Introduction
"Buy low and sell high", says conventional wisdom. Easier said than done, as many investors repeatedly make the mistake of letting emotions influence their investment decisions. Rarely has this been more evident, in our view, than in the current energy downcycle. As oil prices continue to decline at a rapid pace, the Street seems ever more reluctant to dip their toes back into the battered energy sector. The selling frenzy has driven stock prices down across the board, creating opportunities to invest in high-quality names that we find too attractive to pass up - especially if your longer-term investment horizon shields you from the anxiety of watching the frantic market move minute-by-minute.
One such case is Independence Contract Drilling (NYSE:ICD). ICD is a pure-play onshore driller that operates solely in the United States - more specifically in the Texas panhandle and Houston areas. The company went public in August 2014, raising about $125M ahead of its plans to increase its fleet of premium rigs (model ShaleDriller 1500) to 18 units by the end of 2015. We believe that an investment in ICD today could yield returns in excess of 100% over the next 12 months, while we find it unlikely that the downside risk over the same period would exceed a sustained loss of 20%.
ICD is an unlikely defensive small cap stock
Before getting into the details of how we believe ICD can outperform in 2015, let's reverse the order and address downside risk first. Investing in the cyclically fragile energy sector today requires extra diligence and a dose of conservatism. We believe one of the best ways to mitigate risks in this environment is to look for companies with attractive operating assets and a solid balance sheet.
ICD has one of the most modern and capable onshore rig fleets in the industry. The fleet is currently composed of eleven 1,500-hp AC rigs that are bi-fuel capable and pad-optimized, in addition to one similar rig recently built that is currently mobilizing. Ten of the twelve rigs have integrated multi-directional "walking system", making them ideal for extended horizontal drilling projects on multi-well sites. The walking system enables the rig to move from well center to well center faster compared to skidding designs. In addition, moving the rig from one site to the next does not require cranes for "rig-up/rig-down", and 600-feet distances between drilling pads can be "walked" in 12 hours.
To put the quality of ICD's equipment in perspective, management noted, in their most recent Capital One Conference presentation, that the "majority of the existing U.S. rig fleet is made up of legacy equipment": 60% of the total fleet is mechanical or SCR (legacy rigs equipped with diesel-powered electric motors), and 49% is 1,000-hp or less. In addition, "AC-drive equipment represents only 51% of the ~1,300 rigs drilling horizontally", which not only makes ICD's rigs more competitive for new drilling projects, but also presents the company with an opportunity to replace less-capable rigs currently in operation.
From a geographical perspective, ICD is exposed to two of the largest basins in the country. According to the most recent well-count report from Baker Hughes (BHI), the Permian basin, where the great majority of ICD's rigs are currently located, is home to 2,725 wells and 559 rigs - the most in the country. The Eagle Ford basin, where ICD operates its #208 and #209 rigs, accounted for 1,168 wells and 209 rigs - the second largest basin in the country. The significance of these numbers is that ICD, with a relatively small fleet of 12 modern rigs, operates in a market that is unlikely to run out of business, especially for those drillers able to offer the best drilling technology and the most attractive value for the ever more complex horizontal drilling projects.
In addition, despite the recent sharp reduction in the number of rigs operating across the U.S. basins, the Permian and especially the Eagle Ford basins seem to be hanging on more resiliently than the average U.S. shale play. The graphs below, sourced from Baker Hughes data, show that the Eagle Ford rig count has remained nearly unchanged over the past four weeks - although the rig count in the Permian, a higher breakeven basin than the Eagle Ford, has dipped more sharply.
On the balance sheet side, ICD holds, as of the most recently-reported quarter, $13.2M in net cash with no debt in the books, representing approximately $0.70 of net cash per share (15% of the stock value). In addition, the company has recently locked in a total of $155M in secured credit facilities, none of which has been utilized so far. In total, ICD's pro-forma liquidity stood at $168.2M as of 3Q14, including cash on hand and credit lines - the equivalent of nearly 150% of the company's total market cap. At a cost-to-build of approximately $20M per rig and up to 7 new rigs expected to be built and delivered in 2015, ICD's current cash and credit lines should be more than enough to finance the company's growth plans for at least the next 12 months, if the company chooses to do so.
The better news is that ICD has been OCF (operating cash flow) positive since going public ($10.6M YTD as of 3Q14 and $3.2M YTD as of 2Q14). Therefore, we would expect to see the company tap into its reserves only if the investment in new rigs makes economic sense, and not as a necessity to help the company sustain its current operations.
As a takeaway, ICD does not seem to be in any kind of trouble. It has a healthy business with solid fundamentals. Yet, its stock has been hit hard in the past few months (down 60% from its 52-week high of $12.29 in September 2014), along with most other names in the energy sector, opening a window of opportunity for bargain hunters. In the next section, we will address ICD's prospects for 2015 in detail, and explain why, using realistic assumptions, we believe the company could perform much better than the current stock price seems to suggest.
In our base-case scenario, stock could double in the next 12 months
In order to assess ICD's expected performance in 2015 and the potential implications for the stock, we created a sensitivity analysis to project 2015 EBITDA and stock prices under 3 different scenarios. Below, we will go into the details of each line in the summarized income statement.
Average # of rigs: according to the company's December Capital One Conference presentation, ICD finished 2014 with 11 rigs in the fleet, and a goal to add 7 units by the end of 2015. Under the base-case scenario, we assume that the average number of rigs in 2015 is the average between 11 (2014 year-end) and 18 (2015 year-end), which equals 14.5 rigs. For the worst case scenario, we reduce this estimate by 10%. For the best-case scenario, we increase it by 10%.
Average revenue per op day: ICD reported, in 3Q14, that its revenues averaged $23,300 per operating day in the quarter, in a consistently increasing trend from $20,500 in 2Q13. Under our base-case scenario, we conservatively assume that the average revenue per op day in 2015 will be equal to the historical average since 2Q13, which is $21,800. Although we recognize that day rates could dip in a downcycle and that 4 of the 7 rigs expected to be delivered in 2015 do not currently have contracts secured, we believe this drop of 6% in day rate from 3Q14 to be very reasonable, if not overly conservative. For the worst-case scenario, we set average revenue to be equal to the historical minimum of $20,500 since 2Q13, representing a drop of 12% in rates from the 3Q14 levels. For the best-case scenario, we set average revenue to be equal to the historical maximum of $23,300.
Average op cost per op day: The methodology used here very closely resembles the one used for average revenue per op day. We set worst-case average op cost to be equal to the historical maximum since 2Q13 of $13,200, and best-case average op cost at $12,400. Base-case average op cost is the historical average of $12,800.
Rig utilization: ICD has sustained very high utilization rates since it started operations, in May 2012 - 97% historically. In 3Q14 and 2Q14, the company kept utilization at 100%. However, because of market uncertainties, new rigs in the pipeline without contracts, and the risk that existing contracts could be canceled or modified if macro factors continue to deteriorate, we are conservatively setting utilization in our sensitivity analysis at 90%, 95% and 100% for each one of the scenarios.
Total Revenues: this line is a function of the drivers described above. From worst-case to best-case, we expect 2015 revenues to fall between $87.8M and $135.4M. In order to verify the soundness of our conclusions, we turned to backlog. ICD disclosed, in the December Capital One Conference presentation, that it had approximately "$88M in contracted backlog for 2015 at higher average day rates than 3Q14 levels". This number is high enough to cover our worst-case scenario, and very conservatively assumes that ICD will be unable to secure any business for the remaining 4 new rigs expected to be delivered throughout the year or for the rigs coming off contract. Therefore, we find the $109.6M in revenues in our base-case scenario very achievable.
Total Op costs: like total revenues, this line is derived from the assumed drivers that we described above.
SG&A: to calculate selling and administrative, we annualized 3Q14 SG&A and assumed that, for 2015, these expenses would grow by 10% under our base-case scenario, resulting in $15.9M in costs. For the worst-case scenario, we assumed an increase of 20% instead, whereas for the best-case scenario we assumed the 3Q14 run rate would remain flat in 2015.
Total EBITDA: by subtracting total op costs and SG&A from revenues, we arrived at our EBITDA projections: $13.9M for the worst-case, $29.4M for the base-case, and $48.6M for the best-case scenarios. We then used these EBITDA numbers to estimate the intrinsic value of ICD's stock under each scenario.
EV/EBITDA multiple: in order to determine a fair multiple for ICD's projected 2015 EBITDA, we looked at the 5-year historical EV/EBITDA ratios for 3 of ICD's largest competitors: Helmerich & Payne (HP), Patterson (PTEN) and Nabors (NBR) - see graphs below. We then took the average 5-year multiple for each of these companies, and finally averaged those 3 numbers to arrive at a base-case EV/EBITDA multiple of 6.1x for ICD. We believe that this valuation methodology is conservative, since ICD has one of the best operating assets, balance sheets and growth prospects within the peer group. For the worst-case scenario, we discounted the 6.1x multiple by 25%. For the best-case scenario, we applied a premium of 25% to the 6.1x base-case multiple.
To the valuation analysis above, we would like to add a couple of metrics that may help to further illustrate how attractive ICD's stock price is today: the market value of the company's equity represents only 43% of book value, i.e. a price-to-book ratio of 0.43x. It also represents only 0.51x the book value of the company's rig fleet, net of depreciation.
Think about this last metric for a moment. Let's suppose, in a very extreme scenario, that we needed to liquidate the assets of the company. Current assets would be more than sufficient to offset all liabilities by a margin of about $4M. Now let's write off all the intangible assets that could not be recovered. We would be left largely with a fleet of modern rigs, mostly built within the past 3 years, all of them operative and currently locked into client contracts, worth about $223M on the books. The market value of the company's equity, however, is only about $118M today. Even if we were to sell all rigs at a deep discount into a market that could easily absorb 11 new units, it is likely that the remaining assets would still be worth significantly more than the current market value of equity.
Catalysts
In the energy sector, no other factor could unlock stock value as an increase in oil prices. Although some analysts seem to believe that the nose-dive might be nearing an end, it is just too impractical to expect energy prices to stabilize or rebound any time soon.
However, there are other ICD-specific events coming up in the first half of 2015 that could, at least, restore some confidence in the company amongst the investor community. The two most important of them are contract renewals and newbuild rollouts.
ICD has 5 contracts that are expected to end before the end of June 2015, as revealed in the company's most recent earnings conference call. Recall that ICD already has $88M in revenues secured in backlog for 2015, which happens to coincide with our worst-case scenario revenue assumptions. We find it unlikely that none of the contracts will roll into renewals, or that the available rigs coming off contract will not be utilized by any other potential client for the remainder of the year - especially considering the high level of activity in the Permian and Eagle Ford basins. Each contract renewal will add to the existing $88M backlog, and 2015 projections should more confidently approach, throughout the year, the $109.6M in revenues that we assume in our base-case scenario, if not exceed it.
Lastly, ICD expects to deliver 7 new rigs in 2015, 4 of which have not been contracted yet. Similarly to the argument above, revenue generated from new contracts for these new rigs should be additive to what ICD already has secured in backlog. Even if drilling activity cools down and ICD is obligated to scale back on its fleet growth plans, another 2 or 3 new contracts signed should be enough to increase 2015 revenue expectations by a few million dollars. We believe that, by mid-year, investors should already have a clearer view of what ICD might be able to deliver in 2015, and we believe they will be positively surprised.
Conclusion
Our conclusion, based on the analysis above, is that, under a base-case scenario, ICD stock may have a 100%-plus upside from where it currently sits, to $10. On the downside, we see the potential for a drop of no more than 20% in stock price, to $4. We recognize that, due to recent volatility in the sector, the stock could trade outside of this range in the short term. But we find it unlikely that this would be sustainable over a longer time horizon of 12 months and beyond. In any case, we believe that the upside-to-downside trade off (approximately 5 to 1 between the worst-case and base-case scenarios) makes this a very compelling investment case for this underappreciated energy stock.
One final word on risks
Of course, an investment in a small cap energy stock in the current environment is not without risks that investors should keep in mind. On January 7th, in the Goldman Sachs Global Energy conference, market leader HP revealed that the environment for U.S. land drillers in 2015 is nothing short of challenging. "Drilling activity and spot day-rate pricing are now expected to significantly decline in the U.S." HP also reported that the average spot pricing for its FlexRigs is down 10% in the quarter compared to last, and that the company has received early termination notices on 4 long-term contracts (HP currently has an average of 175 drilling contracts signed for the first quarter of 2015).
If HP's grim outlook for the upcoming year is confirmed, even ICD's secured, multi-year contracts could be at risk of being cancelled, and terminating contracts could take longer to renew or renew at lower rates. Under these extreme circumstances, the argument for our worst-case scenario could gain strength (which, remember, points to a fair value of equity of $4 per share), and a bounce back in the stock price could take longer than we expect.
