Description

We recommend a short position in Heckmann Corp. (HEK - $4.20) and we think the thesis will play out over the next few quarters.  HEK is primarily involved in water handling services for domestic land drillers.  Our investment thesis is based on the following factors:

• Based on industry data points, we think their core business is vulnerable (increased competition is resulting in pressure on rates/margins)
• HEK just made a large acquisition.  The acquired company is coming off peak margins and investors will start to see those margins erode (we’ll provide some data points on this)
• With margins and profitability coming down, HEK will look meaningfully more levered than investors perceive today (closer to 4x debt to EBITDA than 2.5x debt to EBITDA)
• Finally, we think that the market is somewhat confused over whether HEK is an Environmental Services company (7x to 9x EBITDA comps) or an Oilfield Services company (4x to 6x EBITDA).  With their recent acquisition, HEK is now meaningfully more slanted to Oilfield Services and should be valued as such

Company Overview

Heckmann primarily does two things.  They collect used motor oil for recycling/disposal mostly in the Western region of the country.  This division represents about 20% of pro-forma revenues.  This is a decent quality business with roughly 30%+ gross margins.  We won’t spend any more time on this division as it is not the major driver of EBITDA nor is it related to the core of the short thesis.

HEK’s primary activity is in water handling for onshore drilling companies - this includes trucking, storage and disposal.  In this write-up we’ll discuss the long term margin potential in this business.  But in general, we see this as a mediocre quality, asset intensive business facing secular headwinds. 

Power Fuels Acquisition

HEK just announced a large acquisition – they are buying Power Fuels, a Bakken focused water handling company (for those who don’t focus on this space – the Bakken has been a rapidly evolving, oil focused play largely in North Dakota).   A summary of the acquisition is as follows:

Consideration

• 95mm Shares ($2.70 pre-deal, $4.20 today)
• $125mm of cash to seller
• Assumption of $150mm of debt
• Total consideration of $530mm based on pre-deal share price; $675mm based on today’s price

Other Key Terms

• Post transaction the power fuels founder will own 38% of the combined entity and will take over the CEO role

Our Thoughts

• This really more of a merger of the two firms.  The Power Fuels founder / CEO continues on with the business, puts $125mm into his pocket, and gets his company’s debt absorbed by a larger entity
• He is diversifying his holdings and selling his business at peak margins so it is a good deal for him

Our concern with the deal is that HEK is buying Power Fuels at highly inflated margins.  Based on page 13 of their merger presentation – Power Fuels TTM EBITDA margin is 43%.  This is dramatically higher than comparable water handling businesses

• HEK’s water business in 2011 had 18.2% adjusted EBITDA margins in 2011 (trending lower in 2012)
• Forbes Energy (Ticker FES) has a similar water handling business focused on the Eagleford with high 20s gross margins and less than 20% EBITDA margins.  (Note that they have a Well Servicing business with very similar gross margins as their water handling business.  Thus if we assume that both business absorb overhead in a roughly proportion way, we can conclude that Forbes’s water handling EBITDA margins are roughly 20%)
• Our conversations with other players in the space suggest that long term EBITDA margins should be less than 20% although quite range of possible LT margins was suggested

So, why is Power Fuels making 43% EBITDA margins and is this sustainable?  Basically, the Bakken is such a hot play that operators have scrambled to establish operations.  Service providers have been able to name their price as operators have been largely insensitive to cost.  This happened in other plays when they were in high growth mode (Haynesville, Eagleford, etc.)  But, eventually service rates and service margins came back to more normalized levels.  There are data points to suggest that such a reversion is starting to happen in the Bakken as activity moderates:

• A number of companies have cut back their Bakken activities (Marathon, Occidental, others)
• Drilling rig activity has been slowing – ND rig count peaked at 218 in May of 2012 – it is 186 today (see recent reports by North Dakota Industrial Commission – Department of Mineral Resources, Oil, and Gas)
• A CEO of a Bakken based transportation company had recently said the following, “What happened the past four to five years, there was a boom because the goal was to get the wells drilled.  Last year (companies) were over budget and now they are paring back to get costs under control.  It’s a normal phase of developing a play; there’s a land grab, a drilling boom and then a slowdown to get cost efficient” (usoilproperties.com; Jim Arthaud – Owner of MBI Services.   Provides water hauling and other transportation services in the Bakken)

We think the above quote summarizes the state of affairs perfectly in the Bakken.  The moderation of activity and focus on cost will push the Power Fuels division from trailing EBITDA margins of 43% to more normalized margins of something closer to 20% (or lower).   Below we provide our pro-forma for the acquisition based on two scenarios: 

TTM Pro-forma

Heckman = $336mm of Revs; $67mm of EBITDA = 20% margins

Power Fuels = $363mm of Revs; $155mm of EBITDA = 43% margins

Combined = $700mm of Revs; $222mm of EBITDA = 32% margins

Leverage:  Total Debt of $540mm = 2.4x Debt to EBITDA

Valuation:  EV of $1,565mm = EV to EBITDA of 7.1x

Pro-forma Based on Normalized Margins for Power Fuels

• Heckman = $336mm of Revs; $67mm of EBITDA = 20% margins
• Power Fuels = $363mm of Revs; $73mm of EBITDA = 20% margins
• Combined = $700mm of Revs; $140mm of EBITDA = 20% margins
• Leverage:  Total Debt of $540mm = 3.9x Debt to EBITDA
• Valuation:  EV of $1,565 = EV to EBITDA of 11.3x

Based on the above back-of-the-envelope analysis it pretty obvious that as Power Fuels margins converge to industry / LT averages (and we think we’re being generous with 20%) Heckmann begins to look rather levered and expensive.

In addition, we think there are mounting pressures on Heckmann’s core water handling business.  A Texas based competitor (FES) had a very poor 2Q and cited increased competition and very aggressive pricing in the Texas market.  In addition, recently commentary from Key (KEG) related to their Fluids business (in TX and elsewhere) has been very negative.  Rates are bad enough in gassy basins (read Haynesville where HEK has large operations) that trucks are moving to other basins in search for work.  This is indicative of a very competitive price environment and declining margins in the core HEK market.  Don’t take our word for it.  HEK’s 2Q 10Q shows their water business in margin decline

• In 2011 2Q they did $5mm of EBIT on $39mm of revs = 12.7% segment operating margin
• In 2012 2Q they did -$2.5mm of EBIT on $58.7mm of revs = -4.3% segment operating margin

Yes, in typical boom/bust industry fashion they added assets into at (and just after) the peak of the market.  We think we’ll see a continuation of this trend in 3Q numbers as everything we’ve heard suggests that the water business in TX remains very difficult.

In fact, we think that some TX assets (water trucks) will head north in in hopes of finding work with better margins.  Yes, some will land in North Dakota and margins will decline there as well.  This is just our opinion but it worth noting that in terms of physical assets, water trucks by definition are easy to relocate to other basins.

What is the right multiple and valuation for HEK shares? 

Well – on a pro-forma TTM a basis (which we hope we’ve demonstrated likely way overstates the earnings power of these assets) – HEK is trading at just over 7.0x EBITDA.  Some analysts comp HEK against environmental services business – maybe this was fair when 1/3 of the business was oil recycling.  They would throw around comps like Clean Harbors at 8x EBITDA and 18x earnings).  However, now that HEK is over 80% water handling for land drillers – we think it will get compared primarily to oilfield services businesses and accorded a similar multiple – more in the 4x to 6x EBITDA range

• Basic and Key are 4x forward EBITDA
• Forbes (50% of their business is water handling) is 3.8x forward (but we expect estimates to come down so real multiple is higher)
• Pioneer is 3.5x forward EBITDA (again we expect numbers may come down)

For purposes of valuation, let’s assume that we’ll see mild weakness in EBITDA next year.  But, let’s not be so draconian to assume that Bakken margins come down too quickly (therefor we’ll not value this on a reasonable downside case of $150mm of EBITDA).  Rather, we’ll throw out a number of $200mm in 2013 pro-forma EBITDA – roughly a 10% decline from the 2Q TTM pro-forma (we know things have gotten worse since then).  If we take a 5x EBTIDA multiple we arrive at an EV of $1.0bn.  Take away $540mm of net debt and we have $460mm of Equity Value.  The new share count will be roughly 246mm so the implied equity value per share is under $2.00 – more than a 50% decline from current levels.

An investor might take exception with our choice of multiple at 5.0x EBITDA – we actually think it is pretty generous given that that is a capital intensive, mediocre return, highly competitive, low barrier business.  There are much better oilfield services businesses to own at lower multiples than this.  Even if you think that a higher multiple is warranted – we think with declining EBITDA you’d have to give it a 8x to 10X EBTIDA multiple to arrive at $4.20 per share

What are the risks to the short thesis?

• First, management may be able to gloss over declining industry conditions in the 3Q call.  Instead they may focus on their excitement for the Power Fuels acquisition and the newly combined company – investors may be distracted by this
• Second, it may take a while for the margin decline in the Bakken to become obvious.  We think the cracks are already appearing in the armor – but whether we’ll see them in the 3Q numbers and whether management will concede to declining margins is another question
• Finally, the meaningful leverage in this situation can surely amplify stock movements in either direction.  In a strong market rally or an energy rally – this stock could bounce quickly.  Short positions should be sized accordingly

One more thought:  The merger has not closed and there is an outside chance it could fall apart.  Especially if there is pronounced operating weakness on either side of the deal.  But, we suspect both sides need/want this deal pretty badly.  For HEK – it allows them to merge a currently high margin business into their weaker business.  For the Power Fuels owner – he takes $125mm off the table, gets his $150mm in debt assumed, owns a large percentage of the combined entity, diversifies his holdings, and becomes CEO of the combined company.  For the above reasons – we think the deal survives.  However, if it does not, we’d expect HEK shares to decline dramatically. 

Catalysts

• Decline in Power Fuels margins from cyclical peak
• Further declines in core HEK water business which began in 2Q
• Optics of increased leverage in light of lower EBITDA
• Investor re-rating of the company from what it wants to be (Environmental Services) to what it actually is (Oilfield Services)

Catalyst