Description

Weatherford is a prime example of an under-the-radar investment opportunity.  The Company emerged from bankruptcy in December 2019, and despite a sizeable $1.9 billion market capitalization, is covered by just one sell-side analyst.  Shockingly, WFRD is considered one of the “big four” oilfield service providers and is effectively ignored by the market in its current post-bankruptcy state.  

Nearly one year ago, we took notice of a transformational shift occurring; energy bankrupt names were now on the verge of re-emerging almost debt free, transitioning their business models toward disciplined production growth, free cash flow generation, and shareholder returns through stock buybacks and dividends.  This behavior, once totally unheard of in relation to the energy industry, was becoming prevalent.  These post-bankruptcy companies, in many instances, were exiting with clean balance sheets, and trading at dirt cheap multiples of 2.0-3.0x EV/EBITDA and 20-30% free cash flow yields.  We believe this is due to a continued lack of coverage in the sector, which is further illustrated by the Weatherford investment opportunity.

Prior to the bankruptcy, the old Weatherford was aptly characterized as mismanaged, unfocused and having a strained balance sheet compared to the other large and diversified oilfield service companies, known as the “big four,” including Baker Hughes (BKR), Haliburton (HAL), and Schlumberger (SLB).  However, Weatherford today is completely different.  It is led by a new management team and has exited most of its unprofitable business lines and territories that plunged the Company into bankruptcy.  Weatherford, once an unfocused story chasing growth all over the globe, is now a lean and measured organization.  And yet, despite now having a much cleaner balance sheet and leverage ratio of 2.2x, which is in-line with its peers, WFRD is trading at a severely discounted multiple based on our 2022 EBITDA estimate, of only 4.7x EV/EBITDA versus its peer group at 9.7x.  The upside potential here is dramatic once the Company simply becomes noticed by the market.  Weatherford is interesting beyond simply this gap in valuation, as the Company is in the midst of a significant operational turnaround, and over the next 12-18 months will approach and sustain a mid-to-high teens EBITDA margin and double-digit revenue growth profile akin to its peers.  While it may lack the flashy profile that has attracted investors in the past, namely North American pressure pumping exposure, we believe we are entering a new paradigm of value-based investment around this space.  The new Weatherford, with its smaller geographic footprint, emphasis on fundamental margin improvement and disciplined growth with a free cash flow focus, aligns quite well with the shift we mentioned earlier occurring across the industry, that of moving away from “cowboy-like” behavior and towards steady shareholders returns.  We therefore use an 8.0x EV/EBITDA multiple which is still below the 9.7x peer group average to derive our price target, resulting in a share price of $59.33, or 117% upside from the current price.  Notably, while we are reluctant to make any singular macro call on the global economy and the price of oil and natural gas, our continued assessment of supply-demand mechanics suggests a healthy outlook supportive of commodity prices and thus demand for Weatherford’s offering.

We believe the following catalysts will unlock the hidden value within WFRD: 1) near-term margins to improve 140 basis points from Q2 2021 towards a 16.5% EBITDA margin target in 2022, as WFRD matures as a post-bankruptcy company, and long-term margins to reach 18.6% as the topline scales in reaction to healthy demand; 2) initiatives taken to reduce elevated working capital inventory, and a refinancing of its high yield debt, to bolster the Company’s free cash flow profile by $111 million annually; and 3) improved margins and free cash flow to help deleveraging towards a modest 1.3x net debt/EBITDA in 2022, thereby alleviating any lingering market concerns with the Company’s post-bankruptcy capital structure.

New Management and Operational Efficiencies to Boost Weatherford’s Margin Profile

Weatherford is a diversified, global oilfield services company which means it services a range of E&P companies who hire it and utilize its products in an effort to find and extract oil and gas, both onshore and offshore.  WFRD can be understood through its two reporting product lines, each contributing about 50% to total revenue.  Completion and Production offers production optimization services and a complete production ecosystem including artificial life, test and flow measurement solutions, and optimization software for well productivity.  Drilling, Evaluation, and Intervention comprises a suite of services for well planning and reservoir management, including drilling, wireline services, and tubular handling.  While energy service companies may tout the differentiation of the above products and offerings, it is our strong opinion that as with any services company in a commodity-driven industry, the key to success is operational efficiency.  

The old WFRD was the opposite of efficient.  Between 2015 and 2019, it lagged its peers by an average 740 basis points in operating margin.  Being late to the US pressure pumping frenzy, it chased growth and expanded into the North America region precisely as the US rig count (a key metric for gauging activity as measured by weekly drilling rigs) began to decline.  It also expanded within risky and volatile markets like Latin America without a clear plan to manage the cyclicality in its operations.  Unlike many of the other bankrupt energy companies mentioned earlier, WFRD was such an operational mess, it actually filed Chapter 11 in mid-2019, about a half year prior to the pandemic.  It is precisely this low benchmark in operational competence and market perception that makes this such an asymmetric investment opportunity.  

In late 2020, the Company overhauled its management team, with Girish Saligram joining as CEO in October, alongside new CFO Keith Jennings.  Saligram’s profile stands in contrast to the old WFRD paradigm.  He has a strong operational background, having led specific business units for decades at General Electric (GE).  The tenor of Weatherford’s recent earnings calls is materially different from the pre-bankruptcy calls, with a focus on operational discipline rather than a lofty and grandiose vision.  This has resulted in WFRD exiting nearly all unprofitable geographies and business lines.  In just a short period, the Company has shrunk its footprint and topline by 37% from its recent peak of $5.7 billion in 2018, to $3.6 billion today.  North America, where competitor Baker Hughes and Haliburton have much stronger footholds, has diminished in importance from the 40% range to the mid-20% range of WFRD sales.  And Latin America and other risky territories have dropped an estimated 45% from their peak influence on WFRD’s exposure.  Margins conversely have expanded materially under CEO Saligram’s direction, improving by 550 basis points, from 9.6% in Q2 2020 to 15.1% in Q2 2021.  In fact, the Company recently pre-released dramatic Q3 2021 preliminary results, including an 18.0% EBITDA margin.  While details around the drivers of the operating margin improvement were limited, it speaks volumes to new management’s ability in transforming WFRD in such an expedited manner.  

With the prioritization of profit over growth now firmly in place, we believe WFRD is just beginning to hit its stride.  Our channel checks and analysis suggest three initiatives will drive a further estimated 140 basis points of margin enhancement: merging the manufacturing and supply chain into a consolidated function (30 bps); reducing variable costs, including real estate and fleet management (80 bps); and streamlining inventory management (30 bps).  These initiatives support our 16.5% EBITDA margin assumption in 2022, which is above the one sell-side estimate of 14.7%.  Based off the street estimated topline for 2022, this margin improvement yields a delta of $69 million of EBITDA, or $7.85 in value per share after applying an 8.0x EV/EBITDA multiple.  Again, while we recognize that our 16.5% margin in 2022 is 150 basis points below the margin just recently achieved in Q3 2021, we prefer to stay conservative, at least until more context is given surrounding the operational improvements on the next earnings call. 

Seen from a different perspective, our 16.5% margin assumption is still 210 basis points below the current average of the peer group.  This is explained by the loss of scale as revenue shrank significantly due to the Company’s decision to downsize alongside a weakening commodity market.  For reference, all three peers are several times the size of Weatherford, and this is a critical factor in understanding the margin potential as revenue scales.  Given the recently strengthening oil price environment, E&Ps will undoubtedly reverse the extreme production discipline of 2021 and increase their budgets meaningfully next year.  As it pertains to Weatherford, we believe the Company is set to benefit from two overlooked themes that will set it apart from its peers.  First, we estimate WFRD is more exposed to the natural gas markets than its peers, a factor that in the past presented a detriment.  Given the recent healthy supply demand-mechanics supporting natural gas prices (and relating to the liquified natural gas market dynamic) for the first time in years, all indicators suggest customer stability and even growth in 2022 and beyond.  Second, WFRD has considerably more offshore exposure than its peers.  Offshore spending tends to be driven by the national oil companies of the world who typically take a longer-term perspective to their spend compared to many of the typical US based shale players.  Again, while this factor negatively impacted WFRD in the past, we see it as a contributor towards steady growth going forward in a post-pandemic world.  Of course, WFRD’s topline will remain well below its peers, but based on our analysis of the Company’s incremental margins we see at least 210 basis points of further margin expansion over the next two years (especially in the context of having just achieved 18.0% in Q3 2021).  Using the sell-side 2022 revenue estimate, achieving the peer margin of 18.6% results in $153 million of incremental EBITDA, or $17.41 per share in incremental value per share after applying the 8.0x EV/EBITDA multiple.  This would result in 64% upside to WFRD shares.

Free Cash Flow Conversion to Significantly Improve Into 2022

Though future accelerated free cash flow generation is one of the highlights of the new WFRD, one of the push-backs historically has been the limited free cash flow it has generated.  Even this year, amidst EBITDA improvements, we estimate $562 million of EBITDA will translate into only $114 million of free cash flow.  However, we believe this is an opportunity for the market to further appreciate WFRD once it begins to actually convert its EBITDA into normalized levels of free cash flow.  The first pivot towards generating cash will be to improve the Company’s days sales inventory (DSI), a metric used to gauge the efficiency of how quickly a company is converting its inventory into actual sales.  Our analysis suggests that WFRD is lagging the industry norm in this regard, and we see the potential for it to reduce this figure by ten days as it continues to mature in its post-bankruptcy state.  We estimate this will reverse the estimated $49 million of working capital usage towards a breakeven point.  The second catalyst for cash flow improvement is refinancing WFRD’s overly expensive debt inherited during its restructuring process, which is already underway.  Up until recently the Company had been incurring an effective cash interest rate of 10.8% on its $2.6 billion of debt.  Management has been proactive in this regard and successfully refinanced $500 million of notes with a new tranche of 6.5% debt this past September.  Also, most recently on October 12th, WFRD announced a proposal to redeem and refinance $1.5 billion of its senior secured notes due in 2024, which were priced at 8.625%.  Extrapolating these recent rates on the remaining debt, we estimate a blended 8.0% interest across its tranches, which results in a potential cash flow boost of $63 million.  Combined with the working capital improvements, this results in a potential year-over year-improvement of $111 million of cash flow.  Therefore, we estimate Weatherford will generate free cash flow of $343 million in 2022 (off our EBITDA assumption of $673 million), implying a significantly improved conversion ratio.  We believe this will better enable the market to value WFRD in-line with the peer EV/EBITDA trading multiple.  Notably, Weatherford is currently trading at a very attractive free cash flow yield of 17.9%.  Applying the average 6.1% free cash flow yield of the group results in an $80.21 share price, significantly surpassing our $59.33 price target based on the peer EV/EBITDA multiple.

Deleveraging Effort to Meaningfully Alter WFRD’s Financial Profile

Another factor impeding broader equity market appreciation of the WFRD story is the Company’s balance sheet and leverage optics, which we believe will be radically improved by strong near-term free cash flow generation.  WFRD’s current net debt/EBITDA using 2021 EBITDA is 2.2x.  Although this is actually in-line with the peer group average of 2.2x, we think the market might be uncomfortable with this leverage for a company that recently emerged from bankruptcy with a troubled past.  In fact, many of the energy equities we have followed have emerged with a net debt/EBITDA ratio closer to 1.0x.  Here again, the WFRD story going forward will provide a meaningful perception change going into 2022.  With strong free cash flow generation and EBITDA improvement going forward, WFRD should pay down debt and achieve a leverage ratio of 1.3x in 2022.  This will serve to transform market perception of WFRD’s financial health and help garner a higher deserved valuation multiple.

Conclusion

Since holding WFRD stock, we have been impressed with management’s ability to deliver and execute upon its goals.  Nonetheless, WFRD still trades at a severely discounted multiple of only 4.7x EV/EBITDA compared to its peer group average of 9.7x.  We expect the Company to move forward with meaningful EBITDA improvements and free cash flow generation, enabling debt pay-down and a vastly improved financial profile.  We therefore believe the market will ultimately reward Weatherford an 8.0x EV/EBITDA, resulting in a value per share of $59.33, or 117% upside from the current price.  

Catalyst

1) near-term margins to improve 140 basis points from Q2 2021 towards a 16.5% EBITDA margin target in 2022, as WFRD matures as a post-bankruptcy company, and long-term margins to reach 18.6% as the topline scales in reaction to healthy demand;

2) initiatives taken to reduce elevated working capital inventory, and a refinancing of its high yield debt, to bolster the Company’s free cash flow profile by $111 million annually

3) improved margins and free cash flow to help deleveraging towards a modest 1.3x net debt/EBITDA in 2022, thereby alleviating any lingering market concerns with the Company’s post-bankruptcy capital structure.