I am recommending a long position in Grant Prideco (GRP). GRP is one of the highest quality companies in the oil field services space and offers a tremendous value trading a approximately 10x next year’s earnings with a nearly 9% trailing free cash flow yield. As the end demand for GRP’s products are better understood by the market (and as the company continues to grow its backlog and post excellent financial results), the market should “re-price” GRP to multiples that better reflect the quality of the company’s earnings stream and management team. As an aside, I believe this recommendation may be particularly timely as the energy markets work thru weather and storage related issues which have put near-term pressure on the price of natural gas and related stocks.

 

GRP is the leading participant in the global drill pipe market and a major player in the global drill bit and domestic premium connections sectors.  Drill pipe, drill bits, and connections are exactly what they sound like – they are boring but necessary components of any sort of E&P drilling operation, be it natural gas or oil.  The market for drill pipe was overbuilt in the early 1990s and GRP acted as a significant consolidator throughout the downturn of the last 1990s.  As a result, the company now has 50%+ market global market share.  As customer inventories of excess drill pipe were worked off in the post-2003 energy upturn, GRP was in position to capture business from both existing rigs in need of upgraded pipes and new rigs coming on line. 

 

GRP’s valuation is fairly straightforward. There is little debt on the balance sheet. Management has an excellent history of converting net income to operating cash flow. Maintenance capex requirements are relatively small and the company does not have major capital investment projects on the board at this time.

 

As the valuation metrics suggest, GRP’s leverage to energy in general, and North American natural gas in particular, cause the stock to trade at relatively low multiples, belying the historical cyclicality of the industry. As investors come to appreciate the long-term demand for GRP’s products, I believe the market should re-price the stock to levels more consistent with a company that grows earnings in the mid-to-high teens each year, converts net income to free cash at an admirable level, and is managed by one of the better teams in the energy services industry.

Valuation & Earnings Power
				2006E	2007E	2008E
Shares Out	128		Revenues	$     1,809	$     2,114	$     2,331
Price	$        40.18		EBITDA	$       630	$       739	$       790
Mkt Cap	$        5,143		Multiple	8.4x	7.1x	6.7x
Net Debt	$           118		FCF	$       454	$       534	$       684
Ent Value	$        5,261		Yield	8.8%	10.4%	13.3%
			EPS	$      3.28	$      3.91	$      4.52
			P/E	12.3x	10.3x	8.9x
			EPS Growth	91.8%	19.2%	15.6%

 

My thesis on GRP does not require an investor to take a view on energy prices (though if you believe natural gas is going back to $2/MCF, you’ve probably already stopped reading). It does require an understanding of the dynamics of the effort required to hold the production of North American natural gas at a steady state, which I believe is fairly easy to understand thru an empirical examination of a few numbers.

 

Natural gas prices are quite volatile, trading primarily on weather and storage levels. In the environment of the last 9 months or so, small changes on the margin of supply have had a large impact on the price of natural gas (and on the trading of natural gas levered securities). However, beneath this marginal activity, I believe an incredibly strong market exists for companies such as GRP that produce the “picks and axes” of the exploration and production industry.

 

Since 1995, the “rig count” or number of machines pumping oil and natural gas in the U.S. has increased 128% (7.8% CAGR). The number of natural gas wells has increased by 47% (3.5% CAGR). One would think all this new drilling capacity would lead to a massive increase in the amount of natural gas production – but it in fact has been almost exactly flat over the last 10 years. Consumption is similarly flat despite a natural gas price that has increased from under $2/Mcf 10 years ago to over $6/Mcf today (with a spike to the mid-teens along the way).

 

	1995	1996	1997	1998	1999	2000	2001	2002	2003	2004	2005	2006E	CAGR
Rigs	723	779	943	843	625	918	1,156	830	1,032	1,192	1,383	1,648	7.8%
Growth		7.7%	21.1%	-10.7%	-25.8%	46.9%	26.0%	-28.2%	24.3%	15.5%	16.1%	19.1%
Wells	299	302	311	317	302	342	373	388	393	405	420	438	3.5%
Growth		1.1%	3.0%	1.9%	-4.6%	13.0%	9.3%	3.9%	1.4%	3.0%	3.8%	4.2%
Total Production (Bcf)	18,599	18,854	18,902	19,024	18,832	19,182	19,616	18,928	19,099	18,757	18,244	18,554	0.0%
Growth		1.4%	0.3%	0.6%	-1.0%	1.9%	2.3%	-3.5%	0.9%	-1.8%	-2.7%	1.7%
Use (Bcf)	22,207	22,609	22,737	22,246	22,405	23,333	22,239	23,007	22,277	22,430	21,999	21,617	-0.2%
Growth		1.8%	0.6%	-2.2%	0.7%	4.1%	-4.7%	3.5%	-3.2%	0.7%	-1.9%	-1.7%
Avg. Nat. Gas Price						$ 3.68	$  4.00	$  2.95	$  4.88	$  5.46	$  7.51	$  8.21	16.4%
Growth		40.0%	6.9%	-15.5%	11.7%	68.0%	8.7%	-26.3%	65.4%	11.9%	37.5%	9.3%
Sources: Baker Hughes rig count; EIA statistics.

My point here is very simple: the North American natural gas industry is using a steadily increasing number of rigs and wells to produce the exact same amount of natural gas year in and year out. Furthermore, consumption does not seem to be hindered by a large increase in the price of natural gas.  This steady increase in the proportion of rigs (or wells) to gas production is a result of increased drilling activity in difficult geologies including tight gas plays (i.e. shales, deepwater GOM wells) and increased focus on traditional reservoirs thru technology designed to extract more of the commodity from the ground (i.e. horizontal drilling).

 

From my discussions with folks in the natural gas industry, I see no reason for this phenomenon to do anything other than continue going forward. Natural gas prices may rise and fall and production may move around on the margin, but U.S. production is well past its peak, and I believe it will take an ever increasing number of rigs and wells to hold production of natural gas in the U.S. at current levels. I believe this industry dynamic creates a fantastic backdrop for GRP, whose products make up a relatively small amount of the total cost of a drilling operation. As new wells are drilled (at an increasing rate) or existing wells are worked more carefully, more rigs will be needed, and each of those rigs will require drill pipe, drill bits, connectors, etc. The fact that these products make up a relatively small cost in what is a very capital intensive business, where down time is very costly, and that GRP provides a premium product, gives me great comfort that they will achieve both he volumes and steady pricing required to continue growing earnings and cash flows at an above average, and essentially non-cyclical rate.

 

I have had the opportunity to spend time with the GRP management team at various times over the last two years; each time I speak with them I come away more impressed. CEO Mike McShane (former CFO of BJS) strikes me as both an excellent operator and allocator of capital.  The company has used their free cash flow in the last couple of years to clean up the balance sheet, repurchase shares, and make small acquisitions. They are cognizant of their leading position in a commodity industry and have been fairly successful at offering premium products and services to differentiate GRP from the competition. Importantly, I believe GRP management has numerous levers to pull to create value. The balance sheet is clearly under-levered and management could buy back over one third of the company by simply moving to a leverage multiple of roughly 3x EBITDA. Alternatively, I believe that GRP’s suite of products would fit nicely within a larger oil field services business, particularly one looking for new management talent. But to be clear, I am not advocating an investment in GRP for a levered recap or a take-out. I am perfectly happy to hold a security with a prospective FCF yield nearly twice that of a government bond, growing earnings at nearly 20% next year, until the market realizes that while the price of natural gas may be volatile, the end markets for GRP’s products are not only stable but growing.