The Spice Must Flow: ArchRock And USA Compression Partners

ArchRock And USA Compression Partners

The core of this article was first released to Cash Flow Kingdom subscribers on Nov. 2. I have tried to update all numerical data since then, but there may be some I missed.

Macro:

Solar and wind proponents will often contend their cost of production has been falling drastically and is now competitive with a natural gas combined cycle plant for electricity generation. However, natural gas isn’t just used for electricity generation. It also has heating, cooking, and industrial uses (e.g. plastics manufacture, fertilizer manufacture, etc.) that solar and wind cannot replace. Moreover, even when restricted to electricity production it simply isn’t true that solar and wind are as cheap as gas.

This is primarily because solar and wind have an intermittency problem that natural gas doesn’t. The wind doesn’t always blow and the sun doesn’t always shine. Thus as California recently saw to its detriment, the need to consistently provide baseload electricity means solar and wind need some form of storage or alternative generation when the sun isn’t shining and the wind isn’t blowing. Factoring in these costs completely changes the picture.

Below is an analysis completed by Professor Stephen Arbogast at the University of North Carolina at Chapel Hill and his associates.

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Source: “Measuring Renewable Energy as Baseload Power”

Scenario 1, the first column, shows the costs of a natural gas combined cycle plant “NGCC” generating 650 MegaWatts “MW” of baseload power over a year. This plant is down 15% of the time for maintenance, but otherwise able to run throughout the year rain or shine and produce power at a cost of $47.1 per MegaWatt Hour “MWh” (including a 10.5% return on equity ‘ROE’ for investors).

Scenario 3, the fourth column, shows the cost of providing the same 650 MWh of baseload power for an entire year via solar including the cost to store it during times when the sun isn’t shining. The main problem here is the sun doesn’t shine at night.

As you can see in the Capital Expenditure line, the Capex needed to do this is more than 10 times that needed for our NGCC plant, raising the cost per MWh to almost four times that of the NGCC plant. Yet, when people are asked whether they are willing to pay even $10 more per month to support clean energy, much less 4x the cost, the vast majority say no.

“A 2017 survey from the Smart Grid Consumer Collaborative came to a similar conclusion: 82 percent of respondents supported utility clean energy expansion at no cost to them, while that number dropped to 39 percent if the change involved a $10 increase to their monthly bill.”

Looking through the various alternatives in the figure above we see the best renewable option to a natural gas combined cycle plant is scenario 2, a natural gas plant plus solar. However it still costs almost twice as much per MWh as the natural gas plant on its own.

Thus I conclude even for electricity generation, much less cooking or heating, natural gas usage isn’t going anywhere any time soon.

Demand:

The Energy Information Administration now expects U.S. natural gas volume consumed to decline 1.8% in 2020 vs. the 3% decline they had predicted earlier. The main driver of the decline is lower consumption in the industrial sector because of COVID-19 related reductions in economic activity as well as the shut-ins of associated gas wells due to the oil price war.

This however is being offset by the expectations of a colder than average winter. Regardless a 1.8% to 3% decline is not significant when compared to how COVID-19 has hit demand for other energy commodities nor the US economy as a whole. The reason for this strength and stability of demand is the main uses of natural gas -electricity production, heating, cooking, and even some major industrial uses such as fertilizer manufacture – continue even as everyone stays at home and practices social distancing. This is not a surprise. Natural gas demand didn’t decline during the Great Recession and even increased slightly during the 2015 oil price shock.

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Source: Energy Information Administration ‘EIA’

Some uses of natural gas, such as LNG export, declined more than expected the first half of 2020, but are since rebounding and the continued ramp of natural gas for electricity production has compensated for the majority of losses elsewhere.

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Source: US EIA Weekly Natural Gas Update

This stability of long-term demand may be part of the reason why Warren Buffett wanted to buy Dominion’s (NYSE:D) natural gas assets. Remember however that it’s not the price of the natural gas (or oil) that matters for most midstream firm cash flows, but rather the volume transported. Furthermore,

“…as long as (natural) gas is being produced and moved throughout the system – pipelines, processing plants, et cetera – compression is required.” In fact, “…as pressures decline, (moving) the same volume of gas requires an exponential increase in compression horsepower.”

– Eric Long, USAC CEO

This chart shows midstream firms that have a sizable natural gas component.

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Source: Stock Rover

In the rest of this article we will review the Q3 earnings of the three firms highlighted in yellow which lease natural gas compression engines to the industry. Again you can’t move natural gas from here to their without using a compressor.

ArchRock (AROC):

ArchRock is my favorite firm in the sector. It managed to post a solid quarter with higher than expected margins (63% GM%, and 55% EBITDA margin), despite low utilization (83%). To be fair however I still have doubts these kind of margins are sustainable. However it’s also clear the combination of an oligopoly in the sector, and high HP units being costly to move, is helping to prop up lease prices. Units placed with customers but held on standby (hence no operating costs) also are helping to goose the margin a bit, but management indicates almost all of those units have since been turned back on. Thus I think margins will one day revert back to about a 58% – 60% level.

DCF coverage came in at 3.5x for the quarter on a 7.7% dividend yield or a 27% DCF yield. EV/EBITDA is only 7.1x. I’m probably sounding like a broken record but this is remarkably cheap for this relatively stable midstream natural gas firm with reasonable leverage and excellent dividend coverage.

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Source: Company 10Q’s

In general I continue to be amazed that Mr. Market is ignoring the high solid cash flow streams the compression sub-sector continues to generate despite COVID-19, recession, oil price war, etc. Even reversing asset sales, tax benefits and other potential one time gains we are only talking 10-12% declines in EBITDA for AROC and USAC from Q4 highs vs. 30 – 40% declines in their stock prices.

With $77.2 million in cash available for distribution this quarter (includes the $9.1 million asset sale), AROC generated $55 million in excess cash flow after subtracting out $22 million in distributions. In other words, AROC is strongly FCF positive after all costs including dividends and has plenty of excess cash to work with.

At AROC’s current price, the firm could start using that excess cash to retire almost 5% of the float per quarter. Total free cash flow after dividends was $117 million year to date, is estimated to be exceed $150 for 2020, and to be even higher in 2021 (the cash keeps coming in but capex spend will be less). So there’s really little need for AROC to be conservative with cash regardless of what happens with COVID-19 or in really in the overall energy sector.

That being said, management states they plan to keep further reducing risk and are now targeting 3.5 – 4x leverage even though refinancing would not be a problem even in a stressed environment given their existing net debt/ EBITDA ratio. So there’s really no need for them to continue paying down debt, especially with rates so low, they are just choosing to do so. I think this unfortunate, and a less than ideal use of cash.

Likewise AROC asset sales tending to result in profit, which is indicative that depreciation, impairment charges, and maintenance already are more than adequate. Granted, the market is clearly not rewarding them for their high, very well covered dividend payout, but their are other uses of capital which are much better than further debt reduction. The best capital allocation choice currently is to use most of the excess cash for stock buybacks. We will see if they go that route or if management’s tendency to pay down debt then use liquidity to pursue M&A once again takes precedence.

In the call management stated “two key priorities: shareholder returns and reducing debt.” Now that it’s more than two days past the conference call let’s see if they stick with that and start buying back shares.

In my opinion, despite some dissatisfaction with their past M&A tendencies, ArchRock is the single best risk vs. return opportunity in the compression space. It enjoys a solid risk rating, a very well covered high single digit dividend yield, and triple digit price upside. In my opinion however, achieving that promise requires them to show increased willingness to reward shareholders via share buybacks.

USA Compression (USAC):

USA Compression Partners is a K-1 issuing MLP which posted a decent quarter despite low horsepower utilization (84%) and the macro challenges already discussed. Management continues to emphasize the stability and resilience of their high horsepower compression business though I’d point out the 70% of USAC’s units which are >1,000 HP is roughly the same proportion as AROC.

USA Compression’s DCF coverage came in at 1.1x for the quarter on a 18.5% dividend yield or a 21% DCF yield. Their EV/EBITDA ratio is relatively low at only 8.4x. However, there’s some risk a firm with only 1.1x coverage may need to cut the dividend in the future.

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Source: Company 10Q’s

With $56.9 million in cash available for distribution this quarter (after paying $12.2 million in preferred distributions), USAC only generated $6 million in excess cash flow after subtracting out the $50.9 million in common distributions. This is not a lot of buffer. However, management has been remarkably devoted to keeping the payout and the firm does enjoy a relatively stable cash flow business.

USA Compression’s third quarter reflected the stability that is inherent in our compression services business, which since our founding has been focused on large horsepower, infrastructure-oriented natural gas applications. This emphasis results in solid revenues and cash flows as well as attractive operating margins.” – Eric D. Long, USAC CEO

Additionally, management indicates they think Q3 was the trough for the business in term of utilization. While their Mid-Continent region is seeing reduced need for compression, the Northeast has seen increases. Additionally, looking forward the Permian and Gulf Coast should improve as a meaningful amount of new Permian to Gulf Coast natural gas pipeline capacity (4Bcf/d) is scheduled to come online in 2021.

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Source: Company Presentation

I personally find AROC and USAC very similar to each other from an operating, compressor mix and management point of view. The main difference between the two firms is financial with USAC choosing to pay out almost all its distributable cash flow, while AROC pays out less than 1/3rd. This makes AROC inherently less risky as they have ample excess cash to pay down debt, buy assets, and/or save for a rainy day. It’s also why you are going to probably continue to enjoy a lower leverage ratio and cost of debt with AROC.

That being said, at current low sub-sector prices I doubt USAC cutting its dividend in half would lead to anywhere near a similar reduction in price. Nor do I have any indications such a cut is imminent.

CSI Compressco (CCLP) Earnings:

Microcap, CSI Compressco is a K-1 issuing MLP which posted Q3 YTD DCF of $22.8 million with $6.3 million of that coming in Q3 (note I reduced management’s stated Q3 DCF by $4.2 million in asset sale profits). This is pretty decent if Q3 proves to be trough utilization as USAC indicates (CCLP utilization for Q3 was 80%). Annualizing CCLPs’ $22.8 million YTD DCF gives a $30.4 million 2020 expectation, or a whopping 64.2¢ / share of annual distributable cash flow. Since CCLP only trades for 86¢ a share this represents an astounding 75% DCF yield. Thus CSI Compressco is expected to produce distributable cash flow this year equal to 3/4’s of its entire market cap. However to be fair, CCLP also is very unlikely to actually distribute that entire 64¢ any time soon.

You see CCLP makes $20 million dollar interest payments on Oct. 1 and April 1, the day after the Q3 and Q1 earnings reports close. This typically uses up all cash on hand which then gets replenished over the following quarter. Thus Q4 net excess cash generation will likely look something like this (includes the cash generated from Q3 asset sales).

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With the average quarterly net cash generation over the next year looking more like this (here I also added back in the cash generated from Q3 asset sales as those sales are expected to occur in Q3, Q4 and maybe also future quarters).

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Thus, CCLP management indicates they expect to have $15 – $25 million of excess cash available to buyback or payoff debt over the next three quarters. They then expect to refinance the remaining $61 million around August 2021 (approximately one year before it comes due). This seems doable as I estimate the firm should have a Net Debt / TTM EBITDA ratio <6x at that time.

Until then I expect management to continue to focus on debt reduction while also spending a bit of cash to enable their new Helix information system. Significant shareholder rewards such as dividend increases or stock buybacks will probably have to wait until Q4 2021. Until then shareholders will have to be satisfied with the current 1-cent payout (5% yield).

However I would be remiss if I didn’t point out that CCLP trades at about 7 EV/EBITDA (=$658 / ($23.6 * 4)) or 1.3x expected distributable cash flow during a period which many think might be the trough quarter for the sector (note for these ratios I once again subtracted out the $4.2 million of Q3 EBITDA benefit from asset sales, without this valuation would have been even lower).

These are multiples typically only assigned to firms in imminent danger of bankruptcy. Yet CCLP is not in such danger. In fact they don’t even have any meaningful debt covenants that could be tripped. The firm eliminated those when it exchanged unsecured debt for 1st and 2nd lien debt last summer. Thus there really is only the $81 million of debt due by August 2022 to worry about. This should not be a problem provided they can get to the 6x Net Debt / TTM EBITDA figure I estimate prior to a refinance. Then the next tranche of debt won’t be due until 2025 ($400 million 1st lien).

Thus the biggest near term risks for CCLP are probably refinancing the August 2022 debt, and the same oil sector sentiment change risk that affects the whole sector. On the latter front an elimination of new drilling permits on federal lands might affect sector sentiment. However this would only have a slight effect on CCLP’s actual cash flows because most of their compressors are leased in the Permian and other non-federal lands. Meanwhile, an increase in flaring regulation and fees coupled with new Permian to the coast pipelines is more likely to help the firm than hurt. Both encourage more natural gas to be moved to market.

Takeaway:

Natural gas demand continues despite COVID-19, oil price wars, and recessions. This provides some inherent cash flow stability for those midstreams firms which specialize in processing and moving natural gas from here to there. This includes natural gas compression leasing companies like Archrock (AROC), USA Compression (USAC), and CSI Compressco (CCLP).

Archrock in my opinion is the best choice for those looking for solid risk vs. reward, and in fact the best investment of the three in my opinion. It’s hard to go wrong with a firm that offers acceptable leverage and a high single digit dividend covered more than 3x.

USA Compression is a bit more risky due to using essentially all its cash flow to pay the dividend. However, that high teen dividend is pretty darn attractive and staunchly defended by management. Dividend hounds may choose to go with USAC, but I personally see little reason to stretch to it when Archrock also offers a good yield, and a cheaper valuation with less cash flow risk.

CSI Compressco is by far the smallest of the three firms. It’s also probably the most risky but has potential to be a multi-bagger return. The risk comes with an ultra-high 75% DCF yield. A cash flow stream that should get turned towards investor rewards once the firm refinances its August 2022 unsecured debt.

Are you looking for a Reliable Income Stream?

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