Precision Drilling Is Attractive at Current Levels

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Aug 20, 2015

I have been looking for value picks in the energy sector in the recent past, and I continue to recommend small investment in the sector with a three-to-five-year horizon. In the onshore drilling sector, Precision Drilling (PDS, Financial) is an attractive stock at current levels. This article discusses the reasons to consider Precision Drilling. I emphasize again that small exposure should be considered in the sector and a big plunge in the sector still needs to be avoided.

The first reason to be positive on Precision Drilling is the relatively positive onshore industry outlook. The rig count data from Baker Hughes suggests that rig count is stagnant or gradually trending higher on a weekly basis. This is an indication that most oil and gas companies are done with their capital expenditure cuts. While the renewed decline in oil price poses a threat to FY16 investment plans, I don’t expect another big round of decline in rig count. Therefore, onshore drilling service providers are likely to see some stability in rig utilization and lower rig cancellations.

Before talking about company specific factors that makes Precision Drilling attractive, I must point out here that Precision Drilling surged to FY15 highs of $7.57 as oil price recovered over $60 per barrel in May 2015. However, with renewed decline in oil prices, the stock has corrected by 42% in a matter of three months. While lower oil prices are a concern, I see this deep correction as an important reason to consider some exposure to the stock. This reason will also be backed by fundamental reasons to be discussed.

The first fundamental factor is the company’s strong balance sheet, robust liquidity and conservative investment profile. As of 2Q15, Precision Drilling had total debt-to-capital of 45% and net debt-to-capital of 35%, giving the company strong financial flexibility. Further, the company’s long-term debt of $2.0 billion is not a concern with an interest coverage of 5.6 that ensures smooth debt servicing. Another important point related to the company’s debt is that the debt maturity profile is excellent with major debt maturity coming on or after 2019.

From a cash flow perspective, Precision Drilling reported operating cash flow of $385 million for 1H15 as compared to $399 million for 1H14. While the cash flow declined, the decline was not sharp due to term contract for rigs. More importantly, Precision Drilling reported net capital spending of $333 million for 1H15, and this implies that the investments were entirely funded by internal cash flows. With the company having a planned capital expenditure of $546 million for FY15, the entire spending is likely to be financed through internal cash flows.

I must add here that, as of 2Q15, Precision Drilling had $434 million in cash and $825 million in available revolving credit facility. With nearly $1.3 billion in liquidity, the company can accelerate capital investments once there is sustained industry recovery. However, a conservative investment profile at this point in time is the right strategy.

From a revenue visibility perspective, Precision Drilling has term contracts for an average of 104 rigs for FY15. While the term contract for FY16 is currently low at 63 rigs, I expect new contracts if oil gradually trends higher in FY16. I will remain cautious and concerned if oil remains in the $40 to $45 per barrel range as these levels might imply depressed rig count addition. The positive point to note here is that in the last four to five years, Precision Drilling has added 143 Tier 1 rigs and these modern rigs will find customers as soon as market conditions improve.

From a valuation perspective, Precision Drilling is trading at price to sales and price to book valuation of 0.86 and 0.72 respectively. These are attractive valuations and considering the company’s fundamental position, the stock is worth considering. However, as I mentioned earlier, small exposure is advisable as the broad industry outlook still remains uncertain. In my view, if oil can trend higher to $55 to $65 per barrel towards FY16, I don’t see meaningful decline in rig count from current levels.

In conclusion, Precision Drilling has continued to report relatively strong results even as industry conditions remain depressed. The company’s conservative investment strategy ensures the fundamentals remain sound through the challenging times. These factors, along with a modern rig, make Precision Drilling an attractive investment option to consider with a time horizon of three to five years. I will change my view if oil sustained at current levels for the next few months. Investors therefore need to keep this risk factor in mind.