Don't Break Up with This Fracking Stock

03/29/2012 3:15 pm EST

Focus: STOCKS

Taesik Yoon

Editor, Forbes Investor and Forbes Special Situation Survey

There is little doubt natural gas is making a big move in supplanting coal as the basic energy source in coming years, and so this stock has big long-term prospects, writes Taesik Yoon of Forbes Investor.

C&J Energy Services (CJES) is a domestic provider of hydraulic fracturing, coiled tubing, and pressuring pumping services used in technically-demanding natural gas and oil drilling.

Fracturing is a well stimulation process that forces fluids and other materials into producing formations under high pressure in order to penetrate cracks from which gas and other hydrocarbons can be extracted.

The company serves basins in central southern states, including Eagle Ford Shale, Granite Wash, and Haynesville Shale. Customers include oil and gas producers such as Apache (APA), Penn Virginia (PVA), and Anadarko (APC).

CJES’s fracturing operations consist of six hydraulic fracturing fleets comprised of 103 pressure pumps with total horsepower capacity of 206,000. It also includes related equipment, such as blending units, manifolds, and data vans. These fleets are specifically designed for unconventional formations requiring long lateral segments and multiple fracturing stages.

The company also provides coiled tubing services, which involves the insertion of steel tubing in wells that transport materials and equipment. CJES also offers related pressure pumping services, such as well injection, cased-hole testing and mud displacement.

Additionally, through its Total E&S subsidiary (acquired last April), the company makes and repairs equipment used in its businesses and for third parties.

CJES reported fourth-quarter 2011 results on February 15, a week after we recommended the stock. Despite the decision by some of its customers to purchase their own sand for certain jobs (which contributed to a sequential decline in average monthly revenue per horsepower), total revenue still surged 156% year-over-year to $220.1 million.

As with the prior quarter, CJES benefited from the deployment of three additional fleets versus 2010. Hydraulic fracturing services revenue jumped 162% to $172.6 million, as it completed 1,151 fracturing stages compared to just 389 in the prior year. Coiled tubing services revenue climbed 105% to $32 million, with the number of jobs completed rising 60% to 849.

Its Total E&S subsidiary added $11.2 million to revenue, up 75% sequentially. The operating margin improved 350 basis points to 35.87%. Net income more than tripled to $53.43 million or $1 per share—9 cents above the consensus estimate.

The strong Q4 showing has helped CJES shares rise about 12% since our initial recommendation. Yet the stock remains well off its post initial public offering peak of $32.80, set last August. It has also come off its recent high of more than $23.

This most recent weakness suggests investors remain concerned over the persistently low natural gas price environment, which has resulted in a dramatic decline in natural gas drilling activity—especially in dry gas basins. Indeed, oil and gas producers continue to cut gas production in order to reduce excess supply.

Magnifying this concern is the surplus of natural gas inventory stemming from the rise in shale drilling over the past several years and unseasonably warm weather during recent months. This is likely to result in elevated natural gas inventory level over the near term, which could keep gas prices low and continue to weigh negatively on drilling activity. We view these concerns as both real and ongoing.

However, industry production cuts and greater demand from utility providers should eventually help stabilize prices. Investors may also be overestimating the negative impact these trends could have on CJES. All of its fracturing equipment is currently deployed in oil and liquids rich basins.

Because liquid gas contains other hydrocarbons that can be stripped out and sold, wet gas drilling activity has fared much better than dry gas due to oil and gas producers shifting their production towards these more profitable basins. CJES also has six term fracturing contracts with major customers—most of which last through the current year. This offers some business stability should industry conditions worsen.

We believe the attractiveness of its modern fleets, which have all been put into service over the past four years, has also contributed to CJES’s recent growth and could help garner contract wins when two additional fleets get deployed in Q2 and Q3.

From a valuation standpoint, CJES’s stock remains exceedingly attractive—trading at a ridiculously low 4.8 times its 2012 earnings estimate. This implies investors continue to maintain low expectations regarding near-term prospects. If CJES’s operating results continue to exceed these cautious views, the stock should rise substantially from current levels.

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