NOTE: All figures in CAD.
Pason Systems (PSYTF, Financial) is an international oil and gas services company headquartered in Calgary, Alberta. Pason provides data management systems for land-based drilling rigs and had more than 2,000 systems installed globally at end of FY2014 (> 55% of active global rigs).
Pason makes money when drilling rig contractors and/or operators pay day-rates to have data acquisition packages permanently installed on their rigs. Packages typically include a series of essential productivity and safety critical tools. A portfolio of additional nice-to-have options provide Pason the opportunity to upsell. Rig packages make up over 90% of annual sales (see 3Q2015 Report).
According to the company’s latest investor presentation, Pason maintains dominant market share in each of its four core operating regions: U.S. (61%), Canada (94%), Latin America (70%) and Australia (85%). Revenue by region for FY2014 as follows: U.S. (60%), Canada (29%), and International (11%).
Pason’s primary competitor is National Oilwell Varco (NOV) through its RigSenseTM Wellsite Informaton System. Pason’s market share has been incredibly stable over the past 12 years, suggesting that the competitors have found a way to co-exist.
I believe there are two primary reasons why this opportunity exists. First, the Street is under-estimating the resiliency of Pason’s profitability and its underlying business model; the company continues to generate FCF through the current industry downturn. Secondly, oil supply cannot continue to outpace demand at current well depletion and reinvestment rates.
Competitive advantage
Pason’s business model has resulted in a highly consistent and profitable business with a strong competitive advantage. Pason has shown remarkable consistency and resiliency despite operating in a very cyclical industry. Despite the industry slowdown, Pason has generated positive free cash flow in all but one of the past eight quarters.
This is a very capital light business with median returns on capital north of 50% and annual maintenance Capex of approximately $25 million per year (around 5% of normalized revenue). The competitive advantage stems from high switching costs and economies of scale. Because many of the products are either safety critical (eg. PVT) or critical to rig performance (eg. Autodriller), Pason’s equipment is indispensable to its customers, leading to significant pricing power. Moreover, once Pason gets a rig monitoring system installed on a rig, it is incredibly difficult to displace by a competitor. It is very costly, risky and inconvenient to get the system replaced with a competitors product, and neither the rig crew nor the operating company have an appetite to change systems once they’ve been trained on a particular one. Pason’s systems are so dominant within Canada that a rig monitoring system is often simply referred to as a “Pason.” The cost of R&D and supporting their rig systems offers significant scale advantages to Pason. Spreading out R&D, a 24/7 call centre, service technicians and an inventory of replacement parts over a larger base of system installations limits new entrants.
Business fundamentals
Pason has a rock-solid balance sheet with no debt and $198 million in cash and equivalents. Pason’s revenue generation and profitability is highly correlated to global rig count, which is driven primarily by oil prices. While it is impossible to predict the exact timing of when prices will rebound, it would be difficult to argue we are not closer to the trough than the peak of the cycle. Evidence for an oil price recovery is strong: The full cycle cost of producing the marginal barrel of supply is estimated at over $60 per barrel, oil demand is set to grow by 1.2 million barrels per day in 2016, well depletion for the average conventional well is 5% per year and reinvestment in reserves replacement is way down.
History has taught us that oil prices usually start to rebound once inventory levels begin falling. Important metrics include the number of EDR and PVT days the company is able to rent into its various markets, and the amount of revenue per EDR day that the company is able to generate. Rental revenue per EDR days is driven by the company’s market share, new bolt-on products, value and product unit price and number of products per rig.
Pason has achieved steady revenue growth at an average annual rate of 5.9% over the past 19 years. Revenue growth has been mostly organic with only three small, strategic acquisitions. Future growth opportunities include expansion in the Middle East and Northern Africa (MENA) region. Rawabi Pason (a 50% JV) will be the exclusive distributor of Pason’s data management systems in the Kingdom of Saudi Arabia. Rawabi Pason will also be capable of servicing other countries in the region. Another opportunity includes new products and sources of revenue developed in-house or acquired through bolt-on acquisitions. Additionally, new global markets for shale drilling can provide more growth. If a market like China were to get serious about reducing coal based power generation, shale drilling could be the beneficiary. The company can also work to gain traction in the offshore rig market and find ways to monetize the geological and drilling data they’ve accumulated.
Management
James Hill, who served as Pason’s president and CEO for 25 years, has been a director of the corporation since 1996 and is currently the chairman of the board. Under Hill’s watch, shareholder wealth has compounded at more than 25% annually since the IPO 19 years ago. Current President and CEO, Marcel Kessler, joined Pason in November 2011.
Hill owns 14% of the shares outstanding and should have the best interest of shareholders in mind. Kessler receives $500,000 in basic compensation plus variable awards that include a bonus and stock options that all totaled to more than $2 million annually. Variable compensation is awarded based on targets including EBITDA, revenue per EDR day and market share. As of December 2014, Kessler owned $667,000 worth of shares.
Overall, past capital allocation choices made by management have been very good. Relying mostly on organic growth has served shareholders very well in the past, and I view the three acquisitions made by management as excellent uses of shareholder capital. The acquisitions provided strategic bases from which the company could further expand globally and/or strengthen their product offerings. Shareholder dilution has not been an issue in the past. Unfortunately, management does not have a track record of making repurchases at attractive prices, but this is somewhat understandable considering the stock rarely has traded at attractive levels.
Key risks
I believe there are three key risks that could lead to an insufficient return or permanent loss of capital. The first key risk would be a prolonged slump (over three years) in land-based rig counts; I view this as unlikely given where we are in the cycle and the current investment level in oil and gas projects. The second key risk would be pricing pressure from competitors or customers. This is a low risk based on the way the industry has operated in the past. Finally, the strengthening of the Canadian dollar relative to U.S. dollar presents challenges. This risk is minimized by Pason’s substantial market share in the U.S. and currency hedging.
Valuation
My valuation model resulted in a three-year weighted fair value of $29 per share for an IRR of 21% (inclusive of dividends) and upside/downside ratio of 6.4x. The model includes three scenarios. The premise for the bear case is a longer than expected slump (over three years) in rig count and market share erosion to recent five-year lows. The base case assumes normalized rig count, market share and pricing within two years as the oil supply glut works its way out of the system. The basis for this scenario is OPEC’s estimate for a balanced market by end of 2016 and the price correcting enough to see drilling levels return to normal in the U.S. and Canada by end of 2017. The bull case assumes rig count normalizes in two years with a kicker from market share penetration in MENA and increasing revenue per EDR day from product additions.
As a sense check on the realism and conservatism of the earnings model, I performed ratio analysis using the company’s own historical P25/P50/P75 ratios of P/TBV, EV/Sales and EV/EBITDA. The ratio analysis resulted in a fair value between $20 and $38 per share.
Catalysts
I believe there are two potential catalysts that could make the mis-pricing go away. The first catalyst would be if Pason continues to generate FCF and strengthen its balance sheet through the downturn. The second catalyst would see rig counts bounce back from their cyclical lows to normalized levels.
Disclosure
I am long PSI.TO.
