Basic Energy Services Looks Too Cheap

| About: Basic Energy (BAS)
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When I was thinking about writing up Basic Energy Services (NYSE:BAS) for Seeking Alpha, I was surprised to see how little coverage there has been on the name on this platform. Sure, this is not a large energy services company (with a market cap around $500 million and an enterprise value around $1.3 billion), but it is the third-largest company in the well servicing industry and this is a business that could do substantially better when (or if?) demand and pricing improve in major basins like the Permian.

It's looking like 2013 is going to finish on a fairly sour note, as competition among service firms continues to keep a lid on prices and profits. The next year should be better, though, and even at relatively modest EBITDA multiples this stock looks undervalued. While I still presently prefer to own Cameron (NYSE:CAM) and Weatherford (NYSE:WFT), it's not by a wide margin and Basic would be high on my list if I wanted to go more overweight towards service companies.

A Triple-Play In Services

Nearly all of Basic Energy's revenue comes from three broad lines of business - completion/remedial services, fluid services, and well servicing - and all of the revenue comes from North America. Although all of Basic Energy's services are essential to oil and gas production, there are numerous competitors in every basin ranging from some large players like Halliburton (NYSE:HAL) and Nabors (NYSE:NBR).

Completion and remediation is about 40% of Basic Energy's business, with more than half of the segment's revenue coming from pressure pumping. While fracking is big business for companies like Halliburton and Schlumberger (NYSE:SLB), Basic Energy doesn't exactly go toe-to-toe with them in this market. Basic Energy focuses more on less complex, low-horsepower activities like cementing casing in place or pumping fluids for well stimulation. Basic Energy also does generate meaningful revenue from operations like coiled tubing and tool rental - the latter which is a big market for Weatherford.

On the fluid services side, Basic Energy supplies and manages the fluid needs for drilling and workover operations. Not only does the company have a fleet of over 950 trucks, but the company also rents portable storage tanks and can manage a client's on-site fluid needs. This is also a sizable business for Key Energy (NYSE:KEG), Nabors, and Superior (NYSE:SPN), but increasing attention to the importance of fluid management should underpin growth in this market for many years.

Last and not least is well servicing, where Basic Energy deploys over 400 rigs and enjoys the #3 position in the market with around 15% share. Most of this business is focused on workovers - repairing or replacing down-hole well equipment and/or moving equipment into and out of the well to enhance production later in the well's life. Key Energy's fleet is more than twice the size of Basic Energy and Nabors is about 40% larger, while Superior is roughly half the size of Basic Energy. As you might imagine, workovers tend to happen later in the life cycle of wells and aren't tied as much to new drilling activity.

Balancing Competition, Geography, And Consistency

Although Basic Energy's relatively higher mix balance towards oil has helped it some relative to more gas-centric service names, it's been a rough ride down from the peaks in 2011. Energy service companies never seem to learn, and they added capacity left, right, and center during the last boom.

Unfortunately, the nature of the business is such that even relatively more responsible companies like Basic Energy pay the price. In this case, overcapacity has led to rampant competition and lower prices, particularly in the Permian basin where Basic Energy has almost half of its rigs and trucks. Equally unfortunate is that the company can't just shift rigs and trucks on short notice - areas like the Bakken may be growing, but it costs money to move equipment and workers may not always be willing to relocate. What's more, chasing business around the country can prove costly as much of Basic Energy's business is relatively short term and short notice in nature.

Over the long term, I'm not too worried about Basic Energy's geographical coverage. More than three-quarters of the company's rigs are located in the Texas/Oklahoma/Louisiana region and I believe areas like the Permian, Eagle Ford, Barnett, and Woodford still have a lot to contribute in terms of drilling, production, and workover activity.

Certainly there are still a lot of unknowns about the pace and extent to which activity and pricing will improve. Frankly nobody has sounded all that optimistic lately about North American drilling activity, with most of the large producers and service companies being quite cautious about projecting much more than a slow recovery off of what they assume was a bottom in 2013. Along those lines, Basic Energy did see some improvements in the second quarter (well servicing rig hours up 6% sequentially, utilization up 5% to 74%), but a big improvement through the balance of 2013 seems like too much to hope for at this point.

Value Is Slippery

Barring a jump in oil and gas prices that producers believe will stick for a while (thus encouraging them to re-accelerate drilling plans), Basic Energy is not likely looking at a V-shaped recovery. That said, 2014 is looking better than 2013, with EBITDA likely to rise around 20% (though still below 2012 levels) and rise again by double digits in 2015.

EV/EBITDA is the preferred method for valuing most service companies, and most readers likely realize that EBITDA estimates can move around quite a bit. At the same time, assigning the "right" EBITDA multiple is just as tricky and just as important. Various analysts claim that Basic Energy's "full-cycle" multiple is 4.0x, 4.5x, or 5x and the difference between those on 2014 EBITDA estimates is considerable - from a low of almost $10.50 to a high of over $18.

I'm going with 4.75x for now. Yes, that is an arbitrary-looking number, but here is my logic. Most small-cap service companies are trading at around 5x to 6x 2014 EBITDA, while onshore contract drillers are trading for around 4x. My own calculations of past multiples for Basic Energy and close comparables like Key and Superior suggest that a 5x multiple is reasonable (or slightly conservative) at this point in the cycle, and I'm trimming that back slightly to account for Basic Energy's above-average exposure to the highly competitive Permian Basin. Using that 4.75x multiple gives me a $16.50 target on the current average 2014 EBITDA estimate.

The Bottom Line

A $16.50 target is enough to make Basic Energy an interesting name to consider as far as I'm concerned. I'd also note that while discounted cash flow is ridiculously tricky to use in the case of smaller service companies, an estimate of long-term growth of 5% would support a floor valuation of around $12.50. As I said in the open, I'm currently holding Cameron and Weatherford, as I want exposure to the offshore activity and I believe Weatherford is a "special situation." Outside of those names, though, Basic Energy would be a name to consider for investors looking for smaller service stocks to play a rebound in North American activity in 2014.

Disclosure: I am long CAM, WFT. 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.