Description

We are recommending a long position in Xtreme Coil Drilling Corp. (Ticker: XDC-CA).  We see 50% to 75% upside over the coming twelve months based on:

• Convergence of the current market value of the company with its Net Asset Value
  • XDC’s assets are new, best-in-class oil services assets that earn solid IRRs (20% to 35%).  We don’t see any reason for these assets to trade at a 40% discount to what they cost to produce
  • Adjusting for asset additions and changes to the balance sheet, such a convergence would result in a move in the stock from roughly $3.00 to above $5.00
• Net debt will peak in 2Q after which the company will start to generate significant FCF and reduce its debt
• The company has faced execution challenges in its coiled tubing unit (“CT”) – but, we think these issues will finally end this quarter (2Q 2012).  Once investors see that such issues are behind XDC and operators in the field appreciate how well these assets perform – we think the stock will graduate from its current ‘show-me’ status
• At some point we think the Founder / CEO will be a seller of this company
• This would be consistent with his history of building technology oriented oil services companies and then selling them
• There are a variety of companies that would be interested in owning this set of assets
• An acquisition could result in more than a 2x from current levels

Brief Business Description and Detail on Company Assets

Description:  XDC is an onshore drilling and well services contractor that works with exploration and production companies in the U.S. and internationally.

Note:  Three of XDC’s drilling assets in Canada are temporarily idle as they wait through seasonal ‘break-up’.  This is an annual occurrence during spring thaw when roads are closed and rigs can’t be moved.   We have not characterized these rigs are technically ‘stacked’ in the long term sense as they are just waiting for the roads to open and then will return to work.

Drilling Assets:  XDC had 21 drilling rigs at the end of Q1 2012 (20 operating).  Four more rigs will be delivered over the course of 2012 (for a total of 25 rigs).  Across the board these rigs are high spec (AC, top drives, high horsepower mud pumps, skid/walking packages, craneless rig-up, etc.).  Upon delivery of the four additional rigs this year the average age of the rig fleet will be less than three years.

Thus, XDC owns what in every regard is a young, very high spec fleet.  These types of assets are garnering near 100% utilization in the market at present.  These are also the kinds or rigs that other drilling companies are eager to build/acquire.

Coiled Tubing Assets:  At the end of Q1 XDC had two coiled tubing rigs operating in Saudi Arabia, three operating in North America, and three more rigs that are substantially completed but are waiting on pumps for deployment.  Coiled Tubing has been a bit of a slow moving train wreck as XDC selected the wrong vendor for mud pumps and that company has not been able to deliver.   As a result these substantially complete rigs have sat idle. 

As this played out investors lost faith in this part of the XDC story – the delays have been a source of constant disappointment.  The good news is we believe XDC has taken control of this process and all five of the new XSR rigs will be in operation by the end of the second quarter (see XDC’s 4/3/12 ops update).  Admittedly this is probably two quarters later on average than originally anticipated and delayed considerable EBITDA contribution – but, we think the wait is almost over.

Importantly, these are the highest spec coiled service rigs in North America.  We don’t have the time/space here to discuss every differentiating aspect of these rigs.  The most important thing to understand is that they use longer, larger diameter (2 5/8”) coiled tubing to reach further into wells (over 20,000 feet) than other coiled tubing units in the field today (most coiled tubing is 1” to 2” in diameter and extends 5000sf to 17,000sf max).  Also, we expect the extra power and more precise control on the coil to allow XDC to perform down-hole work much more quickly with many few motor stalls (again, see XDC’s 4/3/12 ops update).  Although initially they will probably charge 2” CT type pricing – ultimately the XSRs’ benefits will allow them to charge a premium to the market.  It will simply take a few months for ‘company men’ in the field to appreciate the benefits of these super high spec CT units that XDC has brought to market. 

Valuing the Assets

The following section provides a valuation of the assets of Xtreme.  Our valuation of each class of asset is based on a number of things.  First, we looked at the balance sheet to understand the costs to make/buy the drilling rigs and CT units.  Second, we’ve spoken extensively with management and have taken into account their views on the subject.  Third, we’ve spoken to other public companies in drilling and oil services to understand how they view the value of XDC’s assets.  Finally, we worked with independent experts in rig valuation to get their perspective.   (Potential investors who seek to replicate this body of work should not find it too difficult.  Rigs transact pretty frequently and there are a host of people who will provide valuation services.)

The first part of our valuation focuses on how much each asset is worth individually.  Second, we look at how much the company might garner for this set of assets in the aggregate (with the current contracts attached)  

Value of Assets at 2012 Year-End

If you take this asset value, add in net non-cash working capital of $20mm, and subtract year-end net debt (roughly $110mm) you arrive at NAV of $330.  This divided by 66mm share outstanding= $5.00 per share or more than a 60% premium to today’s share price.

We think this is a good baseline valuation and that the stock should trade in line with the net value of its assets (not at a 40% discount as they do today).   Simply improving operations and deploying new assets should be enough to achieve this:

-  Solid economics on newly deployed XSR 500s

• These rigs will start working on multiple year contracts with a $26k to $28k day rates and cash costs of $13k per day
• Assume 96% utilization which is 350 days per year (use 96% utilization rather than 100% due to rigs getting paid less during mobilization days)  This implies just under $5mm in EBITDA annual per rig or ~4 year payback (accounting for minor maintenance capex) 

-  The CT rigs are more of a spot (call out) market but at 65% to 70% expected utilization the payback is less than three years

-  Per 4/3/12 (page 9) presentation on the website – Drilling IRRs are expected at 20%+ and CT IRRs at 35%+  

-  Obviously, the current demand environment (and therefor pricing) can change.  But, given that current pricing is prevailing even in a $2.00 natural gas environment gives us comfort.  Of course, if oil drops substantially then the rate picture will become more challenging (this factor is hard to avoid in any energy services stock)

Overall though, we think that as new drilling rigs come on, XDC finally executes on the CT rigs, and debt peaks in 2Q and then starts to come down, the stock will trade closer its NAV implying a share price above $5.00 per share.

But, we also think there is a reasonable chance that XDC is sold in the coming few years.  Why do we think this?  First, this is the history of the founder/CEO – he somewhat of a serial entrepreneur.  His history includes:

-  Founder and Director of Round-up Well Servicing - eventually sold to Plains Energy

-  Founder and Chairman of Savanna Energy Services Corp (2001-2005) which is at present a Canadian public company (E&P services)

-  Early Investor and Director Plains Energy Corp (Sold to Precision Drilling in 2000)

-  Was involved in Junior E&Ps including Wrangler West Energy (Director) and Player Petroleum (Director)

It is also interesting to note that the current CFO was also CFO for Bronco Drilling when it was sold to Chesapeake Energy in April of 2011.  Given his experience, he would be well prepared to run a sale process if called upon. 

Also, two large shareholders (Lime Rock – Energy P/E Firm at 19.3% and Shell Technology Ventures Fund 1 – Shell’s venture investing effort at 10.6%) will ultimately prefer a sale of the company due to their large positions and somewhat limited liquidity in the stock.

Finally, another key reason that we think XDC will ultimately be sold is that it represents a perfect acquisition for a number of oil service companies.  It could be purchased by an existing drilling company to acquire new, high quality assets and upgrade their fleet.  Alternatively, an oil service company without drilling assets but looking to diversify might also be interested in XDC.  In either case it is a nice bite-size at about $500mm such that it moves the needle for a host of mid-sized companies but is also a deal size that is in reach of many potential acquirers.

In the current environment we would expect an acquirer to pay a modest premium to NAV for the following reasons:

• It is difficult of to find a portfolio of new, high-spec equipment of this size.  To replicate it would take a number of years of new-building.  XDC represents a very fast way to add assets and upgrade an existing fleet
• The majority of the rigs have solid contact coverage with almost 70% of days covered through 2013
• XDC has the highest spec coiled tubing rigs in North America.  Most CT is 2” or below.  XDC CT is larger, will reach out further, and is more precisely controlled than the rest of the market.  As well, they have a fair amount of IP related to CT.  Not only would an acquirer get a great set of assets, they would also acquire some decent IP which they would otherwise have to try to design around

In terms of multiple – we think XDC could probably get 1.25x asset value.  As a reminder, 1.0x = roughly $5.00 per share.  1.25x NAV would equate to roughly $6.60 per share or more than a double from the current price level. 

Are there recent data points which suggest that in an M&A deal an acquirer will pay a premium to NAV?  The answer is yes.  For instance, Pioneer Drilling (Ticker: PDC) just bought Go Coil for $110mm.  Go Coil is a collection of 10 CT rigs (7 onshore, 3 offshore) that are pretty new (2009-2011 builds) and medium spec (1.25” to 2.00” coil).  Our diligence suggests the original cost of this fleet to Go Coil was between $55mm and $70mm.  We’ll get a more precise understanding when we see how much goodwill hits the PDC balance sheet after Q1.  But regardless, we have one recent data point of an acquirer paying at least 1.5x NAV for an attractive set of assets.

Why invest in XDC and not some other North American focused drilling company?  Aren’t there other companies trading at discounts to NAV?   A core element this investment thesis revolves around XDC trading at a significant discount to NAV.   With this in mind – we still want to make sure we are buying high spec, best-in-class assets.  This is because we don’t want to invest in some old, low quality assets that are temporarily making money just because current rates are solid (e.g. old dry bulk vessels in 2007).  Instead, we believe there is margin of safety to owning the newest, highest quality assets because they will typically garner the highest utilization rates even in a down market.  Whereas, older and lower quality assets may sit idle and have much more tenuous long term value.  Having said that, it is rather rare to find best-in-class assets trading at a meaningful discount to NAV.   When we do see this (as in the case of XDC) we are typically quite intrigued.   

Summary

• Owning best in class assets at a 40% discount to year-end NAV provides a solid margin of safety
• There are a number of reasons to think this gap will narrow or disappear completely (implying a $5.00+ share price)
  • New XSR rigs (after painful delays) are finally on a clear deployment schedule.  And, the first units are already demonstrating their operational outperformance in the field
  • Capex cycle is slowing, net debt should peak in 2Q, then debt reduction will commence
  • Optically the performance will continue to improve as the high spec drilling assets start to earn their keep
• There is some chance that Management / Core Investors seek to sell the company (resulting in a $5.00 to $6.50 transaction value)
  • The history of the Founder / CEO suggests he is more of a ‘build and sell’ type of guy
  • There are a large number of potential buyers who would love own these new, best-in-class assets
  • Core holders likely view a sale as the best and only realistic way to realize up their investment

Catalyst