Dover's Spin-Off Apergy Is Fairly Valued Considering Their Increasing Costs And Growth Trajectory

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About: Apergy Corp (APY)
by: Faloh Investment

Summary

Apergy provides services to oil producers, specializing in geological measurement tools, flow optimization software, and larger pieces of hardware.

The company is over-leveraged coming out of Dover so the pressure from debt repayment is dampening growth.

Marketplace factors show at least one major segment of the company's business will slow down by 2019. Overall, I rate APY an Avoid.

Apergy Corp. (APY) formed in 2017 and was spun-off from Dover Corp. (DOV) earlier this year. APY is a service company to oil producers throughout the Permian Basin and the rest of North America. They also do some business overseas.

My view of this stock is an Avoid for the time being for the following reasons, not the least of which is the very short amount of history we have to make our judgement on. Financial statements for APY only go back a handful of years and most of the information is from when APY was still a part of DOV.

The spin-off from DOV's timing was opportune considering 2017's rally in oil prices and an increase in rig counts which followed. APY is a strong collection of respected brands in the oil business. The company has a rounded out portfolio of products to service needs in the oil patch throughout the duration of an oil well's lifespan.

Rounding out the portfolio to service more parts of the well's lifecycle helps get the company away from the shocking ups and downs which take place in companies more dependent on providing the initial major piping and other infrastructure oil wells need when they are being put in place.

Two phases of oil well lifespan are the main revenue drivers for APY: Completion and Low Production. Their measurement tools, software offerings (think CAD for oil well engineers), rods and fittings, and so forth are used during the well's initial design and drilling. This phase of starting a well up for the first time is called the completion phase. So APY makes money on this front end.

The second major phase the company makes revenue through servicing oil producers is the low production phase which takes place four to five years after completion. At this second major phase, the best part of the wells have been used up and producers are effectively scraping the bottom. APY's customers become more price sensitive since they are working with declining and uncertain balances in terms of eking the maximum value out of old wells.

The technology required at the second phase is different from the first, and the conversion to the oil well which can effectively scrape the bottom of the barrel is supported by special offerings from APY.

If you do the math, you can see the company is benefiting from servicing the conversion to low production taking place in the multitude of oil wells drilled during 2013 and 2014. Therefore, we can forecast a slowdown in this segment of the business by 2019-2020 as the 2014 wells are converted and it becomes time for the relatively meager number of 2015 and 2016 wells to go into low production.

By the way, just to head off any nitpickers, I am referring to the second phase as Low Production in this article. I don't know the industry's term for it.

APY Came Out Of Dover With Too Much Leverage

Financially, APY is in a typical position of many middling public companies in America. Their leverage coming out of the spin-off is higher than I'd like to see, and management is in agreement. APY CEO Sivasankaran "Soma" Somasundaram and CFO Jay Nutt reiterated their target for deleveraging the company to a range of 1 and 2 total leverage vs. adjusted earnings several times throughout the Q3 Conference Call.

But the deleveraging can only happen through excess cash flow after necessary capital spending for maintaining and growing the business. The company paid down $20M debt during Q3, using substantially all of their free cash flow.

I like the aggressive debt repayment because these guys need to get their balance sheet right-sized as there is always the possibility interest rates will balloon in the future.

Chart APY data by YCharts

In my view, it's regrettable the company came out of DOV with so much debt.

CEO Soma stated several times the company has restricted its investment into growth assets during the quarter because they need to pay down debt. Excessive debt requires big action to get out from under in any reasonable amount of time. And growing a company meaningfully requires big, smart, risky bets. Right now, APY's growth is hamstrung by the urgent need to get leverage down so their ability to make large bets in the financial sense is curtailed, to the detriment of potential shareholder returns.

Rising Input Costs

It doesn't pay to be an optimist when analyzing stocks for investment purposes. So I don't like how this article's headings are coming out as all negatives, but these important facts about APY need to be discussed.

The company doesn't only produce tools and software. They're also in the business of buying, then leasing out, products which come from China. Tariffs already in effect have increased APY's cost of investment in the Chinese-made equipment. Other tariffs, passed with the intention of aiding the American steel industry, have been working and steel mills across the country are operating at near capacity as work orders many companies like APY were outsourcing overseas comes home to the USA.

For APY, the increase in steel costs is hitting their bottom line as they sell large rods and other equipment, made of steel, which doesn't have the profit margins smaller steel-based tools offer. The company therefore has an unstable cost structure due to their small in-house manufacturing capability relative to their sales. Tariffs are putting pressure on the company's bottom line as a result.

Customer-focused, Collaborative Culture And Hard Work

CEO Soma and the teams at APY explain their company's success is dependent on giving the best service possible to their customer, in build quality, in anticipating their needs, and other aspects of their relationship. The company will continue to succeed in their competitive industry so long as they keep up the quality of their culture and maintain diligence.

The company has a bright future. But I don't see the margin of safety I need to get into a company, considering other opportunities available or which may become available in the marketplace.

APY is going to suffer from declines in their conversion revenues by 2020 as the 2014 wells are completed, and that leaves the company heavily exposed to new rig completion rates through 2019 and 2020. I am not particularly bullish on oil over the next handful of years so there's nothing at APY to get me to speculate on potential appreciation in its stock.

Final Word

Avoid APY as their deleveraging is impeding growth at the firm, and the company needs all the growth it can get while the getting is good.

Disclaimer: This article represents the opinion of the author as of the date of this article. This article is based upon information reasonably available to the author and obtained from public sources that the author believes are reliable. However, the author does not guarantee the accuracy or completeness of this article. It is merely the author's interpretation of the information contained in the article. The author encourages all readers to do their own due diligence. This is not a recommendation to buy or sell any security.

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Disclosure: I/we 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.