Houston-based Key Energy Services Inc. has been one of the more active consolidators in the energy services arena, but its rapid growth turned out to be a lot to handle as far as financial reporting is concerned. Now, after successfully navigating some rocky shoals, chairman, president and chief executive Dick Alario believes the company is about to put those financial-reporting problems behind it and resume growth through acquisitions. The market apparently agrees, for in mid-June, the stock hit a 52-week high of $20.15 per share.

Key was organized as a public company in April 1977 and began operations in July 1978 under the name National Environmental Group. Its modern-day history as a leading U.S. onshore well-servicing contractor actually began in the early 1990s as Key Energy Group Inc. It was renamed Key Energy Services Inc. in 1998.

From 1994 through 1999, in particular, Key aggressively grew, making more than 100 acquisitions. The result is a company that now provides a complete range of services to majors and independents, including rig-based well maintenance, workovers, well-completion and recompletion services, fluid-management services, fishing and tool-rental services, and pressure-pumping services-now a rapidly growing business for the company.

Meanwhile, Key's geographical footprint also expanded rapidly. By 2003, it was operating in the Gulf Coast, the Permian Basin of West Texas and New Mexico, the Appalachian Basin, Michigan, the Rockies and California. It also became involved in Argentina. In addition, it acquired a lucrative pressure-pumping-services business resulting from the acquisition of Q Services Inc. in 2002.

Yet, with all this growth, Key ran into a significant problem.

By early 2004, it became clear that the company's fixed-asset accounting for the 1999-2003 period had become seriously flawed, and that the annual financial-reporting data for that period had to be restated.

Says Alario: "There were a number of acquisitions during the 1995-2002 period where, in hindsight, the internal controls relative to those transactions weren't as strong as they should have been; that, in turn, ultimately led to a number of accounting issues and write-downs of asset values."

Since 2004, the company has undertaken a comprehensive review of its fixed assets and has labored to get its annual financial reporting back on track. The need to accomplish this was underscored in 2005 when, due to the absence of filing an annual report for 2003 going forward, the firm was delisted from the New York Stock Exchange under the symbol KEG. Since then, it has been trading on the OTC Bulletin Board under KEGS.

The good news today is there's light at the end of the tunnel. Alario said at press time he had a target date with the banks of mid-summer to have Key's 10-K annual report filings for the 2004-2006 period done.

When those filings are made, what should be apparent to the market is Key's recent history of steady financial growth, as the company now has a $2.4-billion market cap.

Notably, its first-quarter 2007 revenues were around $406 million versus $347 million for the prior-year period. Similarly, for fourth-quarter 2006, Key's revenues grew to $407 million from $316 million for fourth-quarter 2005. More importantly, Key earlier this year provided guidance that its revenues for all of 2007 are expected to be $1.7- to $1.75 billion.

What is The Street's perception of the company? This May, James D. Crandell, senior oilfield-service equity research analyst for Lehman Brothers in New York, reiterated an Overweight rating on the stock while raising his 12-month stock price target from $19 to $24. The analyst took note of the recent better-than-expected performance of Key's pressure-pumping business while raising his 2007 and 2008 earnings-per-share estimates for the company from $1.90 to $1.95 and from $2.20 to $2.25, respectively.

To find out more about the Key Energy Services saga, Oil and Gas Investor recently visited with CEO Alario. In particular, we wanted to know more details about the company's accounting and financial-restatement saga and where his company goes from here as it returns to transparent financial reporting.

Investor In the 1990s, consolidation was Key's major strategy for growth, right?

Alario Actually our consolidation efforts continued through 2002, but the bulk of it was done in the 1990s, when we went from 50 workover rigs and a few fluid-handling vehicles, to a company that today has about 860 marketed workover rigs and around 1,000 oilfield-service trucks. After 2001, we then began transitioning into a more focused well-service company.

Investor When you say "transitioning," just what sort of strategy did you pursue?

Alario After consolidating the U.S. well service business, we began to focus more on organic growth, that is, strengthening our market positions with bolt-on acquisitions to enhance the company's presence in a given region. In addition, we still had a few holes to plug such as the upgrading of equipment and the training of people.

All these things dominated the company's strategy from early 2004 up until about six months ago, when we told the marketplace that we're now rebalancing our strategy to once again include acquisitions as part of our growth plan. Currently, we have a pipeline of acquisition candidates we're evaluating.

Investor Those acquisition candidates are in what line of business?

Alario Mostly well-service companies that are involved with rig-based services such as workovers, well maintenance, other remedial well activities, and transportation services including fluid handling or hauling operations.

Investor Key is also involved in providing pressure-pumping services.

Alario Yes, that came to us in 2002 with the acquisition of Q Services, and it remains a separate line of business to this day.

Investor Will you be considering acquisitions in the pressure-pumping market as well?

Alario On a limited basis, yes. We would also be a buyer in the fishing- and rental-tools business segments.

Investor Sounds like you're still looking to consolidate the oil-service market even today.

Alario Yes, but I would distinguish between our original consolidation phase and what I would call today strategic acquisitions rather than just amassing assets. By this I mean that today, we're focused on acquiring assets that enhance our position geographically, our service or product offerings, or that increase our technical capabilities.

Investor What does your geographical footprint look like today?

Alario We're in 16 states in the U.S. plus Argentina and Mexico.

Investor Do you consider the international markets an important growth area for Key?

Alario We need to develop our international business more thoroughly, and you saw some of this effort last January with the announcement of our first Mexican contract-a pilot project for well servicing for Pemex by an outside contractor. It involves 22 months of work for three of our workover rigs for $45.8 million.

Investor What's the attraction of the international markets?

Alario We believe they'll help us balance our operating footprint so that we can take advantage of opportunities abroad when the U.S. market isn't so strong or when the domestic market may be experiencing over-capacity.

Investor Besides Mexico, where else are you trying to expand internationally?

Alario In certain Latin American countries like Argentina and the Middle East-those are our two highest priority areas right now.

Investor How have the steps that Key has taken since early 2004 to achieve organic growth translated into improved operational and financial performance?

Alario On the back of strong market conditions, our workover-rig utilization levels have increased steadily and our composite revenues per rig hour have increased significantly-in some markets, doubling.

Investor Any way to quantify these gains?

Alario In fiscal 2004, our rig hours totaled 2.42 million hours; in 2005, 2.60 million hours; and in 2006, 2.66 million hours. As for composite revenues per hour across our rig fleet, they averaged about $275 per hour for 2004, $318 for 2005, and $398 for 2006.

Companywide, our overall revenues increased to around $406 million in first-quarter 2007 from about $347 million for the same prior-year quarter. Similarly, revenues for fourth-quarter 2006 were roughly $407 million versus $316 million for the like 2005 quarter.

Investor What about total debt?

Alario Most recently, it was $420.5 million for first-quarter 2007 [a total debt/market-cap ratio of around 17%], slightly down from $425.2 million for the same 2006 quarter. Meanwhile, our first-quarter 2007 cash position was around $190 million, much stronger than $109 million for the corresponding 2006 quarter.

Investor What about other areas of organic growth, besides your well-servicing business?

Alario We've also managed to organically grow the capacity of our pressure-pumping business-in fact, we've more than doubled it. Currently, we have about 180,000 horsepower of pumping-related equipment and we expect to add close to 20% to that base this year, winding up with about 212,000 horsepower.

Investor Looking at your recent restated financial performance for fiscal 2003, which Key issued last October, it appears the company experienced significant growth in revenues during the 2001-2003 period, yet a decrease in net income during the same time. What caused that?

Alario In that recent restatement, we wrote down millions of dollars worth of assets that were originally improperly valued on our books, and those write-downs negatively impacted earnings. Also, I would point out that 2001 was a strong year for the industry, but after 9/11, business softened in 2002 and 2003.

As for the concurrent improvement in top-line growth during that period, it's worth noting that in 2001 we hadn't made the Q Services acquisition yet. That came in 2002 and had a positive impact on revenues. That's why you see continued top-line growth year-over-year.

Investor This brings us to the issue of Key's problems in recent years with financial reporting and the need to restate your financials. What brought that about?

Alario The problem initially came to light in early 2004, but actually showed up in our original financials for the 1999-2003 period. Very simply, internal reports in 2004 raised questions about whether certain fixed assets-primarily rigs and heavy-duty trucks-were being accounted for properly. So we were unable to file our 2003 10-K in early 2004, and instead we conducted a comprehensive review of our equipment-which took nearly a year to complete-to determine the existence of certain assets, as well as their condition, value and remaining depreciable life.

Investor What's a good example of the problems you found?

Alario A rig would be listed on the books at several hundred thousands of dollars and yet, when we went out and did an asset inventory count in 2004, we saw that this rig which may have been considered an active unit, was really in disrepair and that its value should have been written down at some prior point.

Investor What did the comprehensive review conclude?

Alario It determined that the principal factors that contributed to the deterioration of our fixed-asset accounting records, financial records and disclosures during the 1999-2003 period were several: rapid growth, untimely integration or failed integration of acquisitions, incomplete supporting documentation and poor internal due diligence with respect to acquisitions, and inadequate accounting resources. This resulted in a failure to establish and consolidate effective internal controls over our decentralized businesses.

Investor What steps did you take in the wake of this?

Alario Since the end of 2003, we've put a whole new management team together. No one on the executive team today was here then. In addition, we've put in place a whole new accounting department and beefed up internal controls, both financial and operational. In short, we've turned Key around.

Investor Do you believe greater financial transparency will improve market sentiment about Key?

Alario Actually, market sentiment about Key is already quite good. In mid-June, our stock hit a 52-week high of $20.15-about 60% higher than where it was when our accounting issues surfaced in 2004. That said, greater transparency would help improve investor understanding and our liquidity.

Investor Key recently announced guidance that expected fiscal 2007 revenues would be in the $1.7- to $1.75-billion range. What prompts this positive outlook?

Alario The primary driver is the strength of the U.S. drilling market. With record commodity prices, our customers are generating record cash flows and are spending more to find and develop new reserves, so we're getting the benefit of that. Overall, we think 2007 is going to be better than 2006, and we like our market position now.

Investor Looking forward, will Key be able to add any net capacity in its workover well-service business?

Alario We'll add incrementally, but not significantly. Rather, our intent is to upgrade our existing rig fleet and get it in better shape to meet our customers' demands more efficiently. To that end, we've replaced more than 300 of our workover rigs since 2001.

What customers demand is efficiency. This means they want us to not only help them analyze problems in the wells from which they're trying to produce, but also be as cost- and operationally efficient as possible when we get hired to perform that work.

Investor What could Wall Street better understand about Key?

Alario Analysts tend to put Key in a peer group with land drillers. We don't think that's appropriate, primarily because the land-drilling business is essentially driven by upstream capital-spending programs. Comparatively, our well-service business is driven by maintenance and production-oriented expenditures, not so much by capital spending. This is an important distinction because the well-service business is a lot less volatile and steadier than the land-drilling business.

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