Description

Will oil/energy go to $40 on recession fears or will it for to $200 on a Putin induced short squeeze in Europe? No one really knows.

We think Natural Gas Services is one the best way to bet on energy. Natural Gas Services is one of the only energy linked companies that we have found that is debt free, cash flow positive and trading at ½ of replacement value of its assets with a recurring revenue model. With relatively elevated energy prices the company has a multi-year runway to re-deploy earnings at attractive rates on long-term contracts.

I won’t pretend to be an energy analyst, but Natural Gas Service represents an essential service for non-conventional energy plays. They provide “compression” for wells and formations that extend the life of the well as well as make sure that you “squeeze” out every bit of hydrocarbons. NGS manufactures these compression pumps in two facilities and then largely “rents” them to energy company on a monthly basis over 3-5 year contracts. They also fabricate and sell these compressors albeit that is a small part of the business.  Historically they have sold into Oil production but with Nat gas prices so elevated that market is providing additional growth opportunities.

Over the last 5 years they have transitioned their rental fleet from “small” compression to large horsepower. It’s hard to appreciate the difference without seeing it, which I have. The small compressors are the size of a large SUV. They can be easily moved around and fabricating them can be done by smaller shops. The new, large compressors are enormous. I haven’t measured but my guess is you could fit at most 3 of them on a basketball court. They cost tens of thousands of dollars to transport and install. There are literally high “frictional” costs to relocate these compressors, and there are only a few folks with the capability to fabricate them. On a per horsepower basis NGS achieves far superior economics and far superior barriers to entry on these versus they small HP market. The contracts are longer and more certain, which is why they have and continue to transition away from small HP market. Large compression now represents close to 50% of their horsepower deployed and continues to grow.

Compression to an oil/gas well is as fundamental as air conditioning is to a data center. For large unconventional plays you need compression both earlier and longer. Without compression the well does not produce and it is the last item them operator turns off. Further, NGS largely contracts with the big boys (OXY, Devon and the like). The counter party is not the well but rather the parent. So long as the parent remains solvent NGS gets paid. If they don’t get paid the compressor gets turned off and cash flow at the well starts to evaporate. In addition, many of these compressor have custom tailored aspects to them specific to the formation and well it is being produced for.

NGS has done an admiral job of self-financing their growth over the last two decades and becoming and remaining debt free. They have entered the large horsepower market and shifting their mix from 4% in 2017 to almost 50%+ today, and they will continue this trend. This presents major advantage through the cycle as they are in a position of strength when their customers are strapped for capital. When they deploy capital, they know the return via multi-year contractual arrangement and only build to order. Operators prefer renting compressors (versus purchasing) since it allows them to direct more capital to production.

Competitive position: With 30%+ Adjusted EBITDA margins and 3-5 years+ visibility on their contracts it begs the question on why and how they can command these rates in the cutthroat competitive environment of Oil and Gas. A few bullets:

·      Find a niche – for the unconventional formations that need custom build compressors/configurations

·      Focus on high horsepower, gain economics on $$$/horsepower, few competitors capable to play here

·      Maintain a service infrastructure that can respond that results in 95% uptime. If a compressor goes offline the well goes offline. Very important to operators and difficult to replicate currently

·      Inhouse fabrication. Keeps costs down, and ability to do custom work

·      Be a partner and be local. Energy is a cyclical hard business one needs partners.

Valuation:

A few notes:

·      They depreciate the compressors on a 7-year basis for tax purposes and they say that they’re useful life is closer to twice that on small horsepower but more like 20-25 years on large horsepower.

·      They expense all regular maintenance on the owned fleet.

The company should do about $27 of EBITDA this year. We believe maintenance cap-ex on this asset base is about 12 m a year but given the new nature of the fleet that on a cash basis you will see softer spend for the next 10 years and heaver maintenance after that. Additionally, the company is upgrading its fleet to electric drive which drives pricing and operating cost improvements. Too early to tell how to model that but economics are better.

Most recently the company put out a statement that they believe they will deploy $40-50 m in the next year. We don’t think they can continue to maintain that level of growth but assuming they can do about $100m over the next three years then we think EBITDA comes in at about $40 m three years out. Further they have indicated that they are going to push pricing as energy is doing well and they should share in that upside given they made concessions when things were tough. We also assume they will terminate the stock buyback for now, as they will need to tap the revolver to put out this equipment.

Rolling this forward we get something like the following in three years:

·      $40 m of EBITDA across 13m shares

·      Using an 8X multiple on this get us to about $335 m (320+15 for the building) of Enterprise value. (We think given the debt free nature, required service and long-term contracts in warrants a higher multiple like 10X but for conservatism we use 8X.)

·      Assuming a flat share count and excess cash flow to keep the entity debt free gets us to $25/share

·      Further at the current valuation one has significant downside protection given the dramatic discount to book – ½ books value that is continually checked via third party appraisal by the banks.

·      If energy prices crater, we see it difficult to lose money given the long-term contracts with credit worthy customers, and if prices go nuts then they will likely be able to lock in premium rates and or sell compressors at least book value to customers and close the valuation gap.

·      The have a very low-risk model in that they only commit capital when they have a contract in hand. No spec builds.

·      If they decide to employ some modest leverage (they own their HQ in midland outright $15m value) they could likely get share count down meaningfully and the numbers look a lot better $30-40/share.

In a nutshell NGS, $10 per share today, represents a safe and highly asymmetric way to play the energy markets, or even outside of energy a safe value play.

Risks:

Inflation, supply chain

Dramatic dislocation in energy markets

Catalyst

continued earnings growth

Stock Buy backs

Oil Spike