While some continue to fret over debt issues at Nuverra Environmental (NES), the company recently announced an update to an important credit facility to provide it more time to turn around operations before encountering liquidity issues. The move shouldn't be a huge surprise to investors, as creditors normally want to work with companies to provide ample time to improve numbers to acceptable levels. Not to mention, our previous article highlighted how positive operating cash flows would make it a slam-dunk for the modified covenants, if needed.
The company is dedicated to the protection and enhancement of environmental solutions for the removal and disposal of restricted fluids primarily from shale drilling. It has scattered operations in most of the shale areas with a focus on the Bakken shale from the Power Fuels merger last year. Several catalysts for improving operations include the shift away from contract workers in the Marcellus shale and new management to guide the Eagle Ford segment that struggled during Q213.
The shorts are right that the company is walking a fine line regarding debt leverage ratios, but the company appears set to finally exceed estimates as the industry stabilizes.
Updated Credit Facility Leverage Ratios
The amendment to its existing $325 million credit facility basically increases the allowable debt leverage ratio for the next year on a sliding scale of stricter requirements. As the table below shows, the company will be back on the original schedule starting on September 30, 2014:
Table - Debt Leverage Ratio
Probably the most shocking part of the news was the statement by the CEO that the credit agreement provides amble liquidity to evaluate potential acquisitions as they become available. Probably surprising to most that for some reason thought Nuverra might be headed to bankruptcy, it surprisingly flipped the switch towards returning to growth. The company though doesn't appear to be in a great situation to make more deals from an equity standpoint. Any deal would be too dilutive with stock and adding more debt isn't going to be seen in a positive light by investors. The only real solution is to show investors that the new Nuverra can operate based on the business line that already exists.
What Do These Ratios Mean?
The company needs to generate enough EBITDA on a trailing twelve months basis to cover the outstanding debt of $541 million with the reported numbers. Based on the numbers, the Sept. 30 goal would be $114 million. A level very easily achieved, but the key will be when next year comes around. As the leverage ratio hits 4.0x next June, the company will need to generate roughly $135 million in TTM EBITDA. The interesting part of that level is that the company only forecast an updated target of $135 million on the low end for this year. Nuverra will need to exceed the low end estimates this year or exceed next year's 1H numbers in order to not run afloat of the more restrictive covenants next year.
The updated target for the 2H of 2013 appears very conservative considering the issues in the Bakken region during the 1H of 2013. One concept that the shorts need to understand is the psychology of a management team. After being burned quarter after quarter based on a weak market, the team tends to finally under promise. How many times do you have to be hit in the head to realize you might need to change your tune? Most investors make the common mistake that once a company misses a few times that it will always miss.
Worth nothing, the original article highlighted how the whole industry underwent wholesale reductions in earnings estimates from Sept. 2012 through Sept. 2013. In essence, the data shows that Nuverra isn't any worse at forecasting than the industry as a whole.
Ultimately the future of Nuverra depends on the ability to operate efficiency in the major shales. All of the top four had operating issues during Q213 whether controlled by the company or not. Either way, Nuverra must perform exceptionally in the 2H in order to put the leverage fears to bed. The Bakken has seen improved weather during Q3 and the Marcellus and Eagle Ford situations are completely under the control of Nuverra management. See the below slide for more details on the operational issues during Q2:
Note that while the Bakken saw lower than expected revenues, the company still generated gross margins in excess of 30% in that area. In total, gross margins only amounted to 16% on average company wide. The issue with the whole Heckmann division was the inability to generate decent margins from a far-flung business operating in a large amount of shales. Improving margins of existing business will be paramount to improving profits. The below chart compares the gross margins from the group of smaller energy service firms presented in the previous article - Basic Energy Services (BAS), C&J Energy Services (CJES), Key Energy Services (KEG), and Superior Energy Services (SPN):
NES Gross Profit Margin Quarterly data by YCharts
Some discrepancy exists in how these different companies present the cost of goods component in the gross margin. As an example, Superior Energy breaks out depreciation costs into a separate line so it isn't include in cost of goods sold. Removing the $155 million cost in the last quarter would've pushed the gross margin down to 25%. Conversely, if Nuverra excluded the $22 million depreciation charge from cost of goods sold, it would've generated a gross profit margin of 27%.
Over the last few months, the stock action has been mostly negative for the group, but Nuverra made an extreme turn south when the original report regarding liquidity fears serviced. As the chart below shows, it has vastly underperformed the group over the last 45 days:
NES data by YCharts
While the modified covenants provide Nuverra with a little extra time to prove the business model, the company is closer to achieving operating profits than most expect. Once the market realizes that Nuverra is nowhere close to defaulting on its loan covenants, the stock should turn around and could quickly match the 8% gain of Key Energy in the last 3 months. The company is a lot closer to success than a loan default at this point, but it will need to prove it in Q3 by exceeding the reduced operating targets