Land Ho

Without further ado, here is this month’s new recommendation.

For some, the weather outside has been frightful. For others it has just been bizarre.

Among other things, January brought us 70 degree temperatures in New York City’s Central Park; New England forsythias in joyous springtime bloom; snow in Malibu; more than $700 million worth of freeze damage to California citrus crops; Colorado cattle trapped by 15-foot-high snow drifts; and, last but not least, Midwest ice storms that killed at least 14.

With apologies to Dickens, January was both the warmest of times and the coldest of times. Overall, 2006 was the warmest year in over a century for the continental United States. The mild temperatures enjoyed by the East-even as the West got gob-smacked by Old Man Winter-were enough to send natural gas stockpiles soaring. (No need to heat the house when it’s t-shirt weather outside.)

But now it looks like Old Man Winter could be rolling up his sleeves. Joe Bastardi, Chief Forecaster for AccuWeather.com, believes the whole country is going to get walloped. “Those who think that winter 2006-07 is going to remain mild are in for a shock,” he says. “Winter is likely to come with a vengeance.” Bastardi sees shades of winter 1977-1978, when a warm beginning led to a blizzard-pounding finish.

If Bastardi is right, natural gas storage levels could plummet in short order-reminding Wall Street once again how quickly situations can change. If he is wrong, of course, natural gas will remain mired in negative sentiment for the time being.

Climate change fears suggest a trend of milder winters-a negative for natural gas. But the flip side of that coin is greater temperature volatility and stronger legislative pressure.

Extreme weather patterns (like snow in Malibu, for example) require a larger supply buffer to absorb demand spikes when the outliers hit. Temperature volatility thus lessens the perceived “margin of safety” in existing storage levels. (The more things can swing, the more buffer you need.)

In addition, the more mild and wacky winters we see, the more determined world governments become to “do something” about carbon emissions. This green calculus gives natural gas a leg up on its carbon-spewing rival, coal. While coal is the electricity-generating champ from a financial cost standpoint, natural gas is cleaner and less carbon-intensive, making it the environmentally desirable choice.

Coal will likely remain the electricity king for some time, thanks to its abundance and low cost, but will also cede ground at the margins due to its reputation as a polluter and CO2 spewer. Nuclear power is set to expand its electricity role, but regulatory hurdles and lengthy construction times mean that growth will happen relatively slowly. Solar and wind are ramping up, but starting from a miniscule base. These factors give natural gas a consistent demand edge, in both China and the United States, that will last for quite a while.

All this, too, comes on top of the fact that in terms of depletion rates versus discovery rates, North America is running hard just to stay in place. The new wells are just not keeping up. Elsewhere, industry experts believe the global shortage of liquid natural gas (LNG) could persist until 2011, in part due to the political risk of LNG terminals and the high cost of plant construction. Furthermore Canada’s oil sands expansion plans will suck up a larger portion of that country’s natural gas production over time.

These natural gas musings are the backdrop for the latest Outstanding Investments recommendation.

This drilling company 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. (This company 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 this case, the mystery has already been cracked. We know the problem is the manically gloomy sentiment surrounding natural gas.

This is a small-cap land driller provides 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 their customer base is publicly traded-well-known entities like Devon Energy and Chesapeake Energy. The other half are strong independents. Their 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 15, 2006 and January 11, 2007, the shares of this company 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, and one of the biggest land drillers in existence-announced a fourth quarter earnings warning on January 3. Nabors went into freefall at that point, and this company followed.

At the worst point of the decline, the spread between this driller’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 this 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, this driller also stands out for the quality of its management and farsightedness of its strategy. It 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, the company 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. Their recent acquisition of Eagle Well Service is an example of expansion in this direction. Not to mention they are also mulling over the possibility of international expansion as conditions and opportunities warrant.

This driller reports good visibility with its clients; the CEO 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, they also enjoy 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 this driller 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 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 they 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, they 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 this driller looks worth holding on to for “multi-bagger” upside potential in the years to come.

Till Next Time,
Justice

February 9, 2007