Solaris Oilfield Infrastructure (NYSE:SOI) is looking to tide over the dramatic fall in activity in Q2 when it kept the majority of its proppant and chemical systems fleets idle following the pandemic. As the completion activity shows signs of a revival in Q3, the company can expand at the operating margin level as a result of its flexible direct cost structure. So, the EBITDA can ramp up in the medium term. However, the top line won't back up soon because the company will not add to its existing fleet in the short term and average revenue per system can decrease in the near term.
SOI has initiated various cost reduction initiatives, including revising down the FY2020 capex further to improve free cash flow. It has a robust balance sheet with zero debt and a burgeoning cash balance. Despite losing revenues and profits, it maintained the dividend payout on the strength of the balance sheet. So, the fragility in its fundamental business did not reflect in the stock price movement, and it performed in line with the VanEck Vectors Oil Services ETF (OIH) in the past year. I think returns from the stock will stay muted in the short term, but there are some tailwinds to press its price upward in the medium term.
As the crude oil price continues to consolidate at the $40 level, many operators start to resume completion activity. SOI's management expects to see the U.S. onshore completion activities to recover by 35%-40% in Q3 from the Q2 level. No doubt, the company suffered a significant top-line loss as 76% of the number of fully utilized systems in its fleet stopped operating in Q2. The COVID pandemic crushed energy demand and prices resulting in an unparalleled reduction in oil and gas industry activity. Therefore, the only possible option to hold mitigate the pressure on the margin level is to offer innovative products that improve data and automating processes by redesigning the systems and cost curtailment. A couple of innovations include upgrading and adding new capabilities to Solaris Lens that will help customers gather information and analysis in real time. Plus, it allows tracking sand use data by stage and well more accurately. For a more detailed analysis of how its offerings are benefiting the customers, read my previous article here.
SOI, like many other oilfield services companies, has reduced costs and improved liquidity to manage the downturn. On top of the Q1 cost-cutting initiatives, which reduced headcount by more than 50%, it has now slashed some of the overhead layers in the organization and source several fields and support functions.
SOI's management expects the fully utilized U.S. frac crew count to rise between 35% and 45% in Q3 compared to Q2. Because completions activity is expected to improve modestly in Q3, the company's EBITDA can improve moderately. However, lower pricing can result in a 3% to 5% average revenue per system decrease in Q3. Also, the company anticipates its working capital to dip modestly in Q3. So, it narrowed the capex guidance for FY2020 to between $5 million and $10 million, which can help stabilize free cash flow. Investors may note that free cash flow and a strong balance sheet helped maintain the dividend payment at $0.105 per share for the past couple of quarters, after increasing it by 5% in December 2019. Maintaining dividend despite the fact that earnings turned to a loss has been the key feature for SOI. Going forward, however, I think the company can find it challenging to maintain the dividend payment unless activities improve swiftly.
In Q2 2020, Solaris Oilfield Infrastructure's total revenues crashed by ~80% compared to Q1 2019. Much of the revenue decline came from a reduction in completions activity and last-mile services. The last-mile services constitute a significant trucking component at the margin level. However, during Q2, the fall in demand translated in a 76% lower average mobile proppant management systems (fully utilized) compared to Q1.
Decreased pricing and the impact of adverse product mix led to a 13% lower average rental revenue per system in Q2. As a result of the lower volume, the company saw lower cost absorption, which contracted gross profit margin to 23.7% from 44.6% in Q1. Lower gross profit also resulted in EBITDA turning negative in Q2. Although pricing caused much of the deterioration in the margin, it may well have spilled into Q3, which can further reduce the average revenue per system by 3% to 5% in Q3 compared to Q2.
SOI has no debt, which puts it in a significant advantage over some of its leveraged peers, especially when the fracking and completions related activities are perilously down. As of June 30, 2020, its cash and equivalents were $63 million. Compared to Q2, cash balance increased by 39% due to higher accounts receivable collections.
SOI's cash flow from operations (or CFO) decreased by 40% in 1H 2020 compared to a year ago. However, in 1H 2020, its capex nearly fell to zero following the drop in the manufacturing rate of new proppant systems, which resulted in a higher FCF in 1H 2020.
It has recently lowered its FY2020 capex budget, as I discussed earlier in the article. The FY2019 capex would be a significant reduction compared to FY2019. Lower capex can improve FCF in FY2020.
SOI's forward dividend yield is 5.36%. In comparison, Schlumberger (SLB), the largest oilfield services company, pays a forward dividend yield of 2.6%, while Halliburton's (HAL) dividend yield is 1.1%.
I have observed a regression equation based on the historical relationship among the crude oil price, completions wells count, the U.S. frac spread, and SOI's reported revenues for the past five years and the previous four-quarter trend. Based on the model, I expect revenues to decrease in the next twelve months (or NTM). It can recover in 2022, while the recovery can accelerate in 2023, and will continue to grow in the year after that.
Based on a simple regression model using the average forecast revenues, I expect the company's EBITDA to decline sharply in NTM 2021. The model suggests it can continue to fall in 2022, but will increase dramatically in 2023 and stabilize in 2024.
I have calculated the EV using SOI's past and forward EV/EBITDA multiple. Returns potential using the past average multiple (7.3x since Q2 2018) is much higher (112% upside) compared to returns potential using the forward multiple (47% upside). The sell-side analysts expect much lower returns (9.5% upside) from the stock. I think the stock has a slight positive bias.
SOI's forward EV-to-EBITDA multiple expansion versus the adjusted trailing 12-month EV/EBITDA is in line with peers, which should typically result in a similar EV/EBITDA multiple compared to peers. The company's EV/EBITDA multiple (3.76x) is lower than its peers' (PUMP, WTTR, and LBRT) average of 4.6x. It is also trading at a significant discount to the past average. So, the stock is slightly undervalued at the current level.
Solaris has slashed its proppant and chemical system fleets following the decline in active hydraulic fracturing and completions activities after the pandemic. After a couple of very low-intensity quarters, the completion activity appears to be moving north in Q3. To its advantage, because it is operating at a low-cost level, it will not require to add to the existing general & administrative cost structure or at the direct costs level even if revenues increase from the current level. So, I think its EBITDA margin can expand. However, it will still be significantly lower than a year ago because sales have been severely down, and the company is not looking to add any system anytime soon.
SOI is quite upbeat about the completions activity revival in Q3, but in reality, the industry activity can underperform the management's expectations. To beat the slowdown, the company will reduce FY2020 capex further to improve free cash flow. I think the operating margin-level resilience will drive the stock in the market in the medium term.
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