Weatherford International: Supportive Economics With Price/Value Gap

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In 2024, we are seeking diversified exposure to commodity sub industries via differentiated operators with attractive economics.Weatherford International is well positioned to unlock risk capital for ...

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We are looking for 1) differentiated operators, that 2) present with mouthwatering economics, and 3) aren't necessarily correlated 1:1 with commodity pricing, but have exposure nonetheless. Our bottom up fundamental research has led us to Weatherford International (NASDAQ:WFRD). Based on analysis of the facts, WFRD is well positioned to continue unlocking risk capital for its equity holders into the coming one to 3 year periods in my view. My judgement is the company is worth $141/share in the base case, with upside to this if it continues increasing operating margins. Net-net, I rate WFRD a tactical buy. Background fundamentals WFRD is in the energy services business. It provides equipment and services to a range of oil and gas companies, anywhere from drilling, evaluation, well construction and so forth. Its footprint is in 75 countries across 340 locations. The company operates across 3 divisions: (i) drilling and evaluation, (ii) well construction, and (iii) production and intervention. Its drilling and evaluation business offers managed pressure drilling, drilling services, plus wireline and drilling fluids for customers. This includes early well planning, reservoir management and access to engineering to help productivity. Meanwhile, the well construction line offers Well integrity assurance services. Finally, the production and intervention business helps customers isolate productive hydrocarbon zones and unlock reserves in conventional and unconventional Wells (including deepwater and ageing reservoirs). After emerging from bankruptcy in 2019, the company produced $3.6 billion in sales the following year (Seeking Alpha analyst Fluidsdoc has an excellent appraisal on this about as well - I encourage you to check it out here). It has grown sales substantially since then, and clipped $5.13 billion in top-line revenues in 2023 on pre-tax income of $820 million in 2023. Industry outlook The global oil field equipment and services market is expected to grow at a compounding rate. Consensus projects higher than industry revenue growth rates for WFRD over the next three years, indicating it may capture additional market share. The key driver to the industry's growth is the increasing demand for global energy, and the energy transition. Centres such as India and China, alongside the electrification of vehicles energy, and so forth, are major global forces. When I think of global energy demand over the coming three years, electricity demand is expected to rise by an average 340 basis points per annum until 2026. Electrification is also needed to meet the world's decarbonisation targets, plus, the International Energy Agency predicts that electricity consumption from data centres, artificial intelligence, and cryptocurrency mining could double during this time. And when I think of where this demand is set to stem from, more than 4/5 of this uptake is set to be absorbed in emerging economies, most of which will utilise oil and gas. The industry outlook is favourable to WFRD in my view. Company differentiating factors WFRD differentiates itself amongst an industry with commodity economics by providing services to (that is, \"selling into\") the industry, rather than competing on the product/commodity itself. Industries with commodity like economics involve product or service that are undifferentiated by any customer important way. This is explicitly true in the oil and gas industry. At the end of the day, everyone is selling oil and gas, and the market sets the price, which guides offtake agreements and contractual obligations. Therefore, oil and gas majors and minors are price takers on the market pricing of the underlying, and in that business, returns are awarded to the low-cost producer and/or those with production advantages. Because WFRD sells its service into the industry, it enjoys consumer advantages. This means it can book higher operating profits relative to capital employed, and sell its offerings higher than average. This provides the company with a competitive advantage at the margin. It enjoys a higher gross profit margin than the industry (34.3% versus 29.5%, and a more than doubling of the industry average pre-tax margin (16.4% versus 7.6%). Figure 1 Company filings, Bloomberg. Figures are in a TTM basis. With favourable pricing on oil projected ahead, my judgement is that WFRD has an extensive reinvestment runway in which it can plough back attractive free cash flows into the business. I believe this cash will be produced from the combination of 1) high earnings relative to capital invested in the business, and 2) minimal incremental capital requirements in order to maintain its competitive position and grow earnings overcoming 1 to 3 years. Downside risks to investment thesis The following risk factors must be implemented into investor's reasoning:  Whilst Market pricing for oil and gas has remained buoyant across 2024, lower pricing will correlate to lower trends in exploration and production investment. This is important because rig counts in the industry display covariance with exploration and production spending. So if the floor of the underlying falls out of the market, this could impact the company's stock price. Interest rates continue to be a factor for all companies operating in highly regulated, capital intensive industries. These companies are usually partially funded by debt, and a higher cost of capital means higher debt service ratios for these companies. This cannot be ignored for WFRD along with the entire industry. The company now trains at reasonably high multiples relative to the sector. If it does not hit intended targets moving forward, there may be a resultant multiple contraction and this could impact the valuation thesis.  Should know these risks in full before proceeding any further. Figure 2 Tradingview Factors driving bullish thesis Q1 FY 2024 insights It was a strong period of business for the company in Q1. WFRD put up $1.36 billion in revenues, up 15% year or year. Critically, international revenues were up 21% on the prior year. This adds to our thesis, given we are looking for companies with high international revenue exposure, to reduce US economy beta. WFRD fits the bill here. It pulled this down to operating earnings of $233 million, up 26%, and operating cash flow of $131 million. It paid down $167 million of its secured notes that currently yield 6.5% to maturity as I write. After all debt repayments, the company has $1.6 billion in long-term debt, the earliest maturity 2030. It also has $371 million of available liquidity under its credit facility. The divisional highlights were as follows:   Well construction and completions: The company booked for 150 $8 million in sales for the segment, up 9% year-on-year on a 26.2% EBITDA margin, 340 basis points decompression.   Drilling and evaluation. The DRE business put up $422 million in revenues on $130 million in adjusted EBITDA, growth of 13% and 20% year-on-year respectively. Growth was underlined by wireline activity in the Americas.   Product intervention It booked $348 million in product and intervention sales, flat on the previous year. It recognised a 21% margin on this, with 150 basis points year and year lift off. Operating income was up around 7% on the previous year.   As a result of the strong quarter, management raised EBITDA margin guidance for the full year. It now projects adjusted EBITDA margins of 25% on double-digit revenue growth. Management estimate that capital expenditures will fall to 5% of forecasted revenue, producing around $500 million in operating free cash flow. My view of these first quarter results is that they are both strong and indicate the momentum WFRD company is exhibiting. This plays in to my bullish thesis. Additional fundamental economics adding to the picture According to Wall Street, strong earnings growth is projected off reasonably flat forecast sales growth over the next three years, indicating potential increase in operating margins (margin growth is one key factor to earnings growth). Margin expansion has been a major contributor to WFRD's recent market performance in my opinion. As in Figure 3, pre-and post tax margins have more than tripled since 2021 on a rolling 12 month basis. In December 2021, the pretax margin was 7.5%, and by the 12 months to Q1 2024, it had lifted to 19.3% percent. This tremendous growth in margin is exemplified by the company's competitive advantage in pricing, that sees it capture a higher gross margin with lower operating costs than peers. Figure 3 Company filings The margin decompression has been exceptionally beneficial to the company's business returns, and both of the value drivers behind it. As seen in Figure 4, management have grown the return produced on capital invested into the business. In Q3 2021, on a trailing 12-month basis, the company produced a 5.9% return on invested capital of $3.5 billion. Q1 2023, it did 16% on capital of $3 billion. This increased to a return of 29% on $3 billion during the prior quarter (TTM basis). This equates to a reduction of $8.90 per share in capital deployed since 2021, yet, management have grown earnings by $9.10 per share, indicating a 102% marginal return on invested capital. The drivers of this return - post tax margin and invested capital turnover respectively - have also both increased substantially across the testing period. Seldom do you see both numbers increasing in unison - it is normally one of the two. For instance, companies with high post tax margins, as WFRD has, often benefit from increasing the turnover of sales and capital, and vice versa. Here, we have a situation where both are increasing in near linear fashion. This is tremendously attractive and is conducive to the company adding further incremental value to its intrinsic valuation. Figure 4 Company filings The major economic benefits of this are seen in Figure 5 and Figure 6 respectively. Below, we have the free cash flow per share management has thrown off to shareholders since 2021 on a rolling 12 month basis, with corresponding free cash flow yield. As observed, management has thrown off tremendous piles of cash each period, hitting $12 per share at the end of last year. The yield on this as a function of market capitalisation has ranged between nine and 15% since 2022, and is at 9.3% in the training 12 months. This represents tremendous value on offer. Figure 5 Company filings We employ a 12% total rate across all equity evaluations here at our firm. That means, all respective entities must produce at least 12% return on their invested capital at the minimum to have earnings that are economically valuable to us. Any returns below this 12% threshold margin are considered an economic loss, vice versa, an economic profit. Note - this differs to accounting profit. As seen in Figure 6, the company has produced extensive economic earnings over this period, ranging from $1.66 per share in Q1 2023, to $7.08 per share in the last quarter (rolling 12 month basis). Over the testing period, the company has added $22.30 per share in economic value. Figure 6 Company filings Forward estimates at steady state of operations Both management and consensus project strong pre-tax earnings growth for 2024. Consensus projects revenue growth of 12.7% this year, calling for $5.78 billion at the top in 2024. It forecast 39% growth in pre-tax income on this, getting you to $1.2 billion. This could result in a levered return on equity of 84%, throwing off free cash flow per share of $13.55. Most critically, however, is that the consensus estimate implies a pre-tax margin of around 21% - 400 basis points decompression from 2023. This is a good sign, compared to the 2.97% exhibited in the 12 months to June 2019 (Figure 8). Figure 7 Company filings Figure 8 Seeking Alpha To give context, what this means for WFRD's earnings and corporate value ahead, I'll first deconstruct the company's \"steady-state\" of operations. This illustrates what amount of capital investment was required to produce $1 in new revenues over the last 3 years on a rolling 12 month basis. As seen, sales have grown at ~200bps each period since '21, on an average pretax margin of 13.4%. Each new $1.00 in revenue has required a net investment of $0.11 in net working capital. The investment into fixed capital has been a decrease of one cent on the dollar, as outlined earlier. Figure 9 Company filings If the firm were to maintain this state of operations, with no deviation from what is outlined above, it could produce around $5.8 billion in sales by the end of this year and throw off anywhere from $600-$650 million in free cash flow in my view. It may compound its corporate valuation at around 2% under these stipulations. Figure 10 BIG Estimates I have performed a linear regression on the list of analyst sales estimates and project an average 3-year revenue growth of 7.07%, on an average EBIT margin of 20%. If this is to be the case, the outcome for the company is drastically different. Sales left to $7.4 billion by 2025, on post tax earnings of $1.2 billion, throwing off free cash flow of a similar amount. Under these stipulations, my judgement is the company could grow its corporate valuation at 7% per period whilst remaining a circa 29 to 30% return on invested capital. Figure 11 BIG Estimates My question is immediately - can management sustain this level of productivity, i.e., carry the 29% trailing ROIC going forward? To answer, we must decipher what reinvestment is required to sustain the 29% ROIC. This is extrapolated via the following formula: Reinvestment rate = Est. growth/return on invested capital Figure 12 outlines the numbers required to produce a 29% return on capital over the next 12 months. I'm running with consensus numbers here, as I believe they are fairly accurate and are similar to my own when baking in the higher operating margin. I've also included the marginal tax rate of 21%. My assumptions from modelling its financials to date suspect that management have reinvested around 12% of the company's post tax earnings in the 12 months, tallying $106 million. This would bring the capital base to $3.16 billion Under the pre-tax income and marginal tax assumptions, I get to $954 million in NOPAT for 2024, otherwise 7.8% growth on the trailing 12 months. Using the formula above, the reinvestment rate calls for 27% of post tax earnings to be recycled back into the company, to produce a 29% return on $3.6 billion of capital. This would equate to an investment of $257 million. Management project 85% of revenue capital expenditure this year as mentioned earlier (5% of sales). This gets me to $288 million at consensus revenues of $5.7 billion. Adjusting for the revenue growth, I believe 1) the company could produce a return on invested capital of 30%, 2) that it would need to re-invest ~$260 up to $290 million to get there, and 3) that this is achievable. This is very constructive analysis and valuation discussed below. Figure 12 BIG Estimates Factors affecting corporate valuation The stock sells at 9x forward EBIT, and 7.7x book value. It also sells at 18.3x trailing earnings. Investors have bid up the company's stock price over the past two years, as seen below. Shares have increased from $58 apiece in Q1 2023, to around $115 as I write. My questionnaires what has been specifically the change in market value - is it the investment return, that is earning, or is it the speculative return, that is the change in P/E multiple. As seen in Figure 13 below, it appears to have been the denominator effects, in other words the growth in earnings. The P/E multiple has contracted from 23.5 times in Q1 2023 down to its current level. Meanwhile, earnings have grown from $2.49 per share up to $6.30 per share in the 12 months. This dislocation presents an opportunity in my opinion and when adjusted for growth, investors are paying just $.76 on the dollar for every dollar of future expected earnings. This is important for my scenarios outlined later. Figure 13 BIG Investments I also wanted to address how WFRD is priced relative to the assets in the business. Trading at 7.7 times the net tangible assets employed in the company, the trailing return on equity is 43%. As it is characteristic in this industry, this return is highly leveraged with a 4.6 times equity multiplier (Figure 14). If paying that multiple, the investor return on equity clamps to 9.3% and if removing the leverage, drops to 3%. On the business capital, however, the return of 29% drops to 9.3% if paying the current. This supports the notion of holding a long-term view in owning this company, as there is no statistical advantage in buying it for a short-term investment return due to the fair multiples (over the next 12 months, for example). This is also the reason why the intrinsic value of the company is far greater than the book value of the company - the former measures the economic earnings we can strip out of the company, whereas the latter looks at the net tangible assets with no reference to cash flow. Figure 14 BIG Investments The most attractive feature to the valuation debate here is the company's mouthwatering economics. I shall not get overexcited here, in the interests of remaining cautious. I mentioned earlier that our threshold margin for management capital allocation is a 12% return on investment. We believe we can achieve this elsewhere with a reasonably similar level of risk, so that's the opportunity cost. Here, you can see my projections for the company's earnings out to 2028 in Figure 15. Any profit that produces a return above the 12% threshold is considered economically valuable. For instance, it's not unreasonable for the company to hit $589 million-$600 million in net operating profit after tax this year (with no change in pre-tax margin). It would likely only need to produce $365 million to hit the threshold margin, a resultant $223 million economic profit. Advancing these projections over the forecast period, then discounting them at the 12% rate, I arrive at a value of $141.70 per share, supporting the buy thesis. Winding the operating margin up to the 20% mark which is projected in the coming years, I get to a valuation above $220 per share and this is my blue sky scenario (not shown here). Figure 15 BIG Investments In short WFRD is a differentiated player within the oil and gas services industry. It enjoys higher than industry average gross and operating margins, illustrating it has competitive advantages in pricing versus peers. My judgement is the company is well positioned to continue throwing off strong free cash flow to its owners, and has ample reinvestment runway ahead of itself to make these commitments. With management recently producing nearly 30% return on $3 billion worth of capital employed, my view is tremendously a constructive one, and another 30% return and capital is not unreasonable to expect in 2024. Based on my appraisal, the company is worth around $141/share in the base case, and could push $220 per share in my blue sky scenario that looks to pre-tax margins of 20% percent. Net-net, rate buy.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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