Superior Energy: Well-Positioned
We believe that Superior Energy Services' (SPN; recent price, $30) will outperform its industry peers given its strong position as a niche provider of production-related oilfield services in the Gulf of Mexico, with the ability to offers its services over the full life cycle of producing wells. We believe that the company enjoys certain competitive advantages that make it time-consuming for others to replicate its business model.
In our view, Superior is well-positioned to benefit from a secular trend toward greater production enhancement in the U.S. Gulf of Mexico and offers an attractive value proposition to oil and gas operators. Furthermore, a planned acquisition, if approved, provides a potential catalyst for significant earnings growth starting in 2007, in our opinion. These factors, combined with what we view as a compelling valuation based on our intrinsic and relative analyses, lead us to rank Superior 5 STARS (strong buy).
Superior, headquartered in Louisiana, focuses mainly on the production-related needs of offshore Gulf of Mexico oil fields, with land-based service offerings as well. Products and services include rental tools, liftboats, well intervention services, plug and abandonment (P&A) services, and well decommissioning.
COVERS THE BASES.
In addition, Superior acquires and exploits offshore Gulf of Mexico oil field properties through its subsidiary, SPN Resources. The company also offers its rental tools in certain international markets, including the North Sea, West Africa, and the Middle East.
Superior offers a variety of products and services that, in our view, are built to withstand the vagaries of the energy cycle, from a geographic standpoint (with expansion into international markets), from a functionality standpoint (with the ability to assist in either maintaining well production, or decommissioning such wells), and from a cyclical standpoint (by possessing its own portfolio of properties, available for work in periods of low demand by external customers).
We also view Superior's collection of products and services as time-consuming and difficult to replicate, which offers, we believe, a competitive advantage. The energy industry tends to be extremely conservative due, in part, to the high opportunity costs created by unexpected downtime. Superior's ability to act as a "one-stop shop" for production-related needs reduces logistical complications for customers, and, by our analysis, its strong reputation with customers can only be matched by competitors over time—,if at all.
As of Jan. 1, 2006, Superior had four reportable business segments: well intervention (46% of 2005 revenues, and 25% of 2005 operating income), rental tools (33%, 51%), marine (11%, 20%) and oil and gas (11%, 3.9%).
The well intervention segment offers P&A work, coiled tubing services, well pumping and stimulation, data acquisition, gas lift services, wireline services, hydraulic lifting and workovers, well control services, and ancillary services such as contract operations and maintenance, transportation and logistics, engineering support, and technical analysis.
The rental tools segment rents and sells stabilizers, drill pipe, tubulars, and specialized equipment used in drilling, completion, and workover activities. The marine segment owns and operates a fleet of 26 liftboats for production service activities, production facility maintenance, construction operations, and platform removals.
The oil and gas segment (SPN Resources) acquires mature oil and gas properties and produces and sells any remaining economic oil and gas reserves prior to the commencement of decommissioning services by Superior's other business segments. In 2005, Hurricanes Katrina and Rita combined to significantly reduce daily production from SPN Resources' producing wells. Pre-storm third-quarter 2005 production averaged in excess of 7,000 barrels of oil equivalent (boe) per day, and dropped dramatically following the storms.
Although these storms did adversely affect the oil and gas segment, Superior's production-related services businesses, particularly its well intervention segment, experienced considerable incremental demand stemming from the storms. A similar pattern was seen in 2004 due to Hurricane Ivan, although the extent of the damage from Ivan was smaller than that from Katrina and Rita. Barring further hurricane damage in 2006, we expect SPN Resources to return to pre-storm production levels during 2006.
In May, 2006, Superior announced an agreement to acquire a 40% stake in the overall reserve value in Coldren Resources, for up to $70 million. If approved, Superior expects that the deal could generate incremental oil field service revenues of at least $165 million, which excludes the potential equity income from oil and gas production.
We believe that the approval of the planned Coldren deal would result in pretax income derived from oil and gas production (whether derived via the SPN Resources segment or as equity income) in the 10% to 15% range for the company in 2007, somewhat higher than in 2005, but mitigated by the incremental oil field services business associated with Coldren.
Other potential catalysts include expansion of service offerings into more international regions, including West Africa, the Middle East, and the North Sea.
Based on continued high projections for oil and natural gas prices and continued high levels of capital spending by exploration and production companies, we project that the company will increase total revenues by approximately 45% in 2006, and an additional 20% in 2007. In the marine segment, we project that rental dayrates for liftboats will continue to rise, buoyed by high demand, and we expect average daily liftboat revenues to approach $430,000 per day by late 2007, well above recent levels.
We anticipate strong growth in rental tools demand with the growth of these services in international markets such as the North Sea, Venezuela, West Africa, and the Middle East, as well as expansion of rental tools in certain domestic land drilling regions, such as the Barnett Shale and the Rocky Mountains. In the well intervention segment, we project continued high demand, due to the natural acceleration of decline rates in the Gulf of Mexico, as well as incremental demand from hurricane repairs, which, according to Superior, could take three to five years to complete.
Overall, we see earnings per share (EPS) of $2.30 in 2006, and $3.17 in 2007. Both estimates exclude the potential benefit from the proposed Coldren deal, which we project could add 11 cents to EPS in 2006, and 35 cents in 2007, if the transaction is consummated.
Superior adopted accounting standard FAS 123R beginning Jan. 1, 2006, thus expensing stock options on its income statement. We estimate stock option expense of 7 cents per share for 2006 (included in our estimates of selling, general, and administrative expense), in line with recent pro forma stock option expenses. The company does not offer a defined benefit pension plan, thus, we do not expect S&P Core EPS to be materially different from operating EPS in 2006.
Our intrinsic value estimation is derived by calculating a sustainable growth rate for the company for the next 10 years, plus a terminal growth rate. We then discount the resulting free cash flows by the estimated weighted average cost of capital. We assume that after-tax earnings before interest and taxes (EBIT) growth of 8.0% per year for 10 years is readily achievable for Superior. Beyond the 10-year mark, we assume a terminal growth rate of 3%.
Other factors affecting our estimated free cash flows include net capital spending and changes in non-cash working capital. Over the past 10 years, Superior's capital spending has modestly exceeded depreciation, averaging net capex of about $20 million per year. For 2006 and 2007, however, we expect net capex to rise considerably as Superior embarks on geographic expansion, invests in more production enhancement services, and completes the construction of its new derrick barge.
Over time, however, we expect that Superior will reduce its net capital spending number back to historical levels. Changes in non-cash working capital have averaged about $11 million per year since 1996; we expect an increase in 2006 (to about $30 million), followed by a decline in 2007. Overall, for 10 years, we estimate free cash flow growth of approximately 14% per year.
Our estimates call for a weighted average cost of capital of 11.3%. Applying this cost of capital to estimated free cash flows yields an intrinsic value of about $40 per share.
Given the focus on production-related work, which we view as more stable and less cyclical than drilling-related services, and given Superior's strong track record of return on capital employed, we believe that the stock merits a slight premium to its peers.
Currently at a 6.0 times multiple to our estimated 2006 earnings before interest, taxes, depreciation, and amortization (EBITDA), Superior is trading at a 10% discount to the peer group average of 6.7 times. Using an 8.5 times multiple (slightly above the 7.9 times projected peer average), we arrive at our 12-month target price of $42 per share.
On a price-to-operating cash flow basis, Superior trades at a 6.2 times multiple, about 20% below the 7.9 times peer group average. Using a 9.5 times multiple on projected 2006 operating cash flows—also a slight premium to the group—yields a value of $45 per share. Blending these relative valuation metrics with our discounted cash-flow model yields a 12-month target price of $42 per share.
We believe that Superior's corporate governance practices are generally sound. Independent outside directors represent four of the six seats on the company's board, and board members are slated for reelection annually. The audit committee is comprised solely of such outside directors. All outside directors have a sizable equity component to their compensation, in the form of restricted stock, which vest to the outside directors either upon the termination of their directorship, or upon a change in control of the company.
However, we note that the threshold for awards under the long-term compensation plan to key executive officers is set at the 40th percentile (i.e., slightly below the median) relative to Superior's selected peer group of 12 companies.
Risks to our recommendation and target price, in our view, include events that would cause substantial declines in oil and gas production activity, particularly in the U.S. Gulf of Mexico. Other risks include the potential for a rising supply of modern liftboats to compete with the company's fleet, which may suppress dayrate growth; an increase in labor and equipment cost inflation; and a longer-than-expected recovery period for the company's oil and gas properties from prior hurricane damage.