What The Market Is Missing In Heckmann Corporation


An investment in Heckmann Corporation (HEK) ("Heckmann", or "the company") is premised upon an experienced management team's ability to execute upon an enormous opportunity to provide fluid and waste handling services to drillers of unconventional shale gas resources. In the 1990's, this management team turned a very small water filtration company (US Filter) into a colossal success and is confident of doing the same again.

HEK is a relatively new company that is operating in a young industry and the business is expanding quickly, so it is very hard to determine how much the business may be worth a few years from now. However, we have a good sense of the current and potential profitability of the company over the next 12-24 months and therefore can determine what multiple of those profits we are willing to pay for.

Over the past few years, the nation's largest unconventional drillers have primarily used small "Mom & Pop" companies to handle their fluids handling. This, of course, is where the opportunity lies for a roll-up of the industry as these drilling companies would much prefer to have a $1bn company, that has the capacity to indemnify them against potential spillage and provide them with a one-stop solution for all fluid disposal needs. As a result, we believe that Chairman Dick Heckmann will continue to roll-up this fragmented industry in a similar fashion to how he did with US Filter (which Mr. Heckmann acquired when it had revenues of $7mm in 1990 and sold it to Vivendi for $8bn in cash in 1999, after acquiring 260 companies in the process). But we are not paying for that growth prospect at present share price levels. Heckmann counts Shell (NYSE:RDS.A), Exxon Mobil (NYSE:XOM), Hess (NYSE:HES), Chesapeake (NYSE:CHK), Encana (NYSE:ECA), Chevron (NYSE:CVX), Anadarko (NYSE:APC) and Halliburton (NYSE:HAL), among others, as its customers.

Most importantly, we believe that the unconventional shale industry is still in the 1st inning of its duration as an industry. While recent low domestic gas prices have indeed caused a material slowdown in unconventional well fracking (notably in H2/12), we believe that activity has stabilized in many shale plays. Importantly, from a revenue standpoint 70% of HEK's shale business is related to liquids and oil drilling and the current level of $95/bbl WTI makes these wells hugely economical (Continental Resources (NYSE:CLR) recently reported that the company could still earn 20% compounded IRRs in its Bakken wells at $60/bbl oil). As a result, the company is less exposed to dry gas drilling than it was 12 months ago (however, the Haynesville pipeline is still in place and can become meaningfully profitable should gas prices rebound).

We note that HEK's recent purchase of Power Fuels has garnered some bearish attention in an oft-repeated bear thesis that rental revenues (associated with Bakken frac tank rentals) may have deteriorated sharply in the back half of 2012. We do not dispute this, but we believe that the news is old, and is factored into the company's current share price of $3.80. We also are of the opinion that this deterioration troughed in Q4 and has stabilized since. Indeed, HEK's management pro-actively warned that this would occur with the release of the proxy statement associated with the acquisition of Power Fuels.

It should be noted that the combined shareholdings of Chairman Dick Heckmann and CEO Mark Johnsrud aggregate to 50% of the shares outstanding, so the management's incentives are meaningfully aligned with other shareholders. In addition, the significant short interest of over 30% (as a % of the company's free float) infers that there could be significant buying appetite as the management begins to deliver improving results, which we believe should occur from Q2/13 onwards (as drilling activity potentially increases from recent troughs).

We estimate that organic EBITDA growth will average approximately 10%+ between 2012 and 2014, using conservative growth and margin assumptions. The current price implies a P/E of 10x and an FCF yield of 7% predicated upon our estimates for 2014e EPS and FCF per share, respectively. But relying on this would not be doing the management team justice as they have proved themselves to be masters of making accretive acquisitions and therefore we believe that reported EBITDA growth can grow much faster than our Base Case estimate. In addition, should domestic gas prices revert to the area of $4.00/mcf and oil prices remain at current levels, HEK's organic growth could be far in excess of what we have forecast above.

The management team's strategy is to move away from commoditized services in which incremental competition can negatively pressure utilization, pricing and margins and instead focus on becoming a "one-stop" solutions provider to the largest unconventional drillers, most of which are already HEK's customers. By doing this, HEK can provide water, dispose of drilling fluids and also handle solid waste on a nationwide basis to the largest E&P companies in the US.

There is confusion among investors as to which EBITDA multiple range this business should fetch. Some argue for the 4x - 5x that oil services fetch, while others argue for a multiple range more aligned with logistics and waste management service companies, 6x - 7x. We agree with the latter, as it is plainly obvious that the company's business model and margin profile is much closer to an environmental waste handling businesses, but we acknowledge that the company's end market is of course related to the former group. Over time, the evolution of the business model, customer base and contracted nature of customer relationships will, we believe, result in a higher multiple being afforded to the company.

That fact, coupled with a strong organic and acquisition-led EBITDA growth profile could well mean that the shares trade to a level of $7.00 - $8.00 within the next few years. We acknowledge that this investment is not a classic value play, but the upside potential that comes for free at the current valuation is too powerful to ignore.

Disclosure: I am long HEK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.