Drilling Into Helmerich & Payne's Impressive Dividend Yield

| About: Helmerich & (HP)


We wanted to update investors on our thoughts on Helmerich & Payne, the market share leader in land drilling in the US.

Helmerich & Payne's competitive advantages (better rigs, support structure, maintenance, etc.) translate into higher economic returns, but its industry backdrop remains a concern.

The biggest threat to Helmerich & Payne's dividend growth prospects rests on the fragility of its customer base as a result of the collapse in energy resource pricing.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

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By The Valuentum Team

Helmerich & Payne (NYSE:HP) has a modern and capable land drilling fleet and a strong term contracted backlog, and it is the market share leader when it comes to land drilling in the US. The company's competitive advantages (better rigs, support structure, maintenance, etc.) translate into higher economic returns, but its industry backdrop remains a concern.

The near-term outlook for energy services companies is unfavorable, however, and the executive team stepped up its dividend payout at perhaps the most inopportune time - lower commodity prices mean fewer wells drilled and early termination notifications increase. Helmerich & Payne's balance sheet is better than most competitors, and its dividend track record is solid.

Though management may disagree, the biggest threat to Helmerich & Payne's dividend growth prospects rests on the fragility of its customer base as a result of the collapse in energy resource pricing. Rig counts have fallen considerably during the past several periods, and crude oil prices remain under considerable pressure as a result of OPEC's market-share-grab strategy.

Drilling activity and pricing continue to decline, and investments continue to be cut back. We think management should scale back capital expenditures to ensure that a cash crunch does not eventually ensue in coming years. Management understands that no energy-related company is completely immune to collapsing resource pricing and the team's 'fiscal conservatism' may help.

Helmerich & Payne's dividend is certainly attractive based on its impressive yield of ~4.2%, but we are not fond of the safety of the payout based on its Dividend Cushion ratio of 0. Let's dig deeper into the company's investment considerations as we look to uncover the true attractiveness of shares from a total return point of view.

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Image source: Valuentum

Helmerich & Payne's Investment Considerations

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Investment Highlights

• Helmerich & Payne is primarily engaged in contract drilling of oil and gas wells for others, and this business accounts for almost all of its operating revenues. The company is a share leader in the US land drilling market. Management is focused on innovation and returns on capital. The firm was founded in 1920 and is headquartered in Tulsa, Oklahoma.

• Helmerich & Payne continues to capture land-drilling market share in the US. The firm has increased its share from 9% in October 2008 (peak) to ~19% today, a level above that of PTEN (about 12%), NBR (about 9%), PDS (about 6%) and UNT (about 4%).

• The past several months haven't been great for Helmerich & Payne. Low and volatile crude oil prices have pushed the industry rig count in the US to levels not witnessed since the recession in 2009. Management has indicated that drilling activity and service pricing levels remain under pressure, and 'the major theme across the industry is survival.'

• Earnings will face significant pressure in the near term at Helmerich & Payne, but we're anticipating an eventual rebound. Our fair value estimate is based on normalized assumptions and revenue that approaches, but does not eclipse, the levels of a few years ago by the end of our 5-year discrete forecast period.

• Helmerich & Payne is not immune to the current difficult conditions, but its 'fiscal conservatism,' strong reputation for customer service and long-term contract backlog offers some support.

Business Quality

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Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Helmerich & Payne's 3-year historical return on invested capital (without goodwill) is 9.9%, which is below the estimate of its cost of capital of 10.3%. As such, we assign the firm a ValueCreation™ rating of POOR.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

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Image source: Valuentum

Cash Flow Analysis

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Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Helmerich & Payne's free cash flow margin has averaged about 6.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Helmerich & Payne, cash flow from operations increased about 44% from levels registered two years ago, while capital expenditures expanded about 40% over the same time period.

Valuation Analysis

We think Helmerich & Payne is worth $58 per share with a fair value range of $46-$70.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of -9.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 0.1%.

Our model reflects a 5-year projected average operating margin of 3.9%, which is below Helmerich & Payne's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 10.7% for the next 15 years and 3% in perpetuity. For Helmerich & Payne, we use a 10.3% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

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Image source: Valuentum

Margin of Safety Analysis

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Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $58 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Helmerich & Payne. We think the firm is attractive below $46 per share (the green line), but quite expensive above $70 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

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We estimate Helmerich & Payne's fair value at this point in time to be about $58 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Helmerich & Payne's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $70 per share in Year 3 represents our existing fair value per share of $58 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.