MRC Global: A Play on Oil & Gas Recovery

MRC Global is the largest distributor of pipes, valves, fittings, and related products and services to the energy industry.  The company was founded in 1921 as McJunkin Supply Company and grew organically and through acquisitions over the years.  In January 2007, Goldman Sachs Capital Partners acquired a controlling interest in McJunkin and in October 2007 merged the company with Red Man Pipe & Supply Company.  Over the next four years, several acquisitions were made in a strategy to “roll up” a number of smaller players in the distribution market.  In January 2012, the company’s name was changed to MRC Global and Goldman Sachs took the company public in April 2012 at $21 per share.  Shares of the company fell dramatically in late 2014 and 2015 due to weakness in oil and gas exploration.  Shares have recently been purchased by Fairholme Capital.

Oil Rig Counts

MRC Global’s business prospects are highly correlated with exploration and production activities which, in turn, are very sensitive to the level of commodity prices.  Starting in late 2014, the price of crude oil has been very weak and extremely volatile.  Crude oil prices below the marginal cost of production in many areas has resulted in rig counts collapsing over the past year.  Although MRC Global has international operations, 79 percent of revenue in 2015 was attributable to the United States with an additional 7 percent from Canada.  As a result, examining rig counts for the United States and Canada will shed the most light on industry conditions that most directly impact the company’s revenue.

Baker Hughes publishes extensive data on rig counts as a service to the petroleum industry.  The website is well worth perusing for anyone interested in the dynamics of the industry.  Data are presented in granular formats showing activity by region, well type, and resource plays.  For our purposes, it is sufficient to look at North American rig activity at a fairly high level.  The exhibit below shows the rig count in the United States over the past sixteen years:

US Rig Count Since 2000

As of April 22, 2016, there were 405 rigs operating on land and 26 rigs operating offshore.  This represents a 54 percent decline from the rig count one year ago and a 77 percent decline from two years ago.  The current rig count is at the lowest level in the history of the chart and far below the average level of slightly over 1400 rigs.  During the oil price collapse concurrent with the financial crisis, the oil rig count bottomed at 876 rigs in early June 2009, a level that is more than double of today’s rig count!  To say that the industry is in a severe depression could be an understatement.

The situation in Canada is also extremely depressed as we can see from the exhibit below.

Canada Rig Count Since 2003

The chart shows much more volatility due to seasonal factors in Canada that limit the level of drilling activity during the annual spring thaw.  However, it is obvious that the level of peak activity in 2015 was far below the peak level of any of the prior years in the chart.  Only 40 rigs were active in Canada on April 22, 2016, which is roughly half of the rig count one year ago.

Although the price of crude oil has recovered significantly since the lows of the first quarter, rig counts have not yet responded to higher prices perhaps because the current price of oil is still below the marginal cost of production for many E&P companies.  Additionally, many debt heavy E&P players are in severe financial distress and might not be in a position to quickly resume production unless prices rise significantly from current levels.

In contrast to the depressed state of the North American industry, the level of activity in international markets has not fallen as precipitously.  Baker Hughes publishes global rig count data.  Activity in certain locations with a low marginal cost of production, such as the Middle East, has shown no meaningful reduction.  However, with only 14 percent of MRC Global’s revenue coming from outside the United States and Canada, stability in international markets will not be a major factor in the company’s success in the near term.  MRC Global’s revenue will be highly sensitive to the future trends in the charts shown above.

Operating Performance

MRC Global had total revenue of $4.5 billion in 2015 which represents a 24 percent decline from 2014.  Revenue declined in all three of the company’s segments which are organized by region.  Canada was particularly hard hit with a revenue decline of 47 percent.  The exhibit below shows the company’s revenue broken down by geographic reporting segment:

MRC Global Revenue

The decline in revenue was also evident in all product lines sold by the company but particularly notable in the oil country tubular goods category.  This business is directly tied to drilling activity in the United States and is characterized by high volatility and extremely low margins.  MRC Global disposed of the tubular goods business in February 2016 and posted a loss associated with the disposal in 2015 financial results.  The exhibit below shows the breakdown of revenue by category in 2015.

MRC Revenue by Category

In general, the distribution industry is characterized by relatively low operating margins.  MRC Global has historically realized its best operating margins in the United States segment with more modest performance from Canadian and International operations.  During times of healthy drilling activity, such as 2012 through most of 2014, it appears that the company can generate operating margins in the 5 to 7 percent range.  In 2015, significant goodwill write-downs in the United States and International segments resulted in an operating loss.  Excluding goodwill impairments, the operating margin would have been 4 percent for 2015.  The exhibit below provides a summary of operating results since 2010:

MRC Global Operating Results

Gross margins have generally been in a range of 17 to 18 percent in recent years and management has indicated that gross margin in the high 17 to low 18 percent range is likely for 2016 as well.  The company’s income statements for the past seven years appear in the exhibit below.

MRC Global Income Statement

Free Cash Flow and Capital Allocation

One of the interesting characteristics of the distribution industry is that working capital requirements decline along with drilling activity which generates operating cash flow in years like 2015.  Both inventory and accounts receivable decline when business slows which makes cash available and provides some degree of operational flexibility.  The business has low capital requirements other than the maintenance of enough inventory to satisfy the demands of customers.  As a result, traditional capital expenditures are relatively minor.

As we can see from the income statements above, MRC Global posted a net loss of $345 million in 2015.  However, free cash flow was a positive $651 million.  The goodwill and intangible impairment of $462 million was a non-cash charge that turned what would have been an operating profit into an operating loss.  Additionally, both inventory and accounts receivable balances declined, partially offset by a decline in accounts payable.  Operating cash flow was $690 million and capital expenditures were $39 million.

Over the past five years, the company posted cumulative free cash flow of $919 million, well in excess of reported net income of $112 million.  A significant portion of free cash flow was used to fund acquisitions using $583 million over past five years.  It should be noted that the large goodwill impairments in 2009 and 2015 could be signs that management has overpaid for acquisitions in the past.  On the other hand, both impairments were taken in years when the price of oil declined to low levels and resulted in low rig counts.  Accounting rules require such write-downs even if long term prospects might be more favorable and goodwill that is written down can never be “written up” in future years.  Ultimately, management’s track record with respect to acquisitions will be measured based on free cash flow generation.

The exhibit below is taken from MRC Global’s investor presentation (pdf) at the BB&T Capital Markets 10th Annual Commercial & Industrial Conference on March 24, 2016 and illustrates the company’s use of cash flow over the past six years along with acquisitions since October 2008.

MRC Acquisitions

 

Capital Structure

MRC Global’s capital structure is currently less leveraged than it has been historically.  Management used the strong free cash flow in 2015 to pay down significant debt.  Additionally, convertible preferred stock was issued in June 2015.  Net debt was reduced by $974 million in 2015, a reduction of 68 percent.  Currently the only long term debt is a $524 million loan due in 2019.

Although balance sheet risk has been reduced over the past year, the terms of the preferred stock offering may not be favorable to owners of the common stock in the long run.  The 6.5% cumulative preferred is convertible into common stock at $17.88 per share.  While this is above today’s quote, it is likely that the preferred stock will eventually convert to common stock once rig counts increase and business prospects improve.  As a result, it is probably a good idea to simply assume dilution when analyzing the company.  The share count can be expected to increase by 20.3 million if the preferred stock is converted in full.  With shares outstanding of 102 million as of December 31, 2015, conversion would represent slightly under 20 percent dilution.

We would note that the working capital reductions that made strong operating cash flow possible in 2015 despite the industry downturn will certainly reverse once business conditions improve.  MRC Global will need to direct significant capital toward inventory and an increase in accounts receivable.  It appears that the company should have the financial flexibility to increase working capital once business conditions begin to improve although this might require adding leverage to the balance sheet.

Book value per share was $9.35 at the end of 2015 but tangible book value was close to zero so shareholders cannot rely on any tangible downside protection from a balance sheet perspective.  Shares recently traded at around $14 at a market capitalization of approximately $1.4 billion.

Conclusion

As the largest distributor of critical components and services to the oil and gas industry, MRC Global plays a very important role in the energy economy.  The business is highly correlated to drilling activity as represented by rig counts.  The collapse in energy prices caused rig counts to decline precipitously in 2015 (continuing into early 2016) and this had a major impact on MRC Global’s financial results.  However, management used strong free cash flow primarily generated through working capital reductions to deleverage the balance sheet.  A preferred stock offering, although potentially dilutive, further reduced the company’s risk profile.

MRC Global is not a wonderful business but it is an important business in a very important industry.  If rig counts remain depressed throughout 2016, MRC Global’s financial results will remain depressed as well and it is possible that further write-downs of intangible assets will be required.  Market sentiment would be negative under such conditions and the stock price is also likely to be correlated to the price of oil.  Eventually, supply and demand dynamics should result in a more normalized level of production in the United States and Canada.  The key question is when this “eventual” outcome will materialize.

As long as MRC Global does not face financial distress before a recovery commences, the share price should eventually recover along with industry activity.  The main risk appears to be a prolonged downturn with rig counts remaining at very low levels.  Investors who believe than energy prices will recover over the next couple of years might want to consider MRC Global, or other large distributors such as Now Inc., rather than investing in oil directly or through E&P companies.

Disclosure:  No position in MRC Global.

Microsoft’s Depressed Stock Price Attracts Flock of Value Investors

This is the sixth in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

At the turn of the century, few observers could have possibly foreseen that Microsoft would become a favorite bargain purchase for value investors in 2010.  The dot com boom was in the process of peaking and any company even vaguely associated with software or technology traded at stratospheric multiples of earnings.

Microsoft was certainly no exception.  The company earned $0.85 per share in fiscal 2000 and traded at well over fifty times earnings when Steve Ballmer assumed the CEO position in January of that year.  While the company has increased profits at a moderate clip and reached earnings per share of $2.10 in fiscal 2010, the stock price is now at well under half of the peak levels seen in 2000 and is firmly in “value” territory trading at ten times trailing earnings when adjusted for excess cash on the balance sheet.

Bargain Valuation Not Unnoticed

Microsoft’s bargain valuation has not gone unnoticed among value investors who have flocked to the stock in recent months.  Some of the prominent investors with significant positions in Microsoft include Arnold Van Den Berg, Wally Weitz, David Einhorn, Bill Miller, and Whitney Tilson.  (For a list of fund managers currently holding Microsoft stock, click on this link to view Dataroma’s database.)

Of course, the fact that many value investors have positions in Microsoft does not mean that it is intelligent to blindly follow but it is intelligent to use the positions of successful investors to generate ideas for further independent research.  In the case of Microsoft, the value becomes quickly apparent with a brief review of the key facts.

From Cutting Edge to Stodgy in Ten Years …

We presented much of the bullish case for Microsoft in a recent article regarding Steve Ballmer and will not repeat all of the details here.  To sum up the past decade, Microsoft continued to deliver strong results but suffered a downward revision in valuation so extreme as to deliver negative returns for investors who purchased stock a decade ago.  Earnings advanced from $0.85 to $2.10 over the ten year period which amounts to a compound annual growth rate of 9.5 percent.  During the decade, the company introduced a regular quarterly dividend and paid a one-time $3.00 per share special dividend in 2004.  Profit margins have declined over the ten year period but net profit margin of 30 percent in fiscal 2010 still signals the presence of a very strong franchise. (Download Value Line’s report on Microsoft for more useful statistics.  The report is one of Value Line’s Free Dow 30 stock reports.)

The main problem facing the company is the inability of management to profitably break into a new line of business beyond the core Windows and Office franchises.  Mr. Ballmer is facing a great deal of criticism regarding the failure of Microsoft to break into an entirely new line of business that will deliver new profit streams and potentially mitigate an eventual decline in the core Windows and Office franchises.

One cannot help but compare Microsoft’s performance to Apple Computer particularly given the fact that Apple recently overtook Microsoft in terms of market capitalization.  Steve Jobs has succeeded in creating entirely new categories of products such as the iPod and iPad and he revolutionized the mobile phone industry with the iPhone.  Meanwhile, Microsoft has introduced lukewarm products like the Zune music player and disastrous products like the Kin mobile phone that was taken off the market only months after its introduction earlier this year.  Even successful products like the XBox have not resulted in large sources of profit compared to the company’s core Windows and Office business.  Microsoft has obviously failed to break into new areas successfully and, as a result, the company has taken on a stodgy image.

But Count the Cash …

Despite the well publicized difficulties facing Microsoft, the company continues to generate significant cash flow and had approximately $36.8 billion of cash and cash equivalents as of June 30, 2010 ($4.12 per diluted share).  The company generated over $22 billion of free cash flow for fiscal 2010, paid $4.6 billion in dividends, and used $11.3 billion for share repurchases.  Microsoft is clearly still a cash flow machine. At a recent price of $23.47 and a market capitalization of $203 billion, the overall valuation of the company is clearly depressed.

Microsoft is even cheaper than the “headline” price/earnings ratio suggests when one considers the excess cash on the balance sheet.  The exact amount of excess cash is open to debate, but it appears that at least half of the cash on the balance sheet could be safely distributed to shareholders.  Adjusted for excess cash, Microsoft trades at ten times trailing earnings and less than nine times estimated fiscal 2011 earnings of $2.40 per share.

If someone had told you in August 2000 that Microsoft would be available for under nine times forward earnings one day, it is unlikely that you would have believed them.

Cloud Risks Are Exaggerated

Cloud computing is a long term threat that could erode Microsoft’s Windows and Office franchises over time.  Products such as Google Docs have gained some traction, but Microsoft still controls well over 90 percent of the office market.  The slow moving conservative nature of most information technology departments all but guarantees that Microsoft will retain a very large share in both operating system and office sales for many years to come even if cloud based solutions begin to take more share.

While Microsoft was initially slow to respond to the cloud computing threat, the company has not ignored the risks entirely.  Office Web Apps and related online services are intended to directly address the threat from solutions like Google Docs.  While Microsoft may not be entirely successful in retaining share on the cloud, many risk averse companies could be convinced to stick with a known quantity.  Making a move from desktop based Office products to Microsoft’s web solutions could be seen as a more conservative approach for IT managers concerned with career risk issues.

Tablets Beyond iPads

With three million iPads sold through June 30, Apple has proven that the tablet computer has finally arrived, but it would be a mistake to assume that Apple will “own” this market.  One very surprising aspect of the iPad’s introduction, apparently even to Apple executives, has been the adoption of the device in business environments.  The Wall Street Journal recently reported that businesses are adding the iPad as a rapid clip.  Some executives are using the iPad as a substitute for laptop computers for tasks such as email, reading documents, and even giving presentations.

One of the possible reasons behind Microsoft’s recent stock price weakness is the fear that the iPad will erode sales of traditional laptop computers running Windows.  However, it is very likely that business users have adopted the iPad as a supplement to their laptops rather than as a replacement. In addition, new tablets running Windows and Android will be released in the very near future.

There are some doubts regarding whether tablets are well suited to run Microsoft’s Windows operating system.  Although Windows 7 does have touch screen capabilities, will it provide a good user experience in the tablet form factor?  One potential solution may be the upcoming Windows Phone 7 software which is scheduled for release in October.  Windows Phone 7 has received some positive reviews (click here for one example) and may be better suited for tablet devices.

While no one can predict the market shares different players will have in tablet devices once the market matures, it is very likely that Microsoft will generate significant market share given the strength of Windows Phone 7 and the relationships the company has with corporate users.

Summary

Microsoft is one of the “least loved” companies in America today.  Investors have become disillusioned by the company’s failure to break into highly profitable lines of business beyond the core Windows and Office franchises.  The emergence of highly successful products such as the iPad have generated fears that Microsoft’s moat in operating system software may be facing a more rapid decline than previously assumed.  From an intangible perspective, Microsoft is simply no longer in fashion.

Despite the negative headwinds and many real challenges facing Microsoft, the company does not deserve to trade at current depressed valuations based on its demonstrated earnings power and formidable cash flow.  Windows and Office still have dominant markets shares and enjoy high margins that validate the presence of a significant moat.  The current corporate refresh cycle will help generate record earnings for fiscal 2011 and the company is not standing still in cloud computing, mobile phones, or tablets.  A company with this profile does not deserve to trade for nine times likely fiscal 2011 earnings.

Whitney Tilson summed up the bullish case very well in a recent presentation (pdf).  Mr. Tilson assumes fiscal 2011 earnings per share of $2.40 and assigns various multiples to arrive at a valuation (adjusted for cash/share of approximately $4).  At a modest 10x multiple, Microsoft should trade at approximately $28 per share which would imply an upside of nearly 20 percent from current levels.  A more reasonable 12x multiple would imply a share price of approximately $33 for an upside of 40 percent.  In addition, the company has a 2.2 percent dividend.  Barring an unprecedented collapse in Microsoft’s earning power over the next few years, the risk of permanent impairment of capital seems remote given the company’s current valuation.

Disclosure:  The author of this article initiated a position in Microsoft Corporation today at an average cost $23.67. This article is for entertainment and informational purposes only;  do your own research before making any investment decisions.

A Closer Look at Noble Corporation’s Q2 Results

Noble Corporation recently announced second quarter 2010 earnings of $218 million, or $0.85 per share.  The results were negatively impacted by a combination of lower utilization for the overall fleet and sharply lower average dayrates.  As a result, contract drilling revenues dropped to $687.5 million for the second quarter compared to $808.6 million for the first quarter.  Second quarter 2009 contract drilling revenues were $868.2 million.

We profiled Noble in some detail in early June when the shares traded at approximately $28.  After significant volatility in trading today, Noble shares closed up 4.6 percent at $32.06 on the earnings news despite failing to meet analyst estimates.  In this article, we will take a closer look at Noble’s quarterly results with particular attention devoted to trends on dayrates and Noble’s changing mix of revenues by rig type.

Revenue Trends by Rig Type

It is helpful to examine Noble’s revenue by rig type over the past ten quarters to get a feel for the dayrate and utilization trends.  The exhibit below provides average rig utilization, operating days, average dayrates, and contract drilling revenue for each rig type (click on the image to enlarge it).

Several facts are readily apparent from reviewing the data in the exhibit:

  • Jackup revenues are clearly in a declining trend due to a combination of lower utilization and eroding dayrates.  The average dayrate in the second quarter was $96,677, far lower than the dayrates in the $140,000 to $160,000 range that prevailed during 2008 and the first three quarters of 2009.
  • During 2009, semisubmersible rigs capable of drilling in waters over 6,000 feet produced higher revenues that largely offset the decline in jackup fleet revenues.  However, dayrates for these rigs have been under pressure during the second quarter.
  • Overall fleet utilization has dropped from 94 percent to 80 percent over the ten quarter period.

The following chart shows the revenue contribution of each rig type in a more visually intuitive format and clearly highlights the diminishing contribution of the jackup fleet and the growing importance of sophisticated semisubmersible rigs:

Drilling down to the revenue for the second quarter, the chart below shows the contribution of each rig type to overall contract drilling revenues:

Clearly, the negative sentiment surrounding the Deepwater  Horizon disaster and the Federal Government’s regulatory response has taken a toll on Noble’s second quarter results, but it is also important to note that the decline in overall revenues actually began in earnest during the first quarter prior to any hint of difficulties in the Gulf of Mexico.  The notable change in the second quarter is the precipitous drop in average dayrates for both advanced semisubmersible units and jackups.

Despite the negative trends that have taken shape so far this year, Noble posted net income of $589 million, or $2.28 per share, for the first half.  During the first half, the company generated slightly over $1 billion in net cash from operating activities while investing $490.7 million in new construction and other capital expenditures.  Also, at the end of the quarter, Noble announced the acquisition of Frontier Drilling and a significant agreement with Shell.

Outlook

Noble held a conference call (available for replay at this link through July 27, or read the transcript) for investors today and most of the questions in the Q&A session were related to the outlook for dayrates and utilization in the wake of the negative regulatory climate caused by the Deepwater Horizon disaster. The company also released a fleet status report (pdf) on July 8.

While the company has been able to secure additional work for several jackup units around the world, it is notable that the extensions generally have lower dayrates.  With the exception of the Noble Roy Butler in Mexico and the Noble Hans Deul in the North Sea, all of the newly announced contracts for jackup rigs are at lower dayrates than the contracts they replace.  In some cases, the new dayrates are dramatically lower:  For example, the Noble Gene Rosser in Mexico was on a dayrate of $171,000 until June 19 and was recently extended through December 2010 at a dayrate of $80,000.

The deepwater situation in the Gulf of Mexico remains uncertain due to the moratorium as well as questions regarding the higher cost structure that will inevitably come from tighter regulations if operations are allowed to resume.  The good news is that Noble has been able to negotiate standby agreements with most customers.  The bad news is that the standby dayrates are substantially lower than operational dayrates and appear to limit the ability of the company to relocate rigs to other parts of the world.  Additionally, the company is involved in litigation with Anadarko over a force majeure dispute regarding the Noble Amos Runner.  While the litigation is in progress, Noble is not collecting the $440,000 dayrate for the Amos Runner, although some recovery might be possible in the event of a favorable court ruling.

Summary

There is no doubt that Noble Corporation has suffered along with the rest of the offshore contract drilling industry due to the regulatory uncertainty in the Gulf of Mexico and what appears to be a general trend toward lower dayrates particularly in the jackup fleet.  However, despite these setbacks, the company remains highly profitable and was able to leverage a strong balance sheet in an opportunistic acquisition of Frontier that doubles contracted backlog going forward.  This acquisition should close by the end of July.

Whether Noble represents a good investment at current prices depends greatly on the investor’s time horizon and tolerance for price fluctuations in the short run.  The $8.2 billion market capitalization of the company compares favorably to free cash flow that is likely to exceed $1 billion this year.  With an eventual recovery in dayrates and the contribution of the Frontier acquisition, free cash flow should eventually exceed the peak levels of 2009.

While the most prominent risk to the bullish thesis at the moment is the regulatory climate, the larger economic risk would be associated with a period of sustained low oil prices that would make deepwater exploration uneconomical.  However, with energy use in the developing world growing rapidly (For example, China recently surpassed the United States in energy usage), it seems highly unlikely to expect oil prices to drop significantly over the next five to ten years.

Disclosure:  The author owns shares of Noble Corporation.