Description
Situation Analysis
KLI Inc. (“KLXI”) recently announced the sale of its Aerospace Services Group (“ASG”) to Boeing for $63 a share in cash. KLXI will then spin its Energy Services Group (“ESG”) to shareholders (“KLXE”). In terms of timing, KLXI is guiding to complete the transaction by the end of the third quarter and intends to file the form 10 for SpinCo by the end of May.
This transaction is somewhat unique (cash and SpinCo consideration) with several interesting attributes: 1) At current levels, shareholders can own the ESG SpinCo for less than 4x EV / 2018 EBITDA versus peers that trade in the 8-11x EV / EBITDA range; 2) KLXI mgmt will go with the SpinCo and have opted to forgo cash compensation in lieu of stock creating aligned incentives with KLXI shareholders; 3) KLXE will have a clean balance sheet with an undrawn credit facility and net cash of $50MM post spin affording management with flexibility create meaningful shareholder value (management has a positive track record of effective capital allocation).
Following the spin, I estimate the value of KLXE to be worth $14-18, approximately 56-100% higher than its current stub price of $9 (with KLXI trading at $72). There are some funky tax considerations and one does have to assume a deal spread to close with ASG, but at current prices there is meaningful upside from here.
Background and Overview of KLXE
For historical investors in KXLI, the Energy Services Group was always the drag that masked the earnings power from the Aerospace Services Group (“ASG”) segment and was part of the typical “good business / bad business” investment thesis. The “bad” business, which really isn’t bad but timing was not favorable when KLX management commenced its a roll up of 7 oil field services providers.
During 2015 after oil prices collapsed, mgmt. rationalized the businesses, made them more efficient, implemented best practices and expanded capabilities across all of their regions by picking off more than 100 technical personnel. KLX essentially acquired business with one or two service offerings and expanded into a single brand, KLX Energy Services that offers a complete suite of services supported by product line experts and as a result has driven asset utilization. At the same time KLXE aggressively solicited new customers across their footprint and grew from 400 Master Service Agreements (MSAs) from January 2016 to over 1,000 at present.
Revenue and earnings of the segment are positively inflecting with 2018E revenues of $500MM (up 55% y/y) and EBITDA of $100MM (up 300% y/y). Management indicated there were numerous parties interested in buying the business, but none were prepared to pay what mgmt. felt was fair given the growth and margin profile of KLXE and concluded they could create superior shareholder value with a spin.
KLXE provides mission critical and highly technical value-added services to E&P companies. The business has been described to me as a locksmith to E&P companies when there are having issues with drilling (KLXE is always available to assist 24/7 but charges a premium for their services). 1,100 non-unionized employees provide more than 100 services, tools and technology applications. Management has been focused on R&D and the company has 7 registered patents and 21 proprietary tools.
Service Breakdown: 1) Completions (47% of revs) includes FRAC stack services, pump down wireline services, down hole completion tools, tubulars, etc. 2) Production (23% of revs) includes hydro-testing, certified pressure control, power swivels, down hole tools, 3) Intervention (30% of revs) includes fishin tools, reverse units, pipe recovery, etc.
Geographic Breakdown: 40% North Dakota and Rockies, 34% Southwest, 26% Northeast and Midcon. National presence across all major lower 48 states shale basins (excl. California).
Valuation and Price Target
Comparable companies trade in the 7-12x EV / fwd EBITDA range. Currently the stub trades at 3.8x 2018 EBITDA. I am using an 8x multiple on KXLE 2018E EBITDA to come up with a price target of $18 for SpinCo, approx. 100% higher from where the stock is trading. Applying a conservative 20% haircut due to uncertainties related to potential taxes, deal closure risk, etc. gets me to a value of ~$14.50 which is still 60% higher than where the stub is currently trading.
Risks
· Successful closure of ASG sale to Boeing
· Tax considerations: Somewhat confusing. KXLI shareholders receiving $63 in cash would pay taxes based on that amount and their cost basis. A portion of the value received from KLXI would be considered dividend income and the remainder would be the tax basis. Management is working through this (they have a solid track record avoiding paying tax in the past), so this might take a dollar or two off overall value, but I think it is well discounted with the stock at current levels
· Potential volatility around the spin – it is possible that many investors will sell the spin post-closing. Obviously, this also creates an attractive buying opportunity
· Oil price volatility: these businesses are levered to oil prices and the equities trade accordingly. More bearish investors might ascribe a lower multiple (FTSI, CJ) to EBITDA (4-5x) but it seems those businesses have lower margin profiles. I generally view energy equities as beta but this situation seems materially mispriced given the quality of the business as well as favorable pricing dynamics currently in the oil markets
· Perception of mgmt: Several investors over the years have expressed dissatisfaction with management considering them self-serving, etc. but the results really do speak for themselves (sale of BE Aerospace to Rockwell Collins and the pending sale of ASG at 15.7x EBITDA). These guys are money makers and I think aligning with them with KLXE is a positive
Catalysts
· Filing of form 10 (end of May)
· Closing of ASG deal to Boeing (Q3)
· Potential sale of KLXE (KLXI may pursue a sale of the business until May 30, 2018)
KLXE Management
· Amin Khoury – Chairman and CEO
o Founded B/E Aerospace in 1987 with his brother ($3MM in sales). Rolled up aircraft cabin equipment sector and sold to COL for $8.6BN last year. Started ASG business in 2001 with same strategy, acquired 8 companies over 15 years and selling business to Boeing for $4.3BN
· Tom McCaffrey – SVP, CFO
o Joined Amin when revenues were only $25 million in 1993 and embarked on its rollup strategy
o President and COO of KLX since 2014
· Gary Roberts – VP and General Manager
o VP and GM of ESG since 2014
o 30 years of experience in oilfield services (6 at Baker Hughes and 16 at Weatherford)
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
· Filing of form 10 (end of May)
· Closing of ASG deal to Boeing (Q3)
· Potential sale of KLXE (KLXI may pursue a sale of the business until May 30, 2018)