Herlmerich & Payne Analysis

By

Vitaliy Katsenelson, CFA

Chief Investment Officer

Investment Management Associates, Inc.

Not to buy is an active decision. I took a serious look at Helmerich & Payne and, though we really liked the company, my

conclusion was not to buy the stock at this price (see analysis). However, this research was not a complete waste of time,

because at a lower price, in the $20-30s, HP looks like a very interesting opportunity.

Industry overview

Rig count it is basically at the same level where it was before the recession (source Helmerich & Payne).

But the above chart doesn’t tell the whole story (source Helmerich & Payne):

Oil drilling is a game changer. In 2008 half of gas drilling was vertical drilling. From 2010-2012 over 80% of gas

drilling was horizontal or directional drilling. As natural gas prices declined to $2-3 mcf drilling for gas became

uneconomical, and gas rig count declined from 900 to 450 from 2011 to 2012 – by half! But since oil prices remained

high overall, total rig count has not changed much; it just shifted from gas to oil.

Oil rig count from 2009 to 2012 increased from 200 to 1,200 – a 1000-rig increase!

Drillers are using the same technology to get shale oil that they used to get shale gas. The complexity of drilling for shale

oil and gas has increased dramatically. To do horizontal drilling you need much better rigs.

Oil production in the US has increased significantly: in 2008 we imported 60% of our oil, while by 2013 we will be

importing only 40%.

There are three types of rigs:

1. Mechanical – source of power is a diesel generator – ’70-’80s technology

2. SCR (silicon-controlled rectifier) – source of power is DC electricity – ’90s technology

3. AC – alternating current (AC) is source of power – the most modern, 2000s technology

Mechanical rigs receive power from a diesel generator and through gears transfer that power to the drill and other

equipment.

SCR rigs receive power from a diesel generator, whose AC output is converted to DC (with some conversion losses). A

DC motor has some advantages, but its biggest problem is that it doesn’t idle well.

All rigs can drill horizontal wells but not all are efficient at drilling them. Think of mechanical, SCR, and AC rigs as

being comparable to types of light switches– on one side you have a simple on/off switch, while on the other side you

have a dimmer. AC rigs are much easier to automate than SCR and mechanical rigs.

In October 2008 there were about 1,000 mechanical rigs, but by August 2012 the number was down around 700. 200 AC

rigs displaced 300 mechanical rigs. The rate of replacement is about 1 (AC) to 1.3-1.5 (mechanical).

There is a very significant difference between AC and mechanical rigs, In fact, the difference is so significant that

mechanical rigs are being phased out. SCR rigs are on the decline, too. From 2008-2012the SCR rig count fell from

about 630 to about 570. It will take a lot more time to displace SCR rigs.

Mechanical rigs are simply not economical when it comes to drilling horizontal wells.

Not all mechanical rigs will be displaced: the approximately 50% of them (300-400) that are drilling shallow wells will

not be. The other 300-400 will be replaced over next few years (assuming oil/gas prices are high) by 200-250 AC rigs.

Industry capacity is 150 rigs a year (HP should capture at least a third of that).

HP, Nabors, and Patterson control 50% of unconventional rigs and 90% of powerful rigs (powerful rigs are really

important, as wells are becoming deeper).

HP

In the late ’90s the industry was going through consolidation, and few new rigs were built. HP was either late to that

consolidation party or lucky that it decided that it wanted to grow organically. It started to develop its own FlexRigs,

which were more expensive than existing ones but far better.

HP One-Rig Economics:

Cost to build a rig: $16.2mm

Revenue per day: $28,000 Rig revenue per year: $10.2mm

Rig cost per day: $14,000 Rig cost per year: $5.1mm

Rig gross profit per day: $14,000 Rig gross profit per year: $5.1mm

Rig daily cost breakdown: 60% labor, 30% parts, 10% insurance etc.

HP doesn’t build rigs on spec; doesn’t build unless it signs a 3-4 year contract.

Customer (an oil company) leases rig in the spot market or on long-term (typically 3-year) contract and also

receives an HP crew.

With accelerated depreciation, payback is under 3 years (accelerated depreciation allows the owner to depreciate a

rig in 1 year!)

Economic depreciation is 15 years (useful life is probably closer to 30).

Maintenance capex equals depreciation, about $1.2mm a year ($3,300 a day).

Return on capital (depends on utilization rate after the contract expires and rig goes onto the spot market) is 14-

16%, higher than HP’s cost of capital.

Daily rates are managed for margins. Day rates are up, because costs have been rising. Though rates are

determined by supply and demand, companies do pull rigs out of the spot market when rates decline.

HP vs. Competitors:

Low-cost producer: a rig costs competitors $20mm+

HP charges a premium for their rigs.

There are several reasons for the premium:

1. New fleet – HP charges more for AC rigs vs. SCR/mechanical rigs.

2. HP charges higher day rates for AC rigs – they are simply more productive. This business is completely

based on meritocracy: performance is judged on how fast you can drill a hole and how much time it takes

to move a rig.

3. Fleet uniformity allows HP employees to be better trained and thus more effective than competitors.

The following chart sums up well why HP can continue to charge a premium for its rigs (it can drill a hole 6-8

days faster than competitors, and at $22,000 a day times many holes a year, we are talking about serious money).

HP has historically had a higher rig utilization rate than competitors. This is driven by newness of its fleet. AC

rigs can handle the complexity of horizontal wells better and thus have higher utilization.

This slide confirms it:

Customer risk is much lower for HP. Close to 90% of its customers are majors and large operators, while half of

competitors’ customers are small and private companies. Also, risk to accounts receivables is much lower for HP.

Market share went from 4% in 2001 to 12% in 2012. Market share gain was completely at the expense of Nabors

and Patterson.

HP has the most uniform rig fleet; it did not go through consolidation.

HP has by far the newest fleet: 99% of active rigs are AC rigs (retired all mechanical rigs). Paterson and Nabors

have still a lot of mechanical and SCR rigs (2/3 of Patterson’s EBIT comes from APEX rigs; a lot but not all

APEX rigs are AC rigs). Nabors has 222 AC, 275 SCR, and 116 mechanical rigs.

HP will not make acquisitions – it has the best rig fleet out there, and almost anything it buys in size will be

(quality) dilutive to its fleet.

2/3 of HP rigs are under contract, 1/3 in spot market – but rigs under contract will decline significantly in 2013

and 2014

Best balance sheet. HP has no net debt, while each competitor has plenty of debt. Nabors net debt to

capitalization is 40%. This is important for several reasons: allows HP to get through tough times without issuing

any dilutive equity during a severe downturn. It will help HP to take market share from its more debt-laden

competitors.

HP is the company most focused on rigs. Patterson has a pressure pumping business (1/3 of revenues).

HP Total Business Economics 2008-2012

It is hard to analyze annual HP cash flows and capital expenditures, because they are volatile from year to year. However,

four-year cumulative numbers should shed some light:

Built: 118 rigs

Total capital expenditures (for maintenance and growth): $3,000mm

Total depreciation: $1,165mm

Capital expenditures for growth: $1.834mm ($15.5mm per rig)

HP management says that its maintenance capital expenditures are equal to depreciation. So if we take out depreciation

($1.165 billion) from the $3 billion HP spent on total capital expenditures, we get $1.834 billion, which is $15.5 million

per rig (very close to current rig construction cost of $16.2 million).

Here is an important insight: In 2012 HP is expected to generate net income of $550mm ($5 per share), which is basically

its no-growth free cash flow (assuming the current utilization rate).

HP Valuation

Price: $48

Shares out: 105.7mm

Market Cap: $5,072mm

Long-term debt: $235mm

Cash: $148mm

Marketable securities (SLB, Atwood): $382mm

Tulsa shopping mall (440,000 sq ft @240 per sq ft): $100 mm

Enterprise value: $4,676mm or $44 a share

However, there is a $900mm tax liability (due to use of accelerated depreciation), or $8 a share. Enterprise value is thus

closer to $52 a share.

Replacement value of rigs is roughly $55 a share – 30% premium to its book value (estimated based NPV calculation).

There are several tailwinds and headwinds that impact HP.

Tailwinds:

Natural gas drilling is already low. HP has only a dozen of its own rigs drilling for gas, so if gas prices stay at the

present low level or continue to decline, the impact should not be significant on HP. Also, gas rig count is down a lot

already – only 400 rigs are drilling for gas. The downside here is that if gas prices decline you’ll see more competitors’

rigs hitting the spot market – not good for HP.

Replacement of SCR and mechanical rigs is still ongoing. HP should be able to pick up about 100 rigs over the next

couple of years as mechanical rigs are phased out. Replacement of 100 mechanical rigs over two years (50 rigs a year)

would add $1 to earnings a year (this is not included in the numbers at the bottom). In other words, earnings in 2014

would be a $1 higher, in 2015 $2 higher.

No growth is good. If the industry remains at this level – doesn’t improve much and doesn’t deteriorate – HP free cash

flows will skyrocket to its EPS, and HP will be able to buy back a lot of stock and increase its dividend.

Headwinds:

Macro. If oil prices decline a lot, let’s say to $60 or less, fracking drilling activity will freeze. HP has rigs under

contract, which will help it somewhat in the short term, over next few years; but as rigs roll off the contract utilization rate

will decline.

Other risks: accelerated depreciation expires, environmental disasters (fracking is not loved by environmental groups).

Conclusion: I don’t have a strong view on oil, and it is very easy to imagine how oil prices might decline substantially

from current levels, due to global macro headwinds. To a very large degree your view of HP should be based on what you

think oil and natural gas prices will do. I don’t think there is much risk to natural gas prices at this point, and even if they

decline further the impact on HP should not be significant. Only 400 out of 1800 rigs in the industry are drilling for

natural gas; the rest is oil. So natural gas offers an upside and little downside. Oil, if it declines, presents a significant

risk, which may or may not be offset by natural gas upward price movement.

HP will be a more attractive buy when things look dire and it is more hated. At today’s valuation, risk/reward is too

symmetrical

Things continue as they are – it is more or less fairly valued – $5-6 earnings power, 20% upside – $60-65 stock.

Oil prices remain the same or go higher while natural gas prices remain the same or go higher; upside significant,

$7-9 EPS power – $70-90 stock

Oil prices decline to $60 or below and natural gas stays at $3 or declines; earnings decline to $1-3 – stock will

decline to $20-30.

In my analyses I focused only on HP’s AC US land rigs. Offshore and international are about 10% of revenues, so their impact on

earnings is not meaningful from a scenario analysis perspective.

In the following table I computed HP’s very rough earnings power at different oil and natural gas prices

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is

the author of Active Value Investing (Wiley, 2007) and the upcoming The Little Book of Sideways Markets (Wiley,

December 2010). To receive Vitaliy’s future articles by email, click here or you can read them on ContrarianEdge.com.