|Shares Out. (in M):||217||P/E||N/A||N/A|
|Market Cap (in $M):||2,674||P/FCF||N/A||N/A|
|Net Debt (in $M):||12||EBIT||0||0|
|Borrow Cost:||Available 0-15% cost|
We all know energy’s been one of the most bombed-out sectors out there ever since crude oil prices took a nosedive in the fall 2014. So, the energy space should present abundant deep-value opportunities for the long-term investor, right? Perhaps, but we think there is a large contingent of energy names where investors’ fear of missing out of a potential recovery has led to many cases where stocks are well ahead of themselves trading at asinine valuations. We believe RES is a good example and a timely short idea.
This short idea will get a low rating on VIC. RES is a reasonably well-managed company. It has a healthy balance sheet, and we’re making a bearish call on the most underweight sector in the market. Moreover, we’re not claiming to have an edge on calling earnings estimates, given zero visibility. It is reasonably possible that sell-side earnings estimates are very near the trough. We don’t have any obvious hard catalysts, either. In essence, this is the much-dreaded “valuation short”. But we have seen this pattern before, and we are near certain that the market won’t have the patience to sustain this nosebleed valuation for 3-4 years. All in all, RES is likely to underperform more resilient oilfield service peers (or oil prices, for that matter) by 25-30% within the next few months.
We believe we’ve not seen real capitulation in the energy space. In fact, investors are so starved for bargains across the overall equity market that they have once again dived into the pool too early in hopes of a sharp recovery in the energy space. This turned out to be premature in 2Q15, and we believe we’re at a similar point now. Most energy-related equities have seen a strong bounce off the late-Sep lows, even as oil fundamentals –and the oil price itself- continue to deteriorate.
We get it, multiples expand near the bottom of the cycle, and what looks expensive on near-term multiples often turns out to be a bargain in retrospect. We recognize this is a risk to our short thesis, so we don’t focus on 2016 earnings estimates to call RES ridiculously overpriced. We don’t look at 2017 either. Nor 2018. It turns out we’d need to look at multiples off 2019 consensus estimates for RES to be trading at anything near mid-cycle multiples.
RES is an oilfield services company solely focused on the onshore North America market. The company operates several service lines (pressure pumping, downhole tools, coiled tubing, etc) that are generally highly commoditized and which are currently experiencing significant underutilization. RES’ asset utilization is highly sensitive to E&P spending levels, and its services are largely priced on a spot basis (nearly no long-term contracts). Thus, RES was quick to suffer the impact of declining oil & gas activity, and 2015 EBITDA will end up around $120mm, down 80% from 2014’s near-peak level of $634mm. The flipside is that it’s also perceived as an early-cycle play on a potential recovery, given the high sensitivity of US energy activity to commodity prices.
We don’t have an edge in calling commodity prices: overall it’s true that $40 oil cannot sustain supply-demand balance (given the decline rates of oil wells, which are much higher than most other resource industries) in the medium-term and at some point the market will require a higher price to rebalance. Whether this higher price is $60, $80, or $100, we won’t even try to determine. But the last twelve months have shown that this process will take longer than most expected. In summary, we now find ourselves in general agreement with the “lower for longer” oil price theme that has become consensus.
We opened this write-up indicting pretty much the entire energy space for being overvalued, and certainly all of the oilfield services sector. Every single name is trading materially above its historical trading multiples based on FY1, FY2, and in many cases even 3-year out earnings estimates. Quite bluntly, there is no absolute value to be found anywhere in the space, unless you are ready to endorse materially higher commodity prices.
RES has historically traded at a 5.3x NTM EV/EBITDA multiple, and within a range of 3.0x-7.4x in the 2010-14 period of 2010-14. Let’s discard the 16E multiple of 23x levels (assuming it’s the trough of the cycle). RES’ current EV of $2.7bn implies the company would need to generate $510mm of EBITDA to be currently trading at a “mid-cycle” multiple. That’s above the $490mm EBITDA generated in 2013, when oil prices averaged $96/bbl, natural gas $4/mmbtu, and the US rig count averaged 1,761, versus today’s 737.
Bear in mind that RES’ all time-high EBITDA was $660mm EBITDA in 2011-12. The thing is, consensus estimates only assume RES reaches a $500mm EBITDA number out in 2019. There are only two estimates and given zero visibility in the space, there’s no way of knowing whether we hit that level in 2019, 2018, or never. Our point is, directionally it probably still takes 3 or 4 years for the $500mm earnings level to be realistic, given the severity of the current downturn. The fact that the market has effectively discounted all that recovery in today’s RES stock price speaks to how much the stock is ahead of itself.
Implementing the trade
We get it’s a risky proposition to short a name like this with oil prices so low, no matter how expensive the stock might be. There is a real risk that the stock rips on a slight bounce in oil prices. To hedge that risk, we have paired RES against a long position in the blue-chip in the space, SLB, which has been a lot more resilient in this downturn given its international exposure, diversification, and massive scale. This is not to say SLB is a bargain in absolute terms, but we find it’s much better relative value than RES even assuming a reasonable recovery in the US land market. Even going long crude oil seems like a valid pair – you can easily implement this through the USO ETF.
Picking reference points is rather arbitrary but SLB’s EBITDA will be down 20% YoY this year, while RES -80%. Yet since June 2014, RES as a stock has only underperformed SLB by 13%.
Another data point: Oil prices (WTI) hit $40 in late Aug of this year and then quickly bounced to $50. In the last few weeks, oil has retraced that move and is back to $40. Over those 2 months, RES has outperformed SLB by 33% (and oil prices by 35%) even though the prospects of a recovery in the US land market keep getting pushed to the right. If you believe in mean reversion, either the stocks were massively mispriced in late Aug, or we are facing an extremely attractive opportunity right now.