BJ Services Company: Looking Beyond the Trough

Like most stocks in the Energy sector, and particularly the oilfield services sector, BJ Services (BJS) has been hammered as the price of oil has sunk below 50.

The stock's 52 week range is 34.94 to 8.67, and it closed Thursday at 9.26. Before going over the company's fundamentals, I am going to present some ideas about using Price/Sales ratios to guess how bad the downturn will be and what the potential recovery would look like.

P/S Ratios: Peak to Trough

BJ Services' business is cyclical, and there have been two trough years during the past ten: 1999 and 2002. Revenues for the trough year were substantially less than the preceding year: 26% less in 1999; 12% less in 2002. Price to Sales ratios have varied from .6 to 4.2, with the low point occurring in the year before a trough, presumably because the market was predicting the downturn.

At its low price this year (8.67), BJS had a P/S ratio of .47, well below anything seen during the past ten years. If Mr. Market is correct, revenues for 2009 are going to be 26% less than 2008, if not worse. If history repeats itself, revenues in 2010, the recovery year, will be approximately the same as 2008.

Here's the interesting part – in the recovery years of 2000 and 2003, P/S ratios ranged from a low of 2.1 to a high of 4.2. History does not always repeat itself, but if it does, BJS could trade from a low of 28 to a high of 76 during 2010, assuming the natural gas business is in recovery by then. So this could be a three or four bagger, well worth looking into the fundamentals to see if they provide any support for such a rosy scenario.

Overview

BJS describes itself as a leading worldwide provider of pressure pumping and oilfield services for the petroleum industry. The company operates in 4 segments – US/Mexico Pressure Pumping Services, Mexico Pressure Pumping Services, International Pressure Pumping Services, and Oil Field Services. The prime driver of results is the North American natural gas industry, currently characterized by over-supply and low prices. Predictably, this will lead to a decrease in rig count and a decrease in demand for pressure pumping services.

In addition to the 10-Q and 10-K, I reviewed the most recent conference call transcript available on S-A and the company's Analyst Presentation.

Natural Gas Trends

There has been increasing growth of drilling in formations such as the Haynesville Shale which require more fracturing or simul-fracturing and greater horsepower for pressure pumping. Extraction of natural gas from these formations requires more services. This can be expected to continue as the more easily accessible gas is depleted. North America has quite a bit of natural gas, it burns cleaner than oil or coal: the industry should enjoy good long-term growth based on the fuel's clean-burning properties and availability.

Competition

Several quarters ago, analysts were concerned with “rampant” competition. The high prices of pressure pumping services combined with the easy availability of capital to attract a host of smaller competitors, pressuring margins. BJS did suffer decreasing margins, from very attractive levels, but was able to mitigate the damage by paying careful attention to updating and rationalizing prices for all customers.

Now analysts are concerned with potential acquisitions, from among the same host of rampant competitors. BJS will look at opportunities, but would prefer to buy a business that is complementary to what they do, rather than a small-time direct competitor. Of course, if equipment becomes available at attractive prices, they will look at that.

Capex

BJS has about 25% of its equipment which is becoming obsolete and needs to be replaced. They have been replacing equipment for several years. If and when the replacement cycle is completed, free cash flow should improve. In the event of a slowdown, the company would plan to accept delivery of existing orders when completed and stop placing new orders. This would free up cash flow to help them through difficult times.

Severity of Downturn

Guidance for the first quarter of fiscal 2009 was muted, EPS on a range of .48 to .51. Management has not yet provided guidance for the full year: they expect to have better visibility by the end of the next quarter, after talking to their customers.

BJS has managed through previous downturns successfully, and if conditions deteriorate they would plan to reduce personnel by attrition and discontinue the purchase of replacement machinery, after accepting delivery of outstanding orders.

As of the last conference call, management had not seen evidence of the type of steep downturn that the share prices are anticipating. They acknowledge that if demand falls too far pricing discipline could erode as marginal players struggle to stay afloat. My impression is that BJS has the resources to outlast its smaller competition under this scenario.

Financial Strength

The company has about 250 million of senior notes maturing in 2011 and another 250 million in 2018. They have an unused credit line of 400 million and 150 million in cash as of 9/30/2008. Cash from operations has been between 800 and 900 million for the past years, most of it used for investing in property, plant and equipment – capex.

Summary

Based on the long term potential for the industry, as well as BJS' dominant position and financial strength, I look for the company to emerge from the trough with strong revenue and EPS growth, bringing share prices up to 28 or better, perhaps in 2010. The downturn may be less severe than anticipated, because with the type of formations that are being exploited now, continued drilling is necessary to sustain production.

Disclosure: I am long Jan10 10 calls, and plan to hold the position or even roll it out to 2011 if it can be done at a decent premium. As always, I will monitor quarterly results and conference calls.