Lufkin Industries: Are Today's Low Prices Temporary?

Oil and gas equipment maker Lufkin Industries (LUFK), trading in the area of a 52 week low, is interesting as a value play in the energy sector. With a 52 week range of 31.45 to 95.23, there is the hope which springs eternal that it will go back up to where it was not that long ago.

I have followed the stock for almost a year, and I decided to take another look at it when it came up in a couple of screens published here on Seeking Alpha by Marc Gerstein. First, a look at the four metrics (click to enlarge):

Overview – The company describes itself as follows:

Lufkin Industries, Inc. sells and services oil field pumping units, foundry castings and power transmission products throughout the world. The Company has vertically integrated all vital technologies required to design, manufacture and market its products.

There are two segments, Oilfield and Power Transmission. A third segment, Trailers, was discontinued as of 2Q 2008. I visited the website and checked out a presentation. My take would be that what they do is relatively complex heavy manufacturing and service related to their products. To treat the company as if its stock price should directly track the volatile fluctuations of oil seems an oversimplification.

Estimating Low Price for a Cyclical - As with most cyclicals, prices on a P/E basis look very low at a turning point. Oil has plunged from a high of 147 to under 40 and oil and gas equipment and service stocks have turned down sharply in anticipation of reduced activity. Long term, the stock is attractive right now, but it becomes something of a guessing game as to whether oil will recover or languish at its current levels, and what the effects on Lufkin's revenue and margins will be.

Over the past 10 years, Lufkin had two years where revenue decreased by 13% and by 18%. Reducing estimated 2008 revenues by 15% and applying a low-point P/S ratio of .5, a protracted slump in oilfield activity could push the stock down as low as 20, in which case the patient investor would get a better entry than the 2008 close of 34.50.

That amount of downside potential is unlikely given a secure dividend, currently at .25 quarterly, and excess cash.

Projecting Future Oil Prices and E&P Activity – I subscribe to the Peak Oil theory and believe that most major fields are in decline. It is unlikely that the economies of India and China will not demand increasing amounts of oil over any substantial period of time, or that US citizens will change their energy use patterns until they run out of choices. With these thoughts in mind, a likely scenario is that oil prices will stay low for a while, exploration and drilling will lag, and then oil will head on up to something that will make 147 look like the good old days.

As of the most recent earnings call, management saw its larger and better capitalized customers as planning to “power through,” meaning they would continue activities at a fairly strong level in anticipation that today's low prices will be temporary.

Extra Cash – Lufkin has no long-term debt and has been steadily accumulating cash. There is nothing I am aware of to use as a rule of thumb for how much cash is necessary to run a business comfortably and prudently, but using a ratio of cash and equivalents to revenue, I think I see about 4 more cash per share than they have any need of. Because receivables and inventory are larger than payables and accrued liabilities, a reduction in sales would generate cash as the balance sheet would shrink.

LUFK's share counts historically have had a tendency to increase, but this year they are down from 15 million to 14 million. They could repurchase more shares, do a special dividend: or, not too popular with today's shareholders, hold the funds and deploy them in the business. LUFK pays a dividend, currently .25 quarterly. The past two years saw an increase of .02, and there is no reason not to do an increase again this year: why not another 2 cents, to 1.08 annually?

Regardless of what the company does with the extra cash, it's there, and between that and the very secure dividend, I don't see that much downside risk from where the shares are right now.

Growth and Margins – Between 2003 and 2008, net income as a percent of revenues has progressed from 3.9% to 12.5% last quarter. Part of this would be the removal of the discontinued trailer segment, which had a very low margin: but much of it is because the increased sales permitted spreading factory overhead over more units. That is unlikely to continue indefinitely, and more likely to reverse as business slows.

Growth has been rapid, 22% annualized for 5 years, but is not sustainable under today's conditions.

Target – Taking all of this together, and working off of P/S and P/B in order to get around the issue of margins, I arrive at a two year price target of 40-45 per share. There is a fairly wide range of possible outcomes: note the 2008 high of 95.23 or the hypothetical 20 per share if the energy market tanks long-term.

Strategy – Implied volatility is fairly high here, resulting in decent premium levels for options. A covered combination might be considered, along these lines:

Buy 100 Shares LUFK @ 34.50

Sell 1 UFRFH Jun09 40 Call @ 4.30 (mid bid/ask)

Sell 1 UFRRY Jun09 30 Put @ 4.60 (mid bid/ask)

If assigned on the 30 put, the investor will have an average cost for the 200 shares of 27.80, which is less than the tangible book value. The dividend yield at that price is 3.6%, a consolation while holding and waiting for a recovery. If the shares are called away at 40, annualized return is around 100%: there is nothing wrong with a quick and easy profit.

If I had to generalize on my experience with covered combinations, I would say that the stock either goes over or under the option strikes a lot more often than I expect it to. So any investor who wants to use the strategy should be sure he is comfortable with such outcomes ahead of time.

Disclosure: As of this writing, I plan to buy shares and execute the covered combo strategy.

Comments

[cjwirth:]

The top story of the year is that global crude oil production peaked in 2008.

The media, governments, world leaders, and public should focus on this issue.

Global crude oil production had been rising briskly until 2004, then plateaued for four years. Because oil producers were extracting at maximum effort to profit from high oil prices, this plateau is a clear indication of Peak Oil.

Then in July and August of 2008 while oil prices were still very high, global crude oil production fell nearly one million barrels per day, clear evidence of Peak Oil (See Rembrandt Koppelaar, Editor of "Oil Watch Monthly," December 2008, page 1) www.peakoil.nl/wp-cont.... Peak Oil is now.

Credit for accurate Peak Oil predictions (within a few years) goes to the following (projected year for peak given in parentheses):

* Association for the Study of Peak Oil (2007)

* Rembrandt Koppelaar, Editor of “Oil Watch Monthly” (2008)

* Tony Eriksen, Oil stock analyst and Samuel Foucher, oil analyst (2008)

* Matthew Simmons, Energy investment banker, (2007)

* T. Boone Pickens, Oil and gas investor (2007)

* U.S. Army Corps of Engineers (2005)

* Kenneth S. Deffeyes, Princeton professor and retired shell geologist (2005)

* Sam Sam Bakhtiari, Retired Iranian National Oil Company geologist (2005)

* Chris Skrebowski, Editor of “Petroleum Review” (2010)

* Sadad Al Husseini, former head of production and exploration, Saudi Aramco (2008)

* Energy Watch Group in Germany (2006)

Oil production will now begin to decline terminally.

Within a year or two, it is likely that oil prices will skyrocket as supply falls below demand. OPEC cuts could exacerbate the gap between supply and demand and drive prices even higher.

Independent studies indicate that global crude oil production will now decline from 74 million barrels per day to 60 million barrels per day by 2015. During the same time, demand will increase. Oil supplies will be even tighter for the U.S. As oil producing nations consume more and more oil domestically they will export less and less. Because demand is high in China, India, the Middle East, and other oil producing nations, once global oil production begins to decline, demand will always be higher than supply. And since the U.S. represents one fourth of global oil demand, whatever oil we conserve will be consumed elsewhere. Thus, conservation in the U.S. will not slow oil depletion rates significantly.

Alternatives will not even begin to fill the gap. There is no plan nor capital for a so-called electric economy. And most alternatives yield electric power, but we need liquid fuels for tractors/combines, 18 wheel trucks, trains, ships, and mining equipment. The independent scientists of the Energy Watch Group conclude in a 2007 report titled: “Peak Oil Could Trigger Meltdown of Society:”

"By 2020, and even more by 2030, global oil supply will be dramatically lower. This will create a supply gap which can hardly be closed by growing contributions from other fossil, nuclear or alternative energy sources in this time frame."

With increasing costs for gasoline and diesel, along with declining taxes and declining gasoline tax revenues, states and local governments will eventually have to cut staff and curtail highway maintenance. Eventually, gasoline stations will close, and state and local highway workers won’t be able to get to work. We are facing the collapse of the highways that depend on diesel and gasoline powered trucks for bridge maintenance, culvert cleaning to avoid road washouts, snow plowing, and roadbed and surface repair. When the highways fail, so will the power grid, as highways carry the parts, large transformers, steel for pylons, and high tension cables from great distances. With the highways out, there will be no food coming from far away, and without the power grid virtually nothing modern works, including home heating, pumping of gasoline and diesel, airports, communications, and automated building systems.

It is time to focus on Peak Oil preparation and surviving Peak Oil.
survivingpeakoil.blogs.../
www.peakoilassociates....

Jan 02 08:10 AM