Description

While an earlier write-up on VIC focused on the merits of SPN from a high level, we believe there are several aspects to this story that are critical and which we highlight below, particularly with the SPN/CPX deal set to close in a month:

Synopsis

Superior Energy (“The Company” or “Superior”) provides specialized services and equipment to serve the full drilling-related and production needs of oil and gas companies.  In our estimation, investors have a chance to buy Superior today with an asymmetric risk reward.  David Dunlap joined Superior as CEO in April of 2010, replacing a CEO who ran the company for over 20 years.  Since his joining, he has worked to transform the company from a sleepy business most widely known for its de-commissioning work in the Gulf into a diversified global growth business with multiple high return business lines.  Investors were caught off guard when Superior signed a definitive agreement on October 10th to acquire Complete Production Services (“Complete”) as they had bought into an international expansion story but Dunlap decided to make a bigger bet on land and investors punished Superior with a 14% share price drop.  Post the deal announcement, Superior has been in the hands of arbs, not value investors, and trading at a historically low multiple of 8.4x 2012 EPS, not to mention a discount to much less diversified oil services companies with less balanced growth.  Oilfield service companies have traded at average P/E multiples of 13x+ over the past 10 years and the current discounted multiples imply severe rig count declines of over 20% and future downward earnings revisions.  In fact, in August Superior traded at a forward multiple of over 13x earnings as early evidence of Dunlap’s successful strategy began to emerge.  At today's multiples, we believe Dunlap doesn’t need to be right on the acquisition timing to make money from here as future international and subsea growth will more than offset any future weakness in US land. 

We believe, however, that the market is overly worried about Complete’s pressure pumping exposure as the market continues to grow, street models overestimate the supply coming into the market and 70% of Complete’s fleet is under term contract.  Dunlap’s judgement is credible in that he has been around the land market for a long time during his years at BJ.  At the time of the deal, with the oil price having dropped to $85, the market was worried about where the oil market would bottom, but the oil price has actually rebounded higher since, to $99.  Also, with gas prices near historical lows, there is a free option on any recovery in natural gas.  If Dunlap is proven right on the CPX deal, we believe investors will think of him as a capital allocation genius and after the growth that will come, Superior will be valued as the premiere midcap oil services stock.  Dunlap has been an active buyer in the open market, having purchased at prices higher than current market price ($350K at $34.88 in May) and (875K at $23.40 in August, 2010).  We believe since the CPX deal announcement, the street has been side-tracked in analyzing the merits of the deal at the expense of focusing on the transformation of the Company towards a diversified, high growth business and the significant earnings power that will emerge over the next few years.  We expect investors to shift their focus back to the growth story in 2012 as Brazil builds scale and the long term international growth plan becomes more evident.

While an earlier write-up on VIC focused on the merits of SPN from a high level, we believe there are several aspects to this story that are critical to highlight:

1)      The Company is increasingly becoming a multi-year international growth story, facilitated by CEO David Dunlap’s relationships from BJ Services and further enhanced by the increased cash flow available after the Complete transaction

2)      Superior has invested significant capital over the past few years which is currently not earning.  We estimate this un-earning capital will contribute over $100m of incremental EBITDA over the next two years, representing over 30% of consensus estimated EBITDA growth from 2011 to 2013E for Superior stand-alone, which doesn’t even account for the $1.5 billion in growth capital Dunlap will invest over the next two years at greater than 15% return on capital

3)      Strong secular trends in the North American land market support multiple years of future growth.  The shift towards unconventional drilling has increased well service intensity and created more demand for high specification equipment while the recent shift from natural gas to oil based liquids has resulted in a less cyclical market as compared to the previous cycle which was dominated by gas 

4)      Superior is well positioned to benefit from the continued recovery in the Deepwater Gulf of Mexico

5)      While there is currently little well intervention in the subsea, through its acquisition of Hallin Marine and construction of a new compact semi submersible, Superior has positioned itself to bring well intervention to the deepwater, a large untapped end market with positive long term secular trends

Business Description

Superior Energy is a diversified provider of specialized oilfield services and equipment and operates through three main business segments: 

The Subsea and well enhancement segment provides well intervention services and requires the use of specialized equipment to perform an array of wellbore services.  Key services include coiled tubing, well control, hydraulic work-over and snubbing, electric and wireline and stimulation and sand control equipment and services.  Superior is also the leading provider of decommissioning and plug and abandonment work in the Gulf of Mexico.

The Drilling Products and Services segment is one of the leading providers of drilling products and services.  Superior sells and rents specialized equipment for use with offshore and onshore oil and gas well drilling, completion, production and work-over activities. Through internal growth and acquisitions, Superior has increased the size and breadth of its drilling products inventory and geographic scope of operations and conducts operations in the Gulf of Mexico, onshore in the US and increasingly in select international markets.

Through its Marine services segment, Superior owns and operates a fleet of liftboats that is complementary to its work in subsea and well enhancement.  Superior’s liftboat fleet consists of 25 liftboats, all operating either in the Gulf or Atlantic Ocean. 

Similar to Superior, Complete provides completion and production services that help oil and gas companies develop reserves and enhance production.  Complete operates primarily in basins within North America.  While offering similar intervention support services like coiled tubing, wireline and snubbing, Complete complements Superior by adding a variety of new service lines.  Complete operates fleets of pressure pumping equipment in the Barnette, Bakken, Marcellus and Eagle Ford shales where they provide stimulation and cementing services.  Complete also owns and operates a relatively new fleet of well service rigs, where they have leading market positions in the Barnette, Haynesville and Rocky Mountain region.  Through their fluid handling business, Complete provides a variety of services that help its customers obtain, move, store and dispose of fluids that are involved in the development and production of their reservoirs.  Complete’s Drilling Services business provides contract drilling and specialized rig relocation and logistics services.        

New CEO Drives International Growth

David Dunlap joined the Company as CEO in April of 2010, replacing Terence Hall, who founded Superior in 1989.  Dunlap had a long and successful career at BJ Services, having been a key player in the management team that grew BJ into a global leader in multiple well service product lines.  Under his leadership, BJ Services expanded internationally in the Middle East, Asia, Africa and Russia and expanded from its legacy pumping services into a variety of other products and services.  His experience at BJ gave him experience not only in international markets, but also in the US land pressure pumping market.  Dunlap is maniacally focused on cash flow and returns and will only invest operating cash flow to pursue growth.  Dunlap brought many his international contacts from his years at BJ to Superior, assembling teams of in country management in Brazil and Australia to seek out new opportunities.  The early success in Brazil has been particularly noteworthy.  The Company was recently awarded two new high level sand control completion contract awards with Petrobras and has increased Brazil revenue 50% in 2011 to $45m.  Dunlap is confident in the team’s ability to further expand services with Petrobras and expects revenue contribution from Brazil of over $250m by 2015.  We expect Superior to replicate this success in other high return markets where they’re a fit. They will enter Saudi Arabia in 2012 where they’ve already negotiated a contract with Saudi Aramco and expect to announce another two to three additional countries in 2012 (potentials being Malaysia, Indonesia, India, Kuwait, Columbia and Argentina).  Superior is transforming into a viable competitor to the big four oil services companies; customers are inviting Superior to new international opportunities like Brazil and Saudi Arabia.  The customers know the brands and have called on Superior in the past, but Superior now finally has the full product offering.  Dunlap plans to use the increased cash flows from the Complete transaction to accelerate international growth and we expect each new country after a year of evaluation to get $30-$50m in capital.  We believe investors focus will shift towards the international growth opportunity in 2012 as Brazil builds scale and the potential for 20% international revenue growth over multiple years becomes evident.

Invested Significant Capital

Superior has invested over $350m that is currently contributing little to no earnings.  We estimate this un-earning capital will contribute over $100m of incremental EBITDA over the next two years.

In early 2010 Superior purchased Hallin Marine, an international provider of subsea services for approximately $200m.  Hallin currently contributes little to no EBITDA as the international subsea market is operating in a cyclical trough.  We estimate in a more normalized subsea environment Hallin could earn EBITDA margins in excess of 30%, contributing $40m in incremental EBITDA.  We expect this value to be unlocked as the supply/demand fundamentals in the subsea continue to improve.  Global and Asian E&P spending expectations remain strong going into 2012 and the Hallin team remains highly confident about its future growth prospects.

Superior invested over $100m the past two years on a new compact semi-submersible, with expected delivery in mid 2012.  This new boat will offer many of the same high level capabilities as Helix’s Q-4000 at a lower cost.  Our research suggests that a boat with these capabilities could earn a day-rate in excess of 150K.  At 70% utilization, we estimate the new semi-submersible will contribute $40m in revenue and $30m in EBITDA once operational in 2H 2012.  

In conjunction with Baker’s acquisition of BJ Services, the U.S. Department of Defense required Baker to divest its Gulf of Mexico marine stimulation and sand control completion tools.  As Dunlap was knowledgeable about these assets from his time at BJ, he was able to quickly jump at the opportunity, acquiring these high technology assets on the cheap for only $55m.  We expect these assets to lead Superior into new international markets like Brazil and generate incremental revenue of over $100m at 30%+ EBITDA margins.

Strong Secular Trends in US Land

While investors worry about a slowdown in the land market, activity on the ground suggests continued strength, with recent E&P announcements implying solid growth of over 10% in 2012 US capital spending.  Superior is expecting a US land rig count increase of 3-7% and points out that the market continues to show an appetite for absorbing new capacity for virtually all of its intervention services and drilling products.  The US land market consumed two-thirds of the Company’s capital spend in 2011 and would have been two-thirds of spend in 2012 and 2013 as well to build the US land presence they desire.  The Complete acquisition not only accelerates this US land build-out, but also increases Superior’s scale and product line offerings.  It’s worth noting that the combined Superior/Complete entity will have over 100 coiled tubing units ($600m in revenue), likely the largest fleet in North America.  The US coiled tubing market is witnessing a profound transformation driven by the surge in horizontal and extended reach drilling as well as by the redefinition of coiled tubing from a service that was predominantly deployed as a well intervention remedy to one that is increasingly being used for high end completion work.  There are expected to be 600 coiled tubing units in the market in 2012 as compared to 450 at the end of the last cycle; the Company believes that almost all the current units are being used in completions with few used in intervention, the reason for which the 450 units were used in the last cycle.  The Company believes there is enough demand in the market for the coiled tubing market to double from current levels.

Investors are particularly worried about the exposure that Complete brings to the historically cyclical pressure pumping market.  We believe this worry is overplayed as the Company will have less revenue exposure to pressure pumping than many of its peers: 15% of 2011 pro-forma revenue for Superior as compared to Halliburton (40%), Baker (25%), Basic (25%), and Schlumberger (20%).  Recent anecdotes about pricing pressure are limited to the more gassy basins and in other cases more a reflection of a shift towards lower priced term contracts over spot as opposed to any real loosening in the market.  Pricing has been more rational this cycle and Complete’s current pressure pumping margins under contract are 30% compared with near 40% peak pressure pumping margins for the industry during the last cycle.  Complete is also more cushioned with 70% of its fleet under contract with a 2 yr. average remaining term as compared to the industry average of 40%.  We also estimate that pressure pumping street models overstate the amount of capacity that’s coming into the market next year, as many don’t take into account the increased attrition of existing equipment due to the higher service intensity levels.  We believe the pressure pumping market will remained undersupplied through at least the end of 2012.

One area which stands out for its high return on capital is Superior’s premium pipe rental business.  Superior has essentially gone from scratch to over one million feet of pipe in inventory and currently represents over 20% of NOV’s order book.  We estimate Superior’s premium drill pipe business is second only to Weatherford in size and product offering breadth and offers an future investment payback period of less than one and half years.  We expect the drill pipe business to continue to be a first priority in Dunlap’s future capital allocation plans not only in US land, but also in international markets.     

Positioned to benefit from recovery in the deepwater gulf

Increased regulation of de-commissioning in the Gulf could create incremental demand for Superior’s de-commissioning business.  The BOEM issued a notice to lessees in September, 2010 establishing tighter guidelines for operators to plug and abandon (P&A) and decommission their wells in the Gulf, requiring them to decommission any platform that has not been used in five years or is not actively producing oil.  Our work suggests that if this regulation gains traction, the number of yearly P&A’s could double from 500 to 1,000, doubling Superior’s $100m in yearly P&A revenue.  While Superior has indicated they do not expect much incremental demand from the regulation in 2012, we expect the increased regulatory environment to continue to provide a steady stream of P&A work going forward.

More importantly, Superior has significant upside potential from the rebound in the active rigs in the deepwater Gulf.  Prior to the Macondo incident, the Company had $100m of near 50% incremental margin drill pipe revenue on 31 of 33 active rigs in the deepwater.  With only around 15 rigs active today, Superior has only regained less than half this revenue.  We expect activity in the deepwater gulf to continue to increase in 2012 as existing projects continue and at least 8 new active rigs are added, with a potential to return to a pre-Macondo revenue run-rate by the end of 2012. 

Positioned to bring well intervention to the deepwater

Over the past 10 years, deepwater completions have increased dramatically and according to independent research forecasts global subsea production is expected to increase 70% from current levels by 2015.  The market for subsea completions is largely untapped, limited by the high costs of current technology.  With the completion its compact semi-submersible in 2012, we believe Superior will enhance its ability to provide intervention in the deepwater in a very unique way.  The Company’s broad scope of intervention technologies and lower cost large diameter lubricators for riser-less technology position them to compete more effectively than any other competitor.  We estimate there are conservatively 1,000 subsea wells currently shut in; with an average age before intervention of five years, we could see over 200 subsea well interventions a year.  At $5m per intervention, this would imply a $1 billion market opportunity.  At a conservative 20% market share, Superior could generate $200m in incremental revenue and $80m in EBITDA.  As Superior establishes itself as a first-mover in deepwater intervention, we expect them to become an attractive acquisition target of the likes of larger service companies like Halliburton and Schlumberger, who would very much want an entry into this high growth market. 

Valuation

At 8.4x 2012 earnings, Superior is currently trading like a North American pressure pumping business.  Investors are overlooking the fact that Superior possesses some of the best collection of assets and growth opportunities in the energy services’ industry: the largest coiled tubing business, a leading high return drill pipe business, an international opportunity no other mid cap oil services company can go after, unique well intervention assets, a leading history of P&A work and a new compact semi-submersible with similar characteristics to the Q-400 which makes them an effective first- mover into deepwater intervention.

The pro-forma entity will generate over $1 billion a year in operating cash flow with only $200m in maintenance capital.  We estimate Dunlap will use this $800m in yearly free cash flow to internally fund growth investments in Superior’s multiple high return business lines at paybacks averaging three years, generating yearly incremental EBITDA over $250m.

We estimate Superior is worth $40 a share, 40% higher than the current share price.  Based on Superior’s FCF and return on capital characteristics, we conservatively base our valuation on 7.5x 2012 free cash flow (ex maintenance) and 5.5x 2012 EBITDA.

• Decline in oil price below certain thresholds could result in lower E&P spending in 2012
• Additional pressure pumping capacity could result in declines in pressure pumping margins after term contracts expire
• Merger integration risk

Catalyst

• Investors turn their focus to international growth in 2012 as Brazil builds scale and longer-term international growth plan becomes more evident
• Investors look to 2013 earnings power after Superior announces 2012 guidance in February
• Closing of Complete transaction in January, investors adjust pro-forma for 2012 accretion from Complete transaction
• Negative investor sentiment on US land shifts more positive as E&P’s continue growth plans