|Shares Out. (in M):||83||P/E||0||0|
|Market Cap (in $M):||140||P/FCF||0||0|
|Net Debt (in $M):||96||EBIT||40||60|
Profits In The Next Upcycle Will Exceed the 2014 Peak Profits At This Land Driller
Named Xtreme Drilling & Coil (XDC.CA)
A Second Chance To Make Some High Return Investments:
March 2009 was a great time to invest in the stock market as a recession had led to low valuations, and depressed sales and margins. March 2016 offers a similar opportunity in the energy sector where a 70% decline in oil prices has led to an industry depression with low valuations, depressed profits, and numerous companies approaching bankruptcy. The company we will discuss today has the free cash flow and balance sheet to survive an energy downturn that lasts longer, but will still do exceedingly well when the energy sector recovers.
Xtreme is a land driller with 21 Xtreme Drilling Rigs (XDR) land rigs and 9 (XSR) Xtreme Service Rigs for coil tubing. The drilling segment (XDR) contributed 61% of operating profit in the 2015 with 39% of operating profits earned by the XSR Coil services segment. The XDR rigs transportation system reduces the time it takes to move in, rig up and rig out from days to just hours. The X-Y walking system allows for decreased time between wells on a pad. The XSR coil tubing service sets the standard for projects involving re-entry of existing well-bores to increase production by 100% - 600%. Xtreme is a new player in the drilling industry with under 2% market share, but the opportunity to be much larger.
Xtreme Drilling has the best land based drilling rigs in North America, but with a 0.36x price to tangible book value trades at the lowest valuation among its public drilling peers. The USA rig count has plummeted by (76%) since October 2014. Thus it is no surprise then that Xtreme’s stock price is 69% below its peak levels from June 2014.
Oil exploration customers are expressing their confidence in Xtreme every day by voting with their pocket book. Xtreme’s rigs have not been deactivated at the pace seen by competitors. Xtreme just reported last week that 2015 EBITDA declined (21%) versus 2014. This is very impressive! The other two players with the newest drill rig fleets in the industry are Helmerich & Payne and Patterson-UTI. Both companies experienced a 65% decline in 2015 EBITDA versus 2014.
There is a valuation disconnect as Xtreme is being valued as if the company is in trouble. In fact Xtreme generated free cash flow in 2015 and used the cash to retire some of its long term debt. As of December 2015 net debt to trailing EBITDA was at a 1.55 ratio.
As the chart on the next page shows, there is a strong correlation between oil prices and the Xtreme stock price. Clearly higher oil prices lead to higher profit for oil producers, which provides them more cash flow to spend on drilling. Xtreme Drilling did not dilute its shareholders during this downturn by issuing equity or debt, and we fully expect profits to reach new highs as oil prices recover. A 200% appreciation in the stock price is possible over a few years as the price to tangible book valuation rises from under 0.4x back to 1.2x as it has in past oil price cycles.
The table below shows that near the trough of this drilling cycle Patterson-UTI along with Helmerich & Payne trade at 1.0-1.4x the book value of their drill rigs. To my amazement Xtreme has newer rigs with superior performance but the stock trades at very large discount.
The chart below shows all three stocks price to tangible book value since 2010.
The yellow and blue lines above show that stock prices for HP and PTEN have increased over 50% since January 2016. Xtreme is the small cap Tier 1 land driller and its stock price has only increased by 14%. If you are skeptical about oil prices moving higher in the near term, then Xtreme offers an extra margin of safety as it’s stock price is not reflecting more optimistic investor sentiment yet.
Compelling Customer Value Proposition:
Xtreme does charge more at $32,352 per day to rent its drilling rigs, but can save customers 43% by drilling wells in fewer days. These significant savings have resulted in Xtreme adding a lot of new customers in the current industry downturn.
Best Financial Performance Among Land Drillers
Quarterly profits for land drillers peaked in the December 2014 quarter along with the Baker-Hughes rig count. Even drillers with modern rigs such as Helmerich & Payne and Patterson-UTI (see table below) reported a (65%) year over year decline in EBITDA for the December 2015 quarter. Xtreme Drilling by comparison reported a (36%) EBITDA decline. Xtreme outperformed on the downside yet its valuation ignores this factor.
You can also see below that Xtreme’s rigs are differentiated versus its peers. The Xtreme rigs have a
$32,352 day rate which is a 34% price premium to the rigs leased by Patterson-UTI.
Industry Rig Count At Trough Levels And Likely To Rise In the Months Ahead
The USA drill rig count peaked in November 2014 and collapsed by (75%) by March 2016 to 463 active rigs. This rapid decline in drilling activity was caused by WTI oil prices falling from $100 to $40 per barrel. Numerous oil exploration companies have stated that with WTI oil prices rebounding to $60 per barrel they will deploy more rigs to drill new wells. Thus we appear to be at the trough of this down cycle. As oil exploration firms increase their drilling activity, they will likely call Xtreme first since the Xtreme rigs provide lower drilling costs versus peers per well.
What Can Xtreme Drilling Earn In An Industry UpCycle??
Xtreme has only 30 rigs or under 2% share of an industry with over 1,800 drilling rigs. These patented rigs are best in class and will displace older rigs over time.
Xtreme is going to gain material market share in the next upturn. In the midst of this downturn Xtreme has intentionally been drilling for new customers to prove that their rigs drill wells faster, longer and cheaper than the competition. The number of master service agreements has tripled in Texas in the Permian and Eagleford Basins. Xtreme is also seeking to sign long-term contracts in the Middle East at 100% utilization rates that will generate nearly triple the annual EBITDA per rig versus the United States.
These two factors will allow Xtreme to recover to peak 2014 EBITDA even in a muted recovery where oil prices only rise to $60/barrel. If oil prices recover to $100/barrel then EBITDA could surpass $100 million with the current drilling rig fleet.
Xtreme’s stock price did reach a valuation of 7x times EV/EBITDA in 2014. A return to a 7x EV/EBITDA on $100 million in annual EBITDA, minus debt suggests a stock price above $7.00/share. This EBITDA improvement could take place by 2018. This bullish scenario could be wrong, but it just shows how much more upside there could be for Xtreme. The first objective is just to have the stock price trade at book value.
Rising Oil Prices Expected in 2016
Right now the global oil market has an oversupply of 1.5 million barrels of oil per day out of a market that consumes 96 million barrels per day. Thus supply only exceeds demand by 1.5%. The supply of Non-OPEC oil has already peaked and is expected to decline by 1.0 million barrels per day in 2016. The demand for oil is expected to grow 1.5 million barrels per day in 2016. This 2.5 million barrel tightening in the supply/demand balance will should lead to an oil shortage later in 2016. That is why we expect oil prices to rise and Xtreme's stock price to rise with oil prices.
Xtreme is an acquisition target. A buyer could offer nearly a 100% stock price premium and still be acquiring Xtreme at a discount to book value. Xtreme would be an accretive acquisition for any company with a stronger balance sheet.
We know that new rigs deployed in the USA have a 3 year pay-back, and a bigger company could afford to build more rigs and have the marketing organization to find customers for the rigs.
Crude Oil Prices Could Stay Lower For Longer Especially In A Global Recession:
Xtreme will survive during an extended downturn as they generate free cash flow even with a rig count that has plummeted 75% from its peak. The probability of this negative scenario are low, and Xtreme is already valued at a big discount to the replacement value of it drilling rigs.
Largest Two Customers are 16% & 13% of sales each
Xtreme does have customer concentration risk. If for some reason Xtreme disappointed its two largest customers sales could fall materially. The good news is that Xtreme’s reputation is improving rapidly. In the year Xtreme has added over twenty new customers. These new customers could offset the loss of a large customer given that Xtreme only has 30 rigs in its fleet.
Leverage can hurt companies especially in an industry downturn. The good news is that Xtreme’s net debt of $96 million is only 1.55x times trailing EBITDA. In a worsed case scenario Xtreme could sell some of its rigs that are best in class.
EBITDA Will Likely Decline Again In 2016
We are still in an industry downturn, but drilling rig stock prices do move with oil prices even though a profit recovery will lag.
Rising Oil Prices will drive the stock price higher, and falling oil prices will drive the stock price lower
|Subject||Technology / Historic Valuation|
|Entry||03/15/2016 07:04 AM|
Thanks for the write-up Moneyball
I've seen various companies alleging to revolutionize a service vertical in the o&g space only to disappear / turn into frauds / strengths hyped by super promotional management.
I have no evidence that this is happening here and do not know the company, so excuse the ignorance. A couple of big picture questions:
1) Why has the company traded at a PB discount to peers over the years? Have their returns been lower? In a commoditized sector where they have a product that delivers 50% cost reduction protected by IP, this seems odd. Especially peaking at 1.2x book in a tight energy equipment market
2) Have you got any channel checks with customers / industry people confirming their product performance? And the satisfaction of customers?
3) What is insider ownership / insider buying and selling activity in the stock? Is the compensation structure fair to shareholders? Is there a high quality independent board in place?
4) How does their working capital performance compare to peers? Especially receivables in the last year
5) Any other qualitative assurances?
|Subject||Re: Re: Technology / Historic Valuation|
|Entry||03/15/2016 03:14 PM|
agree - that is the essence of my first question. It seems like they are generating sub-par returns with an exceptional product. Or may be the book value is not accurate for some reason (in which case we can't use it as a valuation tool)
|Entry||03/16/2016 09:42 PM|
Xtreme had excellent drilling technology as of 2012 with weak management that nearly drove the company into bankruptcy despite $100 per barrel oil prices.
The new CEO Tom Wood joined at that time and ovesaw a remarkable operational turnaround from 2012 - 2015.
Extreme frequently gets positive press coverage for it drilling performance. For examples in 2014 they reentered and drilled a 20,000 foot well in 5 days in the Eagleford. The 2 E&P firms I spoke have overserved Extreme operations in Texas and began working with Extreme in 2015.
Insider ownership and purchases would be rated a neutral factor and executives have not been active.
|Entry||04/27/2016 02:57 PM|
Nice call. Any thoughts on the pro forma company? I am trying to figure out what the earnings power of the drilling division could be in a muted 2016 environment and a more "normalized" environment. It looks like the drilling business could still be reasonably priced. Management disclosed that the drilling division did 49m in gross profit in 2015. If you back out early termination payments and allocate 15mm G&A (a guess) 2015 drilling EBITDA could have been 20mm on new EV of 105mm. Am I missing anything? I realize that 2016 will be tough but drilling activity should be increasing by 2017. Any thoughts on the divisions earnings power if they ever get all 21 rigs back to work?
Do you trust managament with 100mm in cash? are they likely to start a new build program in your mind? Are acqusitions an option or do you think they want to keep a similar spec'd fleet with their IP?