Natural Gas Services: Now You're Cooking

Is it better to invest in good management plying its trade in a fair business, or to invest in fair management plying its trade in a good business? Most settle for the latter, some the former, but it's really a false dilemma. There's no reason you can't have both.

Few businesses are as good as energy production these days. Surging world demand — evidenced by $100-a-barrel crude — is well documented. Still, it's a volatile business and battle-tested sagacity (good management, in other words) is a requisite for long-term survival.

Few energy companies have management as good as Natural Gas Services Group, Inc. (AMEX: NGS), a manufacturer, fabricator, seller and leaser of natural gas compressors based in Midland, Texas. Natural Gas focuses on non-conventional natural gas production such as coalbed methane, gas shales and tight gas. Major customers include Dominion Resources, Inc. (NYSE: D), Energen Corporation (NYSE: EGN), XTO Energy Inc. (NYSE: XTO) and Devon Energy Corporation (NYSE: DVN). A testament to Natural Gas’ management is its stock performance against the major indices — while the S&P 500 and Dow Jones Industrial Average have suffered 5% and 6% losses, respectively, the small-cap’s share price has appreciated 12%.

Most of Natural Gas's compressors are leased, with rental contracts providing initial terms of nine to 24 months. As of Sept. 30, 2007, the company had 1,136 natural gas compressors rented to 92 third parties, compared with 909 natural gas compressors rented to 85 third parties a year earlier.

The oil and gas equipment rental business is cyclical. The most critical factor in assessing the industry is the worldwide supply and demand for natural gas and the corresponding changes in commodity prices. On that front, inventory levels in the United States have favored crude oil over natural gas for the past three years. But many experts expect the balance of power to shift as oil becomes increasingly expensive relative to natural gas.

Mother Nature also plays a crucial role in the supply-demand equation. Typically, as winter moves into late spring, prices ease, since most homes heat with natural gas. Of course this seasonality is well-documented, and sophisticated trading schemes have been devised to exploit this seasonality.

But seasonality could play a lesser role in the future: many of the new biofuel plants consume natural gas to produce ethanol. As demand for biofuels increases, so will demand for natural gas. This should naturally increase the demand curve for natural gas and smooth out the seasonality.

Technology will impact industry dynamics as well. Joseph Dancy, an adjunct professor of energy law at Southern Methodist University and fund manager at LSGI Venture Fund, noted in a July's Barron's article that natural gas supply is dwindling as new technologies enable producers to empty wells at increasing rates, from 14% in 1990 to 31% today. Dancy convincingly argues that new technologies mean more natural-gas producers will look to extract gas from unconventional sources (which plays to Natural Gas's wheelhouse) like shale, sands and coalbeds. In fact, they already are; unconventional supply has risen to 56% today from 22% in 1990.

The growing ability to profitably extract more natural gas from unconventional sources is reflected in Natural Gas's recent financial numbers. Net income for the nine months ended Sept. 30, 2007, increased 65% to $8.7 million, compared to net income of $5.3 million for the same period in 2006. EPS increased 53% to $0.72 a share from $0.47 while revenue increased from $46.2 million to $53 million, or 14.7%.

Income and EPS increasing at a faster rate than revenue means one thing — greater efficiency. That's been the case with Natural Gas: overall operating margins increased to 25.6% for the nine months ended Sept. 30, 2007 from 18.8% in the same year-ago period.

Current market forces should continue to play to Natural Gas's strength into the relevant future. Analysts at Morgan Keegan estimate full-year 2007 EPS to post at $0.96 on revenue of $71.4 million, 45.5% and 13.9% increases, respectively, over FY2006's EPS of $0.66 and revenue of $62.7 million. Looking ahead, Morgan expects EPS of $1.13 on revenue of $86.3 million in FY2008. Its 12-month price target is $25 share, a 19% increase from current levels.

Zacks Research also likes what is sees, noting Natural Gas's ability to beat analyst estimates in the past two quarters and ranking it number two in its respective industry classification. Forbes magazine is another fan, rating Natural Gas as the 48th best company on its “America's 200 Best Small Companies” list and identifying it as one of 10 companies on its “Under the Radar” list, defined as “a solid performer with two or fewer analysts on their quarterly call.”

Shares of NGS closed at $18.75 on Thursday. Over the last 52 weeks, shares have ranged between $11.68 and $21.52.

Comments

[Greg Pinelli:]

Some interesting ideas...I think nat gas is tomorrows crude oil.

2008 Jan 20 02:15 PM

[John L.:]

Seasonality is also less of a factor due to the fact that many power plants are using Natural Gas for normal and peak loading. Peak loading occurs during the summer when everyone is running their air conditioners.

Also, the oil sands up in Canada, you know, where the oil reserves equal Saudi Arabia, guess how the oil is removed, they heat up the sand with Natural Gas to separate it out, this will drive up demand for Natural Gas also as the price of oil increases.

2008 Feb 23 08:55 PM