Care to make a wager? The market believes there will be a serious pullback in drilling activity in 2012, judging from the stock prices of the Canadian energy services companies that provide fracking and drilling out in the field. The energy companies whose capital spending foots the bill, however, have made no such predictions, instead forecasting more and more work.
To be fair, there is typically no lack of bullishness in the oil patch, so the energy companies’ optimism may be misplaced. But if you’re willing to bet the market is being unduly pessimistic by sending the energy services sector to near-historic lows, there may be some serious money to be made.
“The equity market appears increasingly skeptical that the current buoyant [fracking]margins can be sustained for much longer,” says analyst Chad Friess of UBS Securities Canada Inc. That’s “in stark contrast to the thoughts of both producers and service companies, most of which are predicting higher spending levels, rising service intensity and a stronger-for-longer ... market.”
BMO Nesbitt Burns analyst Michael Mazar suggests investors are remembering the sharp drop in activity during the 2009 financial crisis, and are expecting a repeat. “[The 2009 experience is]currently viewed as a ‘normal’ down-cycle rather than the ‘once-in-a generation’ event that it was,” he says.
According to Mr. Mazar’s 2012 estimates heading into this fall’s earnings season, the average forward price-to-earnings ratio for Canadian oil field services and equipment companies was 9.2, with a number of quality names below eight; the average for contract drillers is 8.2. In contrast, their U.S. small-capitalization counterparts trade at an average of 10.4. The discounts are similar when comparing enterprise value – market cap plus debt – to earnings before interest, taxes, depreciation and amortization (EBITDA).
Some of the Canadian companies’ shares have popped on pleasant earnings surprises; many still retain their value characteristics, particularly companies that garner a significant amount of revenues from pressure-pumping processes, which includes extracting gas through “fracturing” shale rock. (Colloquially known as “fracking.”)
Calgary’s Calfrac Well Services trades at a forward P/E of about 6.5 and a forward EV/EBITDA of 3.6, according to Standard & Poor’s Capital IQ data service. Mr. Friess uses a forward EV/EBITDA multiple of 4.4 – which, he notes, is a 31 per cent discount to the stock’s five-year average – and gets his target price of $40, well above the roughly $31 it traded at Wednesday.
Mr. Friess says Calfrac’s third-quarter results supported this positive outlook, with margins at a near-record level. While margins did slide from the second quarter, Mr. Friess attributes the decline to high startup costs in a couple of Calfrac’s new plays and higher labour and materials costs, which the company will try to pass along to customers through future pricing. “In our view, the [third-quarter]figure should not be seen as evidence of any market shift,” but as a return to levels of the previous five quarters.
Calfrac, Mr. Friess says, “is buying out the pessimists” with a normal course issuer bid for up to 7 per cent of its shares. The 2012 buyback budget of $271-million, is “dwarfed,” in Mr. Friess’ words, by expected cash flow of over $400-million, cash reserves of $141-million and undrawn credit of $250-million.
Both Mr. Friess and BMO’s Mr. Mazar have “buy” or “outperform” ratings on Calfrac and a peer company, Trican Well Service , with Mr. Mazar calling the two his firm’s “highest-conviction, short-term ideas” in advance of the current earnings season. Trican, UBS’s Mr. Friess notes, had recently been trading at an even larger discount to its five-year average than Calfrac had.
With a gain after Tuesday’s earnings release, Trican is now up nearly 15 per cent this month – but remains 25 per cent below its 52-week high, and now trades for an forward EV/EBITDA multiple of about 4.6.
The discounts may not get deeper any time soon.
Special to The Globe and Mail