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Andrew Pilara, RS InvestmentsNewsletter Value Investor Insight carried an interview April 30th with RS Investments' Andrew Pilara, whose fund has returned 15.7% after fees annually since inception in 1995, versus 10.2% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview in which he and team members MacKenzie Davis, David Kelly and Joe Wolf discuss Key Energy Services (KEGS), which was trading at $18.80 at the time of the interview (current price here):

You run a large natural-resources fund. What general trends are you focused on in that sector?

AP: Resources and commodities have historically been a supply game. What’s driving a lot of the opportunity today is that these areas, because so much capital in the mid-to-late 1990s went to technology and the Internet, essentially missed the last capital-investment cycle. That was rational, given the dismal historical return-on-capital experience.

Our “trifecta” is to identify companies with increasing returns, growing cash flows and an ability to reinvest profitably, which is what we see in natural resources today. The phenomenon of 300 million people moving to the middle class in China is going to have a dramatic impact on the commodity intensity of that economy and the world. I believe that’s the investing story of this decade and beyond.

MD: After the big run up in so many commodity prices, we expect to see the effects of a supply response over the next two or three years. We generally expect commodity prices to be lower three years out – for oil, in the range of $50 per barrel. With that in mind, it’s difficult to argue you can buy a basket of exploration and production companies and expect a decent return over the next few years. As Andy mentioned, that doesn’t mean we aren’t finding plenty of specific opportunities, but the premium will be on picking individual stocks with compelling business models over making general commodity- price bets.

Are you active in technology businesses?

JW: Our technology investments tend to have a durable, predictable business asset that covers most or all of the company’s enterprise value, with a lot of optionality from other businesses, R&D spending or changes in the balance sheet. We’ve owned companies like VeriSign, with its registry business, and NCR, with its Teradata data-warehousing asset. The bigger market overreactions to news that you see in technology stocks eventually can provide opportunities to buy.

Do you use your cash balance as a riskmanagement tool?

AP: We don’t manage cash – it’s a residual of the investment opportunities we’re finding. Our current cash level is around 5%, which is actually quite low for us. On a portfolio basis, we look to balance some sector and industry exposures so that an exogenous event doesn’t excessively hurt us, but most of our risk management comes down to a stock-by-stock obsession with minimizing downside.

Tell us about one of your specific energy ideas, Key Energy Services (KEGS).

MD: Key provides basic maintenance services to existing oil and natural-gas wells, mostly onshore and in the U.S. That accounts for about 80% of cash flow, with the other 20% coming from pressure pumping, which is used to stimulate new wells. They are the U.S. leader in maintenance services with about 35% of the market, ahead of Nabors Industries and Basic Energy. The industry has consolidated fairly rapidly: the top four players control about 65% of the market, with mom-and-pops making up the rest.

We like the service aspect of the business. The company is paid by the hour to make sure existing wells are producing at the levels they are capable of, which results in a more durable and predictable level of cash flow than you would see in, say, contract drillers. Customers understand that Key's service can improve a well's productivity by 30- 35% and it’s viewed as an on-going business expense versus coming out of the capital budget.

Joe spoke earlier about the importance of understanding the unit economics of a business – how attractive are those here?

MD: Key’s refurbished well-service rigs cost around $800,000. Day rates today are $400 per hour and utilization levels are about 85%, with margins running in the low 40%s. That gets you to a roughly 70% pre-tax return on investment at the unit level. Even if you cut hourly rates to $250, utilization to 65% and margins to 30%, they’d still earn a pretax return on capital of over 20%. So even in a bad environment they’ll earn more than their cost of capital and increase overall company value.

Why isn’t the company current in its financial reporting?

MD: They made a lot of acquisitions that were poorly accounted for, resulting in unanswered questions about book depreciation that have kept them from filing since 2003. We actually got interested in Key three years ago after the stock got hit on the news they couldn’t file. I’d spent a lot of time analyzing distressed companies, and in this case it was fairly easy to look at cash flows and see that the assets were generating very high rates of return.

The ongoing financial information we get is fairly good. Creditors require monthly financial updates, which are made public and provide a good picture of how the business is performing. We don’t believe there are accounting issues beyond the depreciation/book value issue.

What has management been doing right operationally?

MD: They’ve done an excellent job of maintaining service levels while also becoming more of a price leader, which they should be as the biggest player in a consolidated industry. They’ve been conservative with capital spending while they get their accounting issues resolved. They’ve clearly benefited from higher activity levels, but as I mentioned earlier, we don’t consider this to be as cyclical a business as the market is implying.

Trading at $18.80, what upside do you see for the shares?

MD: We think the shares are being valued as if this was a highly-cyclical contract driller, when it’s actually a much higher-quality business. We expect them to generate $1.2 billion in free cash flow over the next four years, assuming $50- per-barrel oil and $7-per-mcf natural gas. That’s on an enterprise value of $2.4 billion, including $100 million of net debt. If we run an LBO valuation model, it’s easy to achieve a 30% annual rate of return from today’s price.

What are the biggest risks?

MD: Oil going to $35 per barrel would obviously impact the demand economics. You could also conceivably see increased supply and pricing pressure in the maintenance business, but Key is difficult to compete with because it’s the leader.

The company has said it will file up-todate financial statements through 2006 by the middle of this year. If that slips, it could cause a short-term problem for the stock, but we wouldn’t expect it to impact the long-term potential.

Source: The Long Case for Key Energy Services