CFA-DFW/HSFA Student Research This report is published for educational purposes only by students competing in the Investment Research Challenge TM - Texas. Investment Research Challenge- Texas CFA-DFW/HSFA Important disclosures appear at the back of this report Ticker: HYDL Recommendation: Hold Price: $83.04 Price Target: $91.00 Earnings/Share Mar. Jun. Sept. Dec. Year P/E Ratio 2005 0.64 0.73 0.83 0.90 3.11 20.9x 2006 0.94 1.04 0.88 1.07 3.93 21.1x 2007E 1.09 1.18 1.24 1.34 4.85 17.1x 2008E 1.36 1.41 1.44 1.49 5.70 14.6x • A strong closing quarter for 2006: Hydril reported fourth quarter EPS of $1.07 on revenue of $129.6 million, exceeding consensus estimates of $1.04 and lifting the shares to above the $80 mark in the following trading sessions. A recovery in the Premium Connection segment was the primary driver for the better performance, assisted by a vigorous share repurchase program which Hydril executed throughout the year. • Rebound in the Premium Connection segment: In 2006, the market for premium connections experienced a substantial softening in demand due to warmer-than-expected weather and a pullback in natural gas prices and drilling activity. Hydril responded by altering its product mix, moving away from low margin pipe products toward high margin premium connections, and improving productivity. As a result, segment margins have improved in the fourth quarter and should continue to expand well into 2007. • Pressure Control order backlog triples: In recent years, Hydril received 18 purchase orders for blowout prevention systems, corresponding to about 25% market share, and exceeding Hydril’s production capacity. Last quarter the company received a record $254 million in capital equipment orders bringing the company’s order backlog to $508 million. This is more than three times the 2005 year-end level and corresponds to about 40% market share. This trend should continue as the company expects to get four or five orders for the 11 newbuild deepwater rigs planned in 2007. • Modest upside still implied in valuation: Based on our analysis of historical earnings and cash flow multiples for Hydril and other industry competitors, we are projecting a one-year price target of $91. The target implies a 9.6% increase above the current price, which we believe already captures much of Hydril’s intrinsic value and warrants a Hold recommendation. Hydril Co. February 9, 2007 Oilfield Services HYDL Daily Stock Price $- $20.00 $40.00 $60.00 $80.00 $100.00 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Hydril's Market Profile As of 2/9/2007 Closed: 83.04 52 Wk High: 89.71 52 Wk Low: 48.71 Ave. Vol.: 440K Beta: 1.51 YTD %: 8.73% Mkt Cap: 1.85B P/E (ttm): 21.35 Forward P/E: 16.93 EPS (ttm) 3.89 Return Equity: 28.02% Shares outstanding: 19.25M
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CFA-DFW/HSFA Student Research This report is published for educational purposes only by students competing in the Investment Research ChallengeTM - Texas.
Investment Research Challenge- Texas CFA-DFW/HSFA Important disclosures appear at the back of this report
Ticker: HYDL Recommendation: Hold Price: $83.04 Price Target: $91.00
• A strong closing quarter for 2006: Hydril reported fourth quarter EPS of $1.07 on revenue of
$129.6 million, exceeding consensus estimates of $1.04 and lifting the shares to above the $80 mark in the following trading sessions. A recovery in the Premium Connection segment was the primary driver for the better performance, assisted by a vigorous share repurchase program which Hydril executed throughout the year.
• Rebound in the Premium Connection segment: In 2006, the market for premium connections experienced a substantial softening in demand due to warmer-than-expected weather and a pullback in natural gas prices and drilling activity. Hydril responded by altering its product mix, moving away from low margin pipe products toward high margin premium connections, and improving productivity. As a result, segment margins have improved in the fourth quarter and should continue to expand well into 2007.
• Pressure Control order backlog triples: In recent years, Hydril received 18 purchase orders for blowout prevention systems, corresponding to about 25% market share, and exceeding Hydril’s production capacity. Last quarter the company received a record $254 million in capital equipment orders bringing the company’s order backlog to $508 million. This is more than three times the 2005 year-end level and corresponds to about 40% market share. This trend should continue as the company expects to get four or five orders for the 11 newbuild deepwater rigs planned in 2007.
• Modest upside still implied in valuation: Based on our analysis of historical earnings and cash flow multiples for Hydril and other industry competitors, we are projecting a one-year price target of $91. The target implies a 9.6% increase above the current price, which we believe already captures much of Hydril’s intrinsic value and warrants a Hold recommendation.
Hydril Company (Hydril), headquartered in Houston Texas, engineers, manufactures, and markets premium connection and pressure control products for oil and gas drilling and production worldwide. The company is one of the oldest in the oilfield services business, 74 years old, but has only been public for six and a half years, trading on the NASDAQ. Hydril currently operates 25 sales and service facilities in nine countries, including joint ventures in Russia, India, and China. The company has approximately 1,700 full-time employees, two-thirds of which are in the U.S. Hydril has five manufacturing plants in the U.S., ten in six other countries, and dozens of distributors and authorized repair facilities on six continents. Business Segments Hydril is a leader in both the Premium Connection and Pressure Control segments. The company operates in high cost drilling environments, targeting deep formation and offshore drilling projects, which make up about 85% of HYDL’s output. Hydril has differentiated itself in the market place through technical innovation, a global presence, strong brand name recognition, and financial stability. The company maintains 84 U.S. patents and continues to redefine reliability for the industry. Hydril is divided into four sub-sectors: Premium Connection, Pressure Control, U.S., and International. Figure 1 displays the revenue distribution of the four sub-sectors; the geographic distribution represents where the product is consumed. About 90% of Hydril’s U.S. revenues come from natural gas drilling projects. Figure 1: Hydril’s Percentage of Revenue by Segment and Geographic Location
Over the past few years, Hydril’s business has moved from a domestic focus to an international focus, while other oilfield services companies continue to maintain domestic revenue at 70%-90% of their businesses. Figure 2 displays the swing from U.S. to International revenues between 2003 and 2006. Figure 2: Hydril’s Percentage of Revenue by Region
Source: Company Notes
The Premium Connection segment remains the bulk of Hydril’s revenues. However, as shown in Figure 3, the company has moved more toward a 50/50 split, due to growth in capital equipment revenues in the Pressure Control segment.
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4Q 2005
65%
35% Premium ConnectionsPressure Controls
4Q 2006
54%
46%
Figure 3: Hydril’s Percentage of Revenue by Segment
Source: Company Notes
Premium Connection The Premium Connection segment is a high margin, service industry. Exploration and production (E&P) companies use Hydril premium connections in environmentally harsh and sensitive drilling conditions, especially in deep formations both on and offshore, where extreme pressure, temperature, corrosion, and mechanical stress are encountered. The Premium Connection segment produces threaded connections that join sections of well casing, production tubing, and drill pipe used in various stages of drilling and production. The connections are linked to the ends of a drill pipe and enable sections to be screwed together to line the well. The company threads in seven countries and holds 28 U.S. patents. The segment has low working capital requirements, as Hydril does not own the pipe but rather puts the connections on the pipe. Products The Premium Connection segment produces two main products: integral and coupled (Appendix B shows both products). These products are created to withstand 15,000 psi of pressure and last the life of the well, around 20 years. About 15% of all wells drilled use premium connections. Hydril holds the largest market share, both domestic and international, for integral products. All of the company’s rivals in the premium connection space compete with both integral and coupled products. Deeper wells have more and longer pipe strings and use more premium connections. An API connection is the industry standard, but premium connections are needed to withstand the high tension and pressure, especially at depth. Connections must be placed every 40 feet; therefore, the deeper the well the more pipe and connections the well will need. Hydril targets drilling projects that are greater than 15,000 feet deep to obtain greater revenues. Appendix C displays the potential increase in revenue per well with premium connection strings of pipe in red and API connections in black.
Inventory Correction Issues In 2006, Hydril experienced record inventory backlog in Venezuela, and destocking in the United States. In Venezuela, PDVSA deferred purchase orders for four to five months. In the U.S., distributors drew down inventory. The price of pipe recently leveled off; therefore, distributors prefer to have fewer pipes in inventory. Inventory destocking is expected to end in the first half of 2007.
Pressure Control The capital equipment category of the Pressure Control segment is employed in oil and gas drilling and well completion and maintenance. The pressure control products, purchased by existing drilling contractors, are utilized as safety devices on drilling rigs to ensure that high-pressure fluids and gases remain in the well bore during drilling, completion, and maintenance operations and prevent the dangerous and costly event of a blowout. Pressure control products include blowout preventers (BOP), diverters, multiplex subsea control systems, drill stem valves, production chokes, pulsation dampeners, and various elastomer products, which protect personnel, equipment, and the environment from uncontrolled releases of fluids and gases. Hydril also provides aftermarket parts, repair, field service, and technical support for the company’s line of pressure control equipment. Appendix B displays the various capitals and aftermarket equipment the company provides to customers. Hydril manufactures these products in three different countries and generated $187 million in revenue from the products as of September 30, 2006.
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Hydril invented the annular BOP and holds about 50%-60% of the installed base, which is important to the company’s aftermarket business. Hydril has 56 U.S. patents in pressure control products, but there is a slow rate of technological change as companies are risk averse to adopting new technology. The company follows a “razor/razorblade” business model, where HYDL sells the capital equipment with only a 25% margin, but charges 40% margins on the aftermarket services.
Industry Overview and Competitive Positioning Company Strategy Hydril’s strategy is technical selling of products; competing on high quality, not price. The company is producing new products with a larger diameter which will offer higher margins in a less competitive space. The company plans to forge relationships with developing market steel mills. Hydril has already entered into three joint ventures. In 3Q 2006 the company entered into a joint venture with TMK, a seamless pipe manufacturer in Russia. The plant is expected to begin production in 2H07. Production has already begun in the joint venture in India and China is expected to follow. Hydril has no pricing power in the Premium Connection segment and is unable to charge more than a 10% price premium over the company’s competitors. Given the competitive landscape, Hydril continues to show impressive returns in the Premium Connection segment (Appendix D).
Industry Performance In 2006, integrated oil companies had record earnings. The price of oil remained high relative to historic levels throughout the year. Toward the end of 2006 and beginning of 2007, commodity prices retracted some of their recent gains, sparking concerns about the capital investment cycle. Industry giant, Schlumberger, warned of a possible drilling downturn while another industry leader, Baker Hughes, missed analyst expectations for 4Q06. Nonetheless, strong demand from emerging market consumers and political tensions in producer regions continue to support high commodity prices. Competitive Landscape The Premium Connection segment can be divided into two sub-segments: United States and Ex-North America, about a 50/50 split. In the U.S. and Canada the industry is mature with a highly developed infrastructure. Though end users are independent E&P companies, Hydril obtains the pipe, threads it, and sells it back to distributors. The company has roughly 35%-40% market share in the U.S. and 50% market share in Canada. The U.S. and Canada markets operate on short planning horizons with lead times of two days to two weeks. The Ex-North America market operates differently as a developing industry that lacks infrastructure. Internationally, Hydril has about 12%-14% market share, operating on long planning time horizons with lead times of 6-12 months. In the international space Hydril will occasionally buy pipe and resell it with connections, a mill direct industry. The competitors are generally steels mills which under-price the premium connection in order to sell the pipe. Hydril expects to have at most up to 20% market share Ex-North America, due to the company’s higher margins, 40%-50% on the premium connection and only 5%-10% on the pipe. Hydril has large, concentrated customers, especially in Mexico and Venezuela. In 2005, PEMEX, generated 11% and PDVSA generated 13% of Hydril’s total revenue. National oil companies as well as Super majors are also customers. Competing with Hydril in this area are Hunting, Vallourec (VK), and Grant Prideco (GRP), domestically, and steel companies such as Tenaris, internationally. Appendix E shows Hydril in comparison to the company’s competitors in both segments. In the capital equipment sector, Hydril has a third of the market share, competing against companies including Cameron International (CAM) and National Oilwell Varco (NOV). Hydril only provides aftermarket services for their products; therefore, only grey goods manufactures or bootleggers can obtain a portion of Hydril’s market share. Hydril continues to maintain two-thirds of the available market share. Because Hydril has a smaller product offering than the company’s competitors, HYDL only has 25% of the market share in aftermarket products. Appendix E displays the division of market share in both the capital equipment and aftermarket segments. Capital Equipment and Aftermarket The capital equipment segment market share is expected to double in 2007. Currently there is a boom in the capital equipment business, especially in deepwater equipment. Hydril divides capital equipment up into land, jack up, and deepwater categories. Appendix B shows the increasing nature in revenues depending on the type of project. Hydril not only experiences higher revenue, but also higher margins: 20% land, 25%-
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30% jack up, and 30%-35% deepwater. In the aftermarket segment, Hydril has about 50%-60% market share for land, 75% market share for jack ups, and 100% market share for deepwater. Capital equipment is a cyclical business and is currently mid to late cycle. To deal with some of the capacity issues Hydril opened a new pressure control manufacturing plant in Veracruz, Mexico. The plant began production in 3Q06 of low pressure and small diameter capital equipment. The company also added new machine tools in Houston and is in the process of moving to batch manufacturing to minimize process costs. Though the company has some pricing power, 20% operating margin, Hydril does not want gouge the consumers on the aftermarket products, currently at 30%-35% margin. Capital equipment revenues continue to increase and normally aftermarket revenues lag one year to the purchase of capital equipment.
Investment Summary As E&P companies continue to search for oil in increasingly harsh environments, Hydril should continue to build its presence in the oilfield services industry. Hydril experienced a $508 million backlog by the end of 4Q06. 85% of the October 2006 backlog was due to deepwater capital equipment. Delivery should be mid 2009 on all capital equipment backlogs. Figure 4 shows the quarterly backlog in pressure control equipment over the last five years.
Figure 4: Pressure Control Equipment Backlog
Source: Company Notes
Hydril’s share of this market has already reached over 40% and the firm is planning further capacity expansions in Brazil, Mexico, and Indonesia. Approximately 95% of the company revenue is recognized when a product is delivered or a service is administered. The other 5% of total revenue is recognized using the percentage of completion method. The percentage of completion method will smooth the company’s earnings over time. This other 5% of revenue is generated from long-term contracts in Hydril’s pressure control segment. Customers typically enter these long-term contracts for six to eighteen months with a contract price in excess of $1.0 million. Current backlog for pressure control products is $509 million. The backlog is expected to continue boosting revenues through 2009. Although it is possible for orders to be cancelled, in the event of cancellations all costs incurred would be billable to the customer. Hydril still has a number of weaknesses to consider as well. The company is susceptible to input cost fluctuation, because unlike some of its competitors, Hydril is not vertically integrated through the ownership of steel mills. The company also acknowledges its own limitations with respect to its ability to protect intellectual property rights. A sizable grey goods market for substitute products exists. Although it appears that purchase orders for BOPs have peaked, the company needs manpower to meet the demands of the market. In a tight labor market, Hydril could face challenges attracting and retaining the manpower needed to expand capacity. Currently, the demand for workers in the Houston area is high and the supply is limited, particularly for skilled and experienced engineers and machinists. Many of these individuals chose to work in other industries that are not as cyclical, where lay-offs are not likely to occur.
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Even if Hydril is able to attract and retain employees, the intense competition for them, especially when the industry is at the top of its cycle, may increase Hydril compensation costs. Finally, Hydril has a highly concentrated distributor network and customer base. The loss of any one distributor or customer would substantially impact Hydril’s short-term profitability, especially with its growing dependence on state-owned oil companies. To improve performance, companies in the industry are pursuing growth through acquisition, technological innovation, and geographical and asset base expansion. For Hydril, a steady increase in deep formation drilling activity represents the most lucrative profit scenario. Last year the deep formation rig count rose 29% (from 179 to 232), and the company estimates more than 50 more are under construction or on order. Figure 5 below shows the growth in U.S. deep formation rig count since 2003. Based on rig estimates provided by Hydril, an annualized growth rate of 13% has been assumed for deep formation rigs through 2008. Annual rig count is highly correlated to company revenues.
Figure 5: Deep Formation Rig Count
Source: Smith International
Financial Analysis Short-Term Liquidity In 2006, Hydril experienced a significant increase in both accounts payable and other short-term liabilities, 74% and 268%, respectively. Although the accounts payable account rose, the days payables dropped, which suggests that the increase in accounts payable is due primarily to the increase in inventory and other production costs related to the backlog (see Appendix F). Other short-term liabilities consisted of three accounts: 1) billings in excess of contract costs and estimated earnings; 2) accrued liabilities; and 3) income taxes payable. Billings in excess of contract costs and estimated earnings account was the primary driver for the increase in other short-term-liabilities and can be explained by the company’s large backlog and revenue recognition policy. The dramatic increase in current liabilities has caused both the quick ratio and the current ratio to drop precipitously (see Figure 6). The current ratio indicates the amount of cash coming into the firm over the amount of cash expected to leave the firm; and the quick ratio measures how quickly the firm can convert current assets to cash. Although the current ratio is above one and the quick ratio is above one-half, the volatility of these ratios causes some concern. The lowering of these ratios suggests Hydril could encounter a problem meeting the company’s cash needs in the near future; however, the company has no debt and therefore rely on the capital markets to meet any short-term liquidity needs. Hydril has no other recent history of liquidity problems and has even used some of its excess cash to repurchase shares.
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Current Ratio 2.22 4.28 4.24 5.11 1.98Quick Ratio 1.41 2.84 3.26 3.80 1.29
Long-term Solvency Risks Historically, Hydril has been well above the 20% threshold for cash flow from operations to average total liabilities ratio, a sign of a financially healthy company; nevertheless, the ratio has recently dropped to 26% as a result of some off balance sheet liabilities, such as operating leases. Given the forecasted revenue increases, we feel this will not be a problem.
F-Score The F-score is a metric developed by Joseph Piotroski to determine a company’s financial health. Based on a binary system, a company receives a score of one or zero for nine accounting metrics ranging from the company’s profitability to liquidity. At the portfolio level, firms with scores six and above have historically outperformed the S&P 500 Index, while firms with scores of four or less have historically underperformed. Appendix G provides descriptions of the nine components of the metric. Hydril received an F-score of 6, indicating that those dimensions, Hydril’s profile is consistent with firms that have, on average, outperformed the S&P 500, although a score of 8 or 9 would be more indicative. Appendix G shows the three zeros in Hydril’s F-score correspond to gross margin improvement, LT debt/total assets decrease, and current ratio improvement. Gross margin slightly decreased from 43% in 2005 to 40% in 2006. The current ratio dropped for reasons previously mentioned; and, because Hydril has no long-term debt, the LT debt/total assets remained unchanged. See Appendix G for a breakdown of Hydril’s F-score. Earnings Quality The M-score, developed by Daniel Beneish, encompasses several different accounting ratios in a calculation designed to detect potential earnings manipulation by a company. An M-score greater than -2.22 indicates that a company may be manipulating its earnings. Receiving an M-score of -2.930, Hydril does not appear to be manipulating earnings. Since the company went public in 2000, the company has not had to restate earnings. The low M-score further validates our high regard for Hydril and the company’s management team. For more information about the company’s management please refer to Appendix H. Appendix I details the calculation for the M-Score.
Competitors’ Comparable Analysis Figure 7 contains comparison ratios for key competitors in the oilfield services industry. Among them, Hydril has the highest P/E, P/S, and P/CF, hinting that the company may be overvalued. Hydril’s ROE and ROA are better than the industry average, explaining some of the price premium. Figure 7: Ratio Comparison of Hydril and Competitors
Hydril (HYDL)
Vallourec (VK*)
Grant Prideco (GRP)
Cameron Int.
(CAM)
National Oil Well Varco
(NOV)P/E (Feb. 9, 07) 21.35 12.27 12.34 20.07 17.07P/S (Feb. 9, 07) 3.18 2.29 2.92 1.71 1.66P/CF (Feb. 9, 07) 19.99 36.88 15.87 13.19 13.95EBITDA (End Dec 2006) 147M n/a 614.6M 613M 1.31BEV/EBITDA 13.65 9.77 9.64 10.53 9.01ROA (End Dec 2006) 19.00% 14.93% 26.00% 8.53% 8.73%ROE (End Dec 2006) 28.02% 42.92% 39.44% 19.05% 14.84%Net Operating Margin (End Dec 2006) 26.28% 22.41% 30.74% 13.68% 15.93%Debt to Equity (2006Q4) 0.00 0.54 0.00 0.55 0.17Price (Feb. 9, 07) 83.04 186.20 41.93 57.41 66.54*Used 2005 Data Source: Bloomberg EBIT Margin comparison among competitors Figure 8 depicts the EBIT margin of Hydril’s major competitors since 1998. Hydril appears to have enjoyed a higher EBIT margin and EBIT growth rate than its competitors. Although, this past trend cannot be simply
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extrapolated into the future, it is a positive indication of a strong performance track record. The EBIT margin of Hydril primarily comes from premium connections, where they have operating margin of 30% to 40%, and the aftermarket services in the pressure control industry, where the margin is around 40%. Both of operating margins contributes to an estimated 87% of total operating margin (9 months Ended, ending at 9/30/2006). According to the webcast at Rice University, Hydril has been able to sustain high margin for premium connections and gain more market shares by selling high technology high pressure controllers, where they have higher margin of 30% to 35%, while increasing revenue (by over 20% YoY) in the aftermarket service. Hydril is losing market share in the low pressure controllers, which has margins range from 10% to 25%. EBIT Margin growth and sustainability Hydril maintains a higher EBIT margin over its competitors due to its specialized products and dominant brand name. Sustainability of higher margins is significant rather than higher margins created by large one- time deals, which the company could not replicate in the future. As observed in Figure 8, Hydril has been able to sustain a higher margin than most of its competitors over the past 8 years. Furthermore, Hydril has grown its EBIT margin at a higher rate (slope of 0.0401) than its competitors. The slope of each line is calculated by using the regression model. Understanding that Hydril leads the industry in both growth and sustainability of EBIT Margins, they will either continue at this pace or fall short of these growth rates. It will be difficult to improve beyond these levels, as mentioned during the Rice University webcast by Christopher Seaver. Advantages are priced into Hydril’s stock price With a P/E ratio of 21, we feel that Hydril’s high EBIT Margin growth rate and sustainability have been reflected in the current stock price. However one competitor, GRP, had a higher EBIT margin in 2006 with a low P/E ratio of 12. The low P/E ratio is likely due to market expectations of low EBIT margin for the future. GRP, also, has a much higher ROE than most competitors. This is not reflected the P/E ratio, again suggesting an unsustainable growth rate within the industry. (With further research, GRP could be considered a potentially undervalued buying opportunity.) CAM and NOV were able to sustain lower EBIT margins over the past 8 years, projecting higher P/E ratios of 20 and 17.1. From this analysis, we believe that there is a higher probability that Hydril will approach a mid-range P/E, because current growth rates are less sustainable over time, and Hydril is already at the high end of the range. Figure 8: EBIT Margin Comparison among Competitors
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3 top volume trades are due to:Jul. ’06: HYDL announced lower revenue in Q3 and Q4. Oct. ’06: lowered est. earnings to $0.79~$0.84.Nov. ’06: Mult. Firms recommend “buy”for HYDL
HYDL beats Q3 earnings est. by $0.02.
Q4 earnings exceed $1.05 by $0.02
Big drop due to oil price drop.
3 top volume trades are due to:Jul. ’06: HYDL announced lower revenue in Q3 and Q4. Oct. ’06: lowered est. earnings to $0.79~$0.84.Nov. ’06: Mult. Firms recommend “buy”for HYDL
HYDL beats Q3 earnings est. by $0.02.
Q4 earnings exceed $1.05 by $0.02
Big drop due to oil price drop.
10
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31-Dec-2004 31-Dec-2005 31-Dec-2006
P/E
HYDL P/E
Industry P/E
Stock Performance Initially offered to the public in 2000, Hydril’s stock price remained largely range-bound until 2004. With the initial rise in energy prices and the beginning of a new capital investment cycle in the industry, Hydril’s shares have embarked on an impressive three-year rally. Over the last five years, the stock has returned 361%, outperforming the S&P Small Cap Energy Index by 83%. 2006 has been a volatile year for Hydril shares. Figure 9 shows a one-year price graph and selected events.
Valuation Based on our analysis of historical earnings and cash flow multiples for Hydril and other industry competitors, we are projecting a one-year price target of $91. Following the Bloomberg US Oil & Gas Services Index, comprised of leading oil & gas stocks in the US, Hydril trades at a premium against its peers. Currently, the index trades at a 15x multiple, while Hydril’s multiple experienced a significant expansion over 4Q06 relative to the industry. Some of the expansion can be explained by the strong signal management sent to the market when they repurchased shares. As seen in Figure 10, P/E multiples industry-wide have been contracting since 2004, and we believe the trend will continue. Our price target was established by applying a mid-range 18.8x multiple to our $4.85 earnings per share estimate for 2007, incorporating Hydril’s favorable backlogs, and earnings surprise over 3Q06 and 4Q06. Figure 10: Hydril’s Historical P/E versus Industry Peer Group
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Source: Bloomberg Alternatively, the target corresponds to an 11.2x multiple of 2007 EBITDA, a common proxy for cash flow. Both of the valuation estimates imply an upside potential of about 10% above the current price and reflect our view that Hydril’s valuation is already nearly captured by the current trading range. Hydril’s shares could attract a better valuation to the extent the company is able to outperform the already ambitious earnings expectations in the next quarters. Management is expecting capital equipment revenue to increase another 50% to 60% over the next year, representing both productivity improvements and additional gains in global market share, which already rose from 25% to 40% last year. Double-digit revenue growth is also projected in the Premium Connection segment and should come from overseas markets served by Hydril and partner facilities in Mexico, Indonesia, India, Russia, and most recently China. Much of Hydril’s 2007 capital expenditure budget is already dedicated to expanding production capacity in these facilities. A positive factor for Hydril is the improved capital equipment revenue visibility afforded by the major purchase order backlog. In past quarters Hydril’s stock price may have included an implied discount for the considerable volatility in the company’s revenues and earnings. If these measures become more stable and predictable as Hydril works through the backlog into 2009, the discount may decrease, providing additional upward momentum to the shares. Management recently pre-announced the near completion of the comprehensive share repurchase program that was executed throughout 2006. With major planned capacity expansions and projected growth in 2007, we do not expect Hydril to extend the program; however, better-than-expected earnings may prompt the company to prolong it, which would further support the share price. At the industry level, the near term success of oilfield service companies will hinge on the length and intensity of the current cycle. The capital investment cycles historically depended on and tracked the commodity price performance of oil and gas resources. The current cycle is widely anticipated to persist in a $40 or more market for crude oil. Companies focused on highly engineered premium products would further benefit from the continued E&P sector shift to more challenging offshore and deep formation drilling. We used the deep formation rig count as a major driver for Hydril revenues. With the rig count assumed to expand to roughly 60 additional rigs through 2008, the revenue multiple was adjusted to capture both the backlog in pressure controls and sharp increase in rigs in 4Q06 (see Figure 10 for more detail). Risks to Our Price Target A sustained decline in hydrocarbon prices is the most significant risk to Hydril’s performance and stock returns. Such a scenario would likely end the expansion of the upstream capital investment cycle and would dramatically curb the spending patterns of E&P companies. Extreme volatility of commodities on the upside could also destabilize the capital planning process of Hydril’s customers. Such volatility could be brought on by a number of adverse events including political turmoil, market shocks, weather irregularities, legislative changes, and other global and regional phenomena. With operations in 61 countries, Hydril is exposed to currency exchange rates and may experience potential devaluations based on the strength of the USD. At the company level, Hydril’s execution of the expansion projects as well as the handling of continuing operations will determine the company’s immediate welfare. The ability to secure adequate labor and resources to fuel growth while maintaining profitability will also be vital. Deviations from anticipated plans could result in unforeseen cost overruns.
F-Score Calculation F-score calculationNet income is positive 1Operating cash flow is positive 1OCF>NI 1ROA has increased 1Gross margin has improved 0Asset turnover has improved 1LT-debt/ tot. asset has decreased 0Current ratio has improved 0No new equity issuance 1Total (F-Score) 6
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Appendix H:
Management Overview Frank R. Seaver founded the company in 1933 and ran Hydril until his death in 1964. Throughout its history, a member of the Seaver family has run the company. Christopher Seaver is currently serving as President and CEO and has been in the respective positions since 1993 and 1997. Analysts have estimated that the family has roughly 13% of Hydril’s shares, but the family has 60% of the voting power. For more information about additional members of management, their biographies from the company 10-K, are listed below. Like many companies controlled and managed by founding family members, Hydril is conservatively managed and has a strong execution track record since its 2000 IPO. The only concern we have from a management perspective is a lack of depth. If Hydril should happen to lose any of its senior executives then it would hurt the company. Richard C. Seaver is our Chairman of the Board, a position he has held since 1992. Previously, Mr. Seaver has served as a director since 1964, as President from 1964 to 1986, and as Secretary and General Counsel from 1957 to 1964. Christopher T. Seaver is our President, Chief Executive Officer and a director. He has served as President since June 1993, and as Chief Executive Officer and as a director since February 1997. He is a director and the secretary of the Petroleum Equipment Suppliers Association, a director of the American Petroleum Institute, and a director and vice chairman of the National Ocean Industries Association. Prior to joining Hydril in 1985, Mr. Seaver was a corporate and securities attorney for Paul, Hastings, Janofsky & Walker, and was a Foreign Service Officer in the U.S. Department of State, with postings in Kinshasa, Congo and Bogotá, Colombia. Charles E. Jones is our Executive Vice President and Chief Operating Officer, a position he was appointed to beginning in May 2003. Previously, he served as our Vice President-Pressure Control from November 2001 to May 2003 and as our Managing Director-Pressure Control from March 1998 to November 2001. From March 1996 to March 1998, Mr. Jones served as Director of Subsea Business for Cooper Cameron Corporation, a provider of oil and gas drilling equipment. Mr. Jones served as Engineering Manager for Subsea Offshore, formerly Dresser Industries, a manufacturer of oil and gas drilling equipment from April 1995 to March 1996. Prior to holding these positions, Mr. Jones had 11 years of service with us. Mr. Jones is a graduate of the Harvard Business School Advanced Management Program. Neil G. Russell is our Senior Vice President-Premium Connection and Senior Vice President-Business Development, positions he was appointed to in May 2003. Previously, he was Vice President-Premium Connection, from November 2001 to May 2003 and Managing Director-Eastern Hemisphere Premium Connection, from March 1995 to November 2001. Overall, Mr. Russell has 27 years of service with our company, in which he has held various management positions in our premium connection and pressure control businesses with assignments in Singapore, Switzerland, the United Kingdom, and the United States. E. Charles Chauviere III is our Vice President-Pressure Control, a position he was appointed to beginning in May 2003. Mr. Chauviere joined Hydril in 1998, and previously served as Director of Engineering beginning in February 2001. Prior to joining Hydril he was employed for 10 years with Cooper Cameron Corporation. Mr. Chauviere is a graduate of the Stanford University Executive Program. Chris D. North is our Chief Financial Officer and Secretary. Mr. North was appointed Chief Financial Officer in August 2004 and previously served as acting Chief Financial Officer beginning in March 2004 in addition to his role as the Controller. Mr. North served as Controller from February 1997 to August 2004. Mr. North has a total of 26 years of service with Hydril in which he has held various positions.
IRC-TX February 9, 2007
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Appendix I: M-Score (Manipulation Score)
M-Score Formula and Calculation
Formula
Model Variables (Characteristics) Value DefinitionDays Sales in Receivables 1.42 AR/Sales (t) / (t-1)Gross Margin Index 0.80 Gross margin (t-1) / (t)Asset Quality Index 0.65 Low quality assets (t) / (t-1)Sales Growth Index 1.34 Sales (t) / (t-1)Depreciation Index 1.03 Rate of depreciation (t-1) / (t)SG&A Expenses Index 0.91 SG&A/Sales (t) / (t-1)Leverage Index 2.15 Total liab./Total assets (t) / (t-1)Total Accruals to Total Assets -0.11 Accruals measured for year tM-Score -2.930 If M-Score > -2.22 then indicates
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Disclosures: Ownership and material conflicts of interest: The author(s), or a member of their household, of this report holds a financial interest in the securities of this company. The author(s), or a member of their household, of this report knows of the existence of any conflicts of interest that might bias the content or publication of this report. The conflict of interest is… Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue. Position as a officer or director: The author(s), or a member of their household, does serves as an officer, director or advisory board member of the subject company. Market making: The author(s) does not act as a market maker in the subject company’s securities. Ratings key: Banks rate companies as either a BUY, HOLD or SELL. A BUY rating is given when the security is expected to deliver absolute returns of 15% or greater over the next twelve month period, and recommends that investors take a position above the security’s weight in the S&P 500, or any other relevant index. A SELL rating is given when the security is expected to deliver negative returns over the next twelve months, while a HOLD rating implies flat returns over the next twelve months. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with NYSSA or the NYSSA Investment Research Challenge with regard to this company’s stock.
