Archrock Advantages Hiding In Plain Sight

Summary

• Contract gas compression company Archrock offers well-considered operations in a vital, but easily-overlooked midstream sector: natural gas compression.
• The company’s current market capitalization is $1.4 billion and it pays a 6.2% dividend. Growth comes from the ongoing need to move produced natural gas to domestic and export markets.
• While the company showed a net loss for 2020, free cash flow was positive, offering 2.9x dividend coverage. Earnings estimates for 2021 and 2022 are also positive.
• Looking for a portfolio of ideas like this one? Members of Econ-Based Energy Investing get exclusive access to our model portfolio. Learn More »

Photo by esemelwe/E+ via Getty Images

The oil and gas services sector has been battered for well over a year, so it’s been easy to overlook the vital niche of natural gas compression. Compression services are growing again as drilling picks up, as oil fields get gassier, as LNG exports increase, as producers seek to minimize flaring and emissions, and even as some companies consider retooling their gathering systems for future weather as extreme as the Texas arctic freeze.

Archrock (NYSE:AROC) is a key competitor in natural gas compression, an unheralded sub-sector with attractive prospects.

2020 Results

For 2020, Archrock reported a net loss of -$68.4 million, or earnings per share (EPS) of -$0.46, compared to net income of $97.3 million or $0.70/share in 2019.

This 2020 full-year loss includes:

*non-cash impairment of $99.8 million of goodwill from the 2019 Elite Compression acquisition;

*other non-cash asset impairments of $79.6 million;

*restructuring costs of $8.5 million;

*net benefit from tax audit settlements of $10.9 million.

Trailing twelve months’ operating cash flow was $335 million; while trailing twelve months’ levered free cash flow was $135 million. Cash was available for dividend coverage at 2.9x.

One of the ways the company adjusted to the industry-wide cutbacks in new production during 2020 was to cut growth capital expenditures from $221 million to $79 million.

In February 2021 4Q20 and annual report, Archrock CEO Brad Childers summarized: “Compression fundamentals continue to stabilize, we generated a strong contract operations gross margin, posted flat aftermarket services revenue and extended an additional $300 million in debt maturities to 2028 at a record low yield for the company of 5.183%.”

Contract operations represented 84% of total 2020 revenue and Archrock generated a 65% gross margin in this area. Aftermarket services represented the remaining 16% for which Archrock generated a 15% gross margin.

Horsepower utilization was 82% in 4Q20 compared to 89% in 4Q19.

Guidance

In February 2021, the company’s total revenue guidance for 2021 was lower than 2020 actuals; however, the gross margin percentages were similar. Looking forward, Childers mentioned higher commodity prices as well as higher rig counts and upstream spending, all of which are positive for natural gas production, and thus compression demand.

	Low 2021	High 2021	2020 Actual
Contract Ops Revenue, $MM	645	670	739
Contract Ops Gross Margin, %	63	64	65
Aftermarket Svc Rev, $MM	145	160	136
Aftermarket Gross Margin, %	16	17	15
Cash Avail for Dividend, $MM	182	216	254

Click to enlarge

Gas Demand and Prices

The Energy Information Administration (EIA) forecasts lower US natural gas demand, dropping to 82.9 billion cubic feet/day (BCF/D) in 2021 and 82.1 BCF/D in 2022. In part, this is due to higher expected gas prices: since coal and natural gas compete head-to-head in the electricity generation market, some natural gas would be displaced by coal. Natural gas demand history is shown below.

However, gas has to be moved not only within the US but to borders and ports for export. Export markets are increasing: 6.4 BCF/D of US gas went to Mexico in January 2021, up from 5.3 BCF/D a year earlier. As countries in Europe and Asia seek to reduce their carbon footprint, back up renewables generation, and/or lessen dependence on Russia, US LNG exports have also increased, from 3.6 BCF/D in 2019 to 11 BCF/D now.

In the Marcellus-Utica (PA-OH-WV) gas plays, companies have always sought to capture every molecule. As the focus on reducing emissions and flaring intensifies in oil-prone basins like the Permian and Bakken, even more natural gas compression will be required there. Also, depleting oil reservoirs often become gassier and may require gas lift, both additional sources of demand for compression.

A glance at the growth in dry gas shale production suggests the importance of midstream natural gas compression services.

Henry Hub Natural Gas Price, $/MMBTU

The graph below shows the February 2021 freeze spike in natural gas spot prices. Demand for gas was much larger than expected for both heating and electricity generation. Natural gas systems froze from wellheads all the way through to electric generating plants.

April 9, 2021, Henry Hub natural gas futures price (May NYMEX contract) was $2.56/MMBTU.

Credit: macrotrends.net

Competitors

Archrock is headquartered in Houston, Texas and is a leading provider of contract gas compression services. These include gas lift, transmission and storage, gas processing, and gas gathering.

Among its nearest competitors is limited partnership USA Compression Partners, LP (USAC). CSI Compressco LP (CCLP) is a $92 million market cap company that also provides gas compression services.

Archrock and Exterran (EXTN) were once parts of the same company: Exterran’s service focus is broader and more international, and it is a smaller ($123 million market cap) company.

Credit: Archrock.com

Strategy

The company has 4.1 million horsepower of compression capacity in 5,369 units with about half in the 1000-1500 hp/unit range and the rest split between smaller and larger sizes.

The company’s projected 2021 capital spending budget is $80 million-$106 million, with approximately half for growth and half for maintenance.

The company cites its diversified range of customer relationships (525 customers), multi-year contracts, and track record of managing capex to market conditions.

Other competitive advantages the company has are fixed monthly fees independent of throughput, operations in most major U.S. basins, emphasis on safety, largest fleet of large-horsepower units, and long operating history.

Governance

The company formerly had partnership operations, but the partnership merged into the corporation in 2018.

On April 1, 2021, Institutional Shareholder Services ranked Archrock’s overall governance as 2, with sub-scores of audit (2), board (1), shareholder rights (4), and compensation (2). In this ranking a 1 indicates lower governance risk and a 10 indicates higher governance risk.

Also in its 10-K, the company explains that “In connection with the closing of the Elite Acquisition, JDH Capital, an affiliate of Hilcorp, received 21.7 million shares of our common stock, representing 14.2% of our outstanding common stock as of December 31, 2020. As long as JDH Capital, together with affiliates of Hilcorp, owns at least 7.5% of our outstanding common stock, it will have the right to nominate one director to our Board of Directors.”

Shorts were 4.6% of float on March 15, 2021.

The company’s beta is 2.16, considerably more volatile than the overall market, representing a company on the front lines of the ever-changing natural gas sector.

Financial and Stock Highlights

With an April 9, 2021 closing stock price of $9.39/share, market capitalization is $1.4 billion.

The averages of analysts’ 2021 and 2022 EPS estimates are $0.30 and $0.44, respectively. Using the 2022 estimate gives a forward price-to-earnings ratio of 21.3.

On December 31, 2020, Archrock had $1.84 billion in liabilities, including $1.69 billion of long-term debt. With $2.78 billion in assets the liability-to-asset ratio is a steep 66%.

However, the company’s credit facility of $393 million is redetermined in 2024-2025 and its $1.3 billion in long-term debt is due after 2025.

Archrock's 52-week price range is $3.52-10.80 per share, so its April 9, 2021, closing price of $9.39 is 87% of its one-year high. For perspective because 2020 was so anomalous for the stock market (doubly so for energy stocks), the graph shows three years of prices.

Data by YCharts

The ratio of enterprise value to EBITDA is 8.0, so the company is into investor-friendly (bargain) territory of less than 10.0.

Archrock pays a $0.58/share dividend for a 6.2% yield.

Mean analyst rating is 2.6, between “buy” and “hold” from the eight analysts who follow it.

Archrock's book value is $6.12/share, below market value, and thus a positive investor signal.

Positive and Negative Risks

The impact of the Texas freeze could have no impact, could cause companies to seek freeze operations guarantees from Archrock and others in the midstream, or could cause companies upstream/midstream/downstream to reconfigure at least some of their equipment to protect against similarly extreme weather in the future. Again, failures from the week of well-below-freezing (72-year record) weather extended all along every energy and electricity generation chain, from field production to household pipes.

The company’s major exposure is a derivative of U.S. gas price and gas demand risk. While the Biden administration has switched off federal lands permitting, this largely does not affect the onshore areas in which Archrock operates. Renewed focus on reducing gas emissions and flaring in fact increases the demand for compression.

Recommendations for Archrock

Service companies are at the tip of the spear as illustrated by Archrock’s high beta. Moreover, third-party JDH Capital owns a key share of equity that allows it a seat on the board.

Still, as a leader in contract compression services the company has a history of safe, solid operations, reflected in its good governance score. Archrock flexed capex as needed in 2020, continued paying its dividend (now yielding 6.2%), and most of all it is a generally-unrecognized but critical part of the country’s energy backbone: that of getting natural gas from the field to LNG ports and to residential/commercial/industrial/electrical end-users.

I recommend Archrock to dividend-hunters and to those looking for growth and niche opportunities in the (low-carbon) natural gas midstream sector.

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.

Comments

[ganswijkw]

Europe buys more LNG than ever. Ships redirected from Asia Maior to Europe. Hope that drives EBITDA etcetc.

[Randol33]

Any update on this little disaster of a stock?

[Laura Starks]

@Randol33 sounds like you have one

[Randol33]

@Laura Starks Sitting on a $7 cost basis from last year. Already has given up all gains and I cannot decide if it is time to bail before it bleeds out another 20% or to let it ride.

[Laura Starks]

@Randol33 FWIW, drilling activity is picking up. US nat gas production above 2019 at 96.5 BCF/D with lots of new action in the Haynesville. And worldwide, from Saudi Arabia to Russia to US are discussions of the underinvestment that has occurred. There is even discussion of the Permian being gas-capacity-constrained again within a few years, which could bode well for Archrock. But I appreciate your dilemma.

[gutcheck]

why high ng price not helping aroc stock ?

[Biological]

@gutcheck AROC's fortunes are tied to NG volume(s), not NG price. They produce nothing. They compress gas for shipments. Production has to increase for AROC to benefit. NG prices are providing a market signal that more NG is needed -- there isn't enough. But NG producers got burned chasing NG, too much production, and are these days a bit more owner-centric, cautious.

[Thomas Gandolfo]

@gutcheck If oil and NG stay at current levels for another quarter or two (above $70 oil and above $4.00 NG), AROC will do very well. Their compressor units are used for both oil and NG. E&P companies have not been spending as much on CapX this year. However, at current oil/NG prices that is likely to change soon and in a big way. Once the E&P folks increase activity, they will need AROC's equipment and Compression rates and utilization should increase significantly.

[Laura Starks]

@gutcheck Good responses from @Thomas Gandolfo @Biological The supply of DUCs (drilled uncompleted) is smaller--to keep up production, more spending is needed. The market has preferred companies return $ to investors instead of chasing production, but the huge global gas shortage--if it continues--and the ability to export production may incentivize additional gas production-volumes-compression--AROC.

[Thomas Gandolfo]

Couple things probably going on here. The obvious one is oil prices have dropped from $75 in mid July to $63 today. Nat Gas has held up a bit better ($4.16 to $3.84). Covid come back concerns likely responsible. Second, in the past, Public E&P companies use to pick up capital spending big time at $60 oil. This go around they have been more cautious. I think we will need consistent $60+ and maybe even $70 WTI in order to see Cap Spending pick up significantly. Given the restrictions in certain U.S government land leases and hopefully a post Covid world, WTI should increase. However, no one can know for sure. AROC seems like a cheap option to play a rising WTI price if that is your view.

[khatcher]

If you can afford a hamburger you can can buy this.

[Randol33]

@khatcher Next week will be French fries and next month will be a can of soda.

[Randol33]

Looks like AROC share price is in some serious distress. Not hanging around for another 20% drop in Share price. Getting close to stop loss, will see if it executes today.

[Randol33]

@Randol33 Looks like they need to change the ticket to (A-ROCK) as in falling like A ROCK.

[ganswijkw]

Cannot find reasons SP going South.
Anyone?

[Randol33]

@ganswijkw Probably a 2 pronged response, one the entire sector was getting sold off, mostly irrational due to more lock down fears if I had to guess. Second would be the declining EPS estimates for AROC would account for some of the selling pressure over the last few months.

[Laura Starks]

@ganswijkw @Randol33 has good response. Also El Paso declared forced majeure in w TX (EIA Natural Gas Week.) Strong sense that 2q results will lag current action : 97 rigs now drilling for gas. While publics are hewing to relatively constrained drilling, privates are accounting for a lot of the action--thus, in addition to dry gas drilling, we could see more associated gas from the Permian. These high gas prices due to low inventory in US and Europe (and high NW cooling demand but little hydro in electricity gen) are a strong incentive right now.

[Thomas Gandolfo]

From today's WSJ (June 20, 2021):

"Natural-gas prices are starting the summer air-conditioning season nearly twice as high as they were a year ago.

Demand for the fuel is picking up as the world’s economies reopen and as Americans dial down their thermostats for what is expected to be a hot summer. Meanwhile, U.S. producers have stuck to the skimpy drilling plans they sketched out when prices were lower, eliminating the glut that was keeping them depressed.

Natural-gas futures ended Friday at $3.215 per million British thermal units, up 96% from a year ago and the highest price headed into summer since 2017. Futures traded even higher—and regional spot prices jumped—when triple-digit temperatures baked the Southwest earlier this month. Analysts expect prices to be even higher later in the year when it is time to fire up furnaces."

It isn’t just in the U.S. where gas is running high. Dutch gas futures, a barometer for prices in Western Europe, have more than doubled over the past year—including a sharp rise since February—to multiyear highs. In Asia, imported liquefied natural gas is fetching more than five times what it did last June, beckoning tankers full of chilled shale gas across the Pacific."

[Randol33]

Down -7% from article and its down -22% from its high. Its times like this I am glad I do my own research instead of trusting SA Authors.

[Biological]

@Randol33 I see; so you would rather buy a highly valued stock with immense downside than one that is selling, for whatever reason, at 22% below its high. Nothing has changed in this company's economics. It is still out there compressing gas just as it was last month and will likely bee in two years. I personally suggest you change your investment approach 180 degrees. Buy now; sell later at higher prices. And do own research.

[Randol33]

@Biological Its EPS estimates has been dropping continuously for the last 4 quarters so it is no surprise the share price has fallen continuously for the last 3 months and flat over the last 6 months.
My point was highlighting a bullish article on a stock that has dropped 10% since the article was published. I am a buyer in the $5 range, which shouldn't be too long when losing 5% a day.

[Biological]

@Randol33 Ah, that old chestnut - the last 4Q's....those were, I think, mostly COVID quarters. I am looking forward to the next 4 and I am almost certain that they'll be better than the last. Thus, buying at these levels may make sense.

[Thomas Gandolfo]

Good article, thank you. AROC should be setting up for a strong second quarter and outlook with oil now north of $70. It's important to note that their compressors are important to oil production, not just natural gas. Their customers in the oil/gas industry are in much improved financial condition than last year (again thanks to high oil prices). This is all setting up AROC in a nice position. Note the following from the 10K:

"Gas Lift Applications. Compression is used to reinject natural gas into producing oil wells to maintain reservoir pressure and help lift liquids to the surface, which is known as enhanced oil recovery or natural gas lift operations. These applications utilize low- to mid-range horsepower compression equipment located at or near the wellhead or large horsepower compression equipment of over 1,000 horsepower for a centralized gas lift system servicing multiple wells."

[firemanbob0854]

@Laura Starks Thanks for the article!

[gutcheck]

any update after div and er announcement

[Laura Starks]

@gutcheck Didn't follow up at depth but I'd go to mngmt commentary on stabilization and reduced decline. OFS (oil field services) are coming back but companies are waiting to see improvement outside the US on Covid and are cognizant of continued OPEC+ supply curtailments before increasing budgets to pre-Covid levels. seekingalpha.com/...

[cedarwoodken]

How much of the AROC disrtribution was ROC last year? TIA

[og123]

@cedarwoodken I'm not sure I understand your question. AROC is a C-Corp and pays dividends not distributions

[cedarwoodken]

@og123 Dividends and ROC are both forms of distributions paid by C-corps. I believe AROC in the past has paid significant amounts of ROC which in non-taxable. However Schwab says there was no ROC in the Nov 20 distribution and the AROC website is no help.

[og123]

@cedarwoodken They converted from MLP to C-Corp 2 or 3 years ago. They might have paid their ROC during their time as an MLP.

[Larry Hall]

Very informative, had not heard of AROC until a comment on another article today. Thanks.

[firemanbob0854]

@Larry Hall this is one of a group of companies that we follow. if you would like to have your horizons expanded look into Darp Research blogs here on SA. A very good group of savy investors to follow and debate with.

[LostinShalimar]

@Larry Hall Seriously? Cash Flow Kingdom has been bullish on AROC for years now.

[Larry Hall]

@LostinShalimar Have not delved into CFK's work on AROC..

[metal27]

Utilization percentage was touched on briefly but should be emphasized as a key indicator of performance. AROC and USAC are really asset leasing companies more than oilfield service companies; the higher their asset utilization percentage, the higher their income. Both companies saw lower utilization percentage in 2020, I believe both wrote off material amounts of old equipment and both should see utilization rebounds in 2021.

[Laura Starks]

@metal27 Thx for emphasizing utilization. Yes, lots of asset writedowns in the energy sector in 2020.

[bvrdublin]

Nice piece. You got a new follower!

[Laura Starks]

@bvrdublin Great!

[metal27]

AROC and USAC are in effect a duopoly, both pay very nice dividends and their customers need them regardless of prices, yet they trade with oil prices due to the ETF passive investing effect. Buy them when oil prices take a dip.

[angryprez]

@metal27 I own both USAC and AROC - couple of years with USAC and AROC since Fall of last year. Been dripping both, and USAC has become one of my largest income-producing positions.

Agree but what is surprising is how frequently they don’t move in tandem. Often see one up and the other down, or one up
/down significantly and the other only a bit.

Happy with my results - see this as buying the proverbial ‘picks, shovels and dungarees’ for miners, an essential part of the natural gas infrastructure that isn’t going anywhere.

Long both.

[krc112]

@metal27 AROC/USAC have little to no cash and short term investments $1M/$0. Is that any reason for concern?

[Laura Starks]

@krc112 Clearly the company has cash. Also, per the 10-K, the company has a $393 MM credit line.

[darnoc111]

Like most of the companies in the energy sector they have not performed very well. Since most investors look for income in this sector my question would be is, when will AROC be able to restart their dividend growth. Without a growing dividend, and perceived inflation growing the stock will continue to wallow and even possibly fall slowly in price. I sold out in 2018 and have watched as many have recommended this stock only for it to not do much of anything. Thanks for your help.

[jasonjones]

@darnoc111 At 6% dividend, why worry about inflation? Hard to get that dividend. Love dividend growth investors. Get 2% dividends and thrilled with fractional increases.

[Laura Starks]

@darnoc111 2020 was truly a wallop for OFS (oilfield services) companies Issues were showing up in 2019 as investors wanted more cash back (instead of acreage/production investments by producers) and especially as gas companies experienced a warm winter and even more oversupply.

[CincinnatiRick]

@darnoc111 "Sin" stocks have always been available at a substantial discount...and these days anything related to carbon-based energy is in the cross hairs (pun intended) of our modern puritans. My guess is that the carbon energy curve will more resemble that of the tobacco stocks than the private prison industry simply because of differentials in the relative capacity of government to control the market. So I'm long Archrock with a mid 8 handle and been happy to collect the nice dividend and sell covered calls...rinsing and repeating several times now. Currently have May calls out with a $10 strike. We'll see what happens but it's a profit whatever way the cookie crumbles.

[Greg_Maryland]

Nice note, I'm long.

[deeksha101]

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