Precision Drilling: Follow The Rig Count, Follow The Money

Summary

• 2016 was tough for Precision and other contract drillers as rig count hit a decade-long low.
• 2017 saw strong rebound in rig counts in the U.S. and Canada which have lifted sales and profitability at Precision.
• 2018 is shaping up to be the start of a rebound for contract drillers and valuation remains attractive at Precision.

(All amounts in C$ dollars)

We have been following the onshore drilling market ever since the oil downturn. Precision Drilling (NYSE:PDS) has caught our eye as it traded 50% lower since the beginning of 2017 while oil price rebounded to above $60 WTI and has stayed at that level for a few weeks before starting to recover recently. As one of the most efficient and low-cost operators in the land drilling industry, Precision is poised to gain in 2018 as rig count catches up to the $60+ oil and operating leverage translates into higher profitability.

North American Rig Count

We publish a Weekly Rig Count Report, in which we track rig counts based on Baker Hughes data every week. We are seeing a big increase in U.S. rig count starting in mid-2017. Permian has been driving most of the gains and remained to see strong activities.

Initially, as oil price started its ascend and hovered above $60 per barrel, the oil rig count has not followed the upswing in oil price and has stayed relatively flat. There have been speculations on the potential explanations including more completion stages and pumping intensity resulting in more production per well and a large number of drilled but not completed (DUCs) wells. The share price of contract land drillers including Precision lost more than 50% of its value during 2017 as rig counts continued to hold steady. We believe the rig count has lagged the recent oil rally due to reasons including:

• Large number of DUCs creating a backlog of uncompleted wells
• Hedging limit upside from rising oil prices in the near-term
• Budget for 2018 was set in late 2017 with development program finalized

Consequentially, going into 2018 we believe the drilling demand and rig counts will improve materially due to several reasons:

• As oil price has steadied above $60 for an extended period of time now and OPEC's commitment to keeping production cut in place during 2018 as long as market remains not fully balanced, producers are becoming more comfortable with budgeting under a $60+ oil environment.
• $60 makes many resource plays that became uneconomic during the oil downturn look attractive again. If oil price stays above $60 throughout 2018 there will be increasing appetite from upstream producers to revisit oil plays (i.e. Canadian oil sands) that were put on hold under <$50 oil.
• Natural depletion dictates that during 2018 U.S. producers will have to continue drilling in order to meet their ambitious production targets, capping the downside to rig count and drilling demand.

(Investor Presentation)

Contract Drilling 101

Precision provides contract drilling services for E&P companies so it is important to understand the contract drilling business. E&P companies hire contract drillers to help them drill holes on their property. The drilling companies provide drilling rigs and crews operating the rig. The services are charged with a day rate based on the type of rigs provided. Rigs have different specs, meaning different horsepower and ability to drill at a different depth. Rigs with higher specs are charged with higher day rates, are able to drill at a deeper depth and require higher capital expenditure to upgrade.

(Company Website)

When drilling demand increases i.e. more rigs are at work, there will be increased demand to upgrade rigs resulting in higher day rates being charged by drillers. Also, more complex drilling would also require higher-spec rigs, creating a higher demand and better pricing for these rigs. Bloomberg has recently reported many larger producers have been experimenting with larger rigs in Permian. Cube development has emerged as producers find ways to drill more holes at the same time in pursuit of higher production and shorter payback. As Permian becomes ever more important in the U.S. oil production scene and companies move towards cube development, drillers with higher-spec fleet will continue to benefit from higher demand.

Precision Overview

Precision is one of North America's largest contract driller and well service operator. Precision provides rentals, site accommodations / catering, and snubbing services. Precision has drilling operations in the U.S., Mexico and Saudi Arabia. Currently, the fleet includes:

• 256 drilling rigs: 136 in Canada, 103 in the U.S. and 17 international
• 210 service rigs: 202 in Canada, 8 in the U.S.

Source: Company presentation

Precision works predominantly with large public E&P companies. The average market capitalization of its top 50 clients is ~$45 billion (median ~$11 billion), demonstrating the financial strength of its customers.

Source: Company presentation

Precision has a positive outlook for the contract books heading into 2018. It added 21 term contracts since the end of Q3/17 and has delivered all contracts during the downturn, earning a reputation for reliability and trust. The contract book in 2018 looks robust as Q1 and Q2 saw strong bookings.

Source: Company presentation

Precision has a significant market share in all major basins, with 25% overall market share. It has 25% market share in all oil plays, and it is worth highlighting that it has increased its market share in Permian from less than 2% to ~8%. Permian represents one of the most prolific and fastest-growing shale plays in the U.S. and it is encouraging to see Precision gaining market share in the region.

Source: Company presentation

Investment Highlights

One of the key differentiating factors that set Precision apart from its peers is its fleet of high-spec rigs. Fleet quality matters in the drilling world as it dictates upgrade costs and ultimately the margin each driller realize when demand picks up. Precision is a low-cost operator in the land drilling industry due to its past investment in upgrading rigs (C$3 billion between 2011 and 2017). Precision has invested heavily to build a fleet comprised mostly of Super Series Rigs, which is designed for today's unconventional drilling and offers the following financial benefit:

• Above-average EBITDA yield per active rig
• Better upgrade economics
• Theoretically a higher normalized EBITDA multiple

Source: Company presentation

As the industry endures through the oil downturn, Precision has been able to continue to take out costs and improve operating efficiency. The company has been able to lower total downtime in the U.S. from 1.73% in 2012 to 1.11% in 1H 2017. The utilization rate for its Super Triple rigs has also improved to 87%, per the chart below.

Source: Company presentation

The leaner, more efficient cost structure will enable Precision to enjoy higher torque to rising activity level by leveraging its fixed cost structure and lower variable operating expenses and high level of operation. During 2017 Precision reduced general and administrative costs by ~16% y/y. As rig counts rise in both Canada and the U.S., Precision's SG&A continues to trend down, from over $140 million in 2014 to below $100 in Q3 2017.

Source: Company presentation

Upgraded Fleet An Advantage

Rig counts have stayed relatively stable and have the potential to increase during 2018 assuming oil price cooperates. Precision should be able to benefit from the increased activity level. Another important factor for the drillers that impact their margins is the cost of upgrades.

Precision is very well-positioned in the rig upgrade game. Some research analysts have estimated Precision's next 12 U.S. upgrades will average about US$2.0 million per rig, while other drillers are currently spending US$4 million to potentially as high as US$14 million upgrades. Most drillers' next upgrade is in the US$5-US$6 million range. We believe there is a huge margin advantage for precision compared to its peers as lower cost upgrades today leads to some better economics and potentially rising market share. The lower upgrade cost of Precision is a result of a well-maintained fleet and capital spend over the years to upgrade its rigs.

Superior Profitability

Precision's EBITDA yield per rig-day is unrivaled among its Canadian peers. Precision's advantage comes from its rig mix weighted toward high-spec triple-derrick rigs and lower cost structure.

"EBITDA per Rig-Day - Canadian Peers" Source: Raymond James

Precision's US business is also generating competitive economics among its U.S. peers, keeping in mind that it is only a fraction the size of the three largest US land drillers (H&P, Patterson, and Nabors). Precision has been a top-2 quartile performer for most of the last six quarters.

"EBITDA per Rig-Day - U.S. Peers" Source: Raymond James

Liquidity and Capital Structure

As of December 31, 2017, Precision has total liquidity of $726 million, consisting of $65 million in cash and $661 million in available revolver capacity. Precision does not have any maturity until 2021, which leaves ample time for the company to ride out the trough. We do not foresee any financial difficulty for the company as the maturities are staggered and most maturities are still many years away.

Source: Company presentation

Rig Automation Monetization Opportunity

Precision has been testing and deploying its rig automation technology, NOVOS, which aims to improve drilling tech:

• Automates repetitive drilling activities using pre-programmed routines
• Wired drill pipe enables instantaneous transmission of data, saving time
• Open source software allows for expansive app development to further automate drilling operations
• Connects all rig components to electronically manage, control and monitor rig equipment
• Steering instructions generated using algorithms and real-time downhole data to automate directional drilling
• Using analytics and data to improve performance, drill faster

On the Q4 conference call, Precision management commented:

During Q4 2017, we achieved our commercialization benchmarks and have begun the market rollout of these technologies

We think there is modest revenue potential from NOVOS for Precision as the company tries to bundle software sale as bolt-on to existing rigs based on a fixed daily charge. It is hard to quantify the revenue potential as the services have not been sold to any customer yet. We await initial sales results in 2018 in order to assess the potential from future technology revenue streams.

Source: Company presentation

Valuation

We use DCF and comparable trading to assess valuation for Precision. Our DCF gave us a value per share of $6.47, representing an upside of 48% to the current share price. Our DCF was based on a number of assumptions:

• After a 39% increase in revenue in 2017, we assumed modest revenue increase in 2018 and 2019 of 9% and 15% to reflect higher rig count and increased drilling activities in the U.S.
• We also expect margin to continue expanding during 2018 to 2020 and stabilize around 33% post-2020, back to margins we've seen prior to 2016
• We have assumed $200 million capital expenditure in all the years, given that Precision has spent billions over the years upgrading its fleet and it has entered a period of stable expenditure
• We assumed 10% WACC based on similar companies

	2017	2018	2019	2020	2021	2022	Terminal Year
Revenue	$1,321	$1,444	$1,629	$1,654	$1,687	$1,721	$1,755
Growth	39%	9%	13%	2%	2%	2%	2%
EBITDA	$305	$364	$478	$548	$559	$570	$582
EBITDA Margin	23.1%	25.2%	29.3%	33.1%	33.1%	33.1%	33.1%
Depreciation & Amortization		$360	$349	$340	$340	$340	$340
EBIT		$4	$129	$208	$219	$230	$242
Unlevered Tax (21%)		$1	$27	$44	$46	$48	$51
Capex		$200	$200	$200	$200	$200	$200
Unlevered Cash Flow		$163	$251	$305	$313	$322	$331

Click to enlarge

DCF Value	$3,546
Current Debt	$1,646
Equity Value	$1,900
Equity Value Per Share	$6.48
Current Share Price	$4.36
Upside to Share Price	49%

Click to enlarge

Looking at Precision's historical performance, we can see that the revenue has reached a low in 2016 after years of cutting capex at E&Ps. Starting in 2017 we are seeing a rebound in revenue and profitability and we expect the trend to continue into 2018 as the bull thesis remain intact for North American onshore drilling and completion.

(Company filings)

We also looked at comparative trading to assess Precision's relative valuation. Precision has three closes peers that operate in the high-spec contract drilling space. Helmerich & Payne (HP) is the undisputed leader in the group as its fleets are the most advantaged and upgraded, while Patterson (PTEN) and Nabors (NBR) have worse fleets than Precision.

(Cornerstone Investments)

We think the valuation gap between HP and Precision can be narrowed once the market recognizes the minimal capital spend required at Precision and profitability for its U.S. and Canada operations. If Precision is able to narrow the valuation gap with HP, we can see a substantial upside for the share price.

Multiple	8.5x	9.0x	9.5x	10.0x	10.5x
2018 EBITDA	$371	$371	$371	$371	$371
Implied EV	$3,153	$3,338	$3,524	$3,709	$3,895
Implied Equity Value	$1,507	$1,692	$1,878	$2,063	$2,249
Implied Share Price	$5.14	$5.77	$6.40	$7.04	$7.67
Implied Premium	18%	32%	47%	61%	76%

Click to enlarge

Another point we wanted to make is that historically Precision has traded between 4.5x and 7.5x for the most part during non-downturn years. As EBITDA becomes depressed during the recent downturn, trading multiples was also elevated as a result.

(Raymond James Research)

On a go-forward basis, we tend to value Precision based on 6.5x 2020 EBITDA, reflecting a normalized profitability level. 2020 EBITDA of $548 is still below the levels we have seen in 2011-2014, representing a realistic view of Precision's profitability it rides out of the current cycle. We see a 50% upside based on 2020 EBITDA and 6.5x. Another thing to note is that we have not accounted for the free cash flow that will be generated during 2018 to 2020, which can be used to pay down debt and further enhance equity value.

Multiple	6.5x
2020 EBITDA	$548
Implied EV	$3,564
Less: Net Debt (Current)	$1,646
Implied Equity Value	$1,918
Implied Share Price	$6.54
Implied Premium	50%

Click to enlarge

Putting Everything Together

The North American drilling scene has seen its bottom in 2016 where companies deferred capex due to an uncertain macro environment. Starting in 2017 rigs were put back to work and 2018 is shaping up to be another year of rebound and increasing profitability for contract drillers. We think Precision is well-positioned in that it has one of the higher quality fleets, a dominant position in Canada and competitive offering in the U.S. Valuation remains attractive as the shares are trading at a multi-year low despite DCF and comparative trading shows significant upside to the current share price. We think investors should start paying attention to the drillers as rising U.S. production and higher rig counts will soon benefit Precision's bottom line.

Another group of oilfield service providers we like is the pressure pumpers, which are expected to benefit from higher DUCs and undersupplied market in 2018. For more details, you can check out our article "Calfrac: Best Positioned To Benefit From Ongoing Industry Recovery".

Author's note: If you enjoyed this article, follow us for more oil and gas content in the future. We also publish a Weekly Rig Count Report where we discuss the outlook for the North American oil and gas market.

Analyst’s Disclosure: I am/we are long PDS. 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.