Patterson-UTI Energy, to Hate or to Like?

Investors in Patterson-UTI Energy (PTEN) and other land drillers are at crossroads now. Bears continue to argue about the drill rig overcapacity, the bleak outlook this year, and the perceived anemic growth in the years that follow. On the other hand, the few "remaining" bulls and value investors are pointing to the attractive valuation and the solid fundamental still in place now.

Competing to benefit from the strong commodity prices, land drillers have raced to add drill rigs in the past few years. According to RigData, the average weekly (operating) land rig count increased from 1213 in Jan. 04 to 2018 in Nov. 06, a 66% increase in less than three years. This inevitably led to the oversupply of drill rigs; and rig count (and day rate) finally began to head south in December (See Fig. 1).

Not surprisingly, the rig overcapacity has been widely predicted by the Wall Street. Since early 2006, PTEN has registered nine analyst downgrades as tracked by Briefing.com. In the past three or so months alone, analysts revised the FY07 EPS estimate downward from $3.73 to $2.52. And the current EPS estimate $2.52 represents a 37% drop from the $4.02 reported for last fiscal year, FY06.

Correspondingly the "smart money" exited the stock wave after wave. The April 24 market close of $24.17 was a 37% correction from the peak price of $38.49 back in Jan. 2006. This compares to the Oct low of $20.81, which was a 46% correction from its peak. Practically the mass exodus appears to have abated since last October.

This almost seven-month-long period of price stabilization likely suggests that the worst with this stock is now over. So it could be a good time to think about reasons to own this stock.

What makes me feel comfortable about owning PTEN is that I know I'm buying into a financially sound, quality company, albeit in a cyclic industry. Thanks to the great energy boom since the turn of the century, PTEN has recorded a positive (and often impressive) free cash flow for six years in a row.

2006 was a particularly impressive year in which the company spent $597M in capital expenditures plus $46M in dividend distribution, and yet still was left with $193M of free cash flow. That was part of the reason why they were able to buyback $450M of stock in the year. The ROE (return on equity) and ROC (return on capital) were 46% and 44.2%, respectively. ROE and ROC were close because PTEN's long-term debt was insignificant relative to equity.

I have to admit that this is all history now and the unpleasant side of owning this stock is in the cyclic nature of its business. If the 44.2% ROC has made the management look brilliant last year, then the -5% ROC in 1999 could very well have made them appear sloppy. And what do you think about the YoY revenue growth of 46.3% last year versus -18.8% in 1999?

However, the good days have also prepared PTEN well for any possible bad days. As of end FY06, PTEN has a current ratio of 2.1, quick ratio of 1.6, and accounts receivable turnover cycle of about 65 days. And I have no reservation at all on the company's own liquidity assessment in its recent 10-K filing:

"We believe that the liquidity shown on our balance sheet as of December 31, 2006, which includes approximately $335 million in working capital (including $13.4 million in cash) and $195 million available under a $375 million line of credit ($120 million in borrowings are outstanding at December 31, 2006 and availability of $60 million is reserved for outstanding letters of credit) provides us with the ability to pursue acquisition opportunities, expand into new regions, make improvements to our assets, pay cash dividends and survive downturns in our industry."

Also thanks to the historic growth, PTEN has emerged as the second largest land-drilling contractor in this country. And in fact for the most recent quarter (Q1 2007), PTEN ranked No. 1 across footage drilled, well starts, and directional wells. PTEN drilled 8,920,908 feet (14.0% of total) vs. No. 2 Nabors Drilling's 5,574,886 feet (8.8% of total) in the quarter. It also recorded 985 well starts (10.7% total) vs. Nabors' 595 (or 6.4% total). And PTEN's directional wells drilled were 325 vs. Nabors' 282. For a highly segmented industry (100 drillers ranked by RigData), PTEN's 14% share of total footage drilled is nothing short of impressive.

The reverse correlation between PTEN's (and other rig operators') financial performance and stock price in 2006 appears to be a classical example of stock market acting as an anticipative mechanism of business fundamentals. In this case, the market was discounting the downturn in 2007 rather than the uptick in 2006. Now with the drill rig overcapacity anticipated to be worked out by 2008, the market this year (2007) is likely to look forward to the recovery a year later.

If you find this hard to believe, here is the market anticipation mechanism at work in PTEN's history. In Fig.2 I have plotted PTEN's year-end (YE) closing price together with EBITDA per share (split adjusted) for the period 1994 through 2006. In 2001 (which is between YE 2000 and YE 2001 on the chart), EBITDA per share more than doubled from $1.11 to $2.33 while the stock price lost 37% from 18.19 to 11.38. But what happened in the following year 2002 was exactly opposite. EBITDA took a 74% nosedive while stock gained a handsome 29% simply because the market was looking forward to the good years that would lie ahead. In rear view mirror, 2006 behaved similarly to 2001. And that should prompt you to ask if 2007 could behave similarly to 2002.

During the period plotted in Fig.2, out of the four EBITDA down years (95, 98, 99, and 02) only one (98) was down for the stock. The other three years (95, 99, 02) were accompanied by stock price appreciation, obviously in anticipation of better business outlook in the years that would follow.

In recent years, PTEN's stock price has tracked natural gas (NG) wellhead price almost perfectly. Fig. 3 plots year-end NG wellhead price and PTEN's YE stock price from YE 1993 through YE 2006. It is hard for you not to notice the amazing coincidence of the two price movements following the turn of the century (i.e. after YE 1999 on the chart). As such, one might be able to take clue from NG price outlook for PTEN's (and maybe other drillers' as well) stock performance going forward.

EIA has recently projected the Henry Hub spot price to average $7.83/mcf in 2007, a $0.89 increase from the 2006 average, and $8.11/mcf in 2008. It appears reasonable to expect similar price recovery for NG price at the wellhead which PTEN stock price tracks closely.

Yes, the NG price will be recovering in 2007 and 2008. And so will be PTEN's stock price!

Disclosure: author is long PTEN as of this writing.