Key Energy Services – a punt worth making

Key Energy Services (KEG) is the largest US onshore rig-based well servicing contractor based on the number of rigs owned. Its business consists of helping US onshore oil and natural gas producers get their produce out of the ground. It supports producers throughout the lifecycle of a well – including assistances with drilling and completing new wells, maintaining and working-over producing wells and assisting with plugging and safely abandoning dead wells. However, most of its revenue (~80%) come from production driven services (e.g. maintaining and working-over existing wells). Its services are highly correlated to the WTI crude price because its customers decide their capex commitments based on crude price.

Like a number of its peers, KEG ran up too much debt in the lead up to the collapse in the oil price. FY15 and FY16 has been terrible to its finances which resulted in KEG having to enter chapter 11 bankruptcy in October 2016. It emerged from bankruptcy in mid-December 2016 and has since relisted in NYSE.

The rebound and stability in crude price in the past year has meant that the oil capex cycle is finally turning up. The market anticipates this of course - in the US, the S&P 500 oil equipment and services index, which holds some of the world’s largest service companies, has risen well over 20% in the last year. Valuations have hit near historic highs with the sector trading at an EV/EBITDA multiple of 10 to 11 times.

However, the smaller US players emerging out of bankruptcy don’t appear to have benefited from the uptick in market’s sentiment. And herein lies an opportunity. KEG looks particularly appealing.

KEG has emerged a leaner more focused business post-bankruptcy

-        KEG’s balance sheet has delivered significantly with debt falling from $1bln to $250m;

-        KEG has retrenched from almost all non-US operations (bar Russia where a sale is actively being sought) and is now solely US focused. Overseas operations were EBITDA negative and the real opportunity lies in the US onshore market so the retrenchment is EBITDA positive and augurs well for the future;

-        KEG has significantly cut its annualised G&A from $250m to $100m as part of its organisation wide restructuring exercise. For example - its reduced cost structure would have resulted in EBITDA margin of 17.8% on its FY14 revenues (resulting in an EBITDA of $255m from the actual $124m achieved under the old cost structure).  

Oil price rebound and stability offers multiple growth drivers for demand

-        KEG’s revenues are highly correlated with the number rigs active in the US onshore oil sector; the rig count in turn is highly correlated with WTI crude prices.

-        The median crude oil WTI futures forecast for FY17 of 32 banks comes to $55.63. Whilst it’s impossible to forecast oil prices too far down the line, most estimates support a WTI price of $60 from 2018 - 2021.

-        At $55 a barrel the total economic vertical oil wells in the US is forecast at 196,383 (which is a 35% increase in the US population of economic oil wells compared to economic wells at $40 a barrel price). KEG forecast’s an increase in working rig count of 105% at $55 oil compared to the rig count at Nov 16.

-        The rig count increase should have a direct positive impact on revenues for KEG as it is the largest rig based well servicing contractor in the US. The demand for KEG’s services should come from multiple sources – including increase in well activity for existing wells, demand for well maintenance which has been deferred over the last couple of years, and the aging population of horizontal oil wells which should support material incremental rig demand over the next few years.

KEG’s valuation looks appealing

Based on the most recent share price of $25.45, KEG has a market cap of $511.46m; adding debt and other long-term obligations of $301m and subtracting cash of $90.5m, I get an EV for KEG of $722m. My forecast for EBITDA over the next 12 months comes to ~$166m, giving KEG a forecast forward EV/EBITDA multiple of just over 4. This looks cheap compared to the median EV/EBITDA multiple of ~10 to 11 times for the sector as a whole.

The big issue in analysing KEG (as with most commodity companies) is forecasting revenues. As already discussed, KEG’s revenues are highly correlated with rig demand and oil prices (see table below).

I have pulled the above table using information in KEG’s last 5 year financials. The table is revealing and shows how KEG’s revenues have fallen with the fall in rig count due to falling oil prices. The falling rig count and demand has also impacted KEG’s pricing power with revenue per active rig falling to ~$1.3m for FY16 compared to revenue per active rig of ~$1.7m in FY13 and ~$2m in FY14.

The positive for KEG is its lean cost structure post-bankruptcy; therefore any uptick in revenues augurs well for EBITDA.

To forecast next 12 months revenue, I have assumed revenue per active rig of $1.67m and an active rig count of 511 rigs which is the sum of KEG’s active and warm stacked rigs as at December 2016 (warm stacked rigs are rigs which can come to service with limited repair). My revenue forecast per active rig is roughly the average revenue per active rig achieved over the past 4 years; I believe this is a conservative forecast based - KEG has been actively reengaging with customers on pricing as demand recovers and revenue per active rig should recover from FY16 and FY15 levels.

Based on my forecast revenue per rig KEG could hit total revenues of ~$931.3m over the next 12 months, with an EBITDA of ~$166m (at an EBITDA margin of 17.8% supported by KEG’s revised cost structure). Applying a conservative EV/EBITDA multiple of 5x to my forecast EBITDA gives an EV of ~$829m for a 21% return on current share price.

Indicative returns for a number of revenue per active rig count and EV/EBITDA scenarios is shown in the table below. 

There is high uncertainty no doubt – the oil price could be any number. But most forecasts support an improvement from the lows of last two years which should support increased rig service demand from US onshore producers. Add to this KEG’s significantly delivered balance sheet and low cost structure post-bankruptcy, and things start to look appealing from a risk:reward perspective. While the wider oil services sector has been swept up in the euphoria of forecast demand, KEG continues to be unloved and trades at deep discounts to the sector. It offers a decent bet on a recovery in US domestic oil market.