Cathedral Energy Services Ltd. (OTCPK:CETEF) (TSX:CET:CA) is a Canadian company specialized in directional drilling, operating in both Canada and the U.S. Since the beginning of 2021, Cathedral has embarked on an ambitious strategy to consolidate the fragmented North American directional drilling vertical, under the leadership of Tom Connors, as I detailed in a previous article published in October 2022 and a follow-up piece published in December 2022. The market seems to be responding positively to Cathedral's endeavors. From October 2022, when the investment thesis was initially introduced to the Seeking Alpha community, to early January 2023, its share price more than doubled, as demonstrated in Figure 1.
However, the decline in crude oil and natural gas prices prompted operators to reduce their drilling rig activity starting from December 2022, as depicted in Figure 2. This is the primary reason Cathedral's stock began to experience a decline. By late June 2023, the stock had retraced a substantial portion of the gains achieved since October 2022, until it began to regain momentum over the past month or so, as shown in Figure 1.
At this juncture, the critical questions with regard to Cathedral pertain to the ongoing validity of the investment thesis, the performance of management in executing the strategy, and the appropriate course of action for investors.
Acquisitions
After an eight-month break, Cathedral Energy Services has made another significant acquisition, as indicated in Table 1. On July 11, 2023, Cathedral acquired Rime Downhole Technologies, LLC for a total of US$41 million, which comprises US$21 million in cash and US$20 million in 5% per-annum subordinated promissory notes that are exchangeable for up to 24,570,000 common shares of Cathedral.
Rime, based in Texas, specializes in manufacturing products for the downhole measurement-while-drilling (or MWD) sector, which includes proprietary pulsers, pulser drivers, shock isolators, and gamma modules. Their trademarked Slick-HD Pulser and Agilis Driver are leading solutions in the U.S. onshore market. Currently, approximately 40% of active drilling rigs in the U.S. onshore market operate with either the complete Slick-HD Pulser or Agilis Driver on a stand-alone basis. Cathedral aims to introduce a commercial MWD platform into the U.S. directional drilling sector over the next 12-18 months.
Cathedral is planning to invest between US$5-10 million to establish its own MWD equipment, reducing reliance on third-party rentals. This move is expected to yield potential annual synergies of up to C$34 million. Taking into account both the expected synergies and the associated costs, Cathedral estimates that the total investment in Rime will pay for itself within a two-year timeframe.
Operations
Cathedral Energy Services has reported a robust year-over-year expansion in activity days and average day rates in both Canada and the U.S. for each of the last three quarters, as depicted in Figure 3. For example, activity days in Canada have demonstrated a remarkable year-over-year growth ranging from 37.0% to 83.2% in the last three quarters. Similarly, activity days in the U.S. have witnessed substantial year-over-year growth of 678.6% to 840.1% during the same period. Furthermore, average day rates have exhibited an appreciable increase of 25.6% to 49.9% in Canada over the last three quarters, while average day rates in the U.S. have seen a range of growth from 0% to 182.1% during the same timeframe.
As the driving force behind the upward trajectory in activity days, Cathedral has been making notable strides in expanding its market presence in both Canada and the U.S. In Canada, the market share has surged from 7.7% in 2020 and 18.1% in 2021 to a commendable 25.3% in the 1Q2023. Similarly, in the U.S., the market share has experienced a rise from 1.50% in 2020 and 0.8% in 2021 to some 6.8% in the 1Q2023.
Moving ahead, Cathedral sees opportunities within the equipment rental business segment, encompassing both the potential for organic expansion of product offerings and the prospect of further acquisitions. In the full-service directional drilling business segment, Cathedral is optimistic about realizing substantial organic growth, particularly in rotary steerable (or RSS) applications within Canada. Additionally, the company is confident in its ability to expand its market share in the U.S. to surpass 10% through additional strategic acquisitions.
Financials
Thanks to the rising number of activity days and the favorable trend in day rates, especially in the U.S., Cathedral was able to report remarkable year-over-year growth in revenue and adjusted EBITDAS over the past three quarters, as demonstrated in Figures 4 and 5. The company achieved profitability for the entire year of 2022 as well as the first quarter of 2023, as depicted in Figure 6. These positive indicators suggest that Cathedral has likely just reached a turning point towards accelerated growth, much like the upward trajectory of a hockey stick.
Valuation and risks
Cathedral currently trades at 3.21X EV/EBITDA or 4.67X P/FCF on a trailing 12-month basis. In comparison with industry peers such as Precision Drilling Corp. (PDS), PHX Energy Services (OTCQB:PHXHF), NOV Inc. (NOV), and Helmerich & Payne (HP), Cathedral Energy Services appears to be significantly undervalued.
As Cathedral consistently delivers impressive growth and profitability figures, it is anticipated that the share price will experience a substantial increase. However, this upward potential is accompanied by a set of associated risks. Firstly, the debt incurred from acquisition financing exposes shareholders to credit risk. The net debt to adjusted EBITDAS ratio stood at 0.50X as of the 1Q2023, and the company has been employing its free cash flow to gradually reduce this debt burden. Secondly, the company's strategy of growth through acquisitions comes with its own set of execution risks. Nevertheless, the management team, led by Executive Chairman Rod Maxwell and CEO Tom Connors, appears to have taken prudent steps over the past two years. With the board and management owning as much as 17.5% of the outstanding shares, their substantial stake underscores their commitment. Notably, figures like Maxwell and Connors have continued to personally invest in the stock as recently as July 26, 2022. Their commitment to being shareholder-friendly is evident through their recent decision to initiate a buyback of up to 12,160,008 (or 5%) issued and outstanding common shares of the company, by July 2024.
Investor takeaways
Upon delving into the operational and financial details of Cathedral Energy Services, it becomes apparent that the investment thesis centered around acquisitive growth remains sound. The company's ability to consistently expand its market share, coupled with its impressive revenue and profit growth, reaffirms the validity of the thesis. Despite the recent recovery in its share price, Cathedral Energy Services is still undervalued compared to its industry peers.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
Join The Natural Resources Hubtoday and gain exclusive access to high-quality investment ideas and expert insights from Laurentian Research. Experience the power of informed decision-making and maximize your gains with moderate risk.
Sign up for a free trial now and take your investment strategy to the next level. Click HEREto get started.
