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12thJanuary

Revisiting Bronco Drilling Company

Bronco Drilling A little more than a month ago, The Marley Group initiated coverage on Bronco Drilling Company (BRNC) with a strong buy rating. After initially rising following our recommendation, shares have since fallen to new all-time lows, closing today at $13.61.

The recent slump in shares is the result of irrational trading decisions in my opinion. There has been no major company related news, the only recent event was a small acquisition that was greeted as a non-event in the trading day following its announcement. Natural gas has come down since the time of our recommendation, however it has not dropped to levels that would warrant a 20% drop in market value over the course of a few weeks. Assuming the absence of some sort of catastrophic event that has been driving the trading of the past few weeks whilst unbeknown to the general public, this move can only be rationally viewed as an opportunity to accumulate at an even more favorable risk to reward ratio.

Bronco Drilling Company currently has a book value of $12.95 per share. This means that the market is currently valuing Bronco’s business operations at less than $0.67 per share, $0.10 less than they should earn in the current quarter alone. If shares of Bronco Drilling slide much further, the company will be selling for less than their rigs alone are valued at. If this happens, some one could theoretically acquire all of the outstanding shares of the company, disband all operations and sell the rigs, and record a sizable arbitrary capital gain. This makes the possibility of any further downside in Bronco shares very limited. I reiterate strong buy rating on Bronco Drilling Company and stand by my previous predictions. The fundamental picture remains very strong and in due time will drive a significant appreciation in the value of this company.

Disclosure: Joseph Urgo has a long position in Bronco Drilling Company.

12 Comments

Bo says 16th January @ 12:55

According to S&P Marketstream, the analyst for BRNC at Calyon Securities dropped his estimates and changed his rating on 1/4/2007. His price target dropped from 28 to 17.50 and his earnings estimates are now $2.50 for this year and $2.90 for next (2008). He is basing these changes on a y/y revenue growth of -3% and a belief that the warm winter and oil and natural gas price drops are significant risks.

What are your price estimates for NG and WTI crude oil that underly your view?

Wax says 17th January @ 6:29

I took a few minutes to look at the interim financials for this company and based on my back of the napkin scratching, I figure the stock is fairly valued at $14.

With that said, I will also tell you that in March, when the company files its 10K, that valuation number will likely decrease, as interim financials are always dicey to use.

As I say, I’ve spent more time writing this response than I spent looking at the financials, but a couple of thing stood out.

The first thing was that for every dollar in sales, the company has a net change in cash of ($0.085).

The next thing was that for every dollar in sales the company spends $0.70 on cap ex items. Understandable, they’re in the drilling business, a capital intensive business.

The other thing that popped out at me was the company’s increasing debt, as well as the company’s issuance of new shares of stock.

As an investor, why do I want to applaud management for diluting my investment, which is how I interpreted your post?

So with all of this said, how is the value of an investment in this company at $14, protected?

In my opinion it isn’t. And since I’m not about to pay $14 for a $14 stock, my buy target for the company’s stock is between $4 and $6.

Wax

Joseph Urgo says 17th January @ 9:09

I am looking for a bottom to come in around $50 for crude oil and for natural gas prices to remain above $6 near term and to be back above $7 within a few months time. The Calyon analyst seems to have forgotten to take into account the fact that Bronco has been refurbishing rigs all year and their revenue will grow year over year based on the number of working rigs alone, unless day rates were to topple from current levels.

The refurbishment program is also a main reason that Bronco’s net cash position has actually decreased in the past. Rather than allow their retained earnings to sit on the balance sheet, they have been reinvesting heavily into their business to allow for future growth. I’m not sure what issuance of new shares you are referring to, as they have only had one secondary offering since coming public, which occurred in October of 2005. Also, the two acquisitions that they have made have been very small, small to the point that they did not increase dilution by much. This company will never trade in the $4 to $6 range, the protection that I mentioned in their value comes from the worth of their rigs alone. If they were to disband operations completely, and sell off all of their rigs, they would return nearly $13 per share to shareholders.

Wax says 18th January @ 6:09

Well Jason if their rigs alone are worth $13 and the company is actually worth my estimated $14, I still fail to see where an investment in this company is protected?

As to the price of oil, to be honest, it means nothing to me. What matters is what I believe a reasonable value for my investment is, and at the moment, I believe the stock is worth $14.

Normally, I would employ a margin of safety as protection to the downside of 40-50%, putting my buy target at $7-$8. But because I haven’t had time to fully explore the company’s financials, I have increased my margin of safety to between $4-$6.

As to saying that the company will never trade in the range…well, good luck with that.

As for me, it doesn’t really matter if it does or doesn’t since I have no intentions of becoming a buyer of the stock.

Wax

Joseph Urgo says 18th January @ 9:42

Can I ask what metrics you used to arrive at your $14 fair value estimate?

Wax says 19th January @ 6:10

I don’t use a single metric as each business is different. I pay no attention to growth, beta, or any of the rest of the stuff that analysts are so fond of, and I never ever ever use interim financials.

To me the ultimate value of a company is the free cash it can generate, so to my analysis, free cash flow is everything.

I couple my discounted free cash flow values with some other metrics I have developed over the years for leveraged buyout modeling and lastley I evaluate management by determining what the company’s return on invested capital is and has been.

Just think of it this way. What would this company need to be able to acquire all of the other companies in its industruy?

To me, it would need cash, lots and lots of cash, but cash that would not detract from it’s normal business operations….that to me means free cash, which means management is going to have been managing the company’s business with a bit of forethought and integrity, and it means like it or not, some of the company’s acquired are going to have to be able to finance their own acquisition.

Once I had worked all that out in my head, a very long time ago….the rest of what an anlayst said or I read somewhere, or heard on the news…meant absolutely nothing because it that all meant the folks running their heads didn’t have a clue.

Joseph Urgo says 19th January @ 13:38

Well Wax, to every man his own. I respect your views on valuing a business and agree that free cash flow is very important. However, I feel that in order to truly understand a business, all things need to be considered. You mentioned that you pay no attention to growth. In the case of Bronco Drilling, a company that has experienced rapid growth since going public, I feel it is very much necessary to take their growth into account. Not only for the purposes of trying to predict future growth, but to understand the effect that growth has had on the rest of the company’s financials. Rather than retain earnings, Bronco has been using it to fuel internal growth through an ongoing rig refurbishment program. While this has depressed free cash flows in the short term, the increased amount of operating rigs on line will translate to greater cash flows down the road.

Wax says 20th January @ 6:40

Joseph, I appreciate your position with regards to Bronco and of course wish you all the best with this investment.

As to valuing growth? Well I wish all the best with that also.

Wax

Jason says 25th January @ 22:49

I am kicking myself for not pouncing when I had the opportunity when BRNC closed at it’s 52 week low. Since you wrote this follow-up, shares are up 15% to $15.58.

I am hoping for another dip in the immediate future!

Joseph Urgo says 25th January @ 23:18

It is possible that another dip may occur, however I believe that the bottom is in place already. Even with the 15% rise you mentioned, this company is still attractively valued.

Jerry Black says 16th February @ 16:54

Joseph,

What is your take on Wexford selling? I know they have been there sinice the incept and funded the company (probably with a very low cost base) and are now cashing in. I would think this has put a major damper on a small cap like BRNC.

Also what is your take on BRNC in regards to the Eagle Transaction? Thanks

Jerry

Joseph Urgo says 17th February @ 1:28

I view the Eagle purchase as a positive for Bronco as it makes them slightly less susceptible to a significant drop in day rates, as Eagle’s rigs are service rigs rather than drilling rigs and are not as cyclical. It will also give a slight boost to both the top and bottom line. Even though it was not an extremely large acquisition, it serves to show management’s commitment to growing their business.

As for the selling pressure by way of Wexford, I believe you are correct in assuming it would provide a major damper on the share price of Bronco. The current number of shares outstanding is near 25 million. Wexford has sold 10 million shares since August 15th 2006. Wexford still currently holds just under 3.9 million shares. They will continue selling until left with 4.8% of the shares outstanding or about 1.2 million. So while there will still be some short term downward pressure, at the volume at which they have been selling lately, it wont take long to reduce their holdings to the aforementioned 1.2 million shares.

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