Adams Resources: Snapback Rally Moves The Focus Back To Management
Summary
- AE rebounded quickly from March lows after briefly dipping well below its cash balance.
- The balance sheet took a hit in Q1; combined with the rally, that has returned valuation to more normalized levels.
- But a small acquisition highlights an increasing sense that Adams is becoming a much more shareholder-friendly company.
- There's still value here to be realized, and a management team that seems intent on trying to realize it.
When I recommended (and bought) Adams Resources (NYSE:AE) in March, the case for the stock was relatively simple. Adams Resources finished 2019 with $26.88 per share in cash - and no debt. At March lows, Adams Resources stock traded below $17.
There were some potential complications. For several reasons, the cash balance didn't necessarily have to provide a floor under AE stock. Thanks to the oil rout in March following the Saudi Arabia-initiated price war, Adams faced potentially significant inventory valuation losses in the first quarter, and demand pressure going forward.
But the margin of safety seemed thick enough - and apparently, I wasn't the only investor to think so. AE stock posted a remarkably quick snapback rally. A recent fade leaves the stock still below 2019 levels, and -30% YTD. But the gains in Adams stock since March, along with pressure on the balance sheet in Q1, at least return valuation to levels that appear more normal in a historical context.
That suggests that the easy money probably has been made. But there still is an interesting bull case going forward, particularly with a modest fade over the past three weeks. AE isn't nearly as compelling at $27 as it was at $17, but if a new management team maintains a relatively new focus on shareholder value, there's the potential for more upside ahead.
Normalcy Returns to the Valuation
After Q1 results last month, AE stock still looks awfully cheap. Unrestricted cash per share is near $21. And the company generated adjusted earnings per share of $1.81 in the first quarter alone.
But for a number of reasons, AE stock historically has been reasonably cheap. What was notable about March levels is how extreme the valuation was even in that context. In early June, the fundamentals appear much more in line:
Data by YCharts
Data by YCharts
The fundamentals still look attractive, to be sure. But attractive fundamentals haven't necessarily driven upside: exclude the March sell-off and AE still would be at an eight-year low at the moment. And, again, there are structural reasons why Adams Resources stock should appear and has appeared cheap, particularly from a balance sheet perspective.
AE's valuation in March, fundamentally speaking, was the kind of opportunity the market has not often provided (in any stock) since the beginning of the last decade. That opportunity has basically been captured. The stock rebounded. And Adams saw a significant outflow of cash in the first quarter. The cash balance dipped $25.6 million, thanks in large part to a significant reduction in early payments from customers. (That alone had a nearly $20 million impact, per the 10-Q.)
It's a different bull case in June than it was in March. But even with the higher price and more normalized fundamentals, the bull case still looks intriguing.
A Mixed Quarter for Marketing
The Q1 release creates a mixed outlook for Adams going forward. It's a classic good news/bad news quarter.
The bad news is, again, a significantly smaller asset base. Adams took an inventory valuation loss of $24 million in the quarter. Almost incredibly, per the Q, prices dropped from $62 at the beginning of the quarter to barely $20 by the end. That valuation charge led to a large loss on a GAAP basis.
Looking forward, those lower prices are going to impact demand for the marketing business in Q2, in particular. Adams wrote in the 10-Q that demand "has significantly decreased". The Baker Hughes Rig Count shows a startling reduction in drilling activity:
Data by YCharts
Adams wrote in the filing that it expects the reduction to be temporary. Presumably, there will be some rebound in drilling activity as the economy reopens. The revised OPEC deal adds another potential catalyst.
Still, it does appear that drilling activity - and thus demand for Adams' marketing services - should weaken in the mid-term, not just Q2. And that's an issue for a company that still generates the majority of its profits from its marketing arm.
Of course, revenue isn't the only driver of profits for the marketing business. Margins matter - and from that perspective Adams had a blowout Q1. What the company calls "field level operating earnings", which excludes inventory and derivative impacts, rose 146% year-over-year.
All of the improvement, and then some, came from margins: volume per day dropped almost 4% year-over-year. And at about 66 cents per barrel, those margins reached levels Adams hasn't seen in quite some time:
source: author from Adams Resources filings
The unanswered question is to what extent the chaos the oil market saw in March boosted those margins. There's little doubt it had some impact: the briefly negative oil futures prices seen in May were driven in part by a lack of storage (which Adams offers, and likely could have sold at very high prices in March). That said, the industry-wide storage issues appear to have arisen only in the last month of the quarter, which might suggest some strength in January and February as well.
The concern is that, whatever the cause, margins are going to normalize. As seen in the chart above, margins soared toward the early part of the last decade, as shale drilling commenced and activity sharply outpaced transportation capacity. Infrastructure caught up, the Seaway pipeline reversed and spreads narrowed sharply.
Whatever the cause, the margin expansion helped drive what looks like a massively impressive Q1 print on the earnings side, with adjusted EPS of $1.81. There is a catch, however: a big tax benefit (not excluded from non-GAAP figures) drove much of those profits. Adams on a GAAP basis recorded a tax benefit of $8.3 million.
Much of that benefit appears related to a $6.4 million receivable booked thanks to the CARES Act. Back that out and adjusted EPS came in at 30 cents, up nicely but not spectacularly from Q1 2019's 23 cents.
All told, there are some worries on the marketing side. The company likely will see demand pressure for at least the remainder of the year. The margin outlook is cloudy, but a significant compression seems likely in Q2, with a potential return to 2017-2019 levels even as drilling picks back up.
And that's a concern for AE stock, which historically has been correlated with those margins. The case for selling the stock at this point is based on the combination of a more normalized valuation relative to historic levels and potential earnings pressure on the marketing business over the next few quarters - or, possibly, the next few years.
Solid Quarter for Transportation
The same broad sense holds for the transportation business. Revenue increased 6% year-over-year, and 9.4% net of fuel costs (which are passed through to the customer). Operating earnings declined 28% - but that drop was driven by sharply higher depreciation and amortization, thanks to significant fleet additions in 2019. Segment EBITDA rose 33%.
In the context of the environment, however, this seems like a good quarter. Petrochemical demand plunged toward the end of the quarter - yet Adams was able to pivot to hauling necessities like bleach and soap. Meanwhile, the recovery in the share prices of Dow (DOW) and BASF (OTCQX:BASFY), the unit's two largest customers, suggest the market is pricing in a demand recovery in the core business.
Still, performance needs to get better. Over the last four quarters, the transportation business has generated less than $1.7 million in segment-level operating income. Adams invested $45 million (including a $6.4 million acquisition last year) in the business in 2018 and 2019 combined.
If Transportation can start showing consistent, material profit growth (beyond EBITDA numbers), that alone can drive a re-rating for AE stock. That growth would give the company a second, hopefully, more consistent, profit driver next to the often-volatile marketing business. And it might drive investors to start using small-cap trucking companies like ArcBest (ARCB) and U.S. Xpress (USX) as comparables - which, on an EV/EBITDA basis, suggests fair value for AE could get into the mid-$30s at least.
Can New Management Drive Upside in AE Stock?
Net/net, the news since March seems to suggest that AE is reasonably valued from a fundamental standpoint. In terms of enterprise value (~$31 million), Adams is about where it was in 2019. Price-to-book is more attractive looking backwards, but still clips the low end of the range. Given potential headwinds to marketing volume and a cloudy outlook for margins, a price below 2019 levels broadly makes some sense.
But where that valuation gets intriguing is in the fact that Adams is becoming somewhat of a different company. Part of the reason that AE's valuation has been historically depressed is that the company cared little for shareholder value. Cash piled up on the balance sheet, even though the decline in oil prices from $100+ peaks meant the marketing business required far less capital. Adams didn't make acquisitions. The only moves of significance for over a decade were exits from natural gas marketing and O&G exploration, neither of which were material contributors to profits.
But as I detailed at length in March, Adams Resources is getting much more aggressive. Chairman Townes Pressler said at a conference last year that the controlling Adams family had "embarked on a transition" to grow the business. (Indeed, the very fact that Adams held a presentation was a noted change.) Outside management has been brought in, with the marketing business getting a new permanent chief at the end of March.
The cash is getting put to work. Adams is spending another ~$9 million to buy the assets of CTL Transportation out of the Comcar bankruptcy. That follows purchases in each of the last two years, one on each side of the business.
These are baby steps, to be sure. We still haven't seen Adams hold another conference call after briefly experimenting with the format a few years back. Even with the acquisitions, the balance sheet remains overweighted with cash. A more drastic move, like raising a reasonably-sized revolver backed by inventory, which would free up capital for more investment and/or shareholder returns, maybe too much to ask for.
Still, there's been enough change in the last two-plus years to suggest that Adams has a different focus. CEO Kevin Roycraft is 49 and might be looking to make his mark. There likely will be opportunities to expand both marketing and transportation during this tumultuous time.
To be sure, the efforts could be reversed. They could fail. Any small-cap value investor knows that "management wants to spend the cash on the balance sheet" usually is a risk factor, not an upside catalyst. But for a company like Adams, that historically has had in the range of three-quarters of its market capitalization in cash, the potential for some sort of return on capital at the least makes the stock intriguing.
Whether that's enough at this point likely is in the eye of the individual investor. I'm tempted to take some profits here, and may at least pare down my position in the next few days. Still, in a market where obvious opportunities are not as prevalent as they were in March (or April), AE has one of the more intriguing bull cases. But, ironically, as cheap as the stock looks, it's not really the fundamentals driving that case anymore.
This article was written by
Analyst’s Disclosure: I am/we are long AE. 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.
I may exit or trim my position without notice.
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