I am a deep-value investor. I buy what the stock market hates. It's not easy buying stocks when all other investors and analysts disapprove of a company or sector, but it has been a profitable strategy for me. Plus, it fits my disposition. I guess you can say I like doing things the hard way.
Right now, one of the most loathed parts of the stock market is the land-drilling rig industry. The stocks have experienced a terrible bear market, slumping some 25% or more. Share valuations are downright pitiful at mid-single-digit price-to-earnings ratios as well as similar enterprise-to-EBITDA levels. Most Wall Street firms have tepid outlooks and ratings on the industry.
Not surprisingly, current business conditions are actually quite good for land drillers. Although prices and profit margins have been tapering lately, they remain quite healthy, and therein lies the problem. Cyclically peak business conditions have generated a fair amount of new rig capacity, meaning oversupply may hit the fan this year.
Virtually every negative opinion on the sector is based on these overcapacity/cyclical downturn concerns. I can't even attempt to deny that pricing and profitability for land drillers will erode. It absolutely must. There is no doubt that the fundamentals must fade. Precisely
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the downturn has begun, I think land drillers are an excellent long idea.
That's correct: Buy land drillers because day rates and earnings estimates are dropping. My favorite is
. It's by far the category killer in the space, with the best assets, client/geography diversification and management. I just love the company's balanced business exposure mix of oil vs. natural gas, and domestic vs. foreign. But if my thesis plays out, all of the drillers should work.
A Heavy-Duty Similarity
With the downturn just starting, why is Nabors one of my biggest positions? Why haven't I waited? I may not be the most original thinker on the planet, but I can identify investing patterns such as seasonal trends and copycat trades. One recent sector trade stands out as a perfect analogue to the land drillers: the heavy-duty truck stocks in general, and
The heavy-duty truck industry just began a severe downturn after an explosive multiyear recovery. The current contraction is related to changes in emission regulations and has been very well telegraphed to investors and analysts. Because of this inevitable truck recession, every single Wall Street analyst was cautious about, negative or neutral on, or short the sector over the past 18 months.
And yet a funny thing happened. The shares appreciated nicely in 2006 and are exploding in 2007. As the fundamentals of the truck companies deteriorate, the share prices hit new highs almost daily. I can only conclude that investors discount the next recovery as soon as the current down-cycle begins in earnest.
The land drillers face similar fundamental conditions to those during the heavy truck mini-recession. The drilling stocks today are acting like the truck stocks did in 2005. Land drilling stocks are down and cheap, with a modest fundamental decline starting. The bulk of the sell side is neutral on the sector because of the day-rate downturn. And the rig oversupply has been so well advertised on Wall Street that the drilling stocks are pariahs. This reminds me a great deal of the heavy truck trade.
That said, I wouldn't own Nabors simply because some mo-mo trader has bid up Cummins to an all-time high on declining earnings. (Cummins, by the way, is a long I
wrote about in late 2005, when the stock was trading at about $90; its recent price is above $148.) The Nabors story can work regardless of the heavy truck play. But the similarities between the trucks then and the drillers here are too obvious to ignore.
There are some other fundamental reasons to like Nabors. I believe investors oversimplify the company as a pure North American natural gas play, just as they mischaracterized Cummins as exclusively a heavy truck stock. Nabors should get 50% of its operating profit from oil-related drilling/services this year. As with Cummins, no one seems to give Nabors credit for its commodity exposure and geographical diversification.
I also think the oversupply of land rigs will be relatively short-lived. Secular changes in reservoir characteristics have made dry gas production much more drilling-intensive than it was in the past. We are barely keeping dry gas production flat, with double the rigs from only a few years ago. Canada looks almost ready to decrease its gas exports to the U.S. as it consumes more in heavy oil production. Heck, in 2008, we might even need those 200 or so net rig additions to the fleet just to stabilize a declining production base.
So avoid the naysayers on this group. Forget about the short-term estimate cuts that will happen as day rates continue to correct. Nabors' earnings-per-share estimate for 2007 is around $4, and the stock is trading at about $30. The average stock in the Value Line universe trades for 18 times 2007 estimates, so even if Nabors makes only $3 a share, its stock still looks cheap. Can Nabors and its brethren appreciate as earnings estimates fall? Well, look at the heavy-duty truck companies, some of which are posting 25% EPS declines this year. Ask yourself why they are on the new-high list.
I believe investors and analysts will begin to look past the 2007 dip very shortly. And 2008 can be a very good year for drillers, especially if the natural gas strip holds at $7.50 to $8.50, which is where it is now. A 12 to 14 P/E ratio on Nabors' 2008 EPS estimate, even if it's only $4, gets the stock into the $50s. That's upside comparable to my Cummins trade.
Someday, maybe soon, a prominent Wall Streeter will upgrade Nabors on the belief that the 2007 rig glut is in the stock, and that maybe things are not as bad as investors fear. Out of the blue, investor psychology will reverse, and these compellingly cheap stocks will explode as investors look to more balanced supply/demand conditions in 2008.
And, with shares rising in the face of declining fundamentals, it will be very difficult to get on board. I wouldn't be surprised if most investors miss this trade, just like they missed the truck stocks. Sometimes, a little bit of fundamental certainty can go a long way; unfortunately, the wrong way.
Be patient, Nabors shareholders. Even with a cyclical downturn starting, better days are Cummins.
At the time of publication, Marcin was long Nabors and Cummins, although positions may change at any time.
Robert Marcin is the founder of Defiance Asset Management, a private investment management firm. Client accounts managed by Defiance Asset Management often buy and sell securities that are the subject of commentary by Marcin, both before and after it is posted. Under no circumstances does this column represent a recommendation to buy or sell stocks. This column is intended to provide insight into the financial services industry and is not a solicitation of any kind. Neither Marcin nor Defiance Asset Management can provide investment advice or respond to individual requests for recommendations. However, Marcin appreciates your feedback;
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