Description

I’m not going to pretend this is an investment.  It’s a trade. Or maybe it’s just a gamble – a gamble that reveals the weakness of mental shortcuts I am taking because I am experiencing some pattern recognition and the idea has big upside.  

Even that might be too charitable.  Look, I have to post an idea by close of business today in order to keep my membership alive and frankly what you are getting here is by far the smallest position in my portfolio.  

Please don’t buy this.  It involves Canada and pressure pumping.  It’s a Canadian pressure pumper. Did I mention the CEO has been on the job for nearly 10 years and only owns C$700k worth of stock?  They also did a secondary offering at the bottom of the cycle. I won’t be offended if you stop reading now and vote this a “2”.

The ticker I own is TCW on the Toronto Stock Exchange.  I posted the idea under TOLWF simply because that one is U.S. dollar denominated.  The body of this writeup will look at things from the perspective of TCW, i.e. Canadian dollar denominated.

Canada

Canada is the 5th largest oil producer in the world at approximately 5 million barrels per day.  They only consume approximately 2.5 mmbbl/d so if they want to grow production they clearly need to grow their export sales.  (You can see why refining is a good business in Canada!)

The Canadian energy sector is obviously known for the oil sands but the unconventional revolution arrived there too.  As a result of those twin growth engines, Canadian oil production went from 3.2 mmbbl/d in 2008 to ~5 mmbbl/d today. Canadian demand is only up a few hundred thousand barrels per day in that same time frame.  Industry has had a really hard time gaining approval to build new pipelines. The existing pipes are full now and the differentials collapsed in Q4’18. I don’t have an edge on whether the industry will be able to build any more pipelines but they are very upset and are motivated to get something done.

Pressure Pumping

Pressure pumping has a bad rap with U.S. investors, and it should.  It’s capital intensive with no pricing power and historically it had very low barriers to entry.  It is also very fragmented. It actually used to be a decent business largely controlled by the Big 3 integrated service providers (Schlumberger, Halliburton and Baker Hughes) but the ramp in unconventional E&P activity after the financial crisis led to a huge increase in demand in 2010/11.  Returns on capital within pumping spiked, attracting lots of new capacity. Ever since then the industry has been a black hole for investor capital. The management teams are generally awful with a few exceptions (RES, PUMP and LBRT come to mind).

The Canadian pressure pumping market never became fragmented in the same way the U.S. market did and it remains fairly concentrated.  Six players control 92% of the capacity and it has a Herfindahl-Hirschman Index of approximately 2,000. According to the U.S. DoJ and FTC’s horizontal merger guidelines, markets with HHI’s between 1,500 and 2,500 are classified as “moderately concentrated”.  (HHI’s above 2,500 are highly concentrated). The U.S. pressure pumping market had an index of 700-800 about a year ago but I haven’t updated those numbers in a while. Trican is by far the biggest Canadian player.

Trican’s History

The company was founded in 1979 and is based in Calgary.  Dale Dusterhoff became CEO in 2008. They borrowed heavily and expanded into different countries like Russia and Kazakhstan.  What could go wrong. Debt grew from C$107 million at YE2010 to C$787 million at Q3’14. As a general truism, it’s better for oilfield service businesses if they choose to compete in basins where they have local relationships and can build scale.  Trican took the opposite approach as far as I can tell.

It worked for a while – sort of.  Revenue grew from C$1.5 billion in 2010 to C$2.4 billion in 2014, but EBITDA actually fell from C$333 million to C$222 million.  The stock topped out at C$18/sh in June 20114. Things ended badly when the cycle turned. Trican ended up selling off verything except the Canadian business in order to pay down debt.  The cherry on top was the secondary at C$1.60/sh in June 2016 that diluted shareholders by 25%. I guess it wasn’t that bad if you take the perspective that at least they waited until the stock had been a 3.5x bagger off from the absolute lows around C$0.45/sh.  A smart Canadian analyst told me they probably had to do it order to survive. So be it.

To make matters worse, it appears they significantly underinvested in fleet maintenance during the downturn.  They were so strapped for cash they only spent C$1.4 million of capital in 2016, or 2% of depreciation.

To their credit when they sold their U.S. operations they took stock in a company that later went public (Kean Group/NYSE: FRAC) so they could participate in the upside of a recovery.  

The cyclical rebound eventually came.  The Canadian rig count ripped almost as hard in 2017 (+59% y/y) as the U.S. land rig count (+76% y/y).  Trican bought Canyon Services Group, the 4th largest Canadia pressure pumper, in March 2017 and went from being roughly the same size as its nearest competitor, Calfrac, to being by far the largest pressure pumper.  Importantly, the deal was all stock and was based on a Trican share price that had rebounded to C$3.90. Canyon’s CEO, Brad Fedora, who seems to be well respected, became a director, and Canyon’s CFO became Trican’s CFO.  

Trican’s stock reached a high of C$5.25 in late 2017.  Then in 2018 the wheels came off when differentials blew out.  Canadian producers have cut their capex budgets in 2019 and the YTD Canadian rig count is down 32% vs. 2018.  

The stock is down almost 75% since the peak in 2017 and is down 40% just since September 30.  These stocks have been vaporized.

Variant Perception

At C$1.37 the shares are trading at a 52% discount to my replacement cost estimate of C$2.87 and the company is buying back stock.  If the Canadian market improves, great. The OFS industry structure is consolidated enough that it won’t take much for returns to quickly improve.  If the market doesn’t get better, the equipment is mobile and they will move it to wherever it can earn returns. The CEO confirmed to me a couple weeks ago that all options are on the table.  

They have liquidated the Keane stake.  Proceeds of C$74 million from the final tranche in Q4 alone were equal to 20% of the market cap at the time.  

They have bought back 14.2% of the stock (50.5 million shares) at an average price of C$2.91 since the Canyon deal closed, including 11.7 million shares at C$1.84 in Q4 and 4.5 million shares at C$1.34 from Jan-1-2019 through Feb-20-2019.  The remaining normal course issuer bid (NCIB) is for 14.7 million shares, or 5% of the 297.2 million shares outstanding as of Feb 20.

Net debt was down to just C$38 million at year end.  

Also, the longtime chairman is retiring and Brad Fedora is assuming the role.  Between that change and the former Canyon CFO remaining with the company after the merger it feels to me like the guys who got Trican into trouble in the first place are being phased out.

It’s hard to see a ton of downside.  If you allocate the entire EV of C$450 million to the pressure pumping business (68% of 2018 revenues), the implied valuation at C$1.38 is just C$671/HHP, or US$504/HHP assuming a 0.75 exchange rate.  Replacement cost is ~US$800/HHP.

(Note: I talk about replacement cost in terms of USD because the equipment is made in the U.S.)  

You get the cementing business for free (16% of 2018 revenues) where they have 40-50% market share, along with the other various and sundry service lines (also 16% of revenues).  Consensus estimates imply a 3% FCF yield in 2019 and 6-7% in 2020.

Note that Keane bought Trican’s U.S. business for US$411/HHP at the trough in Jan 2016 and STEP bought Sanjel for US$285/HHP.  Those two markers are pretty much bottom ticks and not too far off Trican’s current valuation if you give them some credit for their other service lines that generate the other 32% of revenue.  Also, GMP First Energy values Trican with an EV of C$440 million on an auction basis – right about the current level.

I value the stock at C$3.40 (150% upside) on a midcycle basis.  I get there by assuming:

• Pressure pumping EBITDA of C$175 million based on US$200/HHP of EBITDA with a normalized 0.78 exchange rate (higher than present because a stronger local energy market would imply a stronger CAD) and 672,000 HHP of capacity.  

• The U.S. comp group (Calfrac’s U.S. operations, FRAC, FTSI, LBRT, PTEN, PUMP, and QES) generated US$222/HHP in 2017 and US$310/HHP in 2018

• Canadian market structure is better than the U.S.

• Note that TCW expenses fluid ends, while CFW, PTEN, and PUMP capitalize them, which hurts TCW when comparing pumping profitability

• Cementing and other EBITDA of C$60 million based on C$360 million of revenue with a 17% EBITDA margin (2008-18 averages for their Canadian operations)

• Consolidated EBITDA of C$235 million

• 4.5x midcycle multiple

• C$37.7 million net debt at YE2018

• 301.5 million shares out at YE2018

The buybacks that occurred in the first six weeks of 2019 are accretive to that valuation appraisal.

Perhaps my C$235 million EBITDA estimate is too aggressive.  The average EBITDA for Trican’s Canadian operations since 2008 has been ~C$170 million.  The same multiples and capital structure would still imply a value with 75% upside to C$2.40, but keep in mind that average includes the financial crisis, an epic industry downturn, and the Canadian differentials blowout.  

It’s worth noting they claim to have taken C$20 million per year of fixed and administrative costs out of the business relative to 2018.  Capitalized at 10% that’s C$200 million of NPV pre-tax or 45% of the EV. It does indeed look like they have reduced G&A from C$60 million annualized to C$40 million.  

Pattern Recognition

This might be a stretch but the situation here reminds me of how Richard Rainwater and Carl Thorn took over Ensco in the 1980s.  The industry was bombed out and they bought the equipment for pennies on the dollar. They didn’t know what was going to happen to the market but they bought so cheap it almost didn’t matter.  As long as something, anything, went right it would be upside.

A key difference between Ensco then and Trican now is Trican has a cleaner capital structure and an ongoing buyback.  Trican’s industry segment has a much better structure than offshore drilling. I would also say Trican has better visibility to the attractive drilling economics and inventory depth of its customers than Ensco did back then.  The problem is also much more clearly defined – it’s takeaway capacity.

What I’m Watching For
This is not a long-term compounder.  If they abandon the buyback I’m out because otherwise it checks a lot of boxes for stocks I want to avoid.  The CEO told me a couple weeks ago they are continuing to buy back stock, but he gave me a qualifier along the lines of future buybacks are going to be “moderate” – or something to that effect – but they are still buying.  Moderate is fine, as long as they keep buying.

Also, I’m out if it becomes apparent the equipment has been neglected to a much greater degree.  The CFO told me in November it would probably cost under C$5 million in aggregate to bring the rest of their equipment off the fence.  I have no way of testing that assertion so I will be watching to see if capex escalates further. It was C$79 million in 2018 vs. C$30 million in 2017 and C$1.4 million in 2016.  That trajectory hopefully suggest they are caught up. We’ll see.

I don’t see any capex guidance for 2019 other than, “a minimum amount of capital expenditures will be required to maintain our equipment fleet”.    

Catalyst

I'd be grasping at straws if I listed one