After years of pilling on debt, Chesapeake Energy Corporation (NYSE:CHK) is slimming down as a new CEO takes the helm. Part of its divestment program was the IPO of its oilfield services company, Seventy Seven Energy Inc (NYSE:SSE), which didn't fetch as much as analysts had hoped for. Nevertheless, Seventy Seven Energy operates in a high-growth industry with a strong portfolio capable of servicing the shale revolution.
Drilling activity has dramatically increased in the United States due to advances in fracking, with the number of oil rigs operating in the US up almost 400% since the beginning of 2006. That number continues to grow, as the rig count is already up 13% this year, mostly due to increases in the Eagle Ford and Permian Basin. Not only is the shale bonanza opening up new opportunities for E&P players like Chesapeake Energy, but also for companies capable of offering the services needed to frack and drill in booming shale plays, like Seventy Seven Energy.
High-grading its fleet
In order to effectively compete in America's oilfield services industry, Seventy Seven Energy has been upgrading the rig portfolio of its subsidiary NOMAC Drilling. By selling off Tier 3 rigs and replaced them with Tier 1 rigs capable of multi-well pad drilling, Seventy Seven Energy is able to offer more compelling services while also significantly boosting its bottom line.
Back in 2011, Seventy Seven operated eight Tier 1 rigs, 56 Tier 2 rigs, and 49 Tier 3 rigs, generating an operating margin of 34%. Now Seventy Seven operates 20 Tier 1 rigs, 57 Tier 2 rigs, and only eight Tier 3 rigs, which boosted the operating margin of NOMAC Drilling to 42%. Going forward these numbers will only get better as Seventy Seven Energy adds 16 new Tier 1 PeakeRigs by the end of 2015, letting go of six Tier 3 rigs in the process.
Shoring up its fleet will continue to boost Seventy Seven's margins while also making sure that it has rigs capable of multi-well pad drilling, which is rapidly becoming the status quo in every shale play. Upgrading its drilling operations is just part of the story, as Seventy Seven is also building out its hydraulic fracking operations.
Drilling away from Chesapeake Energy
Performance Technologies, another subsidiary of Seventy Seven, operates nine hydraulic fracking fleets with a total capacity of 360,000 horsepower, eight of which are contracted out to Chesapeake Energy. The average age of its hydraulic fleet is only two years, making it fairly new. Another fleet is coming online by the fall of this year with 40,000 horsepower, which will complement its Tier 1 rig increases.
Seventy Seven sees future upside from consolidation in the industry, its new fleet, and future acquisitions bolstering its offering. The most upside for investors will come from Seventy Seven being able to effectively steer Performance Technologies toward a new client base and away from being almost completely reliant on Chesapeake Energy.
Many investors are worried that the pullback in spending from its single biggest customer, Chesapeake Energy, will put a dent in Seventy Seven Energy's growth ambitions. Back in the first quarter of 2013, Chesapeake was responsible for 94% of Seventy Seven's revenue. A year later and Seventy Seven was able to reduce its dependence on Chesapeake to 85% of its revenue, with the goal of achieving a 50-50 mix in the future.
To get an idea of how depressed Seventy Seven Energy's stock price could be, shareholders should look toward its price to sales ratio of 0.53 over the past twelve months. The average energy equipment and services company trades at 2.41 times trailing twelve month sales, meaning Seventy Seven could have room to run if it is able to successfully find new clients and diversify its revenue base. Investors should also take note of Seventy Seven Energy's high $1.55 billion debt load, which is 3.7x its adjusted EBITDA over the past four quarters, as it is also depressing Seventy Seven's valuation.
Seventy Seven Energy is building out and improving its operations in an industry undergoing a massive boom, but a high debt load and a heavy reliance on Chesapeake Energy are making investors sour on the stock. By renovating its drilling fleet and increasing its fracking capacity, Seventy Seven is generating larger revenue streams with higher margins, making its debt load much more manageable.
To move the needle further, Seventy Seven needs to keep peeling away from Chesapeake Energy so it can justify a higher valuation and not be at the mercy of Chesapeake's capex budget. While there are plenty of hurdles Seventy Seven will have to jump over, if it can diversify its client base then its stock would be substantially undervalued versus its peers, making this a potential "dirty value" play.
Callum Turcan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.