To The Moon

Summary

• The US rig count has experienced a notable drop this year, impacting drilling activities in the oil and gas industry.
• But Ranger Energy is experiencing better pricing in key segments.
• The company has also brought its debt down to almost zero, which means more cash flows will not go to shareholders as dividends and buybacks.
• Ranger Energy also has the financial muscle to undertake acquisitions, which can help lift growth.

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Introduction

The oilfield services sector is a tough space for many companies. Even with oil hovering near the $90s, the drilling activity in the US continues to decline. In spite of the weakness in the oilfield services sector, there are still some hidden gems waiting to be unearthed. Remember when I wrote about Ranger Energy Services (NYSE:RNGR) a couple of months ago with a ‘buy’ call, suggesting it might be the diamond in the rough? Well, if you took note, you'd have seen its stock surge by almost 38% since. Meanwhile, the S&P-500 took a step back with a 2% dip in the same timeframe. Despite the industry-wide challenges and declining rig counts, Ranger Energy hasn't just weathered the storm—it's shining even brighter. If you're in the market for a robust player in the midst of industry turbulence, you might want to give this small-cap company another look.

Rig Count's Rough Ride

Ranger Energy Services, a small-cap oilfield services company with a valuation of $340 million, offers high specification rigs, wireline services, processing solutions, and additional services to US oil and gas producers. Like its peers in the oilfield services sector, Ranger Energy faces a testing market environment, characterized by a persistent decrease in rig count numbers.

The US rig count is a pivotal indicator of drilling activities. It has experienced a notable drop this year. Indeed, oil producers have pulled rigs from every shale oil region. The most recent data from Baker Hughes (BKR) shows that 622 rigs were operational in the US at the end of the previous week. This is a stark contrast to the 769 rigs from the same timeframe the preceding year. Notably, almost half of these rigs are active in the Permian Basin. This basin, spanning West Texas and New Mexico, stands out as the US's most productive shale oil area. Within the Permian Basin, the count of oil and gas rigs recently plummeted to its lowest level in over 17 months to 309 units by the end of the first week of October, and has since improved slightly to 311 units. I believe the depth of the slump in oil and gas drilling activities is evident when considering the consistent quarterly decline in the rig count this year.

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Oil prices remain notably elevated, with both WTI and Brent hovering around $88 a barrel at the moment and averaging above $75 throughout the current year. The oil and gas producers are reaping substantial profits and robust free cash flows (FCF). Nonetheless, in contrast to the previous year, when prices steadfastly exceeded $100 for a prolonged duration and averaged over $93, the current prices appear somewhat subdued. This can partly account for the decline in drilling activity.

Another significant factor is that oil producers are emphasizing enhanced shareholder returns, through dividends and buybacks. In my view, they are showcasing capital discipline, refraining from aggressively ramping up production by adding more rigs. Such a move could necessitate elevated capital outlays, potentially impinging on the shareholders' cash returns. This poses challenges for Ranger Energy Services and its fellow oilfield service providers.

The future landscape still seems shrouded in ambiguity. Just a few weeks back, the sentiment inclined towards crude possibly touching $100 a barrel, but it has since retracted to the high-$80s. I believe the recent upheavals in the Middle East, following Hamas's attack on Israel, brings further unpredictability onto the oil's prospects. OPEC+, steered by powerhouses Saudi Arabia and Russia, has been constraining output to support oil prices. Indications of a tightening oil market are evident, as seen from weak inventory levels. With escalating geopolitical tensions, there's speculation that the US could intensify sanctions on Iran, curbing its oil exports. By one estimate, this could remove around 500,000 bpd of Iranian oil, intensifying the market's tightness and potentially driving prices upwards.

Conversely, it remains to be seen how long OPEC+ plans to restrict supplies, or if global economic deceleration and potential US interest rate hikes will dent oil demand. Suppose, hypothetically, Saudi Arabia and Russia escalate their exports in a bid for a larger market slice, or if the Federal Reserve increases interest rates to temper inflation, leading to an accumulation in oil stockpiles, then this could exert downward pressure on oil prices. I expect prices to continue to bounce between these demand and supply concerns in the near future.

In this unpredictable oil price landscape, I believe US oil producers may remain cautious. They could maintain subdued drilling activity, just enough to uphold or modestly increase output, all while achieving robust profits and FCF to support dividends and buybacks.

I think this challenging situation is further underscored by Ranger Energy's seemingly dimmed outlook, as reflected in their adjusted earnings forecast. Initially, the company anticipated revenues ranging from $685 million to $710 million for 2023. Now, they project to earn between $660 million and $680 million. Note that the new forecast's upper limit is even below the initial projection's lower limit. While they first projected an adjusted EBITDA of $95 - $110 million, their current expectation stands at $92 - $97 million. And though Ranger Energy has tightened its FCF projection from $55 - $70 million to a range of $55 - $65 million, this indicates a 4% decline at the midpoint.

Ranger's Resilience

However, is Ranger Energy equipped to navigate this market effectively? The short answer is, yes. In fact, I think the company is even more prepared now than it was before, and this can be attributed to two key reasons.

Firstly, Ranger Energy showcased margin improvement in its most recent quarterly report (Q2-2023). A significant aspect of Ranger Energy's operation is its niche focus on completion and production services. A considerable portion of its revenue ties directly to oil companies' operational costs, as they spend money to maintain, enhance, or mend their oil and production wells. This is distinct from the funds dedicated to drilling fresh wells or engaging in exploratory efforts, which demands capital outlays. As a result, even with the challenges stemming from the slowdown in drilling and fracking activities — as the guidance revision indicates — I believe Ranger Energy is well-positioned to sustain a healthy demand.

In the company's second-quarter results, improvements in pricing across all three segments were evident: High-Specification Rigs, Wireline Services, and Processing Solutions & Ancillary Services. The High-Specification Rigs and Wireline Services segments notably felt this positive shift.

Within the High-Specification Rigs domain — typically accounting for over half of Ranger Energy's revenue — there was a reported 9% year-over-year uptick in revenues per rig hour, reaching $682. This occurred despite a 6,700-hour decline in total rig operations. The advantageous effect of this pricing strategy allowed Ranger Energy to grow its adjusted EBITDA by 10%, reaching $15.6 million, even when faced with a modest 2% revenue growth of $77.6 million. In a similar vein, the Wireline Services, which stands as the company's second-largest segment, saw revenues climb by 10%. However, the adjusted EBITDA skyrocketed by 33%. This significant growth in earnings encapsulates the advantageous repercussions of the improved pricing model.

What stands out to me is the consistent trend of these pricing improvements. For instance, in Q1-2023, the company marked positive pricing shifts in both the High-Specification Rigs and Wireline Services domains. In these segments, the Q1-2023 adjusted EBITDA growth also outstripped revenue growth. I believe this consistent ability to raise prices indicates more than just a sporadic success; it suggests a steady strategy that augurs well for Ranger Energy's future earnings trajectory. Even amidst market challenges, the company saw decent demand, managed to elevate prices, and broadened its margins.

Secondly, I believe Ranger Energy has done a commendable job of achieving the zero net debt target, predominantly due to its capability to generate not just profit, but also substantial FCFs. For Q2, the company revealed net profit of $6.1 million and FCF of $16.1 million. For over a year, the company has consistently showcased strong quarterly FCFs. The surplus cash (over and above the capital expenditures) has been judiciously employed to bolster cash reserves and whittle down debt. Over the past year, the company slashed over $56 million of its debt, ending Q2 with a nominal debt of just $300,000. Concurrently, cash reserves grew from $5.1 million a year ago to $6.4 million by Q2-2023's close, which translates into a negative net debt (debt minus cash).

With a pristine balance sheet, Ranger Energy stands fortified against potential market adversities. Despite witnessing a positive trajectory in pricing, should there be unfavourable downturns impacting prices, Ranger Energy's robust balance sheet ensures it is better equipped to weather such storms compared to many competitors.

But pivoting away from dire hypotheticals, with the attainment of the zero-net-debt milestone, I anticipate a renewed Ranger Energy emphasis on lifting shareholder returns. The absence of debt implies that the surplus cash can now be channelled to gratify shareholders via dividends, buybacks, and strategic, value-adding acquisitions that can propel the company’s profits and stimulate revenue growth.

In fact, this trend is already in motion, which is a positive sign. Ranger Energy has committed to return "a minimum of 25% of yearly cash flows" back to shareholders through dividends and buybacks. During Q2, the firm repurchased nearly 2% of its outstanding shares and initiated its quarterly dividend of $0.05 per share, translating into dividend yield of 1.46%, almost mirroring the S&P 500's average yield of 1.56%.

Additionally, a judicious acquisition gesture by Ranger Energy underscores the management's readiness to leverage the firm's financial muscle to augment growth. In Q2, they allocated $7.25 million for the purchase of 15 pumps and associated equipment to bolster its wireline segment. These assets, earmarked for the lucrative Permian Basin and other high-demand zones, will fortify their high-margin pump-down operations, projecting a positive ripple effect on the firm's revenue and earnings in forthcoming quarters.

Takeaway & Risks

Oilfield service providers may grapple with subdued demand, yet I believe Ranger Energy stands resilient in this landscape. The company is showing initial signs of regaining pricing power. The consistent uptick in its pricing suggests an imminent positive influence on its earnings and profit margins. Moreover, with its fortified balance sheet, Ranger Energy appears well-equipped to navigate potential market turbulence. Besides, its pivot towards enhancing shareholder returns via dividends and buybacks signals promising returns for investors.

The company's shares have already clocked an impressive 25% rally this year. And when it comes to valuation? I believe there's still room for growth. Currently, Ranger Energy stock is trading at 9.3x their forward earnings estimate. This sits notably lower than the sector's median of 10.65x, according to Seeking Alpha data. Contrast this with industry juggernauts like Schlumberger (SLB), Halliburton (HAL), Baker Hughes, and NOV (NOV), which hover between 14x and 23x forward earnings estimates. Based on these metrics, I maintain my endorsement of Ranger Energy stock as a 'buy' and project its continued industry outperformance.

However, a word of caution is essential. Ranger Energy remains an oil-centric stock. This ties its fortunes to oil price dynamics. A slump in oil prices, perhaps triggered by dampened demand due to low economic growth, can exert downward pressure on its share price. Moreover, a greater-than-anticipated decline in rig count, especially if prolonged, can negatively dent the stock's performance. Potential investors should duly weigh these risks before deepening their commitment to this stock.