February 14, 2011 - 3:24pm EST by
2011 2012
Price: 7.97 EPS $0.33 $0.79
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 $M): 6 EBIT 10 23
TEV ($): 150 TEV/EBIT 15.0x 6.5x

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CE Franklin Ltd


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.

The Company

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.

Key Points to the Investment Story

1. Leading indicators are strong

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


The above data are readily available at the CAODC website (rigs, completions).


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.



CY           Gas:Oil

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.


2. CFK typically lags the industry by 2-3 quarters. Recent strength in key indicators beginning to show through in Q410 numbers

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%


3. We believe there's significant room for margin expansion with relatively little risk of near/mid-term compression

-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.


4. Despite >100% earnings growth expected in 2011, CFK has the same enterprise value as this time last year

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

5. CFK has a leading position and a management team with a track record of success

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:


                                                2002                       2010

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.


6. CFK has paid down nearly their entire debt balance and has little need for an increase in working capital as sales grow. Therefore we expect cash flow to go toward continued share repurchases and a possible special / program dividend.

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.

Price Target

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.

Primary Risks

- 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)

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