Description

Description

Source Energy Services (“Source” or “Company”) is a producer, supplier and distributor of high-quality Northern White Frac Sand (“NWS”) primarily in the Western Canadian Sedimentary Basin (“WCSB”). The Company provides an end-to-end solution through its Wisconsin sand mine assets which produce 4.8mmtpa of tier 1 Northern White Sand. Source often refers to itself as a “logistics” or “infrastructure” company, but the reality is that it is a cyclical energy service provider. 

Source’s end-to-end solution is shown below:

Source: May 2024 Corporate Presentation

I think Source Energy Services 10.5% 2025 notes are attractive at current prices (par) and provide a low-risk carry of 10.5%. 

10.5% Senior Secured Notes

In December 2020, Source issued $142mm of senior secured notes. The notes are secured by a fixed and floating charge over all assets of the business and have a second lien on accounts receivable and inventory. Book value of PP&E as at Q1 2024 was $271mm. I believe that the book value understates the asset value as the Company’s 9 terminals are strategically located and could likely be repurposed for other energy production-related purposes (i.e. a midstream company like Gibson Energy would value these assets). As of Q1 2024, inventory and accounts receivable totaled $155mm, well in excess of the $37mm drawn on the asset backed loan (which has a first lien claim on the inventory and accounts receivable).  

From December 2020 to February 2022, Source could either pay a 10.5% cash coupon or PIK the bonds at 12.5%. During this period, the Company elected to PIK the bonds at 12.5%. Since February 2022, the Company has been making cash interest payments on the notes. 

For the first few years of the note’s life, the Company struggled to generate meaningful EBITDA and free cash flow. As previously mentioned, the business is extremely cyclical and is a function of production activity in the WCSB. The bonds traded as low 20 cents on the dollar, but with the recovery in the energy cycle, bonds today now trade at par value. 

Source: Bloomberg

There is a mandatory redemption feature on the bonds based on excess cash flows. As a result, Source had a mandatory redemption of $4.4mm of notes in FY2023. The Company has also been actively repurchasing bonds in the open market, including $2.4mm repurchased in Q1 2024. 

With the recovery in EBITDA, leverage is quite low at 1.6x at the secured level, and 2.3x total. 

Why Are These Notes Still Outstanding?

The 10.5% senior secured notes mature March 15, 2025. Given the maturity is inside of one year, the notes are now classified as a current liability. It is rather unusual for companies to let a bond become a current liability unless they cannot access capital markets (i.e. the refinancing window is closed). The lack of refinancing is especially curious given the ABL facility has a maturity of the earlier of October 14, 2025 or four months prior to the maturity of the secured notes. Consequently, the maturity of the ABL facility currently stands at November 15, 2024 (also making the ABL facility a current liability). 

Bloomberg erroneously implies that Source’s notes do not have an optional redemption feature. However, this is incorrect as the bonds can now be called by the Company at par.

Source: Note Indenture

With credit spreads near cyclical tights, high-yield markets are wide open for most issuers and I believe Source could easily refinance these notes in the high yield market (either C$ or US$). The question becomes: Why are these bonds still outstanding? I believe there are a few potential explanations:

Waiting For Interest Rate Cuts

Canada was the first G-7 nation to cut interest rates this cycle in early June. The Bank of Canada has indicated that further rate cuts are likely in the second half of 2024. Accordingly, Source (and its bankers) may be waiting for these further cuts prior to refinancing to optimize the eventual coupon.

Something Else Is Brewing?

Source Energy Services was previously acquired by TriWest Capital Partners, a Calgary-based private equity firm, in 2013. They IPO’d Source in 2017 in a $175mm offering. To this day, TriWest continues to have board representation at Source and own 10% of shares outstanding (through TriWest Fund IV). This context is important because Source was previously owned by private equity. Now that the cycle is on the upswing and Source is generating meaningful cash flow (more on this below), the Company may be a target for another private equity firm. I find it extremely curious that Source has yet to refinance these notes despite the ABL facility maturing the earlier of October 2025 or four months prior to the bonds (i.e. November 2024). I would assume that BMO, Source’s bankers, would be putting a great deal of pressure on them to refinance the bonds ASAP unless they are working on a corporate transaction for Source (which would make the refinancing unnecessary in its current form). 

BMO is currently forecasting 2024 free cash flow to be $40mm-$50mm, which would equate to a >30% free cash flow yield at current prices. Even if a buyer were to pay a 50% premium versus current prices, Source’s free cash flow yield would be >20%. There is also likely to be some low hanging fruit in terms of cost cutting, such that the numbers pencil out even better for a potential buyer. 

Building Cash To Lower Refinancing Needs

During its Q1 2024 earnings call, Source management stated the following:

Source: Bloomberg Transcript

Management has been fairly consistent in previous earnings calls stating that they would like to put up a few strong quarters of EBITDA and free cash flow generation to a) be able to pay down a larger amount of debt in order to reduce the amount of debt needing to be refinanced (perhaps only need a new $100mm note instead of the current $142mm outstanding); and b) lower headline leverage in order to reduce their cost of debt capital. Given management has been consistent in this messaging, I tend to think this is the likely reason they are being patient on the refinancing. That being said, if I were them, I would be hitting that refinancing window now – especially given they have gone through times when their capital structure was in deep distress. 

Source: May 2024 Corporate Presentation

Conclusion

I think Source Energy Services 10.5% 2025 note are attractive at par value. Where else can you find a well covered, short duration note with a 10.5% carry? In a world where generic U.S. high yield spreads are +300bps, Source notes trading a +600bps spread (vs. Canadas) look very attractive.

BUY Source Energy Services 10.5% 2025 notes. 

Risks

-The energy market and credit markets dramatically turn south over the next few months such that Source has difficulty refinancing the notes.  

Catalyst

-Refinancing of the notes