Description

Summary: I believe KLXE’s equity price does not reflect the true option value inherent in the equity. KLXE is operationally levered to an oilfield services recovery, and financially levered due to a mis-timed acquisition by legacy KLXE management. I think the combination of these two dynamics creates extreme optionality. Illustratively, assuming 4x 2023 EBITDA of $150M, the stock could trade to $35.

Balance Sheet Improvement

With $60M of market cap, $275M of net debt and 2021 EBITDA that was slightly negative (2021 10K), KLXE looks to be hopelessly insolvent at first glance. Making matters worse is a $30M drawn ABL which matures in September 2023 (Company filings) and causes near-term liquidity concerns without management action. However, with US Onshore Oil Services activity and pricing rapidly improving, KLXE is on the verge of reaching escape velocity from distress. A continued string of sequential quarterly EBITDA improvement would lead to organic de-leveraging, as well as a free cash flow positive 2023. Depending on the pace of recovery, 2023 EBITDA could range from $100M-$200M reducing leverage to a manageable 1.4x-2.8x. 

A potential sequence of events:

1. Profitability Improvement: 2Q 2022 earnings and 3Q 2022 guide, which is set to be disclosed on August 12th should lend more credibility that the rapid recovery in profitability is continuing. As recently as June ’21, , KLXE was still producing negative quarterly EBITDA , and clocked in at -3M for Full year 2021. It is easy to see why the $250M 11.5% 2025 bonds have seemed daunting. Fast forward to today and the Oil Services pricing environment is improving at a rapid clip, with quarterly EBITDA moving from LSD millions to ~$13M in the 2nd quarter guidance. Given the continued recovery in activity, I believe revenue and EBITDA will continue to sequentially improve in both Q3 and Q4 2022, and approach $20M of quarterly EBITDA by 4Q’22. 

2. Addressing the ABL: The ongoing recovery is supportive of an amend and extend on the Sep ‘23 ABL, which would remove any going concern risk in SEC filings. Without getting into all the gory detail, a Going Concern opinion from the auditors (when the ABL goes current and relevant to the 2022 10-K) would result in a cross default to the bonds. I believe the probability of this cross-default is highly unlikely. The most likely outcome is simply an amend and extend, and the facility size could even be lowered if a few banks decide not to participate.

3. Plan B: Should the amend and extend fall through, the company still has $39M of ATM availability; their $50M ATM is only $11M complete after being outstanding for over a year. This fact pattern implies that management has made a bet on the cyclical recovery, intentionally avoiding equity dilution; however, this is a realistic backup option. 

4. Defense to Offense: If profitability improves to this extent, the company could be in a position to play offense in ’23, beginning to address the ’25 notes with free cash flow. 

Why is the credit still priced for distress, with the 11.5s trading at $60/32% yield? 

1. KLXE capital structure consists of $250M face value 11.5% Nov ’25 bonds and a ABL with $70M of capacity that was $30M drawn at 3.31.22 . According to filings, the ABL matures Sep ’23 and thus goes current Sep ‘22 (KLXE 10-K). An audit opinion from Deloitte identifying substantial doubt of Going Concern would lead to a cross-default on the bonds. Without action, it is reasonable to think auditors would issue an opinion noting substantial doubt that the company can meet its obligations in the following twelve months, as their analysis would not contemplate capital markets access to meet the presumed Sep ’23 maturity.

2. This is a relatively small, CCC rated bond that trades infrequently, i.e. Bloomberg shows many days with zero volume.

3. I suspect bondholders are less likely to call the profitability inflection than we are. To use a common quote: “Not until you see the whites of their eyes” 

Profitability Recovery

I believe US onshore production is functionally the swing capacity for the world, and current prices and forward curves are quite favorable for E&P profitability. This call on US production, coupled with Covid-related bottlenecks and under-investment in various service lines is causing extreme tightness in most OFS service lines. Management teams across the sector are using superlatives to describe the speed at which pricing is improving (we would point to comments from companies like HAL, HP, LBRT)  – I would note this commentary is quite uniform from the majors all the way down to single-line Pressure Pumpers.

While the bet only needs a 2018-like mini-cycle to payoff, there is a reasonable argument that this cycle could surpass 2018 – after all, during that year oil peaked in the low $70s before crashing in October back to the $50 range, functionally killing the cycle. (Natural Gas was also below $3 for most of the year). Oil has averaged $54/$64/$69/$72/$94/$105 from 1Q’21 to 2Q’22 and the 24-month Strip sits at $86 (All commodity prices via Bloomberg). These numbers demonstrate that it is extremely profitable for E&Ps to maximize production in this environment, putting aside the incremental geopolitical argument that is now relevant post Russia-Ukraine.

What would a return to 2018 look like for KLXE? Combining the historical P&L for legacy KLXE, Quintana and Motley, the company produced $1.2 billion of revenue and $196M of Adjusted EBITDA. [Of note, we needed to pull each company's filings separately in addition to the merger docs from Motley to build this pro forma, so you won't see this published anywhere; even the recent investor presentation from KLXE is premised on returning to combined company 2019 financials, with no mention of 2018]. Is this a reasonable base upon which to ‘return’?

(-) According to filings pre-KLXE merger, QES previously had 5 frac fleets but now has 2. While aggregate horsepower is not much lower, it is fair to assume that EBITDA generation potential is lower than the previous peak.

(-) The companies had a combined 2900 employees at 2018 peak , and now has south of 2000 employees as disclosed in the most recent 10-K. While the workforce reduction was much more pronounced in Overhead,  I believe lower headcount could  pose a headwind to achieving bull case scenarios. 

(-) Finally, I believe the Coiled Tubing end market is oversupplied, and pricing is still well below peak – according to the recent investor presentation, this segment represented 17% of 1Q’22 revenues and could have a shallow recovery. 

(+++) A MAJOR mitigant to these 3 caveats is that the downturn and forced marriage (of QES and KLXE) during Covid has led to a substantial amount of permanent cost reduction. Based on filings, combined SG&A was $106M in 2018 and is currently clocking in at $60M - $65M per year. 

The point of the above is that there are some puts and takes, but all things considered, I think returning to 2018 profitability is within a reasonable range of outcomes. Another way to conceptualize this is to assume a similar revenue per industry rig count (as 2022E) and sensitize various levels of KLXE revenue and gross margin at different Industry rig counts. I keep SG&A at $65M in all scenarios below plus $1M for R&D. I would also note that I think this is reasonable versus history: KLXE/QES pro forma gross margins were 26%/26%/21% in 2017-2019. I have highlighted a middle range of potential 2023 industry conditions – this compares to current rig count of 746 at July 29, 2022, and GMs which are currently running ~15% in the 2Q. [All charts below use company filings and Bloomberg for industry activity levels]

Figure 1. Rig Count, KLXE Revenue, GM% & EBITDA: 2023 Range of Outcomes

What if the Company has lost substantial market share?

If this were the case, I would expect the relationship between revenue and industry activity level (e.g., Rigs, Frac Spreads) to have changed; this is not the case, and the correlation over time has been incredibly tight (see below). Quite simply, there is very little difference between betting on Rig Counts and Active Frac Spreads going higher, and KLXE revenue (Inference based on data from company filings and activity data from Bloomberg).

 Figure 2. Revenue versus Frac Spreads

Figure 3. Revenue versus Frac Speads (scatter plot)

Figure 4. Revenue versus Rig Count

Valuation

While I do not have a strong view on valuation, I think a relative comparison versus smaller cap peers indicates that a 3x-5x EBITDA multiple range is reasonable. I chose smaller cap companies participating in the Pressure Pumping and Rig segments and analyzed current, 5-yr avg and 10-yr avg EV/NTM EBITDA multiples. The multiples for larger cap, global Oil Services companies are much higher, and excluded from our comp set. 

Figure 5. Smaller Cap Oil Services Peers: EV/EBITDA NTM (Bloomberg)

In our recent conversations with management, they indicated that there is little need to spend on expansion capex after the merger , and hence this is not the case where an EBITDA multiple is meaningless due to high capex/EBITDA. Should maintenance capex continue in the $30-$50M range for several years (versus $25M-$30M in 2022 guidance), I think $100M-$200M of EBITDA would translate to $25M-$100M of free cash flow. Since a meaningful portion of the delta between EBITDA and FCF is the $28M per year in Interest payments on the 2025 bonds, the story would get even more convex in an upside scenario where the bonds are repurchased or refinanced. 

A Note on the Cycle

While I prefer to assess embedded odds and payoffs rather than make point estimates, there are many reasons to believe this could be a robust NA OFS cycle. The under-investment in E&P since the 2014 industry downturn is catching up to the industry. There are hundreds of approaches to visualizing this, but I will share a recent chart from an Exxon Mobile presentation below.  

Just as important as the GLOBAL under-investment is the reality that the US onshore is likely the best positioned geography in the world to address undersupply; when investment decisions are being shortened due to ESG uncertainty, US supply response is the “shortest-cycle”. I believe a US onshore shale project versus an offshore discovery with 5–7 year lead time between discovery and production is a useful framework. This was all true BEFORE Russia-Ukraine but is now exacerbated due to the call on US LNG production. Some estimates (e.g. recent Bernstein LNG Primer) call for a >20% increase in TOTAL US natural gas production to fill out the LNG build. I believe the next wave of LNG projects will likely be supported by long-term contracts with European customers, creating a persistent growth of US natural gas production, which will pull rigs and frac spreads along for the ride. 

Ok, so why does this matter? With an extremely high correlation between industry activity and KLXE revenue, I feel much more comfortable in understanding whether the bet is supported by historical data. The current 24-month WTI Strip (I prefer to use the Strip rather than Spot) has supported a rig count materially higher than current levels. Much like any other industry that moves atoms rather than bits, there have been many bottlenecks holding back the cyclical supply response – Labor, frac sand, OCTG being the most prominent. For this reason, plus some capital discipline from the OIH side, the recovery in rigs and spreads has lagged the recovery in Oil Price. This is likely transitory, but a nice side effect is that pricing has become very tight at much lower levels of activity than the past (witness Pressure pumping EBITDA/Frac Spread or Rig daily rates). 

Figure 6. Historical Relationship between Oil Prices and Baker Hughes Rigcount (2005-2022)

Risks

• Punitive Balance Sheet Management: An aggressive debt for equity swap, a poorly timed equity raise and/or a take-under from a well-capitalized peer are all things I worry about here. However, the presence of Quintana/Corbin Robertson, John Fredriksen via Archer and the fact pattern around the ATM being so slowly utilized all lead me to believe the management team does not intend to dilute the equity

• Oil Services Cycle: Should the Oil services recovery stop in its tracks, KLXE would be living on borrowed time if they have not addressed the ABL. In a worst case, there could be a downward spiral of needing to raise more and more equity to pay off the ABL and avoid a Going Concern opinion. More likely would be a scenario in which the shape of the cycle disappoints, and the equity trades as a low-value option given the burden of the ’25 notes.

** The thesis expressed above contains forward-looking statements and is intended for informational purposes consistent with the nature of this forum; it is not a recommendation to buy, sell, hold or otherwise trade the securities of the referenced issuer.  The authors/their affiliates do not hold a position with the issuer such as employment, directorship or consultancy.  The authors/their affiliates currently ] own a position in the referenced issuer's securities; however, that [position] may change at any time and without notice.

Catalyst

• 2nd quarter earnings August 12th
• Addressing the ABL via amend and extend and/or other capital markets activity
• Continued segequential improvement in Inudstry rig counts, frac spreds and pricing