Winning With Air Power
The most natural thing for natural gas to do is to stay underground. That’s why drilling the complicated and expensive modern well is only the start of a long struggle to extract the most methane through that opening.
And just as a drinking straw needs suction to move a milkshake from glass to mouth so the natural gas supply chain relies on compression at every stage of the process. Compressors lift gas out of the well, move it through gathering systems in and out of a processing plant and perhaps halfway across a continent along a long-haul pipeline.
The recent U.S. energy production boom has been a godsend to compressor fleet operators. Their revenue has climbed and price increases have padded some of the fattest margins in the oilfield services sector. Naturally, these stocks have been hit hard of late along with the rest of the energy space, on fears that slumping oil prices will end the shale drilling party.
Those worries are likely overdone. Compressor demand is most strongly correlated with production, not drilling. In fact, maturing reservoirs (and this is especially true of shale) require more and more compression to suck the remaining gas out of the well and into a gathering line as years go by and the initially high reservoir pressure drops.
As for commodity fundamentals, declining oil prices and the relatively low domestic gas prices are the byproduct of aggressive shale drilling. If drilling were to stall, prices would very likely jump. North American shale drilling has been in recent years the principal source of new supply required to meet growing global energy demand. That growth in demand hasn’t slowed enough to make U.S. shale expendable.
The leading supplier of compression services in the US now looks like a worthy investment. Exterran Holdings (NYSE: EXH) conducts the bulk of its domestic compression work though the affiliated Exterran Partners (NYSE: EXLP) MLP. EXH also manufactures compressors, provides aftermarket services and contracts overseas.
The stock was up 8% intraday early on Nov. 17 after Exterran said it will spin off its international and manufacturing operations into a separate company, but remains an excellent value.
Source: Exterran presentation
Exterran’s consolidated gross margin was up to 37% in the most recent quarter from 32% a year ago. In North American contract operations, gross margin was up from 54% to 57%. Price hikes have played a part: in the US, outsourced compression industry pricing has risen 7% this year, according to a competitor. Cost savings have contributed as well, as have the two purchases this year by Exterran Partners of compression equipment previously owned by a subsidiary of Chesapeake Energy.
During the first nine months of 2014 Exterran Partners rang up revenue of $420 million, up 21% year-over-year, and turned it into $137 million of cash from operations. Declared distributions over the same span totaled $102 million, highlighting EXLP’s improved coverage ratio. That was enough to push the current annualized yield to 8.1%. The quarterly payout grew 4.7% over the last year.
As the MLP’s sponsor and general partner, EXH doesn’t serve the same generous helpings of tax deferred income. It did start paying a dividend this year with a current yield of 1.6%. The main selling point, all the more so after the spinoff, will be its leveraged and privileged participation in the MLP’s success via partnership interests and incentive distribution rights.
Source: Exterran presentation
The other big lure of EXH lies in its thriving business overseas, which recently accounted for 41% of revenue. Latin America, with 18% of the total pie, is especially lucrative, delivering margins significantly above those Exterran earns in the US. The company expects a growth boost in the region next year as Mexico and Brazil try to ramp up energy production, and it’s also well-placed to capitalize on shale development in Argentina.
The spinoff of the international and manufacturing operations into an independent company would be in the form of a stock dividend to shareholders, and is expected to happen in the second half of 2015.
Exterran is by far the largest specialized supplier of compression services, and the only one with a truly global reach.
Source: Exterran presentation
Leverage is reasonable at 3.1x debt-to-EBITDA on a consolidated basis and 4.1x at EXLP following the two recent acquisitions from Chesapeake.
What seems less reasonable is the low valuation accorded to a surprisingly high-margin business. EXLP’s 8% yield tells that story, and so does the current valuation of EXH at less than 7 times trailing EBITDA (adjusted earnings) based on its enterprise value.
This looks dirt cheap for a business that saw 7% organic growth in its domestic horsepower and continues to raise prices.
In total, Exterran now has nearly 5.4 million horsepower of compression at its disposal, including 4.1 million in the US. Here, the utilization rate recently stood at 87% up from 83% a year ago. Overall utilization has risen from 82% to 84% over the last year.
Exterran’s compressors are increasingly deployed in the Eagle Ford, the Permian and the Bakken, shale basins where they’re needed to lift natural gas from wells drilled primarily for their liquids production, as well as in the Marcellus and Utica, where shale gas is often the primary attraction. The thousands of wells that will be drilled in these basins in the years to come will require significant compression infrastructure for decades.
In contrast with many midstream MLPs, many of Exterran’s compressor contracts can be canceled on short notice, so that could play into the modest valuation. Management recently indicated it hasn’t seen any signs that lower oil prices are hurting business, though it also cautioned that many customers are still drawing up 2015 plans and that compression demand tends to lag commodity price action by six to nine months.
But barring a protracted slump, the sheer scale of oil and gas development across the US is likely to provide a favorable tailwind for years.
Like most MLPs, EXLP issues partnership distributions reported on form K-1, while EXH reports its qualifying dividends on the simpler form 1099. That also makes EXH the better choice for retirement accounts.
We’re adding EXH and EXLP to the Growth Portfolio. Buy EXH below $42 and EXLP under $34.
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