Those unfamiliar with the energy sector often equate the oil and gas industry with drillers and producers, overlooking the industrial companies that provide critical components and services. Here are two small-cap industrial names that generate more than 50 percent of their revenue from the oil and gas industry and stand to benefit over the long term from their exposure to key growth trends.

Mistras Group (NYSE: MG)

A provider of engineering services, Mistras Group specializes in nondestructive testing to evaluate the structural integrity of a wide range of critical infrastructure, from thermal and nuclear power plants to pipelines, bridges and airplane components. Although the company continues to penetrate new markets with its innovative products and services, the oil and gas industry still accounted for 61 percent of the firm’s revenue in its fiscal year ended May 31, 2011 (see graph below).

Source: Mistras Group

Whereas certified personnel traditionally perform these qualitative inspections visually, Mistras Group augments this business line with a high-tech approach that incorporates acoustic emission, digital radiography, infrared, wireless and/or ultrasonic sensors to alert customers to potential problems.

For example, Mistras Group’s acoustic monitoring systems can detect and locate cracking in a coal- or natural gas-fired power plant’s blades before the component’s integrity is compromised and larger-scale damage ensues. Meanwhile, the firm also offers sensors that monitor and record greenhouse gas emissions for the oil and gas industry and supporting software that generates reports which comply with the Environmental Protection Agency’s regulatory requirements.

Customers either purchase a basic sensor and software package or opt for an advanced solution that also includes ongoing monitoring and assessment services. The latter option is enhanced by Mistras Group’s accumulated database of equipment performance, which provides a level of nuance that’s unmatched by rivals’ offerings or companies’ in-house inspection operations. In some instances, Mistras Group’s engineers work closely with their client to develop a customized solution.

Mistras Group’s high-tech solutions offer a compelling value proposition that continues to resonate with its customers. Unlike traditional inspection techniques, nondestructive testing enables customers to assess the integrity of critical infrastructure components from installation to the end of their life cycle without dismantling equipment or shutting down operations.

In addition to reducing unnecessary downtime, Mistras Group’s proprietary sensors and software packages allow for real-time data collection and analysis that can help customers optimize their maintenance schedules by focusing on at-risk components. In many instances, these tests can detect flaws that might go unnoticed in a visual inspection, enabling the equipment owners to address potential problems before they result in expensive operational and reputational damage.

The appeal of these solutions to the energy industry is easy to understand in the wake of the Macondo oil spill in the Gulf of Mexico and a spate of highly publicized midstream incidents, including the 2010 explosion of a Pacific Gas & Electric Co. pipeline in San Bruno, Calif.

Meanwhile, the company continues to benefit from the infrastructure boom that’s accompanied the shale oil and gas revolution.

Surging activity in the Bakken Shale in North Dakota, the Eagle Ford Shale in South Texas and other plays has enabled the US to grow it annual oil output for the first time in decades. Even more impressive, this increase in overall oil volumes has occurred despite a sharp decline in production offshore Alaska and in the Gulf of Mexico. 

Frenzied drilling in the nation’s shale plays have also enabled the US to surpass Russia as the world’s leading producer of natural gas and has dramatically depressed prices in the closed North American market. Despite gas prices that continue to hover near record lows, US output has continued to grow. Exploration and production firms have shifted their emphasis from dry-gas fields to fields such as the Marcellus Shale and Eagle Ford Shale that also produce large amounts of higher-value NGLs that improve wellhead economics. 

This upsurge in onshore oil and gas output has occurred in many regions that lack legacy takeaway and processing capacity, while even the Permian Basin in west Texas–an area that’s produced oil since the 1920s–requires additional infrastructure to handle growing volumes.

In a comprehensive report on this subject, the Interstate Natural Gas Association of America (INGAA) estimates that the US and Canada will need to spend $83.8 billion to build and expand enough midstream infrastructure to support the surge in onshore production. Although a trade organization that represents pipeline owners produced this report, many of the pricing and production assumptions underlying the INGAA’s estimates appear reasonable.

These construction projects and upgrades of existing pipelines should generate ample business for Mistras Group’s weld-testing services. For example, business related to the Marcellus Shale in Pennsylvania has picked up substantially, prompting the company to increase its headcount in the region to more than 50 employees from less than five workers only two years ago. We expect this tailwind to remain in play for some time.

Meanwhile, the surge in shale gas production has helped to revivify the moribund US petrochemical production, a business that most analysts had written off because of the nation’s elevated feedstock prices.

Over the past decade, multinational chemical producers such as Dow Chemical (NYSE: DOW) have gradually shifted their production base from the US to Asia (to build a presence in growing demand centers) and the Middle East (to take advantage of lower feedstock costs).

But over the past 12 months, a number of major petrochemical producers have announced plans to restart shuttered crackers or construct world-class plants to take advantage of favorable pricing on ethane and propane, natural gas liquids (NGL) that tend to trade at a discount to crude oil but still exhibit similar price trends.

For example, Dow Chemical–the world’s second-largest chemical outfit–announced plans to restart its ethane cracker at its St. Charles complex, upgrade one plant in Louisiana and another in Texas to enable them to accept ethane feedstock, and build a new ethylene production plant on the Gulf Coast in 2017. Royal Dutch Shell (NYSE: RDS: A) in June 2011 announced that it would build a world-scale ethylene plant in Appalachia that would source its feedstock from the Marcellus Shale.

The reason for this shift: Over the past five years, rapid development of unconventional fields has increased US natural gas production by 20 percent and ethane output by 25 percent.

Cracking facilities heat ethane and propane with steam to produce ethylene and propylene, the basic building blocks of three-quarters of all chemicals, plastics and man-made fibers.

Ethylene is a colorless gas used to synthesize polyethylene, polyvinyl chloride and polystyrene, plastics used in everything from food packaging to waterproof garments and synthetic fibers. Meanwhile, propylene is used to make polypropylene, a plastic used in electronics, automobile bumpers and consumer packaging.

Although “light” inputs such as ethane and propane accounted for about 85 percent of US cracking feedstock in 2010, NGLs aren’t the only feedstock used to produce these synthetic materials. For example, the American Chemistry Council estimates that Western Europe produces 70 percent of its ethylene from petroleum derivatives such as naphtha or gas oil. Cracking facilities in Asia also rely heavily on naphtha.

In short, the abundance of relatively inexpensive NGLs has revitalized the economics of ethylene and propylene production, giving US producers an unprecedented competitive advantage. We expect this new capacity and the restart of shuttered facilities should also lead to additional work for Mistras Group.

The boom in refinery construction in emerging markets and international oil companies increased investment in offshore production also represent attractive growth opportunities for Mistras Group. In fact, during its fiscal second quarter ended Nov. 30, 2011, an international exploration and production company selected Mistras Group’s enterprise software and risk-based inspection services for two key offshore platforms in the Gulf of Mexico.

Within the energy industry, Mistras Group’s customer base comprises the world’s leading integrated oil and gas companies, including BP (LSE: BP, NYSE: BP), Conservative Portfolio holding Chevron Corp (NYSE: CVX), ConocoPhillips (NYSE: COP), ExxonMobil Corp (NYSE: XOM), Marathon Oil Corp and Growth Portfolio holding Suncor Energy (TSX: SU, NYSE: SU).

This base of large, well-capitalized customers and the recurring nature of much of the Mistras Group’s revenue–48 of which comes from evergreen contracts and 17 percent of which comes from seasonal work at refineries–somewhat insulates the company from fluctuations in the global economy. At the same time, the concentration of the firm’s revenue presents some risks: The engineering firm generates 18 percent of its sales from BP, while its 10 biggest customers accounting for 44 percent of sales. Also, a slowdown in the global economy could dissuade some customers from upgrading to the firm’s advanced services, weighing on margin and revenue growth.

In its fiscal second quarter ended Nov. 30, 2011, Mistras Group’s revenue from the oil and gas industry grew by 21 percent from year-ago levels.

This impressive growth was dwarfed by a roughly 40 percent sales increase across the company’s other end markets. We expect the unique value proposition offered by the firm’s advanced asset-protection solutions to continue to win converts in its primary markets and enable the firm to enter new industries. In particular, management has highlighted opportunities to penetrate the pharmaceutical and food-processing industries.

We also like Mistras Group’s ongoing efforts to expand internationally, primarily through bolt-on acquisitions in Europe and South America that provide entrée into new markets and add personnel with the necessary professional certifications. To that end, the company closed one $5.2 million acquisition during its fiscal second quarter and three additional deals targeting European companies.

Expanding in Europe and South America should enable Mistras Group to win more business from BP and its other multinational customers. Meanwhile, budgetary constraints and economic weakness in Europe should entice infrastructure owners to remove cost centers and outsource their asset-protection efforts. 

Over the past three years, solid execution and secular growth trends have enabled Mistras Group to grow its sales at an average annual rate of 30.3 percent. Organic revenue growth averaged 17.3 percent over this period.

This track record of impressive growth appears set to continue. Management raised its sales guidance for the remainder of its fiscal year to between $400 million and $415 million from $375 million to $390 million. Although this revised forecast equates to 12-month sales growth of 18 percent to 20 percent, analysts have expressed concerns that this estimate implies weak results in Mistras Group’s fourth quarter–traditionally, a period of seasonal strength.

We continue to like Mistras Group’s long-term growth story and rate the stock a buy under 23 for aggressive investors. We will track the shares in our Energy Watch List.

With the stock trading near our buy target, investors should consider wait for a pullback in the broader market to establish a position. With a market cap of less than $1 billion and exposure to an attractive growth market, Mistras Group could be a potential takeover target. But this smaller float also means that the stock is subject to significant volatility and trades at lower volumes.

Robbins & Myers (NYSE: RBN)

Diversified industrial company Robbins & Myers underwent a dramatic transformation in 2011, acquiring T-3 Energy Services in January for $422 million and selling its Romaco food packaging business to Germany-based private-equity firm Deutsche Beteiligungs for USD92 million.

These moves have paid off in the form of higher earnings and record profit margins: In the fiscal year ended Aug. 31, 2011, sales more than doubled from year-ago levels, to $821 million, while operating margin surged to 19.3 percent from 10.4 percent. This strength continued into the fiscal first quarter ended Nov. 30, 2011, in which Robbins & Myers grew overall sales by 69 percent, to $237 million. Excluding the acquisition of T-3 Energy Services, Robbins & Myers’ first-quarter revenue still increased by 21 percent from the prior year.

These strong results prompted management to up its full-year estimate of earnings per share to between $3.00 and $3.20 from between $2.85 and $3.05. This new range implies year-over-year earnings growth of 20 percent to 34 percent.

After the deal, Robbins & Myers generates about 63 percent of its annual revenue from the oil and gas industry, while the specialty chemicals end market accounts for 13 percent and pharmaceuticals represent about 6 percent of revenue. The company in August 2011 also announced plans to move its headquarters to Houston from Dayton, Ohio, signaling its shift in emphasis to the energy and petrochemicals industries.

Post-restructuring, the company operates in two business segments: energy services, and process and flow control. The energy services division produces critical components for upstream and midstream markets, including power sections for drilling motors, blowout preventers and other pressure-control solutions, down-hole pumps for artificial lift, wellhead products and items that prevent wear in the wellbore, and pipeline closures and valves.

Over the past 12 months, the company has benefited substantially from surging activity in shale oil and gas plays. Although slowing growth in the horizontal rig count may weigh on sales in the near term, management noted that the company’s product mix is ideal for the ongoing transition from natural gas-directed drilling to oil-rich plays and should result in additional sales opportunities.

At the same time, the intensity of drilling in shale oil and gas plays takes a heavy toll on equipment, creating significant demand for aftermarket parts and services. As part of Robbins & Myers’ restructuring efforts, management has sought to increase the company’s emphasis on providing cradle-to-grave service for its products. Aftermarket sales currently account for 34 percent of the firm’s overall revenue.

Robbins & Myers process and flow control business specializes in the mixing, blending, storing and pumping processes that are critical to the industrial, chemical, wastewater treatment and beverage industries. Although this segment has benefited from the economic recovery and higher utilization rates at US petrochemical plants, we expect management’s ongoing effort to reorient the division’s focus on growth opportunities in emerging markets to pay off over the long haul.

Management expects sales in this segment to be flat sequentially in its fiscal second quarter but noted that business should strengthen in the back half of the year, when a number of major project awards are expected to be announced.

Investors considering a stake in Robbins & Myers should establish their position gradually over the next several months, as the stock could continue to lag because of concerns about slowing economic growth in Asia and Europe and moderating demand in the North American shale oil and gas market.

That being said, Robbins & Myers’ long-term growth story remains intact: We like the firm’s exposure to the rise of horizontal drilling outside of North America. Management has also indicated that additional acquisitions could be in the works, a tantalizing prospect given the successful integration of T-3 Energy Services. With minimal debt, ample cash on hand and a generous stock repurchase program, Robbins & Myers rates a buy under 45 for investors with a longer time horizon.