Nabors Industries, LTD (NBR) is a company that has significant upside if current land rig day rates stabilize or decline moderately, yet maintains downside protection due to the term contracts that it is currently signing on its existing and new build fleets.With the company trading at $33, we estimate that Nabors will earn approximately $3.80 in 2006 (with negative free cash flow, due to its expansion program), and generate between $18 and $25 of after-tax free cash flow from 2007-2010.Management is shareholder friendly; it recently purchased approximately 37mm shares using in large part the proceeds from a low-cost $2.5bn debt placement.
Nabors is the largest land drilling contractor in the world, with approximately 600 land drilling rigs at the end of the second quarter.The company also owns well-servicing rigs and is a leading provider of offshore rigs as well. Nabors has a 50% ownership interest in a joint venture in Saudi Arabia, and offers a wide range of ancillary well-site services.Nabors’ customers include major oil and gas companies, foreign national oil and gas companies, and independent oil and gas companies.No customer accounted for more than 10% of consolidated revenues in 2005 or in 2004.
Nabors maintains six operating divisions, as well as an oil & gas investment through its Ramshorn business unit.The four largest divisions, which generate approximately 90% of the company’s operating income are the U.S. Lower 48 Land Drilling, U.S. Land Well-Servicing, Canada and International.Their Canada division, which consists of both well-servicing and drilling, should generate a record $225mm+ in operating income this year.
U.S. Lower 48 Land Drilling – Comprised of a fleet of over 400 land rigs.A land-drilling rig consist of engines, a drawworks, a mast (or derrick), pumps to circulate the drilling fluid (mud) under various pressures, blowout preventers, drill string and related equipment.Of the 257 rig years at the end of Q2, 126 were spot, while 131 were term. Notably, as of 1/15/06, the division had 143 spot and only 112 term, which reflects the company’s efforts to lock in cash flow via take or pay contracts. This division is expected to generate operating income in excess of $800mm in 2006, which should account for approximately half of the company’s profits.The average operating margin in this division will be approximately $10,000/day for 2006, versus the current leading edge operating margin of approximately $13,500.This is due in part to the fact that several of the company’s term rigs were signed for below market rates – 100+ of these come off contract over the next 12-18 months.
Additionally, the company has 76 land rigs in their construction pipeline that are already contracted (on a take-or-pay basis) for three-years each, which along with their new build international rigs should generate $370mm of incremental operating income.
U.S. Land Well-Servicing – This division consists of workover rigs in the United States, primarily located in Texas & California.The services this division provides include well-servicing and maintenance, workover services, completion services, and production and other specialized services.The division is expected to contribute approximately $200mm of operating income in 2006, with another 100+ workover rigs being constructed.
International – Nabors has international operations in 26 countries with over 100 active rigs (93 rig years in Q2).Many of the top customers are national oil companies – 60% of all revenues is from nationals.Like the U.S. Lower 48 division, the International has recently been signing 3-5 year term contracts at record rates, with 21 scheduled new builds in Africa, the Middle East, Latin America and the Far East signed to take-or-pay contracts.In total, this division is expected to generate over $220mm of operating income in 2006.
While an evaluation of this investment opportunity is somewhat of a probabilistic exercise, we believe a margin of safety exists due to the visible, locked-in cash flow provided by three-year contracts that the company has been signing (and we expect will continue to sign) at record leading-edge rates.
Although leading edge rates are currently at or near record highs, there are several factors that could suggest that these rates are either sustainable or should decline only moderately over the next 3-4 years.First and most simply, there is a shortage of land rigs in the United States.While the supply of land rigs is expected to increase 15-20% over the next couple years, the supply of rigs would still not meet the demand.Second, international expansion continues to accelerate and is expected to continue over the next 3-5 years.Finally, due to depleted natural resources and drilling alternatives (e.g., deeper drilling, more horizontal drilling, exploration of oil-shale resources), the inherent requirement for rigs (and technologically-advantaged new rigs) should continue to increase.
The underlying rationale supporting the current leading edge rates mentioned above is obviously subject to debate and far from certain.Nonetheless, we believe that while these factors may not support the current leading edge rates, they should help prevent a complete freefall.
If rates do hold or regress slightly to moderately (10-25%), we believe the company will generate approximately $25+ of after-tax free cash flow from 2007-2010 (the company has an NOL, and should pay cash taxes at an approximate10-15% rate for the near future), while earning $6-$7 on a run-rate basis in 2010.The degree of sustainability of this cash flow in subsequent years will depend on the company’s ability to renew their contracts.At a current stock price of $33, this would suggest that the company is undervalued by well over 50%.
At the same time, if the above reasoning does not hold, and rates do indeed crater, the term contracts that the company has signed (and should continue to sign in the near-term) will provide downside support.We believe that in such a scenario, the company will generate approximately $15 of after-tax free cash flow from 2007-2010, while earning between $2-$3 on a run-rate basis in 2010.
Significant decline in natural gas rates
Oversupply of land-rigs
Inability to execute extensions on term fleet
Decline in worldwide economic growth
Increase or maintenance of current leading-edge rates