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Drill Into Oil States’ Looming REIT Play

It’s no secret that I’m pretty bullish on the oil services industry for the long haul. As we drill deeper and into more unconventional resources, the task of tapping all that energy will fall to the providers of fracking pumps, drill bits and other necessary equipment.

For that reason, one of my favorites in the sector has been Oil States International (OIS).

The company operates across a variety of business segments, including offshore products, well-site management and tubular services. All of these businesses are vital components in serving our growing domestic energy sector.

However, the star of the show could be OIS’ accommodations unit.

By providing modular housing facilities for E&P firms’ workers in remote locations like the Bakken or Canada’s Duvernay shale, Oil States has carved out an extremely necessary — and profitable — niche for itself.

I previously argued that this housing unit would be the key to company’s future. Now, it seems like several major hedge funds agree.

For investors, the recent push by these institutional investors to have OIS “carve out” its housing unit into a real estate investment trust could be a huge win for shareholders today and tomorrow.

Big Names Backing

While it has many tricks up its sleeve, Oil States’ driving force for the past few years has been its accommodations unit. Basically, if you’re an energy producer fracking a remote well — too far removed from civilization for a daily commute — and have a ton of employees on the job site, OIS will come in and build a modular housing facility for your operation.

Building these temporary “lodges” — including some that are just glorified shipping crates — is quite a profitable business. Reuters reports that Oil States’ accommodations business accounted for a quarter of the company’s 2012 revenue ($4.41 billion), while clocking in at roughly half of operating income ($342 million).

More importantly, the business continues to grow.

Oil States operates these facilities across many of the energy sector’s hotbeds of activity — including Australia, Canada and the U.S. Rising energy production in these areas — such as new oil sands projects — will require an additional 35,000 to 40,000 workers by 2015 and help drive the firm’s future bottom line. Already, revenues from temporary housing have more than doubled since 2010, when Oil States acquired MAC Services Group for $638 million to expand its Australian operations.

Given the profit potential, it’s easy to see why both hedge fund manager David Einhorn at Greenlight Capital as well as Barry Rosenstein’s Jana Partners have recently taken large stakes in Oil States. Together, the two groups now own roughly 14% of OIS shares.

Having two top hedge funds as fellow shareholders can be viewed as a bullish sign, and helps validate the overall investment thesis for OIS. However, what the pair wants to do with the company could be the biggest gift of all.

The Plan for Profits

Both Jana and Greenlight are pushing for Oil States to spin off its accommodations business into a new publicly traded real estate investment trust.

REITs have a special tax status granted by the IRS to any company that “acts as an investment agent specializing in real estate and real estate mortgages.” By gaining REIT tax status, a company reduces or eliminates its corporate tax liabilities and avoids double taxation of owner income. In return, REITs are required to distribute at least 90% of their taxable income back into the hands of investors. That produces some pretty big dividends for REIT shareholders, with such stocks usually offering yields to the tune of 4% to 7%.

Oil States’ accommodations business fits in perfectly with the REIT model. After all, it’s basically creating mobile apartment buildings for oil workers in the middle of nowhere. By unlocking this segment as a REIT, the pair of hedge funds believe that Oil States will be worth more in pieces than all put together.

Jana Partners estimates the housing unit alone might be valued as much as $5.5 billion under a REIT structure, with a combine value of the two separate companies at $155 a share. That’s about $50 higher than OIS is trading for today.

As we’ve seen with other bouts of shareholder activism — such as with Hess (HES) — sometimes these efforts do pay off for individual investors. Unlike Hess, however, Oil States management seems to be playing ball and has held talks with Jana about separating the business. While REIT conversions do take time, the momentum seems to be behind this spinoff, and analysts seem to think it will happen down the road.

For investors today, the possibility of owning the premier player in modular housing segment via a dividend-paying REIT seems like a very good deal indeed. And Oil States’ other businesses are not too shabby, either. Shares aren’t as cheap as they were before Jana announced its stake — it surged about 17% that day — but the long-term potential is still there as the REIT conversion process takes hold.

Even if it doesn’t, Einhorn estimates that OIS shares still have about $18 worth of gains to go before they get “fairly valued” as a whole entity. That’s still pretty.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

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