|Shares Out. (in M):||18||P/E||24.3x||10.0x|
|Market Cap (in M):||144||P/FCF||6.4x||8.3x|
|Net Debt (in M):||6||EBIT||10||23|
CFT CN / CFK US
7 February 2011
Recent Price: C$7.90 / USD$8.19
We believe that in the most conservative scenario, CFK will grow earnings more than 140% in 2011. Applying a multiple to earnings reflecting a cyclical recovery off of trough business levels renders a target price 80-90% greater than today. In a more realistic scenario (i.e. less conservative) we believe there is considerably more upside. Meanwhile, the Company has paid down debt, generates a 12-15% FCF yield and has been actively repurchasing shares. With a strong balance sheet and an industry leading position, we believe that the probability of permanent capital loss is low, future dividend payout is likely, and share appreciation potential is significant.
CE Franklin Ltd. (CFK) Distributes supplies to the oil and gas drilling and production industry. The Company sells pipe, valves, pumps, fittings, and maintenance supplies and provides inventory procurement and management services across Canada. Commanding roughly 20% market share, CFK operates a Hub & Spoke distribution system with a central distribution center in Edmonton, Alberta and 45 branches in towns and cities that serve O&G fields of the Western Canadian Sedimentary Basin. While the Company serves 3k individual customers on a same-day or overnight basis, CFK's top 10 customers represent roughly 50% of revenue. Through its August, 2010 acquisition of Smith International, Schlumberger now owns more than 50% of CFK's stock. Smith's US-centric subsidiary, Wilson supply, bought the controlling stake in the 90s to provide full North American capabilities to its large customers. CFK/Wilson joint business is roughly 15% of CFK's overall revenue.
The strongest indicator for CFK is the number of well completions in the Western Canadian sedimentary basin. A significant leading indicator for the number of well completions is the average number of active drilling rigs. It's clear that these numbers are bouncing nicely off of their lows and growing at an accelerating pace.
Qtr Rigs Growth% Completions Growth%
1Q09 177 3,944
2Q09 51 1,263
3Q09 102 1,479
4Q09 175 1,574
1Q10 247 39% 2,845 23%
2Q10 99 95% 2,198 18%
3Q10 191 87% 2,605 21%
4Q10 249 43% 4,740 38%
1Q11* 414 68%
*QTD through 2/8/11
There are more rigs currently operating than during any month since January 2007 and more rigs operating today than when oil was at $140 during 2008. In addition to under-activity during the last couple of years, we attribute the increase in activity to structurally higher oil prices (excluding the '08 general commodity spike) pulling up the overall pricing index despite significant weakness in natgas prices. Further evidence of the oil price 'driver' is the mix-shift away from natgas well completions in favor of oil wells over time.
2007 2.3 : 1
2008 2.0 : 1
2009 1.6 : 1
2010 0.9 : 1
We believe the new normal for natgas prices has set in and activity has decreased to largely reflect this reality.
The industry really began to recover in 1H10 but CFK's performance didn't begin to reflect overall industry recovery until 2H10 as their products are typically sold at the very back-end of construction and then ongoing as wells operate. Similarly, CFK is one of the last to feel an industry downturn. As rig counts continue to grow at an accelerating pace, we believe that the full strength of the rebound has yet to be reflected in CFK's numbers.
Growth % 1H10 2H10 Jan/Feb '11
Rig Count 51.6% 59.1% 67.6%
Completions -3.1% 140.6%
CFK Revenue -11.2% 43.1%
-Steel prices rolled over in 2009. CFK spent several quarters working-off higher cost steel inventory and this is largely behind them as of the fourth quarter.
-Mcjunkin Red Man (MRC), backed by private equity, has taken some pricing actions incongruent with healthy competition and management believes this practice is unsustainable, especially given MRC's heavy debt financing. Therefore we don't expect pricing to get significantly worse. This is a potential area of improvement.
-Gas prices plunged, challenging operators' economics and pressuring prices. CFK realigned the business to cope with the new 'normal' including more centralization of the operation for tight inventory management and large project servicing. This has already had a positive margin impact and there is room for significantly more centralization of larger projects.
-Greenfield effort in the oil sands business - lower product gross margin but above average operating margin given the size of the orders. This business is lumpy but we do expect growth in 2011.
-Some vendor shortages given industry contraction and so were purchasing from non-preferred vendors. Through the worst of this.
Overall, management is expecting a better margin picture than we're modeling without any expectation of a natgas price increase. Given the above, our model contemplates a 70bp increase in gross margin to 16% - not significant given that the company had historically generated 20% gross margins and the worst is behind them.
Even with the nearly 70% QTD growth in average rig count, we model only roughly 11% revenue growth for the year. As discussed above, we model a 16% gross margin. We believe that SG&A will actually come down by ~$100k in 2011 as $1.5m of integration costs go away while below normal incentive comp during FY10 catches up. Additionally, management believes they can support 10-15% higher revenue with minimal increases in variable costs. Applying a 37% tax rate results in net income of $14m or $0.78 per share. This compares favorably to the $0.33 CFK did last year (138% growth). Despite strong growth in even a conservative scenario, CFK's enterprise value remains virtually unchanged from a year ago.
February 2010 2011
Shares 18m 18m
Price 6.75 7.97
Mkt Cap 120m 144m
Net Debt 27m 6m
Ent Val 147m 150m
Here is a summary of our model:
2009 2010 2011E Note
Avg. Rigs 135 209 230
Growth -41% 54% 10% Conservative: 1Q11 rig counts are up nearly 70% QTD
Completions/rig 61 59 59
Well completions 8.3k 12.4k 13.6k
Revenue/Well 30 21 21 Not expecting pricing to get better
Capital Proj. Rev. 246 256 284
Capital Proj. Contrib. % 56% 52% 52% Operators hold off on MRO to crucial point during downturn. Should improve
Implied MRO revenue 191 234 264
Total revenue 437 490 548
Growth % -20% 12% 12% Conservative, despite huge growth in rig count and lag effect
Gross profit 77 75 88
Gross margin % 17.5% 15.3% 16.0% Management thinks they can do better
SG&A 64 63 62 SG&A declining in absence of integration costs
D&A 3 3 3
EBIT 10 10 23
EBIT margin % 2.3% 2.0% 4.2%
Interest/other 1 1 0
Tax 3 3 8
Net Income 6 6 14
EPS .35 .33 .79 141.7% growth in EPS
USD EPS .80 Reflecting today's 0.99 CAD exchange ratio
CFK's current CEO, Mike West, joined the company in 2002. At the time, sales were in decline and the company was losing money. Mike began building a team and turning the business around, beginning with the hub/spoke model and a focus on major alliance accounts with Wilson Supply with cross border requirements. Mike also began a building out the oil sands business and developed project capability using the existing supply chain infrastructure. The success of Mike and his management team can be seen clearly in the overall numbers:
Well Completions 12,929 12,388
Growth % -4.0%
CFK Revenue $261.3 $489.6
Growth % 87.3%
EBIT -$2.0 $9.7
Net Debt $14.8 $6.7
Growth % -54.7%
Diluted Shares 17.2 17.5
Growth % 1.7%
Since 2002, CFK nearly doubled revenue through organic growth and a handful of smaller acquisitions. Meanwhile, debt was cut by more than half and investors experienced virtually no equity dilution. All this while the industry contracted! Additionally, management's greenfield initiatives such as oil sands and production services now represent more than 15% of revenue, up from negligible numbers just a few years ago.
Following a significant strengthening of their balance sheet and cash flow generation, CFK has announced share repurchases equal to roughly 10% of shares outstanding over the last two years. The most recent repurchase announcement was made on 1/3/11. While we generally view share repurchases as positive, the stock is already thinly traded due to the smaller size of the company and a float that represents just over 50% of the outstanding shares. We're comfortable that management gets this dynamic. Going forward, with minimal debt and little need for increased working capital to fund growth, we believe management will continue to return cash to shareholders but lean more toward paying a dividend rather than soak up the already small float.
Ultimately, we believe that CFK should command a multiple that reflects a stronger business in cyclical recovery off of trough levels. Historically CFT has traded for between 10 and 25x earnings. We apply a 19x multiple to our 2011 earnings expectation as the business is still well below the overall earnings power of this business at the peak of the cycle. 19 * $0.80 = $15.20 for the US shares (86% upside). We note that our crude assumptions into 2012 result in significantly higher earnings than in 2011 for CFK.
- Schlumberger (SLB), through its acquisition of Smith International, now owns a controlling stake in CFK. Needless to say, SLB didn't buy Smith to get at the distribution segment. While we note that this large ownership stake presents a few issues (reduced float, sell overhang, etc.) we believe that CFK is a natural fit with Wilson supply. CFK tried to acquire Wilson back in 2005 but the deal fell apart.
- Natural gas pricing, especially at the AECO C Hub in Alberta, has been alarmingly weak and will likely remain at depressed levels for the foreseeable future (seasonally adjusted). While oil price increases have pulled the gas/oil pricing index up, if there were a significant decline in oil prices, both natgas and oil projects would have challenged economics.
-Continued competitive pricing pressure keeping margins suppressed
-Lumpiness of oil sands project revenue
-This is an illiquid stock that trades on both the Toronto and Nasdaq. Recently volume has spiked up in the name but overall trades about $225k / day combined.
-Report out on well completions for January 2011 at the CAODC - Within the next 10 days. Rig count increased to 423 at the beginning of February, up from a strong 404 during January and 30% greater than February of last year.
-Significant improvement in 1Q11 sales (April's announcement of first quarter earnings)
-Potential dividend (post 4Q11 earnings)
-Continued share repurchases
-Potential transaction - CFK being either the acquirer or target (next 2 years)
|Subject||Peak completions and valuation|
|Entry||02/16/2011 10:27 AM|
Do you think your number for completions is a normalized level going forward or is it a peak number?
I know markets do crazy things, but why would a rational informed investor pay 19 times if other high quality, higher visibility, lower risk companies sell for significantly less. Except naturally if there is a fair amount of growth left.
Good idea tx.
|Subject||RE: Peak completions and valuation|
|Entry||02/17/2011 07:25 PM|
We don't think our number for completions in 2011 is a normalized level going forward. In fact, we assume that the current average number of drilling rigs this far in 1Q11 (412) will represent 45% of the total 2011 drilling activity while in the last two years 1Q has represented an average of only 1/3 of the activity. If we move that 45 down to the average of 33% the well completions number moves up to 18k wells for the year (keeping completions/rig steady) from our conservative estimate of 13.6k. This is still below peak.
Additionally, our numbers don't t factor oil sands or production service revneue which is a growing piece of business. What's more, despite declining natgas prices and normalizing for the mid-decade commodity spike, the total number of rigs that have moved into the region is steadily growing while rig utilization is currently above the long-term average (72% vs. 59% long-term average). Ultimately I'm not suggeseting paying 19x peak earnings - I'm suggesting paying 19x earnings for a business that is bouncing off of trough levels with a high potential for significant improvement across operating metrics over the next 2-3 years. I remain reasonably conservative (rig count, completions, gross margin, elimination of fast growing non-core/other revenue) in my analysis and even so my assumptions render astronomical earnings growth.