Performance and Valuation Prime Chart
PKD has historically seen volatile profitability related to the shifting nature of the oil and gas industry. In 2000-2002, the firm saw ROA' in negative territory, before experiencing a positive inflection to 6% in 2003. While ROA' subsequently dropped to 3% in 2004, it increased to a peak of 9% in 2008, before declining to -5% in 2010. ROA' again saw a positive inflection in 2011, jumping to 6% and ranging from 1%-3% through 2014, before their inability to offset headwinds related to declining oil prices drove ROA' to 0% in 2015. Meanwhile, Adjusted Asset (Asset') growth has seen similar volatility, positive in eleven of the past sixteen years, while ranging from -29% to 25%.
For context, the PVP chart above reflects the real, economic performance and valuation measures of Parker Drilling Company (NYSE:PKD) after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.
The four panels explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.
The apostrophe after ROA', Asset', V/A', and V/E' is the symbol for "prime" which means "adjusted." These calculations have been modified with comprehensive adjustments to remove as-reported earnings, asset, liability, and cash flow statement inconsistencies and distortions. To better understand the PVP chart and the following discussion, please refer to our guide here.
Performance Drivers - Sales, Margins, and Turns
It can be helpful to break down ROA' into its DuPont formula parts, Adjusted Earnings Margin (Earnings' Margin) and Adjusted Asset Turnover (Asset' Turns), which are the cleaned up margins and turns metrics used to calculate ROA'. The chart below details both Earnings' Margin and Asset' Turns historically, to help us better understand the drivers of the firm's profitability and performance. The detail behind the chart can be found here.
Earnings' Margins were consistently negative from 2000-2002 before experiencing a positive inflection to 15% in 2003. While Earnings' Margins declined to a much lower 6% in 2005, they recovered to 14% in 2008, only to drop to -10% by 2010. Earnings' Margins then experienced a positive inflection to 14% in 2011, before dropping to 2%-6% levels from 2012-2014, and declining even further to -1% in 2015. Meanwhile, Asset' Turns increased from 0.3x in 2000 to peak 0.6x-0.7x levels from 2005-2008, before declining to 0.4x-0.5x levels from 2009-2015.
As the above highlights, Asset' Turns has had two steady cycles over the past 15 years. From 2000-2008, Asset' Turns was improving, as the firm was able to generate more revenue from their assets, due to both a pick-up in day rates and a pick up in capacity utilization. Subsequently, Asset' Turns have declined, also thanks to both of those issues. The company's exposure, which is mostly to the shallow-water Gulf of Mexico jack-up market, can be more natural gas biased than other off-shore drilling companies, and the earlier declines in the natural gas market than the oil market impacted their revenue and days under contract.
Drilling is an industry where margins and asset utilization go hand in hand, even more strongly than in most industries, where overhead and fixed costs related to the asset base can impact margins. For drilling, with so much of the cost of the operation related to the cost of the asset, movement in Asset' Turns has clearly directly impacted margins. Strong Earnings' Margins have generally happened during periods of strong Asset' Turns. When that hasn't been the case, for instance in 2009 or in other years, its generally related to the company's variable costs not reacting quickly enough to the changes in the cyclical business.
Embedded Expectations Analysis
As investors, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends, to give a clearer picture into what the market is projecting for the firm.
PKD is trading at a 0.5x V/A', near historical lows. At these levels, the market is pricing in muted expectations for the firm, specifically a limited recovery in ROA', from 0% in 2015 to 3% in 2020, accompanied by 1% Asset' growth. These market expectations are largely driven by the market's concerns about the firm's credit risk, which is the main reason behind PKD trading at such a substantial discount to Asset' values. PKD is not alone in this regard, with a number of other firms in the Energy sector with similar valuations.
A major benefit of adjusting as-reported financial statements is to clear away accounting distortions, to allow for more accurate peer-to-peer comparisons. To this end we have included a scatter chart below plotting PKD against its peers.
Generally, when looking across industries, markets, and time, there is a very strong relationship between a company's ROA' relative to the corporate average (6%) ROA', and the multiple the market will pay above the company's book adjusted Asset' base, in terms of Adjusted Enterprise Value relative to Assets (V/A' or Value to Assets'). However, when a firm has substantial credit risk, this trend disappears, and instead, the company may trade well below Asset' values, regardless of ROA'.
The below chart highlights this phenomenon, comparing PKD to other firms in PKD's drilling industry, and the energy sector overall, with credit issues: Chesapeake (NYSE:CHK), Diamond Offshore Drilling (NYSE:DO), Transocean (NYSE:RIG), Atwood Oceanics (ATW) and Ensco (NYSE:ESV).
Although each of these firms has different levels of profitability, with ROA' ranging from -10% to +10%, they are all currently trading below book values, largely driven by credit issues. Each currently has debt outstanding with yields in high-yield territory. As can be seen above, most of the peers have Credit Default Swap pricing (CDS) above 800bps. Anything north of 300bps tends to represent high yield credit. Higher CDS levels represent higher market interest rates on the company's debt and higher risk of default, so a 100bps name is a very safe investment grade name, while a 1,000bps CDS name is a name the market perceives to have high risk of default.
The high CDS levels indicate that both equity and credit markets have a bearish outlook, and as such, even if they are able to improve profitability, which generally drives valuations, they may not see an improvement without improving their credit outlook. However, in the case of PKD, their credit outlook may actually already be safer than markets realize, indicating the potential for credit-driven equity upside as the market realizes this opportunity.
Credit Cash Flow Prime Chart
Below, we've included our Credit Cash Flow Prime™ chart for PKD. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Research's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.
The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.
Even in a consensus analyst scenario, where ROA' remains negative over the next several years, credit markets appear to be overstating the firm's risk. The markets appear to be fixating on the fact that while PKD is able to service all operating obligations each year going forward, their combined cash flows and cash on hand would be unable to handle their 2022 debt headwall, and PKD would therefore likely require a refinancing if they are to avoid a liquidity crunch. However, these concerns appear overblown, as PKD has over 6 years to figure out this issue, and has a robust recovery rate of 200% on unsecured debt, which should allow them access to credit markets with limited issue. Additionally, the firm has significant capex flexibility which they could use to their advantage should they need additional liquidity.
Current valuations are not pricing in the company's multi-year window before they have any risk of a credit crunch. Nor are they pricing in the company being able to successfully navigate the debt maturity headwalls they have, that they are likely to be able to. This is also true for CDS and bond markets, that have the company's credit risk at 1,000bps+ for CDS and 13%+ for YTW on the unsecured bonds. On the other hand, Valens' fair value of CDS metric, Intrinsic CDS (iCDS) is at 671bps, representing the company's safer credit risk profile.
Considering the company is trading at a 0.5x V/A' due to these issues, a 50% discount on asset values, were these concerns to be alleviated, there could be substantial upside. For context, from 2008-2013 PKD's valuations ranged from a 0.7x V/A' to a 0.9x V/A'. Were the company to get back to those valuations, there could be 100%-240% upside, as at a 0.7x V/A' the company's equity is worth $5 per share, while at a 0.9x V/A' the equity is worth $8.
PKD does not need to become a better company to have substantial equity upside. The market just needs to realize that PKD is not an imminent bankruptcy risk for the equity to rise dramatically.
To find out more about Parker Drilling Company and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Joana Halcon. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
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.