Is This Drilling Peer Group Too Expensive?

Includes: HP, NBR, PES, PTEN, UDRL
by: Alberto Abaterusso

This article discusses a method of determining the value of this group of companies: Helmerich & Payne, Inc. (NYSE:HP), Patterson-UTI Energy Inc. (NASDAQ:PTEN), Nabors Industries Ltd. (NYSE:NBR), Pioneer Energy Services Corp. (NYSE:PES), by using the price offered by Sidewinder Drilling Inc. to acquire Union Drilling (NASDAQ:UDRL) as a starting point for the calculation.

It is just an approach for assigning a value to a stock on the basis of the price that a knowledgeable acquirer is willing to spend to buy a stock's competitor. The reasoning is based on the fact that there are investors who assign higher values to stocks that produce higher cumulative total returns. Consequently the curves of values and cumulative total returns have similar trends for a stock over time.

FORT WORTH and HOUSTON, Texas, Sept. 25, 2012 /PRNewswire/ -- Union Drilling, Inc., a land drilling services and equipment contractor headquartered in Fort Worth, Texas, and Sidewinder Drilling Inc., a Houston-based land drilling company controlled by Avista Capital Partners, today announced that the two companies have entered into a definitive agreement and plan of merger pursuant to which Sidewinder will acquire all of the outstanding shares of Union Drilling common stock in an all-cash tender offer valued at approximately $242 million.

Union Drilling, Inc. operates an oil and gas land drilling company. The Company provides contract land drilling services and equipment to oil and natural gas producers. the principal operations are in the Appalachian basin, extending from New York to Tennessee, the Arkoma basin in eastern Oklahoma and western Arkansas, the fort worth basin in northern Texas, the perchance basin in western Colorado and the Uinta basin in eastern Utah. It has increased the size of fleet to 76 land drilling rigs, of which 70 are marketed and six are stacked in. It operates in United States and Canada.

As of November 2, 2012, there were 21,398,534 shares outstanding (according to UDRL's Form 10-Q, 30/09/2012).

If we divide $ 242 million by 21.40 million of UDRL's shares outstanding, we have $11.31 per share (approximately).

We hypothesize that in a dream situation 100% of the share capital of UDRL is negotiated on the stock market and an investor (Sidewinder Drilling Inc.) has made ​​an offer through his broker to purchase all outstanding shares of UDRL at a price of $ 1.31 per share.

Sidewinder offered to pay $11.31 for each UDRL's share. So we could look at $11.31 being the price that a company that operates in Basic Materials would be willing to pay to take over companies such as Union Drilling, Inc. which operates in the same industry (Oil Well Services and Equipment) of our target companies (HP, PTEN, NBR, PES). Obviously I'm simplifying the assessment a lot with this model. We consider this value of $11.31 as a benchmark on which to base our construction of a technique that allows us to obtain a value for the target companies' basket.

If we have a look at the chart below, Comparison of Cumulative Total Return 5 Years, we can see that the curves of UDRL and Peer Group intersect each other during fiscal year 2008. That is the cumulative total returns of UDRL and Peer Group are the same around the middle of the year 2008.

Source: UDRL's Form 10-K for FY 2011, page 12

If at that time an investor had to make an investment decision based on the security that had the highest total cumulative return, for him it would have been indifferent - caeteris paribus - to invest in UDRL or Peer Group. So we think it is plausible that investing in UDRL or Peer Group would have had the same value for the investor. For the investor the value of the Peer Group had to be greater than or at least equal to that of UDRL.

Question: assuming that the value of UDRL is equal to $11.31 per share, what is the value of the security during 2008? If you look at the graphic, we can also see that the Curve of UDRL had a decreasing trend from 2006 to 2011. Can I roughly quantify this decreasing trend on an annual basis? I can do this through the use of CAGR (Compound Annual Growth Rate).

UDRL's CAGR for the Cumulative Total Return = [sqrt(44.32 / 100.00, 5) - 1] * 100 = -15.02%.

CAGR allows us to obtain a better approximation of the average slope of the function than the method of linear regression.

So if we assume that a security that generates a higher return on investment has also a higher value for an investor, then we can assume that the value of UDRL was higher in 2008 when its total cumulative return was higher than that of 2011.

Given that the CAGR of UDRL is equal to -15.02% then in order to know the value of UDRL for 2008 it will be enough for us to increase the UDRL's value of 15.02% each year until 2008. We should also take the inflation into account. So in view of this I am going to subtract from 15.02% the rate of inflation from 2008 to 2011. 2% is the rate of inflation in 2012. You can find the CPI inflation calculator here. -7.82% is the CAGR for the 2nd semester of 2008.

FY CAGR - Inflation Rate Rate Value
30/06/2008 - - $16.94
31/12/2008 +7.82% - (4% x 6/12) 5.82% $16.00
31/12/2009 +15.02% - 1% 14.02% $14.04
31/12/2010 +15.02% - 2% 13.02% $12.42
31/12/2011 +15.02% - 3% 12.02% $11.09
31/12/2012 -2% -2% $11.31

So on the basis of this reasoning, we can say that the value of UDRL on 30/06/2008 was $16.94 per share. This should also be at least the value of the Peer Group at that time (please remember that the curves of UDRL and Peer Group intersect to each other during fiscal year 2008).

Now if we bring the value of $ 16.94 ahead through the time from June 30, 2008 to Dec. 31, 2012 and we take into account the CAGR of Peer Group, we can calculate the current value of the Peer Group.

Peer Group's CAGR for the Cumulative Total Return = [sqrt(97.85 / 100.00, 5) - 1] * 100 = -0.43%. The CAGR for the 2nd semester of 2008 is -0.22%.

FY CAGR + Inflation Rate Rate Value
30/06/2008 - - $16.94
31/12/2008 -0.22% + (4% x 6/12) 1.78% $17.24
31/12/2009 -0.43% + 1% 0.57% $17.34
31/12/2010 -0.43% + 2% 1.57% $17.61
31/12/2011 -0.43% + 3% 2.57% $18.06
31/12/2012 +2% 2% $18.42

$18.42 is according to this way of reasoning, the price that should be paid for the Peer Group.

On February 18, 2013 Helmerich & Payne, Inc. closed at $67.83, Patterson-UTI Energy Inc. closed at $24.31, Nabors Industries Ltd. closed at $17.68 and Pioneer Energy Services Corp. closed at $9.66.

Based on the following screening criteria, only Helmerich & Payne has passed the test:

  • Excluding small companies.
  • Stocks with Currents assets at least twice their current liabilities.
  • Working capital (current assets - current liabilities) > long term debt.
  • Some earnings for the common stock in each of the past 10 years.
  • Dividend payments record.
  • Earnings growth. 33% cumulative earnings growth over 10 years.
  • Current price is no more than 15 times avg earnings over the past 3 years.
  • Price to book value ratio no more than 1.5 (as of week 7).

But if we compare the current price of Helmerich & Payne with the value that I estimated for the Peer Group, HP is overrated by the market, so I would not buy this stock today, but wait till it decreases.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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