Natural Gas Services -- VIC writeup
Seizing the opportunity in large horsepower compression
The write-up below is not quite how I would write it as intended for substack specifically, but I will preserve it in its VIC form
The market for large horsepower compression is hot and this is now well-known, as Q3 CEO commentary across the board confirms that lead times continue to extend:
-Archrock is up 74% YTD, excluding dividends -- trading at 7.7x consensus '25 TEV/EBITDA
-USAC is up 30% YTD, excluding dividends -- trading at 9.2x consensus '25 TEV/EBITDA
-Kodiak Gas Services IPO'd on June 30th and is up 20% YTD, excluding dividends -- trading at 6.1x consensus '25 TEV/EBITDA
Additionally, Kodiak has recently announced its intent to acquire CCLP for 6.1x consensus TEV/EBITDA.
Now the market has put its spotlight on Natural Gas Services with the stock currently trading at 5.0x consensus '25 TEV/EBITDA. I believe this consensus estimate is conservative as a result of conservative guidance and general uncertainty with regard to timing of backlog deliveries.
This opportunity exists because analysts (on behalf of major shareholders) were initially incredibly antsy at the announcement of major expansion in the growth capital program because they could no longer model results quarter by quarter. With Natural Gas Services currently trades at a $174mm market cap, CEO Stephen Taylor has indicated plans to invest $200mm or more as financed by a bank consortium at SOFR + up to 3.75% depending on leverage ratios.
Palm Valley Capital likely contributed to a depressed share price by blowing out their position over disappointment regarding the "aggressive expansion plans". The stock was breaking out to $15+ before this expansion was announced. It's understandable why they bailed -- many shareholders bought into this company on the prospect of a clean balance sheet with a simple story of capital return as, prior to the new growth plans, the company stewarded a net cash balance. In their view, the "aggressive expansion plans" are potentially a sign of entrenched management and/or a oilfield services situation of management inappropriately leaning into pro-cyclical investment.
I believe time will prove this to have been both impatient and a poor read on CEO Stephen Taylor's conservative approach to business / investment. In fact, Stephen Taylor is considerably shareholder-aligned with an ownership of 4.4% of outstanding shares. In my view he has been an extremely conservative steward of capital this last several years, saving up balance sheet capacity for the right opportunity. The reason for the enormous investment is that the deals are simply too good to pass up.
In 2022Q4 Stephen Taylor described the underlying financials behind growth investment as such:
"We're looking at five to six years, depending on the equipment, five- or six-year cash-on-cash paybacks. Some are a little higher but none of them are below the 15% to 20% range. Some of them are up into the 20% to 25% range."
So aside from interest expense, the customer is essentially reimbursing us for the full equipment cost over the course of the contract. Keep in mind that a large horsepower compressor has a useful life of 25+ years. Large horsepower compressor contracts are currently being signed with 5 year terms; and in Q2 2023 CEO Stephen Taylor commented with regard to "inflationary protection" in contracts that they were "starting to put more and more in" on a go-forward basis.
If I were CEO, I would invest as much as the banks were willing to finance, too.
Since then, we've only heard indications that contract terms and pricing have improved as the company has become increasingly selective as the company allocates its limited remaining balance sheet capacity sparingly.
If we were talking real estate here, we'd be talking about delivering pre-leased 20+ caps to blue chip tenants; since we're talking oilfield services, it's a show-me story. But it's really quite simple: from now through 2024Q4 each quarter will show sequential operating improvements as more equipment gets delivered.
Furthermore, Natural Gas Services' massive investments will result in the company having the highest quality fleet -- worthy of a premium valuation -- as measured by percentage of high horsepower compressors. CEO Stephen Taylor has also indicated that the company's proprietary designs exceed industry standards -- in particular, uptime. [I've been informed that one should be extremely skeptical of any claims of product differentiation in the equipment rental industry, but I think it's worth noting given my read on Stephen Taylor as one who makes conservative claims.]
Here's some quick and dirty math regarding the potential financial situation by EOY 2025:
- Cash from ops averaged ~$30mm from 2019-2021; let's use this as a baseline (an analyst on 2023Q3 call estimates $35mm TTM "discretionary cash flow") and assume ZERO repricing benefit (despite massively-increased new order / replacement costs) while also noting that a good portion of this revenue was indeed related to smaller horsepower equipment geared toward natural gas projects (the natural gas market has obviously deteriorated but the equipment retains some upside option value)
- $200mm incremental growth cap-ex delivered by 2024Q4 at 20% "cash on cash" returns adds $40mm --> $70mm operating cash flow by EOY 2024
- Subtract 9% interest expense on $170mm outstanding debt (assumes some modest pay-down) --> ~$15mm interest expense
- Free cash flow then gets prioritized towards paying down another $55mm of debt in 2025, reducing interest expense by another ~$5mm
- EOY 2025 --> $60mm free cash flow on long-lived assets with $115mm outstanding debt; company now prioritizes shareholder returns
- Noting that Archrock and USAC currently trade at >9x TTM cash from ops despite worse leverage profiles and lower quality fleets, I value NGS at 6x to 8x operating cash flow
- The result is a $360mm to $480mm market cap for a 100% to 150% gain in 2 years time
- Alternatively, the buyback cannon (which management has shown an willingness to use in the past) simply becomes more powerful
There is an obvious additional catalyst in that major shareholders have been (or at least were, prior to being convinced by CEO Stephen Taylor's strategy) pushing for a sale. An analyst on the 2023Q3 call ball-parked a replacement value of $26 per share. Tangible book value is $18.90 per share. Stifel recently initiated coverage with an $18 price target, the lowest of the three existing street targets.
In conclusion, Natural Gas Services is a company that has been viewed very skeptically and, I would argue, impatiently. Heavy growth investments are generally not in vogue -- especially in the oilfield services sector. However, the massive growth investments currently underway are warranted by leading, top-tier contracts. While a buyout on a shorter time horizon is likely, the market is also likely to reward quarter after quarter of sequential improvement in operating financials with ample opportunity to improve the leverage profile, repricing opportunities, and several years remaining on the bulk of contracts.
Catalysts include a potential buyout (as signaled by industry M&A activity and desire from current large shareholders), recovery of the natural gas E&P market (reactivating the smaller horsepower compressors), relentless sequential quarterly growth in operating financials, and the buyback cannon.