Trican Well Service (TCW-TSX) : Highly Levered, Still Overvalued.
Recommendation
I recommend shorting Trican Well Service (TCW-TSX), an oilfield services company, which currently trades at $ 3.98 per
share, because it is currently overvalued by approximately 25-40%. The company
released its earnings last week and missed analysts’ expectations.
The company is highly levered and is expected to breach its
interest coverage ratio at some point during H2/15 and Q1/16. The high debt
levels in a sluggish industry combined with increased competition and a new NDP
government in Alberta, will lead to a decline in the operating income, increase
in the taxes, decrease in the working capital and a decreased free cash flow.
These factors would lead to a decline in the intrinsic value of the company
from a Discounted Cash Flow perspective.
The company is currently contemplating the sale of its
Russian operations to deal with its liquidity issues. Additionally, it has
taken other cash containment efforts such as suspension of its semi-annual
dividend, cutting jobs as well as ring fenced its fleet to minimize capital
expenditures.
Key investment risks include increase in commodity prices
leading to an increase in activity and decrease in competition leading to higher
margins, and company not having to sell its Russian operations along with an
appreciation of the ruble leading to increase in both the top and bottom-lines.
We can mitigate these risks via call options and by setting a
strict buy-stop order after shorting the company’s stock
Company Background
The company is engaged in the provision of specialized
products, equipment, services and technology for use in the drilling,
completion, stimulation and reworking of oil and gas wells in western Canada,
Russia, Kazakhstan, the United States, and Algeria.
It is currently trading at 11.5 x 2016 E EV/EBITDA which is
higher than its North American peer group average of 9.1 x.
Investment Thesis
The stock
price has declined by 14% following the Q1 earnings release, but I believe the
stock price will go even lower due to the following reasons:
- The company is highly levered and is expected to breach its interest coverage ratio covenant at some point during H2/15 and Q1/16. At the end of Q1/15, Trican held $61 million in cash and had undrawn borrowing capacity of ~ 290 million. However, in order for the company to draw upon this borrowing capacity, it would need covenant relief. Inability to access the borrowing capacity could negatively impact operations, thereby negatively impacting the operating income and the valuation of the company from a Discounted Cash Flow model.
- Trican has $120 million in principal obligations due next year and remains highly levered as it currently had $667 million in debt at the end of Q1, 2015. The austerity measures taken by the company in terms of cutting the dividends, cutting jobs and potential sale of international business may not be enough. There is a risk that the company may go offside on its covenants again and the company can face liquidity challenges later in the year, thereby negatively impacting the free cash flow available and intrinsic valuation of the company.
The
company’s US business has underperformed even during the best times. During
these times, especially, the market is significantly overcapitalized and
although a slight recovery in oil prices is expected, it would not be enough to
overcome excess capacity. Therefore, this would lead to a decrease in margins
as company competes with other players, and these factors would negatively
impact the share price.
The
victory of the NDP in Alberta and its policies on increasing the corporate
taxes and royalty review will impact the company’s bottom line negatively,
further driving share price down.
These
reasons are significant as they directly impact the company’s valuation not
only from a Discounted Cash Flow but also a Public Company Comparable approach.
Even if one of these factors ends up making an impact, there is a significant
upside in shorting this stock.
Catalysts
Catalysts in
the next 6-12 months include, the sale of the Russian operations, increased
competition, and sale of other North American assets.
- Management is currently working with lenders to obtain this covenant relief, and the potential sale of the Russian/Kazakhtsan operations could increase the complexity of management’s discussions with the company’s lenders. Therefore, there is a risk that the Russian operations are sold at less than their true value/ expected prices in order to meet interest coverage covenant. Additionally, demand in Russia is expected to grow and the sale of these operations would lead to foregoing that revenue. These factors could drive the current share price further down.
- In an effort to contain its costs, the company has ring fenced ~35% of its domestic fleet and ~50% of its US fleet to minimize sustaining capital expenditures and remains open to the idea of selling its North American assets, should attractive bids emerge. Due to the increased competition, high debt levels and sluggish industry, it is possible that the company may be required to sell these assets at a loss to overcome its liquidity issues. This will in turn impact the stock price and send a negative signal to the markets.
Valuation
I performed a DCF calculation for FY 2015 E to FY 2019 E
using both a multiples method as well as a Gordon growth method. For the purpose of my calculations, I made
the following assumptions:
- I used a WACC rate of 10% , which is a reasonable rate considering the company is highly levered.
- I looked at the Historical actual statements for FY 2012 till FY 2015 Q1 to make some operating assumptions, such as revenue growth %. I considered the current state of the industry and looked at company’s MDA to ensure assumptions were accurate.
- I performed sensitivity analysis for both the models using a range for the WACC from 10% to 16% and Terminal EBITDA multiple range from 3 x to 8 x. I considered prior periods EV/EBITDA to arrive at this range of 3x to 8x.
Based on the above analysis I got a range of values, which
allowed me to conclude that the company is currently overvalued by
approximately 25-40%.
Risk factors and how to
mitigate them
- Management does not believe that the company’s covenant relief is contingent upon its potential sale of the Russian/ Kazakhstan operations. The company has taken some positive measures such as suspending its semi-annual dividend, which would save the company $45 mm/ year and has also received an unsolicited offer for its Russian and Kazakhstani pressure pumping business for an undisclosed offer price (likely $200 mm). Additionally, Trican has cut 2,000 jobs to save costs. It is always a possibility that the company may be able to get a covenant relief and may not have to sell its Russian operations. The Russian operations form a significant part of the company’s backbone and the demand in Russia is expected to grow. If the ruble appreciates or the weak ruble is offset by a strong demand, and the company has not sold off its operations, it would lead to a positive topline and bottomline for the company, which could drive the prices up.
- It is possible that the oil and gas prices recover significantly, triggering an increased activity and thereby eliminating the current competitive landscape. This in turn could improve the top and bottom line for the company and eliminate its liquidity issues and drive its share price up.
We can mitigate these risks via call options and/or to set a
strict buy-stop order in the $4.75-$5 range to limit our potential losses to
approximately 20-25% (versus the potential upside of 25%-40%).
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