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Executives

Ben Burnham – IR, DRG&E

Chris Strong – President and CEO

A. J. Verdecchia – VP, CFO and Treasurer

Analysts

Steve Ferazani – Sidoti & Co.

Neil Jacobs [ph]

Union Drilling, Inc. (UDRL) Q1 2008 Earnings Call Transcript May 1, 2008 11:00 AM ET

Operator

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the Union Drilling first quarter 2008 earnings conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator instructions) This conference is being recorded today, Thursday, May 1, 2008. At this time, I'd like to turn the presentation over to Ben Burnham with DRG&E. Please go ahead, sir.

Ben Burnham

Thank you, Andrew, and good morning everyone. We appreciate you joining us for Union Drilling's conference call today to review first quarter 2008 results. Before I turn the call over to management I have some housekeeping details to run through. You may have received an e-mail of the earnings release yesterday afternoon. If you didn't get your release or would like to be added to the e-mail distribution list, please call our offices at DRG&E at 713-529-6600. A recorded replay of today's call will be available until May 8. The information for accessing the telephonic replay is in yesterday's press release. The replay will also be available via webcast by going to the company's web site at www.uniondrilling.com. Please note that information reported on this call speaks only as of today, May 1, 2008, and therefore you are advised that time sensitive information may no longer be accurate at the time of any replay listening.

Also, statements made in this conference call that are not historical facts including statements accompanied by words such as will, believe, anticipate, expect, estimate, or similar words are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 regarding Union Drilling's plans and performance. These statements are based on management's estimates, assumptions, projections as of the date of this call and are not guarantees of future performance. Actual results may differ materially from the results expressed or implied in these statements as a result of risks, uncertainties, and other factors, including, but not limited to, the factors set forth in the company's filings with the Securities and Exchange Commission, including Union Drilling's Annual Report on Form 10-K for the year ended December 31, 2007. Union Drilling cautions you not to place undue reliance on forward-looking statements contained in this call. Union Drilling does not undertake any obligation to publicly advise or revise any forward-looking statements to reflect future events, information or circumstances that arise after the date of this call. For further information, please refer to the company's filings with the SEC.

Now, with that out of the way, with me this morning are Chris Strong, the company's President and Chief Executive Officer and A.J. Verdecchia, Chief Financial Officer. Now, I'd like to turn the call over to Chris.

Chris Strong

Thank you, Ben. Good morning, everyone, and thank you for joining us. This was another challenging quarter for Union Drilling. We reported revenues of $64.1 million and EBITDA of $14.1 million for the three months ended March 31, 2008.

As you probably saw in yesterday's press release, most of the weakness was due to a continuation of the issues we dealt with during the fourth quarter. Specifically, the smaller rigs in our fleet experienced significantly lower demand with many working only sporadically on short-term contracts. Additionally, we continue to experience low utilization due to adverse weather in our Appalachian division. That being said, utilization has improved sequentially in the months of March and April and I think the worst is behind us. We expect a significant increase in demand for the balance of 2008 and into 2009 in both Arkoma and Appalachia.

I'll discuss this further in a few minutes but in hindsight it appears that the correct decision was made not to cut back more on crews and expenses to improve short-term results. Numerous rigs that were idle are in better condition than last fall and by retaining the key crew members to work on those rigs during the past two quarters we are positioned to take advantage of much more favorable conditions that has emerged in the last month or two. Construction is well underway on the IDM rig we announced in January and we expect it to be delivered for work in the Marcellus Shale by the end of the second quarter.

In early April, for approximately $7 million, we acquired a 1000 horsepower portable rig that was built in 2007. With tubulars and other extras that came with it, this rig would have cost over $10 million new today, so we are pretty happy with that deal. After some modification work, which includes putting a top drive on it, we should have it drilling in the Marcellus Shale in the third quarter.

Now, I am going to turn the call over to A.J. to review the numbers before I talk about the outlook for various markets going forward.

A.J. Verdecchia

Thanks, Chris. Revenues for the first quarter of 2008 totaled $64.1 million, compared to revenues of $70.5 million in the first quarter of 2007. On the expense side, operating costs increased slightly compared to the first quarter of 2007, primarily as a result of having all six of our Ideal Rigs operating this year. As a reminder, the last three Ideal Rigs were delivered throughout the first three months of 2007.

Q1 operating costs were down slightly compared to last quarter as we were able to cut some cost in the tough market conditions. General and administrative expenses increased 26% to $6.8 million from $5.4 million in the previous year's first quarter largely due to additional personnel expenses. These expenses have been for safety and maintenance programs, division management, and corporate personnel especially in our accounting and IT departments. We also paid higher property taxes mainly from the NOV rigs and increased our bad debt provision.

Income taxes decreased to 35.5% from 41.6% in the first quarter of '07. This decrease was due to clarification of the rules relating to the Texas margin tax, which must be recorded in the period when the change occurs. We expect to have an average effective tax rate of about 43% for the full year 2008, which means our tax rate over the remaining three quarters should be about 44%.

Net income for the quarter totaled $2.1 million, or $0.10 per share, compared to $8.5 million, or $0.39 per share a year ago. First quarter EBITDA totaled $14.1 million in 2008, compared to $23.9 million in 2007. Please refer to yesterday's press release for a reconciliation of EBITDA to net income.

As for our fleet-wide operations, revenue days totaled 3,691, down 15% from 4,344 days in the first quarter of '07. Marketed rig utilization for the first quarter of '08 was 57.1%, compared with 70.5% a year ago. The average day rate in the first quarter was 17,361, up 7% from a year ago average of 16,237. As we saw last quarter, the record average day rate is due to the fact that we had low utilization for our small lower day rate rigs rather than actual rate increases. Our drilling margins per revenue day averaged 5,625 for the first quarter of '08, down 17% from the first quarter 2007 average of 6,741.

Moving over to the balance sheet, you may have noticed that the borrowings under our revolving credit facility have increased, and the balance is now listed under current liabilities. The $4.6 million increase is due primarily to progress payments made on the IDM rig that we are building for the Marcellus Shale. The debt was moved to current liabilities because the agreement matures on March 30, 2009, which is now less than one year away. We expect to amend, renew or replace the facility over the next few months. The balance on the revolver as of today is about $20 million, which increased primarily to fund the rig that we purchased a few weeks ago.

Capital expenditures for the quarter totaled $16.3 million of which $5.2 million was designated as maintenance CapEx and $10.1 million was for progress payments on the new IDM rig being built.

I will now turn the call back to Chris.

Chris Strong

Thanks, A.J. As I was saying earlier, we feel good about the outlook for our markets for the remainder of 2008 and into 2009. Starting in our Arkoma division, which includes the Woodford, Caney, and Fayetteville Shales, I think we will see a steady increase in demand here as acreage continues to be acquired by medium and large independent producers. Historically, the most active players in the Fayetteville have been Chesapeake and Southwestern both of whom have their own captive rig fleets. While we work for both companies, outside rigs are generally the first to be released when there is a pullback in drilling activity.

I am very encouraged by XTO's recent 56,000-acre $520 million acquisition in the Fayetteville Shale, bringing their total Fayetteville position to over 300,000 net acres. On last week's conference call, they said they expect to go from one drilling rig currently to eight by the end of the year on that land. As you may know, XTO has been our largest customer over the last couple of years, so we are certainly hoping to benefit from their expansion in this region as well as from their recent $600 million Marcellus Shale purchase.

We have moved one of our smaller triples out of Texas into the Fayetteville and may move another depending on how tight that market is. Moving over to our Texas division, performance has been steady although we have seen some follow-up in demand for sub-1000 horsepower rigs. We have ordered four new 1000 horsepower draw works and two new derricks to upgrade several of these rigs, and like our other markets, we will be on the lookout for rig deals where the price and type of contract we can obtain will provide a good return for our shareholders.

In Appalachia, things are looking very good for this summer. There is a backlog of demand due to the wet and sloppy drilling conditions we experienced this winter, which held up a number of jobs. Longer term, I am excited about opportunities in the Marcellus Shale. Just to put things in perspective, the Marcellus Shale covers an area roughly 10 times the size of the Barnett shale. If it ends up being only a quarter as productive as the Barnett, that would equate to about 50 rigs to develop the acreage at a pace similar to the Barnett. Currently, I think there are only about a dozen rigs in the region capable of drilling to those depths and we own half of them.

And, as I've said before, you can't just bring any rig into the Appalachian Basin and expect to be successful. They have to be smaller, lighter, and more mobile than the type of rigs we run in the Barnett shale, but since the formation is about as deep and the demand for long reach horizontals looks to be similar, they need hook load, horsepower, and circulation systems that are similarly sized to the rigs we run in the Barnett. Because of the hard rock formations that lie above of the Marcellus, these rigs also need to be equipped with next generation high pressure air circulation systems to drill the vertical section of the wells underbalanced. That's why we recently bought the 1000 horsepower portable rig I discussed earlier and that's why significant modifications have been made to the IDM QuickSilver rig we announced in January.

Finally, I'd like to talk about our capital allocation strategy going forward. In the past, I've often discussed our strategy for entering new markets by making a platform acquisition of five to 10 rigs with a good management team in place and that we only build new rigs with long-term full payout contracts in place. With a potential for rapidly growing demand for larger purpose built rigs in the Appalachian and Arkoma basins, we are going to focus in the near term on migrating our sizable workforces in these areas to this type of equipment and pay less attention to expansion opportunities in other markets. The fact that we have the people, infrastructure, and relationships with customers and vendors in these areas gives us an advantage, but we will not be able to capitalize on that advantage with a portion of our fleet that was built for shallower vertical drilling.

We are currently having discussions with numerous customers and rig manufactures about different designs. The designs we are looking at would be well suited for drilling in either the Marcellus or Fayetteville Shales and I don't expect we will have much trouble putting them to work with our well-trained crews.

While we continue to be mindful of our balance sheet and risk versus reward, I believe it is time to be more aggressive in order to capitalize on opportunities that are quite literally materializing beneath our feet. In closing, I know we've had a couple of tough quarters, but I am really optimistic about what the future holds for Union Drilling. And with that, I think we are ready to open the call for questions.

Question-and-Answer Session

Operator

Thank you, management. (Operator instructions) Our first question will come from the line of Steve Ferazani with Sidoti and Company. Please go ahead.

Steve Ferazani – Sidoti & Co.

Good morning, Chris. I got in a little bit late so I'm sorry if you've addressed some of the things I want to ask. On the cost side, you talked about potentially laying off some crews on the last conference call. It looks like costs didn't fall too much. Can you talk about that a little bit?

Chris Strong

Costs were down a little bit, Steve, but utilization fell more than I had expected, and as a result, the cost per day actually went up. So we were off a bit on that estimate as far as what we discussed on the last conference call.

Steve Ferazani – Sidoti & Co.

Okay. With the big acquisition in the Marcellus Shale acreage from – by XTO, I mean you guys had a pretty good relationship with those guys, you've done some deeper wells. I mean does this increase the opportunity for you to build some new rigs for Appalachia now?

Chris Strong

It may, but we are already drilling for so many different people. We are drilling over near the New Jersey border in the Marcellus, we are drilling in the center of the state already, and we are drilling for folks like Range over pretty much on the Ohio border. So we are drilling in the Marcellus probably 350 miles apart in different areas of this play right now.

Steve Ferazani – Sidoti & Co.

I guess what I'm asking in that question is other contracts like you announced in January probably the higher margin, higher horsepower type rig long-term type contracts.

Chris Strong

That's certainly what we are focused on. I am planning to spend a full week up there in May visiting with customers and we've certainly been visiting with them in the Dallas-Fort Worth area as well as Houston. So it's certainly in our plans to be more aggressive in that area and given all the acreage that's being acquired and what's happening to acreage prices up there, I just see a large demand for rigs in the very near future in that area.

Steve Ferazani – Sidoti & Co.

I guess this will probably be a difficult question to answer – sort of the timetable – we know a lot of the acreage acquisitions and such but I mean does it develop as slow as the Barnett did? Is this going to be a three- to five-year growth plan or are you looking at rigs to double in the next 18 months? Or can you give us some sort of perspective?

Chris Strong

Well, I think you are seeing announcements by some of the people who have been in it for a little while already like Range and Equitable, recently announcing that they are taking a number of horizontal wells that they are going to drill in 2008 I think up from 250 to over 300. Range is certainly not backing down. There are other players up there that are more behind in the play. I think that probably the valuable piece of information that's not out there quite yet is the decline curves off of these wells. We are hearing a lot about IP rates and good successes. But a number of these wells we drilled last fall and those have been hooked up now for maybe nine months or so. Once you get to a year, I think you are going to start seeing investors making – investor presentations, rather, containing information that more speaks to the decline curve and that there really are solid 2 Bcf to 2.5 Bcf wells to be drilled up in the Northeast. That's probably a shift over point where people start seeing that and being able to think in terms of drilling for those kinds of reserves. Fortunately in that area, the pipeline infrastructure is pretty mature, so I don't think we'll have issues that you've seen in the Rockies where you have a very rapidly expanding play that cannot get the gas to market.

Steve Ferazani – Sidoti & Co.

Okay. Great, thanks a lot, Chris.

Chris Strong

You are welcome, Steve.

Operator

Thank you. (Operator instructions) Management, at this time, we have no additional questions in the queue. I will go ahead and turn the conference over to you at this time for any closing remarks.

Chris Strong

Thank you all for joining us today and I look forward to speaking with you again on Union Drilling's second quarter conference call.

Operator

Pardon me, management, we do have an individual that just joined. Would you like to take the question from Neil Jacobs [ph] at this time?

Chris Strong

Sure.

Operator

Please go ahead with your question, sir.

Neil Jacobs

Yes, thanks a lot. I was just curious – I agree with you on your outlook for Appalachia – I just got off Equitable and Cabot's call and both are ramping significantly. Just curious – as you look to build these rigs, what type of return profile you are looking at? And are you only building them with contracts – multiyear contracts in hand as you've done prior or are you going to build them more spec?

Chris Strong

I think we are going to have a combination, Neil. I think there are opportunities to negotiate with some of the rig manufacturers so that if we get say a four or five rig package or maybe a four-rig deal with an option for four additional rigs that we would probably have better pricing power just based on the ability of a rig manufacturer to tool up for a specific type of production run if we negotiated say a four and four type deal. But if we had two or three of those already committed with term contracts that might be the impetus we would need to go ahead and commit to a four rig type program. I think there is enough pent-up demand and enough acreage that's being acquired up there that if we simply wait for full payout term contracts to materialize, we could get behind the curve fairly quickly relative to the amount of rig demand there is going to be in Pennsylvania. And my other concern is our crews. As I mentioned on my conference call comments, that the crews are a very valuable asset up in the Northeast. We are by far the largest drilling contractor in that market. And our challenge is to transition those crews from smaller vertical rigs into this next generation of larger horizontal drilling rigs for the shale plays.

Neil Jacobs

And so, on the return question–?

Chris Strong

I'm sorry. We are certainly not going to do anything that is going to be above our EBITDA multiple. We look at cash on cash returns pretty closely. I think the types of returns that are available up there are probably in the three to three-and-a-half year area – in terms of EBITDA of cash on cash.

Neil Jacobs

Cash on cash returns. Paybacks I mean?

Chris Strong

Payback over three to three-and-a-half years.

Neil Jacobs

Got you. Okay. And on the balance sheet side, what debt to cap are you comfortable with?

Chris Strong

That really depends on how much term contract coverage there is, but I think in a business that still has elements of cyclicality to it, I guess I don't believe completely that it's different this time and we'll never have a significant slowdown. A third debt to cap is probably a good ceiling for a company like ours. We have a lot of headroom right now on our revolver to go ahead and build some additional rigs and be well within that number.

Neil Jacobs

Great. Thanks a lot.

Chris Strong

You are welcome, Neil.

Operator

Thank you. Ladies and gentlemen, at this time, we would like to conclude today's teleconference. We thank you for your participation on the program. At this time, you may now disconnect and please have a pleasant afternoon.

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Source: Union Drilling, Inc. Q1 2008 Earnings Call Transcript
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