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This is undervalued- My Perspective

September 27, 2007

(for details pls visit www.OptionPundit.net)

As you might have noticed in my past few posting that I have been covering this “underlying” for a while. Today I am going to share my thoughts on this purely from “Fundamental Analysis” perspective. Note though, there are several ways to value a stocks and it very much depends on accuracy and assumptions of “variables”. I am presenting on what I think is a right set of assumptions, but feel free to run your analysis. This is just a start !

Alright the company is Grand Prideco (GRP).

Grant Prideco, Inc. is engaged in drill stem technology development, drill pipe manufacturing, sales and service, and drill bit technology and specialty tools, manufacturing, sales and service. It is also a provider of performance engineered connections and premium tubular products and services. Its drill stem and drill bit products are used to drill oil and gas wells, while the tubular technology and services are primarily used in drilling and completing oil and gas wells. The Company’s customers include oil and gas drilling contractors, North American oil country tubular goods (OCTG) distributors, independent and state-owned oil and gas companies, and other oilfield service companies. It operates through three business segments: Drilling Products and Services, ReedHycalog and Tubular Technology and Services.

Over US$2.0billon business is split as per follows:

  1. Drilling Product & Services (US$1.04billions)
  2. ReedHycalog (US$572 millions)
  3. Voest Alpine Tubuars (US$381millions )
  4. Tubular Technology and services (US$370millions)

screenhunter_01-sep-27-2119.gifFrom the attached graph it is quite clear that GRP seems undisputed leader when it comes to drilling product markets. Nearest competitor is Valurac and even that doesn’t come close to GRP. No doubt consolidations may happen and a large competitor may emerge but that is still a long way to go.

screenhunter_02-sep-27-2144.gif

Next I look at comparison with the nearest competitor, my two concerns will be Margin, and an efficient velocity. From a margin perspective, undoubtedly GRP is placed in a leading position.

screenhunter_03-sep-27-2153.gifSLB and HAL seems nearest. Let me pull more data for a comparison with them (using moneycentral.com). SLB is surely a much stronger company, but if I were to choose from Value standpoint, to me it’s GRP, sweetner is little debt. Margin are surely superior as well. You may want to check out further comparisons, with other companies using msn’s research wizard facility. It’s free. To know about the business, you may want to check out GRP’s website. They have assembled a good deal of presentation that can tell you more about the business, segments and it’s competitiveness (click here).

The only portion I am not reviewing is “Management”, that you may wanna checkout by searching their names and their past history.

Let’s dive into two methods of valuations.

First I’ll use discounted cash flow method, adopted from “Warren Buffet Way”. This is a “Two Stage Growth Model” where I have assumed 15% growth for 1st 5yrs and 8% in the next 5 years and so on. 15% is very conservative estimates when compared with >20% estimate consensus by 11 analysts. 2nd stage growth I have assumed is only 8% which is also quite conservative and something what huge companies organically grow by.

My calculation showed $414.8 as owner’s earnings (I have mentioned formulae in the screenshot). Another key variable is the discount rate. I have two choice a) either use Risk Free Rate (US 30year bonds)+ Equity risk premium, that’s roughly 11% or b) Use Weighted Average cost of capital (WACC) which according to S&P is also about 11%. To be little more conservative I am adding one more % and using 12% discount rate.

grp-dfc-sept-27-2007.gifTo calculate terminal value from year 11, I have used “capitalization rate” which is = discount rate-2nd stage growth rate and it is 4%. Using NPV methodology, I arrive at $71.97intrinsic value. You may model is with your own assumptions. If I just change my growth assumptions to 20% (as analysts predict for next 5 yrs) and replace discount rate by WACC (11%), the intrinsic value is close to $117.85. Based on $71.97, I can now purchase the shares at about 25% discount to its intrinsic value.

I’ll use one more method to evaluate whether or not it’s undervalued. This method was brought to my attention by one of the OP readers (Thx Dayton). It is called Rule#1 by Phil Town. Based on fundamental analysis, here are the highlights:

  1. Return on Invested capital is growing, long term > 13%
  2. Equity Growth (The single most important factor that Mr Buffet reported in all the shareholder’s letter’s opening para) is growing, long term > 13%, Short-term > well over 25%
  3. EPS is growing, long term >20%
  4. Sales > 12%, short-term ~20%
  5. Free Cash Flow (as per Morningstar.com) > well over 15%

grp-rule_1-model.gifWhen I plug all those numbers and assume the same growth as I did in DCF Model 15%, I arrive at $51.45 price. This is the price that is with 50% Margin of safety to deliver 15% per annum returns. In fact $102 is the value that I arrive using that methodology.

There are several other methods i.e. comparable but I think those are relatively shaky. But even if I use those methods, it’s quite clear that GRP is undervalued and a great buy in my opion, it has potential to deliver 15% per annum nicely except if the business deteriorates.

There are watchouts though, higher than expected customer inventory of drill products, lower off-shorre and drilling activity, lower oil and natural gas prices, higher cost, delays in intelliserve tech deployment and of course Management (I dind’t much research to find out about them yet). If any of these signs surfaces, time to re-run the model.

Value investing is very different from options trading, and one must understand the business, the management team, industry prospects so as to hold on it during tough times.

Profitable trading, OP

8 Comments

  • bob says:

    Awesome stats to consider- Makes too much sense!!way 2 go!
    ROI and the free cash flow- was wondering if u also consider debt .- Do u like debt equity parameter over pure debt- or at least what value is given by the co.?

    If debt is something over say 25-35% – does it really hinder that company ?
    Your watch out add ons here – WoW! boy that can really skew things- and still with all of these considerations it seems these guys willSTILL make money

  • dayton says:

    Thank for the analysis. Where did you get the first method of calculation value?

    The second method is Phil Towns which is one of the best so far. If the big fives are >10% than its a great business. Technical charts looks sideways for now.

  • OptionPundit says:

    Bob, thanks for the comment. I have considered debt, but relied on debt/equity ratio to guide me. I don’t think having debt is bad. There are “good debt” and “bad debt”. One need to dive deeper if debt is a concern.

    Dayton, first method is a classic text book method to calculate NPV of expected future cash flows using appropriate variables.

    Profitable trading, OP

  • sjfischr says:

    I dunno–Morningstar rates it terribly–way too overvalued. I know they are conservative, but “its broad mix of drill pipe and drill bit businesses
    on several continents helps offset regional or subsector downturns. But the company remains in a cyclical, no-moat business subject to earnings and cash-flow volatility.”

    On the other hand, Morningstar’s modeling is often far too concerned about cash flow, and less about market conditions. The Natural gas market can clearly eek out a few more bucks on the price. I would go for it, with caution. On the other hand, it took Andarko a while to get out of its rut, right?

  • Zach says:

    How would you play this name? Would it be worthwhile to buy some in the money December options so premiums wouldn’t be too high? Sell some at the money puts to capture the current premium?

    It seems the volatility may make purchasing options better than selling them in this situation.

    thanks,
    Zach

  • OptionPundit says:

    Dear Zach, thanks for stopping by.

    There are couple of ways to play this, which depends on how greedy one is.

    1) One can simply buy shares and enjoy the ride.
    2) One can buy shares and buy ATM puts to hedge it.
    3) One can by shares, buy ATM put and sell OOM calls to finance purchase of puts to create bracket and limit the gains. Keep repeating it if GRP either continue to rise or fall (Very little risk).
    4) One can sell naked puts (say if you want to buy at 50), if assigned buy shares, sell puts again and write calls to make money from either side movement.
    5) One can buy simple straight ITM (or OOM) calls, and many more ways (i.e. credit spreads, calendars, etc.)!!!

    I am personally inclined for #3.

    Profitable trading, OP

  • […] assess GRP from two different valuation model perspective and had arrived at $72 as intrinsic value with certain growth assumptions. National Oilwell Varco (NOV) agreed to buy Grant PrideCo (GRP) for […]

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