Description

KGS is a midstream oil field services business with a fantastic risk-reward with near term >1.5x-2.0x potential over next 6-12 months trading at ~6x NTM EBITDA relative to peers at 8-9x EBITDA due to the recent IPO discount and technical reason behind IPO. 

Owned by EQT since 2018, KGS went public on NYSE in June 29, 2023 at a wide discount due to a volatile environment coming out of a regional banking crisis, start of Fed’s ‘higher for longer’ narrative, and Wagner’s mutiny. 

Why is this a good investment? (a) Quality company traits (b) downside protection from valuation given a weak IPO and low leverage levels (c) and near term catalytic upside from valuation re-rate from declaration of dividends. 

Company and Industry: 

KGS provides necessary compression equipment for the extraction of oil (by increasing well pressures) by oil and gas producers, and transportation of natural gas (via increased pipeline pressures) by mid stream companies with a focus on and the most attractive and lowest break-even price basins and large horsepower (“HP”) equipment. 

What is compression? 

A relatively niche industry within midstream, compression is used in natural gas production and transport.

Pipelines provide the roadway for natural gas, but compressors are what drive the gas through the pipeline. 

There are two main reasons why compression is essential in natural gas transportation: 

1. Production / “gas lift”: Compression helps wells produce by boosting the pressure of natural gas from the gas well into a gathering system (which consolidates the gas) . If the pressure of the well is lower than the pressure of the take-away pipeline a compressor is needed to support producing hydrocarbons. Gas naturally flows from higher to lower pressure
2. Transport: compressors also help to add pressure to the transport system to move natural gas primarily to support natural gas gathering by boosting pressure on pipelines to maintain flow rates; Compressor stations are built in intervals along the pipeline route to keep the gas moving toward its ultimate destination

Used to increase reservoir pressure so liquids are extracted more efficiently over the life of the well and to step up pressure to transport natural gas

Why is this mission critical and a high quality sector? 

• Compression is an essential function for oil and gas customers to generate cash flow even in a low-oil price environment
• Constitutes only 5% of overall oil and gas production costs
• Limited oil and gas price exposure - examining the ‘14-’16 and Covid oil price decline effects on revenue, utilization and margins revealed very little impact on USAC and AROC - these were basically flat 
• Stickiness: focus on large-scale equipment means that the costs of removing the units would basically require 20-50% discount to existing rates for payback (they need to pay for transport of the large compressors, shutdown and restart costs, lube oil change, reconfiguration of pipelines 
• Contract terms tend to be ~3 years, and weighted avg. remaining life is 3 years. While 10% contracts are month-to-month currently and. 3 years is great because it gives them room to negotiate pricing increases above typical cost pass through and inflation escalators 

Large compressors that Kodiak uses look like these - which is not easy to remove 

Removal will entail configuring the pipes which are difficult 

Long-term natural gas fundamentals 

• Post Ukraine War, Europe is purchasing more gas from U.S.; more than doubled in 2022 to 2.7tn cubic feet 
  • An example is Centrica buying 1m tonnes a year of LNG, implication: LNG being more important than ever despite the green energy revolution
• KGS has >80% asset footprint in Permian and Eagle Ford. Why is this important?
  • Permian has the lowest cost basins in the country 
  • Volumes in the Permian have remained resilient in the face of weak natural gas prices
  • Customers have strong relative underlying production growth and making it more resilient to quarter-to-quarter swings in natural gas price volatility
  • Permian Gas to Oil ratio has been around 4x, and nat gas likely to grow 6% vs 5% crude oil 
  • Permian should capture some portion of the new LNG capacity coming online in 2025 
• ~5.1 mmHP of new compression demand over the next four years - equivalent to ~1.5x KGS’s entire existing fleet. This number is based on AROC’s HP market data and EIA reported U.S. dry nat gas production 
  • ~500kHP of compression capacity needed for every incremental 1 bcf/d of natural gas volumes; this is based on 1Q23 levels and is largely in-line with data we have for 1Q21 (~450 kHP/bcf) and 1Q18 (~422 kHP/bcf).
  • we estimate an incremental 12.2 bcf/d of LNG export capacity comes online by YE27, and if we assume these facilities run at a 90% operating rate, we arrive at an incremental ~11 bcf/d of gas flow and ~5.1 million HP to support the US natural gas market and thus these new LNG facilities.
    
    

So why is Kodiak a high quality company? 

• No volume risk: Compression is priced on run-time (a fee-for-service basis) vs. other midstream companies that generally have volume risk 
• No gas price risk: USAC for example had maximum of 5% revenue change during downturns, during the 2020 energy price pullback, KGS only had a ~2% dip in utilization, or ~97% quarterly nadir from 99-100% prior and quickly recovering in the following quarter (vs. peers drop of ~10% utilization, and took longer to recover) 
• Pricing power: higher asset utilization due to its unique service model, which has provided better pricing over the past several quarters. The three public contract gas compression providers (KGS, AROC, USAC) are currently operating at average utilization rates comfortably above 90%. There is minimal spare capacity in the field, and lead times on new compression horsepower is a year or longer. This is providing ample pricing power to the contract compression providers, and we expect expanding margins through the next year
• Better customer relationships via longer contract tenors: KGS has just ~10% of revenues on month-to-month contracts currently vs. USAC at ~20% and AROC at ~40%, lower cash flow volatility and 
• Capex: compression systems have very little exposure to drilling, as it is only in operation once the well is producing, and are not used in the development of or drilling of new wells
• Success-based capex: 100% compression units either contracted or with a firm order in place
• Leveraged to large HP compressions, which have longer term contracts. Kodiak has rarely lost any customers and derives its unit stickiness through focus on large HP units which have high switching costs and are typically used as part of centralized systems that have limited exposure to single wells
• Asset base: Fleet age of 3-4 years vs. peers at 10-11 years
• Contract length: 90% on long-term contract vs peers at 40-70%
• CF stability: substantially all of its revenues through recurring fixed monthly fees, annual inflation escalators and no volume-dependent component
• Customer stability: 84% of initially contracted large horsepower for our top four customers is still in service with those customers toda
  
  

Valuation expectations

• Compression peers at 8-9x EBITDA: two main peers are USA Compression (USAC) and Archrock (AROC), both in the $1.5-2b market cap range. 
  • USAC has higher leverage, but also generates slightly higher margins and trades at a better multiple
  • AROC trades at a discount with a higher proportion of short-term contracts and modestly lower margins, despite a similar basin exposure and lower leverage.
  • KGS is demonstrably better: 
    • a lower EBITDA multiple (~7.7x vs. 8x 2023x, 6.6x vs. 7.5x on 2024x); 
    • much higher FCF yield (9% vs. 3% on 2024); 
    • an in-line current dividend yield (~9% ); 
    • in-line EBITDA margins (~55% vs. ~52% on 2024) and in-line EBITDA growth (both ~7% on 2024); 
    • and in-line leverage (~3.8x vs. 3.9x) 
    • utilization consistently at >99% utilization vs. ~80% for USAC and ~90% for AROC
    • youngest fleet age of 3-4 years vs. peers at 10-11 years
    • lowest -month-to-month contracts of 11%, vs. USAC at 23% and AROC at 40%
    • largest (84%) exposure to Permian and Eagle Ford, the best positioned U.S. basins for growth
  • Overall, we expect KGS to trade at a  premium to AROC over time given its stronger asset base, though it could be challenging for the stock to reach USAC’s current multiple given the latter’s support from a high current dividend yield (~11%). 
  • These peers have seen average NTM multiples of ~9.7x (USAC) and ~8.0x (AROC) over the past three years, thus there is upside if the group together can re-rate towards historical levels.
• So why is there a valuations disconnect? Two reasons: 
  • First, the IPO was priced at a wider discount (~50%) than expected for the above mentioned macro reasons 
  • Second, IPO of KGS started trading on June 29, 2023, but the IPO actually only closed on July 3, 2023. As part of the IPO to make the pubco trade better, ~$1B of the Term Loan ($700M net of IPO proceeds) was novated to a parent entity secured by EQT’s shares. It is important to note that the parent entity’s term loan debt is non-recourse to the KGS pubco. However, because of the Q2/Q3 trading/transaction close reason, debt on KGS balance sheet, if you fire up BBG/CapIQ, still shows the $700M TL, which artificially inflates the total debt and TEV by $1B as of 6/30. The lazy investor who does not read the fine print would miss this detail, and miss this valuation disconnect (it still shows TEV/EBTIDA as 10x, 2.5x turns more than it actually is now)
• Furthermore, FWIW, KGS is an extremely well covered name by GS, BofA, JPM, Barclays, and other banks, with price targets well into the $20s. 
  • In fact, if you monitor the timing of IPO, what the KGS IPO has done is to shed light on the attractiveness of the compression industry, and you’d notice that AROC’s valuation went up by 0.5-1x because investors are first buying AROC to express their sanguine views on the compression industry, but would likely rotate to KGS over time as they execute.

Concerns: 

• Long lead times for supply: USAC and AROC reporting 5 quarters of wait for CAT engines 
• Sponsor overhang: EQT still owns ~76% of S/O, although we expect them to be responsible sellers, and KGS remains a strategic asset to their ESG and conversion goals
  
  

Catalyst

• Continued execution against guidance and earnings growth over several quarters
• Increasing investor recognition of the technical valuation disconnect 
• Continued inclusion into more indices (KGS was recently included into 4 Russell indices, and will have more to come e.g. S&P mid cap)