Grant Prideco (GRP)

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Grant in a strong uptrend...

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iBox updated this evening...

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Drilling Down
By Dan Amoss

If the "law of diminishing returns" could ever be repealed, energy exploration companies would certainly vote in favor. But energy services companies would not. Indeed, the law of diminishing returns may be the energy services industry's staunchest ally, as well as the primary reason why stocks like Grant Prideco (NYSE: GRP ) and National-Oilwell Varco (NYSE: NOV ) are likely to reward investors over the coming decade.

The North American natural gas industry is a real-time illustration of the law of diminishing returns. Exploration and production (E&P) companies are sinking an ever-growing number of wells, but extracting an ever-shrinking quantity of natural gas. In other words, the North American natural gas industry is becoming very "drilling-intensive." That's bad news for the E&P companies, but good news for the folks who provide the drill rigs and pipes and other equipment that the explorers use.

The following charts illustrate the rising trend in drilling intensity. This data is publicly available on the websites of the Energy Information Administration (EIA ) and oilfield equipment and service company Baker Hughes (NYSE: BHI ).



The blue line is the Baker Hughes natural gas rig count in the "lower 48" United States, including offshore basins. By "gas" rigs, Baker Hughes refers to rigs drilling for natural gas in U.S. territory. Out of the total U.S. rig count, gas rigs now comprise about 84% of active rigs, with oil rigs comprising the other 16%.

As you can see, the past ten years of data refute the oft-repeated assertion: "A surge of drilling activity will lead to a glut of natural gas and cause prices to crash." Obviously, gas prices have not crashed, despite the sharply rising rig count.

The second chart combines the two data sets from the first chart. It shows the monthly U.S. gas production, divided by the monthly rig count. A simple regression line shows a clear trend running from 3 billion cubic feet (Bcf) per month per rig ten years ago to 1Bcf per month per rig in 2006:




What conclusions can we derive from these charts? Well, they lend heavy support to the view that drilling demand will more than absorb any increase in the rig population. Most E&P companies are earning huge returns on invested capital at current gas prices. So they will bid aggressively to put newly-built rigs to work on their drilling projects.

Another conclusion? Just maintaining current natural gas production will require a steady uptrend in rig activity. Both of these conclusions lead to one over-arching conclusion: the drilling boom is not over yet.

So disregard headlines about the impending wave of new rigs destroying the drillers' profit margins. Instead, keep an eye on the price of natural gas. The trend of natural gas will be the primary driver of drilling activity, and thus, of profit growth at companies like GRP and NOV.

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I don't trust the recent run in Grant as volume has a negative divergence with price trend.

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Make or break time for GRP. See weekly charts in iBox.

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Grant Prideco on the verge of breaking the short-term down trend line. Looks good to go...

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GRP Street.com recommendation

We rate GRANT PRIDECO INC (GRP) a BUY. GRP has posted an impressive financial performance and offers
superior return to its shareholders. Going forward, the company is expected to continue its growth given the
favorable industry outlook.
HIGHLIGHTS
Favorable industry outlook. The increase in world-wide demand for energy products has given a new lease of
life to oil exploration activities. According to the U.S. Energy Information Administration the global demand for
oil is expected to grow from 84.60 million barrels per day in the year 2006 to 98 million barrels per day by the
year 2015. World crude oil demand is expected to rise by 1.5% for FY07 and FY08. Despite the higher oil &
energy prices the demand is expected to grow at a fast pace fueling growth in the production. GRP could
benefit from the buoyant oil and gas exploration markets through increased sales of its drilling and
ReedHycalog products.
Impressive financial performance. GRP revenue increased by 19.8% to $275.95 million in Q1 FY07 compared to
Q1 FY06, due to improved performance from Drilling products and services and ReedHycalog segment. Net
income increased by a higher rate of 42.3% to $131.55 million due to higher non-operating income and lower
taxes, partially offset by higher interest expenses. Earnings-per-shares (EPS) grew by a higher rate of 46.4%
to $1.01 due to lower share count. Going forward, management expects its earnings for full FY07 in the range
of $4.10 per share to $4.20 per share up from $3.50 per share reported in FY06.
Superior shareholder returns. GRP’s return-on-equity (ROE) increased to 34.47% as of the end of Q1 FY07 from
22.33% a year ago, following a robust growth in earnings over the past twelve months. This is significantly
higher than the Energy Equipment $ Services industry average ROE, and more than twice the S&P 500
average. During Q1 FY07, GRP repurchased 1.20 million shares for $45.00 million, which is expected to improve
its ROE further.
Risks to the BUY rating. There has been a rise in oil price in the past two years, which might lead to either
decline in demand or increased use of alternatives, which may ultimately result in the lowering of demand for
oil which in turn will slowdown drilling activity. This may negatively affect the earnings of the company.

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Don't Take Grant Prideco for Granted
Grant Prideco (GRP: NYSE)
By Bear, Stearns & Co. ($49.49, March 29, 2007)

We have raised our rating on Grant Prideco from Peer Perform to Outperform, and we have set a year-end 2007 price target of $65.

The momentum of consolidation and buyouts in the oilfield steel-tubular-products area continues at an astonishing pace. Yesterday's announcement of the acquisition of Lone Star Technologies by U.S. Steel is the fifth buyout of an U.S. oilfield tubular company in the past 12 months.

Buyout valuations also are on the rise. The $67.50-per-share purchase price of Lone Star equates to a multiple of 18 times estimated 2007 earnings and an enterprise value/earnings before interest, taxes, depreciation and amortization multiple of 8.5 times on estimated 2007 EBITDA.

Hydril, a company being acquired by Tenaris, is a closer peer to Grant Prideco than is Lone Star. Hydril at the buyout price of $97 per share is valued at a multiple of 19.8 times estimated 2007 earnings and an EV/EBITDA multiple of 11.6 times on estimated 2007 EBITDA. Grant Prideco at yesterday's closing price of $49.49 is valued at a price-to-earnings multiple of 12.5 times and an EV/EBITDA multiple of 9.1 times (based on our 2007 estimates of earnings and EBITDA).

Grant Prideco's three core businesses -- drilling products, drilling bits, and tubular technology -- are performing strongly as evidenced by the company's operating margins of 30% and EBITDA margins of 32% in 2006. The company is the world leader and the largest manufacturer of drill pipe, with 18 million feet per year of production capacity. It is the premier global franchise in high-performance drill pipe and has maintained both its technology and market share leadership in the current business cycle. Low-cost capacity expansions have helped to boost returns on invested capital to a projected 31% in 2007, up from 26.5 % in 2006.

We believe that near-term weakness and uncertainties relating to the North American gas-drilling market will have little impact on Grant Prideco's earnings, and even less influence on the value of Grant Prideco to a potential strategic buyer of the company. Lone Star Technologies has felt a much greater impact from the U.S. gas-drilling slowdown than has Grant Prideco.

However, Lone Star's attractiveness to U.S. Steel was in no way diminished by the near-term weakness in U.S. gas drilling. In the case of Grant Prideco, we believe that investors can confidently look beyond the impact of a temporary slowing in drill-pipe orders, which might come later in 2007 if the direction of the U.S. gas-drilling market continues to be uncertain.


Grant Prideco is a much larger company than either Hydril or Lone Star (which are both around $2 billion in equity market capitalization). Grant Prideco currently has an equity market capitalization of $6.4 billion and would have an equity market value of $8.3 billion at our price target of $65, which we believe is a minimum buyout price for the company. Despite its much larger size, we expect that there are multiple potential buyers of Grant Prideco that could finance an acquisition in the $8 billion-to-$10 billion range.

As the number of "un-acquired" companies in the oilfield steel-tubular and steel-products niche shrinks, the scarcity value of the companies that remain increases. This is evident in the price paid for Lone Star, which was the last remaining independent manufacturer of oilfield casing and tubing until its purchase by U.S. Steel.

Lone Star's buyout price is at a 36% price-to-earnings multiple premium to the average buyout prices of Maverick Tube, NS Group, and Oregon Steel, the three oilfield steel-tubular-goods companies that were purchased by larger international steel companies last year. We believe that Grant Prideco's scarcity value is growing by the day as the steel industry and the oilfield-service industry consolidate.

Grant Prideco is strongly positioned globally and, more than any other company we follow, has the best prospects of receiving the kind of buyout proposal that simply can't be refused.

-- Robin Shoemaker
-- Jason Strominger
-- Mark Brown