Small Cap Stocks

Like many stocks in recent weeks, Lufkin (LUFK) has sure been a roller coaster. After recommending the stock back in July at about $78, the stock soared after an exceptional earnings report, only to completely collapse over the last week or so in the broader oil/commodity sell-off. Given sharp share price drop, I thought it might pay to take a step back and run an earnings stress test on LUFK assuming oil prices continue to decline dramatically. Interesting, this type of stress test can be done for many other oilfield service shares, in order to determine potential downside in the event that oil prices do not stabilize (an unlikely scenario in my opinion).

In looking at past 10-K’s, I noticed that back in 2006 when oil prices were in the 50′s and natural gas prices were at about current levels ($7.50 MCF), LUFK was still able to earn nearly $5 per share. Going back to 2005, with oil prices below $50 and natural gas at under $6, LUFK earned $3 per share. Even going back to 2000, to before oil even entered most speculator’s minds, LUFK was profitable and was earning over a $1 per share.

As one can see, sharply lower oil prices will have no effect on LUFK’s profitability, though of course the level of profits would fall off. But, since the recent years numbers are prior to the huge jump in oil prices and record profits at oil producers, it seems clear that even if oil prices would fall by another 50%, LUFK would still earn about $4+ per share (Note: oil producers are so flush with cash, they can and will spend on infrastructure for years even at much lower oil prices). This earnings level, combined with $100 million in cash, no debt, and low cap-ex needs, leads me to believe that the downside in LUFK is quite low at current prices.

Assuming 10X low-end estimates of $4 per share (in a $50 crude environment) + cash, LUFK would probably still be worth about $50, or about 30% below current prices.

On the upside, if oil prices remain at higher levels (even assume $80 oil), it seems clear that LUFK will earn well above $5 per share and the stock would be valued at much higher levels. Currently, I actually estimate that LUFK will earn over $6 per share over the next year, giving me an upside value of $100+.

Fair value, given the above numbers, if you assume a 50% chance of oil going back to $50, would then be about $75.

In conclusion, though it’s disheartening to see such huge drops in formerly profitable holdings, I think it’s important to remember that stocks like LUFK are by no means comparable to the .com’s of old, which imploded and never recovered. Those .com’s had no earnings, cash-flow or any type of business model. It was truly a bubble. In the case of LUFK, there has been solid demand for LUFK’s products for over 100 years already, and there will probably be solid and increasing demand for the next 100 years. As such, I see no reason to panic, and believe the stock still represents an excellent investment in the energy space in the year ahead, for the reasons detailed in my first report.

Introduction
Lufkin Industries (Nasdaq: LUFK, Market Cap.: $1.1 billion) is an oil services stock that could move 50% higher by year end. Importantly, the first catalyst for an improving share price may come next week when the company announces second quarter fiscal 2008 earnings. We believe that the upcoming report will finally be the start of renewed earnings momentum at the company after nearly two years of sluggish growth on the back of the disappointing results of the company’s non-energy related trailer business. Importantly, LUFK discontinued the non-energy related trailer business in January 2008, and this will be the real first quarter without the drag of this division, allowing the booming oilfield service and power transmission markets to really improve the bottom line.

The favorable earnings comparisons could boost the shares at a time when many investors are scouring for reasonably valued oilfield service shares following the excellent performance of oilfield service shares over the last few years. LUFK is only one of a handful of oil service shares that appears reasonably valued on an absolute basis, and significantly undervalued on a relative basis. Notably, LUFK is sitting on $100 million in cash and has no debt.

Company Background
LUFK was founded in 1902 and is primarily known for designing, manufacturing and marketing the industry standard conventional, Mark II and other rod lift pumping units that are used to lift oil from wells. However, the company actually currently operates in two broad divisions: Oilfield Services and Power Transmission (actually the fastest growing division at LUFK increasing 27% in 2007 over 2006).

The oilfield services business manufacturers pumping units, as mentioned, however, LUFK also provides additional oil services equipment and services.

The Power Transmission Division, makes precision-made gears in weights from 300 pounds to 250 tons and in power levels from 20 to 85,000 horsepower. These highly engineered products are used in industrial applications in a variety of industries, such as oil and gas, petrochemical, steel, plastics, sugar, rubber, marine and power generation.

What Went Wrong at LUFK?

Basically LUFK has suffered from two major problems: A slowdown in its largest business, i.e. pumping units in the North American market, and the poor performance of the company’s former trailer division.

As regards to the North American market, LUFK had this to say in its 10-K:

During 2007, demand in the North American market has been negatively affected, compared to 2006 levels, by the impact of lower natural gas prices on coal-bed methane and other unconventional gas production that use rod pumps to de-water wells, drilling program delays from M&A activity, cost control efforts deferring or reducing capital spending programs and the competitive pressure from lower-priced pumping units in areas traditionally served by the used unit market.

What Has Changed?
Two significant changes have eliminated the problems mentioned above, and augur well for LUFK’s future operating results.

1. LUFK Discontinues the Trailer Division

As noted in LUFK’s 10-K:

Due to these market conditions, in January 2008, the Company announced the decision to suspend its participation in the commercial trailer markets and to develop a plan to run-out existing inventories, fulfill
contractual obligations and close all trailer facilities during 2008.

As noted in the recent 10Q:

During the first quarter, all remaining trailer orders were manufactured and the manufacturing workforce was redeployed throughout the Company or terminated. Also, several service centers were closed and the inventory was consolidated at the Lufkin, Texas facility for future aftermarket sales. During the second quarter of 2008, it is expected that the remaining backlog of trailers will be sold, the manufacturing facility will be closed, with any remaining equipment sold, and the remaining service center will be closed and consolidated into the Lufkin, Texas facility. The Company is exploring options for serving the future aftermarket parts business and fulfilling contractual warranty obligations.

2. Due to Sustained High Oil and Natural Gas Prices The North American Market is Picking Up

Based on information provided by LUFK and it’s main competitors (i.e. WFT), the North American market is picking up steam.

As noted in LUFK’s recent 10Q:

During the first quarter of 2008, demand levels in North America increased over the levels experienced in the latter half of 2007 as higher energy prices drove increased drilling and workover activity. Additionally, the demand for pumping units, oilfield services and automation equipment continues to increase in international markets. While a majority of the segment’s revenues are in North America, international opportunities continue to increase as new drilling increases and existing fields mature, requiring increased use of pumping units for artificial lift, especially in the South American, Russian and Middle Eastern markets.

Oil Field’s backlog increased to $97.1 million as of March 31, 2008, from $58.1 million at March 31, 2007, and $76.9 million at December 31, 2007. This increase over the December 31, 2007, level was driven by increased bookings for new units for the U.S. market as higher energy prices drove increased drilling and workover activity. The increase over the March 31, 2007, level also reflects the growth of international orders for new units.

Valuation (Upside Case)
I’ll keep this valuation part very short, since the case for LUFK is quite simple. Basically, we believe that by next quarter, LUFK will be on a run rate of $1.50 per share in earnings on a quarterly basis. This works out to $6 per share earnings power on a yearly basis. The best comp for LUFK is WFT, which trades at approximately 20X earnings or so (higher if take other factors into consideration). Given LUFK’s solid growth potential in the coming years, particularly for the company’s lesser known power division, I see no reason why LUFK will not trade at 20X multiple (including $7 per share in cash) once earnings growth resumes. That leads to my target price of $120 on LUFK in the year ahead.

Note: If you go thru LUFK’s past financial statements, you’ll notice that the earnings basically equal the free cash-flow for the company and that the company has been a solid cash generator for years.

Risks
The risk for LUFK is the same as that faced by any other energy-related issue, namely the risk of a significant decline in oil and/or natural gas prices. Obviously, we have no idea where energy prices will head in the coming year, but our strong belief is that even at lower prices the demand for oilfield and power transmission equipment, will still be very high and LUFK will have no trouble maintaining strong cash-flow. If oil prices completely collapsed (say to $50), in the next six months, then of course all bets are off. But we think the odds of that happening are extremely low.