Outline
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What Exterran’s history is and what they do.
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What happened over the past year.
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Why it is interesting.
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My key concerns – maybe we wait until they
guide down / consensus resets.
What
do they do?
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Exterran is in the business of assembling and
leasing gas compressors the up/midstream O&G as well as distribution companies.
These devices typically range from 150 to 1500+ horsepower, cost around $500-1000
/ HP to build, and are essentially at every stop to bring the natural gas from
underground to refineries.
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Historically, EXH was really only in the
business with dry gas companies (low NGL & oil content), but post the
2011-12 collapse due to the natural gas glut and poor operations due to
integration issues, it made a conscious effort to diversify into “oilier” areas
and well-head compressors (which is re-inject natural gas into producing oil
wells to maintain reservoir pressure and help lift liquids to the surface).
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As it stands today, the whole EXH + EXLP
complex derives roughly 40% of its gross profit from US compression, 30% from
international compression, 8% from aftermarket service, and 22% from
fabrication (assembly).
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The current Exterran was formed in August of
2007 when the two largest compressor companies (Hanover and Universal) were
merged. In the course of merging the operations of the two companies, a number
of integration problems developed.
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Sales and maintenance personnel disagreed over
territories and changes in personnel lead to a decline in service levels and to
lost accounts. As a result of these problems and the soft macro environment,
earnings in 2008 plummeted – and EXH’s stock declined from a late 2007 high of
$87 to below $10 (compounded by the already weak stock market). In reaction to
these problems, a few high level management changes were made and considerable
attention was placed on re-hiring capable field personnel.
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Since then, company fundamentals have improved
with the guidance of Sam Zell and buoyed by an improving economic backdrop.
Leverage has been reduced from ~5x to less than 2x EBITDA and 2013E EBITDA has
already exceed 2007 levels. (Courtesy of smash432 from VIC)
What
happened recently?
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While Exterran owns ~36% LP interest and 2% GP of
Exterran Partners (EXLP, its MLP that houses ~70% of the whole complex’s US
horsepower), EXH’s financial statement actually consolidates EXLP. Hence the
argument is that since unit dividends are eliminated as intercompany transfer,
the market is undervaluing EXH due to the lack of LP + GP stream consideration.
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To remedy this situation at Buy-side advice,
EXH announced its intention to separate itself into 2 entities and
deconsolidate EXLP from the financial statements on Nov 17, 2014. The RemainCo
will be a pure-play GP+LP and US aftermarket asset with no debt, while the SpinCo
will hold everything else + debt. Spin is scheduled to effect in “2H of 2015”.
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The pro-forma break-down looks like this assuming operating metrics don’t
deteriorate and drop-down occurs at current EXLP prices (~$23)
Why
is it interesting?
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Assuming numbers don’t fall and continue to
excel at current levels, EXH is too cheap and should be valued at ~$45-50 /
share.
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The remainCo at 10x EV/EBITDA and 5.5% dividend
yield is both at a slight discount to the midstream C-Corps w/ both GP and LP
interest. Arguably, it should never trade at the 4.5-5% range vs. midstream
C-Corps due to clear contractual inferiority, but having it pegged at E&P
MLP C-Corp level isn’t quite right either. The truth is somewhere in the middle
and EXH is the largest scale player, an argument can be made for the 5.5-6%
dividend yield.
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The SpinCo at 5.5x EBITDA is fairly reasonably priced
(if not too low) as a blend of oil servicers and global-oil-related E&C
companies. The international business had been remarkably consistent.
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In terms of transaction comps, Enerflex
(EFX.CN) purchased the international operations from Axip International for
~7.5x EBITDA, while EXH’s international operations four times the size of Axip
and with a gross margin profile nearly 10% higher.
My
key concerns: a few observations on the business:
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So it all looks merry and good with seemingly
no downside – unless numbers get cut.
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The smaller horsepower US well-head compressors
typically do 12 month contracts w/ month-to-month roll thereafter, mostly due
to the lack of visibility at the drilling level. For the larger horsepower,
turnpike US stations or International projects, the contracts typically last
longer (allegedly 3-5 years but mgmt. doesn’t disclose in 10-K) and has better
visibility. I think of the wellhead level capacity as swing supply and most
susceptible to swings in utilization. The 0-500 HP compressors = 21% of total
HP.
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The good thing about the business is that since
natural gas well compression varies drastically overtime, a scale player like
EXH has good staying power given the horsepower offering and servicing
capacity. It cost money to shut things down or get efficiency running at the
well-site, so unless production shuts down or EXH screws up, there is little
reason for customer to switch.
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The flip-side, however, is that making
compressors like these is not hard – the value-add is really the servicing
component and the capital-liteness that it affords E&P players. So pricing &
competition will almost always be competitive (i.e. flat).
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Hence, as you see below, barring integration
issues & recession issues in 2008-2009, utilization had been quite
consistent at 80-90%, yet pricing stayed mostly flat in the US. International
garnered some pricing power thanks to being project-centric and large HP.
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As the gas mile (mmcf * mile) increases in
America alongside production increase, EXH is deemed to enjoy similar level of
utilization & pricing and can continue to expand capacity. I think it can
further enjoy some tailwind as E&P + midstream players shift more towards
leasing (from the current 30-35% total) as the production process becomes more
standardized & capital + return become more constrained. However, I would
assume that EXH’s asset will never be as stable as the company claims – given that
in any stable & permanent structures, the client is more likely to own than
lease to capture the whole economics.
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As we establish that EXH’s current high
utilization (97% as of last quarter at the EXLP level), is largely due to
swing-factor well-head gas-lift demand thanks to oil production, it has no way
to go but down towards the 90% level
when shale oil production potentially slows into the next few quarters. I do
not believe this assumption is in sell-side numbers but it may already be
reflected in the stock.
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Fabrication enjoyed a surge of production
equipment sales (17-20% gross margin vs. 10-13% of compressors) in 2013; while
the backlog into 3Q14 is still strong, it would be more reasonable to expect
a $1.1-1.2 Bn run-rate revenue and 14-15% gross margin division ( vs. the $1.6
Bn rev and 18% gross margin it was in 2013, which sell-side projects for FY15
numbers.)
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So what happens when (a) utilization goes back
to 90% in EXLP, (b) Rates stabilize around $17.50-80, (c) International segment
remains below 80% utilization, and (d) Fabrication dips to $1 Bn in Revenue and
~13% gross margin? To maintain distribution & growth, EXLP will have to pay
out ~95% of its DCF (vs. 75-80% previously) and will the structure to test. And
with a lower LP / GP multiple, EXH should still be relatively fine. The R-R
still seems decent but one can argue for a even lower multiple on GP/LP stream.
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Hence, across a broad range of outcomes
(scenarios 1-9), and assuming that every 5% increase in distribution from DCF =
0.8-0.9 turn on multiple damage, here’s the sensitivity table. Assuming status
quo and everything goes as cheerful as sell-side indicates, the stock goes to
$45-50 shortly as fear setles; but if we assume a more realistic operational
picture, we are looking at maybe 5-10% upside in the base case, around $45 in
our good case, and in the 20’s in our downside case assuming oil gets worse.
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I believe I have sufficiently haircut the
fabrication segment to reflect reality, which is revenue down 30-35% from 2013
peak and gross margin down 40-50%.
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The only nightmare case I can imagine is if oil
goes to $50, and guys start shutting production and terminating leases across the
board. In which case EXLP will have to cut dividend, the GP won’t be worth
much, and we could see a BWP scenario on that side – and it probably won’t be
very pretty for EXH.
Event
Path
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Dec 10, 2014: EXLP at Wells Fargo Symposium
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Dec 11, 2014: EXH at Capital One Southcoast
Energy Conference
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Feb 23, 2015: EXH & EXLP earnings
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Jan-Mar 2015: Expected 10-12B Filing
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Jun – Oct 2015: Expected SpinCo regular-way
trading. 6-10 month post Nov 2014 announcement.
Risk
Considerations
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I think the sell-side numbers have to come
down, which could induce another drop.
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The value realization remains still somewhat
termed out in the interim.
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If interest rate rises in the interim, EXLP
value and distribution metrics could worsen. But EXLP is already trading at
~9.5% dividend yield, so I wonder how much more compression there can be.
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The name still feels like a closeted oil bet to
me; granted, our major downside is a jump-risk in the fear of distribution cut
driven by oil price hit by Chinese demand fear; and if that doesn’t happen I’m
confident that EXH will do fine into the catalyst.
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If sell-side numbers get reset in the next few
months, while oil drops and China stays fine, I think the setup becomes very
favorable.
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