The United States is on the verge of becoming the new Middle-East of fossil fuel energy through the widespread implementation of horizontal drilling techniques and a process called “fracking,” and there are fortunes to be made. This process, in simple terms, injects water under high pressure into wells drilled horizontally into shale formations to fracture the rock and allow the natural gas or oil to flow through the cracks created so it can be economically recovered. Implementation of this process is the primary cause behind the fall in the price of natural gas from around $15/million btu’s (British Thermal Units) to the current price around $3.50.
This has created an interesting situation where the gas producers are now struggling to make a profit because the massive amount of new supply has collapsed the price, but most cannot afford to reduce the supply being brought to market because they need the sales to cover the ongoing expenses of their businesses. This is a situation that most analysts believe will exist in the U.S. for many years to come. However, just because the producers of gas are not doing well, does not mean that everyone is suffering. The service suppliers to this industry are flourishing while the producers struggle. When any industry has massive expansions in production, it is always a good idea to look at the suppliers of the necessary “picks and shovels” to find great investment opportunities.
Just like a diamond, small does not mean low value here
The oil and gas services industry offers numerous opportunities from which to choose and they span the full range of size and services provided. One relatively small player in the hydraulic fracturing industry that appears to be greatly undervalued right now while still offering exceptional opportunities for continued growth is C&J Energy Services (NYSE:CJES) . C&J began trading publicly in July 2011 and reached its all-time closing high a few days later at around $32.80 per share. While the share price has had a bumpy ride since, the operating results the company has posted have been impressive.
In establishing a valuation for a new listing, I like compare the valuations the market assigns to established businesses that have progressed beyond their early hyper-growth stage to the newer, smaller business to see if the business is fairly valued today compared to its future value.
How does C&J compare to the large players?
Three of the most successful drilling and services companies in this industry are Baker Hughes Incorporated (NYSE:BHI), Halliburton Company (NYSE:HAL) and Schlumberger Limited. (NYSE:SLB) . The numbers below provide a good comparison of values using some key metrics.
Business CJES BHI HAL SLB
Market Cap. $1.24B $20.36B $39.2B $103.77B
P/E Current Yr. 8.17 15.1 13.9 16.48
P/E Next Yr. 7.38 11.02 10.6 13.44
5-yr Proj. Gwth. 20% 23% 13.9% 15.8%
Price/Cash Flow 5.4 7.2 9.3 11.4
Net Margin 1-yr 16.4% 6.15% 9.08% 12.92%
Net Margin 5-yr 16.7% 7.7% 10.7% 14.6%
Debt/Equity 0.29 0.28 0.31 0.33
C&J is currently trading at a discount to the other three businesses used for comparison. It also provides the investor with a superior net margin for both the one-year and five-year periods.
Is C&J undervalued or are competitors overvalued?
When valuing businesses, I like to see a price to cash flow below 10 and a current P/E that is less than or equal to the 5-year projected earnings growth rate (PEG) and, preferably below the industry PEG. The less debt a business has the better, and I also believe it is easier for a small business to grow at a faster proportional rate than a larger one. So if it has a relatively small market cap in comparison to competitors, I tend to view that as a positive.
When looking at the competition, the numbers indicate to me that these are all very fairly valued businesses with the potential to reward investors with 12 to 15% annualized returns over the next five years. However, C&J is currently valued at a level that would allow the share price to increase between 50% and 100% just to reach a similar valuation to the other businesses listed. It appears to me that the comparison group of businesses I selected is properly valued and C&J is undervalued. The share price could return to its all-time high and the business would still not be expensive.
Extraordinary potential returns
Based upon my analysis, I think you can buy any of these businesses and achieve market beating annualized returns over the next five years. However, at around $22.73/share today, I think you can purchase C&J with the added prospect of exceptional returns if the valuation rises to equal that of similar businesses. Also, the small size, growth and profitability of C&J could very well make it an attractive target for acquisition and reward existing shareholders with a significant payday much sooner. If you want good profits, buy the large service providers listed, if you want great profits, buy C&J Energy Services.
The article Earn Extraordinary Profits in the New Middle-East originally appeared on Fool.com and is written by Ken McGaha.
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