Liberty Oilfield Services: Surviving The Short-Term Woes Will Yield Results Later

Summary

• The completion activity will slow down further in Q2 2020.
• LBRT plans to reduce staffed frac fleet for the rest of the year.
• The company’s revenue is likely to decline sharply in Q2, while the margin fall will be limited due to various cost-cutting measures.
• The company's low leverage is an advantage over its peers, although negative free cash flow can become a concern.

LBRT Stands On A Fleeting Ground

The sharp fall in the U.S. rig count and loss of demand for fracking activities in the U.S. unconventional shales has forced Liberty Oilfield Services (NYSE:LBRT) to reduce staffed frac fleet considerably in April. Most of the rig count decline is taking place in new and exploratory wells, while the pricing pressure continues in an oversupplied fracking market. So, I think the company’s top-line will decline sharply in the next couple of quarters.

Given the necessity to reduce costs, it has taken additional steps, including a dividend suspension and capex budget cut. I think these measures will mitigate some of the company’s margin-level risks. Over the medium-to-long-term, I believe its dynamic gas blending fleet and other ESG-compliant fleets can see increased demand.

LBRT has very low leverage, which is a significant advantage compared to some of the leveraged oilfield services players. However, its low cash flow is a serious impediment in achieving the cash flow preservation goal. I think returns from the stock may not see improvement unless the completions and drilling activities start inching up once again.

Analyzing The Strategies

LBRT’s strategic focus has gone through a dramatic shift from deploying fracs and improving shareholder returns to preserving cash and ensuring survival. The onshore activity was already grappling with an oversupply of equipment, putting substantial pressure on pricing, when the double swan events hit the industry. The demand loss due to the pandemic and an increase in supply after the OPEC+ deal failed caused havoc to the crude oil price. Although the supply situation has started to improve after many producers shut-in existing production, the crunch for oil storage capacity has set demand for frac services down severely. To know more about the company’s strategies, read my previous article here.

During Q1 2020 (Jan-20 to Mar-20), the crude oil price tanked (66.5% down) due to the concerns over the global demand growth and on fear of lower trade following the outbreak of coronavirus, while the U.S. rig count fall was relatively moderate (9.6% down). Since then, however, the crude oil price has been more resilient (~4% drop until now) although the rig count fall has been more dramatic (44% down since the start of April). The slowdown in drilled wells and drilled but uncompleted wells (or DUC) in the key U.S. unconventional shales held steady during Q1, suggesting most of the decline taking place in new and exploratory wells in the current downturn.

In this context, let us discuss the production dynamics of the U.S. unconventional shales. As energy price falls, the effect of the differential between the Basins becomes more critical. This is because, in some basins, some customers have refineries, dedicated transportation, and offtake agreements at their refineries. So, different Basins will act differently to the energy price crunch. During the current downturn, the production shut-ins initially started in the Bakken. It will occur even more sharply in the Rockies compared to some of the other basins. Since the natural gas price has been steadier than the crude oil price, oil-centric Basins will have less incentive to keep production flowing. Overall, there will be less utilization for LBRT’s frac fleet, and so, it plans to keep 12 fleets in operation by the end of 2020. The company’s management thinks the bottom in fracking activity will happen in the next three months. Once the supply shrinks and an equilibrium is reached, production will slowly pick up, which will lead to a higher fracking requirement.

The upstream producers have responded to the threats by reducing their 2020 capex budget and have focused on free cash flow generation. LBRT, in its Q1 2020 10-Q, states that the upstream producers have revised down their FY2020 capex budgets by 40% from their earlier budget. LBRT’s management expects significantly reduced frac activity in all the major U.S. basins in the short-term. However, it expects economic activity to improve late in 2020, which will lead to more robust fracking activity. Until then, it will rely on a slew of measures.

Margin Pressure Causes Cost Structure Change

In Q1 2020, its return on capital employed (or ROCE) was 6% (ratio of pre-tax net income to average capital employed), which was a fall from 10% ROCE in FY2019 and a significant decline compared to 39% in FY2018. The fall was a result of a dip in net income (93% down) in the past year. Since there has been no change in the company’s debt level in the past year, lower ROCE shows there has been a considerable deterioration in the performance, which is an adverse development when the energy market is going through a downswing.

As the challenges mount, the company turned away from maximizing shareholders’ returns and suspended dividends on April 2. Investors may note that in FY2019, it paid $41 million in cash to shareholders by dividends, distributions, and share repurchases. The company is also adjusting its structural cost base to align with the anticipated 2020 activity outlook. It suspended variable compensation and reduced base salaries.

Although the frac fleet remains nearly unchanged in Q1, the company undertook an initiative in early April to reduce its staffed frac fleet by 50% in Q2. Between the cost structure re-adjustment and employee and executive salary cut, it expects to save $220 million annually.

Starting April, it will implement a temporary measure of employee furlough plan, which will reduce personnel cost portion of G&A by almost 50% from the current reduced levels. The company, being a short-cycle onshore service provider, has the operational flexibility to furlough fleets as the work schedule demands, which enables it to move its cost structure in the relatively shorter notice.

What Are The Recent Drivers?

Despite the industry headwinds, LBRT’s revenues increased in Q1 while operating income improved remarkably. From Q4 2019 to Q1 2020, its revenues went up by 19%, while the adjusted EBITDA went up more sharply, by 77%. The adjusted EBITDA per average active fleet also increased by 81% in Q1 2020 compared to a quarter ago. The primary reasons for the improvement were the higher number of stages pumped, and the sand volume pumped.

Year-over-year, however, the revenue per average active fleet decreased due to oversupply of the staffed frac fleet in the industry and lower industry activity. As the industry condition deteriorated, the company adjusted its cost structure downward accordingly through reduction in the personnel. Importantly, the company kept its entire 24 frac fleets active until the mid-March (i.e., almost throughout Q1), which held the top-line steady.

Capex Plans And Debt

LBRT’s free cash flow (or FCF) turned significantly negative in Q1 after its cash flow from operations (or CFO) nearly became nil. The drop in CFO was primarily led by a 12% drop in revenues in the past year. The company now revises down its FY2020 capex budget to a range of $70 million to $90 million, which is more than 50% below the midpoint of its previous guidance. The majority of the FY2020 capex will primarily consist of maintenance costs.

As of March 31, 2020, LBRT’s liquidity (cash balance plus revolving credit facility) amounted to $259 million. With the available liquidity (cash balance plus credit facility), debt repayment looks comfortable. The company’s debt-to-equity (0.14x) is lower than its peers. While FTS International’s (FTSI) leverage (15x) is significantly higher than the average, Nine Energy Service’s (NINE) leverage (1.0x) is lower than the average.

What Does The Relative Valuation Imply?

LBRT is currently trading at an EV-to-adjusted EBITDA multiple of 3.2x. Based on sell-side analysts’ estimates, the forward EV/EBITDA multiple is significantly higher, which implies a much lower EBITDA in the next four quarters. The stock is currently trading at a modest discount to its average since Q2 2018 (3.6x).

LBRT’s forward EV/EBITDA multiple expansion versus the current multiple is significantly higher than peers, which typically results in a steeply lower EV/EBITDA multiple compared to peers. The company’s EV/EBITDA multiple is lower than its peers’ (NINE, PUMP, and FTSI) average of 5.1x. I have used estimates provided by Seeking Alpha this analysis.

Analyst Rating

Source

According to Seeking Alpha, seven sell-side analysts rated LBRT a “buy” in May (includes “very bullish”), while nine recommended a “hold.” None of the analysts rated it a “sell.” The consensus target price is $5.3, which at the current price, yields ~23% returns. Also, check out Seeking Alpha’s Quant Rating here.

What’s The Take On LBRT?

I see a disconnect between LBRT’s recent performance and the expected performance in the near-term. It kept its frac fleet steady during the majority part of Q1, while various cost-cutting measures resulted in a higher EBITDA margin. However, the steep deterioration in the energy demand post the pandemic eventually caught up with its outlook. The sharp fall in the U.S. rig count and loss of demand for fracking activities in the U.S. unconventional shales forced the company to reduce staffed frac fleet by 50% in April. As the pricing pressure continues, the company’s top-line and operating margin will likely decline sharply in the next couple of quarters.

However, on a more positive note, the company does not expect fracking activity to fall too much after Q2. In April, it unveiled further cost-cutting steps, including a dividend suspension and capex budget cut. I think these measures will mitigate some of the company’s margin-level risks, although the revenues will get marked down considerably.

I the current scenario where the energy market faces insurmountable troubles, LBRT’s efforts to sacrifice shareholder returns is logical. It has very low leverage, which is a significant advantage compared to some of the leveraged oilfield services players. However, the execution can fall short, given its low cash flow level.

Analyst’s 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.