Description

Summary

TLDR:  Natural gas processing, compression and water handling business (tied to recurring oil and gas production) that trades for 2.8x ’23 Maintenance FCF and 3.7x ’23 EBITDA with management starting substantial capital return to shareholders over next 12 months.  Company is easily worth $15/share in 2023 (vs. ~$4.75 current share price) with undemanding assumptions and low leverage profile.

(note: figures in table above and in write-up below are PF for merger with Enerflex - discussed in more detail below)

Exterran Corp (EXTN) is a global energy infrastructure operator and engineering services company that is highly misunderstood and has recently undergone a material corporate transformation in moving to higher-quality business lines.  EXTN builds, operates and services natural gas processing plants, water handling/recycling facilities (resulting from O&G production), gas compression equipment, power gen equipment, etc.  While a small part of their business now, the Company also builds facilities like carbon capture and landfill gas plants tied to the energy transition movement.  EXTN has a toll road-type business model:  passing through production volumes (gas or water) and collecting a fixed fee per unit (with minimums), so they do not have direct contractual exposure to commodity prices.  EXTN benefits from increased natural gas as well as oil drilling (as most oil production also contains natural gas and/or water volumes that must be processed and transported) but the assets EXTN builds/operates for its customers are required to be utilized over the life of the field as they support ongoing production. 

EXTN is nearing its shareholder vote (Oct 11^th meeting) regarding its pending stock-for-stock merger transaction with competitor, Enerflex (EFX).  EFX will be the surviving entity and will also bring its management team.  Purchasing EXTN stock today is a slightly cheaper way to invest in the combined company as EXTN currently trades at a ~3-4% merger spread to acquiror EFX at current USD/CAD rate.  EXTN shareholders will receive 1.021 shares in EFX for each EXTN share.  I will refer to the combined company as Pro Forma Enerflex (PF EFX) to reflect the merger transaction. 

Business Segments Overview

PF EFX has 3 main business segments:  1) Energy Infrastructure operations (~60% gross margins, primarily long term contracts), 2) Aftermarket Services (~22% gross margins, large installed base of plants/equipment to service, recurring revenue) and 3) Engineering Services (~15% gross margins, manufacturing and sale of new plant/equipment, capital-light with end-market demand tailwinds but revenue is cyclical).  70-75% of PF EFX’s total gross margin is derived from recurring sources (i.e,. Energy Infrastructure and Aftermarket Services segments).  Geographically, PF EFX revenue is split:  34% US, 27% Middle East, 22% LatAm, 6% APAC, 11% RoW.  The Company’s customers are large national and/or integrated oil companies with stable credit profiles.  No customer represents >10% of revenues or receivables. 

PF EFX currently trades for just 3.7x ’23 EBITDA and 2.8x Maintenance Free Cash Flow based on recent management guidance (September 8, 2022) yet the business is experiencing organic growth.  With a stable credit profile of just 2.5x Net PF Leverage at merger close (Q2 ’22 LTM EBITDA), management is expected to begin substantial shareholder capital return over the next ~12 months post-merger close.  Given the recurring nature of its cash flows and end-market demand tailwinds for increasing natural gas and energy transition projects, PF EFX shares should trade for at least ~9x 2023 Maintenance FCF, or $15/share (vs. ~$4.75/EXTN share currently).

Historically, EXTN was primarily a Low-Margin, Cyclical Engineering Business

Pre-2020, both EXTN and EFX were more focused on the engineering, manufacturing and sale of natural gas processing plants, gas compression, and related equipment.  This business consisted of one-off, mostly non-recurring revenues at low gross margins and tied to upstream drilling capex.  While it was capital light (great in the boom years like 2014 and 2017), it also was subject to the oscillation of global energy capital expenditures, which took a sharp downturn in late-2014 and again in 2019.  2020 global upstream drilling capex was approximately 50% lower than the 2014 peak.

Now, a Growing, Higher-Margin Critical Energy Infrastructure Business with Recurring Aftermarket Services

However, in recent years, both EXTN and EFX have increasingly transitioned their business towards a build-own-operate-maintain (BOOM) business model whereby they construct and finance the build-out of energy infrastructure (gas processing plants, water handling facilities, as well as compression and power gen equipment) for large, integrated O&G companies.  EXTN/EFX then enters into long-term “take-or-pay” fee-based contracts (with fixed minimum fees to protect against any volume declines) that also have annual inflation escalators.  The Company targets a ~10-15% unlevered return on these long-lived projects and avoids any direct contractual commodity price risk.  At the end of the ~7-10-year initial contract term, the Company typically enters into renewal contracts (~85% average renewal rate) that provide additional project returns beyond the initial targeted IRR. 

The Infrastructure segment’s recent project awards also include large scale water handling/recycling facilities (for water produced in O&G or used in industrial processes) as well as newer energy transition projects such as carbon capture facilities or landfill gas capture/processing plants.  Both represent meaningful infrastructure growth areas beyond traditional O&G production volumes.

Within its Infrastructure segment, PF EFX also has a meaningful gas compression rental business (through EFX’s legacy assets) operating in the US (primarily in Permian and SCOOP/STACK areas), which leases out gas compressor equipment to maintain and enhance natural gas flow rates at the wellhead and for midstream gathering/processing/pipeline applications.  This business is currently operating at 90%+ utilization.  As wells mature and reservoir pressure depletes, the need for gas compression grows over time.  US-based compression rental pure-plays ArchRock (AROC) and USA Compression (USAC) currently trade for ~7-9x ’23 EBITDA.

Finally, beyond the Infrastructure segment, the Aftermarket Services segment has benefitted as the installed base of plants/equipment built and sold by the Company has expanded.  The AS segment generates recurring revenue with mid-20%’s gross margins (with essentially no associated capex) from the maintenance, replacement parts/services, etc. for mission critical infrastructure.  Management has noted pent up demand in this AS segment as many projects were deferred/delayed during Covid. 

From the current valuation, it is clear the market does not fully appreciate that ~70-75% of total gross margin is derived from high-quality, recurring revenue business segments and that such cash flow is growing organically from durable industry tailwinds (i.e., increasing demand for critical infrastructure in traditional O&G following many years of underinvestment as well as energy transition markets). 

Benefits of the Merger:

First, approx. $60 million in cost synergies ($50m from near-term G&A/overhead reduction) have been identified and will be implemented over the next 12 months post-close.  This amount represents 15% of PF EFX 2023 EBITDA, so these cost cuts are materially additive to free cash flow.  Second, while the merger transaction has cleared antitrust issues, the reality is that EXTN and EFX were previously among just a handful of competitors bidding against one another across these large scale international energy projects.  As a combined company going forward, bidding competition for such projects will be reduced, likely benefiting the Company through either more project wins and/or slightly better economics.  There are only a handful of real competitors that can effectively/credibly bid for the scale of projects that EXTN/EFX perform (i.e., having a track-record to construct and operate large scale gas and water handling facilities efficiently with minimal downtime).  Lastly, the combined company will be much less levered than legacy EXTN (~2.5x PF Q2 ’22 LTM EBITDA at merger close and management will pay down debt near-term as the leverage ratio will flex up a bit over the next 1-2 quarters), and the Company should have an expanded opportunity set of growth areas beyond what either company could achieve alone.

Very Cheap on EBITDA and FCF Valuation in ’23, especially given Industry Tailwinds and Modest Leverage:

Both EXTN and EFX were discarded by the market beginning in early/mid-’19 as global E&P capex started to decline.  However, the tailwinds have changed direction, and now the world appears to be structurally short natural gas over the coming decade due to multi-year underinvestment in supply (global energy capex is down 50% since 2014).  Natural gas drilling and development economics globally have never looked better, and while US E&P’s have been restrained in materially increasing capex, many international O&G companies in ME, LatAm and APAC are not as beholden to such public market or ESG constraints and are starting to sanction new long-lived projects.  Additionally, PF EFX will benefit from increased capex spend in the coming decade for increasingly economic projects like Carbon Capture on-site for certain industrial plants as well as landfill methane processing plants, already a highly attractive business today in the US (see Archaea Energy (LFG)).  Given such demand tailwinds plus the transition of PF EXTN to more stable recurring revenue sources, an investor just has to pay an undemanding 3.7x ’23 EBITDA and 2.8x Maintenance ’23 FCF at the midpoint of recent (9/8/22) management guidance.  US-only gas compression peers AROC and USAC trade for 7-9x ’23 EBITDA.  Many US midstream processing peers trade for ~8-10x ’23 EBITDA given the contractual stability of cash flows and critical, toll-road nature of gas processing plants and water handling assets. 

If PF EFX could fetch even just 6x ’23 EBITDA despite a much lower leverage profile and better growth prospects internationally, that would result in a $12/share price vs. ~$4.75/share today.

 Financial Overview

(US$ in mm, except per unit data)

Note:  Maint FCF in table above excludes any discretionary growth capital.

Importantly, this growth in discretionary/maintenance FCF in 2023 vs. 2022 is due to a reduction in net working capital from legacy projects finishing up this year as well as modest ~5% YoY organic growth in EBITDA.  The company does not expect large growth capex in ’23, so management’s prudent capital allocation of the discretionary $1.69/share in 2023 Maint. FCF is a critical piece that the market is missing.

Expected Capital Allocation:

EFX management will be taking the reins of the PF company and has communicated a desire to run the business just under 2.5x Net Leverage (on LTM basis).  Immediately post-close, management aims to further delever to below 2.5x over the next 6-12 months (leverage ratio will tick up some above current 2.5x over next ~1-2 quarters and then decrease with debt paydown).  This leverage profile is considerably lower than US midstream peers (~3-5x leverage).  Once the company is sub-2.5x (likely by mid-2023), management has indicated capital return will commence – starting with a dividend initially and likely including some share buybacks as well given the amount of excess cash they will have.  Any growth capital spend will be highly disciplined and weighed against competing uses of cash.  At such a low valuation, even a dividend of ~50% of Discretionary Cash Flow (Midstream/MLP peers historically around 75%+ payout ratio assuming not overlevered) would generate a 2023 PF dividend yield of ~18% (a 75% payout ratio implies a 27% PF dividend yield based off ‘23 discretionary cash flow).  Any potential share buybacks near these price levels would obviously juice the equity returns even further.

Risks (and potential mitigants):

Merger is voted down (unlikely given 10-20% CFPS and EPS accretion to acquiror EFX and EXTN’s largest shareholder – Chai Trust (Sam Zell’s personal vehicle) owns 25% - has already effectively approved deal via EXTN Chairman Mark Sotir’s (Pres of Chai Trust) stated unanimous Board approval)

Global O&G capex/infrastructure demand is muted over next few years due to ESG/shareholder discipline constraints/large decline in commodity prices (possible although PF EFX trades at such a valuation where even low/zero growth plus capital return should generate a >15-20% return from dividends/buybacks alone given stability of cash flows)

Pending employee severance-related lawsuit in Mexico somehow becomes material (publicized by some analysts on recent earnings calls, but Mgmt continues to state in filings it does not expect any materially negative impact to company once suit ultimately resolved through Mexican appellate courts.  Multiple Mexican expert legal teams have been consulted by the Company). 

Catalysts:

Catalyst

Merger approval by shareholders (Oct 11^th vote)

Market begins to appreciate wall of discretionary FCF in ’23 (~$1.69/share)

Initiation of dividend (initial yield could be >10%) in early/mid-2023 and potential share buybacks

Increased Sell-side Analyst coverage as combined company Market Cap now above $500m and TEV approaching $1.5bn