On Tuesday, September 30, C&J Energy Services filed a form S-4 with significant details about its pending transaction with the completion and production segment (NCPS) of Nabors Industries (NBR $22.76). We believe that the market continues to underestimate the earnings and cash flow power of the combined business and that the stock is set up to be a strong performer in 2015 and 2016.
C&J provided estimated 2015 performance (for stand-alone C&J) including expected revenue of $1.8 billion, EBITDA of $300 million, capital expenditures of $149 million, and net income of $113 million. This compares favorably with the $1.7 billion in 2015 revenue C&J pointed to on the June conference call when the deal was announced. When the deal was announced in June 2014, C&J provided a 2015 pro forma outlook that included revenue of $4.0 billion to $4.4 billion and EBITDA margins in the upper teens (inclusive of perhaps $50 million in cost synergies in 2015 on the way to $100 million in recognized synergies in 2017). We believe pricing in the market has improved since these figures were published and the impact of pass-through costs (for sand in particular) has shifted a bit to be more in favor of the services companies.
Our new 2014 EBITDA estimate is $205 million, up from $189 million previously, and our new 2014 EPS estimate is $1.22, up from $1.03 previously. Our 2015 EBITDA estimate is $318 million, up from $271 million previously, and our new 2015 EPS estimate is $2.18, up from $1.60 previously. We discuss changes to our model in more detail later in this note. The S-4 included projections for stand-alone C&J, C&J’s estimates for NCPS, and Nabors Industries’ projections for NCPS from 2015 through 2018. The projections do not include cost synergies (C&J is targeting $100 million in synergies by 2017), better utilization of NCPS equipment, or anything beyond limited pricing improvement in frac services.
In our note dated June 25, 2014, we had laid out a scenario where the combined company could generate 2015 EBITDA in a range of $600 million ($4.0 billion in revenue at a 15% EBITDA margin) to nearly $800 million ($4.4 billion in revenue at an 18% EBITDA margin). The base- and bull-case scenarios below line up well with our initial take on the combined company, yet it is important to remember that the estimates provided by C&J (the “C&J Est for NCPS (2)” column) do not include any cost synergies or opportunities for increasing utilization of the NCPS assets, something we are confident that C&J will be able to facilitate quite quickly for coiled tubing and wireline and for NCPS’s frac fleet later in 2015 and into 2016. The forward assumptions from the merger announcement presentation also included a comment that the combined company should be able to drive EBITDA margins over 20% including cost synergies (which would contribute roughly 200 basis points of “extra” margin, or a bit more on a $4.5 billion revenue base), implying that management sees some organic (not just driven by expense cuts, but by operating leverage) margin expansion beyond the upper teens expected for 2015. We believe this perspective has not changed and makes the implied margins in the base- and bull-case scenarios in 2017 and 2018 (a range of 19.6% to 21.1%) look quite achievable, in our view.
Given the disclosures in the S-4, continued strength in the North American services market, and our expectation that C&J will be able to deploy its recently delivered frac capacity quickly and profitably, we are raising 2014 and 2015 estimates (for C&J stand-alone only). Our new 2014 revenue estimate is $1.5 billion, up from $1.44 billion previously. We assume a slightly better EBITDA margin than our previous model (13.7%, versus 13.1% previously), driving our new EBITDA estimate of $205 million (which compares with the consensus of $225 million). We now project EPS of $1.22, up from $1.03 previously. We assume a bit of improvement in gross margin in the second half of 2014 from the past two quarters since we believe that service companies are having a bit more success passing through rising sand and rail costs to their customers, an issue that clipped the gross margin in the second quarter.
Our 2015 estimates now include revenue of $1.85 billion, EBITDA of $318 million (17.2% of sales) compared with $300 million in the S-4 filing (but $315 million in the section discussion on the management case for the valuation/fairness opinion) and consensus of $340 million, and EPS of $2.18, up from $1.60 previously (and consensus of $2.21). Part of the change in our EPS estimate was driven by reducing our 38% tax rate assumption to 36% (spelled out in the S-1). We had been modeling capital expenditures of $100 million in 2015 (after $202 million in 2014), and we continue to believe that C&J will spend less than its projections supplied in the S-4 ($149 million for 2015) given the utilization opportunities we believe the NCPS fleets will provide; we project $129 million.
We believe the only asset that may not fit the long-term strategic plan for C&J is the fluid service business (solely from NCPS), which includes nearly 1,500 trucks and more than 5,000 frac tanks in the U.S. market (nothing in Canada). We believe this segment probably generates EBITDA margins in the low-20% range, suggesting that it is a solid cash flow driver. The company’s 29 disposal wells might also make sense to divest, but only if the fluid service business is sold. We doubt that these decisions will be made in the very near term after the deal closes, but given the amount of production and completion activity and the number of producing wells in the United States and the benefits of a having or building a large-scale fluid services offering, we would not be surprised if C&J/NCPS would receive some interest from potential strategic and financial buyers in the coming months. The breakup fee for the deal is $65 million, payable under a number of circumstances, with the most relevant ones being if C&J’s board does not recommend the deal or the financing falls through. C&J could also be on the hook for $17 million in legal and regulatory fees if the deal does not go through because C&J shareholders do not vote in favor of the deal.
We recognize that the macro environment for oilfield services companies in North America is less certain now than it was when the deal was announced, primarily because WTI prices have declined from over $100 in late June to just over $90 today. But we also believe that current commodity price levels have not changed the trajectory of activity levels, utilization, and gradual pricing increases that services companies are seeing. This is primarily driven by continuing strength in Permian and Eagle Ford horizontal drilling (where cash flow breakeven prices for E&Ps are well below current oil prices) and steady and predictable spending from E&Ps that continue to operate within the constraints of their cash flows and balance sheet. We view the opportunity in C&J’s stock as the product of a combination of macro factors (which affect all oilfield services companies) and company-specific factors unique to C&J shares that we believe the market is underestimating. On a pro forma 2016 EBITDA range of $888 million to $958 million from the S-4, and assuming the company makes good on its goal of generating $100 million in operating synergy by 2017, we believe that investors will place a 6- to 7-times forward multiple on the stock. C&J’s advisers used a valuation range of 5 to 7 times forward EBITDA in their fairness opinion, but we believe that the combined company will have sufficient breadth, service diversity, cash flow, and balance sheet strength to avoid the low end of the range used in the S-4.
Assuming $1.3 billion in debt as outlined in the merger announcement release (although given the free cash flow the business should generate in 2015 and 2016, we expect some deleveraging will drive this lower) would generate a stock price (on 119 million shares) between $34 and $51 looking out 12 months from now. We are confident that the opportunities for revenue and EBITDA upside to the pro forma numbers provided in the S-4 are significant given the equipment utilization opportunities in front of C&J’s team, improving frac pricing and utilization, and better cost pass-through dynamics on sand and rail costs. From this perspective, we are confident that the stock has significant upside potential from the current share price of roughly $30. In our view, the risk/reward equation on C&J shares is skewed significantly toward upside from current levels, and this perspective is the foundation for the reiteration of our Outperform rating.