I will begin with a chart that caught my attention when I first came across Titan Energy Services (ASX:TTN):
(click to enlarge)
Titan is growing rapidly. In FY13, the company grew EBIT by 272% and management are guiding c50% EBIT growth in FY14.
What does an investor have to pay for this growth? This was the next question I asked, expecting Titan to be valued at some ridiculous multiple that priced in years of earnings expansion. However, I was pleasantly surprised to find that Titan is priced at only 7.5x FY14 earnings (share price A$2.49).
This seemed like outstanding value, almost too good to be true. I was somewhat skeptical and wondered why Titan was trading so cheaply.
For any astute investor, these sort of figures raise questions:
- Are there substantial risks to the company's earnings stream?
- Are there any one-off factors inflating these earnings numbers?
- Are management's forecasts a bit optimistic?
After further due diligence I have concluded that the answer to these questions is no, no and no. In light of the company's strong growth prospects and attractive valuation, I recommend a long position in Titan without hesitation.
To summarize the short-term story, Titan is trading on a P/E of 7.5x FY14 earnings - well below what an investor would pay for a company experiencing such rapid growth. If the company meets its earnings guidance, it is likely to undergo a re-rating to +10.0x FY14 earnings, driving a +33% return.
Although management's earnings guidance seems ambitious (c50% growth), it is achievable on the basis of Titan's existing contracts, and therefore it is probable that guidance will be achieved.
The story is not just about the short term. There are a number of tangible long-term growth opportunities that give Titan multi-bagger potential. Here are a few which I will elaborate on in the article:
- growing Coal Seam Gas activity in Queensland;
- entry into new markets (new sectors and territories);
- leveraging Titan's management team and board's connections; and
An asymmetric upside opportunity exists because this small cap company flies below the radar of most institutional investors, and the recent correction in mining stocks has left the resources service sector out of favor. However, I suspect this opportunity will not last for long, as there is mounting media and analyst attention around Titan.
Like any investment opportunity, a long position in Titan is not without risk. Risks include reliance on key contracts, price volatility, weather conditions, competition and execution. However, none of these risks have proven significant in the past, and are minor in the context of Titan's substantial upside potential.
Note that this is an opportunity for fundamental investors. It is unlikely to excite technical analysts as Titan's price performance does not exhibit any bullish trends over the last quarter (however, I am not a technical analyst).
Titan provides services to Coal Seam Gas (CSG) projects in Queensland, Australia.
CSG is a gas that is trapped in underground coal seams. The gas is extracted via drilling a well, and is typically wholesaled to electricity generators. It also has retail applications.
Titan operates a simple business model - it provides four services to CSG projects through four subsidiary companies:
1. Atlas Drilling has four drilling rigs (three owned, one hired) which Titan contracts to CSG exploration and production companies. Atlas was formed in 2007 and contributed 43.4% to Titan's total revenue in FY13.
Key drivers for Atlas are the number of rigs and their utilization.
(click to enlarge)
Source: Annual report FY13
2. Resources Camp Hire provides portable accommodation for CSG project workers.
Resources Camp Hire was acquired by Titan in 2011 and contributed 41.5% to Titan's total revenue in FY13.
Key drivers are the number of rooms and their utilization.
Source: Annual report FY13
3. Nektar Remote Hospitality provides catering to CSG project workers. The company was launched in 2012 and contributed 10.5% to Titan's FY13 revenue.
Key drivers are the number of catering contracts and the number of man days catered.
Source: Annual report FY13
4. Hofco Oilfield Services rents drilling equipment to CSG projects. The company was acquired by Titan in March 2013, and contributed 4.5% to Titan's total revenue in FY13.
Source: Annual report FY13
Titan was listed on 7 December 2011, and trades on the Australian Stock Exchange. Its recent performance has been strong, and Titan's stock price has more than doubled for the year-to-date.
(click to enlarge)
Source: Google Finance
There are three key 'take-aways' about Titan's business:
1. Titan is a resource service company. Unlike resource exploration and production companies, Titan still earns its revenue when risky exploration projects are unsuccessful. Titan's business model reminds me of an old quote that goes something like "it wasn't the miners who got rich in the gold rush, it was the people selling the shovels."
2. Titan's core clients are Queensland CSG projects. These projects are expected to grow substantially over the next decade (more below). This is in contrast to the broader mining sector in Australia, which has been contracting in response to softer commodity prices.
3. Titan's expansion is coming off a low base. Titan is a small company, with a few major contracts. Its expansion is coming off a low base, so even a handful of new contracts can result in double-digit (or even triple-digit) growth.
The short-term story
As outlined in my introduction, management are guiding c50% EBIT growth for FY14. If guidance is met, the company will be trading on a P/E of 7.5x FY14 earnings (share price A$2.49). This is an exceptionally low multiple compared to:
- the Australian share market (14.6x);
- comparable resource service companies (c12.0x); and
- Titan's earnings growth rate
The below table shows that Titan's forward P/E is lower than 30 out of 32 comparables. This is despite Titan, in my view, having much stronger growth prospects:
|Australian comparables ($A)|
|Name||Ticker||Price||EPS (FY14)||P/E||Market cap. (M)|
|Downer EDI||(OTC:DNERF) / (OTC:DNERY)||4.83||0.48||10.1x||2,090|
|Leighton Holdings||(OTC:LGTHF) / (OTC:LGTHY)||16.25||1.60||10.2x||5,480|
|Matrix Composites & Engineering||(MCE.AX)||0.91||0.08||11.3x||86|
|Monadelphous Group||(OTCPK:MOPHY) / (OTC:MDPHF)||17.40||1.36||12.8x||1,580|
|Mermaid Marine Australia||(OTC:MMMPF)||3.20||0.29||11.0x||738|
|Orica||(OTCPK:OCLDF) / (OTCPK:OCLDY)||23.80||1.79||13.3x||8,770|
|WorleyParsons||(OTCPK:WYGPF) / (OTCPK:WYGPY)||16.40||1.30||12.6x||4,050|
|Canadian comparables ($CAD)|
|Name||Ticker||Price||EPS (FY14)||P/E||Market cap.|
|Xtreme Drilling and Coil Services||(OTC:XTMCF)||3.71||0.38||9.8x||301|
|Savanna Energy Services||(OTC:SVGYF)||8.41||0.56||15.0x||738|
|High Arctic Energy Services||(OTC:HGHAF)||3.68||0.5||7.4x||183|
|Tuscany International Drilling||(TIDZF)||0.095||0.02||4.8x||36|
|Cathedral Energy Services||(OTC:CETEF)||5.06||0.47||10.8x||183|
|Total Energy Services||(OTC:TOTZF)||19.52||1.71||11.4x||607|
|Ensign Energy Services||(OTCPK:ESVIF)||16.5||1.28||12.9x||2,520|
|US comparables ($US)|
|Name||Ticker||Price||EPS (FY14)||P/E||Market cap.|
|Superior Energy Services||(NYSE:SPN)||25.51||1.88||13.6x||4,070|
|Source: Yahoo! Finance|
Therefore, it seems reasonable that Titan will undergo a valuation re-rating. A modest re-rating from 7.5x to 10.0x FY14 earnings would result in a return of 33%. It is likely that a re-rating will be driven by the following catalysts:
- favourable operating updates; and
- increased attention from the media and analysts
I suspect the re-rating to be much higher, but assume a 10.0x forward P/E for the sake of providing a conservative estimate.
The three catalysts listed above propelled Titan's share price to new highs over 2013. For example, when management announced the company would exceed its FY13 guidance, Titan's share price shot up 35% on the same day. Returns over the next two months were in excess of 100%. So a 33% return from a valuation re-rating does not appear to be out of the ball park.
My return expectation assumes that Titan will meet its FY14 earnings guidance (if Titan fails to meet guidance, this may drive a re-rating in the opposite direction). Whilst c50% EBIT growth seems like an ambitious target, I assess that it is not only possible, but achievable purely on the basis of the company's existing contracts. Here's why:
Resources Camp Hire. The weighted average number of rooms throughout FY13 was 462. At the end of the year, the company had 674 rooms. i.e. going into FY14, the Resources Camp Hire division started with nearly 50% more rooms than its average in FY13. Even assuming no economies of scale, the increased room numbers should translate to 50% earnings growth. An announcement on October 2013 revealed that room numbers are now even higher, and have grown to 894 (nearly double FY13's average room numbers).
Nektar Remote Hospitality. Catering services are often bundled in with accommodation, and are therefore expected to grow in line with Resources Camp Hire.
Hofco Oilfield Services. Titan's FY13 results only incorporated half a year of Hofco trading (as Hofco was acquired part way through FY13). Therefore, EBIT has the potential to double in FY14.
Atlas Drilling. Atlas's fourth drilling rig is expected to be in operation for the full FY14 year. This compares to only eight days in FY13, and implies c33% growth (three rigs were utilized in FY13 and four are expected in FY14).
Atlas presents the biggest risk to meeting management's 50% EBIT growth guidance as it appears to be growing capacity at less than 50% and its first rig has been offline for maintenance. However, management expected it to come back online in mid-November. Also, the company is increasing the fourth rig's contract from a 12-hour day to a 24-hour day, which should offset some of the foregone revenue.
Strong growth from Resources Camp Hire and Nektar is likely to produce earnings growth in excess of 50% and a full year's contribution from Hofco could produce growth of 100%. Considering that my analysis does not incorporate any upside from future contracts, c50% earnings growth seems more than plausible.
Followers of Titan may be wondering why its stock price has undergone a correction recently. The correction was not in response to any specific events or news flow, and the company remains confident of its full year guidance. In my view, the correction provides an attractive entry point.
Pie Funds (a specialist Australasian small-cap fund manager with an enviable track record) wrote the following about the correction:
Titan has also had a pull-back recently. This is no surprise to us and perfectly normal given it has advanced from around $1.00 to a high of $3.70 this year... TTN still remains our largest position and is in all four funds... We believe that if TTN continue to kick goals, then we can see it being worth $5 in 18 months.
There is an old saying amongst analysts in the Aussie market that you buy mining service companies on a P/E of less than 8x and sell them on a P/E of 12x. TTN is therefore firmly back in the our buy zone...
[We] got on a plane to Brisbane to see the CEO. As we suspected, there are no "burning platforms" and the company remains confident of full year guidance. The upside to the story is still very much there, so we remain long term holders.
To summarize the short-term story, Titan is trading on a P/E of 7.5x FY14 earnings - well below market benchmarks and what an investor would expect for a company experiencing such rapid growth.
If the company meets its earnings guidance, it is likely to undergo a re-rating to +10.0x FY14 earnings, driving a +33% return. Although guidance for c50% growth seems ambitious, it is achievable on the basis of Titan's existing contracts.
The Titan story is receiving increasing analyst and media attention, which could also drive a re-rating before the company's FY14 earnings announcement. Any favourable operating updates about new contracts could also propel the share price higher (as was the case over 2013).
The long-term story
The Titan story is not just about the company's short-term earnings. There are tangible long-term growth opportunities that give Titan multi-bagger potential.
I provide a brief outline of the four largest growth drivers below:
1. Growing Coal Seam Gas activity in Queensland. CSG activity in Queensland Australia has been growing rapidly. In the early 1990s, around 10 wells were drilled annually. This has increased to over 720 in 2011/12. The sector is expected to continue experiencing strong growth, with the number of wells drilled per annum forecast to peak at over 2,500 in the year 2021:
As outlined in the company overview, Titan's niche is in providing services to Queensland CSG projects, so it is well positioned to capture this growth.
2. Entry into new markets. Management has stated that Titan intends to pursue growth beyond its traditional Queensland CSG market. There are two types of new market opportunities:
- New industry segments - companies operating outside the CSG sector. E.g. infrastructure and mining projects
- New territories - territories outside Queensland. E.g. Northern Territories and Southern Australia
The broader Australian resource sector is large, so entry into new markets could be a game changer for Titan. However, the company's success will ultimately depend on execution and whether it can claw market share from competitors.
These opportunities appear to be at an early stage, and are likely to be pursued once CSG opportunities mature.
3. Management and board's connections. Titan's board and management team have held (or in some cases, currently hold) numerous senior executive positions in large resource companies. These include Royal Dutch Shell, PetroChina, Santos and Origin Energy.
The management team and board are well connected for a company of Titan's size. Leveraging these connections has been commonly cited as a reason for Titan's recent success, and I expect it to be a continued driver of growth in the future.
4. Acquisitions. Titan has a history of making acquisitions, acquiring Resources Camp Hire in 2011 and Hofco in March 2013.
Acquisitions in the resources service sector produce synergy from cross-selling. For example, clients of Titan's accommodation business are cross sold catering services. This provides additional revenue and earnings for Titan's existing Nektar division.
Whilst my default position is to be wary of companies with an acquisition strategy (as there is a tendency to overpay), I give Titan the benefit of the doubt as its past acquisitions have been executed at low prices. For example, Hofco was acquired for A$20.9m, and had annualised EBIT of A$5.8m. This implies a P/EBIT ratio of a mere 3.6x
To summarize the long-term story, there are four tangible growth opportunities that are likely to provide substantial earnings growth in the long term. These opportunities are large (albeit somewhat difficult to quantify) and do not appear to be factored in Titan's share price. Therefore, if the company can successfully execute on these opportunities, it could have multi-bagger potential.
Long-term growth opportunities should also provide some support under share price if Titan fails to meet its FY14 guidance (although this is not a likely scenario for the reasons I outlined in the short-term story above).
Like any investment opportunity, a long position in Titan is not without its risks. I provide brief commentary on what I consider the five most significant risks.
1. Key contracts. As a small company, Titan relies on few key contracts. For example, its catering division had only six contracts as at October 2013. Therefore, losing only one or two contracts can have a material effect on earnings. Contracts are generally short-dated (lasting 6-12 months) which adds to this risk.
This is a double edged sword. Whilst losing a contract can materially reduce earnings, it also presents upside, as one or two additional contracts can result in double-digit earnings growth.
2. Volatility. Titan is not for investors with a weak stomach. The resources sector is inherently volatile, and the company's small cap nature contributes to wild share price swings. Changes in economic outlook and substantial shareholdings can cause sharp price movements.
However, volatility presents opportunities to enter at a more attractive price point and, at the end of the day, I believe the company's price will follow its fundamental value.
3. Weather. Adverse weather conditions can lead to delays in CSG projects being initiated which, in turn, leads to lower demand for Titan's services.
Whilst the weather is impossible to predict, management has made an allowance for adverse conditions in FY14 guidance. Any unfavourable weather conditions beyond this allowance would affect FY14 earnings, but is unlikely to have an effect in the medium term (as projects are simply deferred to the next financial years).
4. Competition. Titan operates in a growing industry. Growth industries tend to attract competition, which can erode the market share and margins of existing players. Furthermore, Titan's service offerings appear to be commoditized, and easily replicable by competitors.
However, there has been no evidence of competitors stealing Titan's contracts. In fact, the company is continuing to win new contracts.
5. Execution. Like any growth company Titan faces execution risk. In particular, execution risks exist around Hofco.
Titan is investing heavily in growing Hofco. If this does not produce a corresponding increase in revenue in the second half, earnings could fall short of expectations.
As highlighted in the introduction, these risks have been negligible in the past and are minor in the context of Titan's substantial upside potential.
Titan has a robust short-term story. The company is trading on a 7.5x forward P/E, is expected to grow at c50%, and can meet its earnings guidance on the basis of existing contracts. I conservatively estimate a re-rating to 10.0x earnings, which would drive a +33% return by its FY14 earnings announcement.
The long-term story is also compelling. Future growth is likely to be underpinned by growing CSG activity, entry into new markets, leveraging management and the board's connections, and acquisitions. Given the magnitude of these opportunities, Titan could easily be a multi-bagger.
My view appears to be reaffirmed by management (who remain confident of the company's full year guidance), a specialist small-cap fund manager (whose largest holding is Titan), and the three analysts that cover Titan (average price target of A$4.04).
The stock has suffered a correction recently, which appears to be driven by no more than profit taking. The correction provides an attractive entry point which, given mounting analyst and media attention, may not be open for long.
Additional disclosure: I am long ASX:TTN