Bull/Bear Report -- Lufkin Industries: Pumping profits to your pockets

This week's Bull/Bear Report was inspired by blogger conversation regarding the oil patch and equipment suppliers like Dresser Rand (DRC). Our friends at Strategy Lab asked me to provide opinions on sister company, Lufkin Industries (LUFK).

As I wrote in my article for Strategy Lab, I am not one to follow the crowd. Typically I get nervous doing so.

In the case of oil equipment makers, the stocks have moved higher as a result of sky rocketing oil prices. The thirst for crude appears to be triggering a wave of exploration, development and pumping not seen in some time.

The request to make off-shore drilling available is indicative of that demand.

Those providing equipment to the space should benefit greatly regardless of the price of oil. The only trouble is that stocks have risen in anticipation of that demand.

Is it too late to join the party?

In my opinion, these companies will do well regardless of the price of oil. The stage has been set for more supply. Even at $80 per barrel profits should follow.

There were many excellent posts regarding Lufkin (LUFK). Read on for two interesting view points:

The Bull Case - Russ of RD's Picks

Russ thinks LUFK has potential, plus he found another stock in the same space that he likes even more.

Don Ferk, the Viking Warrior from SLO1, commented on my blog last week and asked for my opinion on Dresser Rand (DRC) vs. Graham Corp (GHM) going forward. That prompted our QOTW on another oilfield equipment supplier, Lufkin Industries (LUFK).

First Graham. GHM supplies condensers, heat exchangers and ejectors to refineries, petrochemical and other process industries. The stock has had a phenomenal run this year, moving from a ytd low of 30 at the end of January to over 68 on 13 June. I think the company will continue to do well, but the stock price may be getting near fair value at 17.4 times 2009 earnings estimates. So, Don's comment and the QOTW prompted me to take a look at DRC and LUFK to see if it might make sense to shift out of GHM into one of them.

Dresser Rand

Dresser Rand makes pumps, compressors and other rotating machinery for oil, gas, refining, petrochemical and process industries. The company has a market cap of $3.5 billion, trades at 15.4 times analysts' 2009 estimates, has 370 million in debt, 260 million in cash and an estimated 5-year growth rate of 29%. The company doesn't pay a dividend.

According to the latest earnings transcript the company has a $2.1 billion order backlog. They also have a $150 million buyback authorized; that would be over 4% of the float if exercised at Friday's closing price.

During the earnings call, the company stated that the refinery business is good. Despite US refineries scaling back expansion plans, they are upgrading to handle heavier or high sulfur crude oil. And, overseas refinery equipment orders are strong. "So, maybe there is a bit of a slowdown in the U.S. refining, but I can tell you that on a worldwide basis, there is a heck of a lot of activity." according to Mark E. Baldwin, Executive Vice President and Chief Financial Officer. Strong worldwide refinery business is consistent with statements Graham's management made during their conference call as well.

President and CEO Vincent Volpe stated, "We continue to believe that our 2008 operating income will be in the range of $285 million to $315 million."

Mr. Volpe made an interesting comment concerning R&D efforts to improve the ability of pumps to handle mixed gas and liquid flows. "So, I would say that we are ahead of the game, not behind the game and we're ahead of it with what I believe is leapfrog technology, which we've patented." I'm not sure exactly how much that benefits oil extraction, but at $130+ a barrel, anything that makes extracting crude more efficient would certainly be appealing.

In summary, very reasonable PE, strong order backlog and a customer base covering the upstream and downstream of the oil and gas industry.

Lufkin Industries

LUFK has three different business operations, oil and gas equipment and service, transmission systems for heavy machinery and marine, and truck trailers. They are shutting down the truck trailer business to focus on the other areas. The company has a market cap of $1.16 billion, trades at 13.1 times analysts' 2009 estimates, has no debt, 130 million in cash and an estimated 5-year growth rate of 10.25%. The company pays a 25-cent quarterly dividend for a yield of 1.3% based on Friday's close. LUFK has been a good performer for the CAPS Commando in the current MSN Strategy Lab.

The latest earnings transcript indicated an order backlog of $235.7 million, mostly over the next two quarters. LUFK has $3.5 million remaining in their buy back authorization. They also raised guidance for 2008 earnings to between $5.10 and $5.30 a share.

The company has seen some orders from customers who tried lower price competitor's equipment, but have been coming back to LUFK due to quality and reliability issues.
In summary a PE well below the market, decent order backlog, strong customer base and no debt.

Wrap-Up

I think all three of these companies are likely to outperform the overall market going forward, but DRC stands out. A backlog totally nearly two-thirds of the market cap provides good earnings visibility for at least the next couple of years. That compares with GHM and LUFK backlogs at about 25 and 23% of market cap respectively. Another deciding factor is DRC's much higher estimated earnings growth rate. Even though DRC trades at a slight premium to LUFK on PE, that premium seems more than warranted by the higher projected growth rate. Finally, DRC has under performed the other two stocks over the last 12-months. LUFK is up 21% over the past 12 months, GHM is up over 230% while DRC is up a little under 9%,. I didn't find a good reason for the discrepancy between LUFK and DRC, so it looks like DRC has some room to play catch-up.

I started building a SLO position in DRC on Monday and bought some in real life.

Earnings call transcript information is from Seeking Alpha. Many thanks to them for posting transcripts.

And thanks to my friend Don for the Dresser Rand lead.

Disclosure: At time of posting, I own a few shares of GHM and (now) DRC, but have no position in any other company mentioned.

The Bear Case - auminer

Auminer has made a bunch of money in LUFK over the years, but thinks you need to wait for a dip down in to the $50's before buying.

LUFK was a screaming buy when I first purchased it on Marketocracy: 15APR03 at a price of $19.32. It's been in my energy sector fund ever since, at varying levels of weighting. I've owned it off and on IRL, too. It was during another of those explosive periods of price appreciation that I wrote it up for Marketocracy as a potential Stock Alert pick. Sadly, by the time that alert was published in late 2005, the stock went rangebound at around $60, where it stayed until this most recent run-up.

LUFK is a difficult stock to decide 'pick' or 'pan'. I do think they're in a great potential business, especially given the tremendous resurgence in drilling in West Texas' Permian Basin area. My dad delivers mail to a USPS rural route across a vast area around Odessa, Texas, and has told me every time we talk that he's never seen this level of drilling activity even back in the early 80s. Each of those drilled oil wells will need a pumpjack on the surface, and that's one of the main products in Lufkin's lineup.

They also manufacture reduction gears, which basically take a rapidly spinning shaft and output a slower speed/higher torque shaft. Another product line includes various trailers. I once saw a very happy sight for a Lufkin shareholder: a Lufkin trailer heading west on I-20 (towards the Permian Basin area) with a Lufkin pumpjack on the bed!

That's all well and good, though... but investing is not about what's past, it's about what's ahead. Analysts estimates call for LUFK to earn $6.00/share next year, and forecast an earnings growth rate of 10.25% over the next five years. That computes to a forward PEG of about 1.25 to 1.3 with a price-per-share in the $78-80 range. That's too rich for me. I think there are better opportunities in the oilfield services arena. If you see LUFK pull back to $55-60, and you're patient, then maybe it'd be worth a small portion of your energy sector allocation... but at nearly $80, it's got all the good priced in.

Buying on the dips in this space would appear to be the quintessential no-brainer. I think the sector does well irrespective of the direction of oil. If off-shore efforts increase, demand for equipment will only increase.

The oil equipment manufacturers may be the best way to play high oil prices from current levels. This may be the exception to following the crowd.

Jamie Dlugosch
Executive Editor, InvestorPlaceBlogs

Additional Resources:

Rebecca Witwer: Some Thoughts on Lufkin

Tom Armistead: Lufkin Industries - A growth story with a few sour notes

Don Barrett Lufkin Industries Dry Whole or Gusher

Richard Band - China and India Demand for Oil Begins to Tumble

Jeff Manera: Oil, Solar, Desalinization

Eileen Teska China's Thirst for Oil

by Hillary Mark |  06/20/08  |  Stocks: DRC, GHM, LUFK,