Cactus: Playing The Energy Market Recovery With A Growing Market Share Leader

As a result of the recent rebound in the energy market, U.S. rig count has increased rapidly from 2016 allowing Cactus (NYSE:WHD) to deploy its unique wellhead technology SafeDrill which boosts efficiency and safety for drilling, completion, fracturing and production phases of wells.

With the energy market recovery expected to continue through 2019 and 2020, the company has been deploying its products and services across the United States, growing its market share from under 1% to over 25% since 2011. This, alongside cash raised through its IPO to pay down debt, is resulting in a triple-digit revenue and net income growth for 2017 and higher than industry growth expectations for 2018.

As the market expects rig count and well drillings to increase low-mid double digits through 2018 and 2019, I believe the company has the potential to increase its market share with the efficient offerings and grow overall product sales alongside rentals and servicing contracts they offer.

Industry Overview

Since mid-2014, the oil & gas industry has faced tough times with the rapid decline in the price of Crude Oil (OIL) causing operations and rig counts to fall dramatically. However, prices have stabilized over the last year, rebounding back from a low of around $30 a barrel to over $60 a barrel causing a boom in U.S. Shale production and boosting Natural Gas production, fracturing and other hydrocarbon well activity which in turn caused a rise in industry spending.

U.S. onshore rigs are expected to increase from a 490 average in 2016 to an average of 856 in 2017 followed by a 991 and 1,051 average in 2018 and 2019, respectively. Wells per rig are expected to continue and grow as companies look for more cost efficient ways to extract large amounts of hydrocarbon materials, boosting the number from 12 in 2011 to 22 in 2017, according to Spears & Associates report. As the rebound in demand continues to take place the total numbers of onshore wells drilled is expected to rise from 15,503 in 2016 to 24,255 in 2017 followed by 28,006 and 29,489 in 2018 and 2019, respectively. (Source: Company filing, page 55)

(Source: U.S. Energy Information Administration)

According to the American Petroleum Institute and the U.S. Energy Information Administration (“EIA”), the price of Oil is expected to continue and rise as global demand climbs and other gulf countries keep their output down to help eliminate the glut. As a result, U.S. oil companies are set to enjoy a healthier operating environment where they can invest in infrastructure to improve efficiency and have the ability to reduce costs if need be in the future. Natural Gas producers are set to enjoy a healthier demand and growth as prices remain low, creating a favorable purchasing and use environment.

Business Overview

Cactus sells, rents and services highly engineered wellheads for the oil & gas industry’s onshore unconventional wells with their core offering SafeDrill which uses sea exploration technology to provide for a more efficient and secure operating environment. As a result, operators in the drilling, completion, fracturing and production phases are able to load and secure casing strings without descending into the actual well cellar. The company also rents frac stacks, zipper manifolds and other high pressure equipment for the completion phase of the well. Beyond their product sales and rentals they offer a comprehensive 24-hour servicing package through their 14 centers around the country, located primarily in high activity areas around the United States.

The company holds manufacturing facilities in Louisiana and China. Louisiana is where the majority of their operations takes place to maintain availability for projects with high servicing and parts demand and their facilities in China are for longer term lead projects to save labor and upkeep costs. They also hold a servicing facility in Eastern Australia for their small operation in the country.

Over the past few years the company’s product sales made up over 55% of total revenues with rentals making up around 25% and services holding steady at just over 20%. The company relies on new orders to boost sales growth and derives somewhat of a steady income stream from some equipment rentals and from servicing contracts, which are primarily bid contracts which have terms of service attached on a per-contract basis. The energy market recovery has increased demand for their unique solutions, boosting sales and market share prospects.

Market Share Growth

As a result of their patented technology that enables operators to control well digging costs and provide for a safer working environment for their employees, the company has grown their market share from around 0.8% in 2011 to just over 27% as of January 2018 (Source: Company filing, page 3). According to data released by the Baker Hughes (BHGE) rig count tracking, the company currently operates their wellheads and other products on 249 active onshore rigs out of 919 total active U.S. rigs, up from 15 out of 1,931 total rigs back in 2011.

As the company continues to gain market share while energy market spending increases, management has guided for 2017 revenues to increase 120% to $341.4 million from 2016’s $155 million. Net income is expected to rise as well, from a net loss of $8.2 million in 2016 to a net income of $66.2 million as they expect Q4 2017 net income to be around $22.5 million.

Projections: Continued Outperformance

As onshore rig spending is set to increase around 20% in 2018 and 9% in 2019 as the recovery continues, I believe the company’s gain in market share onward from their current 27.1% can bring the company’s full year 2018 sales to around $425 million (a 25% increase) and full year 2019 sales to around $490 million (a 15% increase), assuming additional market share gain and no changes in industry spending.

Projecting EPS for the upcoming year comes from a combination of sales growth and gross margin improvement. After 2016’s gross margin fell to 19% from 2015’s 29%, the company has enjoyed a much higher figure of around 35% in the most recent quarters, with a similar product sales mix. Company guidance appears to assume a 34% gross margin for the year (with 3/4 quarters already reported) and SG&A expenses of $28.5 million bringing operating income to $87.5 million. The $66.2 million net income guidance therefore implies an effective tax rate of around 24%. (Note: Author analysis).

For 2018, a $425 million revenue figure projects $144.5 million in gross profit alongside $35 million in SG&A expenses (assuming no further improvements), which projects operating income of $109.5 million. A 24% effective tax rate equals $83.22 million in net income, or a 25.7% growth rate from 2017, to $1.10 per share. (Based on 75.18M shares outstanding)

Risks: Volatility and Spending

The key risk associated with the company is an industry wide one. There’s no guarantee that the oil market remains stable and has too many factors creating potential for another volatile session like 2015 and 2016. These include Middle Eastern countries increasing production after a long glut and U.S. Shale overproduction alongside lower natural gas demand heading into the summer. Rig counts and industry wide spending fluctuates quite aggressively throughout the year and the cyclical nature of spending can hurt quarterly results and effect share price and valuation metrics.

Another risk factor is the shift to alternative fuels going on not only in the United States but around the world. As Solar and Wind energy becomes cheaper to produce than fossil fuels and natural gas, demand will fluctuate and cause disruptions in the market place. The company’s products are also used in an industry with significant wear and tear which can result in personal and company liabilities if not properly serviced. As these industries consolidate it can also become difficult to find skilled workers to perform such servicings.

An additional factor to keep an eye on is in the case of a market downturn where not only spending decreases but Cactus remains liable to provide services to certain customers under their contracts at a fixed rate which can result in a significant loss. Similar to the result of the previous market downturn, consumer credit ratings can drop causing defaults on contractual obligations when cost reductions and well closings take place. Default and bankruptcy rates skyrocketed through 2015 and 2016 causing the company’s rig wellhead installations to drop from over 150 to 68, which can inflate losses with current installation numbers.

Valuation

As stated previously, the company is expected to grow revenues and net income by around 25% in 2018, according to my projections based on industry and market share growth expectations, and I expect them to report EPS of $1.10 for the year. As a result of the company’s expected growth in net income alongside revenue and a reduction of its debt I believe the 2019 9% spending growth rate expectation will equal to a ~15% growth rate for the company as they continue to gain market share. Finding an appropriate valuation based on 2018 numbers can be tricky given most peers are expected to report a net loss for the year.

National Oilwell (NOV) is expected to report EPS growth at a slower pace than the overall industry at a 6% rate over the next 5 years and report $1.11 in EPS for 2019. Another competitor, Oil States International (OIS), is expected to report a 5 years EPS growth rate of 19%, which is well over industry average and report EPS of $0.44 for 2019. The former currently trades at a 32x multiple to earnings and the latter at a 56x multiple. (Note: 2019 multiples were chosen since OIS is expected to report a loss for 2018)

As Cactus grows slightly higher than industry average as is captures some additional market share and as industry recovery allows for better margins, I believe the company trading at 25x to 30x 2018 earnings fairly values the company, given their product portfolio differs slightly from the two aforementioned companies and due to the fact I value energy companies slightly less than normal given market volatility. This presents a fair value range of $27.50 per share to $33.00 per share, representing 21% potential upside to the median of that range from today’s prices.

I believe, however, that further market share growth can provide for a nice support of slightly higher valuations and will wait for the actual numbers of their Q4 2017 report due on March 9th, 2018 at around 8:30AM EST. A significant beat on the top or bottom line or a showing of additional market share gain will call for valuation revisions.

Investment Conclusion

Energy markets have recovered nicely since their downturn in 2014 through 2016 and industry spending has increased dramatically. As both Oil rigs and natural gas and other hydrocarbon wells go back in to full scale production mode Cactus’s unique solutions are being adopted in more wells across the United State, increasing their overall market share.

As this spending and efficiency boost continues, Cactus has enjoyed a triple digit growth rate for its sales and net income from 2016 and is expected to report solid double digit growth rates through 2019 as the U.S. Energy Information Administration predicts demand for Oil and natural gas to remain high through that time period.

Given Cactus’s high market penetration and unique technological advantage, I believe the company has more room to grow market share and that current valuations are fairly cheap compared to 2018 expected EPS. A continued surge in industry spending in existing wells and renewed operations in drilled-but-uncompleted (“DUC”) wells around the country will allow the company to grow sales and EPS at a low double digit rate through 2019 and believe the company is undervalued by about 21% for 2018.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in WHD over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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