CJES – A Play on North American Unconventional Resource Exploration

Overview

In combing through the IPO filings this year, I came across an interesting company that looks significantly undervalued: C&J Energy Services (CJES). This is an oil and gas services company that specializes in hydraulic fracturing, pressure pumping, and coiled tubing services, all of which are experiencing massive demand currently because of the interest in service intensive North American shale plays. For more information on why these services are in demand now, click here: http://www.pttc.org/aapg/lafollette.pdf

About a year ago, it was near impossible for E&P companies to get someone to fracture new wells in certain high demand plays like the Haynesville in Louisiana. But now, oil services companies are ramping up the available horsepower in their hydraulic fracturing fleets. This is spelling big growth numbers for the major players.

CJES attracted me because of its Trailing P/E of ~10, and its forward P/E of ~5. Further, it is trading at 42% below its IPO price, suggesting that it is well below proper valuation. I believe this is due to a mix of factors: the markets decreased demand for IPOs (almost all of which are down sharply), the recent downgrading of several onshore oil and gas service companies on concerns over the capital expenditure budgets of the major producers, and the recent drop in oil and natural gas prices. I think that all IPOs should not be traded similarly, so this cause is moot, the concern over capital expenditures is overdone, and oil prices have recovered substantially from their recent lows. The low natural gas prices are a cause for concern, but perhaps not as large as the market assumes. More on this in following paragraphs.

Business description

CJES has “fracking” fleets and coiled tubing units in the following areas: the Haynesville, the Eagle Ford, the Permian Basin, and the Granite Wash. Currently they have 172,000 horsepower available in 5 fracking fleets. They will get 2 more fleets in 2012, providing them with a total of 7 fleets and 270,000 horsepower. This is a 57% growth in available horsepower, and, if demand is sustained, should translate into large revenue growth numbers. CJES can adapt its fracking fleets to conventional, vertical wells, or unconventional, horizontal wells, utilizing one fracking fleet to handle either one horizontal well or two vertical wells at a time. This gives it greater flexibility in case the interest in horizontal drilling decreases, and greater utilization in areas where vertical drilling is used more, like the Permian Basin.

CJES also has 15 coiled tubing units, and 26 pressure pumps.

Since becoming public, their net profit margin is approaching the level that I really like: 20%. Of course, this is a very cyclic industry, depending on the forecast pricing for oil and gas. The financial strength of this company depends on the capital expenditure budgets of CJES’s major customers, which include: EOG Resources, EXCO Resources, Anadarko Petroleum, Plains Exploration, Penn Virginia, Petrohawk, El Paso, Apache and Chesapeake, along with some smaller players.

Risks

There are several major risks I see. One is that if all the major suppliers of hydraulic fracturing services are ramping up their fleets, we could actually run into a glut of supply in the next few years. To acquire the two new fracking fleets, CJES had to issue significant amounts of debt, and without revenue growth from those fleets, CJES will be hard-pressed to pay that off.
The new fracking fleets were not the only reason CJES issued new debt. CJES recently acquired Total, the manufacturer of almost all of CJES’s hydraulic fracturing pumps. This could be a great thing – the vertical integration can help reduce costs, increase maintenance efficiency, and provide opportunities for new growth in research and development of hydraulic pumping technology.  However, if demand falls, or if a supply glut is reached, this only means more debt that CJES is saddled with.

Demand for natural gas drilling is probably not sustainable with natural gas prices below $4. And, as you can see, the trend is clearly down:

These low natural gas prices are caused by over-production of natural gas from unconventional plays. I will write more on this situation in a later post.

However, CJES’s management has been shrewd enough to focus on liquids rich plays; three out of the four areas they are in are liquids rich: the Granite Wash, the Permian Basin, and the Eagle Ford. The demand for liquids is still high, because it is linked to oil prices, not gas prices. And with WTI prices creeping above $90 once again, this demand should be sustained for a while.

Conclusion

Unless the supply of fracking fleets and coiled tubing units outpaces the rising demand, I believe CJES will be able to pay down all its debt, and grow its earnings at phenomenal rates. This could be a huge gainer.

Disclosure: I have no position in any stock mentioned, but I may purchase a position in CJES in the next 7 days.

IMAX – Update

Congrats if you bought IMAX at the last post – you are now sitting on a 10-11% gain. Not bad for four days. If you are only interested in the occasional speculation, now is probably the end of that trade. I, of course, am hanging on to my shares as an investment. I think the upside next year is going to be much greater. I am going to be waiting, watching, and reading as much as I can.
Time to find some new ideas!

IMAX – Final Note before Earnings

I hate to harp so much on one stock, but I just reviewed the Q2 2011 conference call, and I am even more convinced that we will see a quick pop in the stock after IMAX announces earnings for Q3.

I have already expounded on the reasons for IMAX’s drop YTD – the poor quality of films for the first half of 2011. But I believe that the two biggest contributors to IMAX’s revenue this year will be Transformers and Harry Potter, which both occurred mostly in Q3. Indeed, Rich Gelfond mentioned in the conference call that IMAX had already generated $88mm in revenue in the first 28 days of Q3, as compared to a revenue of $98mm in Q3 2010.

Thus, IMAX is likely to post some pretty impressive year-over-year growth figures next week. This is still a risky trade, because the consensus earnings estimate for this quarter is .18, which suggests that the market already expects a 20% year over year growth figure. But, at its current valuation, I still think, even if IMAX only meets expectations, we are likely to see a pop.

I may buy some more shares in the next week, because I think this might be the last time that shares are this cheap.

 

Disclosure: I own shares of IMAX. I may buy shares in the next 7 days.

SDT – Sandridge Mississipian Trust for High Yields

I am looking at SDT as a potential investment for its high dividend yield.

When the market becomes extremely volatile, high dividend stocks become attractive to many investors because of their more certain payouts.

The horizontal Mississipian play that Sandridge Mississipian Trust targets is actually a conventional reservoir, so the reserves are more certain to be recoverable, as compared to shale oil royalty trusts. Because conventional reservoir forecasting has been refined over many years, we can be more certain of the predictions for recoverable reserves made in this case.
At year end last year (2010), SDT had 36 wells producing. The royalty trust has a 90% interest in these wells, meaning it is entitled to 90% of the profits, and a 50% interest in any new wells drilled.

Since the beginning of the year, Sandridge has drilled and completed 23 more wells. By multiplying the number of wells by the amount of interest SDT has in each well, we can arrive at a net number of wells that the trust receives proceeds from:

.5(23) + .9(36) = 43.9 wells

With these 43.9 wells, SDT is currently generating an 11% yield on its current price range, $22-23.
But Sandridge is still obligated to drill 101 more proved undeveloped locations, which would end up giving

.5(101) + 43.9 = 94.4 wells

Now, of course, by the time the new wells are drilled, the old wells will not generate the kind of revenue that they do now.
To get an estimate of the future dividends, let’s look to the Company’s target distributions.
Sandridge has a subordination threshold on its payments that it sets to 80% of its target distribution. If the revenue is below the subordination threshold, Sandridge will give up a portion of its proceeds to match the threshold. So this is a fairly safe level to use as a low estimate.
At this subordination threshold, the dividend yields are as follows for the following years, using a $23 stock price:

Year Threshold Yield Target Yield Incentive Yield
2011 8.06% 10.06% 12.08%
2012 9.80% 12.25% 14.70%
2013 10.54% 13.17% 15.80%
2014 11.70% 14.62% 17.55%
2015 10.47% 13.09% 15.71%
2016 8.52% 10.65% 12.78%
2017 7.39% 9.23% 11.08%
2018 6.63% 8.29% 9.94%
2019 6.11% 7.64% 9.17%
2020 5.76% 7.20% 8.65%
2021 5.47% 6.84% 8.21%
2022 5.17% 6.46% 7.75%
2023 4.86% 6.07% 7.28%
2024 4.58% 5.72% 6.87%
2025 4.32% 5.40% 6.49%
2026 4.09% 5.11% 6.14%
2027 3.87% 4.84% 5.81%
2028 3.67% 4.58% 5.50%
2029 3.47% 4.34% 5.21%
2030 3.29% 4.11% 4.93%
2031 11.08% 13.85% 16.62%
Total Return 138.86% 173.55% 208.26%

 

This means a relatively guaranteed return of capital, but the upside seems limited.

The real upside for this stock could happen if an investor sells in 2014 or 2015, because when the stock yields 14% or so, the market may trade it up above its intrinsic value.

Though this is actually very low risk, I think there are still better opportunities out there. If SDT drops below $20, I may reconsider.

Disclosure: I have no position in SDT or SD. I do not plan to initiate a position in the next week.

All data from the June 30, 2011 10-Q