The Long Case For Exterran Holdings

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Elevator Pitch:

  • EXH has plans for dropdowns at MLP level to EXLP. They intend to use partnership as primary vehicle for the long-term growth of U.S. contract operations business. With dropdown of all domestic fleet-horsepower (HP) to partnership at 650/hp (7-8x EBITDA), it is expected that distributions to EXH are going to increase due to GP IDR interests held by EXH and additional LP units acquired in the process. Analysis of the post drop down scenario shows that there is significant unappreciated value in the stock and this has not yet been incorporated into valuation.

Company Description:

Exterran Holdings (EXH) offers energy solutions through a range of products and services portfolio with operations worldwide. The Company is engaged in the business of natural gas compression and a provider of operations, maintenance, service and equipment for oil and natural gas production, processing and transportation applications. The Company operates in four business segments:

1. North American Contract Operations segment primarily provides natural gas compression and production and processing services to meet customer requirements utilizing Exterran-owned assets within the United States and Canada. The Company owns a fleet of natural gas compression equipment and crude oil and natural gas production and processing equipment that it utilizes to provide operations services to its customers. Contract operations segment include engineering, procurement and on-site construction of large natural gas compression stations and/or crude oil or natural gas production and processing facilities.

In this segment, EXH has 30% of domestic assets at parent level. Rest of segment is managed through Exterran Partners, L.P (EXLP) - owns 70% of total consolidated domestic contract assets. At present, EXH has (39% LP, 2% GP + IDR) equity interest in EXLP. The partnership results are fully consolidated in EXH. Following table provides detail on total horsepower on consolidated basis and its breakup at segment/entity level.

EXH management has plans to dropdown North American domestic fleet (~ 1042 HP) to EXLP over time and use partnership as a vehicle for domestic operations.

2. International Contract Operations segment provides the same services as its North America contract operations segment and services locations outside the United States and Canada.

3. Aftermarket Services provides a full range of services to support the surface production, compression and processing needs of customers, from parts sales and normal maintenance services to full operation of a customer's owned assets.

4. Fabrication segment provides fabrication, installation and sale of natural gas compression units and fabrication services primarily related to the manufacturing of critical process equipment for refinery and petrochemical facilities. The Company's global customer base consists of companies engaged in all aspects of the oil and natural gas industry, including large integrated oil and natural gas companies, national oil and natural gas companies, independent producers and natural gas processors, gatherers and pipelines. EXH fabricates and sells equipment similar to the equipment that it owns and utilizes to provide contract operations to its customers.

At EXH, compression businesses have high margins (50-60%) with fabrication (10-18%) and after sales (15-22%). Such variability in margins is a function of fleet utilizations and dynamics of industry demand and supply. As energy industry capital spending declined in 2009 coupled with certain management decisions on contract terms, business segments experienced a reduction in demand that continued through 2011. However, fundamentals since then have improved and there is more stability and visibility into utilizations and pricing, given strong capital spending projected in the industry from 2013-17.

Following table breaks up consolidated financials into EXLP and EXH Core. At present, EXLP enjoys cost caps on SG&A and OPEX from parent EXH (to be expired in 2014). Post 2014, it is expected that EXLP is going to bear such costs, once all dropdowns are complete. This will lead to an independent EXLP and less burden on EXH.

Thesis & Catalyst For Exterran Holdings, Inc. :

  • EXLP: EXLP carries out domestic contract operations and business fundamentals here are improving.

Contract operations business is tied primarily to natural gas production and consumption, which are generally less cyclical in nature than exploration activities. Changes in oil and natural gas exploration and production spending normally results in changes in demand; however, contract operations business is typically less impacted by commodity prices than certain other energy service products and services.

Natural gas consumption in the U.S. for the twelve months ended November 30, 2012 increased by approximately 4% over the twelve months ended November 30, 2011. The Energy Information Administration ("EIA") estimates that natural gas consumption in the U.S. will increase by 1.2% in 2013 and by an average of 0.5% per year thereafter until 2035. Natural gas marketed production in the U.S. for the twelve months ended November 30, 2012 increased by approximately 6% compared to the twelve months ended November 30, 2011. The EIA forecasts that total marketed production will grow by 1% in 2013. There is more potential as switch is being made from coal to natural gas.

With increasing demand and recent shale play, there are opportunities to grow contract business by continuing to put idle units back to work and adding new horsepower in key growth areas, providing compression and processing services to producers of natural gas from shale plays and natural gas liquids. Management realizes and has growth capex plans of 250-350m for 2013 to add to horsepower capacity.

At domestic contract businesses, fleet utilization slipped from 87% at the end of 2006 to 77% 2008-9 due to management's lack of focus on maintenance and certain sales contract changes that backfired. Since 2012, utilization is higher and assets at MLP level are better utilized. Further, they have taken price as contract roll over, twice in last 12 months. With increased capital spending projected in the industry, domestic contract business should benefit from better utilization and better price/hp

  • Dropdowns: EXH has plans for dropdowns at MLP level. They intend to use Partnership as primary vehicle for the long-term growth of U.S. contract operations business. Table below provides breakup of horsepower at EXH and EXLP.

EXH's strategy is to offer the remainder of its U.S. contract operations business to EXLP over time. (Approximately 1.0 million available horsepower) The last dropdown for around 250 hp occurred on March 8, 2013.

To date, they have dropped down assets 7 times. While average of these transactions is quite high, for the purpose of analysis, it is assumed that ~ 1m hp (Approximately 90-100m of EBITDA) is going to be dropped down evenly i.e. 0.33m of hp in 2Q13, 4Q13 and 2Q14 at an EV/EBITDA of 7.5x ($650/HP). Financing decisions are not going to impact results much given cost of incremental debt is 6.5-7% and stock is yielding 8% currently.

With dropdown of all domestic HP to partnership at 650/hp (7-8x EBITDA), it is expected that distributions to EXH are going to increase due to GP IDR interests held by EXH and additional LP units acquired in the process.

Analysis of the post drop down scenario shows that there is significant unappreciated value in the stock and this has not yet been incorporated into valuation.

  • Core-EXH:

After complete dropdowns of domestic fleet, EXH is going to be left with International Compression, Fabrication and After sales segments.

International Compression: As with domestic segment, this goes in tandem with global/national demand/supply of natural gas and oil related products. The growing global consumption of natural gas and its byproducts is the predominant force driving the demand for natural gas compression and production and processing equipment. As more natural gas is consumed, the demand for compression and production and processing equipment generally increases.

Fabrication: Fabrication is driven by capital spending in the industry. When energy industry capital spending declined in 2009, fabrication business segment experienced a reduction in demand that continued through 2011. However, there was improvement in market activities in North America in the latter part of 2010 and in 2011. During 2012, fabrication backlog increased by approximately 45% from December 31, 2011. This is expected to continue given recent industry stats and increased drilling activity in the shale plays and areas focused on the production of oil and natural gas liquids in North America. The following chart depicts global capital spending on the rise and hence increasing demand of fabrication services.

Aftermarket Sales: Aftermarket sales are more of a function of fabrication and the activity remain in line with fabrication.

Key to the investment thesis here are:

• Increased distributions from EXLP in post dropdown scenario due to GP stake and related IDRs.

• Improving fundamentals at EXLP domestic compression business due to shale play and better utilization

• Improving fundamentals at core EXH businesses expected esp. at fabrication due to increased capital spending in the industry.

Valuation:

For valuation, we have to break up the company and analyze the value of the core and partnership along with related transactions.

EXLP:

EXLP is an MLP and currently distributing around $2/LP unit. Valuing this at 8% translates into $25 and EXLP is currently trading close to such levels. However, with additional dropdowns from the parent ($90-100m of EBITDA; 1042 hp) at 7.5x of EV/EBITDA or $675/hp being financed at 60-40 split between debt/equity is accretive to distributions. Base case dictates that distribution can go up to $2.64 by 2014E. At 8% yield, this means $33 worth of EXLP unit on its own merit.

With increased EBITDA at EXLP level through dropdowns, distributable cash flow increases and GP gets higher proportion of distributable cash flow through IDRs. So EXH benefits from EXLP in two ways; Increased LP Distributions and increased GP Flow through IDRs.

Valuing LP distributions to EXH at 8% and GP stake at 5% translates into $24/EXH share (2014E) alone justifying current trading price and we are still left with EXH core

.

EXH CORE:

Post dropdowns, EXH core is going to be left with International Compression, Fabrication and after sales.

International compression is a similar business to domestic compression but has usually higher margins. EXH management envisages growth in this segment and plans to add capacity in current horsepower. It should trade at similar multiples like domestic at around 7-8x EV/EBITDA.

At fabrication, EXH fabricates and sells equipment similar to the equipment that it owns and utilizes to provide contract operations to its customers. This business is quite cyclical and went down post 2008 when capital spending in the business decline. The situation is improving since 2011 and business is generating revenue at 2007-8 levels with significant backlogs. Similar businesses trade at 5x of EV/EBITDA due to cyclicallity involved.

After sales provides a full range of services to support the surface production, compression and processing needs of customers, from parts sales and normal maintenance services to full operation of a customer's owned assets. It's a stable business and a peer multiple is between 10-12x EV/EBITDA.

Valuing core at aforementioned multiples leads to core valuation at $23/EXH Share

.

Therefore, in total, EXH is worth $47-48 ($24 through EXLP position and $23 through EXH Core).

On FCF basis, at current price, EXH has implied FCF of 12.3% for 2014. At 9-10% target yield, stock should trade around $34 (2014E)

So with Current Price: $28, there is Upside: $33-48 (SOTP 1-2 year upside) with Downside: $25 making Risk/Reward: $5-20 up to $3 down quite attractive.

Variant View:

Natural gas prices in North America are at low levels, which could decrease demand for our natural gas compression and oil and natural gas production and processing equipment and services.

MLP has to take burden of high maintenance capex post drop down which may cause DCF to decrease in earlier years leading to constant/not growing distributions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.