Nabors Could Be Worth Double
publication date: Jun 20, 2012
author/source: RJ Towner
Over the past year, major drilling contractor Nabors (NBR) has seen its share price slide by over 45%. Worries over deteriorating natural gas prices, coupled with recent weakness in oil prices and a highly leveraged balance sheet have weighed on the firm. We think shares are worth $27 each, suggesting the firm has significant upside from current levels. We dig into what we think can drive the company towards its intrinsic value.
Balance Sheet Improvements
The enormous boom in global growth and energy consumption during the mid-2000’s caused several oil and gas companies, including Nabors, to add significant financial leverage. Borrowing costs were reasonable given that the price of oil seemed to steadily rise every year. However, energy prices collapsed in 2008 and 2009, which crushed profitability.
As a result of increased volatility in oil and natural gas prices, Nabors has committed to deleveraging (reducing debt). The firm’s net debt to capitalization ratio is about 42%, but new CEO Anthony Petrello has committed to reducing this ratio to 25%. In the company’s latest annual report, Petrello commented that the firm wasn’t able to buy back stock at increasingly favorable levels as a result of too much financial leverage. Lowering financial leverage could help the firm’s credit standing, while giving the company increased flexibility when market conditions change.
Further, management acknowledged that they are looking to divest the firm’s non-core assets. By eliminating exploration and production assets, we think the company will reduce some of its risks tied to spot market pricing. Selling these assets will also allow the company to reduce its debt load.
The Company Generates Robust Cash Flow
Though shares have tumbled, and only trade at 6x our 2012 earnings forecast, we think the company looks even cheaper on an EV/EBITDA basis, where it is valued at 3.7x our forecast, relative to 6.7x median multiple for its peers. The company has enormous interest costs as a result of its debt load, as well as high depreciation and amortization expenses (nearly $1 billion in 2011). As a result, the firm generated $1.5 billion in cash from operations in 2011, and we expect that figure to grow to $1.7 billion this year and to $2 billion in 2013.
Nabors often spends heavily on capital expenditures, but Petrello has acknowledged that the company intends to greater scrutinize its capital allocation plans to ensure higher levels of free cash flow generation. The firm has around $275 million of debt due in 2012, but it has no other significant debt payments thereafter until 2018. The firm will have several years to focus on reducing this debt balance and generating cash for shareholders.
Significant Earnings Upside
In spite of volatile prices for natural gas and oil, we believe Nabors has tremendous earnings upside. In 2011, international operating revenue increased just 1% as a result of higher utilization; however, operating income fell over 50% thanks to lower day-rates and higher costs. We see revenue upside fairly muted in this segment, but we think the company may see more normalized margins in 2012.
Additionally, the company acquired Superior Well Services in 2010, which has resulted in a robust hydraulic fracturing (better known as “fracking”) segment that should have long-term secular demand as drillable oil becomes scarcer. The segment accounted for $1.2 billion in sales in 2011, while delivering operating income of nearly $230 million. Unlike off-shore drillers like Transocean (RIG), which specialize in deep-sea drilling, Nabors off-shore drilling segment involves shallow water rigs. This lowers the break-even for profitability, and it leaves the firm’s off-shore drilling segment less prone to costly deep sea spills. Plus, we think it’s reasonable that natural gas will recover from all-time lows, and we don’t see global demand for oil subsiding soon. As a result of these factors, we think earnings will grow at nice double-digit annual clip over the next 5 years.
Ultimately, we think Nabors is a very compelling opportunity at current levels. The company trades at a significant EV/EBITDA discount to its peers, and we think the firm’s financial health will improve going forward. The lower-end of our fair value range is $20 (at the time of this writing), which suggests investors currently have a large margin of safety. Since we lack much energy exposure in the portfolio of our Best Ideas Newsletter, we may consider establishing a position on any improvement in its technical and momentum indicators.