Value Play: RPC Inc. (NYSE: RES)

The global demand for energy continues to grow. BP projects energy consumption will increase by 41 percent between 2012 and 2035. Most of this demand growth will come from the emerging markets, but the energy suppliers that will benefit by feeding this demand can be located anywhere. With the explosion in North American energy production thanks to the fracking revolution, energy service firms that focus on North America are in prime position to cash in on the growth in emerging-market energy demand.

Halliburton and Baker Hughes are mega-cap stocks that I can’t recommend in Roadrunner Stocks, but both companies are bellwethers for the energy service industry and their global exposure provide them with the best vantage point to identify key turning points in the industry’s business cycle.

First up on July 17 was Baker Hughes. CEO Martin Craighead stated during the company’s second-quarter conference call:

Turning to North America, we are seeing activity growth in the US onshore market in the form of more rigs, more wells and more horizontal drilling. Demand for drill bits are at record levels, and not surprisingly, we set record revenues in our drilling services and drill bit product lines.

But it’s the production side of our business that’s beginning to deliver truly differential growth in North America. Our customers’ appetite for new technologies, which can boost oil production from shale, is growing.

Next up on July 21^st was Halliburton. CEO Dave Lesar said without hesitation during the company’s second-quarter conference call that the North American fracking cycle had troughed and was turning up:

On our last call some of you may have been skeptical when I said I was beginning to feel the turn in North America, but based on our performance during the quarter I believe this feeling was dead on target. Today we are not feeling the turn, we are in the turn and I feel even more excited than I was last quarter about the outlook for the North American market.

Why is that? During the quarter we saw our completion volumes continue to rise and I don’t see that changing. We estimate the percentage of excess horsepower has dropped below the 10% mark and capacity has tightened to the point that the market will require new horsepower to meet customer demand.

The latest North American rig count from September 5^th shows tremendous growth in U.S. oil and gas rigs over the past year, up 8.9% from 1,767 to the current total of 1,925, which is getting near the 22-year high total of 2,031 that occurred in late August 2008. More than 100% of the rig-count growth comes from oil rigs, which are up 16.0% year-over-year to 1,584 – five shy of the all-time record-high number of rigs set last month (at least since Baker Hughes started keeping records in 1987). U.S. oil rigs have increased 8.8 fold since hitting a low of 179 in June 2009 with more growth expected in the near future. The rig-count report also shows two other interesting facts:

• Horizontally-drilled, fracking wells are the only type showing rig growth, up 24% year-over year.
• The Permian Basin – located in West Texas and Southeastern New Mexico — is the geographical area that is growing its rig count the fastest.

Horizontal wells require hydraulic fracturing (i.e., fracking), which involves pressure pumping liquid down into the ground to create fractures in shale rock and unlock the gas and oil located within the shale rock. Proppant (sand, bauxite, or synthetic ceramics) is subsequently needed to prevent the fractures from closing and thus allowing the oil and gas to continuously flow up to the well head.

In an August 27^th research report, Morgan Stanley analysts discussed the “insatiable” demand for fracking services and predicted that the demand for sand proppant will almost double (96% growth) in the three years between 2013 and 2016. Given that the supply of sand proppant is only expected to grow by 76% during the same time period, the resulting supply/demand imbalance could cause the price for sand proppant to rise by 50%, which would cause overall well completion costs to increase by 20%. The higher cost will not deter proppant demand, however, because the proppant typically increases a well’s estimated ultimate recovery (EUR) by 40-60%.

Roadrunner Stocks portfolio performance has benefited from proppant companies, both past and present. The Value Portfolio sold Carbo Ceramics after it had generated a 73.75% gain for subscribers. The Momentum Portfolio currently owns Emerge Energy Services, which has generated a two-month return of 16.39%.

Family-Run RPC Inc. (RES) Will Benefit From the Macro Trend of Fracking

I’m not recommending another proppant supplier, but I am recommending a provider of fracking services: RPC Inc. (RES), which buys the proppant it uses from several different suppliers. CEO Richard Hubbell assured investors in the company’s second-quarter conference call on July 23^rd that higher proppant prices would not impact RPC’s profit margins:

In general, we’ve started to see raw materials cost increases and we feel good about our ability to pass those cost increases on. We’re not seeing market indications that we can affect net pricing increases at this point, but we do believe that we can pass our cost increases along.

RPC is the largest of a trio of Atlanta-based businesses controlled by the billionaire Rollins family – the other two are “Orkin” pest-control company Rollins (ROL) and recreational boat manufacturer Marine Products (MPX). RPC was spun off from Rollins in 1984 and in 2001 RPC spun off its Chaparral Boat division into Marine Products.

Two Rollins brothers own more than 50% of the stock in each of these three companies, and 68% in the particular case of RPC (page 2). Older brother Randall (82 years old) is the chairman of the board of all three and younger brother Gary (69 years old) is vice chairman of all three, as well as CEO of Rollins. Richard Hubbell is CEO of both RPC and Marine Products. I admit that it is a little strange having a CEO divide his time between two companies in wholly separate industries, but RPC’s financial performance has been excellent.

RPC has exposure to all of the major U.S. shale deposits, with 49% of the company’s pumping capacity in the high-growth Permian Basin (slide no. 6), and operates in several different business segments that specialize in the “completion” stage of a well – after the drilling has been completed and its time to produce the oil and gas:

Source: Company 10-K Filing (pp. 3-5)

RPC’s market share is small, leaving a vast runway of potential growth ahead. Second-quarter financials were excellent, reflecting the upturn in North America fracking activity. Operating profit rose 51.8% and revenue grew 27.4%. The stellar results are not a fluke; the company has been growing and very profitable over the long term. The Holy Grail is a combination of profitability and growth and RPC has both:

Source: Bloomberg

Very Profitable ROIC

Even more important is the company’s focus on return on invested capital (ROIC). Whereas earnings per share can grow without an increase in shareholder value (e.g., stock buybacks), ROIC is the real deal (slide no. 19) when it comes to “economic value added” and long-term wealth generation. I was very happy to read the company’s annual proxy statement (page 25) and discover that executive bonuses are based solely on ROIC:

The Company has used ROIC as the sole performance goal under the Management Incentive Plan for several years. Under the Management Incentive Plan, the Company must achieve at least 80 percent of the target performance goal for executive officers to be eligible for any bonus award. Bonus awards under the Management Incentive Plan are determined on a sliding scale between the threshold performance level and a superior performance level, which corresponds to 175 percent of the target performance goal.

To be eligible for the bonus award under the Management Incentive Plan, the ROIC must be in excess of 16 percent up to a maximum of 35 percent. The Company has consistently followed the same method to compute ROIC, and the Compensation Committee has not exercised discretion to waive the performance goals based on difficult industry conditions or other factors.

The focus on ROIC really differentiates RPC from its small-cap peers and explains why RPC stock has outperformed:

Source: Bloomberg

RPC’s dividend yield is 1.9%, which is higher than the big boys Halliburton (0.9%) and Schlumberger (1.5%), and much higher than other small-cap energy service companies, many of which don’t even pay a dividend. More importantly, RPC has a long history of growing its dividend – 23% compounded annual growth over the past 16 years (slide no. 17).

The company’s balance sheet is strong, with a low debt-to-capital ratio of only 11.4%, which is not only much lower than other small-cap peers, but also lower than the company’s own historical average, having declined from a 30% level in 2008 (slide no. 16).

Even after the strong price run-up over the past two years, the stock still trades at a low EV-to-EBITDA ratio of only 8.6.

Takeover Candidate

Although RPC is family run with majority control and veto power over any takeover attempt, the Rollins family is dysfunctional with lawsuits flying between family members, so there is apparently no desire to preserve a family legacy with RPC when the geriatric Rollins brothers depart the scene.

Back in the summer of 2011, RPC hired Goldman Sachs to explore the possibility of selling the company, but nothing came of it. At the time, analysts predicted that a takeover price would need to be around $23.33 (adjusted for a subsequent 3-for-2 stock split), which would be a 12 percent premium to the current price of $20.80, but I believe the company’s continued growth since August 2011 makes the likely takeover price higher than $23.33 – more in the range of $30.

Even without a takeover, however, RPC is a solid investment with industry-leading profitability, low valuation, growing dividend, low debt, and significant potential growth in a North American fracking environment that has just begun an upward cyclical turn.

RPC Inc. is a buy up to $25; I’m also adding the stock to my Value Portfolio.

Value Sell Alert

To make room for RPC Inc., Roadrunner is selling:

• Fabrinet (FN)

A company press release warning of potential accounting irregularities is very disappointing news from Fabrinet. One thing that is virtually impossible for an investor to guard against is accounting fraud. Fundamental valuation analysis relies on the financial numbers being accurate. Although the press release asserts that an accounting investigation may conclude that no misrepresentations occurred, in my experience a company avoids issuing such a press release unless it is virtually certain some wrongdoing occurred.

I respect CEO Tom Mitchell, who is a legend in the computer industry, and am confident that he not only had nothing to do with the accounting problem, but will also work to fix the problem quickly. That said, accounting fraud is a serious problem that may take a long time to fix. Fabrinet has become a speculation, rather than a value investment, because the accounting numbers cannot be trusted and without accurate financial information it is impossible to value a stock accurately.

Fabrinet is being sold from the Value Portfolio.

Three Momentum Buys:

1. Synaptics (Nasdaq: SYNA)

Synaptics is leading developer of human interface solutions which enhance the user experience in the expanding digital lifestyle. For example, it makes a fingerprint sensor for smartphones like the Samsung Galaxy Note 4. 

• Price gain between 12 months ago and 3 months ago = 133.08% (99th percentile)
• Price gain over the past 2 months = -5.65%
• Price gain over the past month = 3.86%
• Roadrunner Momentum Rating: 133.08 – (-5.65) – (3*3.86) = 127.14

Synaptics is a buy up to $92; I’m also adding the stock to my Momentum Portfolio.

2. The Greenbrier Companies (NYSE: GBX)

The Greenbrier Companies is a leading supplier of transportation equipment and services to the railroad  and marine barge industries. 

• Price gain between 12 months ago and 3 months ago = 181.25% (100th percentile)
• Price gain over the past 2 months = 10.18%
• Price gain over the past month = 14.93%
• Roadrunner Momentum Rating: 181.25 – (10.18) – (3*14.93) = 126.29

The Greenbrier Companies is a buy up to $80; I’m also adding the stock to my Momentum Portfolio.

3. Gentherm (Nasdaq: THRM)

Gentherm is a supplier of actively-heated and cooled seat systems and cup holders, heated and ventilated seat systems, thermal storage bins, heated automotive interior systems (including heated seats, steering wheels, armrests and other components), cable systems and other electronic devices for the automotive industry. 

• Price gain between 12 months ago and 3 months ago = 163.17% (100 percentile)
• Price gain over the past 2 months = 14.46%
• Price gain over the past month = 14.93%
• Roadrunner Momentum Rating: 163.17 – (14.46) – (3*14.93) = 103.93

Gentherm is a buy up to $57.50; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alerts

To make room for these three new momentum stocks, Roadrunner will be selling three price laggards:

• ANI Pharmaceuticals (ANIP)
  
  
• Clayton Williams Energy (CWEI)
  
  
• Darling Ingredients (DAR)