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Select Energy Services: Another Outstanding Quarter; Set To Differentiate Itself In 2019


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By Mr. Bert :

INTRODUCTION

This is an update to my previous reports on this company. In my first report , I explain what the company does and why I like it. In my second report , I explain why I expect growth to continue for at least the next five years.

I also recalculate my valuation and explain why the shares should outperform meaningfully over the next year.

THE Q3 EARNINGS REPORT

WTTR reported another outstanding quarter despite a somewhat tougher industry backdrop attributable to the well-understood capacity issues in the Permian. As can be seen below, revenues for the quarter increased to a record $397.0 million and gross profit increased to a record $59.4 million.

Source: Company reports, author's calculations

While sequential revenue growth of just 1% may seem lackluster, this compares to sequentially down results at most of its peer completions-oriented companies. It is well known that pipeline takeaway constraints are temporarily restraining the pace of completions in the Permian Basin, which accounts for about half of all activity nationwide.

Operating expenses were well contained, declining $2 million sequentially, which presumably reflects the achievement of incremental cost synergies relating to the Rockwater merger. As has been the norm for the last few quarters, operating expenses included a number of non-recurring charges related to that merger, including $2.645 million for transactions costs and $0.495 million for severance expense. This should be the last quarter of any merger-related expenses. There was also another $1.045 million non-cash charge for lease abandonment costs as the company continues to consolidate facilities.

In analyzing the quarter, it is important to strip out the non-cash and non-recurring charges so we can focus on what is happening at the operating level. As can be seen, operating income of $32. million includes several million of non-cash and/or non-recurring charges such as $2.5 million for rebranding in the wake of the merger. After backing those out, I calculate true operating income of $41.0 million which can be used to compare to previous quarters and as a basis for projecting future quarters.

Source: Company reports, author's calculations

As can be seen above, in the three full quarters since the merger, adjusted operating income has increased from $26.9 million to a record $41.0 million, a very commendable performance. For the quarter, adjusted earnings per share was $0.38 compared to an average analyst estimate of $0.27. This is a substantial earnings beat that seems to be underappreciated by investors.

Now, let's get to the meat of the analysis.

The Rebranding Issue

Pursuant to the merger with Rockwater, the company recorded a $2.5 million one-time expense for "rebranding." While I don't know exactly what this entails, I can imagine it involves things like replacing the Rockwater logo with the Select logo on machinery in the field. While technically not a transaction related expense in the same sense as legal fees, it is nevertheless a legitimately non-recurring expense related to the transaction. Therefore, I believe it should be added back to get the most accurate sense of operating profitability.

Water Division Operating Performance

While WTTR has three operating segments, the Water Solutions segment is by far the largest and most important. This is what investors are going to look at when measuring the company's progress.

Source: Company reports, Primary Vision frac spread count, author's calculations

For the quarter, this division grew revenues by 2.8%. The question is, how do we evaluate that? In my opinion, the best metric is to compare it to changes in the frac spread count . As shown below, over the last three quarters, the Water Solutions segment has meaningfully outperformed the frac spread count. Over the last three quarters, water revenues have increased 19.8% against a 12.3% increase in the frac spread count. That's a sign that the company is gaining share.

Source: Company reports, author's calculations

The other critical operating metric is gross margin. As shown below, WTTR reported another 120 basis points of gross margin improvement in Q3, on top of 100 basis points of improvement in Q2.

As management has explained, they are systematically investing about 20% of capital expenditure for margin enhancing projects. For example, the company is investing to automate many of its pumps, thereby reducing the need for labor to monitor and adjust those pumps. Currently, the company has approximately 1,200 pumps and is in the very early stages of automating them at a rate of 5 per week. Labor comprises approximately 40-45% of total expense, and this initiative will provide significant margin improvement for many quarters to come, particularly in the currently tight market for labor.

Oilfield Chemicals Operating Performance

In acquiring Rockwater, WTTR also acquired an oilfield chemicals business. The company has opened an in-basin friction reducer manufacturing facility and this will reduce transportation costs of this commodity product. As can be seen below, gross margins increased a hefty 200 basis points and management has stated that margins will improve to the mid-teens range, suggesting significant margin improvement yet ahead.

Source: Company reports, author's calculations

Oilfield chemicals are part of the fracking process and I would expect that revenues here would also roughly track fracking activity. This quarter, they declined 1.3%, slightly outperforming the frac spread count.

Wellsite Services Operating Performance

The acquisition of Rockwater also added to the company's small suite of wellsite services business, including lodging, sand hauling and a small Canadian operation. Here, revenues declined 6% as the company closed several underperforming facilities in Canada. Despite the reduction in revenues, gross profit was flat and gross margin improved by 110 basis points.

Source: Company reports, author's calculations

As with the oilfield chemicals segment, these are all decent businesses that generate solid and consistent cash flow. But they are non-strategic and, given the opportunity, they could be sold with the capital deployed into more strategic assets.

EBITDA and Free Cash Flow

WTTR had an outstanding quarter from an EBITDA perspective. As seen in the reconciliation below, the company reported EBITDA of $73.7 million, substantially above the consensus estimate of $67.5 million. This is the second quarter in a row that the company has significantly outperformed consensus EBITDA estimates. Adding back the $2.5 million in non-recurring branding costs yields true adjusted EBITDA of $76.2 million, which I believe is the best metric of operating performance.

Source: Company reports, author's calculations

Even more importantly, WTTR is a prodigious generator of free cash flow, which I define as the after-tax cash flow that is available for either investment in growth or return to shareholders in the form of dividends or share repurchases. Thus, I calculate free cash flow for WTTR as below.

Source: Company reports, author's calculations

It is important to understand the linkage between EBITDA and free cash flow. While depreciation is a non-cash charge to earnings, that doesn't mean that it is not a legitimate expense. If you are depreciating your equipment correctly, then for every dollar of depreciation that you incur, you will have to spend a like amount to maintain your capital stock. One of the reasons that I like WTTR is because their depreciation is significantly greater than the maintenance spending required to maintain the capital stock. For example, in the Q3, the company charged $32.8 million against earnings for depreciation, but they only needed to spend 40% of this amount to maintain the revenue generating productivity of their equipment. In a sense, GAAP earnings (which are an accounting construct) are understated by this amount.

In the Q3, the company spent approximately $18-19 million for investment in growth capital expenditures. These are the investments that will ensure future revenue growth and are not appropriately included in the calculation of free cash flow. The company seeks an 18 to 24 month payback period for these types of expenditures, suggesting meaningful EBITDA growth into 2019 and 2020.

The company also spent about $9-10 million on margin enhancing capital expenditures, such as the continued automation of the company's fleet of pumps. These will improve future cash flows by reducing expenses and are also appropriately not included in the calculation of free cash flow.

Since the merger, and excluding merger-related expenses, WTTR has generated an enormous amount of free cash flow-about $55 million for each of the past two quarters. This is money which can be used to fund future growth, pay down debt, pay dividends or repurchase stock. At this rate, they are generating about $220 million in free cash flow on an annualized basis, which translates into an almost 20% free cash flow yield. That's remarkable for a high quality, almost debt-free company with sustainable and growing cash flows.

Accounts Receivable

In my initial article, I called out WTTR for having 98 days of accounts receivable, far more than the industry average of 55 days. I also noted that reducing this to the industry average could generate $180 million in cash which, at this point, is more than 15% of the company's market capitalization. Frankly, I was somewhat disappointed at the progress made here in Q3. Accounts receivable still stand at 96 days, down just 2 days from the prior quarter.

To their credit-and this is important-management has not run away from this issue. In fact, on the most recent call CEO Holli Ladhani addressed this issue at the top of her prepared comments.

However, one area of integration we haven't been satisfied with is the build in our working capital. System and process integration and consolidation of NSAs has resulted in a DSO metric notably higher than either company experienced pre-merger. The team is very focused on this and we expect continued improvement over the coming quarters.

CFO Nick Swyka also addressed this issue head-on.

Merging customers and systems combined with distinct billing processes and resource constraints, resulted in an abnormal build in working capital in recent quarters. This is now a high focus of the team and we're already seeing early improvements that we expect to continue in the coming quarters. With legacy systems fully integrated and internal transparency amplified, we expect to harvest an incremental $50 million to $75 million through the first half of 2019 from accounts receivable through these improvements on a hypothetical flat revenue basis. Expect continued cash flow growth from the underlying business operations as well which had previously been obscured by the expansion of working capital.

I believe that the issue is not how long it takes customers to pay, but rather how long it takes to bill customers for services after they are rendered. Over the past year, management has delivered on its promises and I expect this will be no different. While the company has targeted a $50-75 million reduction in receivables, I think that management should be able to generate well more than that. If they are unable to do so, it just means they are aren't trying hard enough. In either case, what they are targeting is essentially free cash-enough to pay off all their debt or repurchase more than 5% of the company's stock.

Balance Sheet

Other than the elevated level of accounts receivable, WTTR has a clean balance sheet with just $65 million of debt. Given the company's growing free cash flow, the balance sheet is, in fact, substantially underleveraged. On the call, management expressed a willingness to take up debt up to 1.5x annual EBITDA, suggesting about $400 million of incremental debt capacity. The company has ample room to make acquisitions and to repurchase shares, both of which I expect it will do.

Q4 GUIDANCE

For reasons that are now very well understood by investors, Q4 will be a down quarter. Even in the best of circumstances, the fourth quarter is a seasonally slower quarter as activity slows down around the holidays. This year, there are two more factors that are getting significant airtime on recent conference calls. First, there is the notion of budget exhaustion. Many E&P companies have significantly spent their 2018 budgets and are taking a breather until the new 2019 budgets are in place. Second, there is the well-known issue of Permian takeaway constraints.

On the conference call, WTTR guided to a sequential decline in the water business consistent with the decline in completions activity, which it estimated at approximately 10%. The company also guided to a modest increase in revenues for its oilfield chemicals division and flat revenues for its wellsite services division. From an EBITDA perspective, the company guided toward decremental margins of 35-40%.

Putting it all together, I estimate in the range of $371 million in revenues and earnings per share of $0.25, as shown below.

Source: Company reports, author's calculations

This translates into about $64.6 million of adjusted EBITDA, as below.

Source: Company reports, author's calculations

I expect total capital expenditures of $35.5 million, which would land the company in the middle of its targeted full-year range of $140-150 million. Using the company's typical 40/40/20 split, I expect that $14.2 million of capex will be for maintenance, another $14.2 million will be for growth initiatives, and $7.1 million will be for margin enhancement projects.

Source: Company reports, author's calculations

As shown above, this yields free cash flow of $48.1 million-an excellent result for the seasonally slow quarter that is already being impacted by budget exhaustion and Permian takeaway constraints.

I calculate cash flow after all investment to be $26.8 million and, even assuming no improvement in working capital balances, this is the amount that the company can use to retire debt or repurchase shares. Simply put, these are terrific numbers.

OUTLOOK FOR 2019

According to the company, their conversations with customers suggests that North American onshore drilling and completions activity will increase by the "mid-to-high single digits" in 2019. Activity outside the Permian should begin to accelerate as soon as the turn of the year. Because of takeaway constraints, Permian activity will not accelerate until Q2. By mid-year, activity should be in full-swing.

Despite the lack of current takeaway capacity, drilling in the Permian continues unabated. Operators are drilling but deferring completion of the wells, resulting in a significant buildup of DUCs, or drilled but uncompleted wells. As shown below, the non-Permian DUC count has remained relatively steady while the Permian DUC count has grown from 1,000 to almost 4,000 over the past year.

Source: Energy Information Agency

You wouldn't go through the expense of drilling a well unless you were planning to complete it, so think of this as a backlog of almost 4,000 uncompleted wells in the Permian. At the current rate of about 400 completions per month in the Permian, this is about ten months' worth of backlog.

For 2019, I have modeled 10% revenue growth. Based on the company's comments, I assume about 7-8% of organic activity growth. Because of the large build-up in DUCs over the past year, I assume that completion activity will grow significantly faster than drilling activity once the Permian takeaway constraints are lifted as new pipelines come into service around mid-year. I also expect the company to make several tuck-in type acquisitions that will also add to revenue growth. On the call, management announced they had signed a letter of intent to acquire a small service company that would expand their geographic reach. Given that the company can pay all cash for these acquisitions, they will also be very accretive. All things considered, I think 10% is a pretty conservative estimate for total top line growth.

As always, this is just sort of a placeholder estimate. In fact, I believe revenue growth can range from as low as 8% to as high as 15%, depending on activity levels and the company's ability to achieve price improvement and make acquisitions. In the past, the company has given guidance for minimum incremental EBITDA margins of 35-40%. I expect this will be conservative given the company's actual experience and the continued push to improve base margins.

All in, I come up with a 2019 forecast as below.

Source: Company reports, author's calculations

As can be seen, this results in earnings per share of $1.63 and adjusted earnings per share (excluding stock compensation expense) of $1.73 per share.

This should yield about $325 million in EBITDA, as shown below, with incremental EBITDA margins of 38.3%

Source: Company reports, author's calculations

While the company is till in its budgeting process for 2019, it has suggested that capital expenditures will likely be flattish, with the same 40/40/20 ratio of maintenance, growth and margin enhancing investment.

Source: Company reports, author's calculations

As shown above, I expect free cash flow of $261 million, of which $87 million will be spent on growth and margin enhancing initiatives. I assume the company can generate $65 million from its accounts receivable, although I would be disappointed if it did not do substantially better than that. All told, I see the company generating cash flow, after all expenses and working capital changes, of $239 million in 2019. That's a lot of cash flow for a $1 billion market cap company. Combined with the company's $400 million or so in debt capacity, that's also a lot of firepower for acquisitions or repurchasing stock.

2020 AND BEYOND

In my opinion, WTTR is a stock with significant growth prospects well beyond 2020. As I explained in my second article, shale oil has gone from being a modest supplement to traditional sources of oil to being an important part of the baseload global supply. Over the past few years, the growth in shale oil has satisfied the bulk of the incremental global demand for oil. Any meaningful decline in the production of shale oil will fairly rapidly impact global supply and the price of oil.

But shale oil, by its very nature, is a very short-cycle source of supply. It doesn't take long to bring a well on, but production from that oil will peak within the first few months and decline on the order of 60% after one year and 90% after two years. In order to provide a stable source of supply, drilling will essentially have to continue unabated at ever higher levels. I explain this in detail in my second article.

That is exactly what is happening now as production is shifting to essentially a high volume, high efficiency manufacturing mode. What used to be a highly cyclical business is about to become substantially less so, and this means that multiples should rise for service providers like WTTR.

VALUATION

Since coming public in early 2017, the company has done pretty much everything right. They acquired their largest competitor and have firmly consolidated their position as the largest water sourcing and management firm with a nationwide footprint and an approximate 20% share. The next largest competitor has closer to a 5% share. They have a tremendous strategic advantage over the rest of the industry, which largely consists of local mom and pop type operations.

Since the merger, the company has also significantly improved its operating metrics, turning an $11 million operating loss into a $41 million operating profit. During this period, quarterly revenues have increased from $78.4 million to $397 million, which includes the effect of the Rockwater merger. Adjusted EBITDA has increased from $13.7 million to $74 million and shareholders' equity has increased from $329 million to $1.1 billion.

Yet, the stock is currently down 25% from its IPO price and the shares are trading at about one-third of its IPO valuation.

Source: Company reports, author's calculations

As can be seen, the company is selling at an enterprise value to annualized EBITDA multiple of just 4.0x, down from 14.2x at the time of the IPO. It is selling at just 0.7x revenues, down from 2.0x revenues at the IPO. The shares are barely selling at book value.

Why? As I suggested in my first article, this is a company that has no publicly traded comparables. It is unique in that sense and stands as an industry of one. It is not understood by investors and there are no other companies to point to for a valuation benchmark. Because demand for water is almost exactly correlated with demand for sand, many uninformed investors assumed that their stocks should also be correlated. Nothing could be further from the truth. As I discussed in my first article, while the demand drivers for water and sand are essentially identical--they are both driven by the amount and intensity of fracking--the supply side drivers are entirely different.

Over the last year, and particularly in the last three months, stocks of the frac sand companies have been destroyed as pricing for their only product, frac sand, has plummeted on oversupply. For a time, sand was in undersupply and prices were high. But as economic theory would predict, it is those very high prices that brought on an avalanche of supply. This is just another example of a highly commoditized product that transitioned from a state of undersupply to oversupply with extreme rapidity. As things stand now, sand will be in a state of significant oversupply for the foreseeable future. There is no reason to expect sand fundamentals to improve meaningfully over the next two years.

But, as I explained in my first article, water is an entirely different beast. While the company has a competitive advantage in supplying source water, the real money is made by handling water-bringing it from one location to another, storing it, mixing it and recycling it. The bottom line, and this is important, is the frac sand companies are selling a product while WTTR is selling a service. Once again, I refer interested readers to my first article for more detail.

Fundamentals for WTTR are being unfairly conflated with fundamentals for the frac sand stocks. Since water and sand are the two consumables used in the fracking process, it is not entirely illogical; but nevertheless it is wrong. The fundamentals could not be more different and this was essentially proven out this quarter.

Let's take a quick look at Hi-Crush Partners and Emerge Energy Services, the two pure-play frac sand companies selling a combination of both in-basin and Northern White sands.

Source: Company reports, author's calculations

As can be seen, both revenues and EBITDA suffered very sharp declines. Q4 results could be even worse given that the worst of the decline did not begin until midway through the Q3.

As investors begin to understand how and why WTTR was able to deliver such excellent results even in a quarter of moderating completion activity, I expect WTTR stock to move higher.

This leads to the question, what are shares of WTTR worth?

The long answer is that that is a bit of a subjective determination and a lot of factors play into that. WTTR is the dominant company in the water sourcing and logistics business with a 20% market share. The next largest has about a 5% share. WTTR has a highly defensible position with strategic infrastructure and water sources in critical areas such as the Bakken and the northern Delaware Basin portion of the Permian. Financially, WTTR generates a tremendous about of free cash flow and will experience significant growth and margin expansion for at least the next several years. I think a company like that is worth a multiple of 8-10x EBITDA.

The short answer is that I think shares of WTTR are worth in the $24 to $30 range. This would also equate to about 14x to 17x cash earnings per share.

SHARE REPURCHASE

On the conference call, management discussed its pristine balance sheet, debt capacity and broadly hinted at a stock repurchase.

According to finance theory, companies with significant and stable cash flows are more efficiently financed with some amount of debt. The company's current debt of $65 million, which could be entirely repaid by even a modest improvement in accounts receivable, is almost certainly too low considering the company's relative costs of debt versus equity. CFO Swyka even admitted as much, saying, "our debt level as it stands today is probably a little under the long-term efficiency."

In other words, unless they have got an elephant of an acquisition in their sights, further reducing debt is just not a good use of capital. I agree. I also don't think they have such an acquisition in mind because I'm not sure there is one. They are the elephant.

According to management, they would be comfortable with a debt level of around 1.0-1.5x EBITDA. This sounds about right and works out to at least $400 million of incremental debt capacity. Remember, as well that the company is currently covering all its investment requirements out of EBITDA. Incremental debt capacity would be used either for acquisitions, share repurchases, or both.

According to CEO Ladani,

[W]e're in the early stages of preparing our budget plan for 2019, so it's little premature but certainly capital allocation is central to that whole process. And as we've lined out we think that there are good opportunities at the right pricing given where the dynamics of the market are today on the tuck-ins similar to the one that I referenced, it's a service company in the Northern Delaware and we do think there are good opportunities to invest in our services business organically, infrastructure is out there, so all of that will get weighed against our opportunities of returning value for our shareholders because obviously, we're not happy with our stock price. We don't think it reflects the value of our franchise, so that will compete and it's not mutually exclusive I guess I would say, they don't have to go into one bucket or the other, so I think what you'll see from us is a sensible allocation, if you look at things and, as you said, our debt levels are such that debt reduction is not an attractive allocation of our capital unless it is just essentially reloading a deal for future investments that we have one horizon.

[Emphasis mine.]

Putting it all together, Ladani is essentially saying that the company is generating significant free cash flow, above and beyond all investment and reinvestment requirements, and is not interested in reducing its already minimal debt level. There are some interesting tuck-in acquisitions, but the company has significant debt capacity beyond that. Management is not happy with the share price and thinks it does not reflect the franchise value of the firm. It's not too hard a stretch to conclude they are going to begin buying back stock. Certainly, they have the resources to buy very significant amounts of stock should they choose to do so. At just 3.6x forward EBITDA with plenty of free cash flow, I can't think of many better investments.

As Ladani stated, the company is currently going through its 2019 budgeting process. I expect that, when this is done, the company will announce a meaningful stock repurchase. While I do not know the timing of the company's budgeting process, I believe this could happen as soon as December as I would expect the 2019 budget would be set by then.

While I don't know what the company will do, per my earlier calculations the company will generate $239 million of cash in 2019. If they don't spend at least that amount, they will be forced to either accumulate cash or pay off debt, both of which are sub-optimal from an efficiency standpoint. Including the $400 million of debt capacity they have, this gives the company a lot of dry powder. There is room for a very very substantial share repurchase.

CONCLUSION

I believe shares of WTTR are presently worth in the range of $24 to $30 per share, based on an 8-10x multiple of 2019 EBITDA. Against the company's latest stock price of $10.55, this is a significant opportunity with a large margin of safety.

See also PDF Solutions, Inc. ( PDFS ) CEO John Kibarian on Q3 2018 Results - Earnings Call Transcript on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.





This article appears in: Investing , Stocks
Referenced Symbols: PDFS , EMES , HCLP , WTTR




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