Seventy Seven Energy's High Debt Load Makes It An "Avoid"
Seventy Seven Energy was spun off from Chesapeake Energy (CHK), one of the largest natural gas exploration and production companies in the United States. Seventy Seven Energy was the oil services division of Chesapeake. The services include drilling, hydraulic fracturing, rentals, and trucking. Its services are used in many of the major oil and gas fields in the United States.
Total revenue for the past twelve months ending March 31, 2014, was $2.154 billion. The largest percentage of the revenue came from its fracking services, accounting for 44 percent of the revenue. The company decided to use adjusted EBITDA as a profitability measure in their road show presentation. A majority of the EBIDTA came for the drilling division with 59 percent due to its higher margins. Drilling accounted for 37 percent of the revenue. Currently 85 percent of its revenue comes from Chesapeake, and the long-term goal is to have a 50/50 split of revenue from Chesapeake and other oil and gas companies. For overall revenue, Seventy Seven is fifth in relation to its North-American Centric peers behind Nabors (NBR), Superior Energy (SPN), Helmerich & Payne (HP), and Patterson-UTI (PTEN).
When looking at the characteristics of a successful spin-off, I do not see those qualities in Seventy Seven. It is a positive indicator if high-ranking executives leave the parent company to join the newly spun off company. There were no transfers in this case. To be fair, Seventy Seven was run as a separate company within Chesapeake, and its top-ranking executives stayed with Seventy Seven. It is too early to look for insider buying, since a not even a month has passed, but it does not look good that Chesapeake looks to be completely divesting itself of the company. The available information does not show Chesapeake retaining any shares of the new company. As far as stock-based compensation, the information does not seem to be available, yet.
The big negative that I see with Seventy Seven Energy is the debt load. Prior to the spin-off, the division already had long-term debt of $1.114 billion. The company then sold another $500 million in bonds and paid a $400 million dollar dividend to Chesapeake. After the moves, the debt is now showing as $1.55 billion. The latest 10Q showed an equity figure of $547.192 million as of 3/31/2014. Using that figure, debt-to-equity is a high 2.83. If the company’s debt was raised by $500 million and $400 million was paid to the parent company, that would further lower the equity value. We will have to wait until the first earnings announcement to get a clear picture, but their equity could potentially be as low as $147 million with a debt figure ten times as high based on only those two variables. If the company is making a profit, it will increase the equity, but the company had a net loss in the first quarter of 2014.
Where Seventy Seven looks like a bargain is its adjusted EBITDA of $424 million for the last twelve months from Q1 2014. With that kind of cash coming in, it will have plenty to pay the interest expense on their debt. Analysts have been valuing many similar companies on the basis of EV/EBITDA with an expected for EV/EBITDA of about 6.5. The enterprise value of Seventy Seven could be between $1.7 and $2.0 billion, giving it an EV/EBIDTA ratio of 4.72 on the high end.
At this point, I think it is best to wait another month for the earnings announcement to get a clearer picture of the company. Its large debt load is too concerning and will be weighing down the company from the start. The main characteristic of disappointing spin-offs that come to mind has been their high debt load. In Chesapeake Energy’s investor presentation, it was touting its reduction in debt after the spin-off. At this time, a better recent spin-off in the energy industry to consider is Now Inc (DNOW). It passes the tests for management moves, stock-based compensation, and was spun-off with no debt. One of Seventy Seven Energy’s competitors, Helmerich & Payne (HP), looks to be a better buy now. Among its competitors, HP is at or near the top for operating margins, return on equity, and dividend yield. Earnings per share have been growing at a 31.53 percent rate over the past 5 years and the company has minimal debt with a debt-to-equity ratio of 0.04.
Currently there are 15 gurus holding Chesapeake stock, so they are now likely holding Seventy Seven Energy stock as well. Mason Hawkins (Trades, Portfolio) of Southern Asset Management is the largest holder with 10.27 percent of the outstanding shares. The investing gurus will soon be filing their 13Fs giving us a look at their portfolios. It will be interesting the see if anyone has sold their shares. Since the spin-off was close to the end of the quarter, we might have to wait until the end of the third quarter to see any significant changes.