The Energy Report: Are oil and gas field services in Canada a high growth sector?
Russell Stanley: Energy prices drive oil and gas field construction and infrastructure development in western Canada. Other drivers include the need to build out liquefied natural gas (LNG) facilities and rail facilities.
Jennings Capital targets service companies with market caps in the $50 to $200 million ($50–200M) range. These names tend to have fewer analysts following than do the larger names. We like companies that rent out niche-type equipment at high margins. These firms are typically low headcount businesses with a lot of operating leverage. Oil and gas field demand is so strong that these companies must source equipment externally to extend their fleets and meet commitments.
TER: What defines a service company in this context?
RS: The definition is fairly broad. We cover companies that operate oil and gas field rental equipment, and a broad group of what we call services to the services. These companies may be employed by an exploration and production (E&P) company directly, or by one of the companies that services the E&P.
The service equipment supports oil and gas field infrastructure and construction, which is seasonal. But it can also be used for projects managed by utilities or governments that aren't seasonally dependent. Extending the customer base enhances revenue stability, mitigating the impact of the spring breakup. The challenge right now is that traditional oil field demand is so strong that service companies' fleets are stressed. We call that a Hollywood problem, though.
TER: What happens during spring breakup?
RS: During spring breakup, the ground thaws in the northern parts of Alberta and Saskatchewan. The resulting moisture prompts a lot of road bans. The E&P and service firms are not allowed to move heavy equipment because of road instability. As a consequence, drilling activity slows down, as does demand for related services. The spring quarter of the year is generally the weakest quarter for companies in the energy service space.
TER: Is spring breakup the time when the E&P companies are offline? What about during really cold winter weather?
RS: The E&P companies in the northern parts of the provinces like the colder weather. Ground conditions are ideal in the winter. This past winter was longer and colder than normal, and more conducive to rig activity. Drilling in western Canada was at relatively high levels, which supported the service companies.
TER: Do you advise investing in small, growing energy service firms, or in buying shares in companies in the business of acquiring the small firms?
RS: Investing in smaller companies can offer short-term advantages to investors. The speed of execution of a business plan is a simple metric to understand. And investing in a quality startup that is following its business plan is always a good bet. Of course, many of these firms are privately held.
But on a mid- to long-term basis, we are seeing more and more merger-and-acquisition (M&A) activity for a combination of reasons. The larger, more liquid companies have easier access to capital. Smaller companies can run into challenges raising the money they need to pursue immediate growth opportunities. That provides an opportunity for a larger player to acquire the small firm. We are also seeing an increased level of centralized procurement by the end customer. The E&P companies prefer to make one phone call to a service provider. From the customer's perspective, it is more efficient to deal with a large service company that can offer a fuller suite of products and services.
TER: Are acquirers proving to be good managers after the acquisitions close?
RS: The challenge on a post-acquisition basis is preserving the customer base of the company acquired. Small, private companies have often been in operation for 20–30 years. They often have excellent brand value on a local basis. They have longstanding customer relationships. The acquirer does not want to erode that goodwill. The challenge is to optimize the synergies while maximizing overhead savings and cross-selling opportunities.
"The challenge in M&A is to optimize the synergies while maximizing overhead savings and cross-selling opportunities."
The companies we cover do a good job in that arena, and it is a skill we applaud. A key factor in maintaining a smooth transition in M&A is that all the involved parties understand that the buyer's intent is to continue with current management. We like to see the former owner/operators of acquired private companies incentivized to stay on board with earn-out provisions and blocks of stock in the business.
TER: What oil and gas service firms do you favor in western Canada?
RS: One of the companies that we have launched coverage on is Great Prairie Energy Services Inc. (GPE:TSX.V). We have a $0.75 target on Great Prairie. It is involved in oil field equipment rentals, frack fluid management and equipment hauling. About 60% of the company's revenue is from Saskatchewan, which is an overlooked market relative to Alberta. The CEO of Great Prairie, Sid Dutchak, is the former minister of justice for Saskatchewan. The board of directors is strong. By virtue of its position in Saskatchewan, Great Prairie is competing for customers and potential acquisitions in a less intensely competitive environment than other regions of western Canada. The company came off Q2/14 stronger than we expected. It is trading at about 3.6 times (3.6x) our estimate for next year's earnings before interest, taxes, depreciation and amortization (EBITDA).
TER: How can a service company best increase its margin?
RS: We like private companies that are running flat out. Their fleets are extended. They are renting third-party equipment to support customer demand. They have great customer relationships. When they have trouble renting to meet increasing demand for services, they inject capital to expand the fleet. It is better to buy the equipment necessary to meet demand; renting equipment from a third-party reduces margin.
A good example of a company using these tactics is Enterprise Group Inc. (E:TSX.V). Enterprise is involved in oil field construction and equipment rentals, as well as in serving the local utilities and transportation markets in western Canada. It is currently injecting capital to displace the use of third-party equipment to drive margin improvement.
TER: The charts show that Enterprise enjoyed a four-fold increase in share value during the past year. What do you attribute that to?
RS: We attribute Enterprise's performance to its strong M&A strategy. Enterprise recently announced an LNG acquisition in the Fort St. John area of British Columbia. Its last significant acquisition was Hart Oilfield Rentals in early 2014. It acquired a couple of companies in 2013. The companies Enterprise acquired sold at very attractive prices, usually 3x trailing EBITDA. Most are operating in niche markets, offering a service or a line of equipment that is in high demand. Because Enterprise is a public company, it has excellent access to the capital markets. It can support the growth of the acquired companies on a post-strength action basis.
TER: Are Great Prairie and Enterprise mainly acquirers, or are they targets for acquisition?
RS: They have both been acquiring smaller firms. Once they reach critical mass, they will be attractive candidates to a larger player looking to establish a foothold in western Canada.
TER: What financial metrics do you look at in an M&A candidate?
RS: The most popular target from an acquirer's standpoint is a private company that has grown organically and needs capital support to make it to the next level. Trailing EBITDA is the metric that acquiring companies look at in determining the worth of an acquisition target. Most transactions are getting done between 3x and 4x trailing EBITDA on a normalized basis, excluding exceptions consistent with the operation of a private company. Usually the buyers want a mix of cash and stock, and a provision that ensures the continuity of management.
TER: What other names are you following in this M&A and execution space?
RS: We have just launched coverage of CERF Inc. (CFL:TSX.V). CERF recently completed a combination with Winalta Inc. We have a $5/share target and CERF's stock's is currently trading at about $3.50/share. CERF provides equipment rentals to both the oil field and construction markets in western Canada. The Winalta transaction was a $70M equity and debt deal, which added exposure to the well site accommodation space, which means providing shacks that allow staff to live and work in close proximity to rigs operating in extreme weather conditions. Well site accommodation is a high margin business. CERF's existing rental business was doing gross margins in the neighborhood of 35–40%. The well site accommodation business has gross margins of over 60%. On top of that, CERF is paying a dividend yield of 6.7%. It is a relatively high yielding stock with a very attractive earnings growth profile.
TER: Are private equity investors interested in the energy services M&A game in western Canada?
RS: We are seeing more interest from private equity. Private equity firms are starting to participate in managing public entities acquiring the oil and gas field service companies, but that game is still in the fourth inning.
TER: Do acquiring firms typically wait for market corrections to buy target companies on the cheap?
RS: Acquisitive service companies tend to know which smaller companies they want to buy well in advance, so it is a matter of getting to the right price. The market plays a role, but it is not determinate. Enterprise is closing on an acquisition this month that it has been working on for some time. There are counter examples. Back in the spring, Great Prairie acquired some assets from Calmena Energy Services (CEZ:TSX), which was an opportunistic purchase. Calmena has been divesting assets during the last few years due to balance sheet troubles. Its frack fluid management assets were available to Great Prairie at an opportunistic time, and at a very attractive price.
TER: Thanks for the insights, Russell.
Russell Stanley has recently returned to Jennings Capital, having first joined the Toronto office in August 2007. He has worked in the brokerage industry since 1997, with the last 10 years in equity research. He has previous experience covering companies in industrial, consumer and health products, technology, alternative energy, bulk commodities and mining services. Stanley looks for underfollowed micro- and small-cap companies with strong earnings growth potential and solid management teams. He holds a master's degree in business administration from the Schulich School of Business (York University), and is a CFA charterholder.
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