AKITA Drilling Ltd. AKT.A
December 23, 2010 - 11:53am EST by
golfer23
2010 2011
Price: 9.45 EPS $0.00 $0.00
Shares Out. (in M): 18 P/E 0.0x 0.0x
Market Cap (in $M): 170 P/FCF 0.0x 0.0x
Net Debt (in $M): -59 EBIT 0 0
TEV ($): 111 TEV/EBIT 0.0x 0.0x

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Description

[This was my application idea and while it was written a few weeks ago, the opportunity remains depite the recent rise.  For better printing results, on the print preview select landscape and shrink to fit at 70%.]
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A Tribute to a Modern Day Hachiko

There is a little known company that makes its home in Calgary, Alberta Canada.  It is named after a Japanese dog breed and while I doubt anyone at the company was ever directly inspired by the famous akita Hachiko, the company clearly demonstrates a loyalty to several managing principles that is reminiscent of the loyalty of that devoted canine.  While I'll get to the money making part in due course, first the quick story of the dog.  

Hachiko, who now lies stuffed in the National Science Museum of Tokyo, became a national symbol of loyalty in Japan in the 1920's and 30's.  Upon the death of his owner, Hachiko devoutly returned to the Shibuya Train Station where he had met his owner each day before his death.  Hachiko didn't do this for just a few days.  He did it for nine years!  The now long-famous dog has since inspired a bronze statue, an annual ceremony, films and books.  Hachiko's story is a story of loyalty.

The story of AKITA Drilling Ltd. (TSX: AKT.A; OTCPK: AKTAF), on the other hand, is not only about loyalty but also making money.  The C$160 million company is named after that breed of dog to which Hachiko belonged, and has been listed in Toronto since its spin-off from ATCO Ltd. in the early-to-mid 1990's.  AKITA is an oil and gas drilling contractor that primarily conducts its business in western Canada.  While the company performs drilling operations for oil, heavy oil, and potash, the fortunes of the company are highly levered to natural gas.  The company, which operates wholly-owned and partner-owned rigs, owns 39 gross and 37.225 net drilling rigs.  The company has a wide-range of rigs and can service oil and gas companies seeking to drill at multiple depths and can provide horizontal and pad drilling.  While the majority of the company's rigs service western Canada, the company has serviced customers in the lower 48 and Alaska.  However, at the moment, these ancillary markets are a minor part of the company's business.

While there are many unique aspects to the company, the one that immediately jumps out at a potential investor is the company's balance sheet.  In atypical fashion, the company is debt free.  In an industry which freely borrows to support rig construction, that is rare.  In fact, when you look at the history of the company, the company reported positive net debt (i.e. more debt than cash) in only five quarters since the end of 1995.  That was in 2001 and early 2002 when the company last heavily invested in rig construction and at the time the heavy investments were secured by long-term contracts to utilize the new equipment.  I would argue, generally speaking, that the company has managed and continues to manage its balance sheet quite well for the industry in which it operates.

The company's management team, which has mostly been with the company since it was founded in the late 1970's, appears to be committed to operating in a somewhat counter cyclical manner.  As I mentioned, the last wave of rig construction took place starting in 2000, not when natural gas prices were pushing $13 per MmBtu.  Interestingly, the company currently believes now is another opportune time to be spending money and with its balance sheet is has the wherewithal to do so.  The balance sheet boasts nearly $60 million in cash and no debt.  

AKITA is in the process of converting many of their drilling rigs, mostly deeper though some shallow, to pad rigs.  Pad rigs are more mobile rigs which allow for an assembly line-like drilling of prospects.  Right now there is quite the demand for these rigs, which stands in stark contrast to the market for traditional rigs in western Canada.  In fact, the company just announced an agreement to build a new pad rig which I estimate will cost between $15 and $20 million.  The company has perhaps five or six more rigs that it could convert to pad rigs.  Each of these conversions costs approximately $5 to $6 million.  As you might imagine, having the ability to convert older rigs at an incremental cost of 1/3 the price of a new pad rig is potentially appealing to the market.  AKITA, which doesn't focus on IRR's on its assets, but instead focuses on payback periods, looks to secure most, if not all, conversions and new builds with long-term contracts.  It targets four or five year paybacks on new builds and slightly more aggressive targets on conversions (this would suggest at the low end perhaps an incremental $3 million in after-tax cash flows over the next five years from the recently announced deal).  I wouldn't be surprised to see the company continue to spend heavily on pad conversions.  The company has indicated that by the end of 2010 eleven rigs will have been converted to pads.  With one additional conversion in process and five or six more that could be converted, AKITA's fleet could be nearly 50% pad rigs in the not so distant future.  I think this is changing the outlook for the businesses, especially in this difficult operating environment.

The western Canada rig market currently has approximately 840 rigs.  This gives AKITA a rig market share of approximately 4%.  While this is not a large number, in the pad rig business the company is reportedly a much larger player.  Management at AKITA estimates the western Canada pad rig market to be in the 30's, which would suggest a market share in this business of approximately 30%.  

As you might imagine, the current market for drilling natural gas in Canada is not robust.  Below is a long-term picture of the active Canada rig count presented by Baker Hughes.  While 2010 has shown quite a recovery from 2009, the market remains far from its highs.
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Baker Hughes Rig Count      

 

         
Candaian Market                    
  2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
JAN 502 539 405 478 554 550 660 568 494 377 459
FEB 544 562 433 554 568 593 715 635 620 413 564
MAR 394 445 311 449 462 420 620 392 408 196 386
APR 146 217 121 151 153 183 198 101 106 74 123
MAY 189 238 114 150 187 247 240 107 135 72 147
JUN 301 302 205 308 265 293 408 210 266 125 229
JUL 308 319 266 398 351 450 553 349 435 175 350
AUG 319 325 235 404 353 545 482 343 449 178 387
SEP 314 317 250 348 273 497 446 351 435 208 347
OCT 353 304 220 394 372 541 431 338 446 244 398
NOV 362 266 281 412 447 600 432 371 417 277  
DEC 410 264 348 417 440 575 456 360 361 313  
AVG 345 342 266 372 369 458 470 344 381 221  

The following natural gas price chart (www.tradingeconomics.com) provides, in addition to the credit disruptions of the last few years, a good explanation as to the current state of affairs in the drilling business.  

[Was not able to include chart, however the recent changes in natural gas pricing should be fairly well understood to this audience]

This environment has put extreme pressure on rig utilization in western Canada.  The accompanying table presents rig utilization for the industry and for AKITA.  It would appear that there are three primary conclusions that can be drawn.  First, industry wide utilization is far below the 10 year average.  Second, AKITA seems to outperform the industry in terms of utilization.  And, three, AKITA's opportunity in pad rigs, as reflected in the recent disclosure of the utilization of those particular rigs, seems intriguing.
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AKITA Drilling Ltd.        
Rig Utilization vs. Industry        
               
          AKITA Detailed Utilization  
               
  Year AKITA Industry   Conventional Pad  
               
  2010 YTD 36.5 31.9        
  2009 31.1 24.8   23.7 59.5  
  2008 42.2 41.7        
  2007 40.9 37.0        
  2006 56.6 55.1        
  2005 59.3 58.8        
  2004 52.2 52.9        
  2003 54.7 53.1        
  2002 46.8 39.2        
  2001 56.9 53.0        
  2000 60.0 55.2        
               
    00 - 09 Avg 50.1 47.1        
               

As you might next imagine, this state of affairs, especially given the high fixed costs of the business, has led to pricing issues.  The following set of tables shows what the last few years have looked like for AKITA.  Generally speaking, operating margin per operating day has been under a fair amount of pressure.  This is in spite of the fact, in AKITA's case, that the company has gradually been becoming more of a pad rig player where utilization and pricing has been much stronger.  
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AKITA Drilling Ltd.         AKITA Drilling Ltd.      
Revenue per Operating Day         Operating Margin Dollars per Operating Day  
  2006 2007 2008 2009 2010     2006 2007 2008 2009 2010
Q1 $22,911 $24,661 $23,012 $24,923 $19,539   Q1 $9,984 $10,596 $9,746 $9,890 $6,788
Q2 $19,993 $23,412 $21,665 $29,604 $22,173   Q2 $8,880 $9,708 $7,346 $11,477 $7,455
Q3 $21,003 $20,755 $19,723 $21,018     Q3 $8,885 $6,834 $7,747 $6,061  
Q4 $22,912 $22,595 $23,212 $21,840     Q4 NA $9,390 $6,739 $7,713  
AVG $21,705 $22,856 $21,903 $24,346     AVG $9,250 $9,132 $7,895 $8,785  
                         
AKITA Drilling Ltd.         AKITA Drilling Ltd.      
Operating and Maintenance Costs per Operating Day   Operating Margin per Operating Day    
  2006 2007 2008 2009 2010     2006 2007 2008 2009 2010
Q1 $12,927 $14,065 $13,266 $15,033 $12,751   Q1 43.58% 42.97% 42.35% 39.68% 34.74%
Q2 $11,113 $13,704 $14,319 $18,127 $14,718   Q2 44.42% 41.47% 33.91% 38.77% 33.62%
Q3 $12,118 $13,921 $11,976 $14,957     Q3 42.30% 32.93% 39.28% 28.84%  
Q4 NA $13,205 $16,473 $14,127     Q4 NA 41.56% 29.03% 35.32%  
AVG $12,053 $13,724 $14,009 $15,561     AVG 43.43% 39.73% 36.14% 35.65% 34.18%


Accounting Can Be Important

As with any capital intensive business, depreciation is a significant factor.  For instance, over the last ten years depreciation has represented, on average, 15.2% of AKITA's revenues and 17% of its total costs.  This makes the assumptions which drive depreciation quite important.  What is particularly interesting and illuminating when it comes to assessing management is that the company depreciates its rigs over 2,000 operating days (the company does also depreciate five rigs over 3,600 days).  According to my work, this is far faster than most drillers in the industry.  See the chart below for a sample of what the industry uses for depreciation rates.
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AKITA Drilling Ltd          
Comparable Company Depreciation Rates          
             
             
  Company Low High Method Additional Notes  
             
  Cathedral Energy Services Ltd. 4 yrs 10 yrs declining balance    
  Total Energy Services Inc. 5 yrs 15 yrs straight line    
  Ensign Energy Services Inc. 3,650 days   unit of production on rigs  
  Tuscany International Drilling Inc. 10 yrs   straight line    
  Precision Drilling Corporation 5,000 days   unit of production    
  Technicoil Corp. 2 yrs 15 yrs straight line  more geared toward well servicing  
  Nabors Industries Ltd. 4,900 days   unit of production on rigs, not jack-ups  
  Trinidad Drilling Ltd. 4,200 days   unit of production on rigs only  
  AKITA Drilling Ltd. 2,000 days 3,600 days unit of production just 5 of 37.225 net rigs at 3,600  
  Xtreme Coil Drilling Corp. 5,000 days   unit of production slightly different tech  
  Savanna Energy Services Corp. 1,500 days 4,125 days unit of production    
  Helmerich & Payne Inc. 4 yrs 15 yrs straight line includes contract drilling equipment  
  Patterson-UTI Energy Inc. 2 yrs 15 yrs straight line includes other equipment  
  Unit Corp. 15 yrs   unit of production rates starting at 15 yrs  
  Rowan Companies Inc. 12 yrs 15 yrs straight line    
  Pioneer Drilling Co. 3 yrs 25 yrs   rigs and equipment  
  Parker Drilling Co. 15 yrs 20 yrs   land drilling equipment  
  Union Drilling, Inc. 2 yrs 12 yrs   includes related equipment  
  Bronco Drilling Co. Inc. 3 yrs 15 yrs   includes related equipment  
             

                                               
While it is certainly difficult to compare each of these companies, especially when several companies have chosen to use a different depreciation method than AKITA and several companies do little more than disclose a range for their entire rig segment (which often includes non-rig ancillary equipment which tends to be depreciated much faster), the table suggests AKITA depreciates its rigs far faster than many in the industry.  In fact, you could say that it depreciates its rigs nearly twice as fast, when operating, as many in the industry.  This obviously has a large impact on earnings.
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Below is a chart showing net income, cash flow from operations and estimated free cash flow (excluding growth cap ex):
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AKITA Drilling Ltd.                
Cash Flow vs. Net Income                
                       
                       
  Year Net Income   CF From Operations CF - NI CF / NI   Cap Ex CF - Cap Ex CF / NI  
                       
  31-Dec-09 $8,380,000   $29,235,000 $20,855,000 3.49 x   ($12,341,000) $16,894,000 2.02 x  
  31-Dec-08 $14,847,000   $19,367,000 $4,520,000 1.30 x   ($19,567,000) ($200,000) -0.01 x  
  31-Dec-07 $20,752,000   $38,876,000 $18,124,000 1.87 x   ($40,948,000) ($2,072,000) -0.10 x  
  31-Dec-06 $33,755,000   $61,152,000 $27,397,000 1.81 x   ($49,698,000) $11,454,000 0.34 x  
  31-Dec-05 $29,264,000   $37,490,000 $8,226,000 1.28 x   ($25,325,000) $12,165,000 0.42 x  
  31-Dec-04 $20,875,000   $25,663,000 $4,788,000 1.23 x   ($15,308,000) $10,355,000 0.50 x  
  31-Dec-03 $18,822,000   $32,764,000 $13,942,000 1.74 x   ($17,261,000) $15,503,000 0.82 x  
  31-Dec-02 $14,345,000   $25,335,000 $10,990,000 1.77 x   ($5,831,000) $19,504,000 1.36 x  
  31-Dec-01 $17,889,000   $29,368,000 $11,479,000 1.64 x   ($70,459,000) ($41,091,000) -2.30 x  
  31-Dec-00 $11,157,000   $14,745,000 $3,588,000 1.32 x   ($34,649,000) ($19,904,000) -1.78 x  
  31-Dec-99 $5,211,000   $5,074,000 ($137,000) 0.97 x   ($7,670,000) ($2,596,000) -0.50 x  
  31-Dec-98 $12,907,000   $11,875,000 ($1,032,000) 0.92 x   ($7,832,000) $4,043,000 0.31 x  
  31-Dec-97 $11,363,000   $22,309,000 $10,946,000 1.96 x   ($15,372,000) $6,937,000 0.61 x  
  31-Dec-96 $7,113,000   $8,144,000 $1,031,000 1.14 x   ($3,760,000) $4,384,000 0.62 x  
  31-Dec-95 $6,053,000   $6,770,000 $717,000 1.12 x   ($3,655,000) $3,115,000 0.51 x  
                       
        Total $135,434,000       $38,491,000    
        15 Year Average $9,028,933       $2,566,067    
        5 Year Average $15,824,400       $7,648,200    
                       
 
 
AKITA Drilling Ltd.            
Cash Flow vs. Net Income            
                 
                 
  Year Yr End Rigs Per Rig Maint Cap Ex Maint Cap Ex Est FCF Est FCF - NI Est FCF / NI  
                 
  31-Dec-09 39 $175,000 $6,825,000 $22,410,000 $14,030,000 2.67 x  
  31-Dec-08 41 $169,750 $6,959,750 $12,407,250 ($2,439,750) 0.84 x  
  31-Dec-07 42 $164,658 $6,915,615 $31,960,385 $11,208,385 1.54 x  
  31-Dec-06 40 $159,718 $6,388,711 $54,763,289 $21,008,289 1.62 x  
  31-Dec-05 38 $154,926 $5,887,197 $31,602,803 $2,338,803 1.08 x  
  31-Dec-04 37 $150,278 $5,560,303 $20,102,697 ($772,303) 0.96 x  
  31-Dec-03 36 $145,770 $5,247,724 $27,516,276 $8,694,276 1.46 x  
  31-Dec-02 36 $141,397 $5,090,292 $20,244,708 $5,899,708 1.41 x  
  31-Dec-01 36 $137,155 $4,937,583 $24,430,417 $6,541,417 1.37 x  
  31-Dec-00 32 $133,040 $4,257,294 $10,487,706 ($669,294) 0.94 x  
  31-Dec-99 30 $129,049 $3,871,477 $1,202,523 ($4,008,477) 0.23 x  
  31-Dec-98 30 $125,178 $3,755,332 $8,119,668 ($4,787,332) 0.63 x  
  31-Dec-97 30 $121,422 $3,642,672 $18,666,328 $7,303,328 1.64 x  
  31-Dec-96 28 $117,780 $3,297,833 $4,846,167 ($2,266,833) 0.68 x  
  31-Dec-95     $2,800,000 $3,970,000 ($2,083,000) 0.66 x  
                 
        Total   $59,997,217    
        15 Year Average $3,999,814    
        5 Year Average $9,229,145    
                 
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When you look at the difference between cash flows and net income and you contemplate the different accounting assumptions, perhaps AKITA is more profitable than it first appears.  The five year average cash flow from operations and more importantly FCF (excluding growth capital expenditures) significantly exceeds reported net income.  The company simply operates from the perspective that is should never have to write-down the value of its equipment.

In 2011 the company, as most Canadian companies are doing, is converting from Canadian GAAP to IFRS.  This could serve as a possible catalyst for a change in the manner in which the company records and depreciates its rigs.  The company recognizes the growing disparity between net income and cash flow.

Valuation

AKITA is currently trading at approximately 80% of tangible book value.  Given the company's aggressive depreciation rates, it is safe to assume that the tangible value of its assets is at least book value.  I think there is a case to be made that it is significantly more than stated book value.

In his 2009 shareholder letter, Mr. Ruud, the company's Chief Executive Officer noted:

"As well, the carrying value for the Company's fleet was only $142.2 Million ($3.7 Million per rig).  Although an evaluation of replacement cost for AKITA's fleet has not been performed, management is confident that the cost to replace the Company's fleet is significantly higher than its carrying value."

While it is somewhat tough to find exact comparables in an industry where it is all about the nature of a particular rig or fleet of rigs, a recent transaction provides at least some scope for Mr. Ruud's claims.  In May of this year, CanElson Drilling Inc. acquired Totem Drilling Ltd. which operated rigs in the south east of Saskatchewan.  The company's primary focus was on the Bakken play.  The fleet consisted of 5 double rigs with one additional rig on order and CanElson paid $40 million in cash and stock and assumed approximately $12 million in debt.  The implied price per rig was approximately $8.5 to $10 million, the implied P/BV was 2.0 x and the implied EV/EBITDA was 15.5 x.  Certainly rigs are different and certainly Totem was about to increase the size of its fleet by 20%, but the transaction at the very least provides a frame of reference.

While AKITA is certainly not a household name, it has in the past received its due share of respect in the marketplace.  The charts below show how AKITA has been valued in the past.  It is important to note, in my opinion, where it has traded in better operating environments.  

[chart could not be provided; while you can look it essentially shows that the company has traded between 1 x and 3.5 x in relation to TBV over its public history]

While it would be improper to suggest that the company could trade at the multiples it did in 2005 through 2007, it is important to realize that in a stronger operating environment this company has traded at significant premiums to book value.

It also is illustrative to look at where other drilling companies are trading.  Below is a chart for Canadian drillers and one for US drillers.  The US chart includes offshore drillers, which, while a somewhat different business, is provided for reference.
 
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AKITA Drilling Ltd                      
Driller Comparables                      
Canada                      
                       
16-Nov-10                      
                       
Company Ticker Cap Revenue EBITDA Debt Cash Debt/Equity Debt/EBITDA EBITDA Margin P/TBV EV/EBITDA
                       
Cathedral Energy Services Ltd. TSX: CET $257 $136 $25 $49 $1 47.40% 2.64 18.33% 3.03 12.23
Total Energy Services Inc. TSX: TOT $346 $176 $48 $79 $0 41.83% 1.84 27.20% 1.85 8.88
Ensign Energy Services Inc. TSX: ESI $1,864 $1,230 $281 $138 $82 8.81% 0.12 22.87% 1.19 6.82
Tuscany International Drilling Inc. TSX: TID $239 $15 -$2 $51 $11 33.08% NM -16.09% 1.51 NM
Precision Drilling Corporation TSX: PD $2,066 $1,280 $383 $684 $209 26.13% 1.52 29.89% 1.21 7.30
Technicoil Corp. TSX: TEC $93 $78 $19 $0 $2 0.00% 1.39 24.08% 1.29 4.88
Nabors Industries Ltd. NBR $6,073 $3,695 $1,121 $4,509 $772 86.59% 2.59 30.33% 1.28 10.02
Trinidad Drilling Ltd. TSX: TDG $597 $609 $175 $574 $12 62.77% 2.97 28.68% 0.78 6.63
AKITA Drilling Ltd. TSX: AKT.A $159 $104 $25 $0 $59 0.00% NM 23.67% 0.79 4.04
Xtreme Coil Drilling Corp. TSX: XDC $215 $89 $24 $35 $3 13.30% 0.88 26.32% 0.84 10.50
Savanna Energy Services Corp. TSX: SVY $456 $388 $67 $105 $6 13.39% 2.21 17.14% 0.59 8.35
Stoneham Drilling Trust TSX: SDG.UN $69 $92 $26 $53 $0 49.57% 4.29 28.12% 0.65 4.71
                       
                       
  Average $1,036 $658 $182 $523 $96 31.91% 2.04 21.71% 1.25 7.67
  Median $301 $156 $37 $66 $9 29.61% 2.02 25.20% 1.20 7.30
                       
  Min $69 $15 -$2 $0 $0 0.00% 0.12 -16.09% 0.59 4.04
  Max $6,073 $3,695 $1,121 $4,509 $772 86.59% 4.29 30.33% 3.03 12.23
                       
   
AKITA Drilling Ltd                      
Driller Comparables                      
United States                      
                       
16-Nov-10                      
                       
Company Ticker Cap Revenue EBITDA Debt Cash Debt/Equity Debt/EBITDA EBITDA Margin P/TBV EV/EBITDA
                       
Diamond Offshore Drilling Inc. DO $9,447 $3,373 $1,885 $1,496 $986 40.01% 0.32 55.88% 2.53 5.28
Royale Energy Inc. ROYL $21 $12 $3 $3 $3 23.75% NM 22.95% 2.03 7.43
Helmerich & Payne Inc. HP $4,758 $1,875 $709 $360 $63 12.82% 0.42 37.83% 1.76 7.95
Transocean Ltd. RIG $21,106 $10,149 $4,731 $12,861 $4,668 61.14% 1.78 46.62% 1.65 6.19
Atwood Oceanics, Inc. ATW $2,276 $651 $359 $230 $181 16.79% 0.14 55.24% 1.75 6.86
Patterson-UTI Energy Inc. PTEN $3,090 $1,171 $398 $100 $74 4.69% NM 33.97% 1.50 7.83
Noble Corp. NE $9,198 $3,104 $1,808 $2,762 $367 39.04% 0.00 58.26% 1.30 6.48
Unit Corp. UNT $1,918 $807 $399 $137 $1 8.14% 0.21 49.50% 1.19 5.14
Pride International Inc. PDE $2,066 $1,376 $375 $1,872 $640 42.00% 0.68 27.25% 1.25 7.30
Rowan Companies Inc. RDC $3,751 $1,760 $585 $1,684 $893 45.72% 0.32 33.23% 1.02 7.77
Pioneer Drilling Co. PDC $374 $420 $78 $283 $17 70.99% 2.98 18.62% 0.99 8.19
Parker Drilling Co. PKD $475 $662 $143 $469 $47 78.28% 2.05 21.61% 0.79 6.27
Union Drilling, Inc. UDRL $126 $175 $23 $38 $0 18.71% 0.26 13.32% 0.63 7.02
Vantage Drilling Company VTG $471 $232 $68 $1,100 $117 140.75% 13.39 29.38% 0.60 21.33
Bronco Drilling Co. Inc. BRNC $134 $111 $3 $8 $7 2.79% 3.77 2.67% 0.43 278.82
Hercules Offshore, Inc. HERO $310 $662 $124 $879 $135 93.94% 5.41 18.80% 0.33 8.48
Seahawk Drilling, Inc. HAWK $104 $97 ($65) $18 $41 4.71% NM -66.55% 0.27 NM
                       
                       
  Average $3,507 $1,567 $684 $1,429 $485 41.43% 2.27 26.98% 1.18 24.90
  Median $1,918 $662 $359 $360 $74 39.04% 0.55 29.38% 1.19 7.37
                       
  Min $21 $12 ($65) $3 $0 2.79% 0.00 -66.55% 0.27 5.14
  Max $21,106 $10,149 $4,731 $12,861 $4,668 140.75% 13.39 58.26% 2.53 278.82
                       
                                                                                            
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While it is difficult to make substantive relative value conclusions based on the survey presented, it might be fair to say at the very least that given AKITA's balance sheet and operating performance, the company is not overvalued relative to its peers.  In this author's opinion, given AKITA's depreciation decisions, balance sheet and operating performance, AKITA is in fact at a fair discount to its peers.

So at the end of the day what is AKITA worth and what rates of return could an investment at these prices produce?  At current prices AKITA is trading, net of cash, at approximately 21 times trailing-twelve-month earnings (earnings which I've suggested could be overburdened by excess depreciation charges).  To put that in perspective, the company is also trading at less than 3 times peak trailing-twelve-month net earnings which were achieved in June 2006.  In that year gas prices hit $14 per MmBtu and the company had one additional gross rig.

The exhibit below looks at several valuation scenarios based on replacement cost and long-term earnings.
  
-
AKITA Drilling Ltd.                
Valuation Possibilities                
                     
  By Replacement Cost / Rig                
                     
                     
  Replacement Cost Est.   3,500,000   6,000,000   9,000,000    
                     
  Number of Net Rigs   37.225   37.225   37.225    
                     
     Total Replacement Cost $130,287,500   $223,350,000   $335,025,000    
                     
  Net Cash     $60,000,000   $60,000,000   $60,000,000    
                     
     Total Replacement Cost $190,287,500   $283,350,000   $395,025,000    
                     
  Shares Outstanding   18,040,513   18,040,513   18,040,513    
                     
     Total Replacement Cost per Share $10.55   $15.71   $21.90    
                     
                     
  By Multiple to Long-Term Earnings              
                     
  Multiple to Earnings   10.00 x   12.00 x   15.00 x    
                     
  10 Year Average Earnings ^ $19,723,000   $19,723,000   $19,723,000    
                     
     Earnings Value   $197,230,000   $236,676,000   $295,845,000    
                     
  Net Cash     $60,000,000   $60,000,000   $60,000,000    
                     
     Total Value   $257,230,000   $296,676,000   $355,845,000    
                     
  Shares Outstanding   18,040,513   18,040,513   18,040,513    
                     
     Total Value per Share   $14.26   $16.44   $19.72    
                     
                     
  ^ 10 Year Average Earnings includes the years 2001 through 2009 and the LTM as reported through Q3 2010  
                     

Presented below is are two exhibits that looks at return possibilities based on changes in book value and multiples to book value over the next five years.  The first extrapolates long-term book value growth into the future and the other provides a reduced book value growth rate to reflect a protracted poor drilling market.

-
AKITA Drilling Ltd.                
Return Possibilities                
                   
        + 1 YEAR + 2 YEAR + 3 YEAR + 4 YEAR + 5 YEAR  
                   
  Implied Future Book Value $11.00 $11.55 $12.13 $12.73 $13.37 $14.04  
  Reduceed Avg BV Growth   5.00% 5.00% 5.00% 5.00% 5.00%  
                   
  Multiple to BV     1.00 x 1.00 x 1.00 x 1.00 x 1.00 x  
  Share Price   -$9.00 $11.55 $12.13 $12.73 $13.37 $14.04  
  IRR     28% 16% 12% 10% 9%  
                   
  Multiple to BV     1.50 x 1.50 x 1.50 x 1.50 x 1.50 x  
  Share Price   -$9.00 $17.33 $18.19 $19.10 $20.06 $21.06  
  IRR     92% 42% 29% 22% 19%  
                   
  Multiple to BV     2.00 x 2.00 x 2.00 x 2.00 x 2.00 x  
  Share Price   -$9.00 $34.65 $36.38 $38.20 $40.11 $42.12  
  IRR     285% 101% 62% 45% 36%  
                   

Potential Risks

Investing in the common stock of a contract drilling company, even one trading at such a discount to replacement cost and book value is still not without its risks.  The following are a sample:

- The company is certainly levered to natural gas pricing.  Since the summer of 2007 the price for natural gas has declined considerably.  This has put pressure on exploration and development drilling, especially in traditional gas drilling.  A continued poor pricing environment for natural gas will not produce an ideal operating environment for the company.  Cash flows, while currently significantly positive, may face continued pressure.

- AKITA is a relatively small player, even in the western Canada drilling market.  As mentioned, the company has an approximate 4% share of the market.  Larger players like Nabors and Precision may get aggressive in a tough market looking to gain market share or push other players out of business.  At the very least they could "throw their weight around."

- Included in the rig fleet that AKITA maintains are several older rigs that the company admits are more marginable.  These rigs present concerns not only about the duration of cash flow particular to them, but also valuation metrics based on average rig market price or replacement cost.


Other Considerations

Ownership

AKITA is governed by a two class share structure.  The more liquid class of shares is the A shares, which carry no voting rights.  While the voting class B shares are traded, they are much less liquid and are controlled by Sentgraf Enterprises.  Sentgraf is controlled by Mr. Ronald Southern who is deputy chairman of the company.  In total Sentgraf owns a 32.73% economic interest in the company.  Mr. Southern is also the chairman and CEO of ATCO and its major shareholder.  Through Sentgraf he owns 31.66% of that $3.3 billion company.  

While there is certainly interested ownership on the board of directors, the company is clearly controlled by Mr. Southern.  Without any voting rights, shareholders are completely dependent on Mr. Southern for his stewardship of the company.  Mr. Southern is 79 years old and is the founder of ATCO, the former parent of AKITA.

Related Party Transaction

The company discloses a fairly sizable related party transaction.  Each year the company pays several hundred thousand dollars ($325,000 in 2009) as sponsorship and advertising to Spruce Meadows, which is controlled and founded by the Southern family.  Spruce Meadows hosts international horse jumping competitions and other events in Calgary.  While I don't condone such arrangements, given the status of the events and their importance to the area I am willing to tolerate it.  The company makes the case that while it may be pricy it does provide them an opportunity to entertain a great number of customers and potential customers.  

Dividend and Buyback

At current prices, the company shares yield approximately 3.1%.  The company has paid a dividend since 1996.  Given the current level of cash flows, there appears to be adequate capacity to continue to pay the dividend even in an environment of continued poor natural gas pricing.

The company does have a buyback authorization in place through a normal course issuer bid.  AKITA has a history of authorizing the buybacks, though rarely have they been utilized to their full extent.  In the second quarter of 2010 the company repurchased $1.3 million worth of shares, though conversations with management suggest this is not a priority at this time.

Commodity Pricing

It is perhaps foolhardy to predict where natural gas and oil prices will be in the future.  Given the developments in the US shale business over the last several years, perhaps the gas industry is in for a prolonged period of lower prices.  

Natural gas companies however do have to earn an economic return to justify their existence.  Of the individuals operating in that business that I respect, Ken Peak at Contango Oil & Gas is probably at the top.  In a late 2009 presentation entitled "The Big Lebowski and the Zen of E&P" he stated:

"I think the industry needs $6.00/mcfe to earn a 5-10% ROR"

While it is perhaps impossible to predict prices, it is not impossible to predict that the natural gas industry will at least need to generate a 5-10% rate of return.  If one believe in Mr. Peak's assessment, one might plausibly argue that over time natural gas prices will need to be at least $6.
Canadian Oil Sands Opportunity

Management at AKITA views the opportunity to supply rigs to the oil sands industry in Alberta, and potentially in Saskatchewan, as the most substantial prospect going forward.  While the company of course will not provide rigs for the mined extraction of bitumen, it will drill for the in-situ producers.  According to the Alberta Energy and Utilities Board (AEUB), 80% or more of all the recoverable oil in the sands will come from deposits which are too deep to be mined.  Several years ago AKITA's work for oil sands companies was just a few percent of its business.  Now it approaches 20%.  The future direction of the mix of business will certainly depend on the future of the gas business; however AKITA could become much more levered to oil over the course of the next several years.


Conclusion

Like Hachicko, AKITA ought to be known for its loyalty.  Of course, in this case it is the loyalty to a basic set of operating principles that, in this author's opinion, are prudent for a capital intensive, cyclical and at times unpredictable business.  The hallmark of those principles appears to be:

- An avoidance of significant levels of debt
- A focus on investing in assets when others are less willing and / or able
- A belief in conservative accounting
- A desire to build and upgrade assets when the asset's future use is secured by long-term contracts

The purchase of shares of AKITA Drilling Ltd. at recent prices appears to provide a significant risk / reward opportunity.  Given where the shares trade in relation to book value and potential replacement cost, there appears to be little downside.  With the company's ongoing investment in pad conversions and possible new construction, it would appear that the upside, particularly in an environment of higher-priced natural gas or sustained additional investment in the oil sands, is significant.





Disclosure:    I co-manage a partnership that owns shares in AKITA Drilling Ltd.  It may in the future buy or sell shares and it is under no obligation to update its activities.  Please do your own research.

Catalyst

- Possible change in accounting in 2011
- Any upturn in utilization has a huge impact on earnings
- Any acceleration of oil sands drilling
    sort by   Expand   New

    Description

    [This was my application idea and while it was written a few weeks ago, the opportunity remains depite the recent rise.  For better printing results, on the print preview select landscape and shrink to fit at 70%.]
    -
    A Tribute to a Modern Day Hachiko

    There is a little known company that makes its home in Calgary, Alberta Canada.  It is named after a Japanese dog breed and while I doubt anyone at the company was ever directly inspired by the famous akita Hachiko, the company clearly demonstrates a loyalty to several managing principles that is reminiscent of the loyalty of that devoted canine.  While I'll get to the money making part in due course, first the quick story of the dog.  

    Hachiko, who now lies stuffed in the National Science Museum of Tokyo, became a national symbol of loyalty in Japan in the 1920's and 30's.  Upon the death of his owner, Hachiko devoutly returned to the Shibuya Train Station where he had met his owner each day before his death.  Hachiko didn't do this for just a few days.  He did it for nine years!  The now long-famous dog has since inspired a bronze statue, an annual ceremony, films and books.  Hachiko's story is a story of loyalty.

    The story of AKITA Drilling Ltd. (TSX: AKT.A; OTCPK: AKTAF), on the other hand, is not only about loyalty but also making money.  The C$160 million company is named after that breed of dog to which Hachiko belonged, and has been listed in Toronto since its spin-off from ATCO Ltd. in the early-to-mid 1990's.  AKITA is an oil and gas drilling contractor that primarily conducts its business in western Canada.  While the company performs drilling operations for oil, heavy oil, and potash, the fortunes of the company are highly levered to natural gas.  The company, which operates wholly-owned and partner-owned rigs, owns 39 gross and 37.225 net drilling rigs.  The company has a wide-range of rigs and can service oil and gas companies seeking to drill at multiple depths and can provide horizontal and pad drilling.  While the majority of the company's rigs service western Canada, the company has serviced customers in the lower 48 and Alaska.  However, at the moment, these ancillary markets are a minor part of the company's business.

    While there are many unique aspects to the company, the one that immediately jumps out at a potential investor is the company's balance sheet.  In atypical fashion, the company is debt free.  In an industry which freely borrows to support rig construction, that is rare.  In fact, when you look at the history of the company, the company reported positive net debt (i.e. more debt than cash) in only five quarters since the end of 1995.  That was in 2001 and early 2002 when the company last heavily invested in rig construction and at the time the heavy investments were secured by long-term contracts to utilize the new equipment.  I would argue, generally speaking, that the company has managed and continues to manage its balance sheet quite well for the industry in which it operates.

    The company's management team, which has mostly been with the company since it was founded in the late 1970's, appears to be committed to operating in a somewhat counter cyclical manner.  As I mentioned, the last wave of rig construction took place starting in 2000, not when natural gas prices were pushing $13 per MmBtu.  Interestingly, the company currently believes now is another opportune time to be spending money and with its balance sheet is has the wherewithal to do so.  The balance sheet boasts nearly $60 million in cash and no debt.  

    AKITA is in the process of converting many of their drilling rigs, mostly deeper though some shallow, to pad rigs.  Pad rigs are more mobile rigs which allow for an assembly line-like drilling of prospects.  Right now there is quite the demand for these rigs, which stands in stark contrast to the market for traditional rigs in western Canada.  In fact, the company just announced an agreement to build a new pad rig which I estimate will cost between $15 and $20 million.  The company has perhaps five or six more rigs that it could convert to pad rigs.  Each of these conversions costs approximately $5 to $6 million.  As you might imagine, having the ability to convert older rigs at an incremental cost of 1/3 the price of a new pad rig is potentially appealing to the market.  AKITA, which doesn't focus on IRR's on its assets, but instead focuses on payback periods, looks to secure most, if not all, conversions and new builds with long-term contracts.  It targets four or five year paybacks on new builds and slightly more aggressive targets on conversions (this would suggest at the low end perhaps an incremental $3 million in after-tax cash flows over the next five years from the recently announced deal).  I wouldn't be surprised to see the company continue to spend heavily on pad conversions.  The company has indicated that by the end of 2010 eleven rigs will have been converted to pads.  With one additional conversion in process and five or six more that could be converted, AKITA's fleet could be nearly 50% pad rigs in the not so distant future.  I think this is changing the outlook for the businesses, especially in this difficult operating environment.

    The western Canada rig market currently has approximately 840 rigs.  This gives AKITA a rig market share of approximately 4%.  While this is not a large number, in the pad rig business the company is reportedly a much larger player.  Management at AKITA estimates the western Canada pad rig market to be in the 30's, which would suggest a market share in this business of approximately 30%.  

    As you might imagine, the current market for drilling natural gas in Canada is not robust.  Below is a long-term picture of the active Canada rig count presented by Baker Hughes.  While 2010 has shown quite a recovery from 2009, the market remains far from its highs.
    -
    Baker Hughes Rig Count      

     

             
    Candaian Market                    
      2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
    JAN 502 539 405 478 554 550 660 568 494 377 459
    FEB 544 562 433 554 568 593 715 635 620 413 564
    MAR 394 445 311 449 462 420 620 392 408 196 386
    APR 146 217 121 151 153 183 198 101 106 74 123
    MAY 189 238 114 150 187 247 240 107 135 72 147
    JUN 301 302 205 308 265 293 408 210 266 125 229
    JUL 308 319 266 398 351 450 553 349 435 175 350
    AUG 319 325 235 404 353 545 482 343 449 178 387
    SEP 314 317 250 348 273 497 446 351 435 208 347
    OCT 353 304 220 394 372 541 431 338 446 244 398
    NOV 362 266 281 412 447 600 432 371 417 277  
    DEC 410 264 348 417 440 575 456 360 361 313  
    AVG 345 342 266 372 369 458 470 344 381 221  

    The following natural gas price chart (www.tradingeconomics.com) provides, in addition to the credit disruptions of the last few years, a good explanation as to the current state of affairs in the drilling business.  

    [Was not able to include chart, however the recent changes in natural gas pricing should be fairly well understood to this audience]

    This environment has put extreme pressure on rig utilization in western Canada.  The accompanying table presents rig utilization for the industry and for AKITA.  It would appear that there are three primary conclusions that can be drawn.  First, industry wide utilization is far below the 10 year average.  Second, AKITA seems to outperform the industry in terms of utilization.  And, three, AKITA's opportunity in pad rigs, as reflected in the recent disclosure of the utilization of those particular rigs, seems intriguing.
    -
    AKITA Drilling Ltd.        
    Rig Utilization vs. Industry        
                   
              AKITA Detailed Utilization  
                   
      Year AKITA Industry   Conventional Pad  
                   
      2010 YTD 36.5 31.9        
      2009 31.1 24.8   23.7 59.5  
      2008 42.2 41.7        
      2007 40.9 37.0        
      2006 56.6 55.1        
      2005 59.3 58.8        
      2004 52.2 52.9        
      2003 54.7 53.1        
      2002 46.8 39.2        
      2001 56.9 53.0        
      2000 60.0 55.2        
                   
        00 - 09 Avg 50.1 47.1        
                   

    As you might next imagine, this state of affairs, especially given the high fixed costs of the business, has led to pricing issues.  The following set of tables shows what the last few years have looked like for AKITA.  Generally speaking, operating margin per operating day has been under a fair amount of pressure.  This is in spite of the fact, in AKITA's case, that the company has gradually been becoming more of a pad rig player where utilization and pricing has been much stronger.  
    -
    AKITA Drilling Ltd.         AKITA Drilling Ltd.      
    Revenue per Operating Day         Operating Margin Dollars per Operating Day  
      2006 2007 2008 2009 2010     2006 2007 2008 2009 2010
    Q1 $22,911 $24,661 $23,012 $24,923 $19,539   Q1 $9,984 $10,596 $9,746 $9,890 $6,788
    Q2 $19,993 $23,412 $21,665 $29,604 $22,173   Q2 $8,880 $9,708 $7,346 $11,477 $7,455
    Q3 $21,003 $20,755 $19,723 $21,018     Q3 $8,885 $6,834 $7,747 $6,061  
    Q4 $22,912 $22,595 $23,212 $21,840     Q4 NA $9,390 $6,739 $7,713  
    AVG $21,705 $22,856 $21,903 $24,346     AVG $9,250 $9,132 $7,895 $8,785  
                             
    AKITA Drilling Ltd.         AKITA Drilling Ltd.      
    Operating and Maintenance Costs per Operating Day   Operating Margin per Operating Day    
      2006 2007 2008 2009 2010     2006 2007 2008 2009 2010
    Q1 $12,927 $14,065 $13,266 $15,033 $12,751   Q1 43.58% 42.97% 42.35% 39.68% 34.74%
    Q2 $11,113 $13,704 $14,319 $18,127 $14,718   Q2 44.42% 41.47% 33.91% 38.77% 33.62%
    Q3 $12,118 $13,921 $11,976 $14,957     Q3 42.30% 32.93% 39.28% 28.84%  
    Q4 NA $13,205 $16,473 $14,127     Q4 NA 41.56% 29.03% 35.32%  
    AVG $12,053 $13,724 $14,009 $15,561     AVG 43.43% 39.73% 36.14% 35.65% 34.18%


    Accounting Can Be Important

    As with any capital intensive business, depreciation is a significant factor.  For instance, over the last ten years depreciation has represented, on average, 15.2% of AKITA's revenues and 17% of its total costs.  This makes the assumptions which drive depreciation quite important.  What is particularly interesting and illuminating when it comes to assessing management is that the company depreciates its rigs over 2,000 operating days (the company does also depreciate five rigs over 3,600 days).  According to my work, this is far faster than most drillers in the industry.  See the chart below for a sample of what the industry uses for depreciation rates.
    -
    AKITA Drilling Ltd          
    Comparable Company Depreciation Rates          
                 
                 
      Company Low High Method Additional Notes  
                 
      Cathedral Energy Services Ltd. 4 yrs 10 yrs declining balance    
      Total Energy Services Inc. 5 yrs 15 yrs straight line    
      Ensign Energy Services Inc. 3,650 days   unit of production on rigs  
      Tuscany International Drilling Inc. 10 yrs   straight line    
      Precision Drilling Corporation 5,000 days   unit of production    
      Technicoil Corp. 2 yrs 15 yrs straight line  more geared toward well servicing  
      Nabors Industries Ltd. 4,900 days   unit of production on rigs, not jack-ups  
      Trinidad Drilling Ltd. 4,200 days   unit of production on rigs only  
      AKITA Drilling Ltd. 2,000 days 3,600 days unit of production just 5 of 37.225 net rigs at 3,600  
      Xtreme Coil Drilling Corp. 5,000 days   unit of production slightly different tech  
      Savanna Energy Services Corp. 1,500 days 4,125 days unit of production    
      Helmerich & Payne Inc. 4 yrs 15 yrs straight line includes contract drilling equipment  
      Patterson-UTI Energy Inc. 2 yrs 15 yrs straight line includes other equipment  
      Unit Corp. 15 yrs   unit of production rates starting at 15 yrs  
      Rowan Companies Inc. 12 yrs 15 yrs straight line    
      Pioneer Drilling Co. 3 yrs 25 yrs   rigs and equipment  
      Parker Drilling Co. 15 yrs 20 yrs   land drilling equipment  
      Union Drilling, Inc. 2 yrs 12 yrs   includes related equipment  
      Bronco Drilling Co. Inc. 3 yrs 15 yrs   includes related equipment  
                 

                                                   
    While it is certainly difficult to compare each of these companies, especially when several companies have chosen to use a different depreciation method than AKITA and several companies do little more than disclose a range for their entire rig segment (which often includes non-rig ancillary equipment which tends to be depreciated much faster), the table suggests AKITA depreciates its rigs far faster than many in the industry.  In fact, you could say that it depreciates its rigs nearly twice as fast, when operating, as many in the industry.  This obviously has a large impact on earnings.
    -
    Below is a chart showing net income, cash flow from operations and estimated free cash flow (excluding growth cap ex):
    -
    AKITA Drilling Ltd.                
    Cash Flow vs. Net Income                
                           
                           
      Year Net Income   CF From Operations CF - NI CF / NI   Cap Ex CF - Cap Ex CF / NI  
                           
      31-Dec-09 $8,380,000   $29,235,000 $20,855,000 3.49 x   ($12,341,000) $16,894,000 2.02 x  
      31-Dec-08 $14,847,000   $19,367,000 $4,520,000 1.30 x   ($19,567,000) ($200,000) -0.01 x  
      31-Dec-07 $20,752,000   $38,876,000 $18,124,000 1.87 x   ($40,948,000) ($2,072,000) -0.10 x  
      31-Dec-06 $33,755,000   $61,152,000 $27,397,000 1.81 x   ($49,698,000) $11,454,000 0.34 x  
      31-Dec-05 $29,264,000   $37,490,000 $8,226,000 1.28 x   ($25,325,000) $12,165,000 0.42 x  
      31-Dec-04 $20,875,000   $25,663,000 $4,788,000 1.23 x   ($15,308,000) $10,355,000 0.50 x  
      31-Dec-03 $18,822,000   $32,764,000 $13,942,000 1.74 x   ($17,261,000) $15,503,000 0.82 x  
      31-Dec-02 $14,345,000   $25,335,000 $10,990,000 1.77 x   ($5,831,000) $19,504,000 1.36 x  
      31-Dec-01 $17,889,000   $29,368,000 $11,479,000 1.64 x   ($70,459,000) ($41,091,000) -2.30 x  
      31-Dec-00 $11,157,000   $14,745,000 $3,588,000 1.32 x   ($34,649,000) ($19,904,000) -1.78 x  
      31-Dec-99 $5,211,000   $5,074,000 ($137,000) 0.97 x   ($7,670,000) ($2,596,000) -0.50 x  
      31-Dec-98 $12,907,000   $11,875,000 ($1,032,000) 0.92 x   ($7,832,000) $4,043,000 0.31 x  
      31-Dec-97 $11,363,000   $22,309,000 $10,946,000 1.96 x   ($15,372,000) $6,937,000 0.61 x  
      31-Dec-96 $7,113,000   $8,144,000 $1,031,000 1.14 x   ($3,760,000) $4,384,000 0.62 x  
      31-Dec-95 $6,053,000   $6,770,000 $717,000 1.12 x   ($3,655,000) $3,115,000 0.51 x  
                           
            Total $135,434,000       $38,491,000    
            15 Year Average $9,028,933       $2,566,067    
            5 Year Average $15,824,400       $7,648,200    
                           
     
     
    AKITA Drilling Ltd.            
    Cash Flow vs. Net Income            
                     
                     
      Year Yr End Rigs Per Rig Maint Cap Ex Maint Cap Ex Est FCF Est FCF - NI Est FCF / NI  
                     
      31-Dec-09 39 $175,000 $6,825,000 $22,410,000 $14,030,000 2.67 x  
      31-Dec-08 41 $169,750 $6,959,750 $12,407,250 ($2,439,750) 0.84 x  
      31-Dec-07 42 $164,658 $6,915,615 $31,960,385 $11,208,385 1.54 x  
      31-Dec-06 40 $159,718 $6,388,711 $54,763,289 $21,008,289 1.62 x  
      31-Dec-05 38 $154,926 $5,887,197 $31,602,803 $2,338,803 1.08 x  
      31-Dec-04 37 $150,278 $5,560,303 $20,102,697 ($772,303) 0.96 x  
      31-Dec-03 36 $145,770 $5,247,724 $27,516,276 $8,694,276 1.46 x  
      31-Dec-02 36 $141,397 $5,090,292 $20,244,708 $5,899,708 1.41 x  
      31-Dec-01 36 $137,155 $4,937,583 $24,430,417 $6,541,417 1.37 x  
      31-Dec-00 32 $133,040 $4,257,294 $10,487,706 ($669,294) 0.94 x  
      31-Dec-99 30 $129,049 $3,871,477 $1,202,523 ($4,008,477) 0.23 x  
      31-Dec-98 30 $125,178 $3,755,332 $8,119,668 ($4,787,332) 0.63 x  
      31-Dec-97 30 $121,422 $3,642,672 $18,666,328 $7,303,328 1.64 x  
      31-Dec-96 28 $117,780 $3,297,833 $4,846,167 ($2,266,833) 0.68 x  
      31-Dec-95     $2,800,000 $3,970,000 ($2,083,000) 0.66 x  
                     
            Total   $59,997,217    
            15 Year Average $3,999,814    
            5 Year Average $9,229,145    
                     
    -
    When you look at the difference between cash flows and net income and you contemplate the different accounting assumptions, perhaps AKITA is more profitable than it first appears.  The five year average cash flow from operations and more importantly FCF (excluding growth capital expenditures) significantly exceeds reported net income.  The company simply operates from the perspective that is should never have to write-down the value of its equipment.

    In 2011 the company, as most Canadian companies are doing, is converting from Canadian GAAP to IFRS.  This could serve as a possible catalyst for a change in the manner in which the company records and depreciates its rigs.  The company recognizes the growing disparity between net income and cash flow.

    Valuation

    AKITA is currently trading at approximately 80% of tangible book value.  Given the company's aggressive depreciation rates, it is safe to assume that the tangible value of its assets is at least book value.  I think there is a case to be made that it is significantly more than stated book value.

    In his 2009 shareholder letter, Mr. Ruud, the company's Chief Executive Officer noted:

    "As well, the carrying value for the Company's fleet was only $142.2 Million ($3.7 Million per rig).  Although an evaluation of replacement cost for AKITA's fleet has not been performed, management is confident that the cost to replace the Company's fleet is significantly higher than its carrying value."

    While it is somewhat tough to find exact comparables in an industry where it is all about the nature of a particular rig or fleet of rigs, a recent transaction provides at least some scope for Mr. Ruud's claims.  In May of this year, CanElson Drilling Inc. acquired Totem Drilling Ltd. which operated rigs in the south east of Saskatchewan.  The company's primary focus was on the Bakken play.  The fleet consisted of 5 double rigs with one additional rig on order and CanElson paid $40 million in cash and stock and assumed approximately $12 million in debt.  The implied price per rig was approximately $8.5 to $10 million, the implied P/BV was 2.0 x and the implied EV/EBITDA was 15.5 x.  Certainly rigs are different and certainly Totem was about to increase the size of its fleet by 20%, but the transaction at the very least provides a frame of reference.

    While AKITA is certainly not a household name, it has in the past received its due share of respect in the marketplace.  The charts below show how AKITA has been valued in the past.  It is important to note, in my opinion, where it has traded in better operating environments.  

    [chart could not be provided; while you can look it essentially shows that the company has traded between 1 x and 3.5 x in relation to TBV over its public history]

    While it would be improper to suggest that the company could trade at the multiples it did in 2005 through 2007, it is important to realize that in a stronger operating environment this company has traded at significant premiums to book value.

    It also is illustrative to look at where other drilling companies are trading.  Below is a chart for Canadian drillers and one for US drillers.  The US chart includes offshore drillers, which, while a somewhat different business, is provided for reference.
     
    -
      
    AKITA Drilling Ltd                      
    Driller Comparables                      
    Canada                      
                           
    16-Nov-10                      
                           
    Company Ticker Cap Revenue EBITDA Debt Cash Debt/Equity Debt/EBITDA EBITDA Margin P/TBV EV/EBITDA
                           
    Cathedral Energy Services Ltd. TSX: CET $257 $136 $25 $49 $1 47.40% 2.64 18.33% 3.03 12.23
    Total Energy Services Inc. TSX: TOT $346 $176 $48 $79 $0 41.83% 1.84 27.20% 1.85 8.88
    Ensign Energy Services Inc. TSX: ESI $1,864 $1,230 $281 $138 $82 8.81% 0.12 22.87% 1.19 6.82
    Tuscany International Drilling Inc. TSX: TID $239 $15 -$2 $51 $11 33.08% NM -16.09% 1.51 NM
    Precision Drilling Corporation TSX: PD $2,066 $1,280 $383 $684 $209 26.13% 1.52 29.89% 1.21 7.30
    Technicoil Corp. TSX: TEC $93 $78 $19 $0 $2 0.00% 1.39 24.08% 1.29 4.88
    Nabors Industries Ltd. NBR $6,073 $3,695 $1,121 $4,509 $772 86.59% 2.59 30.33% 1.28 10.02
    Trinidad Drilling Ltd. TSX: TDG $597 $609 $175 $574 $12 62.77% 2.97 28.68% 0.78 6.63
    AKITA Drilling Ltd. TSX: AKT.A $159 $104 $25 $0 $59 0.00% NM 23.67% 0.79 4.04
    Xtreme Coil Drilling Corp. TSX: XDC $215 $89 $24 $35 $3 13.30% 0.88 26.32% 0.84 10.50
    Savanna Energy Services Corp. TSX: SVY $456 $388 $67 $105 $6 13.39% 2.21 17.14% 0.59 8.35
    Stoneham Drilling Trust TSX: SDG.UN $69 $92 $26 $53 $0 49.57% 4.29 28.12% 0.65 4.71
                           
                           
      Average $1,036 $658 $182 $523 $96 31.91% 2.04 21.71% 1.25 7.67
      Median $301 $156 $37 $66 $9 29.61% 2.02 25.20% 1.20 7.30
                           
      Min $69 $15 -$2 $0 $0 0.00% 0.12 -16.09% 0.59 4.04
      Max $6,073 $3,695 $1,121 $4,509 $772 86.59% 4.29 30.33% 3.03 12.23
                           
       
    AKITA Drilling Ltd                      
    Driller Comparables                      
    United States                      
                           
    16-Nov-10                      
                           
    Company Ticker Cap Revenue EBITDA Debt Cash Debt/Equity Debt/EBITDA EBITDA Margin P/TBV EV/EBITDA
                           
    Diamond Offshore Drilling Inc. DO $9,447 $3,373 $1,885 $1,496 $986 40.01% 0.32 55.88% 2.53 5.28
    Royale Energy Inc. ROYL $21 $12 $3 $3 $3 23.75% NM 22.95% 2.03 7.43
    Helmerich & Payne Inc. HP $4,758 $1,875 $709 $360 $63 12.82% 0.42 37.83% 1.76 7.95
    Transocean Ltd. RIG $21,106 $10,149 $4,731 $12,861 $4,668 61.14% 1.78 46.62% 1.65 6.19
    Atwood Oceanics, Inc. ATW $2,276 $651 $359 $230 $181 16.79% 0.14 55.24% 1.75 6.86
    Patterson-UTI Energy Inc. PTEN $3,090 $1,171 $398 $100 $74 4.69% NM 33.97% 1.50 7.83
    Noble Corp. NE $9,198 $3,104 $1,808 $2,762 $367 39.04% 0.00 58.26% 1.30 6.48
    Unit Corp. UNT $1,918 $807 $399 $137 $1 8.14% 0.21 49.50% 1.19 5.14
    Pride International Inc. PDE $2,066 $1,376 $375 $1,872 $640 42.00% 0.68 27.25% 1.25 7.30
    Rowan Companies Inc. RDC $3,751 $1,760 $585 $1,684 $893 45.72% 0.32 33.23% 1.02 7.77
    Pioneer Drilling Co. PDC $374 $420 $78 $283 $17 70.99% 2.98 18.62% 0.99 8.19
    Parker Drilling Co. PKD $475 $662 $143 $469 $47 78.28% 2.05 21.61% 0.79 6.27
    Union Drilling, Inc. UDRL $126 $175 $23 $38 $0 18.71% 0.26 13.32% 0.63 7.02
    Vantage Drilling Company VTG $471 $232 $68 $1,100 $117 140.75% 13.39 29.38% 0.60 21.33
    Bronco Drilling Co. Inc. BRNC $134 $111 $3 $8 $7 2.79% 3.77 2.67% 0.43 278.82
    Hercules Offshore, Inc. HERO $310 $662 $124 $879 $135 93.94% 5.41 18.80% 0.33 8.48
    Seahawk Drilling, Inc. HAWK $104 $97 ($65) $18 $41 4.71% NM -66.55% 0.27 NM
                           
                           
      Average $3,507 $1,567 $684 $1,429 $485 41.43% 2.27 26.98% 1.18 24.90
      Median $1,918 $662 $359 $360 $74 39.04% 0.55 29.38% 1.19 7.37
                           
      Min $21 $12 ($65) $3 $0 2.79% 0.00 -66.55% 0.27 5.14
      Max $21,106 $10,149 $4,731 $12,861 $4,668 140.75% 13.39 58.26% 2.53 278.82
                           
                                                                                                
    -
    While it is difficult to make substantive relative value conclusions based on the survey presented, it might be fair to say at the very least that given AKITA's balance sheet and operating performance, the company is not overvalued relative to its peers.  In this author's opinion, given AKITA's depreciation decisions, balance sheet and operating performance, AKITA is in fact at a fair discount to its peers.

    So at the end of the day what is AKITA worth and what rates of return could an investment at these prices produce?  At current prices AKITA is trading, net of cash, at approximately 21 times trailing-twelve-month earnings (earnings which I've suggested could be overburdened by excess depreciation charges).  To put that in perspective, the company is also trading at less than 3 times peak trailing-twelve-month net earnings which were achieved in June 2006.  In that year gas prices hit $14 per MmBtu and the company had one additional gross rig.

    The exhibit below looks at several valuation scenarios based on replacement cost and long-term earnings.
      
    -
    AKITA Drilling Ltd.                
    Valuation Possibilities                
                         
      By Replacement Cost / Rig                
                         
                         
      Replacement Cost Est.   3,500,000   6,000,000   9,000,000    
                         
      Number of Net Rigs   37.225   37.225   37.225    
                         
         Total Replacement Cost $130,287,500   $223,350,000   $335,025,000    
                         
      Net Cash     $60,000,000   $60,000,000   $60,000,000    
                         
         Total Replacement Cost $190,287,500   $283,350,000   $395,025,000    
                         
      Shares Outstanding   18,040,513   18,040,513   18,040,513    
                         
         Total Replacement Cost per Share $10.55   $15.71   $21.90    
                         
                         
      By Multiple to Long-Term Earnings              
                         
      Multiple to Earnings   10.00 x   12.00 x   15.00 x    
                         
      10 Year Average Earnings ^ $19,723,000   $19,723,000   $19,723,000    
                         
         Earnings Value   $197,230,000   $236,676,000   $295,845,000    
                         
      Net Cash     $60,000,000   $60,000,000   $60,000,000    
                         
         Total Value   $257,230,000   $296,676,000   $355,845,000    
                         
      Shares Outstanding   18,040,513   18,040,513   18,040,513    
                         
         Total Value per Share   $14.26   $16.44   $19.72    
                         
                         
      ^ 10 Year Average Earnings includes the years 2001 through 2009 and the LTM as reported through Q3 2010  
                         

    Presented below is are two exhibits that looks at return possibilities based on changes in book value and multiples to book value over the next five years.  The first extrapolates long-term book value growth into the future and the other provides a reduced book value growth rate to reflect a protracted poor drilling market.

    -
    AKITA Drilling Ltd.                
    Return Possibilities                
                       
            + 1 YEAR + 2 YEAR + 3 YEAR + 4 YEAR + 5 YEAR  
                       
      Implied Future Book Value $11.00 $11.55 $12.13 $12.73 $13.37 $14.04  
      Reduceed Avg BV Growth   5.00% 5.00% 5.00% 5.00% 5.00%  
                       
      Multiple to BV     1.00 x 1.00 x 1.00 x 1.00 x 1.00 x  
      Share Price   -$9.00 $11.55 $12.13 $12.73 $13.37 $14.04  
      IRR     28% 16% 12% 10% 9%  
                       
      Multiple to BV     1.50 x 1.50 x 1.50 x 1.50 x 1.50 x  
      Share Price   -$9.00 $17.33 $18.19 $19.10 $20.06 $21.06  
      IRR     92% 42% 29% 22% 19%  
                       
      Multiple to BV     2.00 x 2.00 x 2.00 x 2.00 x 2.00 x  
      Share Price   -$9.00 $34.65 $36.38 $38.20 $40.11 $42.12  
      IRR     285% 101% 62% 45% 36%  
                       

    Potential Risks

    Investing in the common stock of a contract drilling company, even one trading at such a discount to replacement cost and book value is still not without its risks.  The following are a sample:

    - The company is certainly levered to natural gas pricing.  Since the summer of 2007 the price for natural gas has declined considerably.  This has put pressure on exploration and development drilling, especially in traditional gas drilling.  A continued poor pricing environment for natural gas will not produce an ideal operating environment for the company.  Cash flows, while currently significantly positive, may face continued pressure.

    - AKITA is a relatively small player, even in the western Canada drilling market.  As mentioned, the company has an approximate 4% share of the market.  Larger players like Nabors and Precision may get aggressive in a tough market looking to gain market share or push other players out of business.  At the very least they could "throw their weight around."

    - Included in the rig fleet that AKITA maintains are several older rigs that the company admits are more marginable.  These rigs present concerns not only about the duration of cash flow particular to them, but also valuation metrics based on average rig market price or replacement cost.


    Other Considerations

    Ownership

    AKITA is governed by a two class share structure.  The more liquid class of shares is the A shares, which carry no voting rights.  While the voting class B shares are traded, they are much less liquid and are controlled by Sentgraf Enterprises.  Sentgraf is controlled by Mr. Ronald Southern who is deputy chairman of the company.  In total Sentgraf owns a 32.73% economic interest in the company.  Mr. Southern is also the chairman and CEO of ATCO and its major shareholder.  Through Sentgraf he owns 31.66% of that $3.3 billion company.  

    While there is certainly interested ownership on the board of directors, the company is clearly controlled by Mr. Southern.  Without any voting rights, shareholders are completely dependent on Mr. Southern for his stewardship of the company.  Mr. Southern is 79 years old and is the founder of ATCO, the former parent of AKITA.

    Related Party Transaction

    The company discloses a fairly sizable related party transaction.  Each year the company pays several hundred thousand dollars ($325,000 in 2009) as sponsorship and advertising to Spruce Meadows, which is controlled and founded by the Southern family.  Spruce Meadows hosts international horse jumping competitions and other events in Calgary.  While I don't condone such arrangements, given the status of the events and their importance to the area I am willing to tolerate it.  The company makes the case that while it may be pricy it does provide them an opportunity to entertain a great number of customers and potential customers.  

    Dividend and Buyback

    At current prices, the company shares yield approximately 3.1%.  The company has paid a dividend since 1996.  Given the current level of cash flows, there appears to be adequate capacity to continue to pay the dividend even in an environment of continued poor natural gas pricing.

    The company does have a buyback authorization in place through a normal course issuer bid.  AKITA has a history of authorizing the buybacks, though rarely have they been utilized to their full extent.  In the second quarter of 2010 the company repurchased $1.3 million worth of shares, though conversations with management suggest this is not a priority at this time.

    Commodity Pricing

    It is perhaps foolhardy to predict where natural gas and oil prices will be in the future.  Given the developments in the US shale business over the last several years, perhaps the gas industry is in for a prolonged period of lower prices.  

    Natural gas companies however do have to earn an economic return to justify their existence.  Of the individuals operating in that business that I respect, Ken Peak at Contango Oil & Gas is probably at the top.  In a late 2009 presentation entitled "The Big Lebowski and the Zen of E&P" he stated:

    "I think the industry needs $6.00/mcfe to earn a 5-10% ROR"

    While it is perhaps impossible to predict prices, it is not impossible to predict that the natural gas industry will at least need to generate a 5-10% rate of return.  If one believe in Mr. Peak's assessment, one might plausibly argue that over time natural gas prices will need to be at least $6.
    Canadian Oil Sands Opportunity

    Management at AKITA views the opportunity to supply rigs to the oil sands industry in Alberta, and potentially in Saskatchewan, as the most substantial prospect going forward.  While the company of course will not provide rigs for the mined extraction of bitumen, it will drill for the in-situ producers.  According to the Alberta Energy and Utilities Board (AEUB), 80% or more of all the recoverable oil in the sands will come from deposits which are too deep to be mined.  Several years ago AKITA's work for oil sands companies was just a few percent of its business.  Now it approaches 20%.  The future direction of the mix of business will certainly depend on the future of the gas business; however AKITA could become much more levered to oil over the course of the next several years.


    Conclusion

    Like Hachicko, AKITA ought to be known for its loyalty.  Of course, in this case it is the loyalty to a basic set of operating principles that, in this author's opinion, are prudent for a capital intensive, cyclical and at times unpredictable business.  The hallmark of those principles appears to be:

    - An avoidance of significant levels of debt
    - A focus on investing in assets when others are less willing and / or able
    - A belief in conservative accounting
    - A desire to build and upgrade assets when the asset's future use is secured by long-term contracts

    The purchase of shares of AKITA Drilling Ltd. at recent prices appears to provide a significant risk / reward opportunity.  Given where the shares trade in relation to book value and potential replacement cost, there appears to be little downside.  With the company's ongoing investment in pad conversions and possible new construction, it would appear that the upside, particularly in an environment of higher-priced natural gas or sustained additional investment in the oil sands, is significant.





    Disclosure:    I co-manage a partnership that owns shares in AKITA Drilling Ltd.  It may in the future buy or sell shares and it is under no obligation to update its activities.  Please do your own research.

    Catalyst

    - Possible change in accounting in 2011
    - Any upturn in utilization has a huge impact on earnings
    - Any acceleration of oil sands drilling

    Messages


    SubjectMissing Chart
    Entry12/23/2010 03:31 PM
    Membergolfer23
    My apologies for forgetting one chart.  I meant to present two return possibility charts.  One based on long-term growth in BV/Share and one on a reduced growth in BV.  The reduced BV growth chart is presented in the main text.  The chart showing returns based on the past long-term growth was obmitted and is below:
    -
    AKITA Drilling Ltd.                
    Return Possibilities                
                       
            + 1 YEAR + 2 YEAR + 3 YEAR + 4 YEAR + 5 YEAR  
                       
      Implied Future Book Value $11.00 $12.47 $14.15 $16.04 $18.19 $20.63  
      Long-Term Avg BV Growth   13.40% 13.40% 13.40% 13.40% 13.40%  
                       
      Multiple to BV     1.00 x 1.00 x 1.00 x 1.00 x 1.00 x  
      Share Price   -$9.00 $12.47 $14.15 $16.04 $18.19 $20.63  
      IRR     39% 25% 21% 19% 18%  
                       
      Multiple to BV     1.50 x 1.50 x 1.50 x 1.50 x 1.50 x  
      Share Price   -$9.00 $18.71 $21.22 $24.06 $27.29 $30.94  
      IRR     108% 54% 39% 32% 28%  
                       
      Multiple to BV     2.00 x 2.00 x 2.00 x 2.00 x 2.00 x  
      Share Price   -$9.00 $37.42 $42.44 $48.12 $54.57 $61.88  
      IRR     316% 117% 75% 57% 47%  
                       

    SubjectMaintenance Capex
    Entry01/07/2011 07:12 PM
    Memberroc924
    Thanks for the report.
     
    Can you provide more detail on the assumptions for your $175k/year.rig maintenance capex figure?

    SubjectQ4 Results
    Entry03/21/2011 11:54 AM
    Membergolfer23
    The recently released results...
    Adjusted for the 2009 actuarial gain, operating income was up over 4x and EBITDA was up 67%.

    SubjectRE: Q4 Results
    Entry03/21/2011 02:28 PM
    Membergolfer23
    My apologies... operating income up 79% adjusted for actuarial gain.  Not quite sure what I was thinking!

    SubjectQ1 Results
    Entry05/02/2011 04:42 PM
    Membergolfer23
    While we'll have to wait for a couple of details on the accounting, the change to IFRS and the resultant decisions are reducing the desparity between earnings and cash flow.  Aside from the significant accounting changes impacting the reported results, the business is performing well.  Utilization was higher than its been in several years.  I was also intrigued given the nature of management that the company is optimistic that their deepest capacity rigs will see better activity later in the year.  In addition to the continuing leverage to a strong pad rig market, a better deep market would be extremely positive for the company.
    golfer23

    SubjectUpdate
    Entry02/10/2012 12:13 PM
    Membergolfer23

    I thought I would post a quick update as much has transpired since my write-up.  Of course the one thing that hasn't transpired is much movement in the share price.

    The company converted if IFRS and adjusted its accounting practices to more closely conform to industry standards and economic reality.  They reduced their depreciation rate by moving to a 3,600 day depreciation schedule from 2,000 operating days.  They also adjusted salvage value assumptions to 20% of cost versus company estimates of $50,000 to $300,000.  As you might imagine this has had an impact on the earnings recognized.

    AKITA continues to be unloved relative to others in the industry.  In Canada the rig companies are trading at a median EV/EBITDA of 7.3x and at a median P/TBV of 1.3x.  For AKITA those multiples are 3.8x and .9x respectively.  The multiples are fairly similar in the US.

    Rig activity, despite natural gas prices, is still robust.  In 2011, rig counts were up 20%.  In January that slowed to 2.3% over the previous January, with oil rigs up 6% and gas rigs down 5%.  Oil rigs now account for over 2/3rds of the industry.

    Operationally the company has spent heavily on cap ex in 2011, spending $35 mm YTD vs. $22 mm the prior year.  Q4 should be another rather good quarter for the company.  The stock came down in the summer swoon last year and has not really climbed off its low.  I’m fairly perplexed.  (and would appreciate any thoughts)

    As a side note… this year volume has really exploded.  Given the large blocks that seem to be trading on a regular basis, someone appears to be building a large position.  There have been no filings yet, but over $10 mm worth of block-type trades have hit the tape this year. 

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