By David Sterman
One of the real charms of energy sector is the potential for fast gains. Unlike staid utility stocks, energy stocks are so volatile that a six or 12-month price target can be secured in a matter of months.
My "Better than Exxon" pick of Sandridge Energy (SD) in January rose 40% in just six weeks. That kind of quick move came despite a lack of important catalyzing news events, so I later suggested closing out that play and putting it in to two other energy plays.
Since March 1, shares of Newpark Resources (NR) and Parker Drilling (PKD), my two subsequent picks, are up 37% and 38%, respectively. Though each stock may have a bit more upside to the targets I noted back on March 1, the moves have come so fast, that I think profit-taking is now the wise move.
I've been in this business long enough to know that luck can aid even the wisest investors. Those three stock plays were clearly undervalued, in my view, but I can't deny the reality that my timing was quite lucky as well. So I'm always cognizant that these kinds of plays -- especially in such a volatile sector -- can move down as fast as they move up. That sentiment keeps me humble enough to never become too bold when picking stocks. I still prefer them cheap and unloved, which limits downside.
Now it's time to move on to a pair of new unloved energy plays that could have clear upside in the next 6-12 months.
1. Hercules Offshore (HERO)
A heavily-indebted company in a struggling industry can look toxic. If conditions fail to improve, then the company may become a candidate for bankruptcy. Yet if conditions do improve, then investors can quickly shift from fears of a weak balance sheet to promises of a surging income statement. That's the case for Hercules Offshore, which has nearly doubled since I profiled it in January, but could have additional upside of at least 50%.
Hercules owns drilling platforms and other equipment, along with a marine towing business. and the company is largely focused in the U.S. Gulf of Mexico. Business has been lousy in recent quarters, largely as a result of the drilling ban. Hercules leases its gear, and when business slows, lease rates plunge. Revenue fell more than 10% in 2010 to $657 million, and the net loss rose more than 50% to $134 million. That's a scary proposition for a company with $700 million in net debt.
To keep lenders at bay and its stock from falling to zero, Hercules needed to prove that it could generate improving EBITDA (earnings before interest, taxes, depreciation and amortization), which thanks to rising demand, finally appears to be happening. Fourth-quarter 2010 and first-quarter 2011 results came in ahead of plan, and analysts expect EBITDA to jump 20% this year to around $185 million.
Why the increase? Because Hercules is finding more customers for its equipment and services. The market still has a good deal of slack as drilling activity in the Gulf of Mexico recovers, so pricing is still not where it had been a few years ago. At the end of the fourth quarter, the company earned roughly $40,000 per day for its drilling rigs. That figure rose to $42,000 at the end of the first quarter and now stands at $44,000 in the middle of the second quarter. As long as lease rates don't pull back, EBITDA should be able to move well north of $250 million by 2012, according to analysts at Global Hunter Securities.
As another key catalyst, Hercules now controls 20 drilling rigs bought out of bankruptcy from Seahawk Drilling, as I noted in late January. A number of those rigs sit idle but are likely to be put back into service later this year and into 2012. That should provide a further lift to EBITDA.
Hercules was a "messy story" that is now getting much cleaner. As it continues to generate improving lease rates and higher utilization (the percentage of rigs that are being leased), investors are likely to keep warming to this stock. With the prospects of $300 million in EBITDA by 2013 coming into focus, I think the EBITA multiple can expand up to seven times that target, putting shares into the $9 to $10 range.
2. Weatherford International (WFT)
This might seem to be a bad time to be recommending shares of this energy services firm. Rivals such as Schlumberger (SLB) are pounding out great quarters while Weatherford continues to miss the mark. The company has missed profit forecasts for two straight quarters, and analysts have been steadily lowering their outlooks for 2011 and 2012.
All of the blame resides beyond our waters. Rising tensions in the Middle East, contract troubles in Russia and flooding in Australia all conspired to push international sales and margins down sharply in the first quarter. That obscured very impressive results in North America. The good news: those international factors should turn around in a few quarters, as management noted (though the Middle East is something of a wildcard). When that happens, investors will again take note that this is a very cheap stock relative to peers.
Analysts at Citigroup think results will turn up within a few quarters, and over time, Weatherford will be a cash flow machine. They forecast EBITDA to rise from $1.8 billion in 2010 to $4 billion by 2013, thanks to a wide range of operational improvements. Shares trade for just five times their 2013 EBITDA forecast, on an enterprise value basis. If Weatherford can't boost results quickly, another catalyst may emerge: "Absent a meaningful profit rebound WFT could be acquired at a substantial premium," according to Citigroup, which has a $27 price target.
Both of these firms have struggled in recent periods, which is why they remain as bargains while the rest of the sector has surged. But a clear path to better results is in focus, and as that plays out over the next few quarters, shares should finally reflect a fuller valuation and generate gains for shareholders.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.