On October 26, 2017, I recommended the stock of Mammoth Energy (TUSK) at $16.58, suggesting the shares could double or triple in 12 to 18 months with relatively little downside risk at that price. Since then, the shares have traded as high as $25. On Friday, the shares closed at $21.82, declining more than 8% in a sloppy tape. For the reasons I discuss below, this represents another low-risk entry point.
The company will report earnings on February 21. I believe the shares can trade to $28-30 in the wake of a blockbuster earnings report. On the conference call, management will no doubt discuss the longer term potential for the Puerto Rico contract. Longer term, I believe the stock can easily trade to $45-60 by the end of the year. This is a quality company with quality management, and it is going places.
The shares sold off more than 8% in a sloppy tape on Friday. This provides what I believe to be another attractive low-risk entry point.
A Brief Overview Of The Company
I will start with a brief overview of the company for those who are new to the story. More details, of course, can be found in my original write-up.
Mammoth Energy is a mid-sized ($1 billion market capitalization) oilfield service company originally focused on providing hydraulic fracturing services (pressure pumping, directional drilling, natural sand proppant and logistics ) in the lower-48 states. The company has a broad national footprint focused on the most attractive unconventional shale plays, including the Permian, the SCOOP/STACK and the Marcellus basins.
As a company, Mammoth is perhaps best distinguished by something relatively intangible - the quality and philosophy of its management. CEO Arty Straehla is not the typical oilfield CEO. He spent 26 years at Goodyear, eventually running their manufacturing operations. A recent Credit Suisse report described him as a "smart, well trained, opportunistic, and has the goals of making money and a positive return." This is a company that does not define itself by its size or its market share or by what it did yesterday. Rather, it is a company focused on making smart investments and earning the highest return on capital in the world of tomorrow.
In my original recommendation, I explained that management had internally identified the utility infrastructure business as a highly promising adjacent business with good margins, stable cash flows, strong returns on capital and the potential for significant growth. They described the business as "less cyclical and less capital intensive, but equally technically challenging with the ability to cross-sell to its existing customers" as compared with its core oilfield services business. In mid-2017, Mammoth stealthily acquired two small companies (for a total of about $8 million) to use as a springboard for launching into this new line of business. While well-established, these companies were starved for expansion capital - a matter which was promptly rectified by management.
The Puerto Rico Contract And Extension
In October, before most analysts even knew they were in this business, management announced its new Cobra subsidiary had been awarded a massive $200 million contract with the Puerto Rico Electrical Power Authority (PREPA) to help rebuild the island's utility and energy infrastructure, which had been all but obliterated by Hurricane Maria.
This contract was originally scheduled to run for approximately 120 days, suggesting a revenue run rate of approximately $1.7 million per day. On this basis, I originally estimated that perhaps $125 million of revenues would fall into Q4:17 and the balance into Q1:18. For context, without this contract, Mammoth would have reported in the range of $150 million revenues for the fourth quarter. In other words, this one contract would have increased Mammoth's revenue fourth quarter by more than 80%. While management has not revealed the expected EBITDA margin on this contract, it has affirmed that it will be accretive to the corporate average EBITDA margin. On that basis, I estimate an EBITDA margin of 20%. Thus, this one contract would produce $40 million in cash flow over just 120 days - that's a stunning return on an $8 million initial investment.
Unfortunately, at about the same time, another small company called Whitefish Energy was also awarded a similarly massive contract by PREPA. But this contract immediately erupted into a raging national controversy amid charges of shady dealings, political influence, and price gouging. Within weeks, that contract was cancelled, and Ricardo Ramos, the then-head of PREPA, was forced to resign. Because the same management at PREPA which awarded the contract to Mammoth was also involved in the tainted Whitefish contract, there were obvious questions over the propriety of Mammoth's contract as well.
On January 30, Mammoth made several startling announcements, all with significant implications for near-term revenues and earnings. Any lingering concerns over the propriety and potential of the original PREPA contract have now been entirely put to rest.
First, the $200 million of revenue for the original contract, which was expected to be recognized over 120 days extending well into Q1:18, was in fact all recognized in the fourth quarter. According to the company's 8-K filing, "Subsequent to Cobra's initial mobilization to Puerto Rico, PREPA asked Cobra to increase its staffing on multiple occasions." In discussions with investors, management has explained that its team has been performing exceptionally well, essentially "turning the lights on" faster than anyone else. Thus, instead of recognizing perhaps $125 million of revenue (and $25 million of EBITDA) in Q4:17, the company recognized at least $200 million in revenue (and therefore, approximately $40 million of EBITDA).
Second, and more importantly, the company announced that it had been awarded a further $245 million extension to the contract. According to the 8-K,
Due to the continuing need for Cobra's services, on January 28, 2018, Cobra and PREPA amended the Initial PREPA Contract to increase the total contract amount by an additional $245.4 million to a total of $445.4 million (the "Amendment"). Under the terms of the Amendment, the number of workers requested by PREPA and provided by Cobra increased to at least 882, up from 434 in the Initial PREPA Contract, and the billable daily rate for those workers was decreased. Based on the current level of services provided, Cobra anticipates the additional amount specified in the Amendment will fund an additional 77 days of its services.
In other words, this $245 million contract extension will be fully recognized by mid-March, meaning that contract revenues for Q1 will be at least that amount. (Almost certainly, the contract will again be extended again and, at the current $3.2 million/day run rate, Q1 contract revenue could be closer to $300 million with corresponding EBITDA generation of $60 million.) According to management, pricing in this contract extension will be about 6-8% lower than in the original contract - a very modest decrement considering the company has likely been able to reduce its costs by at least that amount.
Finally, and perhaps most importantly, the company also disclosed that,
Cobra intends to seek additional repair and restoration work for PREPA's electric grid beyond the service period provided for in the Amendment, as well as work rebuilding and modernizing PREPA's electrical grid once the repair and restoration phase is complete. However, there can be no assurance that Cobra will be successful in securing this additional work.
In discussions with investors, management explains that the rebuilding and reconstruction of the Puerto Rico power grid is a long-term project that will require many tens of billions of dollars over many years. Currently, efforts are in what is known as the "rebuilding" phase - that is, where the primary goal is to turn the lights back on as rapidly as possible. For example, if one in three wooden utility poles is down, the focus will be on that downed utility pole. Once power is fully restored to the island, efforts will focus on "reconstruction" of the entire power grid - where the primary goal is to strengthen and modernize the electrical grid so that this kind of disaster can never happen again. Here, for example, all three wooden utility poles may be replaced with something more hardened and storm resistant.
So, how long will the rebuilding effort take? Hurricane Maria made landfall in Puerto Rico on September 20, 2017. A recent report was issued showing that more than months later, 43% of customers are still without power. As things stand now, many of the rural areas will not get power for another five months, and the most remote mountainous regions will not get power for as long as eight months. A recent article in the New York Times explains why it is taking so long.
"The sheer amount of work," said José E. Sánchez, an engineer at the corps who leads the power restoration task force. "The first time I saw it, I thought: 'This is going to take a long time.'"
The damage to an already outdated and poorly maintained grid was comprehensive. Lines went down, poles snapped, towers fell and substations flooded. There are 30,000 miles of electrical line in Puerto Rico, and about 63 percent of it was affected.
To underscore the scope of the work: Almost 50,000 power poles need to be repaired or replaced. Add 500 towers to that. And the towers are so heavy that helicopters cannot carry them, so they have to be installed in stages. It can take up to 10 days just to finish one.
And some of the supplies, such as the 30,000 power poles that were ordered on Oct. 6 - 16 days after the storm - are beginning to arrive only now. Some 400 miles of cable are expected to reach the island in the next two weeks, Mr. González said.
Indeed, it would seem that efforts to restore power are only starting to hit their stride. And once power is fully restored to Puerto Rico, that only means that the reconstruction phase will begin in earnest, potentially providing years more work for Mammoth. During that phase, the entire electrical grid will be modernized and brought up to modern standards. Wooden utility poles will be replaced by environmentally hardened alternatives. Fifty-year-old substations will be rebuilt in their entirety. Of course, there can be no guarantee that Mammoth will participate in further rebuilding or reconstruction work, but that would be an unlikely scenario. The company is now a known entity that has proven itself under the most arduous and time-sensitive conditions. They have already been paid to mobilize over 882 workers and many millions of dollars of equipment to the island, so now, they are essentially competing for work on only a variable cost basis. As long as they keep executing, they will get a significant piece of the work.
How long can this upcoming reconstruction phase last? The answer is measured in years. By way of example, management notes that the Federal Emergency Management Agency (FEMA), which is also involved in the overseeing the Puerto Rico rebuilding effort, is currently still awarding contracts for reconstruction related to Hurricane Sandy more than five years ago.
Current staffing on the island is "at least" 882 workers, more than double the initial 434 workers. The language of the 8-K suggests that staffing has not yet hit a plateau and there is significant potential for yet a further increase in the daily revenue (and EBITDA) run rate.
One final note - bear in mind that Mammoth's utility infrastructure business is not only about Puerto Rico. In the lower-48 states, the Cobra division is currently running at a $54 million annual run rate, and management's goal is to grow that run rate by 75-100% in 2018. Management estimates that this is a $65-70 billion annual business over the next five years, and I would expect significant further growth into 2019 and beyond.
The Pressure Pumping And Hydraulic Fracturing Business
While mammoth outperformance for the company's Cobra division is all but assured, I expect that the company will also deliver substantial outperformance in its core hydraulic fracturing business.
In my original article, I explained that the cost to produce oil from unconventional (shale) basins such as the Permian and the Bakken had declined precipitously since 2014. Shale oil is now an important swing producer and, as I wrote, "$50 oil is approximately the price that makes it all happen." At the time, oil was at $52. Today, oil is at $65. In sum, business conditions can best be described as tight and tightening. Both utilizations and pricing are rising, and over the next year, I expect significant outperformance relative to current expectations.
The chart below is an excellent summary of the current market for all things fracking related - that is, pressure pumping, sand proppant, and trucking demand. As can be seen, even though the rig count remains far below its 2014 peaks, the fact spread count has fully recovered to its peak level. Demand for all of Mammoth's services is back to peak levels.
Source: Primary Vision
For Q3:17, Mammoth reported EBITDA of $27 million, which was substantially better than consensus estimates of $23 million. About half of this $4 million outperformance was attributable to its nascent Cobra operations, with the rest attributable to the pressure pumping services, where the company was beginning to experience significantly better pricing.
Significantly, however, the company was able to achieve this level of outperformance despite a severe miss in its sand proppant business, which was impacted by larger-than-expected start-up costs. Raymond James, for example, was estimating EBITDA of $8.7 million in this business, about $5.2 million more than the company actually reported. In other words, despite falling dramatically short by more than $5 million in its frac sand business, the company was still able to outperform oilfield EBITDA expectations by $2 million - a $7 million outperformance in the rest of its business lines.
According to the company's current presentation, it recently invested $23 million to increase capacity at its Taylor, WI sand mine from 0.7 million tons per annum (tpa) to 1.7 million tpa. This is a particularly attractive mine which can produce the highly desirable Northern White Sand at a cost of just $10-12/ton, placing it within the top quintile of the industry from a cost perspective. The Taylor expansion should be complete by now, and the incremental 1 million tpa of sand can produce an incremental $50-55 million in annual revenues against a variable cost of just $10-12 million. That's almost $1 per share of incremental gross profit.
While the Q4 may also reflect some amount of start-up costs, I think there is the potential for a major upside EBITDA surprise from this division. As can be seen below, since Q1:16, the company has increased sand capacity almost tenfold. While this may have seemed a dubious decision as pricing collapsed throughout 2016, pricing has now fully recovered to earlier levels. Through Q3:17, EBITDA from this business line has not kept pace owing to lower pricing and the aforementioned start-up costs.
Source: Author estimates
Beginning Q4:17, the company will also commence shipments under a three year take-or-pay contract at a rate of 720,000 tpa, or 180,000 tons per quarter. With continuing tightening in the sand market, I expect the company to report mine gate sand realizations of approximately $48.50/ton. (Current spot prices are in the $50+ range.) A dramatic increase in EBITDA is all but inevitable. I have penciled in some estimates, but really, they are just a guess. By the third quarter of 2018, the company expects to increase sand capacity by another 50%, while at the same time, significantly decreasing its costs. With continued pricing support from a tight sand market, Raymond James estimates that the company could report $72 million in EBITDA from its sand business in 2018.
While the major frac sand producers have yet to report fourth quarter earnings, Eagle Materials (EXP), a smaller provider of Northern White, reported that they were essentially sold out during the quarter. Management's decision to increase sand capacity was both foresightful and timely, and it is reasonable to assume that its sales volumes will only be constrained by capacity.
So, with all that said, what are the company's revenue and EBITDA prospects for 2018 and, more importantly, what is the stock worth today? My response is that when opportunity knocks, sometimes, it is more important just to answer the door and figure out all of that other stuff later.
Neither I nor any of the analysts following the stock have a full grasp of what the ongoing work in Puerto Rico can contribute to the company's top and bottom lines. In sum, I believe that the company will work unimpeded in Puerto Rico for at least the next three years. As per the New York Times article, I believe that in the fourth quarter, the pace of work was hampered by start-up issues such as supply chain inefficiencies, and the rebuilding efforts are only now hitting their stride. I believe that the pace of work will continue to increase, and Mammoth's revenue run rate has not yet plateaued. When the current $245 million contract extension expires in mid-March, I am almost certain that it will be replaced by a further extension of comparable if not greater size.
In my opinion, there is a lot of visibility to the scope and duration of the work in Puerto Rico. To understand the potential here, all you need is a little common sense. But because of the nature of the governmental agencies that fund that work, I expect that there may never be a lot of long-term contractual visibility. That doesn't bother me. That's the way a lot of businesses work. I may not be contractually committed to the guy who mows my lawn, but I've been using him for 15 years. I know him, and he knows the property. As long as he continues to do a good job, he's got the job. This is much the same.
All of the analysts also appear convinced that this contract extension is likely just the first of many for the company. But for the purposes of their published estimates, they include nothing beyond what has been publicly announced. Therefore, their revenue and EBITDA estimates for 2018 are absurdly low.
For example, Raymond James (which has a first-rate energy team) is currently estimating as follows:
Source: Raymond James report dated January 29, 2018
Even using its estimates, TUSK is now selling at an enterprise value of just 3.9x 2018 earnings, a remarkably attractive valuation for a company with a clean balance sheet, healthy margins, and a suite of rapidly growing businesses.
But, as can be seen, Raymond James is forecasting no Puerto Rico business after Q1:18. Is this what it really believes? I don't think so. The reality is that it simply doesn't know what to forecast, so it has chosen not to forecast. In my opinion, its forecast for Q1:18 is low because while the Puerto Rico contract will be fully recognized into earnings as early as March 18 work will almost certainly continue after that. In fact, I assume that the company will work unimpeded in Puerto Rico for all of 2018 at approximately the same run rate. While certainly not assured, I think it is a reasonable assumption. Certainly, it is more reasonable than assuming it will get no more work.
This leads to the following estimates for 2018:
Source: Author estimates
The only change I have made is to assume that the Puerto Rico contract continues at the current revenue run rate of $3.187 million/day at a 20% EBITDA margin. In this scenario, which I think is far more likely than the overly conservative Raymond James scenario, we can see that the company is in fact selling at just 2.3x potential 2018 cash flow generation.
The implications to the balance sheet are extraordinary. In the analysis below, I have adjusted cash balances only for the cash generated by the Puerto Rico contract. I assume that cash flow generated by the company's oilfield business is reinvested into supporting and expanding the business.
As can be seen, at the end of Q3:17, the company had net debt of approximately $80 million. I expect this will be reduced to net debt of just $38 million after the fourth quarter, and by the end of 2018, the cash generated by the Puerto Rico contract should see net cash balances swell to over $200 million.
Source: Author estimates
So, what are the implications of having that kind of a cash balance?
On November 1, 2017, the company filed an S-3 for the registration of primary and secondary stock. At the time, the shares sold off because the market became concerned about the potential for significant near-term issuance. In my opinion, the likelihood of any near-term stock issuance is now highly unlikely. The company just doesn't need the money.
Management here has proven itself to be an astute capital allocator. Thus, my thought at the time of the S-3 was that any capital raise would be a net positive because it meant that management had uncovered further opportunities for investment and expansion. Now, with a clean balance sheet, and given the likelihood of immense organic cash generation through 2018, any potential expansions can almost certainly be financed internally. In my opinion, a primary offering is now off the table, yet management will still have plenty of funds with which to find new opportunities - a win-win situation for all.
To be clear, a significant percentage of this company is still owned by private equity. It will eventually want to monetize some of its holdings, but these are savvy players. They understand what the stock is worth, and they aren't going to give their stock away. When prices hit the right level, I would not be surprised to see some sort of secondary distribution. But I don't think we are anywhere near that right level currently. Maybe at $28-30, but if I were them, I would not be in any rush. They are smart, clever, and patient. They will find a way to monetize their holdings - perhaps even by selling the entire company.
Disclosure: I am/we are long tusk.