It is unusual that I would spend so much time writing about one company like I have over my past three articles. I look at hundreds of balance sheets and cash flow statements in hopes of finding that always elusive diamond in the rough, so writing about one stock three times is unique for me. Yet I remain perplexed at the value the market continues to offer their shares of C&J Energy Services (CJES), and therefore want to reveal it yet again to those patient enough to wait for fair value.
C&J Energy is a pure play company in a highly debated industry: Hydraulic fracturing. My gut tells me this is one reason the stock remains below fair value and seems to trade like a lead balloon. Also - the short interest in the stock has steadily risen to around 20% of the outstanding shares. My guess is those shorts are made up of traders who think a fracking moratorium is around the corner, as well as investors who purchased during private placements (pre-IPO) at the $10 range. The pre-IPO crowd may want to lock in profits against shares they were not able to sell yet in a strategy known as "shorting against the box." CJES disclosed in their original S-1 Registration filing that these PPO investors had the ability to hedge in this manner.
Regardless of the reasons why CJES remains undervalued, patient investors really should take a look at owning this company for a potential double from these prices, if only for the sole reason I am about to explain.
One way I judge a company to be extremely undervalued is by calculating if they can borrow money to buy themselves. Today, CJES is sporting a market capitalization of $995 million. Last quarter, they earned $53 million in net profits, and analysts expect them to grow earnings by 35 percent in 2012, compared to 2011. That calculates to over $220 million in earnings. As mentioned in my previous articles, I like to be conservative when I calculate numbers in the future, therefore, I am going to assume that CJES will only earn $3.19 per share in 2012, which is the same as 2011. Again, to stress how conservative this is, my number is 35% below analysts estimates for 2012, and CJES has added many more coiled tubing and fracking fleets since 2011. This will help emphasize the massive value at current prices in these shares. So I am going to assume CJES will net only $165.5 million this year.
Here is where I hope to drive home the value in your brain. Pretend with me that CJES is able to go and borrow $995 million from an investment bank at above market rates of 10%. Pretend also that the loan is a 15 year amortizing loan. Based on that figure, the yearly outlay for the loan would be $128.3 million. Do you see the value?
CJES could borrow the money to buy itself completely today, have enough net income to make the loan payments, and still be left with $37 million per year -- assuming no growth for the next 15 years! CJES is so cheap today, that there is value in leveraging the balance sheet to buy itself. Imagine the return a private equity company could recognize by taking a loan to buy the company, or a larger competitor:
Invest $250 million in cash and borrow $745 million at 10% for 15 years. The yearly payments on the loan would be a tad over $96 million per year. Since the company is earning $165.5 million, the net income for the acquiring firm is $69.5 million. That is a 27.8% return per year for the $250 million of cash they put into the deal..... and in 15 years, they will have $1 billion in equity because the earnings from the business had been paying the loan down. We're nearing a 50% annual return after 15 years, and this is assuming no growth! We've also used a 35% income reduction this year while extending that out to the next 14. Chances are - there is growth ahead, but I want to remain conservative.
If I were a private equity firm, I would be tempted with these types of numbers to go and get that loan take over the entire company at these prices. What is exciting is that I do not need to do that. I can just go buy fractions of the business and have the same fundamentals working in my favor by buying shares of CJES at these deeply undervalued prices. Based on current earning projections, they could borrow money to buy themselves up to around $38 per share using a 15 year loan at 10%. My guess is that any opportunity to buy under that number is still a decent value in the long run. I continue to add shares while the sale lasts.
Disclosure: I am long CJES.