Shares of Kodiak Gas Services (NYSE:KGS) have seen a lackluster public debut with shares trading flattish in the aftermath of its public offering, even as pricing took place at a discount from the preliminary offering range.
While I am typically attracted to discounts being offered in public offerings, I fail to see the appeal here amidst a very leveraged balance sheet and concerns on the cyclical element (among others) of the business here.
Delivering Horsepower
Kodiak claims to be the leading operator of contract compression infrastructure in the US. These commercial operations are key to produce natural gas and oil reliably, as the company operates horsepower compression units under fixed-revenue contracts with both upstream and midstream customers.
This partnership model, in key regions like the Permian basin (where about 70% of capacity is stationed) and the Eagle Ford Shale, means that the company plays a key role in the energy infrastructure, with LNG only set to grow requirements for compression horsepower in this region for the foreseeable future. That at least is the claim of the company itself.
The company operates a fleet of 3.2 million horsepower of compression units, with over 3,000 actual compressing units, most of which have over 1,000 horsepower each, badly needed as these unconventional resources require more pressure than traditional oil wells.
The company has a fixed revenue contract with major players, in fact, it generates about 40% of sales from the four largest customers, with the leading customer being responsible for a percentage in the low double digits.
Having just owned 650,000 horsepower of capacity in 2017, the company grew to a 2.6 million horsepower capacity base in 2019 which it has steadily expanded to 3.2 million horsepower, with occupancy rates surpassing 98% over time (and often approaching the 100% mark).
Given the rapid ramp-up of the fleet and capacity, the average life of these units is only seen at 3.7 years. With mechanical availability being key and oil majors and unconventional players looking to forfeit capital spending, Kodiak believes that it is well positioned to operate successfully in this niche segment as a key partner to these operators.
Valuation & IPO Thoughts
Kodiak, initially aimed to sell 16 million shares in a $19-$22 range, but demand for the offering was soft, resulting in pricing of the public offering being reduced to $16 per share. This reduces the gross proceeds of the offering to $256 million, money which is earmarked to lower the net debt load of the business.
With a total of 75 million shares outstanding, this implies that former shareholder EQT will remain a majority shareholder post the offering, as equity of Kodiak is awarded a $1.20 billion equity valuation.
The IPO documents reveal a pro forma net debt load of $1.78 billion post the offering, yet this was based on the midpoint of the preliminary offering price. Given that the lower offer price resulted in $72 million in fewer gross proceeds from the offering, that net debt load actually increases to about $1.85 billion.
Looking at the actual results, we see that the business grew sales from $606 million in 2021 to $708 million in 2022, driven by higher capacity and pricing. Operating earnings rose from $189 million to $222 million, in the absence of a modest impairment charge in 2021. This is a significant profit, but of course comes ahead of interest expenses, which in 2022 were very high at $170 million, in part made up from gains on derivatives. Adjusted EBITDA of $399 million is high, with leverage ratios coming in at over 4.5 times.
First quarter sales for this year rose about 13% to $190 million as the company grew operating earnings in a rather similar fashion to $60 million, with EBITDA of $106 million meaning that it tops $400 million per year here. The question is of course how much earnings power is reasonably expected going forward with energy prices having retreated from 2021 highs.
With operating earnings trending at $240 million, and assuming that the company can (over time) finance at around 6% (given leverage ratios and prevailing interest rates), I peg annual interest expenses around $110 million. After a 25% tax rate, that works down to earnings of around one hundred million per annum, for earnings of around $1.30 per share.
Concluding Remark
While the earnings power calculated above looks interesting given the prevailing share price, I am extremely cautious here. Even as the company has nice words about its strong competitive position, I regard this business as somewhat of a commodity-like business.
This creates of course cyclical uncertainty as oil prices have seen their swings (this year as well). Moreover, there are many more uncertainties in the long haul related to the electrification of the equipment (perhaps due to more stringent environmental regulations), but of course also the impact of continued focus on ESG on the long-term perspective for the customer base of Kodiak, which is the biggest concern after all.
Amidst all this, while the balance sheet remains heavily leveraged, I find it very easy to avoid the shares here, as I have no interest to get involved here, despite the optics of a cheap price-earnings multiple.
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