Description

Summary: At C$5.55 per share, CES Energy (CEU) is a US$931MM market cap North American oil field services company (OFS) focused on drilling fluids and production chemicals. CEU trades at ~8.5x 2024E PE, in line with small cap OFS peers. Unlike its peers which are often capital-intensive businesses facing secularly declining demand due to increasing service efficiency, CEU is an asset lite business which benefits from this same trend. Since 2017 CEU has grown its topline organically at a ~13% CAGR.

Going forward we expect CEU to grow earnings by mid-single digits per year while returning the majority of its cashflow to shareholders equating to a ~13% dividend + buyback yield today. We believe a more appropriate multiple is 12x PE, leading to a FY25 FV target of ~C$10 per share or ~75% upside.

Overview: CEU specializes in designing and selling proprietary chemical solutions for Exploration and Production (E&P) companies. Although the specific breakdown is undisclosed, analysts estimate that CEU’s business is evenly split between drilling fluids, used during the drilling process and correlated with rig count, and production chemicals, used throughout a completed well’s lifecycle. CEU undertakes the entire process from designing and blending to storage and shipment of these chemicals to customers sites. While competitors may service a well remotely, CEU has a very hands-on approach and will often have staff onsite to help its customers. Competitors include Halliburton, Newpark, Secure Energy Services, Champion X, and Baker Hughes, with CEU being the sole remaining listed pure play. Notably, both the drilling fluid and production chemical sectors are witnessing increasing consolidation, with a mere three companies controlling the Canadian drilling fluids market and two dominating 39% of the North American production chemicals market. CEU's competitive advantages stem from its patents and branded products, vertical integration, and a culture fostering entrepreneurship and decentralization.

CEO Ken Zinger was one of the founders of the company in 2001. CFO Tony Aulicino was previously a banker and joined the company in 2018. The management team’s long-term financial incentives are tied to total shareholder returns and return on capital employed (ROCE). The company operates in a decentralized manner, with ROCE serving as the primary metric for evaluating divisions and headquarters. In FY23 CEU generated a 17% ROCE and 25% ROE. The management team and board collectively own ~6% of the company and instill a culture of acting like owners.

Between 2017 and 2023 CEU organically grew revenues at a ~13% CAGR driven by market share gains and increasing service intensity. Since 2017 CEU has increased its market share in the US drilling fluid’s business from 11% to 21%. The company believes it has scope to expand in the US to the ~34% level it currently has in Canada and continues to enter new basins. Its largest market in the US today is the Permian where it has 33% market share. Beyond market share gains, the company benefits from increasing service intensity. Operators are drilling more complicated wells with longer laterals which require more chemicals and result in higher revenues per well drilled, and drilling wells faster which leads to more revenue per day. These trends are secular with scope to increase as E&Ps continue to drive for cost efficiencies.

Capital allocation for CEU is relatively straightforward. CEU has excess production capacity and the business is asset light with the exception of a modest required investment in working capital as the company grows (~29 cents per additional dollar of revenue). Beyond this investment, CEU has committed to returning its remaining free cash flow to its shareholders. The company targets a 1-1.5x net leverage ratio and ended the year within its target at 1.38x. Importantly, the company's C$435 million of net debt at year-end FY23 was covered by net working capital of C$586 million, suggesting resilience in times of downturns, as any decline in revenue would be proportionally offset by reduced working capital, covering the debt.

On April 2nd, 2024, Schlumberger announced its plans to acquire CEU peer, Champion X for 20x FY24E PE. Champion X has historically been valued higher as it is larger and a pureplay on the less volatile production chemicals business. While there is not a perfect comparable company left for CEU, one candidate that is a similar size is Pason Systems which trades at 13x PE and has a similar, cashflow, return and growth profile.  The remaining comp set consists of drilling, fracking or other auxiliary service companies which while in the same industry have different return and cashflow profiles.  

The primary risks are oil and natural gas prices which would impact the drilling fluids business, E&P consolidation which could lead to increased customer bargaining power, and competition.

Conclusion: At C$5.55 per share CEU trades at 8.5x FY24E EPS. The company is guiding to mid-single digit topline growth and the dividend / buyback yield today is 13%. We value the business on an absolute basis and apply a 12x PE multiple to our 2025 EPS estimate and arrive at a FV of C$10 per share.

Catalyst

Continued positive results and shareholder returns