A company I have been following with rapt attention in recent months is Heckmann Corporation (HEK). The company was founded by Richard Heckmann, who earned a reputation as a great M&A man as he steered U.S. Filter through a series of acquisitions and organic growth opportunities through the 1990s that ultimately resulted in a HUGE return for shareholders when the company was sold. Mr. Heckmann has recently demonstrated his propensity for accomplishing fantastic M&A activities again with HEK's merger with Power Fuels. The combined companies businesses will operate together under HEK's fluid management division with Power Fuels CEO Mark Johnsrud assuming the CEO role at the new combined HEK.
Briefly stated, this division makes money from the transportation of fresh water and salt water by owned or leased trucks or pipelines, gathering fees from water disposal wells, and by renting water storage tanks to those who need them. These services primarily center in the service of those drilling oil and gas wells utilizing the hydraulic fracturing method, a method that uses vast quantities of water for each well drilled. The company is also beginning to take action to recycle and reuse this water for use and reuse in hydraulic fracturing.
In a previous article, I briefly outlined that I believe Heckmann Corporation's merger with Power Fuels really sets the stage for great growth opportunity in the fluid management segment of HEK's business. This deal was recently "overwhelmingly" approved by HEK shareholders and has now officially closed.
I'd like to now review the most recent conference call and investor presentation to refine some previous commentary regarding the benefit of the merger to shareholders, particularly taking a look at where margins may head for the combined company in the coming fiscal year and beyond. This paper will take a look specifically at a few factors that will have an effect on EBITDA margins in the near future. But let us first compare the legacy Heckmann fluid management business and Power Fuels business separately.
For the quarter ended September 30, 2012 Legacy Heckmann Water brought in revenues of $93 million and change and demonstrated a gross profit of $16.4 million, for a gross margin of 17.64%. While the revenue number is up over nearly 100% year over year, the gross margins have contracted from 25% last year to the current sub 18% number. The adjusted EBITDA of the legacy HEK fluids business was $17.3 million, for an EBITDA margin of 18.6%.
This decline in gross margin is due to a variety of factors. First of all, the depression of natural gas prices throughout the past year has created a slowing of drilling activity in dry gas shales such as the Haynesville. Subsequently, the company has spent much of the first portion of this year redeploying disposal trucks from the Haynesville area into new, more active shale plays. This has caused overall fleet utilization to suffer for some time, simultaneously deflating margins. There has also been lower pricing and business mix, partially due to the fact that the Haynesville shale area has been converted to an entirely produced water (water returned to the surface over the entire life of a well) business model, reducing the flow back water exposure (water returned to the surface in the first few weeks of the well's life) which is the higher margin portion of each well drilled, though the produced water flow through established pipelines is a great stable business.
In contrast, take a look at the legacy Power Fuels numbers. They achieved revenues of $96.5 million and EBITDA $36.1 million for an EBITDA margin of 37.4%. It doesn't take a trained eye to see that this EBITDA margin is double that of the legacy HEK business, and no rocket science to understand that if the entire combined business can achieve margins approaching those of the Power Fuels component, profitability would increase substantially. So this begs the question of whether Power Fuels margins are so much better than legacy HEK's simply because they operate in a more active shale? Or can Power Fuels business practices be applied more broadly to the entire combined company to drive margin expansion in the years to come?
Let it be noted that management has targeted normalized margins of "mid 30s" in this business space. I personally believe margins will expand substantially as we move into and throughout fiscal 2013 for HEK for a variety of reasons. Let us take a look at these individually.
1. First: I believe Mr. Johnsrud of Power Fuels has much to teach the legacy HEK component. This should include allowing legacy HEK to move into and help the company expand Power Fuels' higher margin Rental business. I also believe the combined company will learn to optimize trailer configurations for maximum productivity.
2. Second: It appears that natural gas prices may be at a minimum stabilizing, if not actually poising themselves to improve. As companies begin resetting their drilling budgets for the beginning of 2013 we may see more activity in many areas, including dry gas shale areas. This is significant because these areas like the Haynesville already have extensive pipelines in place, meaning there will be little or no cost necessary to be prepared for greater water handling. This translates into increased revenues with almost no marginal cost, which should be a huge EBITDA contributor as these plays become a factor again. In the most recent conference call, HEK management notes that they are beginning to hear that customers are going to start moving some rigs back into these regions, though obviously this is going to be contingent on commodity pricing which I will not venture to predict.
3. Much of the reallocation of assets (namely trucks) into more active areas has been completed. Over the course of time, as dispatchers and truckers alike become more efficient, utilization of these trucking assets should greatly increase, becoming a direct contributor to increased margins going forward. In some of the business areas, trucks are already beginning to run two shifts compared to the original one, essentially doubling the utilization of these assets.
4. Another component of the business strategy going forward is the use of water treatment plants for disposal and recycling/reusing fracking water. Management has stated that these plants will allow the elimination of a lot of unnecessary trucking, which is a lower margin business component. For a better discussion of this concept, let me again refer you to the recent call for a look at what the Appalachian plant is accomplishing. This particular plant is operating at what management describes as "extremely attractive internal rates" with returns in significant excess of their weighted average cost of capital.
5. There are already strong signs for increased activities in the already active Bakken Shale. There are currently 5,000 wells producing in the Bakken, and the company believes that approximately 2,500 new wells will be drilled in 2013 alone based on current rig counts in this Basin. This high level of activity predicted in an area producing already strong margins should bode well for increased revenues and earnings for the combined company.
6. Finally, I would like to discuss commentary by management regarding a so-called inflection point for both businesses. They discuss the idea that the asset network of each company has been built out, which has been very capital intensive. This build out of assets is essentially completed, and they note that capital expenditures should be much lower going forward.
I believe that each of these initiatives and accomplishments should allow the combined company to achieve the much better margin numbers the company has targeted going forward, allowing for earnings increases to outpace revenue growth in the years to come. Additionally, I am of the opinion that these margin increases will occur within the context of rapidly increasing revenues.
Several already known factors exist that will grow revenues in 2013. The first of which occurs in the Eagle Ford Shale where a "big customer" has asked for a 60% increased presence, as a portion of which driver headcount has already been increased 26% in quarter 3. There are 2 permits for new disposal wells which should be accretive in the coming quarters, which will bring the total in the shale up to 7 from the original 3 of not so long ago.
There are additionally 2 new disposal wells in the Utica shale which will be additive to Q4 revenue.
There are new opportunities in the Mississippian Lime shale of Kansas and Oklahoma. 30 trucks have been moved to this area in Q3, with little of these results reflected until Q4. This is also thought to be a prime area for the expansion of Power Fuels' rental model to drive strong margins and return on capital. In fact, there are already the strong beginnings of a rental business with 250 rental assets in Kansas and Oklahoma at the conclusion of the 3rd quarter. It is also worth noting that the movement of the trucking assets to this area did not take any revenues away from established areas.
I would like to close this discussion with a few additional comments regarding the somewhat intangible benefits of this merger. First of all, I believe this merger gives the company a much greater degree of flexibility within their business model, and decreases dependence on high commodity prices in either oil or natural gas individually. With the completion of this merger, 70% of revenues come from oil shales, which eliminates pressures caused by gas business to a large extent. However, should this dynamic swing in the other direction, there are assets in place to take advantage of higher activity in dry gas shales, and assets can fairly rapidly be transitioned to the most appropriate locations with little additional capital expenditures. With the closure of this merger, every one of the top 10 producers in the U.S. are regular customers of the combined Heckmann fluids management division, which should allow the leveraging of each business name into other areas of exploration for large players in the business.
In the opening of this paper I mentioned incredibly briefly the track record of wonderful mergers and acquisitions completed by Richard Heckmann. I believe he will have his eyes open for many more, with the obvious ones in the near term being open to taking an interest in various water treatment plants.
This leads me to my final comment on the pros of this merger. Upon the closing of this merger, debt falls to only 2.6 times EBITDA levels. If margins do indeed improve going forward as I believe, this debt to EBITDA ratio only falls becoming more and more reasonable for a company in such a rapid growth mode. Additionally, the liquidity profile of the combined company is much better than before, with 178.5 million in available liquidity currently thanks to the expansion of debt facilities and the sale of secured notes. This should mean that should an attractive acquisition opportunity present itself, the company will have the bullets necessary to pull the trigger, and Mr. Heckmann has earned the reputation of a savvy add-on man.
In the 3rd quarter of 2012, the combined companies achieved EBITDA of $53.4 million, while only showing a total capital expenditure number of less than half that number at $22.4 million, and cap ex should remain well within EBITDA for a long time to come. This EBITDA number comes on revenue of $189.6 million, for a margin of 28%. With the hypothesized margin expansion and increasing revenue and earnings, and promise by management of maintaining lower cap ex going forward, I think this company has earned a second look as a potential long position candidate in any growth oriented portfolio.
Analysts are currently projecting full fiscal year 2013 revenues of $781.4 million according to Yahoo Finance. If the company can improve the EBITDA margin to 30% via initiatives discussed above, this would yield $234.4 million in EBITDA for the full year 2013. With a current market capitalization for HEK at $613 million, the price-to-EBITDA multiple becomes only about 2.6x, well below the targeted range for acquisitions Mr. Heckmann has maintained with some consistency of 4-5x EBITDA. I think this is a reasonable valuation to initiate a long position, and I additionally think 30% EBITDA margins should look conservative if natural gas prices should indeed recover further (especially considering management themselves are targeting mid 30s margins). I also think the discount to the EBITDA multiple HEK management has negotiated acquisitions for in the past demonstrates the premium HEK investors may receive should HEK be purchased by another large oilfield service company for example. For example, an EBITDA multiple of 4 represents a nearly 54% increase from current levels, or in other words a share price approaching $6. Just a rough way to evaluate a "fair" valuation for now.
Also worth noting is the fact that the company will have approximately $160 million in net operating losses going forward as of the conclusion of Q3 2012. This should greatly reduce the tax bill in the next couple of years. Also, as of November 15, 2012, short interest in the company is above 30% which could prime the shares for a short squeeze with a great surprise quarter. Just fuel for thought.
As always, the take on this company represented above is purely my own musings supplemented by public data and management commentary. I would encourage all investors to perform their own due diligence and come to their own conclusions. I also welcome all comments that would support a balanced decision making process, as I have highlighted a portion of the positive case only.
Additional disclosure: I am long HEK via $3 January calls in addition to my core long share position.