Nabors Industries Looks To Clear Path For A Recovery

About: Nabors Industries Ltd. (NBR)
by: Badsha Chowdhury

Pricing and margin for Nabors' U.S. onshore drilling business may improve in Q1 2019.

Nabors expects lower day rates in many of its international operations in the near-term.

NBR will further reduce net debt and cut capex in FY2019.

The company has announced an 83% dividend cut.

NBR's stock price has headwinds in the near-term

Nabors Industries (NBR) provides drilling and drilling-related services for land-based and offshore oil and natural gas wells across the world. I do not expect the stock price to exhibit a positive momentum in the short-term, given the pressure in the international markets and the time needed to upgrade its legacy rigs to higher-margin, advanced rigs. Once the process completes, I think NBR will start to shoot up in the medium- to long-term.

NBR's management sees weakness in some of its global markets where rig dayrates are likely to decline in Q1 because of an uneven market recovery. In the U.S., while higher adoption of advanced rigs can improve margin, revenues may fall due to the idled time required for rig refurbishments or upgrading. The company has been reducing debt to clean up its leveraged balance sheet. It also plans to reduce the FY2019 capex spend, which will effectively increase its free cash flow.

In the past year, the stock price has gone down by 53% and underperformed the VanEck Vectors Oil Services ETF (OIH), which declined by 33% during this period. OIH represents the oilfield equipment & services (OFS) industry.

Q4 performance drivers

In Q4 2018, Nabors' top line remained steady compared to Q3 2018, while its bottom line deteriorated. On a year-over-year basis, revenues showed improvement in Q4 2018, but it was not as impressive as many other oilfield equipment & service providers in the industry. From Q4 2017 to Q4 2018, the revenue growth was 10%. Not only did NBR's average rig count fell marginally, but its margin per rig day also declined. Although NBR's U.S. operation improved its performance, it lost some of its workover rigs in Argentina and Venezuela in Q4. In Q4 2018, net loss decreased to $0.55 per share compared to a loss of $0.31 per share in Q3. NBR's Q4 bottom line deteriorated, primarily due to impairment charges and the establishment of a deferred tax reserve.

FY2018 performance drivers

If you compare NBR's FY2018 revenues with the prior-year revenues, the growth was a lot more impressive (19% up). Two things positively affected the financial results in FY2018: one, a much improved energy market environment in 2018, which benefited all of NBR's segments, and two, ~$187 million revenue addition following the Tesco acquisition in December 2017. Although operating income increased significantly in FY2018, NBR's net loss deepened in FY2018 following the impairment charge due to the crude oil price decline at the end of 2018 and the loss on the sale of eight workover rigs and three offshore drilling rigs in NBR's international operations.

Let us try to gauge the energy industry's perception and which way it can sway in the coming days. From the beginning of October until the end of 2018, the WTI crude oil price decreased by 30%, losing most of its gains since the recovery following the 2016 crude oil price crash. This put the upstream energy companies' 2019 capex program at stake and stopped many of the operators from committing any significant increase in the E&P investment. However, as it turned out, the crude oil price has been volatile, as it once again went north since the beginning of 2018. The 24% rebound in the WTI price meant that pricing on the more capable rigs is not weakening. Typically, the more advanced AC rigs capable of multi-pad horizontal drilling in the unconventional shales command a premium pricing. This also means lower margins for low-grade rigs where there is still competition.

U.S. Drilling performance can improve in FY2019

NBR has also been upgrading its rigs to enhance performance. It has recently upgraded one of its PACE-M550 to PACE-M750, which has already bagged a drilling contract. In Q4, NBR's U.S. Drilling segment revenue increased by 11% due to the company's higher market share in the U.S. onshore and offshore segments. Its EBITDA margin in the U.S. onshore segment improved by 1%, while NBR added five more rigs in the region. Due to the upgraded rig deployment, NBR expects to price up its rigs in the U.S. onshore segment, which can lead to the higher daily margins in Q1 2019. The U.S. Drilling segment accounted for 34% of NBR's FY2018 revenues.

By 2018-end, NBR had 114 rigs in the U.S., and the average rigs in Q4 increased by five compared to Q3. In Q1 2019, the company expects to field 111 to 112 rigs in the U.S. onshore. The current weakness in the upstream industry, mainly due to the headwinds from the completion activity, means some of NBR's rigs will not get contracts. Although the rates on the contracted rigs may improve, the contract on non-renewals will eventually lead to a revenue loss. Investors may note that as the mechanical rigs are idled and reconfigured into more advanced or super-specification rigs, it usually leads to idle time between the contract periods. This can lead to lower utilization for the larger drilling contractors. During 2018, such a churn out resulted in the rig count dropping by 30 in the U.S. NBR's silicon-controlled (or SCR) rigs, which use diesel power, saw poor utilization (17% only) in 2018 as compared to 88% utilization for the AC rigs with higher horsepower (>1,500 HP). Not just that, but also the average utilization rate for NBR's offshore rigs went to as low as 25%.

The benefits of higher pricing for NBR's high-specification rigs are reflected in its Q4 results. The margin for the U.S. onshore rigs during Q4 was $9,400, which was up by $700 compared to Q3. As of the beginning of 2019, NBR signed contracts for nine additional rig deployments. By FY2019-end, the daily gross margin can exceed $10,000 per rig and the rig count could increase to 120.

NBR's international operations may weaken

On the other hand, NBR's international customer base, which primarily consists of the national oil companies and the integrated oil majors, saw much fewer churn-outs. This is because these companies are more resilient to the crude oil price volatility. Despite that, NBR sold seven workover rigs in Argentina and three of its five jack-ups in the Middle East. The company also idled its rigs in Venezuela following the political uncertainty in that region. So, its EBITDA from international operations decreased by ~20% in Q4 compared to Q3. As it turned out, after the contract expiration of the newbuild rigs in Saudi Arabia, Saudi Aramco (ARMCO) (Saudi's integrated oil major) re-contracted the rigs at a significantly lower rate. This plus the U.S. sanctions in Venezuela affected NBR's international margin adversely. So, its daily margin was $13,500 in Q4, which was a drop of $1,500 from Q3. The International Drilling segment accounted for 46% of NBR's FY2018 revenues.

In the Goldman Sachs conference held in January, NBR's CFO pointed out that its focus is on reactivating rigs that require limited capex investment. In the international market, the leading-edge rig dayrates remain below the prior peak because of an uneven market recovery across the significant markets. In 2019, NBR expects to deploy rigs in Mexico, Argentina, Saudi Arabia, Kazakhstan, and Algeria.

In Q1 2019, the international rig margin can deteriorate further because of rolling contracts at a lower day rate. However, in Q1, the international rig count may increase to ~92 from 88 in Q4. EBITDA from the international operations may reduce to a range of $85 million to $90 million due to the uncertainty in Venezuela, lower revenue days in Q1, and startup costs for additional rig deployment. In comparison, the adjusted EBITDA from international operations was $94 million in Q4 2018.

Drilling Solutions segment strengthens

Nabors' Drilling Solutions segment revenues witnessed the most robust growth in FY2018 (78% up) compared to FY2017 among its other segments. Through the Drilling Solutions' products and services, NBR enhances the drilling performance and wellbore placement. These products are RigWatch Suite, REVit Software, DrillSmart Software, ROCKit Software, and the MWD (measurement while drilling) systems and services. Revenues from all of these product categories increased in FY2018. In October 2018, NBR acquired PetroMar Technologies, which specializes in the LWD downhole tools in the unconventional reservoirs. The acquisition complemented NBR's wellbore placement capabilities and boosted its segment sales. Also during Q4, NBR completed the first commercial run of its rotary steerable tool.

In Q4, the segment adjusted EBITDA margin was ~35%. For Q1 2019, the management expects EBITDA to remain nearly unchanged. For FY2019, the expectation is for EBITDA from this segment to improve significantly compared to FY2018.

Capex plans

In FY2018, NBR generated $325 million in cash flow from operations (CFO). On top of the 19% increase in revenues, the remarkable improvement in CFO in FY2018 was aided by working capital improvements, primarily from lower accounts receivable. In FY2018, capex was $453 million. In FY2019, the company plans to reduce capex to $400 million.

NBR has planned to reduce its quarterly cash dividend to $0.01 per share from $0.06 earlier. This signals a likely pressure on margins.

Debt reduces, but the balance sheet is still leveraged

Liquidity as of December 31, 2018, was $2.24 billion, which included $1.76 million available for borrowing under the revolving credit facilities. It will have ~$1.8 billion in long-term debt due for repayment between 2021 and 2022. During Q4 2018, the net debt decreased by $151 million after the company repurchased senior notes and reduced its revolver balance. In FY2019, NBR plans to reduce its debt further. Regarding this, it commented in the Q4 earnings press release:

Based on assumptions for our operating results and expectation of low capital spending, we are aiming to reduce net debt by an additional $200 to $250 million during 2019.

NBR's debt-to-equity ratio (1.36x) is higher than its peer average of 1.1x. Pioneer Energy Services (PES) has much a higher leverage (2.6x). Helmerich & Payne (HP) and Patterson-UTI Energy (PTEN) have lower leverage (0.11x and 0.30x respectively) compared to NBR. With the available liquidity (cash balance and revolving credit facility), the current cash flow generation, lower capex, plus no debt repayment obligations in the near-term, NBR's balance sheet looks in a comfortable position. However, the company will need to improve its CFO further to generate positive free cash flow consistently, given its high capex spend.

What does NBR's relative valuation imply?

NBR is currently trading at an EV-to-adjusted EBITDA multiple of ~7.6x. Based on sell-side analysts' estimates, pulled from Thomson Reuters, the forward EV/EBITDA multiple is lower, which implies higher EBITDA in the next four quarters. Between FY2013 and FY 2018 and excluding the FY2017 EV/EBITDA when the ratio was extremely high due to a very low EBITDA, NBR's average EV/EBITDA multiple was 6.3x. So, the company is currently trading at a premium to its past.

The forward EV-to-EBITDA multiple contraction versus its adjusted trailing twelve-month EV/EBITDA is steeper than the industry peers' average multiple compression, as noted in the table above. This is because NBR is expected to improve its EBITDA more sharply compared to the increase in the peer average in the next four quarters. This would typically reflect in a higher current EV/EBITDA multiple compared to the peer average. NBR's TTM EV/EBITDA multiple is higher than its peers' (HP, PTEN, and PES) average of 6.7x.

Analysts' rating on NBR

According to data provided by Seeking Alpha, 17 sell-side analysts rated NBR a "buy" in March (includes strong buys), while seven of the sell-side analysts rated NBR a "hold". One of the sell-side analysts rated NBR a "sell". The analysts' consensus target price for NBR is $5.65, which at the current price yields ~70% returns.

What's the take on NBR?

Since Q3 2018, Nabors' management has expressed caution on the declining operating margin in its international operations. Uneven recovery in global markets will likely keep rig dayrates below the prior peak in some of its international markets. The company also sold rigs in some of its international geographies during Q4. In the U.S., while the higher adoption of advanced rigs can improve margins, revenues may fall due to the idled time required for rig refurbishments or upgrading.

The management is reducing the net debt to clean up its leveraged balance sheet. It also plans to reduce FY2019 capex spend, which will effectively increase its free cash flow. I do not expect the stock price to exhibit a positive momentum in the short-term, given the pressure in the international markets and the time needed to upgrade its legacy rigs to higher-margin, advanced rigs. Once the process is done, I think NBR will start to shoot up in the medium- to long-term.

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.