Natural Gas Services Make a Difference in Utilization and Margin (NYSE:NGS)

NGS Engine Footnotes

The Natural Gas Services Group has discussed (New York Stock Exchange: GS) in the past, and you can read the most recent article here, published on July 6, 2023. Over the past year, it has shifted its strategy to maximizing the utilization of the charter fleet, enhancing Operating profit margin. Although it reduced its rental units and horsepower after natural gas prices fell, its focus on crude oil-focused shale operations has paid off. I think it will have more contracts for high-strength units under long-term contracts that will stabilize its cash flows in the medium to long term. As it reviews its underutilized fleet, it estimates that many of these assets can be upgraded to smart systems.

However, investments in new assets caused a drain on cash flow in the first quarter of 2024. Inflationary pressure in labor and lubricants could also keep operating margin under pressure in the short term. However, it is reasonable A healthy balance sheet will ensure that its finances do not get out of balance even if energy prices fluctuate negatively. The stock is reasonably valued compared to its peers. I suggest investors “hold” the stock.

Why do I keep my rating unchanged?

In my previous article published on July 6, 2023, I discussed how NGS has maintained stable compressor units and horsepower despite a challenging industry environment. I also discussed the increasing cost of new natural gas compression equipment. I wrote:

In the first quarter, it accelerated the construction schedule and secured contracts worth between $20 million and $25 million. Its services will be “sold off” by 2023. However, new natural gas compression equipment is becoming more expensive. The sharp decline in natural gas prices is unlikely to lead to any sharp recovery any time soon, although it could show gradual improvements.

Nearly a year after the last article, NGS has shifted its operations to the oil-dominated shale fields and modernized its fleets. This has helped improve the utilization of the charter fleet. It also raised prices in selected categories, which would mitigate the inflationary impact. However, in the first quarter of 2024, natural gas compressors in the charter fleet and pumping capacity decreased. As it created several new units, it depleted working capital, shifting free cash flow to the negative side. Given the fairly reasonable relative valuation, I keep my rating at ‘Hold’.

Crude oil prices and their effects

On its first-quarter earnings call, NGS management seemed upbeat about its outlook, citing primarily the relatively stable crude oil price. Over the past year, the price of crude oil has increased by 10%. Given the current momentum, I expect energy production to rise in the near to medium term. The stability has kept demand for the company’s rental equipment strong because 75% of its active fracking fleet is located in oil-dominated shale basins.

Main strategies

One of NGS’s core strategies is to optimize the existing fleet in use. Utilization of its charter fleet increased from 62% in FY2021 to 66.5% in FY2023. It remained steady at this level in Q1 2024. Therefore, the company finds it beneficial to stabilize utilization in view of maintaining a stable operating margin. It also plans to invest short-term assets. As short-term assets decrease, this will increase the working capital of the company. Through this process, it will look to generate $12 million in cash by FY 2024. In order to also boost margin, the company is raising prices in select categories, which will also mitigate the inflationary impact.

The company has begun the process of reviewing its underutilized fleet. It estimates that 650 of these assets could be upgraded to smart systems, including electric motors or high-pressure gas lift units. This could reduce operational uptime in the coming quarters. It has increased automation for increased interface and more accurate customer services.

In addition, the company will expand its rental fleet. As the energy environment improves with crude oil prices, it can contract for high-horsepower units under long-term contracts. However, it will take a cautious approach in committing to capital expenditure in this regard. Contract terms will improve, and NGS will continue to seek M&A opportunities to enhance its growth trajectory.

Operating margins remain strong

As of March 31, 2024, NGS had 1,245 units leased with power greater than 444,220 horsepower. This means that natural gas compressors in leased fleet units decreased compared to the previous quarter. However, the total HHP was relatively resilient, as a result of the activation of a new high-horsepower unit. Not only did rental unit utilization improve in the first quarter, but gross margin and EBITDA also increased.

My estimates

In light of the recovery, NGS expects adjusted EBITDA growth in the range of 34% – 47% in fiscal 2024. This strong growth could significantly improve the company’s financial position (and valuation), since a significant portion of its revenue Repetitive in nature. Therefore, it will have stable and growing revenues tied to long-term contracts, which will likely put it ahead of some of its competitors.

Over the past 12 quarters, NGS’s EBITDA has risen 32% on average. Its eyes will be keen on maintaining stability, although short-term pressures from inflationary costs will dampen its outlook. So, I think the growth estimates released by management are a little more optimistic than they deserve. I would reasonably consider EBITDA growth of 15% to 25% over the next four quarters.

Challenges and risk factors

U.S. natural gas production rose last year through February 2024. However, the EIA expects natural gas production to decline 2% from the first quarter to the second quarter as a result of lower natural gas prices. In 2025, production is set to rise by 2%, according to the Energy Information Administration. I believe the natural gas market will remain volatile in the near term, with a negative bias, following abundant supply and low prices.

Although the overall drilling environment has been favourable, natural gas production lacks a strong growth story, especially with uncertainty around LNG exports. Likewise, a sudden drop in crude oil prices could have a more serious impact on its performance. Investors should keep in mind that the commodity market tends to slide quickly when it is negatively affected.

In 2022, inflation negatively affected the US economy. Although it was under control after interest rates rose, in 2024, I see the possibility that inflation will hit again. This can raise NGS’s cost structure, including labor costs, parts costs, lubricants and other items used in its operations. The Company, from time to time, passes on higher costs to consumers through higher prices. However, it has also reduced its advantages in the competitive market.

Analysis of first quarter performance

In the earnings press release announced on May 15, the company revealed that its sales increased marginally in the first quarter of 2024 compared to the fourth quarter of 2023. Although rental units were down a lot, higher horsepower packages and pricing improvements kept Production line stability.

The company’s adjusted gross margin expanded 40 basis points (quarter-over-quarter) in the first quarter. As the company deployed relatively new fleets, repair and maintenance costs decreased. However, investors should keep in mind that as volume increases, additional labor and overhead costs will grow. As a result, recent margin expansion momentum may not be sustained, and gross EBITDA margins may come under pressure in the near-term quarters.

Debt and cash flows

In the first quarter of 2024, despite higher revenues, NGS’s cash flow from operations (or CFO) declined sharply (by 69%) compared to last year. The working capital problem is primarily related to the rise in receivables as the company has established several new units. The company is working to resolve these issues and expects to see progress in the second quarter or third quarter of 2024. Capital expenditures also decreased. Therefore, free cash flow (or FCF) remained negative in the first quarter of 2024 but has improved for more than a year.

In 2024, the company estimates capital expenditures will remain at $40 million-$50 million, which would be 16% lower than in fiscal 2023. The company’s liquidity (cash and cash equivalents plus available borrowing from credit facilities) was approximately $46 million US as of March 31, 2024. Its leverage (debt to equity) is lower than its peers (NOA, CCLP, AROC). So lower capex, with stable liquidity, should keep the balance sheet under little pressure in the near term.

Target price and relative valuation

NGS’s current EV/EBITDA multiple (8.6x) is higher than the five-year average (6.4x). So, it seems like it’s overrated compared to its past. If the stock traded at its five-year average, it would provide a 40% decline. The stock price has more than doubled since my last post on July 6, 2023, erasing any potential upside.

Multiple contractions of NGS’ future EV/EBITDA versus current EV/EBITDA are less severe than for peers. Therefore, adjusted EBITDA is expected to rise less sharply than its peers in the next four quarters. This typically results in a lower EV/EBITDA multiple. Its current EV/EBITDA multiple (8.6x) is lower than its peers (NINE, OIS, and PTEN). Therefore, the stock is reasonably valued compared to its peers at this level.

As I discussed earlier in the article, I expect adjusted EBITDA growth of 15% to 20% in the next four quarters. By feeding these values ​​into an EV account and assuming a multiple EV/EBITDA futures contract, the stock could trade between $19.2 and $22.1, implying a slight decline in the near term. However, given my expectations for a recovery in natural gas prices, I also believe investors can expect upside in the medium term.

Analyst evaluation

According to data provided by Seeking Alpha, three sell-side analysts have rated NGS a ‘buy’ (including a ‘strong buy’), while none of them have rated it a ‘hold’ or ‘sell’. The consensus target price is $31, suggesting an upside of 42% at the current price.

What is the position of NGS?

NGS is focused on increasing charter fleet utilization to improve operating margin. It reduced leased fleets in the first quarter compared to the previous quarter as it monetized short-term assets to improve working capital. With a better energy environment, it will contract high-horsepower units under long-term contracts. Given the recurring nature of revenue, the long-term contracts will enhance its overall stability and cash flows in the coming quarters. Therefore, the stock has strongly outperformed the VanEck Vectors Oil Services ETF (OIH) in the past year.

However, continued weakness in natural gas prices has forced NGS to reorganize its operations, resulting in increased working capital requirements. There are also concerns about an inflated cost structure related to labor costs, spare parts costs, lubricants and other items. The company has a low debt level. Given the reasonable relative valuation, my expectations for higher operating profit margin, and its impact on valuation, I think investors will want to “hold” it at this level.