Bronco Drilling is a rare find: a small-cap growth stock with a beaten-down value profile.
Normally it’s very tough (if not impossible) to find small-cap companies with excellent growth prospects, strong cash flow, and minimal long-term debt trading a mere twenty to thirty percent above book value. (Bronco is trading just under $16 as of this writing, with a $396 million market cap.
Book value is $12.95 per share according to the Wall Street Journal.)
Most of the time, companies trading close to book have an outlook ranging from “blah” to “ugly.” If a business sells for a just few dollars more than what the parts are worth, the natural assumption is that something is very wrong with that business.
If that same business is well run, making solid profits, has the means to retire its long-term debt in a short period of time, and could theoretically generate enough cash to buy back all its own stock in the next few years… now you’ve got a real head scratcher on your hands.
Except in Bronco Drilling’s case, the mystery has already been cracked. We know the problem is the manically gloomy sentiment surrounding natural gas.
Bronco is a small-cap land driller, headquartered in Oklahoma City, Oklahoma. They provide contract drilling services—land rigs—to oil and natural gas exploration and production companies, with ongoing contracts in Oklahoma, Texas, Kansas, Colorado, and North Dakota.
Approximately half of Bronco’s customer base are publicly traded companies—well known entities like Devon Energy and Chesapeake Energy. The other half are strong independents. Bronco’s customers have at least two things in common: they are committed to the long-term bullish case for natural gas, and they are committed to drilling.
Between December 15th 2006 and January 11th 2007, Bronco Drilling shares were pummeled, registering a 30% decline in less than two months. The selloff came during a period of general carnage for the drillers, as oil declined and natural gas fears escalated with the persistence of mild winter weather.
Things were orderly at first, and then Nabors Industries—a large competitor of Bronco’s, and one of the biggest land drillers in existence—announced a fourth quarter earnings warning on January 3rd.
Nabors went into freefall at that point, and Bronco followed.
At the worst point of the decline, the spread between Bronco’s share price and book value shrank to about sixty-seven cents… less than the company’s third quarter diluted earnings of 70 cents per share.
When the implied value of the entire business operation is compressed to less than one quarter’s worth of earnings, you know there is some panic in the house.
Legendary value investor Ben Graham liked to talk about “Mr. Market,”
analogizing the stock market to a human being subject to fits of optimism and depression. Thanks to the dominance of fast money and short-term time horizons, Mr. Market is a bit of a drug addict these days, downing copious quantities of quaaludes and methamphetamines. When Mr. Market gets exceptionally out of whack, opportunities arise like this one.
The real worry for companies like Bronco and Nabors is what’s happening in the land rig market. Nabors’ cut of fourth-quarter earnings guidance, which it blamed on slowing North American gas markets, led to dire scenarios of collapsing day rates and rigs sitting idle as result of a glut.
In Outstanding Investments’ opinion, these fears are overblown. There is fair reason to have concern, but nothing to justify the crush of pessimism that has weighed down the drillers so heavily. That is, if one understands the basic realities of peak oil and the compelling long-term case for natural gas.
In regard to rigs and day rates, Bronco Drilling also stands out for the quality of its management and farsightedness of its strategy. Bronco keeps close tabs on market conditions, and is careful not to “compete with itself” by putting out more rigs than the going market can support.
When the market is less conducive to putting out refurbished rigs, Bronco scales back and uses its cash flow to diversify into other complimentary businesses, like workover rigs—the mobile machines that handle cleaning, service and maintenance for wells already in production. Bronco’s recent acquisition of Eagle Well Service is an example of expansion in this direction. Bronco is also mulling over the possibility of international expansion as conditions and opportunities warrant.
Bronco Drilling reports good visibility with its clients; CEO Frank Harrison reported on the third quarter earnings call that there seem to be no issues with drill budgets, and “if anything we’ve seen a push to continue to drill.” Because of their high-tier focus on support, service and safety, Bronco Drilling also enjoys stronger relationships with clients than many of its smaller independent competitors. This adds a layer of stability to revenues, as the less established fringe players are the ones to see their rigs idle first in adverse market conditions.
The land rig market is not without risk in the coming months, but the potential reward seems well worth it. While Bronco Drilling has already bounced off its oversold extremes, it is still trading under its $17 initial public offering price as of this writing—and this comes with excellent management and excellent results.
Book value acts as a floor underneath the stock—if worst comes to worst, a vulture investor could break up the pieces of Bronco and sell them off for
$13 a share or so, if not more under the right circumstances. But that isn’t likely to happen by any stretch of the imagination. What is far more likely, in our opinion, is that day rates and rig utilization will stabilize and resume their upward trend in due time, and Bronco will continue to grow and thrive.
Of course, if Mr. Bastardi of Accuweather is right in his weather predictions, sentiment for the land drillers could turn extremely quickly.
At a current price to earnings ratio of less than eight, Bronco could theoretically see 50% or more upside simply by way of removing the cloud of pessimism overhead.
Even if the weather remains mild and the sentiment adjustment a ways off, the natural gas case is solid—and Bronco Drilling looks worth holding on to for “multi-bagger” upside potential in the years to come.