Cash-Rich PTEN Can Handle a Market Slump

For the last several months, as most of us were complaining about the price of oil at the pump, oil drillers like Patterson-UTI (PTEN - commentary - Cramer's Take), Helmerich & Payne (HP - commentary - Cramer's Take), Grey Wolf (GW - commentary - Cramer's Take) and Unit Corp. (UNT - commentary - Cramer's Take) have been seeing customers push back on the rates they charge for operating rigs. Morgan Keegan analyst J. Michael Drickamer described the fourth quarter as "choppy."

The latest PPI report backs up that assessment. Despite the rising oil price, price increases for drilling equipment have been quite constrained -- in the mid-single-digits compared to a year ago.

Year-Over-Year Price Change for Oil and Gas Equipment

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Source: Bureau of Labor Statistics

Helmerich & Payne has survived the choppiness relatively unscathed, as its FlexRig design is more efficient than traditional rigs and is allowing for higher dayrates. Patterson has been the dog of the group, shedding nearly half its value over the last two years.

From a perfunctory look at valuation using traditional measures such as P/E or price/book, Helmerich & Payne and Unit look like the cheapest stocks, while Grey Wolf has the best growth potential. The momentum is clearly with HP, and I wouldn't blame anyone for wanting to let that winner ride.

But Helmerich's success has come at a significant cost, with capital expenditures exceeding the cash flow provided by operating activities over at least the last four years (free cash flow has been negative). It has made up this gap by piling on half a billion in new debt. Unit has been in similar straits. Thus, my preferred valuation metric of free cash flow yield (free cash flow divided by enterprise value) is rendered meaningless for these companies. Suddenly, the lower P/E multiples start to make sense.

There are several reasons I like looking at the free cash flow yield. For one thing, doing so avoids some of the most common earnings management ploys. For another, cash represents the real money the company has available for growth, acquisitions, dividends and share repurchases.

And Patterson has been doing plenty of share repurchases. During the three months ended Sept. 30, 2007, the company purchased 2,275,000 shares of its common stock and the board has authorized approximately $200 million more for repurchases. These buybacks have reduced the share count from 170 million in the first nine months of 2006 to 156 million in the same period of 2007. That is a 10% gain in earnings per share for any given level of net income.

Unfortunately, the net income has been declining due to the lower rig utilization. This is not expected to reverse soon, as analysts are currently expecting revenue to decline a further 5% in 2008. That's an improvement from the 17.6% decline in 2007, though, so value investors may want to start looking for the bottom around here. The big fear, of course, is the economy. If demand for oil slows, will prices collapse?

Oil Stocks: Days Sales in Inventory (Including SPR)

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Source: Energy Information Administration; compiled by William A. Trent

I don't think so. For one thing, most commodity cycles are driven by supply rather than demand. While a reduction in economic activity may have a short term impact and keep a lid on prices, the longer-term outlook is still driven by long-term economic growth and the growth in supply. If $100 oil doesn't bring new rigs on line, eventually the demand will catch back up to supply, and the price of oil will go higher.

The latest inventory data notwithstanding, oil inventories are at a historically low level relative to sales. A downturn would allow inventories to be rebuilt to something in line with the historical average, but over the long term, supply -- not demand -- will dictate price.

A recent Howard Simons article on what really moves energy stocks showed that Patterson is one of the most sensitive names to crude oil prices, natural gas prices and even the crack spread. Little of that has applied in the last two years, of course. But it might be worth speculating that in the long term, Patterson will again benefit from higher energy prices.

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At the time of publication, Trent had no positions in the stocks mentioned, although positions may change at any time.

William A. Trent, CFA, is a freelance equity analyst based in the New York metro area. He has been an equity analyst since 1996 and is co-author of Understanding and Evaluating Prospectuses, Offering Documents, and Proxy Statements. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Trent appreciates your feedback; click here to send him an email.