After my recent investment in Geospace Technologies, I am buying another service provider to the upstream sector of the oil and gas industry. Pason’s equipment is installed in over 1,000 onshore drilling rigs or 65% of all rigs in the Western hemisphere. Mid cycle operating margins reached 25% over the last cycle with ROCE in the 15%+range. Operations have been very volatile during periods of squeezing demand (like in 2009, 2014 to 2016), but Pason has been a steady compounder taking the last two decades of the company’s history into account.
I think that the company is well equipped to profit from an industry recovery due to (i) a strong competitive position, (ii) new product introductions and geographic expansion opportunities, (iii) high operating leverage and (iv) relatively low investment requirements going forward. On top of that, I get a pristine balance sheet and high historic earnings quality.
The key to Pason’s operational success is the application of technology to recording what is occurring at the well head. 20 years ago, this was an area where bigger companies were not paying attention to. Pason under the leadership of Jim Hill used this lack of attention to develop products that quickly covered the market before the competition could react.
Pason’s Electronic Driller Recorder (EDR) is the company’s primary product and generates 45% of total revenues. The EDR links the rig manager, rig crew, operator, geologist, mud logger, directional hand, and drilling operations technician, on a common data network. By providing secure communications via broadband satellite or wireless networks, the EDR system enables rigs to share drilling data, reports, and real-time well information with office-based personnel. The system can also provide Internet access for wellsite users. Additionally and very importantly, the EDR provides the platform for other Pason products like the Pit Volume Totalizer (15% of revenue), AutoDriller (6%), Gas Analyzer (7%).
In terms of new product development, the company has recently invested in data management solutions to help the customers to increase drilling data streams to the back office and provide analytical tools for these data streams. In addition, the company is improving its offerings with regard to so called drilling intelligence to further enhance drilling optimization and automation at the rig site (for instance Pason received the license for Exxon’s Drilling Advisory System). Lately, Management reported that these products are gaining traction based on first trials with customers. If these new product launches turn out to be successful, this will be a direct consequence of keeping investment activity in R&D stable during the current downturn. Pason is investing a healthy 10% to 15% of revenue in research occupying 25% of the workforce. New products will also have the potential to increase revenue per installed EDR.
Over the last three years, the company has been shifting its investment activity from the hardware side to software development and solutions. They spent CAD 192 m in 2013 and 2014 combined to invest in new hardware for rental equipment. Capex spending came down significantly from 2015 to 2017. Management expects annual capex to stay around CAD 25 m to CAD 30 m over the coming years (one fourth of 2014 spending) as the focus on software product development will require less capital expenditures going forward. This has already a positive effect on cash flows and will also provide support for income generation over the coming years as D&A continuously decreases.
During the latest downturn beginning in late 2014, management has reduced operating run rate costs by CAD 100 m (20% of 2014 peak revenue), helping the company to stay free cash flow postive.
Management summarized the effect of cost reduction in the Q2 2017 conference call:
“The impact of previously implemented cost reduction programs is highlighted by comparing this quarter’s results with the second quarter of 2015. While revenue was essentially at the same level, EBITDA increased from $7.5 million the second quarter of 2015 to $21.1 million in the second quarter of 2017. Our recorded net income was also much improved. We expect to continue to reap the benefits of our lower fixed cost structure into the foreseeable future.”
In addition and according to management, PSI was able to defend market share in all key markets with limited price concessions.
Speaking of market share, PSI serves close to 90% of its home market in Canada and 50%+ of the US market. They also have a leading position in LATAM and Australia and are currently gaining traction in the Middle East. According to management, the company is now operating in a stable duopoly with a third player operating an inhouse system in the US. At the moment, there is strong investment activity in the US (mostly Permian basin), while Canada is behind due to the reasons discussed in this article.
Over the long term, Pason has shown terrific growth rates being one of the best performing E&P servicers listed on the stock market. At the same time, operating volatility has been high following the E&P industry cycle. For instance, in 2014 revenues reached an all time high of CAD 500 m and declined to only CAD 160 m in 2016. In 2017, revenues recovered to CAD 245 m. While management reduced the cost base over the last three years, there continues to be a large degree of operating leverage in this business. According to management, in 2017 incremental EBITDA margins were 79%. Management believes that incremental margins might be even higher by a couple of hundreds basis points going forward.
Pason has a CAD 1.5 bn market cap, no debt outstanding and CAD 154 m in cash. Management has been focused on increasing the dividend over the years and mentioned that given current company’s excess cash on hand a further increase in the dividend is likely. Historically, the company’s acquisition paved the way to enter new markets. Recently they made a small purchase by acquiring visual analysis software company Verdazo. Managements remuneration is skewed to a relatively high equity component with more than 5 m stock options or 6% of total shares outstanding. Options vest over three to five years. Current average exercise prices are roughly 15% above the current share price. Management has generous change of control clauses in their contracts and will be rewarded in case of Pason being acquired. James Hill, who led the company for 25 years is now Chairman and still holds 10%+ of the company. He has been selling shares but this might be related to financing his interest in philanthropy and horse racing.
In 2017, the company generated EBITDA of CAD 85 m. Accordingly, the company is valued at a 16 times trailing enterprise value to EBITDA multiple.
I think this is an attractive price for the following reasons.
I think it is likely that we are at the beginning of an industry recovery with demand increasing over the coming years. According to management, recent forecasts expect E&P spend to grow 5% internationally and 15% to 20% in US in 2018. If this expansion scenario comes true, there will be substantial top line growth potential and therefore margin enhancement due to operating leverage. Assuming that revenues will revert to a normalized level of 60% of peak levels (achieved in 2014) this results in a revenue potential of CAD 300 m. Based on 80% incremental margins, EBITDA can reach roughly CAD 130 m. This turns then into 10 times multiple.
- Pason’s earnings quality has been excellent. Cash conversion from EBITDA is usually very high. Return on invested capital and operating margins over the business cycle have been strong.
- New product releases should help to foster the company’s competitive position and provide additional revenue upside.
- Pason can grow internationally. For instance, they started to install on Saudi Aramco’s rigs in Q2 2017. As of Q3 2017, they already had a market share of 15% in Saudi Arabia with 30 of a total of 200 drilling rigs using Pason’s solutions. They are also starting activities in Oman, the United Arab Emirates, Qatar and Kuwait.
After the release of Q4 2017 numbers, I bought a 3% portfolio position at CAD 18.2 per share.
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