Description

Secure Energy Services Inc: Long Thesis - Mkt Cap: $666M, EV: $1.2B, 6.5x EV/EBITDA, 2.6x net debt/EBITDA, 6x 2020E FCF, 6.4% Dividend Yield, $3.2M ADV

Thesis summary: Secure is trading like a cyclical energy service company despite nearly all its EBITDA now coming from its midstream division. The company has generated positive FCF through the cycle and is trading at 50% of replacement value with a mgmt. team who is incentivized and who has a track record of creating shareholder value.

Overview: SES operates three business lines: Midstream Infrastructure (87% of EBITDA), Technical Solutions (7% of EBITDA), and Environmental Solutions (6% of EBITDA).[1] About 75% of EBITDA is production related or recurring in nature, with the other 25% being driven by drilling and completion activity. Recurring cash flows primarily come from oil production processing and disposal, crude oil logistics, marketing and storage. The company generates a mid-teens ROIC and should be able to grow FCF at a similar clip. Below is a chart that demonstrates SES’ midstream EBITDA growth and stability over a period where activity/crude have collapsed:

This mix has shifted meaningfully since 2014 when recurring revenue was only 40% of the business and 60% was driven by activity.  Nevertheless, the transition has been masked by a sector trounced by crude falling from $80 to $50. SES was not immune as the stock has collapsed from $20’s to $4.50 in 2019. SES has been active even in this operating environment. 17 midstream assets have been added over the last 3 years and the company acquired a  Cushing crude oil storage facility interest.

Management Team: Rene Amirault, CEO and Chairman, is a top tier manager with a history of creating shareholder value. He was instrumental in selling CCS Income Trust, a similar business, to PE in 2007. He owns 4.4M shares and is clearly aligned with shareholders.

Setup/Why does this opportunity exist? Small/Mid cap Canadian stocks have been under pressure over the last few years, with the energy sector taking the brunt of it. SES missed EBITDA estimates in the last quarter (42M vs 50M est.) for the first time in 3 years. Accounting for 2 weeks of delayed activity on weather, number would have been 46M so a roughly 10% miss on the quarter => yet the stock was down 25%. We find it shocking that a company that is seeing EBITDA down –LSD% in a downturn is trading at the same valuation as cyclical peers with 50%+ EBITDA drawdowns:

Value backdrop:  SES seems undervalued for a several reasons:

1. Replacement Value: With $5.60 in NTA, SES is trading at 80c on the dollar from a tangible asset/share basis. True replacement value, even with all the permitting /regulatory/environmental hurdles, would likely require $1.5B ($8/share) to replicate[1].  
2. Precedents: US Ecology bought NRC Group Holdings for 10.5x 2020 EBITDA in June. While not a perfect comp, the significant energy exposure would suggest SES shouldn’t be half that valuation.
3. Comps: Tervita, (TEV:TSX) is  a direct competitor in the market is currently exploring a sale of the business. TEV trades at 7.5x EBITDA and has more cyclical exposure than SES. As an aside, this is the asset the current SES mgmt. sold to PE…

Risk/reward:

We see a favorable 5:1 upside/downside skew with base case returns of 30%+.

• Bear Case: Assume SES loses all its “cyclical EBITDA”, sees multiple contraction on midstream assets of another 1x, and never grows off the annualized weather impacted Q3 2019 numbers (accounting for seasonality), the stock would be worth $3.70 (15% downside).

• Base Case: Assume SES doesn’t grow EBITDA off normalized levels of 176M, sells T + E at the midpoint of the guide[1], and becomes a pure-play midstream asset that trades at the low end of the peer group (8x), stock would be worth $6 (36% upside).

 

• Bull Case: SES gets back to historical mid-teens growth in midstream, sells T+E at the high end of guide (200M) and trades at low end of group on 2020E, stock would be worth $7 (60% upside).

 

 

In a blue sky scneario,  if SES was to trade to  replacement value, historical valuations, M&A valuations, or a normalized drilling environment would imply the stock could double (note: it was there 6 months ago on EBITDA revisions that were only 15% higher than current).

 

Balance Sheet/FCF: After a couple years of elevated growth capex spending with mid-teens return, SES is set to reduce their growth spend from $100M this year to 40M next. This would imply a 30% payout ratio and a positive after growth capex FCF number of 30M which will be used for de levering (falling from 2.9x exiting 2019 to 2.5x in 2020).   

Conclusion:  SES is cheap at 6x CF and has 3 events on the horizon that suggests the company could trade to a narrower discount to midstream peers, offering 30%+ upside potential.

 

Catalyst

Catalysts: SES is definitely cheap on an absolute and comparable basis (trades at the same multiple as FCF negative frackers), but we see three events over the next 12 months that should unlock value: 

1) Divestiture of lower value, cyclical segments: SES has actually seen multiple contraction as the recurring piece has nearly doubled as % of the overall total. Mgmt has been frustrated with the status quo and announced with its release last week that it is looking to divest those lines and “expects any divestitures will be completed by the end of 2020. Aggregate proceeds for these divestures could range from $100 million to $200 million depending on which service lines are divested.[Q3 earnigns release]” Even without multiple expansion on becoming a pure-play midstream asset, the sale should represent 15% + upside at the low end of the range. 

2) Back to growth with higher FCF conversion: Yes, h2 2019 will be the first down period for SES in nearly 4 years. We think this is transitory around unusual weather patterns and missed production weeks during Q3. Normalized levels of activity + a historically conservative 10% return on capital deployed in 2019 suggests SES should grow EBITDA and FCF by high teens in 2020 even in this environment. Growth capital has inflected from 100M this year to 40M next year, implying FCF inclusive of growth capex of 50M and (130M on main. which implies 6x cash flow). Not to call a quarter as an inflecction, but current estimates for Q4 EBITDA of 45M (we beleive it could be closer to 50M) discount the seasonal lift SES historical sees and suggests little if no recovery from the Q3 softness (activty may have been pushed out).

3) Flipping into higher quality assets: Crescent Point Energy has announced that several infrastructure assets in SE SK are on the docket for sale. A couple pipelines in particular would be of strategic/geographic interest to SES (we note that CEO of SES was on the board of CPG and resigned earlier in the year...) Assuming these assets transact in the 4-5x range given the capital requirements (we estimate $75-100M to buy and a similar level to build), SES should be able to solidify its transition to a midstream asset and build in “take or pay” contracts for highly visible low teens EBITDA growth to 2021.