How is value measured? Analysts talk and write about a stock because the company creates value. Does “value” mean “cheap?” Buy low, sell high. That formula is not working with Facebook (ticker: FB) at the moment. That’s more like buy high, short sell, but we recognize that it is early for FB and its “friends.” Yahoo (ticker: YHOO) went public in April 1996 at $24.50. At year-end 1996 Yahoo’s market capitalization was $16.9 billion. On January 3, 2000, Yahoo reached its share price zenith, $118.75, valuing the company at $126.8 billion. Today YHOO has a market capitalization of $18.5 billion. We are doomed to failure if we fail to learn the lessons of the past, or willfully ignore history. FB, which started its public life as a $110 billion company, could be in for a very bumpy ride. Today, FB’s market capitalization is $67 billion.
Turning back to equities, what exactly is “value?” Is paying more for a Lexus and less for a Toyota mean that the “parent company” is cheap? Inferior? Lexus’ tagline is “the pursuit of perfection.” On May 16, 2012 Lexus announced a voluntary safety recall of certain 2013 model year GS 350 F sport RWD vehicles. Click here for the news release. Toyota vehicles have experienced mechanical issues forcing the car maker into multiple recalls. In this example, expensive and less expensive cancel each other out.
Blue versus Pinstripes
The Los Angeles Dodgers was purchased in March 2012 for $2.18 billion, including the assumption of debt. The New York Yankees are “rumored” to be entertaining “for sale” offers. George Steinbrenner bought the team in 1973 for $8.8 million. In 2011, Forbes valued the Yankees at $1.7 billion, or 66 times operating income. Click here for the Forbes list. The Dodgers value of $2.18 billion represents the same 2011 66 times price-to-operating-income ratio as the Yankees. The Dodgers have won six world championships, the Yankees 27. Which team has more value and which team is more valuable? The new owners of the Dodgers could, through strategic execution of their business model, luck, and perseverance have a chance of creating an organization that is every bit as valuable as the Yankees. The Yankees could, if they fail to draft, over-spend for free agents, or fall on years of bad luck could be less valuable than they are today.
Value versus valuable. Is the ratio of Stock Price to Cash Flow (P/CFPS) the “best” methodology for determining a company’s value or if it is valuable? If it is, then Nabors Industries (ticker: NBR) offers excellent “value.” Helmerich & Payne (ticker: HP) could be considered valuable.
Nabors is the largest onshore rig operator, with 501 land drilling rigs. The company trades at an estimated best estimate (Bloomberg aggregation) 2012 forward P/CFPS ratio of 2.3 times. The second largest onshore drilling operator in the U.S., (with 330 marketable rigs) is Patterson UTI Energy (ticker: PTEN). This stock trades with a 2.8 times forward P/CFPS ratio. Helmerich & Payne trades with the highest forward P/CFPS ratio of 5.1 times, among the “pure” drillers, which we define as those companies having revenues generated from drilling 70% or more. For example, Chesapeake Energy (ticker: CHK) owns rigs, but by our definition, we do not classify CHK as a “drilling” company. H&P (a side question here: what would Hewlett Packard pay Helmerich & Payne to have the HP ticker?) owns 270 land rigs in the U.S. and as of April 26, 2012 “the Company is scheduled to complete another 34 new H&P-designed and operated FlexRigs under long-term contracts with customers. Upon completion of these commitments, the Company’s global fleet is expected to have a total of 330 land rigs, including 293 FlexRigs.” The addition of 34 more rigs represents a 12.6% “growth rate.” In the pure drilling category Union Drilling (ticker: URDL) has a P/CFPS ratio of 1.9 times. Investors, it would seem, are willing to pay more for H&P than any of the pure drilling companies. But does that mean H&P isn’t a value or that Union Drilling isn’t valuable?
In terms of business model, H&P has taken a different, or rather differentiated, approach to the land drilling market. The Company introduced the concept of the FlexRig to increase efficiency, reduce mobilization times (and downtime) and ultimately to reduce the number of days it takes to drill a well. The modular design and other operational features of the FlexRig enables E&P companies to not only reduce the total cost of drilling, but also to drill more wells for the same amount of capital spending. In a commodity business where the generic business strategy is to be the low-cost producer, that is a compelling value (valuable) proposition.
And the proof is on the financial statements. H&P has the highest dayrate charge per day, per rig. H&P isn’t just about top-line growth. The company also earns the best per day, per rig margin. If the P/CFPS ratio is an indicator of what is valuable, then H&P’s dayrate and margins are implied to be valuable to the institutional investor. Click here to review the onshore drilling company dayrate and margin comparison charts.
Competitors have worked to build their version of the FlexRig, but H&P has been able to continue innovating improvements to its rig design, maintaining its competitive advantage and higher profit margins. That is what makes H&P a more valuable company in the eyes of investors.
The Cost of Capital
Another key factor in assessing value is a company’s Weighted Average Cost of Capital (WACC), which forms the “hurdle rate” for generating an economic return. Both Nabors (9.98%) and Patterson UTI (13.37%) have a lower WACC than H&P (14.48%), implying that those companies have an easier time generating positive returns. But, the WACC ignores financial risk, something anathema in a cyclical industry. Nabors and Patterson have a low WACC because their management teams have assumed greater financial risk by levering-up their balance sheets. For example, the debt-to-market capitalization ratios for Nabors and Patterson are 119% and 20%, respectively, as compared to H&P’s conservative 7%. This isn’t the entire story.
Core Laboratories – A Case Study in What is Valuable
This brings the final thought to Core Laboratories (ticker: CLB). “Too expensive” is the usual thought we hear from investors when they evaluate the company’s P/CFPS ratio. On May 25, 2012, Core Lab enjoyed a 25.6 times forward 2012 P/CFPS ratio. “Enjoyed” is appropriate here. As we noted back on April 17, 2012, CLB derives much of its business from big, global and oily projects. And those big, global and oil-weighted projects are genuinely valuable to the large oil companies, including the national oil companies that are developing them.
Using an average 5-year P/CFPS ratio suggests that Weatherford (compared to Core Lab) has been a value buy for the last five years, but year-to-date 2012 the stock has lost 11% of its “value” for its shareholders. For service companies, capital intensity, or the amount of capital spending required to generate $1 in cash flow, is a key metric in our view and provides an indication of growth potential and profitability. Weatherford must invest $0.64 to generate $1 of cash flow. On the other hand, it’s all about the Roosevelts for Core Lab – the company generates a $1 for every $0.11 cents of spending, just more than a dime. This is better than the value menu at Taco Bell (ticker: YUM)!
Given Core Lab’s low capital intensity and propensity to generate large amounts of cash with low investment requirements, it stands to reason that the market rewards the company with an above-average P/CFPS ratio. The company does pay an annual dividend of $1.12/share, a 0.80% yield. Not eye-popping, but Core is one of 11 of the 20 companies in the above chart that pays a dividend. Additionally, on July 7, 2010 and July 13, 2009 the company issued a $0.55 and $0.32 special dividends, respectively.
We also note that the company has an active share repurchase program. From the activation of the share repurchase program in 1995 through December 31, 2011, CLB repurchased 33,123,122 shares for an aggregate purchase price of approximately $788.0 million, or an average price of $23.79 per share and canceled 27,537,600 shares at a cost of $466.2 million. At December 31, 2011, CLB held 1,408,334 shares in treasury and has the authority to repurchase 11,145,344 additional shares under the current stock repurchase program.
Like H&P, Core Lab took the innovative and differentiated path to its business strategy. One of the keys to Core Lab’s profitability and strong record of growth is the company’s competitive advantage — its data library. To our knowledge, Core Lab has the most comprehensive data library and reservoir samples of any other similar company in the world, which provides the company the ability to provide greater insight than its competitors into how to extract more value from existing oil fields. Given that all the “easy” oil has already been found and the typical conventional reservoir only produces 10% on average of the estimated original oil in place, it makes sense that oil companies are highly likely to increasingly turn their attention to the kind of services and technologies that will enable them to increase recovery factors from existing fields. Those are the offerings at the core of Core Lab’s service lines.
Investors have to ask just how durable this competitive advantage is. After decades, none of Core Lab’s competitors have been able to duplicate the company’s data set, so it is either impossible or prohibitively expensive to replicate.
Free Cash Flow in a Cash Intensive Business
We analyzed each company’s valuation based on a trailing twelve month (TTM) of unlevered free cash flow. We calculate unlevered free cash flow per share as TTM EBITDA less TTM capital expenditures all divided by shares outstanding. The ratio we will refer to now is a Price/TTM Unlevered Free Cash Flow (P/TMUFCF) ratio.
The more cash it takes to generate a dollar of cash flow, then the more likely it is that the company will trade at a high P/TMUFCF ratio. The most important part of this equation is Free Cash Flow. Using our earlier drilling company example, H&P’s P/TMUFCF ratio at May 25, 2012 is 21.8 times. Nabors and Patterson are nil, meaning neither company generates free cash flow. The value versus valuable point is clearer here, as PTEN and NBR may be value buys, but H&P is clearly valuable.
Core Laboratories generates TMUFCF of $5.27 per share. Four companies produced better figures: National Oilwell Varco (ticker: NOV), CARBO Ceramics (ticker: CRR), Oil States International (ticker: OIS), and Diamond Offshore (ticker: DO). The four companies generated free cash flow per share of $7.64, $6.11, $6.09, and $5.40, respectively.
Although companies like Lufkin Industries and FMC Technologies have P/CFPS ratios that are lower than Core Lab, and thus present a “value” option, look closer at each company’s P/TMUFCF ratio. For the 12 months ended March 31, 2012, Lufkin generated free cash flow of $1.65 per share, or $3.62 less than Core Lab. For FMC, the company generated $1.56 of free cash flow per share during the previous 12 months. The resulting P/TMUFCF for Lufkin is 36.8 times, or 101% higher than its P/CFPS of 18.3 times; the comparison is similar for FMC: P/TMUFCF of 26.8 times versus P/CFPS of 17.4 times.
Core Laboratories trades at a P/TMUFCF of 25.6 times.
Our earlier question of how “value” is measured is especially timely when the energy sector looks poised to enter another down cycle. All of the aforementioned names have enjoyed higher stock price valuations in times past. Our question in this note has to do with what is valuable. Each time a name is thought to be a “value” perhaps there is a good reason for it — operating execution is not as it once was or current market conditions are working against a particular set of assets.
Core Lab’s focus on services that increase a client company’s production outflows, resulting in an increase in a well’s or field’s ultimate recovery and value, is, we believe, valuable and the name, a “value”.