Description

I am recommending a long position in Exterran Holdings (“EXH”). EXH has undergone a massive transformation over the past three years, overcoming a botched merger integration and an over-levered balance sheet. Under the leadership of Sam Zell and his team, EXH has right-sized its operations with all segments benefiting from a growing cyclical tailwind. At this point, I believe that EXH will be focused on shareholder returns by pursuing the last, large-scale drop down into its captive MLP (NYSE: EXLP) and monetizing its GP stake. Interestingly, EXH’s current stock price implies nearly no value to the GP stake, which are in the high-split IDRs. On a SOTP basis, accounting for the market value of EXH’s equity interest in EXLP and conservatively ascribing a 7x EBITDA multiple to the fabrication and international segments is where the stock trades today. By adopting the midstream C-Corp structure, we believe EXH’s GP could generate $60M of FCF in 2015, which at a 25x-30x multiple would imply more than 50% upside and $70 price target. Under Mark Sortir, hand-appointed by Sam Zell and current Chairman of the Board, management should be motivated to restructure the business and enhance shareholder returns.

Brief History:

Exterran’s largest business is in natural gas compression and generates revenue by building and renting compression equipment used during the extraction process and pipeline transportation. Exterran was formed in August of 2007 when the two largest compressor companies (Hanover and Universal) were merged. In the course of merging the operations of the two companies, a number of integration problems developed. Sales and maintenance personnel disagreed over territories and changes in personnel lead to a decline in service levels and to lost accounts. As a result of these problems and the soft macro environment, earnings in 2008 plummeted – and EXH’s stock declined from a late 2007 high of $87 to below $10 (compounded by the already weak stock market). In reaction to these problems, a few high level management changes were made and considerable attention was placed on re-hiring capable field personnel. Since then, company fundamentals have improved with the guidance of Sam Zell and buoyed by an improving economic backdrop. Leverage has been reduced from ~5x to less than 2x EBITDA and 2013E EBITDA has already exceed 2007 levels. Interestingly, EXH stock price is still down over 50% from that time.

Exterran operates in four business segments:

• North American Contract Operations (24% of sales / 36% of Gross Profit). NACO consists of Exterran’s fleet of compressor units in service in the U.S. The fleet is made up of approximately 7,700 individual compressor units and has #1 market share by operating h/p.
• International Contract Operations (17% of sales / 29% of Gross Profit). This segment serves primarily Latin America (Argentina, Brazil, Mexico) and is twice the size of the next competitor in these geographies.
• Aftermarket Repair & Service (14% of sales / 9% of Gross Profit). Maintenance services are provided for compressor units, as well as other oil & gas processing infrastructure to third party owners/operators.
• Fabrication (45% of sales / 26% of Gross Profit). This segment designs, fabricates and sells compression units, largely for the company’s own fleet but also for upstream and downstream operators. Exterran also builds other production and some downstream oil & gas equipment. The company performs work from eleven fabrication facilities globally, including six in the U.S. (primarily in Texas and Oklahoma).

Notable Recent Events:

• During Q3’13 earnings call, management officially announced that it converted the remaining compression contracts at EXH such that they qualify to be dropped down in EXLP.
• EXH declared its first dividend in Q1’14 ($0.15/share).
• Through two transactions in 2/14 and 7/14, EXLP purchased the compression assets from CHK for $360M and $135M, respectively. We consider this a milestone in EXH’s turnaround as the company is now in a position to acquire accretively.
• EXLP announced its intention to eliminate cost caps by end of 2014, which are contributions by EXH to EXLP for incremental SG&A and “operating costs” after the drop downs. These contributions help support EXLP’s distributions, which has been a mild overhang on EXLP’s valuation and yield.

Brief Industry Overview: Favorable Natural Gas Supply and Demand Dynamics are here for the Long Term

The industry backdrop bodes well for EXH growth prospects, which is highly correlated to E&P spend and projected to grow MSD in the near term. Long-term growth prospects are very much in intact with world natural gas consumption projected to increase by 64 percent from 2010 to 2040. In the short term, however, a massive natural gas export boom is already in motion – and with the US’s neighbor, Mexico. Mexico’s national energy secretary (SENER) has reported that U.S. natural gas exports to Mexico doubled between 2009 and 2013. Exports in 2013 alone averaged 1.8 billion cubic feet (bcf) per day, and SENER predicts that will more than double by 2018 to 3.8 bcf per day! The main reason for the massive upsurge in imports is that Mexico plans to add at least 28 gigawatts of power generating capacity over the next 12 year. The companies that are set to win this race will be the pipeline companies that transport gas from Texas gas fields – mainly the Eagle Ford Shale – to Mexico where EXH has a dominant position.  

In addition, LNG exports, which are travelling via pipeline, are at their highest levels ever and growing. As U.S. production of natural gas soars, companies are investing $120 billion in North American export projects that could increase domestic gas prices. According to Goldman, net exports of LNG will be near 1.7bcf/d starting in 2017.

Why now?

EXH definitely has wind at its back. Exterran has undergone a massive operational transformation over the past 3 years and is now in a position to improve its growth algorithm and margin profile. Below are a few of the opportunities that should bode well for EXH in the short and long-term.

Abundant opportunity for accretive M&A in fragmented market:

The backdrop for consolidation could not be better for EXH. Although EXH has nearly 45% market share, nearly 22% of the US compression market are small, sub-$100M mom-and-pop compression shops, which provide for fertile ground for continuous bolt-on acquisitions.  Above all, EXH is now in position to acquire accretively as demonstrated by its back-to-back acquisitions of CHK Midcon assets in Q1’14 and Q3’14. A function of this has been EXH’s campaign to right size its cost structure and optimize its supply chain. Back in 2006, EXH was achieving peak NACO gross margins and EBITDA margins of 62% and 45%, respectively, until margins rapidly troughed in 2011 to ~47% and 34%, respectively, due to mismanagement and a soft macroeconomic environment. Over the past two years, however, EXH has been standardizing and automating its supply chain practices. For example, EXH took a high-touch, paper-based system of deploying its fleet to one in which is highly automated through upgraded ERP software and hand-held devices. In addition, EXH took a decentralized structure of deploying labor technicians (which were effectively managed like contract workers) to a more centralized and automated system of assigning these technicians to geographic coverage zones. Since then, NACO gross margins have approached peak margins of 57% and EBITDA margins to 46% with management alluding to more opportunity for cost reduction given the structural improvements (we think ~200-300bps). With a cost structure superior to the vast majority of other compression assets (which operate near 45% gross margins), we believe EXH will be able to accretively add to its fleet which will only support GP value and net cash to EXH.

Growth Capex Is Actually “Growth” Capex

The amount of growth capex EXH has spent over the past four years – nearly $800M – gives most investors pause especially when trying to reconcile the declining-to-flat available horsepower growth during that same period. EXH had nearly 5.5M of available horsepower in 2010 which has declined and subsequently stabilized around 4.7M available horsepower in 2013. During that time, EXH retired and sold over 1M hp of idle or aged compression units in its fleet – a combination of a terrible market, an aging fleet, and over-indexing in dry-gas plays as gas prices plummeted near $2.

What few investors appreciate is that EXH is in the final innings of upgrading its fleet and deploying these assets toward attractive wet gas areas and retiring their aged fleet in dry gas regional plays. The average age is now 15 years old, down from 21. From conversations with management, any growth capex spend will be dedicated toward organic growth opportunities rather than replacement from 2015-onward. As highlighted in the Q2’14 transcript, we believe we’re already seeing signs of this capital deployment as EXH achieved net organic growth of 77k hp during the quarter out of 100k hp gross additions with management guiding toward strong organic growth for 2H’14. Finally, due to this fleet upgrade, maintenance capex per hp should actually stay steady at around $16 to $17/hp, although I conservatively forecast maint-capex of $21/hp or $85M.

Assumptions for EXH Valuation

The lease-like model of the Contract Operations business provides for a very stable revenue stream, which bodes well for income-seeking investors. Although gas production and well count drive demand for compression services over the long term, Exterran’s compressor units typically remain at a gathering line, processing facility, or wellhead for 4-5 years. As EXH drops down the remaining compression assets into EXLP, EXH will assume a midstream C-Corp structure in which it will be able to dividend its LP/GP distributions – a structure in which the market has clearly rewarded a la Williams (WMB), Spectra (SE), Targa (TRGP) and Teekay (TK). Currently, over 70% of EXH’s compressional rental fleet is owned by captive publicly traded MLP, EXLP, of which EXH owns 100% of GP and 35% of LP. We assume that EXH will drop down 700k h/p in addition to its aftermarket services (AMS), which are eligible also for drop-downs. My financial projections are as follows for 2015:

Summary Operating/Fin Stats:              2015E

Average US Horsepower (HP):                 4M

US Fleet Utilization:                               92%

US Rental Rate ($/HP/month):              $18.50

Total Revenue:                                    $818M

Gross Margin – US:                              58.8%

Gross Profit:                                         $480M

EBITDA:                                              $410M

Dropped Down AMS EBITDA:                 $35M

Total EBITDA:                                     $445M

(Maintenance Capex):                          -$85M

(Cash Interest):                                  -$80M

Total Distributable Cash Flow:              $280M

Distribution Percentage:                         90%

Distribution to all Unitholders:                $250

The incentive distribution right (IDRs) for EXLP assume that the GP/LP split dividends 50-50 once the quarterly distribution to all units holders exceed $0.525/share. At nearly $250M of FCF, we are at a quarterly distribution of over $1/share, resulting in GP unit holders the clear beneficiary of being in the IDR high splits. From our waterfall math, EXH’s LP units will generate $69M of FCF with EXH’s GP generating $69M. Assuming a 15% tax rate and 90% payout EXH will generate $1.50 in dividends from these interests.

GP/LP Valuation

Current consolidated structure of EXH and EXLP entirely obfuscates the enormous value of these GP/LP interests. Peer sets trade near 2.5% to 4% 2015E dividend yield, which demonstrates the market’s inclination for these structures. If EXH divests its international and fabrication businesses, FCFs would be split nearly 50-50 from GP and LP interests. Pro forma for the remaining drop downs, EXH should be able to grow its dividend ~5%-6% (excluding M&A) for the foreseeable future.

EXH’s valuation can be pegged to existing C-Corps that have LP/GP interests, which include SE, WMB, OKE, and TRGP. When comparing the aforementioned companies across metrics, C-Corps that 1) exhibit weaker forecasted dividend growth and 2) have meaningful cash generation from non-MLP assets trade at higher yields that those that are pure-play GP/LP interests. In addition, FCF generation that is attributed to GP interests, LP, interests, and non-MLP assets are wide ranging.

• TRGP trades at a 2.5% 2015E dividend yield and does not have any meaningful non-MLP business. Consensus is forecasting a 21% dividend growth CAGR to 2017. The majority of the cash flows are generated at the GP level.
• OKE trades at a 3.6% 2015E dividend yield and does not have any meaningful non-MLP business. Consensus is forecasting a 11% dividend growth CAGR. Cash flows are fairly evenly split between GP and LP interests.
• SE: trades at 3.5% 2015E dividend yield with non-MLP assets generating up 30% of the distributable cash flow. Consensus is forecasting a 8% dividend CAGR to 2017. Roughly half of the FCF is generated from LP interests and about 20% from GP interests.
• WMB trades at 4.2% 2015E dividend yield and has non-MLP distribution (NGL & Pet. Chemical Services) but is very small compared to the MLP distributions ($155M non-MLP vs. $1.6bn in MLP distributions). Consensus is forecasting an 18% dividend growth rate. About half of the FCF is generated from LP interests and about one-third from GP interests.

Although we could debate at length on what yield EXH would trade at, ascribing a 4% yield on EXH’s cash flows seems conservative and defensible. EXH’s FCF will be derived solely from GP and LP interests which we assume grow at 5%-6% organically. The complexion is a cross between OKE and SE, and I believe investors would pay up for the M&A optionality. By adopting a similar structure, EXH’s GP/LP interests alone would contribute $38/share of value by applying a 4% dividend yield to the $1.50 in dividends from these interests.

Valuing the Stub International Ops and Fabrication

Ascribing value to the remaining segments (Fabrication and International) may prove to be more difficult, so we err on the side of conservatism. Fabrication has generally been a lumpy business, but we have a few data points to draw from to peg valuation. Late in 2013, TPG’s owned Valerus sold its fabrication business to Kentz (KENZ-LON) for $435M while retaining ownership of Valerus’ contract compression and after-market support business. The Field Solutions portion of Valerus has grown significantly in recent years (EBITDA of US$51 MM in 2012 vs. US$11 MM in 2010), and Kentz was guiding to EBITDA increasing by ~50% between 2012 and 2014. Based on these metrics, the purchase price implies an EV/EBITDA multiple of 8.5x 2012 EBITDA, 7.2x 2013E and 5.9x 2014E. Given the size of EXH’s fabrication business of over $1 billion in revenue at 18% gross margins, I believe this business would conservatively achieve a 6x multiple.

In addition, EXH’s international operations is a great business with an equally attractive margin profile as its North American contract operations, representing 17% of total revenue and 29% of gross margin. We benchmark to another publicly traded compression company, specifically to USA Compression (USAC) – which is a pure-play North American compression company. USAC currently trades at 10x 2015 EBITDA with a superior growth profile off a smaller base of compression assets, yet EXH’s international ops generates 2x revenue and is the #1 player in all geographies. In terms of transaction comps, Enerflex (EFX.CN) purchased the international operations from Axip International for ~7.5x EBITDA. With EXH’s international operations four times the size of Axip and with a gross margin profile nearly 10% higher, a transaction multiple in the 9x-10x would defensible.

Conservatively ascribing a blended 7x multiple to both fabrication and international ops with EBITDA of $320M, yields $32/share.

The remaining sources of value are from the $179M in remaining payments from PDVSA, who nationalized and assumed control over all EXH assets in Venezuela, which are $2.50/share.

Net debt at EXH is consolidated at EXLP, which is non-recourse to the parent. Excluding EXLP, there is $760M of net debt at the parent. Netting against this will be the payments to EXH for the eventual dropdowns, which we assume will be $525M or approximately $750/hp for the 700k utilized h/p. This is conservative to the $800-$900/hp that EXLP has historically paid in 2011 and 2012. In sum, there’s about $230M in remaining debt, or $3/share of net debt. 

Summing up the pieces, we get to a $70 price target, which is over 50% from current levels.

Key Risks

• Deterioration or slowdown in nat gas demand, tempered drilling activity, or reduced customer outsourcing trends could hurt compression rental demand
• Delay of compression asset drop-downs into the MLP can have a significant impact on valuation

Catalyst