of 2005 from 80,292 to 83,921 (up 4.5%) in spite of a Q3 pilot strike which had an estimated impact of about 3,500 lost flight hours. The strike-adjusted total flight hour demand increased by 6.0% for the first 3 quarters, and by 13% in Q3 on a YoY basis, highlighting the accelerating trend.
Competitive analysis:
Although there are two main competitors (Seacor and Bristow) as well as a number of smaller players, most competitors have carved out their own smaller niches in servicing the oil companies in the Gulf of Mexico. Smaller competitors primarily service the shallow water (shelf) or have built and maintain relationships with a limited number of oil companies. There are two primary reasons why the commoditization that has occurred in the light aircraft business serving the shelf will not occur with PHI’s deepwater business: lockup on new heavy aircraft and great safety track record.
With what the company believes is 90% of deepwater market share, the company’s lockup on new build heavy aircraft through 2008 positions PHI to at least defend, if not gain, market share in the growing deepwater segment, and keeps other competitors from entering the market and competing on price. The key to being able to serve the deepwater, which lies 200 miles from the shore, is having the 19-passenger Sikorsky S-92 aircrafts. Currently PHI has claim to all of these aircrafts in Sikorsky’s pipeline, and there is a 24-month lead time required from order to delivery. Competitive risks from other types of transportation are minimal since helicopter is the only practical way to transport personnel and selected equipment to the deepwater platforms and rigs.
The other reason PHI will be able to maintain share is the vital importance of an exceptional track record in safety. PHI’s record over a 10-year period through 2004 was 1.12 accidents per 100,000 flight hours, well below the 2.16 accident rate of competitors, according to the National Transportation Safety Board. Newcomers cannot demonstrate such a track record, and PHI’s long-standing relationships with the integrated oil companies serves as validation of its quality operations and a significant barrier to entry.
PHI’s relationships with its customers are contractual in nature and have a long-standing foundation . For example, in 2005 PHI secured a 7-year contract with the #2 GoM oil producer, BP. The lengths of PHI’s relationships are detailed in the table below:
|
|
GOM Ranking by Production |
GOM Floating Rigs Under Contract |
Length of Relationship (Yrs) |
PHI Status |
|
Shell |
1 |
3 |
46 |
Sole Provider |
|
BP |
2 |
5 |
27 |
Sole Provider |
|
Exxon Mobil |
4 |
0 |
23 |
Sole Provider |
|
Kerr-McGee |
6 |
5 |
33 |
Sole Provider |
|
El Paso |
8 |
0 |
30 |
Sole Provider |
|
Dominion |
12 |
0 |
30 |
Sole Provider |
|
Noble |
14 |
1 |
30 |
Sole Provider |
|
Nexen |
17 |
0 |
31 |
Sole Provider |
|
Eni |
19 |
2 |
23 |
Sole Provider |
|
Conoco Phillips |
22 |
0 |
30 |
Sole Provider |
|
BHP |
27 |
3 |
<1 |
Sole Provider |
|
|
|
|
|
|
|
*Based on 2004 Production |
|
|
|
|
|
|
|
|
|
|
Source: PHI, ODS-Petrodata, Herman Weil |
|
|
Pricing:
Increasing demand and strong market presence in the deepwater have enabled PHI to raise prices, and of the 24.9%, or $38.7M increase in operating revenues YTD in 2006 which management mainly attributes to increase in the deepwater segment, only 5% is due to flight hours. The remaining 20% increase is due to a higher average price per flight hour (from $1,935 in 2005 to $2,319 in 2006), which is a combination of different routes and higher comparable prices.
Margins:
The investment in medium and heavy aircraft will begin to pay off over the next few quarters as these new aircraft become operational and the older light aircraft are retired and sold. The 16% operating margin per flight hour in Q3 was slightly depressed from its Q1 and Q2 average of 20% due to the strike, and as the business continues to move toward the higher margin heavier aircraft flights from the commoditized light aircraft flights, PHI could see operating margins per flight hour of 30%. Such margins assume another 20% increase in prices, owing to the newer fleet and continued pricing power due to the high demand for deepwater transportation.
The positive underlying fundamentals discussed above have a synergistic effect to yield sustainable revenue and earnings growth. I expect the trends to continue in Q4 (barring the effects of the end of the strike), and the segment’s 25% growth in revenues for the first three quarters of 06 should be surpassed in 07 as additional helicopters already purchased become ready for use and the deepwater exploration trends continue.
Air Medical Business
The Air Medical business provides a good amount of diversification from the oilfield services business, as well as upside as past investments are beginning to pay off. Due to the investment in new facilities in late 2005 which take 4-6 quarters to ramp up to run-rate operational metrics, and the short-term revenue lost from the Q3 pilot strike, the payoff has been delayed. Now, however, with the strike having subsided and facilities increasing utilization, PHI should begin to see the fruits of the investment.
While the Air Medical business represents 31% of revenues and PHI has incurred negative operating income for the first three quarters of 2006, margins have been depressed purely in the short-term. Operating margins have gone from -8.9% in Q1 to 3.1% in Q2 and were 4.0% in Q3 in spite of the strike. When all facilities are at run-rate utilization, margins should surpass 10%, contributing roughly 15% of PHI’s operating income. For comparative purposes, market leader Air Methods will reach estimated 9.0% margins for 2006. Air Methods margins should be slightly lower than those obtainable by Air Medical, however, because it has a higher mix of lower margin “hospital-based model” business. The rest of Air Methods business primarily is comparable to Air Medical’s “community-based model” type business, where revenues are on a variable, per transport basis.
Drivers of Intrinsic Value Calculation
The DCF sums the contributions from each of the business segments and separately calculates the contribution from new aircraft starting in 2007. All four business segments and the investment in new aircraft each have positive net present values. In the Domestic Oil and Gas segment, the analysis uses conservative near-term price per flight hour projections of less than 10% given the growth in 06 was 20%. Demand growth projections are 5% next year and trend down to 0% in the out years as PHI cannot increase utilization. The Air Medical segment analysis assumes operating margins get to 10% by the end of 2007, and revenue growth continues to slow from the actual 45% growth in 2005 and 19% in 2006 to 10% by 2010.
The investment in new aircraft contributes significantly to the valuation, where I have taken the new aircraft being added each quarter through the end of 07 and assigned revenue estimates obtained from management. I assume the aircraft will be fully operational the quarter after they are up and running, which can be a few months after they have been purchased. Finally I assume their EBITDA margins are the same as that of the current DO&G business.
Capex continues to be a heavy cost to the business, so I have assumed a maintenance capex cost per aircraft based on historical financials of ~$0.2m. This is in addition to the $195m being used to purchase new aircraft through 2007, $81m of which has already been spent in the first three quarters of 2006. For the new aircraft, which are heavier, I have assumed maintenance capex to be $0.3m. All capex costs are assumed to increase yearly at a slightly greater pace than inflation, at 4%.
I have scaled working capital with revenues, assumed a 38% tax rate in line with the historical average, and set future growth in all business lines to be slightly lower than GDP at 2%. Given the company’s capital structure and an assumed 13% cost of equity, the WACC = 11%. If one assumes a WACC of 10%, the DCF share value is $58.
Risks
As with any investment, PHI is not without risks. In fact, some shorts are apparently extremely bearish to incur a significant number of days to cover (over 15 days based on the 4% of PHIIK’s float currently short and volume of ~28k shares per day when calibrated over three-month average). The bullish arguments described above coupled with additional research I’ve done fortifies the conviction level that a short squeeze could be among the catalysts to drive the stock more quickly to our perception of “intrinsic value”. The main risks to our thesis and presumably among the arguments for the short interest are as follows:
Decrease in energy prices:
Lower energy prices (in the $40 range) would decrease deepwater drilling, leading to a situation in which there is an oversupply of helicopters servicing deepwater sites. Nonetheless, the outlook for oil prices continues to be favorable, and the nature of an investment in the deepwater platforms by an oil company is such that it cannot easily walk away. Establishing a deepwater platform is a multi-year investment due to the difficulty in finding and extracting oil.
Air Medical segment underperforms:
While the company provides minimal disclosure, the Air Medical segment has significant risk related to bad debt. Since PHI executes the community based model, it is responsible for collecting payment. There are three potential sources of payment: insurance, Medicare/Medicaid and the patient. Community-based operators face significant earnings volatility due to bad debt risk, and exposure to weather.
Additionally, a decision to expand the Air Medical segment while taking on a short-term loss could depress PHI’s valuation over the medium-term. However, PHI does not have plans to expand the fleet in the near-term. In fact, during its latest fleet expansion it redirected two of the aircraft originally assigned to the Air Medical segment to the Domestic Oil and Gas segment.
CEO Al Gonsoulin holds 52% of voting shares:
Gonsoulin’s voting power allows him to make decisions in the best interest of himself and not the company, but a removal of the dual-class structure would be a meaningful catalyst to the stock. We believe there is a high likelihood that the dual-class structure is removed.
Regarding Gonsoulin, it is important to note that he has meaningful economic alignment (despite the higher voting interest relative to his economic interest) at ~20% and has proven his ability to drive value in the energy service sector in the past with Sea Mar and McDermott. It is also notable that Gonsoulin bought ~$600k of stock at $31 in May and $3.5m during a secondary in April at $35. In an environment of record insider selling among management and Directors, the insider purchase is meaningful in reinforcing the most aligned shareholder’s interest.
Other risks:
Additionally if another strike were to occur, or if PHI’s safety track record were to deteriorate, there could be meaningful revenue losses. The current outlook is that these two possibilities are unlikely, however, given that PHI recently re-negotiated with pilots and PHI’s safety record thus far gives little reason for concern.
Valuation
The stock currently trades at a significant discount to intrinsic value and the peer group because the impact of continued growth in the deepwater business as well as higher earnings contributions from the Air Medical segment is not being taken into account. If PHI were to trade at the peer group multiple, the stock would appreciate by almost 100%.
It is also quite notable that there has been significant private equity interest in the space. In April 2006 two buyout firms made a bid for CHC Helicopter. The rejected $1.1B offer was 5.6x the estimated next twelve month EBITDA. Another example is Rotorcraft Leasing, which serves the shallow water Gulf of Mexico, and which was taken private by HIG Capital in 2005.
Another metric by which the stock looks cheap is its value at just 1.2x Tangible Book. This is cheap relative to the peer group as well, which averages 2.2x, with the high being Air Methods, trading at 3.4x, and the low being Bristow Group (which is in a highly controversial situation), at 1.5x. Although air transportation services is a capital intensive business, and the fact that helicopters are a depreciating asset, the useful life of helicopters is up to 15 years despite their being fully depreciated in less than 10 years. The fact that there is no economic substitute for transport to the deepwater rigs coupled with the lead time and lockup on Sikorsky heavy aircraft gives us additional comfort that the TBV is understated. Nevertheless, based on stated TBV of $27, PHI’s “downside” is $27.
Catalyst
Catalysts
Intrinsic value is its own catalyst
Q4 Earnings:
Sell-side estimates are currently low because they conservatively assume PHI does not staff back up until the new year. Assuming PHI has been able to staff up by the end of November, UBS estimates there is $0.14 upside to their current $0.16 earnings estimates.
Dual-class stock removal
Air Medical margin improvement:
If Air Medical can demonstrate ability to obtain historical margins of 10% or more, investors can be assured the negative contribution to operating income through the first three quarters of 06 was purely a short-term phenomenon.
Absent improvement in the stock price, we believe that Gonsoulin’s confidence in the ROIC of recent investments coupled with stability and growth prospects will lead to a going-private with a financial sponsor (as noted, private equity is already involved in the industry and continues to evidence interest at EBITDA multiples 50% more than PHIIK’s current 3.7x).