Bargain Bin: U.S. Energy Equipment And Services Sector

I have noticed that names in the US Energy and Equipment sector seem to be declining even while energy prices and production volumes are increasing. This makes me start to wonder if their might be an opportunity or two in this sector for the new year. First to check out whether my impression was correct, I produced this chart comparing the iShares US Oil Equipment & Services (IEZ) with the Powershares Energy ETF (DBE).


Source: Yahoo Finance

I chose DBE specifically because I didn’t want to just focus on the price of domestic oil ‘WTI’ but also wanted to bring in natural gas and other energy commodities which can support demand for the equipment and services sector. As you see in the chart above, my hunch appears justified. Throughout 2016 until June 2017, the IEZ and DBE move roughly in unison; however, starting in July the two have become decoupled (IEZ is -20%, DBE +10%).

Next, I wanted to check what a favorite macro indicator for the sector, North American drill counts indicates.

Source: Baker Hughes Drill Count data

Drill counts climbed steadily from the summer of 2016 lows until August 2017 when they started leveling off. Just about the same time we started seeing the disparity between the IEZ and DBE. Energy prices have been climbing for the last 5 months, but drill counts and service provider stocks have stayed relatively flat.

That drill counts are in tune with energy equipment and service sector stocks, makes sense. What doesn’t is that energy prices are not in turn driving drill counts. At least not yet.

What may partial explain this phenomenon is the annual budget cycle. Remembering the 1st half of 2017 showed a relentless climb in drilling. Anecdotal evidence suggests many companies used up much of their approved capex budgets in the first half of the year, so by Q3 the cash available for drilling was getting restricted, and by the time Q4 rolled around there just wasn’t a lot of approved funds left.

Additionally, the nature of the business is cash flows out of the company up front to drill the well, but only starts to return after the drilling is complete and the oil and gas start to flow to market. Recovery of this cash thus is both delayed and happens over an extended period of time. This, too, may have created a pause. Before increasing drilling to the next level, drillers need to get more money from funders; funders who sometimes want to see the cash flow first. E.g. “I already gave you a bunch of money to fund new drilling. I’m not dipping back into my pocket, you need to make do with what you have, plus production profits from the new wells.”

Thus, while there are still plenty of profitable projects, demand supported by increasing exports, and improving prices for their output, drilling has been delayed pending the new capex budget and funding. Most companies start there next year budget in November, but don’t really get to a finished approved plan until the new year. Thus, to the extent this theory is true, the decoupling of drilling counts and service company stocks from energy prices may be a temporary phenomenon likely to start returning to the mean in late Q1 and Q2. If so, this would spark a significant rally in the energy service sector stocks.

Sector:

With the help of Intrinio.com I compiled a list of publicly traded companies in the sector along with some favorite ratios and statistics. There were 48 firms, so I needed reduce the list. Return on Invested Capital is one of the better measures of management effectiveness; what they have been able to do, with what they have been given. I limited that to a positive number, thereby culling my original list to roughly 1/3 its previous size.


Data Powered by Intrinio.com

Next, I decided to highlight in green those companies with an ROIC above 6% as being more attractive half. In other words, looking backward I wanted to favor managements who had been producing at least a 6% return on the capital they had been entrusted with.

Similarly, I decided to also highlight in green those companies on the list which had: EV/EBITDA < 10, EV/FCF < 15, P/E < 15, P/B < 1.3, and D/E < 0.7. The idea here was to a pick a level considered “decent” or “acceptable” which also caused roughly 1/3rd of each column to become green. Other users could of course choose their own limits. Finally, I counted the number of green cells, sorting first by that number and then by ROIC, and for information purposes, added in a Market Cap column. Readers may find it useful to look at the chart above and decide which opportunities are the most interesting for them.

In the mega-cap space, $10B+, Schlumberger (SLB) and Halliburton (HAL) look pretty close to each other. I think you can just throw a dart, I picked SLB.

In the large-cap space, $1B – $10B, McDermott (MDR), Diamond Offshore (DO), Rowan (RDC), and USA Compression (USAC) all looked interesting. I personally decided to throw out USAC because I already considered them previously when I researched companies in the gas compression sector. In my opinion, it’s a fine investment. However, I like ArchRock Partners (APLP) a bit better, and don’t need more than one company in gas compression. Of the three remaining names, MDR has both the highest number of green cells and the highest ROIC so I picked it.

In the small-cap arena, where I prefer to spend most of my time, I picked three names I chose Flotek (FTK). It has four greens, and fairly decent ROIC.

BriChem (OTC:BRYFF) was my top choice in the micro-cap arena. It comes out with 5 greens and what appears to me to be the best numbers on the entire list. I already follow it, writing most recently in the blog post “BriChem Refinance Should Increase Earnings By Over 50%”.

The high-yield name that seemed to stand out was Cypress Energy Partners (CELP). It not only had three greens, but a double digit ROIC, and sports a 12% dividend yield.

All five look the worthy of further due diligence. However the reality is that this further due diligence is much more likely to uncover hidden value in the smaller three names than the larger two. I weighed this five towards the smaller less well known names not because Halliburton, Diamond Offshore, or Rowan might not also be worthy investments, but rather because these larger firms are likely very well followed. When dozens of Wall Street analysts follow a firm, and dozens of funds own it, the chances of me finding anything meaningful that isn’t already priced is remote. I would even go so far as to say when I think I have found hidden value with firms of this size, it’s more likely I am missing something important, than Wall Street is.

To this point, I have identified a macro-economic environment which I think will favor a particular a sector in the near future, North American energy equipment and services. I then used intrinio.com to provide data on valuation (EV/EBITDA, EV/FCF, P/E), management effectiveness (NASDAQ:ROIC), and risk (D/E, P/B, Market Cap), in order to narrow down that sector down to a more manageable list of five names: Schlumberger, McDermott, BriChem, Flotek and Cypress. While I suspect one could do OK just putting a small percentage of one’s assets in each, the next step is to delve deeper into each stock. Comprehensive looks at five different stocks however would be much too long for one article. Therefore, for now, I will leave you with a brief synopsis of each, as well as a few links to existing articles by other authors.

Individual Company overview:

Schlumberger at $27.8B of annual revenue in 2016 is the behemoth of the energy services and equipment sector. Even number two Halliburton, $15.9B in 2016 revenue, is dwarfed by it. Schlumberger has been around since 1926, is headquarter in Houston, TX (like many in this industry), and operates worldwide. It provides: drill bits, drilling tools and equipment, drilling fluid and chemicals, reservoir characterization imaging and software, pressure and flow measurement systems, engineering, logistics, procurement, completion, stimulation, cementing, pumping, management systems, and probably a few other things. If it is in the energy equipment and services field, SLB can help. HFIR wrote about SLB recently in “Schlumberger Points To The ‘Paradigm Shift’ Taking Place”. SLB currently offers investors a 3.2% dividend yield.

McDermott, also located in Houston, provides design, engineering, procurement, construction, pipeline installation, and subsea systems for offshore energy projects. Orthodox Investor has written a number of articles on it. The latest being, “McDermott International: More Upside Despite Oil Weakness”. Interestingly, in, “New Stocks On Most Attractive/Most Dangerous Lists – July 2017” David Trainer of New Constructs pointed out a number of changes to MDRs financials which may indicate the ROIC quoted above may be overstated. Anyone performing further due diligence on the stock would want to look into these adjustments further to see whether they felt them justified.

BriChem is a company which supplies drilling mud and drilling mud chemicals. I follow it pretty closely for Cash Flow Kingdom members. Publicly the last article I published was, “Drill Baby Drill: Bri-Chem Earnings Preview And Forecast Update”, but there is also a more timely blog post, “BriChem Refinance Should Increase Earnings By Over 50%”, available. I can tell you in addition to having some of the most attractive valuation and Return on Invested Capital numbers in the chart above, this name has both been growing significantly, and is highly likely to continue doing so in the near future. EBITDA, earnings and cash flow more than doubled in the last year. There recent refinance of some key debt not only takes one of the biggest risks off the table, but will increase earnings and cash flow significantly. If you are open to owning a micro-cap stock, this is one you should look in to.

Flotek is yet another Houston based company. Interestingly it provides drilling mud chemistries under the Complex nano-Fluid brand name, and citrus oils for food and beverage companies. The latest earnings released talked about hurricanes affecting it, not so much due to Harvey’s impact on the gulf coast energy market as Irma’s impact on Florida citrus production. Another quote from that release referred to “tightness in horsepower availability” becoming a limiting factor in the industry which is a positive indicator for companies like APLP and USAC. This one is sparking my interest enough, and is obscure enough, that I will probably look into it further. No one has written anything on it in the last 9 months, though Michael Filloon appears to have followed it at one time, even making it his top stock pick at one time.

Cypress Energy Partners is another stock which interests this author. It is an MLP involved in pipeline inspection and hydrostatic testing, as well as saltwater injection, flowback and disposal services. It cut its dividend last year, which contrary to many increases my interest in learning more, rather than less. There haven’t been any public reports on it recently, but Value Digger follows it for his Value Stock Investor’s Stock Club members. CELP currently has a 12% dividend yield, but I would need to look into the cash flows and business more before deciding whether that is now sustainable.

Conclusion:

You will note the much lower coverage of the last three companies on the list. This in and of itself makes it more likely we could find hidden value which produces outsized returns. Cash Flow Kingdom members, can expect more in depth analysis, articles and/or blog posts from this author on BriChem, Flotek, and Cypress Energy Partners. Schlumberger and McDermott are less likely but also possible (if I can find anything to say which hasn’t already been said). After a respectable delay, I will make this analysis available publicly either through articles and/or blog posts. Please follow me to receive notice of when each of these articles or blog posts becomes available. It is my understanding that the only way to receive notice of blog posts such as, “BriChem Refinance Should Increase Earnings By Over 50%”, is by leaving the get email alerts box checked when clicking the follow button.

Disclosure: I am/we are long BRYFF, APLP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article covers a number of risky investments, some of which are thinly traded micro-caps. I do not know you: your goals, risk tolerance, or particular situation. Therefore, I cannot recommend this or for that matter any investment to you. Please do your own further due diligence.

Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

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