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Internal Review Conclusion Frees Up ProPetro's Stock, But Some Headwinds Remain

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About: ProPetro Holding Corp. (PUMP)
by: Badsha Chowdhury
Badsha Chowdhury
Value, long/short equity, research analyst, oil & gas
Summary

The conclusion of the internal review resulted in no financial restatement, prompting the stock price run-up since October 2019.

Lack of demand for pressure pumping will lead to the reduction of pressure pumping fleets in Q4.

Although its free cash flow was negative in 9M 2019, the balance sheet is strong.

PUMP's current EV/EBITDA is at a significant discount to the past average.

PUMP Gets A Relief

ProPetro (PUMP) provides hydraulic fracturing and other related services to the key unconventional resource basins in North America. Operationally, the lack of pressure pumping demand and upstream energy company's budget exhaustion can affect its top-line adversely in the short term. Although the conclusion of the international review process has pushed the stock price up in the past couple of months, I think the current headwinds can weaken the price in the short term.

Over the medium-to-long-term horizon, the company should benefit from the ten-year agreement with Pioneer Natural Resources (PXD), following the pressure pumping asset acquisition from PXD struck in early 2019. The company has a strong balance sheet, but its free cash flow was negative in the first nine months of 2019. However, its long-term agreement with PXD, investment in the DuraStim frac pump, and a much higher asset base will boost the stock price in the medium-to-long term. On top of that, the stock is trading at a significant discount to the past average, which should keep investors interested in it.

Understanding The Key Strategies

The DuraStim pump is ProPetro's key offering because it has several advantages over the conventional frac units. Read more on this in my previous article here. The company expects to operationalize the first fleet in the Delaware Basin by the end of 2019 or may push it back to early 2020.

ProPetro will continue to reinvest in its existing fleet. Regarding higher pumping hours per fleet, we are likely to see the upstream operators add more wells per pad. In the past few years, the company migrated from being a one-well pad servicing company to servicing four and six-well pads in the Permian. The higher-well pads allow the company to pump more hours in the day.

The upstream energy companies have been pushing for higher-efficiency fleets because of the on-going movement to operate on lower capex and maximize cash flows. Over the past couple of years, the company's operation shifted to pad development, longer laterals, and larger job volumes in the Permian Basin. While PUMP's management expects E&P activity to rebound in 2020, it will continue to lower costs. Also, even if activity rises in 2020, it is unlikely to contribute to an increase in profitability per fleet.

Although the pressure pumping demand in the industry is going through a lull, much of the company's asset growth was attributable to the addition of Pioneer Natural Resources' pressure pumping assets, which added 510,000 hydraulic horsepower (or HHP) by the end of 2018. Following PXD's asset acquisition, ProPetro now has a 10-year strategic service agreement with Pioneer Natural Services, as I explained in my previous article. Currently, most of its assets are going through a rebuild or refurbishment program, which will change the company's asset-mix. While the fluids-end has decreased in the mix in the past two quarters, the company expects that aspect of the business, too, to revive once the retired equipment re-joins the fleet. The company has accelerated its refurbishment program by the end of the year, and so, we may expect some turnaround later in 2020.

Internal Control In Focus

While PUMP's stock price declined by 22% in the past year, it has recovered by 31% since the October-low. Much of the appreciation can be attributed to the changes to its executive leadership team in connection with the completion of an internal review in early October. The investigation expanded the audit committee's report on expense reimbursements and certain transactions involving related parties or potential conflicts of interest. While the company's third-quarter filing with the SEC (Securities Exchange Commission) was delayed in anticipation of a restatement following the review, the review did not reveal any misstatement.

Along with the management restructuring, the review forecast an effective utilization of 18-20 fleets in Q4 compared to 25.1 fleets in Q3. Customer budget exhaustion, softening industry demand, and the seasonality led to the change in the outlook. I think the review, despite a negative outlook, cleared the air of uncertainty. The market was likely expecting something worse, and no change in financial statements came as a positive surprise to the investors.

Although there was no restatement, the company did acknowledge the internal control deficiencies and the likely presence of material weaknesses in the control process. Aiming to strengthen the process, it made changes in delegating duties at the top level. Phillip A. Gobe, the executive chairman, will also act as the principal executive officer to oversee the remediation process. In that capacity, he will share the dais with the Chief Executive Officer Dale Redman, whose job will now limit to pursuing business development initiatives and managing day-to-day operations. Besides, Jeffrey Smith was re-allocated the duty of the Chief Administrative Officer, while the management began the search for a new Chief Financial Officer. There were other reshuffles in the responsibilities in different executive positions, too.

Growth In The Unconventional Shales

PUMP's operations are primarily focused in the Permian Basin. The Permian Basin accounts for 51% of total crude oil production in the key unconventional shales. The Permian crude oil production increased by 18% in the past year until November 2019, while the rig count there decreased by 17% during the same period. EIA's estimates also show that the Permian crude oil production can grow by 2.3% by January 2020. On average, crude oil production is expected to remain unchanged in the key unconventional shales in the next two months. So, with botched E&P activity in the U.S., the company will have limited opportunity to increase its top line in the short-run.

Understanding The Value Drivers In Q3

In Q3 2019, ProPetro completed a record number of frac stages and pumping hours. It also pumped record volumes of sand. The factors helped the company utilize the crew basis more effectively. As I was discussing earlier, the company's servicing of the multi-well pads led to a 92% zipper stage. Increased level of throughput and utilization at the well site led to favorable returns for the company.

One of the challenges faced by the company is the decline in fleet utilization, which can reduce the operating margin in Q4. The company, based on its experience, expressed concerns that the deterioration in margin can underperform the market expectation in Q4.

If we look at the company's cost structure, pressure pumping cost of services as a percentage of revenues remained flat at 73% in Q3 2019 compared to a quarter ago. The general and administrative expense was also flat in Q3. Revenues, however, saw a modest increase of 2% in Q3 compared to Q2, led by efficiency gains and beneficial changes in the work mix. Adjusted earnings remained nearly unchanged from Q2 to Q3.

Leverage Is Low

In 9M 2019, PUMP's flow from operations (or CFO) was $307 million, which was a 22% increase compared to a year ago. Despite a 20% fall in revenues, the rise in CFO in 2019 was due to working capital improvement, primarily due to the fall in accrued and other current liabilities.

In 9M 2019, the company's capex increased significantly (86% up) compared to 9M 2018. The acquisition of frac fleets and coiled tubing units in the PXD transaction, as well as the two new-build DuraStim hydraulic fracturing fleets, accounted for the higher capex. As a result, its free cash flow turned negative in 9M 2019.

PUMP's total liquidity as of September 30, 2019, was $173million, which included $64 million of borrowing capacity under the revolving credit facility. Its debt-to-equity ratio (0.14x) is significantly lower than peers, which include Patterson-UTI Energy (PTEN), Pioneer Energy Services (PES), and Nabors Industries (NBR). The company has limited short-term risks, as I explained in the previous article here.

What Does The Relative Valuation Imply?

PUMP is currently trading at an EV-to-adjusted EBITDA multiple of 2.5x. Based on sell-side analysts' estimates, the forward EV/EBITDA multiple is lower, which implies higher EBITDA in the next four quarters. The stock is currently trading at a steep discount to its EV/EBITDA average of 9.1x, which was observed from Q3 2017 through Q3 2019. So, it is relatively undervalued at the current level. I have used estimates provided by Seeking Alpha in this analysis.

Analyst Rating

According to data provided by Seeking Alpha, fifteen sell-side analysts rated PUMP a "buy" in January 2020 (includes "very bullish"), while seven of them rated it a "hold." None of them rated it a "sell." The consensus target price is $13.5, which at the current price, yields ~23% returns. According to Seeking Alpha's Quant Rating, the stock receives a "Neutral" rating. It scores highly on most of the parameters, including growth, profitability, and value, but scores poorly on EPS revisions and momentum.

What's The Take On PUMP?

The weight on the PUMP's stock was lifted after the reinforced internal control did not find any requirement for financial restatement. Although the review indicated the presence of material weakness, the company has made considerable changes in the decision-making process to improve the control system. Material weakness or not, the company cannot ignore the presence of the near-term headwinds at the operational level. The lack of pressure pumping demand and upstream energy company's budget exhaustion could lead to significantly lower utilization in Q4, which can affect its top line in the short-term. The company managed to keep its cost level unchanged while improving efficiency, which helped it keep operating profitability steady despite the revenue fall.

Over the medium-to-long-term horizon, the company should benefit from the ten-year agreement with Pioneer Natural Resources, following pressure pumping asset acquisition from PXD struck in early 2019. Plus, the deployment of three DuraStim hydraulic fracturing fleets will mitigate some of the top-line loss in 2020. The company has a strong balance sheet, but its free cash flow turned negative in the first nine months of 2019. I think the stock price can produce positive returns in the medium-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.