Back on November 7th, I submitted an article about Helmerich & Payne (HP). They showed up on my radar around August of this year when they rewarded shareholders with a major dividend increase. My article was an attempt, by a complete outsider to the energy industry, to understand and share some key points about the company and stock. I should have made that more clear.
There were some good comments from readers on this site. However, the article also appeared on my Wisdom's Reward website. Some of the more knowledgeable readers shared comments that were really thoughtful and informative. I thought I would share them, as well as my further thoughts, with Seeking Alpha readers. To be clear, though some were very knowledgeable on publicly available information, none of the readers indicated that they had any sort of affiliation with the company.
First was this thoughtful comment:
"When thinking about the debt here I think it is important to realize that they have no net debt. Their securities holdings (SLB & ATW) alone equal $1.50 for every $1.00 of debt outstanding. As with most asset intensive businesses, the deferred tax" (liabilities) "come from the timing differences on book vs. tax depreciation rates on their PP&E. It will only come down if they stop growing. What's important to understand is that they haven't used leverage in an industry that is prone to booms & busts and almost every new rig they build is on a long-term contract that insures it will cover all of its construction costs."
This is a great point about the company's extremely conservative management of its capital structure, as well as other prudent risk management practices they have adopted. The managers of this company probably could have taken greater risk, using debt to fuel more speculative growth at a time when they have the advantages running in their favor. Doing so would have probably resulted in increased returns to equity holders over the short term, but it would have also greatly increased risk. Instead, the company has been prudent and careful in managing the business for the long term.
However, I don't believe the tax liability can be ignored. Further, when you don't fully understand something, it is best to err on the side of caution, or conservatism. After reading this comment, I decided to go back to the CFA material to see if my inclination to recalculate the Debt/Equity ratio was correct. From a publicly available CFA exam guide on Investopedia.com:
"If a tax asset or liability is simply the result of a timing difference that is expected to reverse in the future, it is best classified as an asset or liability. But if it is not expected to reverse in the future, it is best qualified as equity.
Deferred tax liabilities that should be treated as equity in the following circumstances:
- A company has created a deferred tax liability because it used accelerated depreciation for tax purposes and not for financial-reporting purposes. If the company expects to continue purchasing equipment indefinitely, it is unlikely that the reversal will take place, and, as such it should be considered as equity. But if the company stops growing its operations, then we can expect this deferred liability to materialize, and it should be considered a true liability.
- An analyst determines that the deferred tax liability is unlikely to be realized for other reasons; the liability should then be reclassified as stockholders' equity."
Based on this, I would have to continue erring on the side of caution. I am not able to determine if the deferred tax liability will ever reverse or if it will be permanent. It appears that there has never been much of a reversal in the past, based on this chart (click to enlarge images):
So, ultimately, readers can decide whether it's something they want to factor in as a liability or not. Maybe the right way to factor it in is to say that future cash from operations, as a percentage of revenue, could go significantly lower than its current level (if growth ever slows such that the company has to pay a higher effective tax rate). It does not represent the same kind of risk as debt, as noted by a reader:
"Think of it this way, say there's a big down-turn in the energy industry and especially in US land drilling. During this period HP's earnings drop to breakeven or they actually lose money. At that point they will pay no taxes. Whereas if they had debt they'd still have to pay their debt service. It's not that DTLs are unimportant, it's just that from a risk/margin of safety standpoint they are completely different from debt."
Moving on, I also noted my concern about recent insider selling in the stock. A reader responded,
"You may want to take a closer look at the Form 4s that has Helmerich files. I think you'll find that his large sales are for shares for which he disclaims any beneficial interest. He is the Trustee of various family and charitable trusts (his father's estate plan was very complex) so his name goes on every transaction."
First of all, I need to apologize to Mr. Helmerich (though I seriously doubt he reads my articles) and readers for writing what I wrote without fully investigating the matter. I am sorry. A list of the relevant Forms 4 in question can be found here. I do see family trusts listed for some of the sales I was referencing in the article, and they are listed as "Indirect Ownership". They appear to have been "gifted" to a family trust, and then sold by the trust. That doesn't mean I believe they are entirely irrelevant. But it is different, and the difference should have been noted.
Second, a more recent transaction (that I don't recall showing up on the Morningstar insider transactions page at the time I wrote my first article) appears to show that Mr. Helmerich is actually holding recently acquired shares. He appears to have exercised an option for 80,000 shares and sold only the amount required to purchase the shares and/or cover the tax bill associated with the transaction (code F - Payment of exercise price or tax liability by delivering or withholding securities). So, the most recent transaction left him with a net increase of almost 40,000 shares.
My main point with my comments about insider transactions was one of basic common sense, that investors should pay attention not only to what company managers say, but also what they do. I noticed that the company had touted its now attractive dividend yield alongside its competitive advantages, opportunities for continued growth, etc. in recent investor presentations. While they should always be informing investors as much as possible about the strengths, weaknesses, opportunities, and threats of the company, touting the relatively new dividend yield kind of left a bad taste in my mouth when I saw what appeared to me to be little interest in holding onto shares themselves. But, there have been a lot of transactions reported since I wrote that first article, including relatively small purchases at market price. The company should be praised for rewarding shareholders with dividend increases, but why not let the market/public at large do all the praising? That's just my two cents on that topic. But hey, if I had delivered the kind of results to shareholders that these guys have, in a highly competitive industry, I would probably be doing a little bragging myself.
Next, was feedback regarding a poorly worded comment in my first article, in which I stated, "It is true that technological breakthroughs could erase their competitive advantages in a short amount of time." I was noting that while this theoretically could happen, it was not likely. An informed reader noted,
"I don't believe it is true that technological breakthroughs could erase their competitive advantages in a short period of time. Due to the high cost of capital equipment and industry caution in adoption of new tech, you are usually talking a decade or more to see fundamental change. You can see that very clearly in how long it took them to overtake NBR & PTEN in US land drilling even though they had clearly superior performance."
Given the feedback, I'm not sure my comment came across the right way. Either way, the reader makes a good point about the slow rate of change in the industry.
I also previously noted the low level of Free Cash Flow of the company, relative to earnings. A reader noted,
"As for the cash flow, it's really simple, they've used it to fund the new build program."
I apologize again for the lazy journalism in my first article. That was my first article and I was originally thinking that I would find interesting companies to write about, find a few interesting details to highlight, and then pound out as many articles as possible to increase my own exposure. Shortly after submitting that article, I decided I didn't like that approach as it is pretty selfish, and not nearly as helpful to readers as a more thorough approach. I don't like leaving unanswered questions for readers when I can easily find the answer with a little more digging. I wanted to go ahead and set a few things straight with this article. But, from this point forward, I will do my best to deliver quality over quantity in regard to my articles.
Back to the topic at hand, low free cash flow is always the result of 1) low cash flow from operations or 2) a high level of capital expenditures, or both. In the case of Helmerich & Payne, it appears that Cash from Operations is typically a good bit higher than Net Income, which should be the case. Further, it is clear that a lot of the Cash Flow from Operations is going right back into "Investments".
The question becomes, is this a capital intensive business or a high growth business? It's hard for me to say. They are growing. However, the new builds also are coming at a time when some of the previously existing assets are sitting idle. The relevant questions to me are, when will the assets in which the company is currently investing become obsolete? Will the level of free cash flow increase greatly once growth slows, or is this just a capital intensive business that will always eat up a good bit of cash through what is commonly called "maintenance capex"? Unfortunately, I would have to leave it to someone more knowledgeable than myself, regarding the industry, technology, etc. to answer that question. As much as I want to inform readers, I'm not going to try or pretend to be something I'm not. I apologize if it seemed that way before.
Someone else brought up a point about natural gas prices as a potential driver of returns for this stock. In recent history, the correlation has not been nearly as strong with natural gas, as with oil:
Of course, that is backward looking. I think the point being made was that if the price of natural gas spikes upward, that would affect Helmerich & Payne in a significant and positive way. Unfortunately, after a short but sincere attempt, I have not been able to figure out how to quantify their current exposure to natural gas prices, as an effort to determine any related downside risk. I was hoping to find something along the lines of very little downside risk, but a lot of potential upside associated with natural gas prices. I looked through their latest report and earnings transcript, and could not find anything that said something along the lines of, "Of X total active rigs, Y number are drilling natural gas wells." But, it is entirely possible that I missed it. A recent investor presentation does show that 93% of the company's active rigs have "Oil and Liquids-Rich Gas" as their primary hydrocarbon target. Unfortunately, to an industry outsider, that doesn't explain the level of downside associated with natural gas prices since "Liquids-Rich Gas" is lumped in with oil.
One other quick point, the company's own statements continually point out that demand for its services are tied to expectations about future commodity prices, which are strongly, but not perfectly correlated with spot prices. So for example, a short-term supply disruption that led to temporarily higher prices would not necessarily help this company. Don't look at that type of situation as a reason to buy this stock. In fact, if that happens, and everyone else does look at it that way, maybe you could consider it a reason to sell. But a long-term increase in demand caused by a shift away from coal fired power plants and toward natural gas, for example, should be the type of fundamentals that would be good for this company. While I find it interesting and want to learn more, I do not know or understand the energy industry all that well. So, that is my best attempt at understanding some of the driving forces around this company.
One other quick item worth a follow up was that I mentioned risk associated with the company's international and offshore segments. I should have noted that those portions combined account for only 31 active rigs, out of a total of 288, according to the company's latest investor presentation.
My mention of the PE10 was also questioned by some readers. I look at PE10 as one of many relevant pieces of data, mainly because of this study. The more important point is that this is an industry which is almost certain to experience major fluctuations in earnings. For example, HP's TTM earnings were $146 million in June of 01, and $4.3 million in September of 04. They were $500 million in December of 08, and $124 million in June of 2010. So, investors with only a basic understanding of stocks (like me) need to be aware that when thinking about HP as an energy industry dividend play, it may be a different ride than some of the different, and more stable types of energy industry plays, such as XOM, CVX, KMI, etc.
I think a lot of readers took my article to be more negative than I intended. That may say something about my ability as a writer, but it may also say something about the sentiment of many investment related articles on the internet. Mine was an attempt to give a balanced view. The title of the article was a reference to the fact that sometimes we let emotion drive our decisions (the title of the current one is an attempt to capture the coveted Tina Turner fanbase demographic). If we collectively get too excited about a stock, we can squeeze everything good out of it, turning good companies into bad investments sometimes. I know that this is the case, because I experience it personally. When I see a company with almost no debt, a low payout ratio, and a nice dividend yield, my initial reaction is to get a little excited.
However, in regard to emotion, there are others besides just excitement, greed, love, etc. I'm referring only to love as an emotional feeling, unhealthy attachment, etc. Love the action is something else entirely, and contrary to popular belief, it is very relevant to the business world. But back to emotions as they may influence our investment decisions, we, of course, should never allow greed or excitement to cloud our judgment. But, neither should we should allow fear to keep us completely on the sidelines.
Indeed, there is no such thing as a perfect stock. I am not saying people interested in this stock should avoid buying it. I'm saying you should think through the risks, potential drivers of returns, etc. before investing. You should also consider other options that may represent similar risk profiles, but have lower levels of overall risk. As for my overall personal take, the contrarian in me says, "The ship has sailed… should've bought this stock when it was clear the company still had first mover competitive advantage, but before everyone else started to take notice." The value investor in me says, "But, it still has some significant advantages, is still delivering good results, and is still reasonably valued (but not incredibly cheap)." It's worth mentioning that of all the thoughtful feedback I got, not one person argued that the stock was currently undervalued.
My goal with my articles is never to convince readers what they should or shouldn't buy or sell. So, thank you to Seeking Alpha for allowing me to submit articles anyway. Even with my Dividend Focus newsletter, in which I highlight companies that I believe represent attractive value, enjoy sustainable competitive advantages, reward shareholders properly, etc., my goal is to help readers to become better investors by thinking for themselves. I hope to help readers to think rationally about investments, using basic principles and analysis that everyone can understand, to the best of my ability. Most analyst reports, company presentations, earnings calls, etc. are full of industry jargon and accounting terms that are hardly discernible to the average person. Yet the experts, with all of their superior knowledge and sophisticated discourses about what makes a particular stock attractive/unattractive, don't seem to be able to produce better results than the broad market, on average. However, my personal opinion is that the experts could make very good use of their knowledge by sharing it in a way that helps average individuals to better understand investments.
For example, I recently saw here a comment that HP was, "...developing a new data-driven, computerization-enabled approach to replicating best-in-class drilling performance that, medium to long term, should become its next moat". Oh, they're using computers now? Guess I should buy the stock. Seriously, you can't get very much from that comment alone. I'm not saying there is anything wrong with the analyst's comment. There isn't. In fact, it piqued my interest. But much of the commentary you find for free on the internet is nothing but a basis on which to start asking questions. To me, it sounds like they're using some sophisticated analytical and control software, as part of a holistic approach to somehow improve the drilling process. That information by itself doesn't help very much. But it causes me to ask, is the software third-party custom fitted, or truly internally developed and proprietary? If it's third party and available for sale to competitors, you can be rest assured that while it might be an improvement to the industry, it is not a sustainable competitive advantage. Second, if it is proprietary, does it actually result in any advantage? The company seems to indicate that it does. They list, as a key advantage, having a "computerized electronic driller that more precisely controls weight on bit, rotation and pressure." However, the closest competitor, Nabors Industries (NBR), lists proprietary drilling software and third party licensed technology among its competitive advantages (by the way, when you click on 3 of the 5 "proprietary" software products, you are taken to a third party website which appears to be advertising those products for sale). So maybe they both have advantages over the much smaller competitors, or maybe there isn't much of an advantage at all. I don't know.
While it certainly doesn't hurt, you shouldn't have to be an industry analyst or expert to attempt a basic understanding of the stocks you are thinking of buying. I will continue to do my best to help in that regard. If you can't develop a basic understanding of a business and stock with a reasonable amount of effort, maintain your skepticism. Your money will still be in your account (or in a stock you do generally understand) tomorrow! Thank you very much for taking the time to read my article!