- Revenue: about $1BN in 2018;
- Operating margin: about 15% in 2018;
- EPS: about $2.50 per share in 2018.
Let's dig deeper into these 3 key elements to evaluate how realistic the plan is.
Revenue of about $1BN in 2018
As per the company's 2013 10-K (p.17), Tesco generated revenue of $525MM in 2013. To get to revenue of $1BN, the company would have to generate additional $475MM revenue, which at a first glance may appear quite challenging, as it would imply effectively doubling of revenue in 5 years. However, detailed revenue build shows that majority of the growth target can be accounted for by planned acquisitions of $250MM and growth capital expenditures ranging from $75MM to $125MM. The remaining revenue growth would imply global rig/well count change driven organic growth rate of about 4.35%, which appears to be somewhat conservative (see table below).
Source: image created by the author
Other factors contributing to growth but not included in my analysis: potential revenue synergies from acquisitions, price inflation, and much larger global footprint than 5 years ago, where rig count growth has been meaningfully faster than that in North America (see company presentation p.16).
In summary, the $1BN revenue number in 2018 appears realistic, if not conservative assuming the company executes on acquisitions and capital spending.
Operating Margin Build to 15%
The company's adjusted operating margins (adjusted margin excludes Casing Drilling results) ranged historically from 1.7% to 16.3%. The Casing Drilling division was sold to Schlumberger.
Assuming that 2008 adjusted operating margin of 16.3% was driven by energy boom peak of that year, and 2009 1.7% margin was driven by sudden collapse of energy spending driven by the deep recession, a 10% current run-rate operating margin appears reasonable.
The above operating margins include SG&A and R&D expenses. To get to the 15% operating margin in 2018, we need to estimate what would incremental margins be on incremental revenue, which means understanding business segment operating margins. As per table below, Top Drive segment margins ranged from 21.7% to 31.3%, and the Tubular Services from -2.5% to 17.4%.
Going forward, it would be reasonable to assume that the company should do at least 22% segment margin in the Top Drives business (management targets 25%). In the Tubular Services, the company guides for 20% operating margin (May 5 investor presentation p.22), and given consistently expanding margin profile since 2009, which already achieved 17.4% in 2013, it would be reasonable to give the management benefit of the doubt, and assume that 20% margin would be achieved by 2018 (this is not just a simple benefit of the doubt, the company has developed a proprietary tubular services offering compared to conventional one which was big chunk of that business segment pre-crisis; there are also scale benefits that should help the margin further).
In summary, it would be reasonable to assume at least 20% incremental margin on incremental revenue. Since incremental revenue in 2018 with an operating margin of 20% is approximately the same amount as 2013 revenue, which had an adjusted operating margin of over 10%, we get a blended operating margin of 15%. In other words, 10%*0.5+20%*0.5 = 15%. Therefore, 15% operating margin in 2018 appears realistic.
EPS of $2.50 per share
Clearly, revenue and operating margin assumptions are critical when evaluating EPS targets. Assuming revenue of $1BN and operating margin of 15% are achieved as per the analysis above, we get operating profit of $150MM. Assuming effective tax rate of 35%, average share dilution of 440K shares per year, and estimated buyback of $100MM shares at a price of say $25 per share, we get an EPS in 2018 of about $2.57, as per the table below.
Source: image created by the author
Note that share buyback of $100MM was announced as per the company's investor presentation on May 5, 2014. Share dilution of 440K per year represents average annual dilution from 2009. $25 per share assumed buyback price is about 19% higher than current share price.
Based on the analysis presented above, the revenue, operating margin and EPS targets outlined by Tesco's 5-Year Plan are realistic. One way of thinking about valuing Tesco's stock would be to assign a multiple to 2018E EPS of $2.50. For a company with a ROCE of 20% and modest growth, a PE multiple ranging from 14x to 16x would be reasonable, potentially valuing the stock within the range of $35 to $40 per share in 2018. Discounting the 2018 median price estimate of $37.5 for 3.5 years at a rate of 10% gives an approximate price target of $26.8 per share for 2015.
Disclosure: The author is long TESO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author has not traded this stock in the past 72 hours and does not intend to trade the stock over the next 72 hours.