In recent weeks, we’ve noted our own emphasis on FCF yield as an increasingly important part of the valuation framework in a “no-growth” OFS – perhaps replacing (or at least supplementing) a shaky EV/EBITDA convention that does little to capture how drastically OFS earnings power, and the shape of the upstream spending cycle, have changed in recent years. “Have we found the valuation bottom?” is ubiquitous in meetings and calls. In recent weeks, non-covered OFS (namely BAS & HCR) have demonstrated that accelerated buybacks could be the sector catalyst that helps establish this valuation floor, having vastly OP the WR OFS index on the day of buyback announcement (and subsequently). LBRT, PTEN & PUMP screen the best in our coverage in terms of accelerated buyback potential, but we suspect the broader sector will follow suit until market expectations are properly calibrated across both OFS and E&P. Details on current authorizations within.
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This week, we caught up with members of the BHGE team to get an updated lay-of-the-land across an otherwise capricious global oil patch. Two key takeaways (our view) 1) OFS is still on track to outperform large-cap peers in terms of growth, with the ‘Big 3’ now uniformly signaling better pricing discipline from the int’l collective (perhaps upside to incrementals), and 2) the 2020 TPS ramp is still very much intact (consensus ests having tightened), and investor fears are likely overblown regarding TPS equipment margins. No further detail on the GE selldown, and we maintain that FCF execution should help alleviate this overhang organically – with cash on hand a potential buyback backstop down the road. Capital strategy remains firm and focused, with no major M&A plans within the OFS purview. Artificial lift remains a bright spot (APY-OP).
March was exceptionally strong for US frac activity, with fracs/day having increased steadily through 1Q19 – most notably in the Permian (tracking to +0.4% sequentially in 2Q19) and Bakken (tracking to +75% QoQ in 2Q19 after a soft Jan/Feb). This momentum could acquiesce to a “flattening” in the summer months, as early Rystad data indicates modest declines in both April/May. Although filings are still nascent for 2Q19, this trend jives with the broader follow-through of discipline among E&Ps, a narrative that portends downward spend through FY19 (into what pumpers anticipate to be a 4Q19 slowdown looming). Recall E&Ps spent slightly less than 30% of FY19 budgets in the first quarter.
NESR CFO change is (understandably) a tough look – We caught up with mgmt briefly to discuss – No change to our OP thesis. Yesterday (05/28/19) AMC, NESR announced that CFO Melissa Cougle was leaving the company for ‘family considerations’ to assume the CFO role at Frank’s International (as per the concurrent FI-NC press release). We caught up with NESR briefly to discuss, as CFO continuity (even prior to Melissa) has been a point of pushback among investors in the context of unfamiliar MENA accounting/disclosure. Our NDR in mid-April (link) was constructive on the financial disclosure front, and anecdotally it is worth noting that much of the FI team hails from Melissa’s home state in LA (a much more forgiving travel paradigm compared to a MENA-focused OFS company!). NESR’s new CFO, Chris Boone, is a seasoned industry veteran with over 25 years of experience (TESO prior to NBR acquisition & LUFK prior to GE), and his existing ties to the NESR management team make for a relatively seamless transition. As such, we do not change our constructive view of NESR (OP, $23 YE19 PT).
Updating our macro and sector-specific thoughts following a sell-the-print 1Q19. Like many of our clients, this past week was one filled with ceremonies, commencement speakers, and renewed optimism as graduates at every level persevered through finals, put painful learning behind, and began to look forward to a better days ahead (congrats to the GW Sciences & Penn Law classes of ’19). Similarly, this past week largely closed the book on a painful 1Q19 earnings for OFS, one in which E&P discipline and risk-off market forces drove capital rotation out of the sector (following YTD OP of broader energy). Better days are ahead for OFS, simply on the premise that FY19 will mark the first year since ’14 that int’l upstream drives the bulk of spending growth (as OFS earnings power should improve with this capex mix-shift). The key learning from 1Q19 however, is that OFS growth, no matter the return profile, will be ill-received by a market that now demands excess cash flow be used to deleverage/returned to shareholders. FCF will be king moving forward.
In conjunction with this report, we have also updated our macro/activity view in this report. The key takeaway from the activity update is further flattening of the US oil growth trajectory, productivity slowdown in key shale basins (an important OFS catalyst), and an implied 2H19 E&P production ramp that we don’t see as being priced into OFS activity levels.
We are updating our Capex, Drilling, Pumping, and Production models, in tandem with our 1Q19 Quarterly Crew Change.
In our view (and based on overwhelming investor feedback) an SPN sale of Pumpco would yield a rapid upward SPN re-rating on both balance sheet and revenue quality tailwinds for the remain-co (7x EBITDA, discounted by a mere 20% of TTM EBITDA would imply much more equity value). From Spears, we estimate that DRILCO, Thomas Tools, and SLB’s fishing business generated $600M of FY18 revenue, which at 15% EBITDA margin implies a 4-5x TTM EV/EBITDA takeout on these recently sold Smith segments. We would assume that SPN’s DPS segment yields a greater margin (given its competitive moat in more differentiated deepwater locales) and the midpoint DPS valuation (vs. SLB comp) on a 25% EBITDA margin implies that DPS alone is worth as much as SPN’s total equity value.
Another PUMP beat – Capex cause for concern? No. PUMP continues to defy gravity, having posted another revenue/EBITDA beat yesterday AMC. Despite the expected throughput dilution associated with the integration of the acquired PPS spreads, 1Q19 annualized EBITDA/spread (conservatively adjusted for 100% of disposal) held strong at ~$20M/spread-year. A short thesis around PUMP has gained appreciable traction over recent months, with a combination of 1) operational mean-reversion, 2) over-earning on sand, and 3) longer-term fleet fatigue/capex ramp representing key points of pushback. Upon the release last night, investor reactions were decidedly split between the P&L beat and substantial cash burn headline. Beyond the $100M payment to PXD, we believe the ~$80M pumping capex number was reasonable assuming a ~$50M POC DuraStim payment for the two newbuild spreads. The remaining ~$30M would imply an in-the-fairway $4.5M R&M/spread-year. Tomorrow, we look for confirmation of the capex breakdown, but nevertheless point to substantial FCF potential through 2H19 and into FY20, should PUMP continue to execute at its current, sector-high EBITDA/spread level.
If Buffett was really bullish shale, he’d buy USL frac. Jokes aside, our E&P/IOC colleagues have been busy with a deluge of earnings and an ongoing CVX/OXY/APC saga that brings a long-forgotten USL upstream back into the market limelight. The Buffett bid marries both yield (to de-risk shale execution) and a call option on oil, a powerful combination by OFS equity standards. While services remain subordinate to this market chatter, we outline our Permian rig read-throughs in our HP F2Q update.
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