Is Select Energy Undervalued?

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About: Select Energy Services (WTTR)
by: Kenrun Investments

Summary

Adding post frac water services for the E&P industry means more opportunities to attract top-tier accounts.

Accretive mergers created economies of scale.

Select's proprietary AquaView and AquaLogic and chemical manufacturing at their Midland plant gives Select a strong competitive edge.

Revenue, margin and cash flow continue to grow.

By all metrics, Select is selling at a bargain.

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Until recently Select Energy Services (WTTR) maintained that they are a pre frac service provider to the E&P industry and will remain that way for the foreseeable future. But as of the last conference call it seems the foreseeable future has come and gone and the unforeseeable future has arrived. Cradle to grave water services that covers both pre and post frac has become an important and valued service to E&P and Select plans to include it in their bag of tricks.

As Holli Ladhani, Select's President and CEO put it when addressing the large amounts of produced water in the Permian during her Q2 '18 conference call on August 10:

It's clearly going to be a big market. ... it allows us to leverage our full suite of services including the treatment and recycling of water. And I think we're somewhat uniquely positioned when you start to think about the cradle to grave solution to be able to do that.

According to CEO Ladhani in Select's Q2 '18 conference call, the water reuse in the Permian is probably still 20% or less, but growing to 50% in a few years is very possible. "That's where the industry is headed," says Ladhani, "because that's where the economics are driving the decisions."

The whole is greater than its parts and other competitive advantages

Their latest merger with Rockwater not only further strengthens their lead in water solutions in all service lines across all geographies but is accretive and expected to top $20 million in cost savings for 2018. It has also made Select the market leader in automated water logistics and water monitoring technologies in nearly every major basin.

Their proprietary AquaView and AquaLogic suite of monitoring and automation technology provide a safer and more efficient solution for their customers, while also providing improved margins through decreased labor cost.

Their automated and remote-controlled water transfer pumps, manifold, proportioning systems and telemetry meter trailers respond to changing conditions in real time, including shutting valves and powering down in the event of a failure. Additionally, these technologies allow for the continued improvement and expansion of their ability to capture real-time data across the supply chain - a very valuable resource for both Select and their customers.

With the start of their friction reducer manufacturing at their Midland plant last quarter Select anticipates continued margin improvements across the rest of the year, largely from lower freight costs for their friction reducer product line, as well as a shift in product mix.

Increasing revenue, margins and cash flow

With the majority of their integration activities and focus on efficiencies and margin enhancement completed, Select is beginning to reap the benefits. Revenues of $393 million for the second quarter of 2018 are up 4% sequentially from the first quarter.

Adjusted EBITDA was $68.2 million, up 14% from the first quarter and net income for the second quarter was $25 million, up 55% from $16.1 million in the first quarter. Their water solutions segment generated gross profit before depreciation and amortization of $70.1 million compared to $63.5 million in the first quarter is an increase of 10%.

Gross margin improved by a full percentage point to 25.6% with strengths concentrated in their water transfer, sourcing and flowback and well testing business lines. Select anticipates achieving further margin increases in the second half of the year through continued operational efficiencies, as well as from other margin enhancing capex, which includes rental replacement and automation.

Gross margins in chemicals are expected to increase from 9.7% currently to the low to mid-teens percentage range in the second half of the year due to the reduction of freight costs from the recent opening of their Midland friction reducer in-basin production line and a couple of large new contract awards starting in Q3. Their wellsite services segment generated gross profit before depreciation and amortization of $10.8 million compared to $8.8 million, a 22.7% increase in the first quarter. They anticipate moderate improvement driven by increased utilization in their accommodations and cranes businesses along with the closure of underperforming yards in Canada.

Their free cash flow fully covers their net capex. Significant uses of cash during the quarter included net capex of $28.1 million and working capital growth of $31.1 million. While their accounts receivable and inventory balances support the borrowing base for a low-cost debt facility, Select expects to make meaningful progress on their cash conversion cycle in the back half that will finish the year with a lower working capital balance than they had at the end of the second quarter.

Risks

There are a lot of players and new players entering the post frac market and margins there are thinner. If Select slips in cost estimates within that market, it could stunt or temporarily reverse their margin growth. Permian take away issues continue to hamper growth and WTI below $50/bbl could push down revenue and margins.

Conclusion

With CBOE's measure of volatility of crude oil futures continuing to rise, and the Baker Hughes rig count that increased 5% sequentially while new wells grew by 8% during the second quarter and my belief that the Permian will be producing oil for decades to come, Select is in an excellent position to take advantage of their ongoing economies of scale to become the top expert and trusted player in the water, chemical and logistical needs of both pre and post fracking that will enable them to attract and partner with top-tier customers on the leading edge of increasing completions in this rapidly evolving, unconventional landscape.

With a forward P/E of 10.6, P/S of 1.23, P/B of 1.7 and a current ratio of 2.4 the price is right. Q2 '18 net margin over Q1 '18 net margin increased 160% to 6.5% ($.24/share). If revenue growth matches rig count of 5% per quarter and assuming a matching 20% jump in their revenue over the next 12 months without factoring in anticipated margin increases for the rest of the year, a P/E of 15 would move Select to $18.00 a share. If Select should acquire one or two new key accounts throughout the year as well as obtain further margin improvements, $20.00 is not out of the question.

Disclosure: I am/we are long WTTR.

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.