Google brought some great earnings to the table on Thursday, which everyone heard, and I've been generally impressed with the continued strength across my portfolio companies here, early in earnings season. However, I didn't see any prices that made me stand up and take notice or add to any of my positions.
What I did do last week was buy a small opening position in Precision Drilling Trust (PDS). The catalyst for this was the writeup by the excellent 10QDetective, but I wouldn't have bought this quickly if I hadn't already been looking at this sector. I didn't know that PDS existed, but once I found out about it and did my research, I was sold.
I have mentioned a few times that I have a great fondness for some oil services and energy companies -- I only own a few, including SeaDrill [SDRL.OL] and Chesapeake (CHK) [Preferred B], but I still believe that energy is in a long term bull market as long as economic growth, particularly in the developing world, continues to outpace alternative energy development.
Royalty Trusts- Not the Right Time
Canadian income trusts come in several flavors, for those who don't know, and they have grown exponentially over the past few years as the tax advantages they convey have migrated out of the oil patch and into nearly every Canadian boardroom. Royalty trusts are open-ended trusts that pay a royalty on the commodities they mine or drill, but business income trusts, like PDS, are operating businesses that pay a high percentage of their income out as dividends to unit holders.
You can buy trusts that are tied to everything from ice to restaurant chains to the yellow pages, and Canadian Bell phone company BCE and Telus are converting to trusts this year. So there is some risk that this bubble of trust conversion will cause a regulatory or tax backlash (though I'd guess that's not terribly likely as long as Canada's budget surplus continues to climb on high energy prices).
I've been recently thinking for awhile about diversifying my energy holdings. Two options that were on the table were a return to some Canadian Royalty Trusts I owned shares of years ago, including Enerplus Resources (ERF). I took great profits from those holdings when I sold at the end of 2004, but also missed an even stronger run in 2005 and early 2006 ... and the fact that the recent 25% haircut in oil prices caused these shares to dip made me think it might be a buying opportunity.
But I think it's probably not the right time to pick up these royalty trusts. While the income is great, they rely on purchasing new fields and new resources and they'll be paying pretty solid prices for those going forward if they want to replenish their reserves and keep the monthly distributions high. They have the same problems with reserve replenishment as the oil majors, even though some of these trusts have a good number of years of reserves at current rates of depletion, and they're no longer the "undiscovered" gem that they were just a few years ago, so valuations are still pretty high.
And I thought about some more of the drilling names as well. Nabors (NBR) in particular caught my fancy, as I've noted a few times, and it is so ever-loving cheap that I still find it hard to resist. But then I read David Phillips' excellent analysis of PDS and it looked like an excellent mix of the dividend yield and energy services exposure I'd been looking for.
PDS: Diversified Oil Servies and Dividend Yield
I won't go into much detail here, because that work has been done by Mr. Phillips so recently. But PDS became an income trust (a lot like the REIT conversion process in the US) less than a year ago, and has slowly raised the monthly income distribution since then. It still distributes a nice, low percentage of their free cash flow compared to many US REITs, and with very low debt levels.
They are a broadly diversified oil services company, not unlike a Schlumberger (SLB) or Nabors or Halliburton (HAL), and they provide drilling and a broad array of oilfield services. PDS is one of the largest diversified operators in Canada, which is quietly one of the world's great petroleum powers (and certainly the biggest one to have very limited political risk for the US).
So this nets me a company with a great cash distribution policy in a good business that shows no signs of what I would consider to be serious decline (not unlike Rayonier (RYN), one of my favorite core holdings), but one without the reserves replacement risk or the hair-trigger relation to oil prices of the royalty trusts.
I really just like the idea of buying an excellent land drilling company with a focus on high dividends but a relatively low payout ratio that allows for expansion. PDS also has a valuation comparable to Nabors and lower than almost any other major company in the sector.
A couple other nice things to recommend PDS, and which helped in my decisionmaking: They are considered a corporation for US tax purposes, so their dividends qualify for the 15% tax rate (some trusts are Partnerships, which give me tax headaches); They may well have a big end-of-year distribution since they're required to pay out a large percentage of their distributable income; and unlike many other income trusts, they have pretty ambitious growth plans, including re-expansion to the US market (often conversion to a trust hobbles a business, preventing them from investing in growth -- that appears not to be the case, at leaste not yet, for PDS).
We'll see how it works, as we learn more about the company after they've finished their first year as a trust I may be interested in building on this position a little further (unless, of course, natural gas really does return to $3 as some pundits appear to believe ... then all bets are off).
Distribution cuts are probably pretty likely in the next year or so if natural gas prices remain depressed and Precision's more desperate small competitors slash prices to keep equipment out of mothballs, but even a lowered distribution would probably keep the yield at 8-10% (it's nearer 12% at the moment), and my guess is that over the next several years prices are more likely to go up than down and that PDS' position as a dominant service provider in Canada's busiest energy patch will enable them to keep prices fairly firm.
Plenty of risk, but an intriguing company. Thanks to the 10QDetective for calling it to my attention at what seems to be an opportune time. I bought shares of PDS at $28.90.
PDS 1-yr chart:
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