Keeping an Eye on the Seventy Seven Energy Spin-Off

With the spin-off from Chesapeake Energy (NYSE: CHK  ) finally here, investors can start watching Seventy Seven Energy (NYSE: SSE  ) . The oilfield services firm has had limited publicity typical of spin-offs, providing the opportunity for an attractive valuation.

One important thing investors need to understand about spin-offs is that the new companies typically come out in disarray. The parent company wouldn't typically perform the split up if it weren't for a desire to unload an underperforming unit, or at least one viewed as undervalued. In the case of Chesapeake Energy, the natural gas exploration and production firm was originally hoping to sell the company for several billion to help reduce debt at the corporate level. The spin-off was the last option.

Though the company relies very heavily on the former parent company that is cutting capital spending, Seventy Seven Energy is in the attractive oilfield services business in North America that might provide some opportunity eventually. Schlumberger (NYSE: SLB  ) recently upped guidance for profit growth, suggesting the industry is starting to fire on all cylinders.

Business
As of the first quarter, Seventy Seven Energy operated a fleet of 114 land drilling rigs, nine hydraulic fracturing fleets with 360,000 horsepower, a fleet of oilfield trucks, cranes, and forklifts, and an oilfield tool rental business.

First quarter revenue came in at $510 million, with the majority focused on the drilling rigs and hydraulic fracturing fleet with combined revenue of over $380 million. Revenue for the first quarter of 2013 was $544 million. Total revenue from Chesapeake Energy hit $431 million, down from $513 million in 2013. More importantly, revenue from third parties more than doubled to nearly $79 million from only $30 million in the prior year period.

Valuation metrics
The spinoff from Chesapeake Energy involved issuing one share for every 14 shares of Chesapeake stock outstanding. With the company listed as having roughly 650 million shares outstanding, it would place Seventy Seven Energy somewhere in the range of 46 million shares outstanding after the split. At the current stock price around $25, the new stock is worth in the range of $1.2 billion.

Even the weakest oilfield services stocks trade at roughly 1x sales, so Seventy Seven Energy is worth an extremely low valuation due to the reliance on Chesapeake Energy. Any stability in revenue from the previous parent combined with sustaining the fast growth from other energy customers would make this new stock extremely attractive. Unfortunately, the agreement with Chesapeake suggests that the former parent can release rigs when external customers are found, suggesting stability might not exist for a while.

Leading oilfield services firm Schlumberger trades at over 3x revenue even with revenue approaching $50 billion. Back at the end of June, the services giant upped annual earnings growth guidance to 20% on the high end. For the large firm to obtain that type of growth, it suggests a strong underlying business that could provide opportunities for a new independent firm like Seventy Seven Energy.

Bottom line
Any investor looking at Seventy Seven Energy must review the results with a grain of salt. The extreme reliance on a customer pulling back on spending is both a major concern about growth potential, but also a possibility that Chesapeake has reduced capital spending to the point the oilfield services spin-off is left with outdated equipment. With a revenue run rate of $2 billion, the company offers value worth keeping an eye on it once the threat of more downside from the previous parent wears off.

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