Description

I am recommending a short position in Poseidon Concepts (PSN.TO). It is highly compelling investment opportunity given the abnormally high returns the company is now demonstrating in what should become a competitive space.  

Poseidon Concepts is an oilfield services company that provides fluid-handling services to E&P companies during their onshore drilling campaigns. In particular, they handle the water and fluid that is used during the “frac”ing stage of the process. Given the regulatory and environmental issues controversy that surrounds this practice today, Poseidon provides an integral, high value-add service in the oilfield value chain.

When you dig in more, the story becomes a lot less compelling. In simple laymen’s terms, Poseidon provides what can best be described as an above-ground pool in which the E&P companies store their water and drilling fluid before using it. To be fair, this is a large improvement from the plastic lined-pits that the oil companies evolved from, but still a relatively basic structure. Poseidon does not help handle the fluid and they don’t process the used fluid. They simply show up, erect the tank and charge the oil company for its use.

So in summary, you have a simple solution to a problem that has plagued the oil companies since the advent of the shale revolution. Poseidon deserves credit for uncovering this niche and stepping into it. The question now becomes – how much credit do they deserve, and more specifically what should they earn for providing this service?

Before we study Poseidon’s economic model, let’s take a step back and look at the oilfield services sector in a broader light. For the purposes of this analysis, let’s focus solely on the onshore sector. There are four major subsectors of the onshore oil and gas services business:

1. The Big 4 Oilfield Service Giants – HAL, SLB, BHI and WFT. These companies focus on the highest value-add, technical aspect of developing an oilfield.
2. The drilling companies - Helmerich & Payne, Nabors etc. These companies provide the actual drilling rigs that are used.
3. The small-cap services / pressure-pumpers – Calfrac, C&J Energy Services, Canyon etc. These companies provide the pressure pumping fleets that allow E&P companies to frac their wells
4. The cap-equipment manufacturers – National Oilwell Varco, Cameron etc. These companies manufacture a lot of the equipment used by the above and are not relevant for the purposes of this analysis.

All of these sub-sectors provide various services to the oil company as they develop an oilfield and are paid a return for those services. In the case of the drilling companies and the pressure pumpers, that return is basically a rental fee for the use of the equipment and the provision of people to operate the equipment. In other words, they operate a similar business model to Poseidon but they also employ and provide highly-trained people to the oil company.

 And yet of all of these business models, Poseidon earns the highest rate of return on its assets (as measured by operating income over adjusted long-term asset base, which should be proxy for capital equipment). And the difference isn’t tiny. Below is a summary of the various ROA’s for the industries discussed above.

• Big OFS (HAL, SLB, BHI, WFT): 34%
• Pressure Pumpers (Calfrac, Canyon, Trican, CJES): 62%
• Land Drillers (Helmerich & Payne, Patterson UTI): 18%
• Equipment Rental Companies (United Rentals and RSC Holding): 13%
• Energy Tranport/Logistics (Bristow and Tidewater): 7%
• Poseidon: 180%

Against this comp set, Poseidon’s returns are phenomenal but the question is how sustainable?

• The Big 4 OFS businesses should, and do, earn the highest return on assets through the cycle. They have largest collection of proprietary technology in the sector and have chosen to focus on relatively asset-lite parts of the industry
• The land drillers are providing big, complex equipment, but a 20% return is at or near their cyclical peak.
• The pressure pumpers stand out as their current returns are high for a relatively commoditized product, but in the current environment it makes sense. The manufacturing plant that provides the pressuring pumping equipment is maxed out at the moment, so the service providers can charge a scarcity premium until that capacity catches up with demand (which it always does). Back in the 2009 when this happened, margins and returns fell precipitously
• I think it is interesting to look at both the equipment rental business (United Rentals leases industrial equipment) and the energy transportation business (helicopters and boats which provide logistic support to oil companies offshore) because they are analogous to Poseidon and both these sectors earned fairly low returns on assets in a decent energy cycle

Poseidon’s current returns are somewhat understandable. They are providing a new product in an industry that needs a solution and they are taking advantage of that need. But a water tank isn’t exactly ground-breaking technology; it is just being applied in a different capacity. Once other companies start to figure out how fantastic Poseidon’s economics are, they should start to offer competing products that will force Poseidon to drop its’ price. Before today there had been no public declaration of competition. As of this afternoon, however, the Mullen Group announced that they were entering the water / frac fluid “containment” business and expected to be up and running by the 3^rd quarter.

http://mullen-group.mediaroom.com/index.php?s=5558&item=127400

Once the industry normalizes, I would expect to see returns at or around the level of a basic equipment rental business (10ish%).

From a valuation perspective, the Company trades at a trailing ~18x EBITDA multiple but only 7x forward. While 7x forward doesn’t seem too rich for a growth business, it does look very rich a) compared to the comp space (the big 4 OFS businesses currently trade at 5.8x) and b) the fact that their EBITDA margins will likely come under assault as competition comes in.

In terms of price target, using a DCF, I think Poseidon is worth under $5 a share using a fairly conservative forecast. The high level assumptions are as follows:

• Poseidon is able to continue to penetrate the rig market at a 20% CAGR over five years
• Rental pricing falls 30% per year starting in 2013 to reflect competition
• 2016 ROA is 10% (meaning the company “outearns” its’ comp group for 4 more years)

In terms of risk, there a couple to think about:

• The company currently pays 7.5% dividend which may support the stock price near-term
• The company could develop a more technical product that would strengthen its’ competitive moat

Catalyst