- The stock of PDS has more than doubled this year thanks to the rally of the price of oil to a fresh 3-year high.
- However, PDS has incurred excessive losses for seven consecutive years and it is still far from becoming profitable.
- It also has a high debt load.
The price of oil has rallied to a fresh 3-year high thanks to the recovery of the energy market from the pandemic and the discipline of OPEC and Russia. As a result, the stock of Precision Drilling (NYSE:PDS) has more than doubled this year. On the one hand, the rally of the oil price will greatly benefit Precision Drilling, as it will increase the drilling activity in North America. On the other hand, the company is still far from becoming profitable. Therefore, in my view, investors should take advantage of the rally and sell the stock.
Precision Drilling provides onshore drilling and completion & production services to exploration and production companies in the oil and natural gas industry. Precision Drilling is based in Canada and is diversified among the U.S. (54% of rig utilization days), Canada (38% of rig utilization days) and international markets (8% of rig utilization days).
Precision Drilling has incurred heavy losses of -$144 million in the last 12 months due to the coronavirus crisis, which has caused a fierce downturn in the business of the company. The drilling activity in North America has partly recovered but it is still much lower than its pre-pandemic level. To provide a perspective, the active rig count of Precision Drilling is 100, which is 56% lower than the rig count of 226 in the fourth quarter of 2019. The losses over the past 12 months amount to 28% of the current market cap of the stock, which raises a big red flag for me.
On the bright side, the energy market is recovering strongly from the pandemic this year. According to the latest report of the Energy Information Administration [EIA], global oil consumption is expected to surge from 92.4 million barrels per day in 2020 to 97.4 million barrels per day in 2021 and the pre-pandemic level of 101.0 million barrels per day in 2022. As a result, drilling activity is poised to increase significantly, in tandem with global oil consumption. This will provide a tailwind to the business of Precision Drilling next year.
However, Precision Drilling is far from becoming profitable. In its latest earnings report, its revenue grew only 6% over the depressed level of last year's quarter and thus the company widened its losses per share, from -C$3.56 to -C$5.71.
Even before the coronavirus crisis, Precision Drilling was struggling to become profitable due to a dramatic shift in the strategy of oil producers, who have markedly tightened their budgets in recent years and try to operate within the limits posed by their cash flows. In addition, technological advances have made it possible to produce more oil from a given number of wells. These advances have taken their toll on the results of Precision Drilling and other service providers, who now make less money at a given production level. It is thus not surprising that Precision Drilling has failed to make a meaningful profit for seven consecutive years.
Analysts seem to agree that Precision Drilling is far from turning a profit. They expect the company to lose -$9.04 per share this year and another -$2.97 per share next year. Given also the ongoing transition from fossil fuels to renewable energy sources, which has greatly accelerated since the onset of the pandemic, it is evident that Precision Drilling has a high amount of inherent risk right now.
Precision Drilling has a high amount of debt. On the bright side, the company has drastically cut its capital expenditures in the last five years. To be sure, its average annual capital expenses in 2017-2020 have amounted to only $79 million. This amount is 82% lower than the average annual capital expenditures of $431 million in 2013-2016. As a result, the company has posted positive free cash flows in each of the last five years.
The benefit from the positive free cash flows is evident in the slide below.
Source: Investor Presentation
According to its financial statements, Precision Drilling has reduced its long-term debt from $1.6 billion in 2015 to $0.9 billion and its annual interest expense from $110 million in 2016 to $82 million now.
However, the company still has a long way to go to claim that it is in a solid financial position. Its net debt (as per Buffett, net debt = total liabilities - cash - receivables) currently stands at $922 million. As this amount is nearly twice as much as the market cap of the stock, it is certainly excessive. Moreover, as the operating income of Precision Drilling has been lower than its interest expense in each of the last seven years (including this year), the company has failed to cover its interest expense for seven consecutive years. It is thus evident that the company is struggling to service its debt and hence it is vulnerable to the downturns of the energy market.
Moreover, the drastic cuts in capital expenses mean that the company has hardly invested in its business in the last five years. This raises some concerns over the future prospects of the company, particularly given the aforementioned secular headwinds facing the oilfield services providers.
Furthermore, the difference between earnings (negative) and free cash flows (positive) is caused primarily by the high depreciation amounts of Precision Drilling. While these amounts do not affect the cash in hand, they reflect the erosion of value in major assets like the drilling equipment of the company. At some point, the equipment will have to be replaced by new one. Therefore, the high depreciation amounts should not be ignored by long-term investors.
As long as the price of oil remains in an uptrend, it will provide great relief to Precision Drilling, as it will help the company narrow its losses. On the other hand, whenever the energy market faces its next downturn, it will exert great pressure on Precision Drilling. Given the dramatic cyclicality of the energy market, investors should be aware of the risk of the stock.
Leveraged companies outperform financially solid companies by a wide margin during favorable times. This is why the stock of Precision Drilling has more than doubled this year. However, the stock will have excessive downside risk whenever it faces an unforeseen headwind. The devastating losses it has caused to its shareholders over the last decade (-78% vs. +274% of the S&P 500) are a testament to the risk of this stock. Overall, the stock may be suitable for traders who are confident in the continuation of the rally of the oil price but I believe that it is not suitable as a buy-and-hold stock.
This article was written by
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