The Weir Group operates in 2 main divisions. Weir Minerals is a world leader in slurry pumps and valves manufacturing for the mining industry. Weir Oil & Gas provides high pressure pumps and fracking equipment, valves and engineering support for upstream and downstream oil & gas projects. It is worth saying at the outset that Weir Group is not the company it was even three years ago, it has been involved in some transformative acquisitions and the source of earnings are now substantially different – the price chart and previous comparisons are not hugely instructive.
Weir possesses strong market positions in highly engineered and specialised products; they are benefitting from growing installed bases with highly resilient and growing cash generative aftermarket revenues. This is a high quality, secular growth story which is integral in the supply chain for an industry which might provide “the answer” to many of the worlds largest economies economic and political problems. What price would Barack Obama put on an answer to the problems of blue collar unemployment, gasoline prices hurting consumers, energy independence and Middle Eastern political involvement?
Extracting Energy from Shale Rock & Horizontal Drilling
It is not easy to extract gas or oil from shale rock. It is tough and uncompromising, even by the standards of other rocks! The rock traps the gas and oil so tightly that it has never been economically viable to extract. Over the last few years technology has developed which has allowed the rock to be cracked enough to release its valuable cargo. Below is a video from The Weir Group website on the process of horizontal drilling and fracking.
David Yarrow of Clareville Capital described the process of horizontal drilling and hydraulic fracturing very well in his outrageously good write up on Weir in April 2011
So as to tap the thin layers of shale, wells are drilled vertically to intersect the shale formations – often at depths of 10,0000 feet. The well is then deviated to achieve a horizontal wellbore within the shale formation. These horizontal wells can now travel up to 2 miles along the shale seam in parallel with the ground 2 miles above.
The poor permeability of the shale is addressed by hydraulic fracturing. A “perforating” gun is fed down the bore and gives off a string of explosives that blow holes the width of a fine knitting needle 18 inches into the shale.
Then comes the genesis of the SPM story. At least a dozen trucks with pumping equipment generate enough horsepower to blast a mixture of fine sand, water and lubricant chemicals into the bore. The sand blasts into the piercings in the shale and jams open crevices so that the gas can find its way into the bore. As much as 10 million gallons of water and 10 million pounds of sand can be pumped into a single well during the fracturing stage. It is a fluid intensive process…..
The recovery rate in aggressive and unwelcome shale formations will depend less on skill and more on the power and pressure of your pumps. Furthermore the pumps are going to take a hell of a beating in an intensive programme of trying to smash the gas out of the shale. In this underground battle zone, horsepower, precision and durability are key variables.
It is intuitively comfortable to contend that operators will not then compromise on the integrity of the pumps or the quality of the after service. After making the well, there would seem no point in cutting corners in well stimulation in a rock that doesn’t really want to “play ball”. Those that build wine cellars, don’t tend to fill them with too much Bulgarian red.”
Energy Independence in the US
“You can always count on Americans to do the right thing – after they’ve tried everything else.” Winston Churchill
“Energy independence is the best preparation America can make for the future.”
President Ronald Reagan
“Our goal should be, in 10 year’s time, we are free of dependence on Middle Eastern oil. And we can do it. Now, when JFK said we’re going to the Moon in 10 years, nobody was sure how to do it, but we understood that, if the American people make a decision to do something, it gets done. So that would be priority number one.”
President Barack Obama
The US drive for energy independence is ongoing. The Shale energy story is an exciting one because it offers light at the end of the tunnel for potentially hundreds of thousands of American citizens humbled by unemployment and impoverished by high oil prices. If anyone doubts the gravity of the situation I suggest you observe the following….
Shale Oil offers highly attractive break-even levels estimated around $50 per barrel by both insiders and industry consultants, with increasing recovery rates driving significant growth in the industry. This healthy cushion between current spot of north of $100 and these breakevens gives a margin of safety to anyone planning these types of projects.
The US EIA predicts that Shale Oil production growth will be 12% per year out to 2035, a clear indication of the US appetite for self sufficiency. The International Energy Agency forecasts that growth in Shale Oil production in the US of 265% from 2010 to 2016.
The US market accounts for 75% of Weir O&G orders (for now) and in particular unconventional oil sources which are expected to account for 17% of US production by 2016, a 30% CAGR between now and then. The chart below demonstrates the scale of the boom we are currently experiencing, US shale gas production has increased by a factor of 12x of the last decade and now that focus is switching to Shale Oil due to the current pricing differential. Although Weir’s pumps are used in the extraction of both oil and gas the process for oil is more intensive; it requires longer laterals, more frac stages/pumps and increases the service intensity – Halliburton have estimated that this means revenue per well could be 1.4x to 1.8x higher for the service companies that for that of a dry gas well.
Some estimates suggest that just the Baaken in North Dakota could be producing 1m barrels per day by 2020 which is circa 1% of global production from one US state. Even today North Dakota produces more oil than Ecuador which is an OPEC member!
Some have suggested that the Baaken has more crude than Saudi with an estimate of 300 billion barrels of oil. The main reservoir occupies around 200,000 square miles deep underground.
How much of the 300 billion barrels is actually accessible is dependent on the extent to which technology and expertise continue to advance. What was once impossible is now practiced widely, the recoverable percentage is likely to go up and the breakeven on the extraction may well fall. For clarity, in 1995 the recovery rate was estimated at 0.1%, in 2008 it was estimated at 1.5% and now it is gravitating towards 3%. What does seem likely however is that the complexity and intensity of the drilling process will continue to ramp up, it might just become more “normal”.
Horizontal Drilling – The Game Changer?
Horizontal Drilling has been described by former BP CEO Tony Hayward as a “game changer” and by Sir Ian Wood, founder of The Wood Group, as the most significant development in the industry in a generation.
The dynamics of the industry are extremely attractive for Weir. There is growth on top of growth here. Increased expertise and advancements in technology have led to the fracking process becoming increasingly more intensive. More wells being drilled, lateral lengths are increasing, greater horsepower and increasing frac stages per well leads to higher operational intensity and more wear and tear on equipment which flows through to higher servicing requirement and greater parts turnover. Fleets are now operated 24/7 due to the shortages of manpower and equipment, downtime is a luxury that cannot be afforded and utilization rates are increasing.
Operational efficiencies and attempts to maximise returns have led to operators working the equipment harder and longer, this is of course great news for Weir’s pumps. Data from Halliburton shows that service intensity in 2010 was 7x greater than that in 2006 and doubles that of 2008 just 2 years earlier.
Car tyres have a pressure of around 30 pounds per square inch, Weir pumps operate at 15,000 pounds per square inch and therefore are require extreme care when operating. As Yarrow recalls in his report
“Steve Noon told me that he had seen a controlled blow out of a SPM pump in an empty field. One of the iron components which weighed the same as a small child, ended up 250 yards away. Sadly, every year there are deaths adjacent to the pumps in horizontal drilling – it is a tough old game.”
A frac pump previously had a life expectancy of 5-7 years but this is being worn down (literally) to 4-5 years and sometimes just 2-3 years for the fluid end which deals with the proppant. In 2008 the average number of pumps or frac stages per well in the Baaken was 5, it is now 17 and many wells have more than 20. This directly and obviously equates to more ancillary equipment, more horsepower, more wear and more service requirements.
Below shows the trucks on which the SPM pumps are mounted linked to the green and orange frac tree (manufactured by Seaboard)by other SPM made flow control products. This highly technical spaghetti junction is where the Weir portfolio is dominant.
When operating to tight schedules in dirty, harsh environments with life threatening equipment it seems unlikely that frac team operators will be willing to cut corners to save a few dollars. They are likely to gravitate towards the counterparties with the responsiveness, history and quality of product to make sure that they get best in class service. Weir has 141 years of operating history associated with the proud industrial heritage of my hometown Glasgow, it has the widest most responsive service centre base in the US and SPM product is best in class. Furthermore one could add that the drilling industry cannot risk “a Macondo” accident, the going is too good, too lucrative for these oilmen to jeopardize lives and livelihoods with substandard equipment or safety procedures.
The minerals division provides around 40% of revenue and has been the core of The Weir Group for a long time leading the world in slurry handling. Weir enjoys a strong position in slurry pumps, holding no. 1 market share at 28%. It has leading positions in other products like cyclones and critical valves too. 75% of the revenue from this division comes from the mining sector with key customers include Alcoa, BHP Billiton, Rio Tinto and De Beers. The key drivers to the division are mining capex and commodity production volumes. The business is also very well diversified geographically with orders split almost evenly across all 6 continents.
The mineral division receives a large part of revenue from the aftermarket (circa 60%) which has historically helped protect it against any slowdown in the global economy or alternatively new equipment orders. Although a look at the WEIR price chart would not reveal this, the minerals division was very resilient during the last recession due to the aftermarket performance; it even managed to expand its margins by around 1% over the period from 15.4% to 16.4%. It seems likely that this division will grow slightly ahead of mining production growth due to the lower quality ores being mined and increasing industrial intensity of extraction meaning greater throughput and wear on parts.
Cross State Air Pollution Rule?
From what I understand this legislation mandates companies to monitor and improve their emissions/pollution and will be quite beneficial to Weir as it gives them a fairly large addressable market and a timeline by which these works must be completed. Specifics were pretty hard for me to come by but it seems that your average power plant/mill/mine will require more pumps/controls/valves as a result of the legislation as their by products will be closely monitored.
Weir Oil & Gas
The Weir Group is the market leader in high pressure well service pumps, flow control equipment and services used in unconventional oil and gas drilling. In high pressure frac pumps and fluid ends it has an estimated market share of 50% and in flow control equipment 25-30% share. The key driver for this division is the number of wells being drilled globally and the complexity of those wells – both of these factors are currently booming. Weir O&G has gone from 13% of revenue in 2006 to around 40% today and in terms of profit, after the recent Seaboard acquisition it accounts for around 45% of profits up from 11% just 6 years ago.
There has been a step change since the last economic cycle in how Weir’s pumps are being used; in terms of what they are used in the extraction of, the intensity of their use and the number of them being used. The rate of technological advance and increasing complexity in this field is quite striking.
Seaboard is a US wellhead and pressure controls manufacturer focused on the North American unconventionals market which was purchased for £431m. Revenue is growing at around 30% per annum for the last few years, much of this coming at the expense of competitors. This has broadened The Weir Group product portfolio and will enhance their aftermarket proposition. The graphic below demonstrates how the acquisition is expanding the potential customer base.
Weir has a history of value accretive acquisitions, not least with SPM which is likely worth multiples of what they paid only a few years ago, so they have shareholder’s support for these bolt on transactions.
The Weir Group have a much better infrastructure in place when it comes to servicing their customer’s needs via service centres. The SPM and Seaboard acquisitions have allowed Weir to offer 30 outlets across the US which allows them to get closer to their clients and meet their needs more effectively with unrivalled response times. For contrast, Gardner Denver have just one service centre. Nobody else can match Weir in this category right now.
The aftermarket potential is extremely important, especially in light of Weir’s potentially unassailable advantages in the field. Not only is aftermarket revenue achieved at a higher margin (1.5x original equipment margin) but it can be quantified at roughly 4x (BarCap estimate) the original equipment. They estimate a $200k pump leads to an $800k aftermarket opportunity and current expectations are that this market will grow at 20% per annum for the next few years as the replacement cycle kicks in amongst the growing installed base as it begins to age.
Power & Industrials Division
Not hugely significant at around 7% of group profits and operating at a lower margin of around 9% the business is seen as unsexy and non-core. Revenue growth is lacklustre after the Fukushima disaster and it is possible that this division will be exited at some stage. Weir has a history of portfolio rationalisation in the last decade so this would be no surprise.
The US is at the cutting edge of the Shale Oil revolution but is crucial to understand that it does not have a monopoly on the resources. Many countries possess large estimated resources of shale oil; China is believed to have 1,275 trillion cubic feet of gas, compared to the US with 872 trillion cubic feet, that’s 50% resource more in an economy that is currently still considerably smaller. The US is estimated to possess only around 15% of world recoverable shale energy reserves so this is a story in its infancy. Furthermore as technology improves the recovery rate will improve. Argentina, Australia, South Africa, Libya and Brazil also possess resources of a size which are large enough to provide the impetus for energy independence.
There is a real bottleneck of supply in this energy arms race, Halliburton recently commented that although the US has only 15% of global reserves it currently has 85% of the equipment operating globally and it is still suffering from supply constraints.
As more countries see to emulate the US potential for energy self-sufficiency, Weir is positioned as the world leader in facilitating these countries in their own efforts to manifest destiny. The WEIR products stand between these countries and the monetization of their natural endowment. I think this is an exciting dynamic that is not reflected anywhere in the current WEIR price, and why would it be? The 60% owned JV in China with Shengli Oilfield Highland Petroleum produced revenue of just £20m in 2011. Weir is position to participate fully in any Chinese energy drilling boom and I think you get that for free.
One broker report I read on Weir dismissed the international opportunity out of hand seeing no impact on a 24 month horizon therefore excluding it from valuation completely. I think this is totally wrong and it could be a catalyst on good news.
Use of the Balance Sheet
The Weir businesses generate a lot of cash with a reasonable degree of certainty and visibility, you know if pumps are being used that they are getting worn down and will need replaced on a certain time horizon.
The balance sheet is pretty clean with total debt quite manageable relative to cash flow at around £800m of which £710m is long term. Cash on the balance sheet is greater than short term debt by a margin of around £20m. The pension deficit is only £85m which is actually pretty good for a company with 141 years of history.
Furthermore, Weir issued $1bn of debt in Feb 2012 with maturities in 2019, 2022 and 2023 with an average coupon of 4.16%. This looks like a very attractive deal which allows them to take advantage of ultra low rates to fund their growth and facilitate any opportunistic deals they may wish to do. Further acquisitions or maybe even buybacks are an option over the next few years. Management are accountants not engineers by trade so they should know what to do here.
Share Price – 1700p
Shares Outstanding – 211.34m
Market Cap – £3.83bn
Dividend Yield – 2%
Recently Released 2011E was 133p and estimates for 2012 are around 150p putting WEIR at 12x NTM earnings.
I really don’t think it’s easy to see where the business will be in 3 years time due to the exponential growth of the industry and the possibility for further transformative acquisitions. However, it’s instructive to play about with some numbers.
It is estimated that Weir Oil & Gas will do £270m of EBIT in 2012 and at least £310m in 2014. Given the various growth drivers for US and international expansion plus the transformational political significance of the projects which their pumps facilitate I think a mid teens multiple is quite reasonable.
15x £270m 2012 EBIT = £4.05bn
£4.05bn/211.34m shares outstanding = £19.16 for Weir Oil & Gas
This doesn’t seem unreasonable when put into the context of GE paying The Wood Group 16.7x EBIT for their similar well support division in Q1 2011.
Clearly then if this is true we are looking at a margin of safety that allows us to pay very little or nothing for Weir Minerals, Weir Power & Industrials and any further optionality on the International take up of Shale drilling.
Add this to the fact that we know Weir Minerals did £200m of EBIT in FY2011 and that this business must surely be worth 10x for its market leading position.
10x £220m 2012 EBIT = £2.2bn
£2.2bn/211.34m shares outstanding = £10.40 for Weir Minerals
Weir Power and Industrials is a near insignificant part of the business that they will hopefully spin off so that investors can focus on the areas of growth. It produced £27m of EBIT in 2011 which is forecast to rise to more than £30m over the next year. Let’s be conservative and give it an 8x multiple.
8x £30m 2012 EBIT = £240m
£240m/211.34m shares outstanding = £1.13 for Weir Power & Industrials
Total Sum of the Parts
£19.16 for Weir Oil & Gas
+ £10.40 for Weir Minerals
+ £1.13 for Weir Power & Industrials
+ Free Option on International Shale Drilling or WEIR being subject to a bid
– £0.40 per share for Pension Deficit
– £3.70 per share in Total Debt
= £26.59 per share or around 50% upside.
Currently WEIR trades at a P/E premium to the UK industrials but a 20% discount to oil services sector. I would contest that this is undeserved due to the secular growth, higher margins and lower earnings volatility that I expect the company to benefit from.
A recessionary environment in the US would of course be a big risk to a stock that is fairly cyclical and perceived to be highly cyclical. One might contend however that a US recession would actually strengthen the case for the energy independence mandate. WEIR is highly geared to commodities and global growth and demonstrates a high beta; I am quite convinced that a market selloff would lead to short term price weakness. The stock is however trading at a 3 month relative low as of this week.
Commodity price weakness – the current oil price is substantially above the breakevens for most projects however there is almost no doubt that some capex could be held back or projects deferred if prices fell. Management have stated that even at $80 oil there is a strong incentive to drill. The Minerals division could equally be effected by weakness in the price of mined commodities.
Regulation – France became the first country in the world to ban fracking and there are noises that this is possible elsewhere. This could of course be nearly catastrophic for Weir O&G but as far as I am concerned the economic benefits of continued unconventional oil and gas industry far outweigh the benefits of pandering to a few environmental interest groups. I suspect that Capitol Hill agrees.
To quote David Yarrow again..
“Obama’s populist response to Deepwater Horizon is proof that there will be times in the battle between the environment and US energy independence, when the environment – briefly at least – comes out on top. However, since 2011, events in the Middle East have again caused America to obsess about its reliance on oil importation.
However, the Gulf of Mexico is not Pennsylvania – a state reeling from the decline of the coal industry and manufacturing generally. Nor is it Republican Texas where the oil lobby wins or North Dakota that could well do with a new industry employing tens of thousands of workers.
The critical point surely is that the shale oil revolution is a huge boost for America and Americans. Environmental issues will not go away and there will be new legislation that curtails certain practices in, for instance, water disposal. However as with all hot potatoes, and this one is red hot, there will be no winner and loser, but a series of fudges and compromises.”
New Entrants – National Oilwell Varco has recently suggested that it is looking to expand into the pumping segment and it has launched an organic initiative to develop their own. On the Gardner Denver conference call there was mention that Schlumberger are now using a contract manufacturer to make their Fluid Ends. This is the part of the pump that wears down fastest and therefore is the most demanded in the aftermarket. This is a significant risk but I would counter that as a relatively insignificant part of the total cost of the drilling operation, operators are not inclined to cut corners, especially when dealing with their own lives and reputations.
Short Interest– There is currently a short interest in the stock of around 16% of the float. WEIR is the most shorted stock in the FTSE right now, clearly people are nervous. This is obviously quite significant and is potentially a quite painful unwind if drilling activity continues apace and Weir delivers operational performance. However, maybe they know something I don’t? I would be interested to hear any bear arguments.
A bad acquisition – the SPM deal was a home run and the Seaboard acquisition looks like it will be a good deal too but there is no guarantee that they will all run as smoothly. Every time the company gears up to buy someone there is a risk they overpay or that they do not integrate the acquiree smoothly.