After declining 50% over the last year, 3Q12 will present a great opportunity to take a long position in Nabors (NBR) for those investors looking to profit from NBR's turnaround in FY2013.
- Long: Nabors Industries
- Current share price: $13.90
- Potential Return: $ 6 to $ 10 per share with a short term $1-$2 downside
- Market Capitalization: $4.2B
- Cash: $460M; Total Debt: $4.7B
- Leverage: 2.1x; Interest Coverage: 8x
- Shares Outstanding: 290M
- Gross Margin: 35%; Operating Margin:12%
- Tangible BVPS:$16.30; 2013 Forward P/E: Approximately 5x
- Sector: Basic Materials; Industry: Oil & Gas Drilling & Services
- Trading timeline: 15-18months; Important time: 3Q-2012
- Main Catalyst: Ongoing Divestitures, Management changes, Changes in NBR bylaws in addition to Sector M&A; turnaround in International and offshore operations, deleveraging of balance sheet and realignment to business leading to better company valuation; Fundamentally undervalued
- How might I trade: Start a tracking position and build it up through 3Q12.
Nabors Industries' restructuring catalysts present a compelling opportunity for investors looking to benefit from investing in a stock that has fallen more than 50% over the last year. The downtrend in the share price is caused by a mix of certain events - some firm specific while some arising due to macro economic and political headwinds. On a macro level, NBR's exposure to the natural gas industry has been a negative. The downfall in natural gas prices led to depletion charges in NBR E&P properties, negatively impacting earnings. Furthermore, business in Alaska has also been on a downtrend due to delay in expected tax laws. However NBR seems to be regaining its footing in Alaska and seems to be trending back to 2008/09 revenue numbers.
The macro impact was further exacerbated by the occurrence of the BP oil spill in the Gulf in FY10 that negatively impacted the drilling industry by increasing regulatory risk leading to significant potential cost increases. In addition to the macro headwinds, the Arab uprising in the Middle East and the political unrest in Latin America has been a negative for NBR. 50% of NBR's international business is exposed to North Africa & Middle East while 38% of international exposed to Latin America.
On the factors specific to NBR, concerns that the firm was overexposed to the gas industry, in addition to the negative publicity from shareholder lawsuits related to the $100M payout controversy regarding the then CEO, Eugene Isenberg created doubts in the minds of shareholders leading to the major sell-off.
Despite the negative factors, I am convinced that NBR will make a good investment for medium- to long-term investors. My conviction is borne out of certain ongoing hard and soft catalysts that are in play. One is the ongoing restructuring that NBR has been undergoing, which includes realignment of NBR business into two reportable segments. This should lead to better future valuation for the firm.
Another is the ongoing divestiture of $600M-$800M in non-core and Oil & Gas (O&G) assets, 33% of which is already been completed. The proceeds are intended to go towards deleveraging the balance sheet. Then there are the recent management appointments and changes to NBR's bylaws that include removal of the former CEO and declassification of the board. If industry consolidation were to occur, then the change in bylaws coupled with recent restructuring of the business and new management changes may signal a potential future sale of the company. The sale thesis is further supported by the strategy implemented by the new management, which includes a change in revenue mix and creation of a better hedged revenue model, where drilling is complemented by well servicing operations, and rig exposure is now majorly focused on drilling for oil & gas liquids.
Adding to the upside is the turnaround in Alaskan and international operations created by restructuring and calm in the Middle East & North African political climate. The restructuring efforts are obvious from the reported data over the last 25 quarters where NBR is finally reporting a turnaround in its 1H12 revenue and operating earnings. Furthermore, competitive analysis and some of the parts analysis shows that the firm remains fundamentally undervalued. The ongoing catalysts should close the gap between the current valuation and NBR's fair value over the next 12 months creating substantial upside for shareholders.
Nabors Industries is a land drilling contractor with significant exposure to horizontal drilling as per management remarks in 2Q12. As recently as 1Q12, NBR started reporting as two different segments, Contract Drilling Services and Completion & Production Services.
Contract Drilling - Simply put, this segment consists of Rigs that are deployed around the world to drill for Oil, Gas and Gas liquids. Rigs usually work under either long-term contracts, which last of 1-3 years or under day work contracts. Long-term contracts have recently shrunk from 1-3 years to 6-9 months. The demand for contracts is driven by commodity costs that directly impact cash flows and demand from oil & gas majors who are NBR clients. Contract Drilling segment contains six sub segments; U.S. Lower 48 land drilling (27% of total revenue, 40% of total Operating income, 26% operating margin); U.S. Offshore (4%; 2.4%; 11%); Alaska (3.4%; 8.5%; 44%); Canada (11%; 8.5%; 26%) and International (17%; 6.5%; 6.9%). The other rig services is about 13% of total revenue, 9% of total operating income and 12.3% operating margin.
Despite pressure on the drilling industry, NBR reported QoQ increase in revenue and operating income in 2012, which speaks to management's efforts to slowly restructure the business by reigning in costs, selling non-core assets and creating best-available revenue opportunities for the deployed assets. Although margins per rigs have increased sequentially in 2Q12 for the U.S. lower 48 and offshore segments, the Canadian and Alaskan segments have reported a marginal decline due to seasonal factors and weather coming into play. Despite major headwinds, NBR's operating income and revenue have reported QoQ increase for 2012 and the firm has been able to withstand Marco pressures - a positive for shareholders.
Completion and Production Services - This segment consists of pressure pumping services and oil well services. The firm added pressure pumping services to this segment in 2010 and this segment has grown to 33% of the total revenue. QoQ, the segment was up in terms of both revenue and operating income. Operating margins for the segment are seeing a turnaround in 2012, increasing from the lows of 7% in 2009/2010 to approximately 14% in 1H12.
Well services, part of C&P, provides a good hedge to NBR's revenue model, especially with pressure pumping business coming under pressure. In the 2Q12 conference call, NBR acknowledged that despite pressure pumping business reporting a decline, the segment reported higher QoQ revenue as demand for servicing wells has increased. The growth of this segment due to current restructuring in E&P industry, which is expected to create higher demand for NBR's well servicing segment, provides a good revenue hedge thereby positively impacting NBR's shareprice.
A lot has been made of NBR's rig exposure. Of the total NBR rigs, which include well-servicing, offshore and onshore rigs, approximately 65% of rigs are exposed to the U.S. Another 15%-20% have exposure to Canada and the rest are international. Within the U.S., the rig exposure looks decently well hedged. Of the total deployed rigs as of 2Q12, about 130 have exposure to oil, 36 are exposed to dry gas, 41 exposed to gas liquids and 3 rigs for other purposes. NBR has deployed 11 new rigs in 2Q12. In Canada, NBR is divesting certain assets since they do no complement its services business in the region. Internationally, 50% of rig exposure is to Middle East and North Africa.
As has been noted earlier, despite reported decline in the pressure pumping segment expected to report decline in 2H12, the growing well services business provides a good hedge. Moreover, management has stated that offshore operations have reported decent demand and are expected to see a pickup in the activity in 4Q12, after the hurricane season. Data mentioned by the management indicates that concerns regarding NBR's rig exposure may be overblown. With the revenue and margin numbers finally turning a corner and NBR's hedged exposure to the oil & gas drilling still largely not discounted in the share price, it might be a good time to investors to look at the firm.
MAJOR CATALYST -
Divestitures to de-lever Balance sheet - The implementation of the new divestiture strategy followed the 2H11 appointment of the new CEO and the lead director to the board. Management declared that it intended to divest Oil & Gas (O&G) operations and certain non-core assets to raise $600M -$800M. According to the firm, the cash generated from this sale will be used to directly pay down debt and de-lever the balance sheet. Since the announcement, the firm has already raised $154M in proceeds from the sale of certain O&G assets. According to NBR, another $225M-$325M divestitures of O&G properties including those in Eagle Ford are in process but slightly delayed due to its partner, Geo Resources recently getting a buyout offer from Halcon.
Despite the delay, what's positive for NBR shareholders is that Geo's buyout affirms valuations for NBR assets in the region. Divestiture related to non-core assets, which include properties in Canada and Alaska are expected to raise another $300-$400M. O&G properties in Canada are said to be in the same region as that of Nexen Inc, which is currently being bought out by China's COONC for $15B. Additionally, certain offshore rigs are being currently evaluated for sale. Assuming a 6.5% weighted average coupon on the debt and a 25% tax rate (higher than median tax rate since 2006), a reduction in the debt of $1B should add approximately $0.22 to the EPS. With a P/Ex of 9.5, the debt reduction might add $1.50 to $2.50 to NBR's share price.
Additionally, NBR took $198M in impairment charges for FY11, $100M related to the compensation of former CEO and $98M related to assets. NBR has also recorded depletion expense over the years related to its O&G properties. However, with the divestiture of its O&G assets, reversal of $100M CEO compensation and sale of certain older offshore rigs, NBR should be able to add $3.50 to $4.50 per share, assuming 25% tax rate and a P/Ex of approximately 9.5x.
Potential turnaround in International operations - According to NBR data, international rig exposure excluding well-serving operations constitutes 26% of the total NBR rigs. Of this, more than 50% is exposed to North Africa and Middle East. This sector has seen marginal decline in revenue from $1.3B in 2008 to $1.1B in 2011. This represents a decline from 25% of the total revenue to 16%.
Furthermore, operating margins for the business has significantly declined from 30% in 2008 to 7% as of 1Q12. The decline in the operating margins despite only a marginal decline in revenue does speak to the rising costs. NBR admitted in 2Q12 that it was forced to increase salaries and pay one-time compensation to workers in countries such as Saudi Arabia. Furthermore, certain contracts for which NBR won the rights were cancelled due to political reasons in countries such as Algeria.
Another reason for cost increases could be a decline in drilling activity that could have also resulted in higher fixed costs for the firm. These governmental dictates to raise salaries or cancel contracts might be due to recent Arab uprising in the Middle East and political instability in the North African nations. However, with elections being held and the political climate somewhat stabilizing, I believe that international operation should show marginal improvement in the business and add to NBR's bottom-line in 2H13. Another segment, U.S. Offshore, which constitutes only 4% of total revenue reported negative operating margins in 2011.
Certain rigs related to offshore drilling are currently under consideration to be sold. Certain industry reports have indicated a comeback in the offshore drilling market. This was confirmed by NBR, which stated in 2Q12 call that they saw better performance from their offshore segment (operating revenue improved from (1.1M) in 2Q11 to $10M in 2Q12) and believe the business will pick up post hurricane season in 4Q12. It should also be noted that after accounting for seasonality in the business, the firm is reporting a turnaround in its segments in 1H12 after reporting major declines since FY09 and FY10. This segment along with the turnaround in international operation remains largely undiscounted and should create shareholder upside.
Management changes and Business Realignment may signal better valuation and future Sale - After the controversy over CEO payout in 2011, which subsequently led to shareholder litigation, there are certain noticeable changes in the ranks of NBR. First among them is the removal of Eugene Isenberg who earlier was supposed to be paid $100M and later chose to forgo the payment due to shareholder lawsuits. The person replacing him is the current CEO and former deputy chairman of the board, Mr. Anthony G. Petrello who has been historically known as a hands-on manager with intense focus on operations - the kind of leadership that NBR currently needs.
Another noticeable promotion was of John Yearwood, who was promoted as the lead director in 2011. He is the former CEO of Smith International where he was instrumental in successfully negotiating and completing the sale of Smith to Schlumberger in 2010. Prior to that he spent 27 years with Schlumberger in numerous operations management and staff positions throughout the world including as President and in financial director positions. In addition to make certain noticeable changes to the management and the Board, NBR also made changes to its bylaws where is decided to declassify its board. Moreover, NBR adopted a shareholder rights plan on July 17, 2012, which is set to expire on July 16, 2013. Although the management is not opposed to an offer, the firm is opposed to someone acquiring NBR shares without paying a control premium.
This action speaks to management's belief that firm is currently undervalued firm. New management's decision to report operations in two distinct segments to potentially unlock value is a proof that it is determined to execute the strategic initiative and create better shareholder value in an event of an offer. In addition to reporting in two different segments, the company also recently appointed new management teams for the two divisions making them fully functional. As noted earlier, NBR's increasing balanced revenue mix also makes it attractive, both as an investment and as a target. Given the new management, current strategic initiatives and a potential consolidation in the industry, shareholders should benefit even if NBR chooses to remain a standalone company and an eventual sale does not go through.
Fundamentally Undervalued - NBR has $460M in cash and $4.7B in debt on its balance sheet. Despite the debt, NBR is leveraged 2.4x while its interest coverage ratio is 8.0x. Of the total $4.7B in debt, only $275M are due until 2018 while NBR's $1.4B credit facility of which $490M is still available is due in September, 2014. Firm has $1B available in total liquidity, which should help alleviate any liquidity concerns - a major issue with capital intensive business.
For the first time in 2H of 2012, the firm generated more operation cash flow than it spent on Capex demonstrating management's commitment to rein in costs and increase its cash flow. Looking at approximately 25 quarters of data, the year-over-year operating margins, both for the Drilling as well as Completion & Production Services have started to move up again toward the 2007 highs. This is a result of management's effort to slowly restructure the company whose share price is weighed down by Oil & Gas pricing pressure as well as from 2011 controversy surrounding NBR's CEO. After performing valuation on the company, the shares can be valued at $22.50 to $24.00 per share by the end of 2013.
The $22.50 valuation is derived by assuming that the firm only pays off $500M in debt instead of $1B, only generates $1.50 in EPS in 2013 instead of industry estimates of $2.20 while reporting $2B in 2013 EBITDA. I have used 2013 EBITDAx of 5.15x, 2013 EV/REVx of 1.39x and 2013 P/Ex of 9.5x.
Breaking the firm down and performing SOTP analysis yields $24.15. This assumes a 2013 P/REVx of 1.39 and 2013 P/EBITx of 7.2 for Drillers while 0.95x and 2.78x respectively for Completion & Production services. Moreover, if NBR becomes a takeover targets due to above mentioned catalysts, a modest 15% takeover premium for NBR yields an average price of $26 per share.
Assuming that Pressure pumping decreases by another 10% and U.S. lower 48 by 5% in 2013 while all other segments increase by a modest 3%, I still come up with a 2013 EPS of $1.9. Assuming an industry estimated forward P/Ex of 9.5x, that still yields a price of approximately $18.00.
With current share price trading at $13.90, the shares still offers a 30% margin of safety to investors who are pessimistic about a major NBR turnaround. As the above mentioned catalysts play out, I believe that investors will benefit.