Weatherford International (OTCPK:WFTLF) is a tier 2 oil services company that was badly mismanaged for a decade before a new CEO, Mark McCollum, took over in 2017. McCollum, a Halliburton alumnus, began an aggressive campaign to restructure the business by high-grading the company’s portfolio but couldn’t outrun a bankruptcy filing in 2019. While his efforts did lead to improved financials, the company managed to exit Chapter 11 literally just before the oil industry cratered due to coronavirus demand destruction. It didn’t take long for the market to price in a high likelihood of another bankruptcy taking the shares from a high of $37.00 after emerging from Chapter 11 to about $3.00 currently. To top this off, McCollum announced his immediate resignation shortly after the industry and stock cratered, and the company’s CFO announced his resignation after that.
So, at this point, I am guessing anyone reading this article is assuming I am on a mission to break Seeking Alpha’s record for least-viewed article. Not quite, because the reason I even know about this tier 2 small cap is due to Morningstar’s analyst having a 5-star rating and a $55.00 fair value on the stock before the industry meltdown and for a while into the meltdown. The analyst did eventually drop the fair value to $10.00 per share after factoring in a 70% chance of bankruptcy wiping out shareholders. While I’m sure this is not offering much in the way of optimism, I would point out the downgrade was before Weatherford recently reported its second-quarter results and, probably just as importantly, announced a commitment to refinance its debt with the intent to alleviate covenant issues. The commitment to refinance was extended a couple of times, but literally at the last minute on Friday night, they finally announced the execution of the refinancing.
As I mentioned, the refinancing is not the only reason for optimism in Weatherford’s second-quarter financials, which, at the height of the industry turmoil, were certainly not good with a 32% sequential decline in revenue, but Morningstar’s analyst pointed out the company’s performance by market was on par with the rest of the industry and it managed to generate $31 million in cash flow from operations. I’m going to post some quotes from the company’s recent earnings conference call to shed some light on how it managed to generate positive cash flow, including a discussion related to the sustainability of cash flow.
For guidance on unlevered free cash flow, Q2 was strong despite lower profitability due to the unwinding of working capital driven by strong receivable collections. As revenue starts flattening in Q3 and Q4 versus Q2 levels, the company does not project significant contribution from lower receivables. We are seeing a lengthening of payment terms with some NOC customers such that any further benefit of the unwinding of working capital will be associated with modest reductions in inventory. For 2021, our view is that unlevered cash flow – free cash flow is going to be about half of 2020 levels, as we do not expect the benefit from the unwinding of receivables in 2021 to be as significant as what we are projecting for 2020.
Yes. Okay. In terms of the outlook for cash generation, so $108 million of unlevered free cash in the second quarter. It looks like there was $130 million working capital release and the outlook doesn’t really contemplate a lot of working capital benefit. So if I exclude that working capital release, it would appear you were consuming some cash in the second quarter. Revenue trending lower, albeit with tempered decrementals because of the cost-saving program. But if I just sort of put all that together, it would seem like you’d have negative unlevered free cash in the back half of the year. Am I right about that? And are there other levers that you’ve got where you can get that back into positive territory here?
Right. So we expect to be positive unlevered free cash flow in the second half of the year. So let me just walk you through how we think about the unwinding of the – benefit of the unwinding of the working capital. So as you’ve mentioned, we saw $130 million of benefit from the unwinding of working capital in the second quarter. Of that amount, approximately $275 million came from receivables, a very small contribution from inventory, and the rest is negative outflow from payables. Now going forward in the second half, as revenues flatten out and the potential delays in customer payments, we expect that any contribution from receivables will be offset by lower payables and that the net working capital will be from inventory. At this point, we expect that the opportunity in inventory for the second half is maybe about $100 million. So which – that $100 million is more weighted towards the fourth quarter. So we continue to believe that there is some benefit from working capital that we expect in the second half. So I hope that helps.
That’s helpful. I just have 1 more as it relates to kind of the new capital structure here. And unlevered free cash flow does exclude interest expense, but it is a cash cost. So when we do think about that interest expense, you will be consuming quite a bit of cash here. What level of revenue do you think the company needs to be at, given the capital structure going forward, assuming the deal is closed, to be comfortably generating free cash flow, including all obligations that you have?
Yes. So let me just – clearly, that’s just a projection that we’re not willing to provide but what this capital raise does is 2 things. One is that it replaces the ABL credit facility, and eliminates the risk of noncompliance, which is a big issue for the company. The second is that it provides a liquidity runway for the company to meet its obligations and continue to address the challenges of this market. So with that, we believe that we actually believe that this is a good transaction for the company.
I have no formal financial training or background, so analysis of debt and liquidity are not in my wheelhouse, and therefore, I’ll leave it to readers to interpret the information from the conference call. However, I will note that Morningstar’s analyst does think Weatherford has a viable business and that the issue the company faces is one of liquidity. In regard to the announcement of the commitment to refinance, he noted it would probably buy Weatherford two years if the refinancing went through, which it finally did.
In regard to valuation, as I pointed out, Morningstar had a $55.00 fair value before CoV, and the stock briefly traded for $37.00 in its very short stint before the oil market cratered. Based on the analyst current $10.00 fair value and stated incorporation of a 70% chance shareholders are wiped out, it looks like his fair value would be about $33.00 ($10.00/0.30 = $33.00), if the company survives intact.
So, the opportunity is that the recent refinancing probably buys Weatherford a couple of years for the oil industry to recover to the point where liquidity concerns are off the table and your reward will be maybe 10X or more upside. The downside is the company doesn’t escape liquidity concerns and you lose the entire investment. As a frame of reference, Schlumberger (SLB), the cream of the oil services industry crop, is trading for $19.00 with a Morningstar fair value of $48.00. So, while Mr. Market does not have much hope for this little tier 2 small cap, it’s also taking the rest of the industry out to the woodshed. I own a sizable stake in SLB and a modest stake in WFTLF. Morningstar currently suggest WFTLF could be suitable for investors with a high tolerance for risk, and based on the way they’ve managed to navigate the unprecedented industry downturn so far, I tend to agree.
Disclosure: I am/we are long WFTLF, SLB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.