|Shares Out. (in M):||77||P/E||19.4||18.2|
|Market Cap (in $M):||2,134||P/FCF||19.4||18.2|
|Net Debt (in $M):||672||EBIT||171||187|
|Borrow Cost:||General Collateral|
Apergy is a 2018 spin-off of Dover’s oilfield service business. The Company was marketed as a roll-up of the most attractive segments of the oilfield products space...a sub-industry that is riddled with poor quality companies and low ROIC returns. Apergy has enjoyed a darling reputation which has led to a market multiple far above the general industry at 15x EBIT (that’s expensive!). But we believe Apergy is facing declining macro trends that have been historically masked by an increasing well count.
As the well count begins to tail-off, the challenging operating environment will begin to illuminate in APY’s financials. If APY’s earnings begin to decline or become impaired, the high leverage ratio will increase exponentially, and the company could face serious downside to the equity valuation. We believe that APY’s equity deserves consideration as a short by the VIC community due to its downside exposure and high valuation multiple.
Production and Automation
Apergy has ~80% of its revenue close to 50% of their earnings associated with Production and Automation. Their products revolve around Artificial Lift, which are technologies that enhance the flow rate of natural resources and ultimately the economic recovery of oil wells.
For non-oilfield investors, we would like to provide the following short primer:
Operators have the following options, in order of well life-cycle, when choosing an Artificial Lift solution.
1. ESP (Electronic Submersible Pumps) – an extremely expensive downhole motor which sucks oil out of the formation and pushes it to the surface. This is the largest segment of the US onshore space (representing 500 – 5,000 BOE per day) and 40% of APY’s production earnings.
2. Gas Lift – a compressors which pushes gas in the formation stimulating higher production flow rates (200 – 500 BOE per day) and a small percentage of APY’s production earnings.
3. Plunger – a metal plunger which cleans the wellbore of water / condensate (100 – 200 BOE per day). A small sub-segment of the oil-well’s life-cycle and a small percentage of APY’s production earnings.
4. Donkey Pump – classic oilfield machine which moves up and down in perpetuity (0 – 100 BOE per day). Represents about 40% of APY’s earnings.
Operators Moving Away from Apergy
Almost every well in the US has some form of Artificial Lift. The oil and gas well count in the US is close to 1m wells, and tends to be largely independent of the drilling / completion environment. Many investors view this sector as somewhat un-correlated to the oil price and drilling environment. The sub-industry is regarded as a higher re-occurring, more stable and therefore deserving of a higher multiple.
But a large % of APY’s business focuses on ESP – the first artificial lift solution in a well life-cycle. ESP is usually installed shortly after the well is completed; and is generally related to rig count / completion count rather than total well count. Both rigs and well count have grown dramatically over the last few years and have masked the operating environment of APY’s production business.
The majority of operators are choosing Gas Lift as their first option over ESPs. The ROIC on installing ESP to the operator has gone down as they do not perform well in high-sand environments. High sand content is inherent in the shale revolution…More sand enhances recovery. These dynamics are not good for the ESP market. They significantly lower the life of the product and as such the economic benefit to the operator. If you call any of the top operators or service companies (EOG, DVN, Concho, XTO) they understand this dynamic and are actively reducing their ESP rentals and moving toward Gas Lift. Gas Lift has a longer life and can pushout the need for Donkey Pumps in the life of the well. IHS thinks that new well ESP adoption has decreased from 90% to 40% in the Permian. As operators move from ESP’s to Gas Lift, APY’s effective ASP gets reduced by 80% (They make 1/5th the profits for a Gas Lift job vs an ESP job).
In an increasing rig count environment this dynamic is hard to see. But with rig count expected to tail-off/declining in the $50 oil environment we believe APY’s business climate will begin to deteriorate.
Apergy participates on the drilling side of the upstream world with their Diamond Cutters which are inserted at the end of a drillbit. The quality and arrangement of the cutters are extremely important to the ROP (Rate of Penetration) and ultimately the cost per barrel to drill. Drill Bit manufacturers have historically paid a premium price to companies able to offer a higher quality diamond cutter. There is a high technology barrier to entry in this space and the market is dominated by Apergy and De Beers (Element Six). Essentially, Apergy converts a very cheap CO2 powder into an artificial diamond with intense pressure. The business has a ton of operating leverage because the powder is so cheap relative to the cost of the diamond. The powder is worth pennies and converts into a $500 diamond.
This business has benefited from high margins and a duopoly market structure historically. We don’t believe this dynamic will not continue going forward because of the following:
1. Customer Concentration Risk– Ulterra is a drillbit manufacturer which is the fastest and now largest player in the US onshore Drillbit space. They were recently acquired by Blackstone for a very hefty price ($700m). That is a very high price and we don’t think BX could justify that price unless they were underwriting a decline in cutter prices. Ulterra is 50% of Apergy’s drilling business and should have the scale and financial incentive to request a pricing concession. After speaking with APY’s investor relations we know that Ultera has never asked for a pricing concession despite huge pricing compression in the Drillbit manufacturing business model so we believe this is a likely scenario.
New Hyperion Technology - KKR acquired Hyperion from Sandvik earlier this year. Hyperion is a subscale diamond cutter manufacturer which the market hasn’t adopted yet. We think that KKR acquired them for the purpose of improving the technology and installing another formidable competitor in the space.
We believe APY could see considerable downside with its inherent risks. However the benefit from a 15x EBIT multiple and a reputation for being protected from the current market cycle. We believe APY has significant macro challenges and deserves a multiple more in-line with the current OFS comps. Given the high leverage ratio this could create and very challenging environment for their equity and a strong risk-return relationship to shorting their stock.
Decrease in EP spending due to the decline in oil prices