Drilling Tools’ Improving Drivers 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 life cycle in North America, Europe, and the Middle East. Its products include various bottom-hole assembly components, Drill-N-Ream (in the wellbore optimization tool), RotoSteer (rotational steering tool), and ancillary equipment and handling tools. DTI is also one of the market leaders in the Gulf of Mexico deepwater drilling operation tool rentals business.

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

While DTI’s cash flows turned negative in 1H 2024, I expect a turnaround by the end of the year following lower capex and operating profit improvement. As of June 30, its debt-to-equity was comfortably low. The stock appears relatively undervalued compared to its peers. I think the business conditions are sufficiently promising to assign a “Buy” call on the stock.

Industry Drivers And DTI’s Strategy

In 2023 and early 2024, M&As marked the E&P industry and percolated in the oilfield services industry. More recently, however, the energy industry appears to stabilize as operators focus on efficiency improvement. Operators utilize as few rigs as possible and will look to redeploy additional rigs when demand picks up. Producing wells typically peak early in their life and then decline year by year. If demand rises, more wells will be needed to meet the additional demand.

The company has shifted its pricing strategy from price per day to footage drilled in some product lines to reflect the changed scenario. DTI’s tool recovery revenue (i.e., lost and damaged equipment charges) allows 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 has captured market share. In the short term, it will continue to focus on lowering its cost structure. The long-term demand for the company’s products remains robust, as shown by EIA’s oil demand growth projection for 2050.

The Q3 Outlook

Until mid-2025, DTI expects energy activities in North America to remain soft, while rig counts and well counts can rise in late 2025. International markets can remain “flat to upwards.” As a result, its core rental tool business can remain under pressure from competition. 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. Also, higher electricity demand from data centers can increase natural gas demand.

In FY2024, DTI expects revenues to increase by 7% compared to FY2023. Adjusted EBITDA, on the other hand, can decrease by 13% during this period. Net income, too, can decline by 20% in FY2024. However, its free cash flow can be more than double compared to FY2023 because it trimmed its capex budget for FY2024.

SDPI Acquisition And Synergies

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

DTI expects to realize ~$4.5 million in SG&A synergies and NOL tax benefits over the next year. It expects vertical and horizontal integration synergies that can result in 60% capex savings on new DNR tools and 45% margin capture on repair and maintenance of global drilling remit assets. The integration synergies can assume an even greater proportion of the total expected synergies when the rig count, and market activities improve in 2025. In addition, the company gained $6.6 million in receivable from the selling party from debt extinguishment, effectively reducing the transaction’s total purchase price. Overall, the total synergies, rentable assets, and infrastructure investment can bring long-term accretive 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 geographical presence in the Middle East.

My Estimates

Over the past ten quarters, its adjusted EBITDA increased by 8% on average. Given the impact of cost reductions and SDPI acquisition, I expect the topline and EBITDA growth to accelerate moderately. Over the next four quarters, I expect its adjusted EBITDA to increase by 8%-10%.

Analyzing The 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 revenues decreased marginally by 1.1%. Although adjusted EBITDA decreased, its EBITDA margin expanded following a cost reduction program that resulted in an annualized savings of $2.4 million. To mitigate the pressure of declining rig count and US activity, it boosted revenues by acquiring Deep Casing, strengthened its customer base and distribution service and support network, and brought new product offerings.

Cash Flows And Liquidity

In 1H 2024, DTI’s cash flow from operations decreased by 69% compared to a year ago. Lower revenues in the past year primarily led to the fall. Its free cash flows remained negative in IH 2024 compared to the past year.

DTI’s liquidity was $86 million as of June 30, 2024. Its leverage (debt-to-equity) was 0.26x as of that date. In March, it amended the revolving credit facility by increasing the 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 the consolidation in the upstream industry as the players seek to achieve economies of scale and pricing concessions. At present, the company faces challenges from the flat global rig count. The depression in natural gas prices can make returns from investment challenging. However, I think the gas price can recover in the medium to long term.

Analyst Rating

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

Relative Valuation And My Target Price

DTI’s forward EV/EBITDA multiple versus the current multiple is expected to contract as opposed to an expansion of in multiple for its peers’ (KLXE, PFIE, and GIFI) average. This implies its EBITDA is expected to rise marginally compared to a fall in EBITDA for its peers next year. This typically 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 I discussed earlier in the article, I expect 8%- 10% adjusted EBITDA growth in the next four quarters. Feeding these values in the EV calculation and applying the current sell-side EV/EBITDA multiple of 3.8x, I think the stock should trade between $5.2 and $5.3, implying a ~41% upside.

What’s The Take On DTI?

DTI’s core rental tool business can remain under pressure until 2025 due to soft rig count and well. Natural gas demand, however, has a robust long-term outlook based on new LNG capacity. The company looks forward to gaining from the acquisition of SDPI, which offers Drill-N-Ream well-bore conditioning tool. The acquisition will expand its geographic reach and lower capital requirements and operating costs. Synergies from the integration should be substantial, especially when the energy activity recovers in 2025. So, the stock outperformed the VanEck Vectors Oil Services ETF (OIH) in the past year.

In 2024, DTE suffered from declining rig count and US energy activity, which affected its revenues and operating profit. So, it reduced costs and boosted its revenue base through acquisitions, strengthening its customer base and bringing in new product lines. Although cash flows declined in 1H 2024, its significantly low leverage would allow for an increased debt level. With relatively undervalued trading multiples, I would suggest investors “Buy” it at this point when M&As can take it to an inflection point.