Value Library

The following is an excerpt from the ABC Perspective - April 2011 - Pg. 4-5

ABC Fund Value Favourites

Savanna Energy Services Corp.

Savanna Energy Services (TSX:SVY) is focused on the drilling, well services and oilfield equipment rental segment of the oilfield services industry. In addition to representing one of Canada's largest drilling and well servicing contractors, Savanna’s fleet, which consists of approximately 166 rigs, is also deployed in the United States, Mexico, and Australia. Approximately 80% of the company’s revenue is derived from contract drilling services, with the balance derived from well services and oilfield equipment rentals.

In our view, Savanna is a prime example of how a strong management team can add value in challenging market conditions. Under the leadership of Chairman Jim Saunders and CEO Ken Mullen, Savanna persevered in 2009 through an exceptionally challenging year. The industry was facing strong headwinds due to the significant increase in North American gas supplies, which were met with a concurrent sharp decline in demand as a result of the global economic slowdown. Furthermore, the significant drop off in demand for oilfield services in the conventional basins in North America pushed rig utilization levels in Canada to near record lows.

Over the course of 2009, Savanna took several measures to reposition the company, including diversifying operations into new markets and implementing cost saving initiatives. In Q3 2009, Savanna deployed four rigs to Mexico – its first expansion outside of Canada.  Shortly thereafter, in Q4 2009, the company entered into a five-year contract to initially deploy four rigs to Australia. In addition, Savanna reduced wages and froze capital expenditures.

As the economy recovered through 2010, demand for Savanna’s services gradually improved.  By mid-2010, oil prices had rallied considerably, effectively doubling to $80/bbl from its 2009 lows. This helped propel Savanna’s U.S. conventional drilling rigs to meaningfully higher utilization rates in 2010, and its Canadian drilling rig fleet to above-market utilization rates.

However, despite the sharp increase in oil prices, natural gas prices continued to remain soft, resulting in a shift in demand for oil services from natural gas. To address the new operating environment, Savanna refocused its efforts and repositioned its rig fleet. This included the retrofit of four hybrid drill rigs, which were primarily used for shallow drilling – two of which were deployed in Australia. By Q3 2011, Savanna expects to have a fleet of four hybrid drilling rigs and three service rigs operating in Australia.

In early December 2010, ABC initiated a position in SVY by acquiring approximately 1.8 million shares at an average price of $6.76/share. We continued to add to our SVY position in late 2010 and early 2011, such that the average price on our 5,675,000 shares was under $6.85/share. Given our favourable outlook for the company, we allocated shares to all five of our ABC funds.

In a nutshell, Savanna caught our attention for several reasons. First, our calculations suggested the company was inexpensive, trading at an approximate 30% discount to its tangible book value of $9.90/share.

Second, recognizing the company’s resilience through difficult market conditions, we believe Savanna possesses a strong management team. In our view, Savanna took appropriate measures to weather the market downturn in 2009, while repositioning itself for an eventual industry recovery.

Third, we believe there are catalysts that could increase the company’s share price over time. For instance, we expect Savanna to target the reconfiguration or transfer of at least 25-30 additional hybrid rigs to new markets. Should the company be able to secure new business, we believe the operating leverage could be very positive for its stock price.

Interestingly, it did not take long for our investment thesis to play itself out. Shortly after we acquired our position, SVY’s share price increased by over 40% from a late January closing. We believe that investors are beginning to recognize that Savanna is undervalued and possesses considerable potential under more favourable market conditions. Accordingly, without disappointment, on March 10th, 2011, Savanna reported its 2010 year-end results and demonstrated significantly improved operating results, with a 71% increase in revenue and an 86% increase in its operating margin.

Despite its recent share price appreciation, we continue to believe that SVY remains inexpensive. At its current price of approximately $10/share, Savanna is trading at only a slight premium to its tangible book value. Moreover, considering the industry improvement due to rising energy prices and the potential for new business wins, we remain quite positive on Savanna’s future.

Emerge Oil & Gas Inc.

Emerge Oil & Gas Inc. (TSX:EME) is a junior oil and gas company that develops and explores for oil and natural gas in Western Canada. Through two acquisitions completed in 2009, Emerge assembled an asset base in the Lloydminster heavy oil area of Saskatchewan and Alberta, and the Battlebend medium oil area of Alberta. Current production is approximately 7,000 boe/d, which is about 90% weighted to heavy oil.

In early March 2011, Emerge reported its 2010 year-end financial results, and demonstrated significant year-over-year growth in production. To put this into perspective, production grew by approximately 300%, which is attributed to a combination of drilling success (66 net wells with a 98% success rate), reactivation activity on standing wells, and a 400 boe/d asset acquisition at Reward/Ear Lake, Saskatchewan, that was completed in June 2010.

Similarly, Emerge’s reserves grew by 51% year-over-year, and currently total 13.6 mm boe on a proved and probable basis. Of particular note, base production declines throughout 2010 were shown to be lower than previous reserve reports had indicated. According to management, this is a recognition of the longer reserve life and potential higher recovery factors of its heavy oil wells.

Going forward, Emerge has identified several avenues for growth.  By year-end 2011, the company is targeting a production rate of 8,100 boe/day – an approximate 15% increase from current levels. Consistent with this objective, Emerge’s 2011 capital budget, which has been set at $75 million, includes a 70-80 well drilling program on its two core producing areas. Year-to-date, the company has drilled 20 wells that are at various stages of completion. In addition, Emerge also recently drilled its first horizontal well targeting light Viking oil, and is also active on its reactivation/recompletion program, consisting of 80 sites.

Given Emerge’s significant weighting to heavy oil production, its operating costs tend to be above industry averages. To reduce these costs going forward, Emerge recently invested $18 million in infrastructure projects, including $8 million in water disposal facilities and gathering systems, and $10 million to expand its central oil battery in Silverdale, Saskatchewan. Factoring in these improvements, Emerge is targeting a reduction in average operating expenses to approximately $22/boe in 2011, compared to $27/boe in Q4 2010.

At ABC Funds, we were attracted to Emerge due to the growth potential of its heavy oil assets, a strong management team lead by Chairman, President, and CEO Tom Greschner, in addition to its attractive valuation.  ABC Funds initiated a position in Emerge in early February 2011 by acquiring 2.3 million shares under $3.30 per share, and we continued to add to our holdings to the end of March.  

As mentioned above, Emerge reported its Q4 2010 and year-end results in early March. Notwithstanding strong growth in production and reserves, Emerge’s Q4 2010 financial results appeared to have disappointed the street. Although production met expectations, operating costs appeared to be higher than analysts’ projections. As a result, EME shares declined by almost 10%, dipping below $3.00. Nonetheless, given our confidence in management’s ability to both execute on its growth strategy, reduce its operating costs, as well as positive momentum of energy prices, we took the opportunity to add to our EME position on weakness.

With respect to valuation, we believe Emerge continues to trade at a discount relative to its peers. Based on fiscal 2011 consensus estimates, the company is currently trading at a P/DACF multiple of approximately 6.8x, compared to its peer group at 7.8x. From a balance sheet perspective, after completing a $30 million equity financing priced at $3.40/share in Q4 2010, Emerge exited the year with net debt of approximately $55 million. In addition, the company has total credit facilities of $75 million, about half of which was drawn at year-end, and tax pools in excess of $200 million.

Irwin A. Michael, CFA