Investors are funny. When the price of their stock goes down by a lot, they immediately begin to worry that the "market" knows something that they do not. Conspiracy theories begin to make their way into the investor's head, allowing them to justify the reason they sold near the lows. "Something is wrong" they conclude.
When their stock is flying high, a sense of pride begins to take hold. They believe they are smart, and the market proves it daily. Often times, they add to their position as they are thankful they found the source of happiness and wealth for their family.
As an investor, we must begin to look to others' fear as a good thing. It is this fear that causes great values to occur in the market. Investors must learn to value a business, and wait for the market to offer that business at a deep discount to what it should be worth. Often times it takes worrisome data to cause that needed fear. If things were clicking on all cylinders, investors would be required to pay up for the same business. Fear should create good buying opportunities while greed should create great selling opportunities.
With that long introduction to basic investing theory out of the way, I sit back and ponder the amazing value being created in oil services stocks (OIH) at the moment. While the overall stock indexes have nearly recovered the losses they have experienced since spring of 2011, the oil services sector is still about 25% below its 2011 spring time highs.
There are many reasons for investors wanting to sell this sector. Natural Gas prices are plummeting in the face of endless supply in newly developed shale plays. As the price drops, the economic factor of pulling this energy out of the ground diminishes. Investors begin to worry about massive losses piling up at these companies as demand for their services supposedly evaporates.
Besides low natural gas prices, the method for getting to the gas hydraulic fracturing (fracking), is currently a hot topic for debate. As the energy industry attempts to prove the safety of the procedure in the face of accusations being brought about by environmental groups, as well as the EPA, that fracking will kill many people because it pollutes the drinking water. The truth, as is usually the case, probably lies somewhere in the middle of both sides. This article is not meant to defend or accuse the fracking process as that debate is being handled in the public arena. For more information on fracking in general, I would turn you to this website.
This debate, as well as the low price of natural gas (UNG), have caused shares of many companies in the business of fracking to plummet over the past 3 weeks. It is this kind of worry that creates impressive long term value. With that in mind, I want to look at one company which I think is the cheapest stock in the sector, maybe even in America, at the moment.
C&J Energy (CJES) has a handful of Hydraulic Fracturing fleets, Coiled Tubing units, and multiple double and single pressure pumps. About 80% of their revenues come from fracking, which as of right now is a bad word. Technological improvements in fracking have allowed these massive shale plays to finally be reached, which in turn has caused fracking capacity to skyrocket.
CJES went public in August of 2011, with the share price performance since then leaving much to be desired. Currently, the stock is down about 50% since the IPO, after a 10% hit just Thursday alone. Investors seem scared, and shorts are piling on. As of January 13th, nearly 20% of the stock has been shorted.
Many reasons on chat boards are being given, from a potential EPA fracking moratorium, to the 6 month IPO lock-up expiring which will cause millions of shares to hit the market. Whatever the true reason, the battering of the price has caused huge value in the stock.
Let's take a look.
In the most recently reported quarter (Q3-11), the company reported a net profit of $46.3 million. This was 335% more than the same quarter a year ago, and 39% higher from Q2-11. The massive growth can be attributed mainly to the fact the company increased the number of fracking fleets substantially. For Q4-11, based on 7 analysts who follow the stock, CJES is expected to earn .91 cents per share. The average estimate for the full year is $3.17 per share. With the stock trading currently at $17, that means CJES is trading at a very cheap price-to-earnings ratio of 5.36.
Imagine for a a moment that CJES does not grow from this point. Imagine that they are only able to earn $3.17/sh per year for the next 5 years. This would equate to about $163 million in earnings per year for this example. With no debt, the enterprise value of the company at the moment is roughly $880 million.
Let me ask you a question. If the local corner gas station was for sale for $1,000,000, and you could earn $185,000 a year from it, would you consider buying it? I would. That is an 18.5% return per year. Buying CJES at $17 today is the equivalent of buying that gas station.
It gets even better. CJES is not just staying stagnant. In fact, they just signed a contract for their 6th hydraulic fracking fleet, and have fleets 7 and 8 on order. They own the manufacturing company that make their fleets, allowing them to gear their production to the demand of their drilling customers. With 2 new fleets due this year, analysts are expecting $4.28/sh earnings in 2012. The lowest estimate is for them to earn $3.81. That means CJES is currently trading a a forward P/E of 3.97 to the average estimate, and 4.5 to the lowest. Either way you want to skin it, that is cheap.
Just look at a few competitors and the prices they are currently trading:
CJES currently trades at nearly half the values of these stocks, meaning their earnings are twice as valuable.
Looking at the expected earnings growth rates for 2012, CJES is expected to grow 35% compared to:
PTEN - 24%
CPX - 38%
HAL - 16%
BHI - 17%
Granted, HAL and BHI are much larger and more diversified, but you would think since CJES is growing faster than PTEN, and about the same as CPX, that they should be trading at about the same P/E.
Another interesting note from a valuation standpoint is that CPX was recently involved in a buyout offer from Superior Energy Service (SPN). When the purchase price of $2.7 billion was announced, CPX was sporting 315,000 Horse Power worth of fracking capacity. That is $8571 for every horse power CPX had at the time of purchase.
With fleet 6 currently being finished, CJES will have 200,000 worth of fracking horse power. Using the same $8571 per horse power buyout offer, CJES would be taken over at a market cap of $1.7 billion, or about 95% higher than the current price! This valuation does not include fleets 7 and 8, which are to be delivered this year. Each of those fleets is expected to be 32,000 HP each, bringing the total horse power capacity for CJES to 264,000. Using CPX's buyout valuation again, that would put CJES at $43.69 per share, which is 157% higher than where it trades today.
Bottom line is that CJES is way too cheap in relation to other companies that are facing the exact same issues in the industry. While companies like Chesapeake (CHK) have recently announced a massive slowdown in drilling of natural gas, fracking demands for existing wells should remain high. 75% of CJES's jobs are currently in areas that are drilling for oily-liquids, so a slow down of natural gas drilling should not be an issue in the short term. For the 25% that are in dry-gas regions, where drilling is being cut back, you can expect demand for their services to stay strong. You see, when a company like Chesapeake leases land for drilling, they are required to drill or produce, or risk losing the lease. These producers have drilled many wells, creating a backlog of wells needing to be fracked. In fact, we can see this mentioned in the Q2-11 earnings call with CJES, when an analyst questioned the CEO about all the new capacity coming online:
Steven Goode - Newland Capital, Analyst:
So, my question was asked. I was curious if you could expand on the visibility of this cycle and customer demand. I think you addressed that by saying there's some discussions on contracts which commenced in the fourth quarter of 2012.
Is there anything else you could point to in terms of uncompleted wells or customer demand that shows us how this cycle may persist?
Josh Comstock - CEO:
Well, in December of last year (2010), it was estimated there's about 2,500 wells uncompleted. From December through the second quarter of this year, there's been about 2 million, 2.5 million hp capacity come on. I mean rig counts increased, but it's not increased as significantly as frac capacity and that well backlog has increased to 3,500 to 4,000 wells uncompleted.
So when you say we've added capacity at a rate faster than we've ever added in history, and backlog has continued to creep up.
There you have it. Even with the low prices of natural gas, and the massive amount of new fracking capacity that has come online, the amount of wells that still need servicing and completion have increased nearly 50%
As Bloomberg reported Thursday:
There isn't a lack of total demand for fracking work.
People want to frack wells.
You can bet that CJES will be there for years to come to make sure those people get what they want. Right now, investors can get a piece of them at a valuation that is arguably 50% lower than where their competition is trading.