BAS formulates strategies to recover from the weakness
Basic Energy Services (BAS) provides completion and remedial services, water logistics, well servicing, and contract drilling for the upstream companies. I expect the stock to pick up some momentum in the second half of 2019 as completion activity headwinds recede. But you can expect turbulence in the near term.
In 2019, we can expect a couple of boosters to benefit BAS. Higher workover and maintenance activities and completion of long lateral wellbores, as well as strong growth in the midstream water logistics business, should help BAS. BAS looks to keep utilization steady by relocating assets interchangeably among the various functions. The company’s cash flow from operations improved significantly in FY2018, but its free cash flows have not been steady over the past years. The company has no near-term financial risks.
In the past year, Basic Energy Services’ stock price has dipped by 76% and underperformed the VanEck Vectors Oil Services ETF (OIH), which declined by almost 34%. OIH represents the oilfield equipment & services (or OFS) industry.
Analyzing BAS’s Q4 2018 performance
In Q4 2018, Basic Energy Services’ top line declined by 6.5% compared to Q3 2018. On a year-over-year basis, the company’s revenue was relatively resilient in Q4 2018. From Q4 2017 to Q4 2018, the revenues declined by 2%. A large part of BAS’s weaker Q4 performance can be attributed to the seasonality factor typical in the energy E&P activity and inclement weather in Texas and Oklahoma. On top of that, a 35% dip in the crude oil price during Q4 resulted in lower servicing frac fleet and pumping fleet utilization.
In this context, investors may note the effect of completion activity slowdown in the Permian and other key U.S. unconventional reservoirs. The crude oil price has become more volatile in the past quarter and early 2019. This, plus the tightness in the upstream customers’ budget has resulted in a temporary weakness in hydraulic fracturing demand and supply. Despite the short-term weakness, the growth of the U.S. completions market should return by the end of the year. The recovery signals in the U.S. completion market activity reflects in 28% higher drilled-but-uncompleted (or DUC) wells in January 2019 compared to a year ago.
If we compare the segment operating margins, the Well Servicing segment operating margin was resilient in Q4 2018 compared to a year ago. Although BAS’s average number of servicing rigs declined by 26% in Q4 versus a year ago, the company was able to achieve higher rig utilization and higher revenue per rig, which offset much of the negative effect. In the Completion and Remedial Services, the segment operating profit margin declined sharply to 21% in Q4 2018 from 30% a year ago. There was lower demand for hydraulic fracturing, particularly with regard to completion activity due to the overbuild of frac horsepower. So, a reduction in pressure pumping activity and pricing caused the lower profit margin. These two segments together accounted for 74% of BAS’s Q4 2018 revenues.
As opposed to this, operating margins in BAS’s Contract Drilling and Water Logistics segments improved in Q4 2018. The company was able to achieve higher revenue and profit per fluid truck in the Water Logistics business, despite lower trucking hours. The water disposal volumes via the high margin pipeline increased in Q4 2018, which benefited the segment margin. In Contract Drilling, BAS’s drilling utilization rate more than doubled in the past year, which led to a 92% higher profit per rig in Q4 2018. However, Contract Drilling’s contribution to BAS’s revenue base is insignificant (2% of Q4 2018 revenues).
What are BAS’s strategies?
During 2018, Basic Energy undertook an initiative to exit non-core operations. As part of this strategy, BAS relocated frac assets from the Permian Basin into the Mid-Continent to gain from the higher utilization rates and cost efficiency. Investors should note that the takeaway capacity bottleneck in the Permian has led to a reduced local crude oil pricing as compared to the WTI and Brent-linked benchmarks. So, the region’s pipelines constraints led to its customers reducing their drilling and completion activities. BAS has also relocated rental tools, water trucks and well servicing rigs to core markets like the Permian Basin, the SCOOP/STACK, and the Eagle Ford. BAS’s management considers these moves are resulting in steadier utilization rates of assets and higher gross margin potentials.
These initiatives, although necessary from the business point of view, did cause short-term disruptions to BAS’s revenues in Q3 and Q4 of FY2018. On the positive side, it reduced BAS’s capex requirements, streamline its asset fleet, and cause changes in asset footprint. I expect the initiative to yield benefits through higher asset utilization and lower maintenance capex. As BAS kept its idled rig fleet warm stacked, it enjoys the flexibility to move by the demand in the market. As part of the strategy, BAS is relocating some idle frac pumps to the servicing side to work for the larger workover and completion projects and high capacity mud pumps.
BAS’s outlook and guidance
Before I discuss BAS’s outlook and guidance, let us understand the industry undercurrent. In Q4, the sharp drop in the crude oil price delayed upstream companies’ demand for hydraulic fracturing jobs, and they decided to wait for the price recovery. The frac pricing, which was already low due to excess supply of equipment in the market, received another beating now from the demand side. The competitive pricing fell below break-even cash levels in some markets. BAS, on its part, did not push for higher utilization at the cost of margin compression. In response, the company stacked three of its eight active spreads during Q4 2018 and may continue to do so in Q1 2019.
In Q1 2019, BAS’s management expects revenues to decline by 14% compared to Q4 2018 due to the effect of the current completion activity slowdown. However, by the end of the year, the upstream activity in the U.S. is expected to increase, which would push its FY2019 revenues in line with FY2018. In FY2019, BAS’s operating margin is expected to improve as BAS’s cost restructuring initiatives begin to lower its cost structure. Let us look at the outlook for BAS’s two most significant segments.
In the Well Servicing segment, demand is expected to remain steady in FY2019, particularly in workover, maintenance, and completion of long lateral wellbores. This is because as the upstream operators’ realized prices decline, they would focus on workover and maintenance projects in the absence of newbuild rigs and fracking activities. BAS expects to deliver two more fleets during 1H 2019, which will be packaged as a combination of high-spec rigs and the rental assets.
The other function where BAS is concentrating is its midstream water logistics business. Following a strong trend in Q1, BAS has announced plans to build gathering and infrastructure projects for saltwater disposal. These projects would be set up in the Permian as the pipeline capacity bottleneck issue hit the Basin in the past couple of quarters. BAS has long-term contracts for pipeline water and the disposal facilities. The de-bottlenecking process coupled with high drilled but uncompleted well counts in the later part of 2019 should benefit BAS’s completion rig activity in FY2019.
Regarding BAS’s long-term strategy and investment focus, this is what the management commented in the Q4 earnings call:
However, we are poised to adjust spending based on market conditions and we have flexibility in our spending program. Our three-year strategic plan, 2019 through 2021 includes a significant focus on segment investments to drive margin expansion while reducing services with particularly challenging commercial economics and higher maintenance and labor intensity where constraints are real in our core markets.
Debt and cash flows
In FY2018, BAS generated $74.3 million in cash flow from operations (or CFO). This was ~186% higher than the FY2017 CFO. On top of a 12% revenue hike, BAS’s CFO benefited from better working capital management, mainly from lower accounts receivable balance in FY2018.
In FY2018, BAS spent $68.7 million in capex. In FY2019, the company plans to increase capex by 37% to ~$94 million. Approximately, 33% of its FY2019 capex is expected to be spent on Midstream Water Disposal expansion projects and on the 24-hour rig packages and rental tools, which typically are higher-margin services than many of BAS’s other offerings.
BAS has $300 million of long-term debt, which would be due for repayment in 2023. The company has ~$90 million as cash & equivalents as of December 31, 2018. Although it has no near-term financial risks, BAS might want to improve its cash flows over the medium to long term given the higher capex spend.
What do BAS’s relative valuation multiples say?
Basic Energy Services is currently trading at an EV-to-adjusted EBITDA multiple of 7.7x. Based on sell-side analysts’ EBITDA estimates in the next four quarters, BAS’s forward EV/EBITDA multiple is 4.0x. Between Q1 2018 and Q4 2018, BAS’s average EV/EBITDA multiple was 9.3x. So, BAS is currently trading at a discount to its past six-year average.
Basic Energy Services’ forward EV-to-EBITDA multiple compression versus its adjusted trailing twelve months EV/EBITDA is steeper than its industry peers’ average, as noted in the table above. This is because the sell-side analysts expect BAS’s EBITDA to rise more sharply than the peers’ average in the next four quarters. This would typically reflect in a higher current EV/EBITDA multiple compared to the peers’ average. BAS’s TTM EV/EBITDA multiple is higher than its larger market cap peers’ (Helmerich & Payne (NYSE:HP), Keane Group (NYSE:FRAC), and RPC (NYSE:RES)) average of 5.9x. I have used sell-side analysts’ estimates provided by Thomson Reuters to pull the estimates.
Analysts’ rating on BAS
According to data provided by Seeking Alpha, four sell-side analysts rated BAS a “buy” in March (includes strong buys), while three recommended a “hold.” None of the sell-side analysts rated BAS a “sell.” The analysts’ consensus target price for BAS is $8.1, which at BAS’s current price yields ~110% returns.
What’s the take on BAS?
So, in 2019, we can expect a couple of boosters to benefit BAS. I expect the upstream capex spend on the workover, maintenance, and completion of long lateral wellbores to increase, as new drilling activities decelerate in the absence of a firm crude oil price. This, plus strong growth in the midstream water logistics business should benefit BAS. BAS looks to keep utilization steady by relocating assets interchangeably among the various functions.
On a positive note, the company’s management does not see a significant drop in its customers’ drilling budget. This can keep revenue flowing until the overall energy market environment improves. Although the company’s cash flows improved significantly in FY2018, it needs to maintain a steady rate now that its capex has gone higher. The company has no near-term financial risks. I expect the stock pick up some momentum in the second half of 2019. You may look to buy BAS with a long-term view, but expect turbulence in the near term.
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.