Drilling Tools Enhancement Factors and Relative Undervaluation Are a Catch (DTI)

DTI offers balanced growth

Drilling Tools International (NASDAQ:DTI) provides oilfield services, tools and solutions for the well lifecycle in North America, Europe and the Middle East. Its products include various downhole assembly components, Drill-N-Ream (in well optimizer), RotoSteer (rotary steering tool), as well as auxiliary equipment and handling tools. DTI is also one of the market leaders in the tool rental business for deepwater drilling operations in the Gulf of Mexico.

At the start of Q3, DTI faced some challenges due to the slowdown in energy activity in the US. While this may hurt its performance in the short term, I see the company’s performance improving following the recovery of natural gas. Its outlook will get a shot in the arm with the acquisition of SDPI and the synergies from the deal. Its well-drilled conditioning tool and geographic coverage will expand its geographic reach and decrease its operating costs. Investors may note that DTI’s recent acquisitions have positively impacted its financial results.

While DTI’s cash flows turned negative in the first half of 2024, I expect a recovery by the end of the year due to lower capex and improved operating profit. As of June 30, the debt-to-equity ratio was comfortably low. The stock seems relatively undervalued compared to its peers. I think business conditions are promising enough to assign a “Buy” call on the stock.

Industry drivers and DTI strategy

In 2023 and early 2024, mergers and acquisitions marked the E&P industry and seeped into the oilfield services industry. More recently, however, the energy industry appears to be stabilizing as operators focus on improving efficiency. Operators use as few platforms as possible and will look to redeploy additional platforms when demand increases. Typically, producing wells peak early in their lives and then decline from year to year. If demand increases, more wells will be needed to meet the additional demand.

The company has changed its pricing strategy from price per day to drill shots in some product lines to reflect the changed scenario. DTI’s revenue from instrument recovery (ie, lost and damaged equipment fees) enables it to sustain its fleet and generate positive cash flows. From the company’s operations, I notice that blue chip customers rent tools from the company because these tools have extorted configurations, hole sizes, geographies and engineering requirements.

With new products and revenue opportunities, the company captured market share. In the short term, it will continue to focus on reducing the cost structure. Long-term demand for the company’s products remains robust, as shown by the EIA’s projection of oil demand growth to 2050.

Outlook Q3

Through mid-2025, DTI expects energy activity in North America to remain weak, while rig count and well count may increase in late 2025. International markets may remain “flat to high.” As a result, its core instrument rental business may remain under competitive pressure. Natural gas demand, on the other hand, has a robust long-term outlook based on new LNG capacity anticipated to come online in 2025 and 2026. Higher electricity demand from data centers may also increase demand of natural gas.

In FY2024, DTI expects revenue to grow by 7% compared to FY2023. Adjusted EBITDA, on the other hand, may decline by 13% during this period. Net income may also decline by 20% in FY2024. However, its free cash flow may more than double compared to FY2023 as it has reduced its capex budget for FY2024.

SDPI acquisition and synergies

In August, DTI announced the acquisition of Superior Drilling Products (or SDPI), which offers PDC milling and bit repair, for $32.2 million. SDPI’s Drill-N-Ream (“DNR”) drill conditioning tool is one of its core offerings and would enhance DTI’s technologically differentiated solutions and services. SDPI is also expected to expand its geographic market potential, reduce capital requirements and operating costs, and improve operational efficiency. SDPI has recently established a footprint in the Middle East, bringing great value to DTI.

DTI expects to realize ~$4.5M in SG&A synergies and NOL tax benefits over the next year. Vertical and horizontal integration synergies are expected that can lead to 60% capital savings on new DNR tools and 45% margin capture on repair and maintenance of global drilling assets. Integration synergies may account for an even larger proportion of total expected synergies when counting platforms and market activities improve in 2025. Additionally, the company earned $6.6 million in sell-side receivables from debt extinguishment, effectively reducing the total purchase of the transaction. price. Overall, total synergies, rental assets and infrastructure investments can bring long-term cumulative value to DTI.

Earlier in April, it acquired UK-based Deep Casing Tools. The acquisition strengthened the company’s well construction, well completion and casing installation processes and expanded its geographic presence in the Middle East.

My estimates

Over the past ten quarters, adjusted EBITDA has grown 8% on average. Given the impact of cost cuts and the SDPI acquisition, I expect top line and EBITDA growth to accelerate moderately. Over the next four quarters, I expect adjusted EBITDA to grow 8%-10%.

Analyzing Q2 performance

As disclosed in the Q2 2024 earnings press release dated August 6, from Q2 2023 to Q2 2024, DTI’s year-over-year revenue decreased marginally by 1.1%. Although adjusted EBITDA decreased, the EBITDA margin expanded following a cost reduction program that resulted in annual savings of $2.4 million. To mitigate the pressure of declining rig count and activity in the US, it increased revenue through the acquisition of Deep Casing, strengthened its customer base and distribution service and support network, and brought in new product offerings.

Cash flows and liquidity

In the first half of 2024, DTI’s cash flow from operations fell 69% from a year ago. Lower revenues in the past year primarily led to the decline. Its free cash flows remained negative in FY 2024 compared to last year.

DTI’s liquidity was $86 million as of June 30, 2024. Its leverage (debt-equity) was 0.26x at that date. In March, it amended its revolving credit facility by increasing its borrowing capacity from $60 million to $80 million. It also extended the maturity date to March 2029.

Risk factors

DTI will continue to face energy price volatility. Another risk factor relates to consolidation in the upstream industry as players seek to gain economies of scale and price concessions. The company is currently facing challenges due to the flat global number of platforms. Falling natural gas prices can make investment returns difficult. However, I think gas prices can recover in the medium to long term.

Analyst rating

According to Seeking Alpha, one analyst rated it a “Buy” (including “Strong Buy”), one rated it a “Hold” and none recommended a “sell”. The consensus price target is $6.7, suggesting an 81% upside to the current price. Given the balanced factors, as discussed in the article, I think sell-side analysts are more bullish than warranted.

My relative rating and price target

DTI’s forward EV/EBITDA multiple to the current multiple is expected to contract, as opposed to an expansion in the multiple for the average of its peers (KLXE, PFIE and GIFI). This means its EBITDA is expected to grow marginally, compared to a decline in EBITDA for its peers next year. This usually results in a higher EV/EBITDA multiple. The company’s EV/EBITDA multiple (3.8x) is lower than its peers’ average of 4.5x. So, I think the stock is undervalued compared to its peers at this level.

If DTI trades at the peers’ average (4.5x), the stock price can increase by 54%. As discussed earlier in the article, I expect adjusted EBITDA growth of 8%-10% over the next four quarters. Plugging these values ​​into the EV calculation and applying a current sales EV/EBITDA multiple of 3.8x, I think the stock should trade between $5.2 and $5.3, implying ~41% upside.

What is The Take On DTI?

DTI’s core rental tools business may remain under pressure until 2025 due to the number of soft rigs and wells. However, natural gas demand has a robust long-term outlook based on new LNG capacity. The company looks forward to earning from the acquisition of SDPI, which offers Drill-N-Ream well conditioning tool. The acquisition will expand its geographic reach and reduce capital requirements and operational costs. Synergies from the integration should be substantial, especially when energy activity picks up in 2025. Thus, the stock has outperformed the VanEck Vectors Oil Services ETF (OIH) over the past year.

In 2024, DTE suffered from a decline in rig count and energy activity in the US, which hurt its revenue and operating profit. So it cut costs and increased its revenue base through acquisitions, strengthening its customer base and bringing in new product lines. Although cash flows declined in the first half of 2024, the significantly reduced leverage would allow debt levels to rise. With relatively undervalued trading multiples, I would suggest investors to ‘buy’ it at this time when M&A may lead to an inflection point.