We are bullish that the Permian basin will be the first place a US onshore oil recovery will occur, but bearish on RES, which we believe is an overhyped trading vehicle that investors are utilizing to gain short cycle oil field services exposure to the play. While beyond the scope of the below memo, we are also long UNF and strongly agree with the three key bull points in grizzlybear's 10/30/16 write up. Investors looking for a free call option on a Permian rig count recovery, while also getting an attractive net cash balance sheet and defensive high quality business, should look closely at UNF.
RES is an onshore oil field service company focused on pressure pumping, which accounts for over half of revenue, along with other related services (e.g. coiled tubing, snubbing, nitrogen, rental tools) that are also highly correlated with the onshore rig count. 70% of services relate to drilling and production activities for oil, with the other 30% relating to drilling and production activities related to natural gas.
We believe that RES is a low quality, commodity business operating in a highly fragmented, oversupplied industry that is egregiously overvalued due to technical factors that are likely to subside in the short to medium term. We have an opportunity to short this commodity business at 4.7x tangible book value in an environment where both public and private market comparables are trading at only a fraction of book value.
RES is majority owned and controlled by the Rollins family. The public float is less than 30% of shares outstanding, of which the majority is already sold short. In our view, this low float, high short interest dynamic has led to an extreme overvaluation in RES shares in 2016 (the stock is up 30% this year from an already extreme valuation level entering 2016) as bulls have piled into RES shares on some derivative of the below bull theses:
For long-only sector specialists, RES is a great place to hide for those investors that are required to maintain sector long exposure in a highly challenging oil field services investing environment. The company sports a rock solid balance sheet ($139MM of net cash) and will survive this market downturn unlike some of RES's more levered peers (e.g. CJES). The RES management team is conservative and won't torch your cash. The company has maintained its pressure pumping equipment better than many industry peers and is ready to put its equipment back to work as we enter the next upcycle. Furthermore, the next upcycle may even be stronger than the previous pressure pumping bull cycle (~2011-2014) since the industry is moving towards slickwater fracs that use higher volumes of water and need to be pumped at a higher rate because of lower proppant carrying capacity versus gel based fracs and are targeting rock formations with unconventional wells at higher pressure, which requires more pressure pumping horsepower per well.
For long-short relative value sector specialists, RES's is attractive since the company is overweight the Permian, the most prolific onshore US basin. As we enter the next oil bull market, the Permian is seeing the first signs of the nascent oil market recovery. Since the trough in May, according to BHI, the Permian oil rig count is up 65% compared to a 36% increase in the total US onshore oil rig count. RES represents an attractive long trade -- go long short cycle (cyclically recovering) onshore low-cost unconventional exposure (RES) and short offshore deepwater long cycle, secularly challenged, overlevered companies (e.g. RIG, SDRL, OII, TDW, GLF). To add icing to the cake, RES has faithful bullish sellside following that is slow to update quarterly numbers! Indeed, ahead of the 3Q16 print, the sellside did not move numbers up a single penny from their initial estimates in early May even though BHI reports weekly rig count figures and RES results are extremely correlated with the onshore US rig count that rose sharply intra-quarter in 3Q16. RES beat 3Q16 results (posting negative net income of $4.4MM vs Consensus of negative $15MM) and showed encouraging incremental margins (44% quarter-over-quarter) as greenshoots in both pricing and volume are materializing. The company is in the early stages of an earnings upgrade cycle.
The above may sound like a disastrous set up for a short case, but we believe the "set up" is the precise reason why we have the opportunity to short RES at 4.7x tangible book for a business that isn't worth much more than replacement value plus cash.
We view a "bottom of the cycle" stock like RES as similar to a low quality internet/tech stock (think W, DDD, TSLA, or GRPN). The worst thing these types of businesses can do is make money, since then the blue sky upside case becomes benchmarked to actual financial results. 3Q16 marked the first real positive inflection in RES results. The quicker the rig count recovers, the higher expectations will be for RES and the quicker the story will unwind.
Pressure pumping is the ultimate commodity industry with dozens of competitors fighting for market share. Equipment can easily be transferred between oil basins, so RES's advantage of having its equipment focused in the Permian is fleeting. Currently, the industry is operating somewhere between 30-40% utilization, or higher if you believe that there is a labor shortage or a lack of refurbished equipment in the short term. Most players we've spoken with claim they are maintaining their equipment while their competitors are not, which is a key debate in the sector right now (what is the true amount of marketable pressure pumping capacity?). We don't think it really matters. Once the market recovers to the point where industry participants can earn a reasonable return on capital, other competitors will invest in labor and equipment. There may be a couple quarters of overearning at some point, but not much more. In the event new pressure pumping equipment is actually needed (in 2018+), the equipment suppliers (GE, CMI, CAT, WEIR LN, GDI, NOV, FTI, etc.) who are well capitalized themselves, will be happy to supply it to them.
Last cycle, RES earned $1.35 of peak EPS at a 37% ROIC when the company benefited from long term contractual arrangements that contributed to very tight utilization levels in what was then a capacity constrained industry (the last of RES's long term contracts expired in 2014 as the industry has migrated towards spot). We think a return to a 30%+ ROIC in a fragmented, competitive industry like pressure pumping is highly unlikely. Replacement value is ~$1,000 per horsepower and RES has ~930k HP (note tangible book value is $805MM). Using a very generous 10-20% mid-cycle ROIC RES should earn ~$0.40-.85 per share. Our conclusion is that RES is dramatically overvalued in most reasonable mid-cycle scenarios:
Net Cash per Share
Undiscounted Price Target
Mid-cycle Achieved in:
2018 @10% Discount Rate
2019 @10% Discount Rate
2020 @10% Discount Rate
Mean of Discounted Target Price
% Change from Current
Like a sexy low float tech internet IPO, RES is currently benefiting from scarcity value. Investors are looking for an oil field service sector trading vehicles to play the short cycle recovery in the Permian basin. RES is only liquid pure play way to gain pressure pumping exposure without a toxic balance sheet. We think this dynamic will likely change in the next 6-12 months, which should cause RES equity to become a source of funds for sector focused investors. There are many pressure pumping players undergoing various stages of restructuring today and it is possible some may enter/emerge from bankruptcy in the short to medium term (e.g. CJES, BAS, SSE) and re-emerge with a cleaner balance sheet and lower cost basis in their equipment (with which they can then further add pressure to industry pricing dynamics to fight for market share). TUSK IPO'ed last month. BHI is nearly complete on evaluating strategic alternatives for its pressure pumping business. Private Equity firms like Cerberus and Energy Capital Partners back private companies in the space. While we do not know what the precise landscape of publicly traded pressure pumpers will look like in 2017, we believe that investors are likely to have considerably more "investable" choices than just RES, which should pressure RES's premium valuation over time.
As discussed earlier, we believe the short-term set up (low float, high short interest, sellside numbers too low) is a key reason this opportunity exists, but it's also obviously a key short-term risk. Size accordingly and prepare for mark-to-market risk.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.
A recovery in the onshore rig count causes a rebasing in expectations.
Emergence of other public traded investable pressure pumpers causes RES scarcity value to dissipate.