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Summary

  • Over the last 5 years, drilling activity has grown 48% which is significantly faster than the industry's 5-year average growth rate of 6.5%.
  • Management is expecting revenue to grow at a CAGR 2 percentage points higher than the sector's 5-year average.
  • Doubling current operating margins will be difficult based on historic industry margins.

Tesco Corporation (NASDAQ:TESO) manufactures top drives and tubular casing for the oil and gas drilling industry. Demand for their products is directly affected by the amount of rigs in operations. From 2008-2013, the correlation between Tesco's revenue and rig count was .9 with a R-squared of .82. Although a small sample size, the high correlation makes economic sense. The more rigs in service, the greater the demand for parts and services.

Recent Rig Count Growth

Average Annual Rig Count

Year/Year Growth

2014(YTD)

3,580

4.9%

2013

3,412

-3.0

2012

3,518

1.5

2011

3,465

16.0

2010

2,985

29.6

2009

2,304

-30.9

2008

3,336

Table Data:Baker Hughes International Rig Count

From 2009-2013, Average Annual Rig Count (AARC) grew a total of 48%. However, this massive growth isn't the result of expansion in the drilling industry. The growth is a recovery from the substantial decline in 2009. From 2008-2013, AARC grew a total of 2.2% which is a much slower growth rate than 2009-2013. Since 1976, AARC grew an average of 6.5% on a trailing 5-year basis. The 48% growth rate experienced over the last 5 years was higher than 28 out of the 34, 5-year trailing periods. The next 5-year growth rate should be lower than the past 5 years due to slow global growth and a return to a more normal AARC growth rate.

How Did Tesco Perform Over The Past 5 Years?

Tesco was able to grow revenue from $356.5 million in 2009 to $522.25 million in 2013. Tesco's revenue grew 46% which kept pace with AARC's growth of 48%. From 2009-2013, Tesco's stock increased 226% compared to a 107% return for the S&P 500. Tesco's performed well over the last 5 years. However, there was abnormally high growth in drilling activity. Even with the last 5-year's massive growth, Tesco wouldn't have met many of the goals in their current 5-year plan.

Tesco's 5 Year Plan

During the Q1 2014 conference call, Tesco presented their 5-year plan.

Highlights from the presentation:

  • A billion in revenue by 2018
  • EPS of $2.50 by 2018
  • Operating margins approaching 15%
  • Research and Development 1%-2% of revenue
  • Administrative expenses around 4% of revenue

Tesco's 5-Year Plan Based On Historic Data.

Revenue

In 2013, Tesco's total revenue was $525 million. To reach $1 billion, Tesco's revenue would have to grow at a Compound Annual Growth Rate of 13.5%. This rate is higher than the growth rate from 2009-2013 which was 10.1%. Tesco's 10.1% CAGR can mainly be contributed to the massive growth in AARG. Additionally, Tesco's target CAGR (13.5%) would need to exceed the sector's 5-year average of 11.4%, according to Reuters.

EPS

Over the last 3 years, Tesco's share count has grown on average 0.36% per quarter. Assuming 1 billion in sales and 43 million shares outstanding, the company's $2.5 EPS goal would require a 10.75% profit margin. Tesco's average profit margin, over the last 13 quarters, was 6.65% and their highest profit margin occurred in Dec. 2012 at 9.69%. From 2011-2013, Tesco's annual profit margin averaged 7.06% peaking in 2012 at 9%. Based on the average annual profit margin, Tesco would need to increase their profit margin by 52% to meet their EPS goal.

Operating Margins

For the first quarter of 2014, Tesco's operating margins was 7.5% and 9.23% in 2013. How does this compare to the industry and sector?

Company

Industry

Sector

Operating Margin (TTM)

10.20

12.30

15.42

Operating Margin - 5 Yr. Avg.

7.56

14.71

20.05

Table Data: Reuters Company Financial Section

Tesco wants operating margins of 15%, but will need to reverse a troubling trend. Tesco's Top Drive operating margin has fallen from 25% in 2011 to 21% in 2013. Fortunately, Tubular service's operating margin has grown from 11% in 2011 to 17% in 2013. Tesco will need to continue increasing tubular service's margin. However, Tesco will yet again need to exceed the sector's 5-year averages to reach their goal.

R&D And Administrative Expenses

Research and Development is currently around 2% of revenue which means Tesco needs to maintain their current spending percentage to meet 2018 goals. Yet, General Administrative expense will need to fall as a percentage of revenue by over 50%. Currently, administrative expense is 9.4% of revenue. Tesco won't reach their goal of 4% even if administrative expense remains flat for the next 5 years. This means Tesco will need to try and reduce administrative expenses while increasing revenue.

5-Year Plan Too Optimistic

Tesco's 5-year plan requires exceeding not only sector averages but their own past averages. Drilling activity grew rapidly over the last 5 years mainly recovering from the decline in 2009. Activity grew over 48%, over the last 5 years. Even with similar industry growth, Tesco's revenue would need to double the industry's growth rate. Tesco's margins are below industry average and would need to be significantly improved while still increasing sales. Tesco will need to grow revenue while not growing administrative expenses which will be very difficult. Tesco's 5-year plan is too optimistic based on short- and long-term industry growth rates and margins.

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.

Source: Tesco Corporation's 5-Year Plan: Too Optimistic Based On Historic Data