Description

ARIS is a broken pure-play water midstream IPO situation.  The Company timed its IPO well in 2021 as the energy markets were strengthening and the investor outlook for midstream companies was continuing to improve.  After a strong start out of the gate where the units traded above $20.00, the wheels started to come off in the second half of 2022 due to missing expectations and poor investor communication.  The units have yet to recover and trade close to all-time lows even as the business remains stable and is poised to improve in the coming quarters and years.  

Recommendation

Buy common units.  At 5.3x FY24 EBITDA, I believe ARIS offers good value for a growing business operating in a segment that is expected to grow nicely over the course of the decade.  While not the most attractive business out there due to its high capital requirements, I still believe the units are worth at least $11.00 today (at a 6.0x EBITDA multiple) with a path to $15.00 – 18.00 over the next couple of years or so as the Company’s aggressive capex spend starts translating into higher EBITDA levels in the coming years.  

I expect ARIS to be FCF positive in FY24 to the tune of $25 – 30mm, which represents a FCF yield of ~6.0%.  EBITDA should be materially higher in FY25 and FY26 allowing for a potential rerating of the units.  If the Company executes on the volume and margin front, I believe there is room for multiple expansion though it’s not required for this to become a successful investment.  

The Company offers an unexciting distribution yield of 4.2% which is low by midstream standards and likely a contributor to the low multiple.  The distribution will grow over time as capex levels off and FCF further improves.  Other reasons for the low valuation could be the still-nascent public market for water midstream assets, the capital intensity of the business, the ConocoPhillips overhang (both as a significant owner and customer) and an openly acquisitive business strategy.  Valuation is also not helped by the Company’s lack of engagement with the investor community.  I can’t recall seeing them at any industry conference and my repeated attempts to engage with IR and management have been ignored.  This doesn’t seem like a productive strategy with the units trading near the lows.  

The senior notes trading at par are money good (levered only 2.3x) for those looking for short duration paper with decent yield.  

Company Overview

ARIS is an infrastructure company that provides full-cycle water handling and recycling solutions to E&P companies. The Company went public in October 2021, raising ~$246mm in proceeds from an IPO that priced at $13.00/unit. ARIS is a holding company, and its principal asset is a membership interest in Solaris LLC.  As the sole managing member of Solaris LLC, the Company operates and controls all the business of Solaris LLC. It is responsible for all operational, management and administrative decisions relating to Solaris LLC’s business.  ConocoPhillips and Yorktown Energy Partners are the Company’s two largest holders with ownership interests of 22% and 18%, respectively.  

As the only publicly traded pure-play water midstream company, ARIS has built integrated pipelines and infrastructure used to provide produced water management, recycling and supply solutions to operators in the core areas of the Permian Basin.  Its customers include many of the most active and well-capitalized companies operating in the Permian Basin including ConocoPhillips, Mewbourne Oil and Chevron.

E&P companies are focused on minimizing their environmental impact by rapidly increasing the use of recycled produced water in oil and natural gas production.  They are increasingly outsourcing water management to infrastructure companies like ARIS to manage their water-related needs in a cost and capital effective manner.  The need for comprehensive, proven large-scale water management solutions for produced water handling and supply for completions is of increasing importance to customers and the Company’s expanding infrastructure network is well positioned to capture additional volumes over time. The steady production growth by customers in the Permian has supported the Company’s development to date and its future looks bright as the high-quality acreage under contract with decades of remaining inventory will be developed consistently under a wide range of commodity price environments.

Many view ARIS as a natural consolidator in the water infrastructure service industry, which is fragmented, private and operator-owned.  While very little consolidation has happened to date, it is expected that activity will pick up this year and beyond.  Given where management sees pricing for deals, it believes that higher returns can be achieved by continuing to invest in their footprint (and they haven’t been shy about doing this).  Management continues to evaluate opportunities and has made approaches, but nothing has materialized. ARIS believes time is on their side and ultimately consolidation will happen.  This is both a risk and an opportunity depending on what they end up doing, how much they pay and how much leverage they take on.  

Quick Overview of Water and Fracking

Oil and natural gas production in the U.S. is at an all-time high made possible by fracking.  The use of water in drilling has long been necessary, but water scarcity and the emergence of ESG initiatives has led the industry to refocus its attention on minimizing freshwater use and finding better ways to work with produced water sourcing and delivery.  

As the industry continues to improve its efficiency by drilling ever-longer horizontal wells, it also increases the amount of water it uses to fracture the rock to release the gas. The fracturing process uses millions of gallons of water for a single horizontal well.  Water pumped into fracking wells doesn’t all stay in the ground as much of it comes back up along with extracted oil and gas. The water that comes up has a much different chemistry than the water that goes down. Produced water includes salts, radioactive substances, and chemicals added during the fracking process.  Produced water is produced throughout the entire life of the well and is of particular importance to operators in the Permian Basin given the high produced water-to-oil ratio prevalent across the basin.

The chart below shows the stunning growth of produced water volumes in the Permian:

Produced water historically has been disposed of by injecting it into deep underground wells, but the geology in some parts of the country is not amenable to such practices, and concerns about inducing seismic activity have the industry looking for alternatives. Increasingly, the industry is reusing produced water for drilling and fracking.  Recycling produced water displaces the use of scarce groundwater which would otherwise be used for fracking.  Produced water treatment involves separation, where oil and gas are separated from the water, followed by physical, chemical, and biological treatment processes to remove impurities. The treated water can then be safely disposed of or reused for various purposes, such as irrigation, industrial processes, or even reinjection into oil and gas reservoirs. 

The global produced water treatment market size is estimated to be at ~$8.0bn and is anticipated to grow at a CAGR of 7.5% from 2024 to 2030. The U.S. market is approximately a third of this amount, or ~$2.5bn.  These markets are expanding because of the rapid urbanization and population growth, rising demand for water supplies, and efforts to combat diseases brought on by contaminated water.  Additionally, the use of a newer technologies, including oxidation, ceramic micro- and ultrafiltration, media filtration, adsorption, etc., is anticipated to boost market expansion.

Business Overview

The Company’s assets include pipelines, pumps and handling and recycling facilities in the core of the Delaware and Midland Basins of the overall Permian Basin. Operational area and assets are located primarily in Eddy and Lea counties in New Mexico, and in Martin, Howard, and Midland counties in Texas.  These interconnected assets support both of its produced water handling and water solutions businesses. The pipeline network consists of ~730 installed miles of gathering pipelines, which includes ~500 miles of larger diameter (12- to 24-inch) pipelines.  The Company also operates 65 produced water handling facilities and 23 high-capacity produced water recycling facilities. The water handling facilities are designed to process, store and/or dispose of produced water that is not recycled. The recycling facilities include water filtration, treatment, storage and redelivery assets.  

The Company’s business is driven by gathering produced water volumes and delivering recycled water volumes to customers. The produced water handling business gathers, transports and, unless recycled, handles produced water generated from oil and natural gas production. The water solutions business develops and operates recycling facilities to treat, store and recycle produced water.  

The figure below demonstrates the movement of produced water through the Company’s pipelines for handling or recycling and the multiple points at which it can collect fees on the same barrel of water:

The volume of water the Company processes is driven by crude oil and gas production.  Volatility in oil and natural gas prices affects the spending patterns of customers and impacts the level of drilling or completion of new and existing wells.  Demand for the Company’s services, as well as rates and utilization of assets, would be impacted by these drilling decisions.  In addition, one significant customer contract provides for rates that periodically fluctuate with changes in the price of oil which means a portion of the Company’s revenue is directly exposed to fluctuations in the price of crude oil.  As part of its water processing activities, ARIS aggregates and sells recovered crude oil, also known as skim oil. Cash flow is dependent on skim oil sales, which is directly exposed to fluctuations in the price of crude oil. 

While there’s commodity price risk, as produced water volumes from oil and natural gas production in the Permian Basin have significantly grown, long-term contract structures like those used in the hydrocarbon midstream sector have also been adopted for water services.  In the Company’s produced water handling business, long-term customer contracts include acreage dedications and minimum volume commitments.  Currently, the Company has more than 650k acres under contract with nearly 8 years average remaining contract life.  The Company’s contracted aggregate MVCs totaled greater than 155k bwpd of produced water and nearly 3 years of average remaining life.  All produced water transported on Company infrastructure is subject to fee-based contracts, which are subject to CPI adjustments.  The Company does take on some spot produce water business but this accounts for less than 15% of annual volumes.  

The Company’s water solutions contracts are primarily structured as spot contracts or acreage dedications where it supplies water, including recycled water, to customers for their operations.  Increasingly, however, ARIS is entering into longer-term contracts with new and existing customers to provide recycled water and groundwater.

Customer concentration is heavy here.  Top four customers represent 77% of the Company’s revenues. ConocoPhillips is the largest customer at 35%, followed by Chevron at 21%.

Capitalization

The balance sheet is straightforward.  There’s a $350mm credit facility in place that matures in October 2027 with a springing maturity ahead of the maturity of the senior notes.  As of September 30th, $34mm has been drawn on this facility.  There’s a max total leverage covenant of 4.5x and a max secured leverage covenant of 2.5x.  Interest rate on the borrowings is currently ~8.2%.  The facility is secured by all the real and material personal property owned by Solaris LLC or any of its subsidiaries.

There’s $400mm 7.625% senior sustainability-linked notes outstanding that matures in April 2026. The notes are unsecured and subordinated to the credit facility and are guaranteed on a senior unsecured basis by all wholly owned subsidiaries.  The bond indenture permits Solaris LLC to pay distributions to ARIS if total leverage is less than 3.5x after giving effect to such distribution. In addition, if Solaris LLC’s fixed charge coverage ratio is not less than 2.0x, the indenture permits Solaris LLC to make distributions to ARIS.  

There’s a tax receivable agreement in place with the legacy owners of Solaris LLC.  As of September 30th, this liability is estimated to be $98.2mm. 

Summary Financials 

ARIS is one of the fastest growing midstream businesses in the country.  Revenue this year will exceed $400mm, up substantially from $171mm in FY20.  EBITDA growth is even more impressive, up from $52mm in FY20 to an estimated $190mm this year.  The not so great news is that it took over $650mm in capex to achieve this growth.  Many investors, including myself, struggle to calculate what the ROIC is on all this spend.  It’s my understanding that management looks for a 2.5- to 4-year payback on capex but it’s impossible to see that in the numbers so far.  Granted these infrastructure investments will generate revenues for a very long time in the future but some perspective by the Company on potential returns should be expected.  Management has done an extremely poor job of helping investors with this exercise in their financial disclosure and on quarterly conference calls and as I mentioned earlier, the Company’s investor relations efforts are completely lacking.  

The Company has been reinvesting all its cash flow (and then some) back into the business, but I expect it to be FCF positive in FY24.  

My impression is that ROIC on the capex will be acceptable over time but not anywhere near spectacular.  I believe the Company was on its way to producing higher margins per barrel of water around the time of the IPO but then failed to execute and margins collapsed in FY22 and are just now starting to get back near FY21 levels.  Management has historically over-estimated its margin improvements efforts as the Company was unable to execute on cost reduction efforts which resulted in resetting expectations for FY22 and FY23.  Overall, however, I would be surprised if ARIS wasn’t able to execute lower costs in the long-run, supporting higher margins and EBITDA growth.  

The drop in margins was the major contributor in the rerating of the company valuation.  The chart below shows the key metrics over time:

Management’s primary initiative for FY23 was to improve the profitability and recapture lost margins.  In the most recent quarter, focus on electrification of infrastructure, efficiency in the field and business process improvement helped deliver $0.02 per barrel sequential improvement in margins per barrel to $0.40 per barrel.  Management expects the momentum to continue but we’ll see when the report Q4 shortly.  Unfortunately, they also continued to expand its infrastructure footprint.  They argue that the capex spend is necessary to support customer growing volumes in the core of the Northern Delaware Basin.  Ideally, I suspect the market would have preferred slowing down the infrastructure growth and instead demonstrate strong ROIC on past capex so that future capex could be better justified.  Total capex will be ~$165mm in FY23 based on currently contracted customer outlooks on the Company’s dedicated acreage. Capex in FY24 will be lower than in FY23 but they haven’t guided to a specific range yet.  

Industry trends remain favorable for the Company going forward.  The Company’s key customers’ capital allocation to the Permian Basin and New Mexico remains consistent and significant, including on acreage where the water sourcing and production is dedicated to ARIS.  Permian Basin oil and associated water production growth continues to outpace production growth in other parts of the U.S.  Other dynamics such as simultaneous multi-well operations and reuse applications of produced water, particularly in the areas of the Permian Basin, are improving efficiencies and returns and provide the Company with significant opportunities for both the produced water handling and water solutions businesses.

Thoughts on Valuation

I believe ARIS should trade in the 6.0 – 7.0x EBITDA range.  Until management proves that the business can generate acceptable ROIC on what it calls ‘growth capex’, the business should trade at a material discount to the midstream sector.  Accordingly, I value the Company at $1.1 – 1.5bn assuming a near-term EBITDA range of $175 – 205mm.  This values the units at $9.50 – 16.00.  Conservatively, I think the units should at least trade at $11.00 based on 6.0x my EBITDA estimate of $190mm for FY24.  I suspect it could take a while before the market rewards this business with a 7.0x multiple.  

Assuming the Company can execute and produce healthy returns on the growth capex, EBITDA and FCF should increase meaningfully in the coming years.  There would be significant upside in the units over time under this scenario.  Just for perspective, here is one sell side company’s top line and EBITDA estimates for ARIS for the next several years:  

Catalyst

* continued improvement in $/bbl operating margins back to FY21 levels

* pare back on capital expenditures and demonstrate returns on the significant investments already made 

* improve investor communication