Natural Gas Services Group: A Misunderstood Energy Play

| About: Natural Gas (NGS)

Natural Gas Services Group (NYSE:NGS), a provider of small to medium horsepower compression equipment and flare systems to the energy sector, is one of the best risk-reward energy stocks available today. Mr. Market does not truly understand the story here and has chucked it in the trash heap with the rest of the natural gas industry. I believe NGS is worth approximately $23.43 per share, a 94% premium to the $12.05 closing price on May 4, 2012.

First, the name "Natural Gas Services Group" is a little misleading. NGS does not only supply the natural gas industry. Over the past few years, the company has become a player in the oil industry as well. By the end of 2012, NGS anticipates 30% of its active rental fleet being used in the production of oil (up from 20% at the end of 2011).

Second, the revenue mix at NGS has changed over the past several years. In 2007, the company generated $41.1 million from the sale of equipment and $30.4 million from its rental business. In 2011, NGS generated $15.4 million from the sale of equipment and $48.6 million from its rental business. Why the mix change? Due to lower natural gas prices, E&P companies are choosing to rent equipment versus purchase. Is this good or bad for NGS? Well, I would argue that it's good. The rental business generates a 57.5% gross profit margin (excluding depreciation) compared to 40.3% for the equipment sales business (excluding depreciation). Also, the predictability of rental revenues (6-24 month contracts) and "hard asset" value of the rental fleet demand a premium valuation.

United Rentals (URI) trades at 15.6x EV/EBITDA while Avis Budget Group (CAR) is currently valued at 11.4x EV/EBITDA, and Dollar Thrifty Automotive Group (DTG) trades at 8.8x EV/EBITDA. The NGS rental business generated $23.5 million of EBITDA (including corporate overhead allocation based on percentage of sales) over the last twelve months. Assuming a 10x EBITDA multiple, the rental business is worth $235 million or $19.11 per share. On a combined basis, the equipment sales business and service maintenance business generated $5.4 of LTM EBITDA (including corporate overhead allocation based on percentage of sales).

If a 7x EBITDA multiple is applied here, these businesses are worth a total of $37.8 million or $3.07 per share. This multiple is in line with the market's current valuation of compressor manufacturer, Gardner Denver (GDI), and significantly less than the market's valuation of Dresser-Rand Group (DRC). According to the 2011 annual report, NGS had $15.4 million of net cash or $1.25 per share on December 31, 2011. Therefore, using a sum of parts analysis (including net cash), NGS is worth $23.43 per share.

Third, NGS manufactures its own rental fleet. Because the value of the rental fleet is accounted for on the company's balance sheet at lower of cost or market, it is significantly understated. Over the last twelve months, the equipment sales business generated a 40.3% gross profit margin. That means COGS was 59.7%. As of December 31, 2011, book value of the rental fleet (net of accumulated depreciation) was $142.5 million. If book value represents Natural Gas Service Group's cost, then replacement value of the same fleet for a customer or non-manufacturer would be approximately $238.7 million (replacement value = $142.5 / 0.597) or $19.41 per share. This means the carrying value of the rental fleet is understated by $96.2 million or approximately $7.82 per share.

Fourth, NGS has very little maintenance capital expenditures. Greater than 95% of the company's annual capital expenditures are growth related. The company continues to self fund its rental fleet expansion into the oil market. Maintenance capital expenditures related to the rental fleet are expensed entirely in cost of goods sold. Therefore, you could make the argument that the company's LTM EBITDA margin of 44.3% is understated. If the company chose to stop growing its rental fleet tomorrow, it would become a cash generating machine. With $28.9 million of LTM EBITDA, the company would generate a free cash flow yield (defined as [(EBITDA - CAPEX) / Enterprise Value]) of roughly 21%.

Fifth, the company's equipment is not used in the drilling of wells. Its compressors are used in a number of applications for the production and enhancement of wells and in gas transportation lines and processing plants. One could argue that new drilling will stop or slow dramatically before existing wells are turned off in any meaningful number. NGS management has consistently mentioned that its business is tied more closely to levels of natural gas moving through the system than to prices.

In a low-price natural gas environment, NGS should continue to perform well because of its rental business. If and when natural gas prices rebound, the company will be poised to benefit through either additional rentals or the strategic sale of underutilized rental equipment (roughly a 74% utilization rate at the end of 2011). The margin of safety found in the company's balance sheet, specifically its rental fleet and net cash position, makes NGS an attractive investment opportunity that is difficult to pass up.

Disclosure: I am long NGS. The accounts I manage also own shares of NGS.

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