As a shareholder of Ensign Energy Services Inc. (ESI-T), I am in favour of management’s recent lowball offer of $1.68 cash for all the shares of Trinidad Drilling Ltd. (TDG-T). But as a shareholder of Trinidad Drilling, I believe that the offer dramatically undervalues the company, and I won’t be tendering my shares anywhere near the current offer price. In fact, less than four months ago I wrote in the Report on Business that Trinidad Drilling, which was then trading at $1.75, could be bought for less than the collateral value of its drilling rigs, estimated at about $3.00 a share.
Since April, the operating environment in the oil service sector has improved, and Trinidad has seen the benefit. Revenues for the first half of 2018 were up 21 per cent and operating income grew by 28 per cent over the same period last year. U.S. and international operations, which account for 60 per cent of activity at Trinidad, were particularly strong, so the company paid down $37-million in long-term debt while reducing general and administrative overhead at the same time.
As a result of this positive industry momentum, the balance sheet at Trinidad has improved, and I now estimate that the collateral value has edged up to $3.04 a share.
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To revisit this process of estimating the collateral value of a company, assume for a moment that you are a banker deciding on how much, if anything, you will loan to a customer. For this exercise, I assume that you will loan 100 cents on the dollar against cash and short term investments, 75 cents for accounts receivable, 50 cents for inventory and 100 cents for the net depreciated value of fixed assets – mainly drilling rigs, in the case of Trinidad. That takes care of the asset side of the balance sheet.
From this total, I then deduct all the liabilities to derive net collateral value per share.
In theory, when a stock trades below collateral value, an acquisitor could borrow this entire amount based on the collateral value of the assets currently on the balance sheet, buy up all of the shares and still have cash left over. No wonder investment bankers refer to this tactic as “buying a company, no money down.”
In the case of Trinidad Drilling, the collateral value calculation based on the June 30 balance sheet generates a value of $3.04 a share. This is below the tangible book value of $4.29 a share, but still well in excess of the recent stock price and the opening bid of $1.68 from Ensign Energy Services.
The press release from Ensign makes frequent reference to the fact that the cash offer is fully-funded. Well, of course it is: if the calculation of net collateral value is even remotely accurate, the net assets of Trinidad alone are more than enough to finance its own takeover.
Consolidation in the oil service sector is inevitable and desirable, and a combination of Ensign and Trinidad probably makes a good deal of business sense. To be realistic, the fact that Trinidad recently concluded its strategic review process without identifying a value-creating transaction suggests there was not overwhelming interest in their assets. Having said that, being taken out for cash at half of collateral value at a time when the industry fundamentals are improving does not hold any appeal for a value investor. In the absence of a significantly better offer from Ensign or another industry player, I will be content to remain a shareholder of an independent Trinidad Drilling.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.