April 8, 2005

Research Associate: Priyanko Basu, ACA , ICWA

Senior Analyst: James Weber, CFA

Editor: Ian Madsen, MBA ,CFA 800-767-3771, x417

North Wacker Drive  Chicago, IL 60606

Grey Wolf Inc (GW-AMEX) $6.84

Note: This report contains substantially new material. Subsequent editions will have new or revised material highlighted.

Overview

Grey Wolf, Inc. is a provider of contract land drilling services in the United States. Currently the Company operates 127 rigs. Grey Wolf conducts its operations in the following domestic drilling markets: Ark-La-Tex, Gulf Coast, Mississippi/Alabama, South Texas, Rocky Mountain and West Texas. The Company's contract drilling customers include independent producers and oil and gas companies. The Company’s head office is located in Houston, Texas with employees totaling 1,750. Additional information about the Company can be found at: GW operates on calendar year basis.

Analysts have identified the following factors for evaluating investment merits of GW.

Key Positive Arguments / Key Negative Arguments
  • Leading edge bid rates showing increasing trends.
  • Strong activity and increasing dayrates throughout US caused by lack of excess capacity.
  • Balanced mix of long-term and spot contracts.
  • Daywork drilling margins have improved.
/
  • The introduction of more affordable land rig system marketed by National Oilwell Varco may negatively impact the economics of the land rig industry.
  • GW is highly sensitive to oil and natural gas prices due to declining land oil and gas reservoirs compared to offshore drillers.
  • Lead-time for replacement parts and drill pipe is increasing.
  • Lower than expected turnkey margins compared to last quarter.
  • High financial leverage with debt/capital ratio of 54%

The company’s strategy of providing premium equipment, highly trained personnel with drilling expertise, and a solid management team should continue to serve it well during all phases of the industry’s cycles. (Aperion) This philosophy is already being reflected in GW’s 4Q04 results, high dayrates and improving margins.

Revenues

Total Revenues (Contract Drilling)

Fiscal Year Ends: December $ in millions / 1Q04A / 2Q04A / 3Q04A / 4Q04A / FY2004A / FY2005E / FY2006E
Digest High / 75.2 / 103.8 / 116.3 / 129.4 / 424.6 / 591.0 / 688.0
Digest Low / 75.2 / 103.8 / 116.3 / 129.4 / 424.6 / 562.3 / 648.9
Digest Average / 75.2 / 103.8 / 116.3 / 129.4 / 424.6 / 583.2 / 663.1
Digest Average YoY Growth / 20.5% / 55.1% / 60.6% / 55.0% / 48.9% / 37.4% / 13.7%

Dayrate-based contractsgenerated $100 M of revenue in 4Q04. Average revenue per day improved $994 sequentially, to $12,453. Grey Wolf had an average of 87.6 rigs working under day rate-based contracts in 4Q04 versus 84.3 in 3Q04.

Turnkey contractsgenerated $29.0 M of revenue and in 4Q04. Turnkey operations accounted for 8.3% of total rig days versus 10.1% in 3Q04.

Consolidated revenue for 4Q04 was $129 M which was up 55% YoY and 11.3% sequentially. Total revenues for FY2004 was $425 M. The Company averaged 98 rigs working in the quarter, up from 94 in 3Q04.

Management commented that recent trends in increasing dayrates should continue through 1Q05, as leading edge dayrates now range from $10,500 to $17,000 per day without including fuel or top drives. Management also anticipates a sequential dayrate increase of approximately $1,200 over fourth quarter levels, which would indicate an overall fleet average dayrate for 1Q05 of $11,800.

Please refer to Zack’s Research Digest spreadsheet for specific revenue estimates.

Margins

FY2003A / FY2004A / FY2005E / Trend
(up/down)
Operating Profit Margin / -7.5% / 6.6% / 20.9% / UP
Pre-tax Margin / -15.8% / 3.4% / 19.4% / UP
Net Profit Margin / -9.9% / 1.9% / 12.0% / UP

The strong pricing environment is the main factor for the upward margin improvement.

GW posted gross margins of 27.9% for 4Q04 versus 20% for 4Q03 and 24.8% for 3Q04.

Overall EBITDA margin improved to about $3,725/day, up from $2,972, and EBITDA margin was 25.3%, up from 21.9% in 3Q04. Both drilling activity and pricing moved higher.

Operating margins in 4Q04 were $3,725 per day. Turnkey margins were $7,438 per day, which was down from the prior quarter. Dayrate margins were $3,389 per day, up $1,059 per day over the prior quarter. Operating results improved sequentially, as day work margins improved sharply.

Pretax and net profit margins are also showing improving trends.

Please refer to Zacks Research Digest spreadsheet for more details on margin estimates.

Earnings per Share

Fiscal Year Ends: December / 1Q04A / 2Q04A / 3Q04A / 4Q04A / FY2004A / FY2005E / FY2006E
Zacks Consensus / $0.34 / $0.45

Digest High EPS

/ $(0.03) / $(0.01) / $0.03 / $0.05 / $0.04 / $0.39 / $0.57
Digest Low EPS / $(0.03) / $(0.01) / $0.03 / $0.05 / $0.04 / $0.31 / $0.38
Digest Average / $(0.03) / $(0.01) / $0.03 / $0.05 / $0.04 / $0.34 / $0.47
Digest Average YoY Growth / 40.0% / 83.3% / 175% / 1225% / 126% / 758% / 37.2%

GW reported 4Q04 earnings of $0.05/share beating the consensus of $0.04 /share. 4Q04 EPS was positively affected by higher average daily cash margin on dayrate-based contracts caused by more rigs working at higher dayrates and internal efforts to reduce interest expense and expand the market for its rigs. The company expects the first quarter to produce earnings of $0.07 per share based on the current assumptions of accelerating day rates and increased margins of $1,200 per day.

Almost all the analysts reporting have increased their FY2005 & FY2006 earnings estimates based on increasing day rates and higher rig count forecast.

Please refer to Zacks Research Digest spreadsheet for more extensive EPS figures.

Target Price/Valuation

Seven of the analysts have positive recommendations while five have neutral recommendations. Target prices for GW range from $6.70 to $10 with an average model price of $7.85. The low end of the target price is derived from 9x2005 EBITDA estimates, while the high end of the target price uses 20x 2006 estimated earnings. However most common valuation metrics applied by the analysts is 9-12x 2006 cash flow per share estimates.

Rating Distribution
Positive / 58%
Neutral / 42%
Negative / 0%
Average Target Price / $7.85
Digest High / $10
Digest Low / $6.70
Number of Analysts / 12

Most of the analysts have increased their target price based on improving market dynamics.

A major impediment to our price target is a substantial weakening of commodity prices, resulting from global supply/demand imbalances that would cut short the cyclical recovery.

Please refer to Zacks Research Digest Spreadsheet for further details on valuation.

Other Discussion/Capital Structure/Cash Flow/Solvency/Governance

GW ended 4Q04 with $275M of long-term debt, $72 M of cash and $237M of equity. Thus GW ended the year with a debt-to-total capitalization ratio of 54% and net debt-to-capital ratio of 46%. Recent refinancings have reduced the risk of high financial leverage to certain extent.

Upcoming Events

COMPANY EVENT / DATE
1Q 05 Earnings Release / April 28, 2005

Long-Term Growth

Long term growth rates vary between 30% (Banc of America) and 120% (Aperion) with an average of 75%. Looking forward, analysts believe that GW is well positioned to benefit from continued drilling activity as the Company anticipates activating approximately four rigs in the first two quarters of 2005 and has the capacity to activate an additional 10 cold-stacked rigs. To activate the rigs, GW is likely to spend approximately $1-$3 M per rig excluding drilling pipe. GW also has an additional 15 rigs in inventory that may be reactivated at a cost of approximately $6 M per rig.

GW and other contractors are now passing through significantly higher dayrates that will roll through the Company’s financial statements over the next few quarters. Analysts believe that onshore rig demand could continue to grow over the next several years as natural gas prices remain in the $5.00-$7.00 per Mmbtu range and operators continue to explore new areas like the Rocky Mountains, the Barnett Shale, and other regions in west Texas and the northwest U.S. In fact, it is possible that demand could grow to eventually absorb all reasonably available rig capacity in the U.S. However, as onshore pricing continues to increase, analysts believe that projects in some regions will become more price sensitive, potentially neutralizing dayrate increases and prompting some contractors to expand market share through new builds or large-scale refurbishments to grow earnings. (Jefferies)

Individual Analyst Opinions

POSITIVE RATINGS

Aperion Group, LLC – Buy ($10): 02/24/2005 - The analysts raised their rating from Hold to Buy with a price target of $10 due to the current bullish outlook presented by the company.

First Albany Capital – Buy ($7.50): 02/25/2005 - The analysts have rated the stock a Buy with a target price of $7.50 based on the improved drilling market with accelerating dayrates with GW benefiting from it.

Jefferies – Buy ($7.50): 02/25/2005 - The analysts have maintained their Buy rating on GW while increasing the price objective from $7 to $7.50 to account for increasing onshore dayrates and possible rig activations.

Raymond James – Strong Buy ($8): 02/25/2005 - The analysts have maintained their Strong Buy rating while increasing the target price to $8 based on strongly rising trends of US land rig dayrates.

Sanders Morris Harris – Strong Buy ($7.75): 02/24/2005 - The analysts have reiterated their Strong Buy rating with a target price of $7.75 based on strong industry fundamentals and the prospects for additional estimate and price target increases.

NEUTRAL RATINGS

Banc of America – Neutral ($6.70): 02/24/2005 - The analysts have increased the target price from $4.60 to $6.70 based on favorable near-term pricing environment from strong demand and lack of surplus capacity. However they have maintained their Neutral rating based on their belief that EV/EBITDA multiples will not expand beyond current levels due to the limitation on improvement in current activity levels.

CSFB – Neutral ($7.80): 02/24/2005 - The analysts haveincreased the target price from $6 to $7.80 based on the fact that GW is highly leveraged to improve activity trends in the U.S., and they expect to see the rising North American onshore drilling activity setting the stage for further price improvement and earnings acceleration as GW move through 2005.

Lehman Brothers – Equal Weight ($7.30): 02/28/2005 - The analysts have raised their price objective from $7 to $7.30 while maintaining their Equal Weight rating based on their belief that the current cycle of high dayrates will be of longer duration than prior cycles, that commodity prices will remain at highly attractive levels over the intermediate term, and that rig pricing will meet and in some cases exceed prior peaks.

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