Is there anyone out there who could explain how under normal efficient market conditions a very profitable company could trade at 60% of its tangible book value? And by profitable, I mean very, very profitable. For the first 9 months of 2008, Precision Drilling Trust (PDS) reported net GAAP income of $1.67/trust unit, with last quarter's earnings beating average analyst expectations by more than 8%. Expectations for Q4 are another 64 cents/unit. With PDS trading at $6.33/unit, the price at which I bought them shortly before Thursday's market close, that works out to an estimated 2008 PE of under 2.75!
Amazing, you would think, but that's far from the whole story, of course. And as is most often the case with equities trading at deep discounts to their peers, there are many important facts hiding behind the surface. Why these facts didn't dissuade me from buying PDS is yet another question, which I will attempt to answer here shortly.
I'll start by telling you what PDS is, was and plans to be. PDS currently provides contract drilling, completion and production services to oil and natural gas companies in Canada (mostly) and the United States. This one very agile company has Canadian roots going back to the early 1950s. By 2004, this trust's predecessor company had grown to include operations virtually world-wide and then by the end of 2005, the company divested all its non-Canadian operations and converted to a unit trust income structure for tax reasons. Expansion outside Canada started again the following year with a rig in Texas.
By the end of Q308, PDS had expanded its US operation to 28 rigs and its Canadian drilling fleet stood at 220 rigs, with operating days up 14% from last year. Yes, you read that right, up 14% from last year and BTW and at that time PDS units where trading at about 3x their current price. In fact, I first bought these same PDS shares at $17.91 just over a year ago and sold them for a whopping $23.51 at the end of March this year. At one point in 2006, these units even traded at over $38. But that's all history. What I want to know is how much these units are worth today, in today's tough economic environment and with prices of oil having come down by over a factor of three from their peak. I also want to know where this company is going in the future.
Let's look into the crystal ball first. On December 23, PDS is expected to complete its acquisition of Grey Wolf, Inc. (GW) - a US based drilling competitor. When this deal was first announced on August 25, the world was quite a different place and paying $5 plus 0.188 PDS shares per share of GW, a competitor with a decent footprint in the US, may have looked quite reasonable. On the date of the announcement, PDS closed at $20.18 and GW at $8.48. At those values, PDS was paying an equivalent of $8.79 a share, or a mere less than 4% premium. Borrowing costs were still reasonable for viable businesses like PDS and PDS was expecting to be able to borrow the money needed for this transaction at 8%.
However, times have changed… Grey Wolf shareholders are actually getting a very sweet deal at this point - a blended equivalent of approximately $6.20/share. (Which actually begs a different question, "Why didn't I buy GW shares, which closed at $6.03 today in anticipation of the exchange?" I will leave the answer to this question to my readers' imaginations, or another day's discussion topic.) While this deal was pending, financing rates have also skyrocketed and PDS is now expecting to borrow at 11% and incur additional upfront costs in the form of original issuance discounts and fees of approximately US$76 million! To stay within caveats of financing, PDS will also have to significantly reduce its monthly distributions - they are anticipating paying out less than 1/3 of what they have paid before.
All that sounds rather disastrous, doesn't it? And to some extent, it really is and on some level I am even hoping that this deal will not close, but I know that it will and that the very astute PDS CEO - Kevin Neveu has some very good reasons to stick to the deal. I am convinced that the scare over GW acquisition costs is what drove this stock into the ground. More so than any other factor like the precipitous drop in the price of oil. This scare is also what created the present buy opportunity.
For other reasons I still like PDS, please take a look at my previous notes on the company from 2007 at http://stockvalues.org/new-investment-strategy.
Disclosure: long PDS.