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.
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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.
We began calling out NBR’s advantaged alignment with IOCs in USL back in a Feb ’19 weekly CHOW (link), and 1Q19 results affirm that NBR could continue to outperform super-spec peers in the L48. However, improvement in the int’l business remains core to our constructive thesis, and while we are encouraged with the directionality of activity in the E-Hemi, pricing has largely underwhelmed in the cycle (as it has for other OFS segments, especially in MENA). We aren’t fully convinced that 1Q19 was the bottom for int’l margins, but key upside catalysts including 1) Mexican platforms targeted for deployment in 2H19, and 2) a highly-accretive Kazakh activation for 3Q19 could be supportive of improvement in the near-term. Until then, USL outperformance will likely drive incremental FCF improvement over the coming quarters, as NBR affirmed its net debt reduction target of $200-250M in FY19.
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.
Despite a more tepid outlook for USL activity conveyed by land drilling peers, NBR continues to put rigs to work. Overall, a USL-driven topline beat was offset by underwhelming margins in US Drilling & Rig Services. NBR currently has 115 rigs operating in USL (+3 from 1Q avg) and expects to be operating 120 rigs by YE19, indicative of share gains against peers that anticipate a rig count bottom in 2Q19. Another quarter of int’l sluggishness was due to disruptions in Argentina and Venezuela, but results are expected to improve in 2Q to prior-consensus levels of EBITDA. NBR addressed concerns over the $100MM increase in net debt and front-loaded capex ($146MM) by reaffirming its prior FY19 capex guide and net debt reduction range of $200-250 million.
The burden has long been on OFS to prove 1) business model improvement & 2) sustainable value creation in the current upstream cycle, and sentiment swings with crude oscillation has all but eliminated “benefit of the doubt” for the sector. Solid 1Q19 prints for both SLB and HAL saw opening gains disappear with intra-day commentary around minimal 2Q19 upside, evidence that the market expects OFS to be closer to an upward revision cycle, particularly with int’l geomarkets now leading YoY spending growth. We’ve emphasized before that the land/shallow-water hue of the cycle makes the bridge to lofty 2020 estimates somewhat untenable for certain names in our space (SPN, CLB, NOV, SLB). Unlike 4Q18, the sector no longer possesses the “capex-cut lever” to curry market favor – investors need to see N-T pricing/margin improvement at current crude levels, anything else could be viewed as negative.
Methodology details within, but in general our frac count allocation involves taking raw Frac Focus/State O&G filings (from Rystad) and allocating “unknown” frac counts to specific companies based on active spread counts by basin. This month, we employ a real-time frac spread efficiency metric (rather than an all-encompassing ‘nominal’ efficiency factor). This has proved to smooth out the processed output.
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