Future Growth Opportunities Push Solaris Oilfield To Reduce Capex

Summary

• Solaris is unlikely to add to the proppant solution system fleet in 2H 2019.
• The last mile proppant supply system can push the company’s growth upwards in the medium-term.
• It has lowered capex guidance to improve free cash flows in FY2019.
• The company’s balance sheet, which has a zero-debt, will give it an advantage if the energy price declines.
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Solaris Is Unlikely to Recover Soon

Solaris Oilfield Infrastructure (NYSE:SOI) provides supply chain management and logistics solutions to the energy industry, including mobile and permanent infrastructure that increases proppant throughput capacity. Given the current headwinds in the energy market, I do not think the stock price will exhibit positive momentum in the short-turn. In the medium to long term, I expect the company to increase market share, which will lead to higher returns from the stock.

SOI is integrating the Last Mile trucking with the well site rental equipment, which can become the growth catalyst. Its operating margin is expected to hold relatively steady due to potential re-contracting at more favorable rates and the application of the fully delivered systems.

The primary challenge for SOI is the tightness in the upstream companies’ capex budget. To increase free cash flow, the company plans to reduce capex in FY2019. As growth hit the ceiling, the company has started focusing on shareholder returns by initiating dividend payment. A zero-debt balance sheet and ample liquidity ensure that the company has the ability to carry out business even if the energy market environment deteriorates.

How Is SOI Delivering Value?

The specialized rental business typically has high margin and payback periods are low. So, the company is trying to position itself as a premium provider for bundled solutions. While the commoditized rental business (premium drill pipe) generates ~60% EBITDA margin, the manufacture-owned specialized rental products yield ~70%. You may note that the company’s customers include operators, pressure pumpers, sand companies, and logistics companies. In Q2, SOI recorded 63% EBITDA margin on this business. So, if it can gain market share as a premium provider, there is an opportunity to improve margins as well.

Although offering bundled solution constituted only a minor portion of the total revenues (5% of sales in Q2), it seeks to push such sales given the company’s conservative outlook in 2H 2019. Many of its customers, bound by limited capital investment, will require efficient systems to shift toward more efficient completion operations such as longer laterals and multi-well zippers. Solaris' gross margin in Q2 improved marginally compared to Q1, due primarily to the increase in system count.

According to the company’s estimates, using the Solaris rental system can save the customers ~$200 per hour if we discount the lesser downtime in using the company’s solutions. The customer retention rates for system rentals have averaged ~90% for the past couple of years until Q2. Although many competitors offer a significant upfront discount, the benefits are likely to get eroded if the downtime is more than a few hours. So, the company’s competitive advantage can help it gain market share in the coming quarters.

Mobile Chemical System Hits A Wall

In Q2, the company reduced capex by 60% versus Q1 in response to the manufacturing rate slowdown of new proppant systems. However, the company did go ahead with the plans to introduce its Solaris Lens software in the chemical systems as well as deploying blending technology for the system. Currently, the company has eight chemical systems completed, and six more are waiting in the wings.

However, those six systems will need design modifications based on field trials. I do not think the company will deploy additional systems soon (on top of the six being modified), not until the E&P activities pick up to ensure a sufficiently high-profit margin for the systems to run. Most of the company’s chemical systems are located in Texas, New Mexico, and Oklahoma, while it plans to foray into the Northeast.

Analyzing Strategies and Outlook

SOI’s management believes the U.S. hydraulic fracturing activity will go down as the energy operators’ budget cut takes its full effect. So, its outlook for 2H 2019 is cautious with targeted customer wins. The company expects to field 166 mobile proppant systems by the end of Q3, which means it will keep the proppant system fleets steady. Following the design modifications of the chemical systems, the number of such systems will jump from 8 to 14. Because some of the company’s customers own contracts to operate in different basins and for different periods, the company will also have the opportunity to re-contract in 2H 2019 and early 2020. So, the current market sentiment is better than what it was a couple of quarters ago. The demand for the company’s last-mile business solution is winning the battle for the company in terms of volume and market share gains.

The company’s strategy has primarily revolved around providing the lowest delivered cost for the customers, while not compromising on quality and reliability. The management accedes to the fact that competitors who gave discounts lured away some of its customers, but the company did win back a majority of the lost ground by providing consistently reliable products and services. Pricing will continue to affect the industry dynamics, but I think SOI’s superior offerings will lead to market share gains in the medium to long term.

Proppant Management System Grew In Q2

In Q2 2019, Solaris Oilfield Infrastructure’s top line increased by 4% compared to Q1 2019. During Q2, it added nine mobile proppant management systems to the fleet. From Q1 to Q2, the average West Texas Intermediate (or WTI) crude oil price increased by 8.5%, while the completion activity slowdown continued in many unconventional resource basins. So, the addition to the systems was quite remarkable in a challenging backdrop.

What effectively added to the top line was the contribution from the last mile management service, which offers a low-cost bundled solution in place of renting the mobile proppant system alone. In this context, investors may also note that SOI uses the fully utilized system count rather than the system count, which is a more effective metric because the parameter takes into account the white space in the calendar.

In 2019, one of the most notable products that came out of SOI’s stable is the AutoHopper system. The system is expected to eliminate multiple people from the well site, which will keep operating costs down at the current price, thus improving margin.

Free Cash Flow And Capex

SOI’s debt-to-equity (equity includes Solaris LLC’s non-controlling interest) is nil because it had no borrowings as of June 30. The advantage of having a zero or low leverage is that when energy price nosedives and the company’s earnings dip, and servicing of debt becomes difficult. In that scenario, the company is better equipped to survive compared to many of its OFS peers. Keane Group’s (FRAC) debt-to-equity stands at 0.71x, which is quite high in the current environment. Select Energy Services (WTTR) has no debt, while ProPetro’s (PUMP) debt-to-equity stands at 0.17x.

SOI’s cash flow from operations (or CFO) increased significantly (101% up) in 1H 2019 compared to a year ago, due primarily to higher revenues arising from an increase in the number of proppant systems deployed, as well as an increase in working capital. Due to such significant improvement, its free cash flow (or FCF) turned positive in 1H 2019. Also, its capex decreased significantly in 1H 2019 following a drop in the manufacturing rate of new proppant systems and completion of the Kingfisher Facility construction.

Recently, the company has lowered its FY2019 capex guidance to a range of $40 million to $50 million compared to the previous guidance range of $40 million to $60 million. The slowdown in capex can result in positive FCF in FY2019. The company plans to use the additional FCF in making shareholder returns through dividend payment.

As of June 30, 2019, SOI’s liquidity was $80 million, including $29 million of cash and $50 million availability under the revolving credit facility. In late-April 2019, the company amended the facility and increased the revolver size by $30 million.

Dividend

The company pays a $0.10 quarterly dividend per share, which translates into a forward dividend yield of 2.92%. It initiated the dividend payment in December 2018.

What Does The Relative Valuation Imply?

Solaris Oilfield Infrastructure is currently trading at an EV-to-adjusted EBITDA multiple of 3.9x. Based on sell-side analysts’ EBITDA estimates, the forward EV/EBITDA multiple is 4.1x. Between Q2 2017 and Q2 2019, the stock’s average EV/EBITDA multiple was 8.6x. So, it is currently trading at a discount to its past nine-quarter average.

Solaris Oilfield Infrastructure’s forward EV-to-EBITDA multiple expansion versus the adjusted trailing 12-month EV/EBITDA is marginally steeper compared to the peers because analysts expect the company’s EBITDA to decline more sharply compared to peers in the next four quarters. This would typically result in a lower EV/EBITDA multiple compared to peers. However, the stock’s EV/EBITDA multiple is higher than its peers’ (PUMP, WTTR, and FRAC) average of 3.4x. So, the stock’s relative valuation can be stretched at the current level. I have used estimates provided by Seeking Alpha in this analysis.

Analyst Rating

According to data provided by Seeking Alpha, 11 sell-side analysts rated SOI a “buy” in September 2019 (includes “outperform”), while three recommended a “hold.” None recommended a “sell.” The consensus target price is $18.6, which at the current price yields ~38% returns.

However, according to Seeking Alpha’s Quant Rating, the stock receives a “Neutral” rating. Although its ratings are high on growth, profitability, and momentum, the ratings are poor on value and EPS revisions. SOI’s year-over-year revenue and operating profit growth rate have been higher than peers. However, the quarter-over-quarter revenue growth rate has slowed down in the past couple of quarters. So, I think Seeking Alpha’s high rating on growth is a little aggressive. The company’s operating margin has outperformed most of its peers. So, I think Seeking Alpha’s moderately high rating on profitability is on target. I also think the low rating on EPS revision is too conservative, given that its earnings beat analysts’ estimates in three out of the past four quarters. I think its relative valuation multiple is below-par, as I discussed earlier in the article, and so, I think Seeking Alpha’s low rating on value is justified.

What’s The Take On SOI?

After reducing the fleet count in Q1, SOI seems to have gained market share over in Q2 after adding to the mobile proppant systems count. The company may hold back further deployment of the mobile chemical management system until demand improves. As growth hit the ceiling, the company has started focusing on shareholder returns by initiating dividend payment. It has also reduced the capex guidance for FY2019 to increase free cash flow. However, lowering capex can also limit the company's ability to product innovations and, therefore, improving market share. A zero-debt balance sheet and ample liquidity ensure that the company has the ability to carry out business if the energy market environment deteriorates.

It now integrates the Last Mile proppant system with the well site rental equipment, which can become the growth catalyst. I think SOI’s margin will hold relatively steady because of the application of the fully delivered systems and potential re-contracting at more favorable rates. Overall, I do not think the stock price will exhibit positive momentum in the short-turn. In the medium to long term, continuous gains in market share through adaptive technologies can pave the way for much better returns.

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.