CSI Compressco: Looking Beyond Valuation

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About: CSI Compressco LP (CCLP), Includes: AROC, USAC
by: Michael Boyd
Summary

CSI Compressco looks super-cheap. Is there more to the story?

There is some nuance. Fleets are not where they need to be for natural gas growth and despite utilization returning to cycle peaks, margins remain low.

That indicates pricing pressure. Further, maintenance capex is not straight-lined. As the fleet ages, CSI Compressco might face challenges with limited capital markets access.

"Growth" capital spending has not driven any gains in fleet horsepower. While that could have stemmed from capital rotation into higher horsepower platforms, there has been no signs of that in margin.

CSI Compressco (NASDAQ:CCLP), by any measure of EBITDA or distributable cash flow ("DCF"), looks like a screaming buy on the surface level. Macro tailwinds look extremely healthy, EBITDA multiples look discounted, and the company recently committed to balance sheet repair by ridding itself of what have been extremely dilutive Preferred Units. Is this the deal of 2019, or there is more to the story?

While there is no denying the deep value nature at work here, I wanted to elaborate on some concerns I have with how CSI Compressco has run its business over the past several years. Compression has never quite been an area of the midstream market I favor, and I'll work through those issues as well.

Operations Refresher, Compression Business Outlook

CSI Compressco is a provider of compression equipment utilized throughout the natural gas value chain from wellhead to end market. For those unaware, as natural gas is moved through pipe, a combination of factors (friction, distance, elevation changes) all slow down movement and reduce pressure. Compression equipment is used throughout the gathering and processing and transportation chain to maintain pressure and keep flows up - without compression there is no natural gas transportation.

CSI Compressco, coupled with Archrock (AROC) and USA Compression (USAC), dominates this industry with most of the market share. However, CSI Compressco trails its two peers significantly, particularly when it comes to high horsepower platforms. This has been a pain point for several years as fleet utilization on low horsepower platforms has been painfully low.

While the company describes itself as the largest vertically integrated compression solutions provider in North America, offering compression services to many major large-cap customers as well as new equipment sales and aftermarket support, CSI Compressco is in the distant number three position when it comes to actual assets deployed in the field.

Given steady growth in natural gas production - production only fell 2% during the 2015 pricing collapse - as well as potential tailwinds from liquefied natural gas ("LNG") export, there are clear and present tailwinds to volumes. More volumes necessitate greater deployed compression horsepower.

*Source: EIA, 2019 Energy Outlook, Slide 72

These tailwinds are not likely to shift any time soon. The EIA, in its 2019 Energy Outlook, sees healthy production growth in nearly all of its scenarios through 2050 (see above). However, a substantial majority of natural gas production growth will come from shale gas and tight oil plays. Most of that will be from Eastern basins such as the Marcellus and Utica where CSI Compressco does not have a domineering presence; it is primarily Texas and Mid Continent based (three quarters of revenue). I do think investors have to consider where the company has already prior established relationships and how difficult it will be to break into the Eastern region where the firm has not traditionally generated a substantial portion of its earnings.

Still, domestic demand drivers such as electric power and industrial, coupled with the nascent but growing LNG export business, all will combine to drive substantial demand: a rising tide should lift all boats. There is no way around the fact that in order to get natural gas from Point A to Point B, compression equipment is necessary. While many exploration and production ("E&P"), midstream, or downstream operators will buy equipment outright, using outside service providers is still incredibly common.

However, there is some lumpiness to get over. In 2014 and 2015, many midstream and E&P operators were structurally overbuilt when it came to compression. Long-term shale growth expectations were so high that they had put in place a large amount of assets with the expectation that volumes would grow to match. That did not happen at expected rates, and quite a bit of compression equipment was outright eliminated or returned to suppliers like CSI Compressco. Those familiar with upstream production know that a lot of cost has been taken out of oil and natural gas production to lower breakevens - much of that was to the detriment of oilfield services firms. This was my primary reason for staying away earlier, and admittedly, those issues are easing today.

*Source: Author estimates

While CSI Compressco is forecast to book just $101mm in EBITDA this year, sell-side forecasts expect a pop to $125mm EBITDA in 2019 and 2020 - levels last seen in 2015. Of note, this is at the bottom of the guidance range provided by management in their December update ($125-140mm), so there is some skepticism from the Street. Nonetheless, $125mm in EBITDA is likely good for $50mm in distributable cash flow using prior figures as a baseline. That cash flow will, after the recent cut, be dedicated to removing the $43mm in toxic Series A Preferred Units that remain outstanding. Once those Preferreds are gone, market view is that the company's balance sheet will be in better shape, and the distribution will be reinstated. Taking a cash flow agnostic view (cash flow to the firm is as good as cash flow in my pocket), $50mm DCF is a massive implied free cash flow yield.

That begs the question: Why are the units so cheap? After all, the macro just looks so darn good? Is this really just a dumb sell-off based on a distribution cut that is right-sizing the balance sheet?

My Concerns: Pricing Power and Invisible Growth Capex

Besides the ancillary point above (positioned in the wrong basins), I have substantial concerns on margins and pricing power. North American natural gas production is up 17% since 2014, and basically, that has been a straight lineup. The bull thesis, at its core, has been pretty simple: more demand for more compression horsepower means more profits for CSI Compressco. If the story was that simple, why is the company having such a hard time on margins? Especially as new equipment sales had tanked (at least through 2017), which should have been a tailwind to consolidated margin.

Like is often the case, I think many investors are underestimating how deep the competition is here and how that impacts margins. Despite total horsepower utilization jumping to 86.3% in Q3 2018 - the highest since 2014 - reported gross margin in the most recently reported quarter within the Compression business (excluding aftermarket and equipment sales) came in at 47.2%. That is 300bps below 2015 levels despite the 2015 utilization rate coming in at 82.0%, a much lower figure. That is as good a sign as any that despite the oligopolistic market for compression, there are still some clear pricing power issues at work.

I also struggle to reconcile growth capital spending. I want to call back to my recent musings on maintenance capex and whether currently reported levels in midstreams are unrealistic. In short, I've always been inherently skeptical of management figures and think investors who are long here are, on the whole, taking management figures at face value. Stated DCF coverage does not always equal out to reality. There are a few nuances here.

Number one, maintenance is going be lumpy as the fleet ages. This is something peers like USA Compression readily admit:

We classify capital expenditures as maintenance or expansion on an individual asset basis. Over the long term, we expect that our maintenance capital expenditure requirements will continue to increase as the… age of our fleet increases.

Investors tend to think of maintenance capex companies' book as a straight line. That is, if a pipeline records $2mm in maintenance this year, then that figure can be extrapolated forward. That is substantially true of pipelines but less so within the compression business. Lumpy maintenance is a risk, and CSI Compressco is, comparative to the industry, already running older equipment on average. Maintenance spending per dollar held on the balance sheet is already at double (or more) the level of peers, and that is likely to worsen with time, especially as the firm continues to be capital-constrained.

My other concern is on growth spending. To illustrate, let's rewind the clock back to year end 2014. CSI Compressco had $595mm in long-term debt and 28.1mm diluted units outstanding. In 2018, CSI Compressco will finish the year with $606mm in net debt, those prior mentioned toxic Preferreds that still have to be paid off, and 44.8mm units outstanding. There is $54mm more in net debt floating around there, and the unit count has grown more than 60%. Liabilities are up, units outstanding are up, EBITDA is down.

This is despite a long history of management stating that there was free cash flow after the distribution that would be retained for investment. All of that cash, plus capital raised from debt and equity, has funded sizeable stated growth capital expenditures: $170mm booked from 2015 through Q3 2018. This is net of sales proceeds (from equipment sales).

Investors are left pondering: Where has all that growth capital spending gone? As shown above, stated gross compressor assets are up incrementally, but overall horsepower in place has stayed flat. It appears - at least to me - that growth capital spending has done little to raise the overall horsepower or earnings power of the fleet.

On the optimistic side, this is a mix issue. Management has stated often that the company is trying to rotate into newer, higher horsepower compressors that have greater demand and utilization within the market. Along that vein, the company has noted large sales of equipment several times over the years, including the sale of 45,123 horsepower of older equipment in 2015 (Q4 2015 conference call). These sales have not historically resulted in very large impairment charges - at least relative to GAAP book value - because those impairment charges are based on GAAP depreciation using 25-year useful lives on the equipment. However, investors have to remember that non-GAAP stated maintenance expense on new equipment implies 75-100 year lives on compressor equipment; based on those metrics, there likely would have been substantially larger impairment charges taken.

Complicating matters, Archrock and USA Compression do not seem to have this same issue. Growth spending has resulted in horsepower gains in the fleet. USA Compression, even before its acquisition of CDM Resource Management for $1,800mm, had added more than 400,000 horsepower to its fleet from year-end 2014 to Q2 2018. The firm spent roughly $1,000/hp to do so, which is right about in line with actual market costs.

Could the fleet in place today have greater earnings power going forward? Potentially, but there just isn't much sign of it within EBITDA and, despite the rotation, margins and revenue have held up much better at larger peers in recent years. In my opinion, CSI Compressco has not proven out that its growth capital spending is (or will) creating positive cash flow and generating economic returns. This is despite what management has stated during conference calls (such as the below from Q3):

We are only targeting new investment opportunities with return of 20% or higher, focused on high horsepower equipment in geographic areas where we have existing strengths and customers who continuously wants to partner with CCLP as a supplier with flexibility and the experience to offer compressor systems solutions.

Recap

  • Fleet assets are positioned in arguably the wrong basins. While not fixed assets, CSI Compressco has stronger relationships with customers outside the main areas that will see long-term natural gas production growth.
  • Despite fleet utilization returning to cycle peaks, margins have not followed in kind. Customers are clearly much more price conscious and often have access to multiple potential service providers.
  • Maintenance capital expenditures are not straight-lined. As the fleet ages, costs rise. With limited access to capital, CSI Compressco might not be able to keep its average fleet age stable.
  • Growth capital spending has not driven gains in fleet horsepower. While that could be from capital rotation into more expensive, higher horsepower platforms as lower horsepower assets fall off, there have been no signs of that in margin.

I get the bull story here. From a strict company-stated DCF perspective, this looks wildly cheap. But, is that truly a good number? Perhaps the truth is somewhere in between my own and the firm's view and maybe, given all of the above, this is priced in. But it is hard to get behind an investment where the macro trends are so strong regarding demand on the surface, and pricing/margin does not follow alongside it. In my view, that is indicative of a commoditized business where it is going to be extremely difficult to generate cash flow margins above cost of capital, especially to support a yield-based investment over time.

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.