Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
Last June, I profiled Calgary-based oil service company Xtreme Drilling Corp. because the company chose to return excess cash to its shareholders through an unusual process known as a Dutch auction. Shareholders who tendered to the auction received $2.40 a share in cash and the company reduced the share count from 85 million to 75 million.
I chose not to tender my shares to the auction because the book value per share was close to $4 and the quarterly revenue trend suggested that the industry fundamentals were slowly improving. As I said at the time, I am a patient investor and Xtreme Drilling appears to be a survivor.
With the stock now trading at about $2.10, the market clearly disagreed with my initial assessment, but my enthusiasm for the stock remains in place as it now appears on a classic value screen – stocks trading below net collateral value per share – plus industry fundamentals continued to improve during the third quarter.
Dealing first with this method of valuation, I suggested in a recent column that Ben Graham's iconic net-net working capital screen suffered from a major defect: The assumption that all current assets (cash, accounts receivable and inventory) can be sold for 100 cents on the dollar before deducting all liabilities to derive net-net working capital. I proposed that assets should be weighted according to the collateral value that a lender would apply in such a situation.
Not all companies trading below net collateral value are candidates for a takeover, but the numbers do make it feasible for an acquirer to buy the company with no money down as long as the lender accepts the collateral value assumptions.
My weightings are 100 cents on the dollar for cash, 75 cents for receivables, 50 cents for inventory and 100 cents for the net depreciated book value of fixed assets. This last assumption is the weak spot in this version as it depends on the age and nature of those fixed assets. For example, an old economy steel plant is more likely to be an environmental liability than a source of collateral value, so this item should always be the focus of additional research.
David Sandel of Simcoe Capital in New York was sufficiently intrigued by my article on net collateral value that he ran the screen on his own database and sent me the output. Of the 40 names that passed the screen, 27 of them are involved in the energy sector, either as a contract driller, oil and gas producer or tanker fleet operator. Either the energy sector contains the deepest value stocks in the market or the collateral value of their fixed assets is vastly overstated!
Unlike the net-net working capital screen, which tends to throw up thinly traded microcap stocks, the collateral value screen features NYSE-listed stocks with a market cap in excess of $1-billion (U.S.), such as Transocean Ltd., Diamond Offshore Drilling Inc. and Rowan Companies PLC. The sole Canadian name to appear on this list is Xtreme Drilling with a collateral value of $216-million (Canadian) and a market cap of $160-million.
The company only has $30-million of current assets in the collateral value, so the attraction of the stock is very sensitive to the value of the fixed assets, which are primarily drilling rigs. Based on the current large spread between the company market value and the collateral value, an acquirer would still be at break even even if the collateral value of these rigs were, by my calculations, only 70 cents on the dollar. On the face of it, we have a reasonable margin of safety.
By chance, the third-quarter report provides some insight into this topic. During the quarter, Xtreme Drilling sold some older technology rigs that were no longer core to its future strategy for $9.2-million and recorded a loss of $3.2-million on the transaction, which implies that these older rigs were sold for 74 per cent of net book value. This is more than the 70 per cent needed for break even and the remaining rigs on the balance sheet are newer and higher tech, so we can be confident that the collateral value is in the ballpark.
Finally, as evidence of improving momentum, the third-quarter commentary states that operations were at the highest level since the fourth quarter of 2015, the backlog is increasing and the rig fleet is ideally suited to focus on deeper U.S. basins with complex well designs.
Xtreme Drilling appears to be a deep value stock with positive industry momentum. This is typically a winning combination, which explains why I remain not only patient but also more optimistic than at the time of the Dutch auction.