Kodiak Gas Services: Horsepower in the Field, not in the Stock

The public debut of Kodiak Gas Services, ( NYSE KGS), was a lackluster one. Shares were flat after the public offering even though the pricing was a discount to the initial offering range.

While I’m usually attracted by discounts offered in public offerings I don’t see the appeal of this one, given the very leveraged balance sheets and the concerns about the cyclical nature (among other things) of the business.

Delivering Horsepower

Kodiak claims that it is the largest operator of contract compression in the US. The company’s commercial operations are crucial to the production of natural gas and oil, since it operates horsepower compression units with fixed-revenue contracts from both upstream and middle customers.

In key regions such as the Permian Basin (where 70% of the capacity is located) and Eagle Ford Shale the partnership model means the company has a major role in energy infrastructure. The demand for compression horsepower will only continue to increase in this area in the near future. This is at least the claim made by the company.

The company has a fleet of 3.2 millions horsepower in compression units. There are over 3,000 units that actually compress, and most have more than 1,000 horsepower. This is a critical need, as unconventional oil resources require higher pressures.

The company has an agreement with major customers that guarantees a certain amount of revenue. In fact, the four biggest clients account for about 40% of the sales, while the largest customer is responsible for a low-double digit percentage.

After only having 650,000 horsepower in capacity in 2017, the company has grown to a base of 2.6 million horsepower in 2019. Its capacity has been steadily increased to 3.2 millions horsepower with occupancy rates exceeding 98% (and sometimes approaching 100%).

The average lifespan of these units, due to the rapid expansion of the fleet and its capacity, is only 3.7 years. Kodiak believes it can be a successful partner in this niche market as mechanical availability is key. Oil majors and unconventional operators are looking to reduce capital expenditure.

Value & IPO thoughts

Kodiak initially planned to sell 16,000,000 shares at a price between $19 and $22, but the demand was weak, so the company reduced the price to $16 per stock. The gross proceeds from the offering are now $256 million. This money is used to reduce the net debt of the company.

This means that EQT, the former majority shareholder, will continue to be a major shareholder after the offering. Equity of Kodiak has been valued at $1.20 billion.

The IPO documents show a pro-forma net debt load after the offering of $1.78 Billion, but this was based at the midpoint of preliminary offering price. The lower offer price led to $72 million less in gross proceeds, so the net debt load increased by about $1.85 Billion.

In actual results, the company’s sales grew from 606 million dollars in 2021, to $708 millions in 2022. This was due to higher pricing and capacity. In the absence of an impairment charge, operating earnings increased from $189 to $222 millions. This is a substantial profit but it comes before interest expenses which were $170 million in 2022, largely due to gains from derivatives. The adjusted EBITDA is $399 million, which is high. Leverage ratios are over 4.5.

The company’s first quarter sales rose by about 13%, to $190 millions. Operating earnings grew in a similar manner to $60 million. With EBITDA at $106 million it means that the company tops $400,000,000 per year. It is important to ask how much future earnings can be expected, given that energy prices have fallen from their highs of 2021.

After a 25% tax rate, that works out to earnings of around one hundred million per year. With a tax rate of 25%, this translates to an annual income of about $100 million, or $1.30 per share.

Final Remark

Although the above earnings power calculation looks interesting, given the current share price, I’m extremely cautious. Despite the company’s nice words about their strong competitive position, this business is a commodity.

There is cyclical unpredictability as the oil price has fluctuated (also this year). There are also many uncertainties over the long term, mainly due to the need to electrify the equipment, or perhaps because of stricter environmental regulations. But there is also the concern of how the continued focus on ESG will affect the Kodiak customer base in the future.

Despite the cheap price-earnings ratio, I am not interested in investing here.