KLX Energy: Corporate Turnaround Into Debt Refinancing

Summary/Thesis

We recommend investing in KLX Energy (NASDAQ:KLXE), a dynamic and growing oil and gas service company operating within the expansive US shale basins. The company has recently experienced a notable shift from losses to profits, indicating improved financial performance, despite this the stock is in our view undervalued, trading at a low multiple of 2.4 times the annualized 2Q23 EBITDA and 4.0 times the annualized net income. We believe a significant catalyst lies in the company's balance sheet, as they actively reduce debt and have secured a recent amendment on their Asset-Based Lending (ABL) facility. Additionally, we anticipate their plan to refinance costly bonds, due in Nov 2025, during either late 2023 or early 2024. We set a price target of $40 per share, reflecting our optimism regarding the company's future potential.

Background/History

KLX Energy is a prominent oil and gas service company with a focused presence in the major US shale basins. The company was established through the consolidation of seven privately-owned oilfield service companies, which were acquired between 2013 and 2014. In 2018, KLX Energy transitioned into a publicly traded entity after spinning off from KLX Inc., a provider of aerospace fasteners, consumables, and logistics services. The Spin-off was a result of the sale of KLX Inc. to Boeing, with the condition of divesting KLX Inc.'s Energy Service Group.

In October 2018, KLX Energy initiated a debt offering to finance the acquisition of Motley Services, LLC, a renowned provider of coiled tubing services. This offering resulted in the issuance of 11.5% Senior Secured Notes maturing in 2025, enabling the company to strengthen its cash reserves and execute the aforementioned acquisition. Subsequently, in 2020, KLX Energy completed a merger with Quintana Energy Services (QES) and began operating under the experienced leadership of QES' management team, including Christopher J Baker as CEO and Keefer M Lehner as CFO. The board of directors now comprises five directors from KLX Energy's legacy board and four directors from QES.

The merger with QES positioned KLX Energy as one of the largest wireline fleet operators in the United States, further solidifying its market presence and capabilities. Demonstrating a commitment to expansion and growth, the company has continued its acquisitive strategy. Notably, in March 2023, KLX Energy completed the acquisition of Greene's Energy Group, a notable provider of wellhead, flowback, and well testing services. This acquisition was an all-equity transaction, with a total of 2.4 million shares exchanged, valuing the acquisition at $30 million.

Greene Energy Group reported revenue of $68 million and EBITDA of $15 million in 2022, indicating an accretive acquisition by KLX Energy. As a result of these strategic moves and strong financial performance, we believe that KLX Energy is positioned to thrive in the evolving oil and gas industry.

Ownership

The ownership structure of KLX Energy comprises various stakeholders, with former owners of Greene's Energy Group holding a significant portion of the company's stock, accounting for 14.7% of the ownership (dispersed among previous owners of Greene Energy). Among the notable shareholders, Tontine Associates LLC emerges as the largest individual owner, holding a position of 1.41 million shares, equivalent to a 8.6% ownership stake in KLX Energy. The firm has recently added to its position. Tontine Associates LLC operates as a hedge fund under the leadership of Jeff Gendell, who also maintains a significant ownership stake in Nine Energy Service, a competitor to KLX Energy. Apart from Tontine Associates LLC, there are no other investors currently holding positions exceeding 5% of the company's stock. There are currently 16.4mm shares outstanding.

Segment Contribution and Financial Performance

The company delivers various services to primarily independent major oil and gas companies focused on drilling, completion, production, and intervention activities for wells. This is made from over 50 service facilities located across the US. In total the company has 740 customers and the five largest contributed 21% of the company's revenue in 2022 and no single customer accounted for more than 5% of the revenue.

In 2022, KLX Energy reported impressive financial results, with revenue reaching $781.6 million, a substantial 64.3% increase compared to the previous year. Gross profit grew to $160.3 million from $50.4 million, and EBITDA improved significantly to $96.7 million, compared to a negative $3.1 million in 2021. 10-K 2022

For the first quarter of 2023, KLX Energy reported revenue of $239.6 million, up from $152.3 million year-over-year and sequentially higher than the fourth quarter of 2022, which stood at $223.3 million. Gross profit increased to $58.7 million from $17.3 million, and EBITDA reached $38.2 million. The company's earnings have turned positive, with a net income of $9.4 million and fully diluted earnings per share of 65 cents in the first quarter of 2023. The earnings improvement continued in the second quarter and the company posted EBITDA of $39.7mm and earnings of $11.4mm or 71 cents per share. The company did reduce guidance as the US rig count has continued to come down and the company is seeing some pricing pressure. However, as oil has been trending higher for the last couple of months the management commented on the second quarter call that we will most likely see a bottom in rigs in the third quarter and a move higher in the fourth quarter.

While KLX Energy did not generate significant free cash flow in 2022, as working capital grew, experiencing a 60% sequential increase to $115.1 million in the first quarter of 2023, they have now turned the corner and generated $47.3mm of free cash flow in the second quarter alone. Notably, the company reported an improved cash balance, with $82.1 million at the end of June, compared to $40 million at the end of March. KLX Energy's net debt was $201.7 million, with a leverage ratio of 1.5x based on trailing twelve-month (LTM) EBITDA. However, leveraging the annualized 2Q23 EBITDA, the leverage ratio decreased to 1.3x.

Guidance and Acquisitions

KLX Energy provided guidance for the third quarter of 2023, projecting revenue in the range of $215 million to $230 million, with an expected EBITDA margin of 14% to 16% ($30.1 million to $36.8 million). For the full year 2023, the company anticipates revenue in the range of $900 million to $950 billion, with an EBITDA margin of 15% to 17% ($135 million to $161.5 million). The full year capital spending is estimated to be between $45 million and $55 million.

KLX Energy continues its acquisitive strategy, and the recent acquisition of Greene's Energy Group is expected to contribute to both revenue growth and increased EBITDA as outlined in the 2023 guidance, beginning in August 2023 the company expect to realize the full annualized impact of the $2-$3 million in annual synergies.

Balance Sheet Improvement and Refinancing

Achieving balance sheet improvement is a key focus for KLX Energy, given its high leverage. The company aims to refinance its capital structure before its maturity at the end of 2025. Improved earnings and cash flow will play a crucial role in achieving this goal. As of the second quarter of 2023, KLX Energy reduced its leverage to 1.3x. If the company meets its guidance (at the higher end), leverage will decrease further, enabling the company to refinance its expensive Senior Secured Notes with a lower interest rate. We expect them to do this after a few more quarters of reduced net debt, as they are now generating cash. Currently, the $237 million bond carries an 11.5% interest rate and matures on November 1, 2025. In the fourth quarter of 2022, KLX Energy conducted debt-for-equity swaps, reducing the principal outstanding from $250 million to $237 million. Moreover, the company recently extended the maturity of its Asset-Based Lending (ABL) facility from October 2024 to October 2025. As of the recent amendment, the outstanding borrowing capacity increased to $120 million, up from $100 million. Availability on the revolver as of end of June 2023 was $61.6mm and with cash included total liquidity was $143.7mm.

Industry Backdrop

KLX Energy primarily serves oil and gas producers, with a significant focus on the oil sector. However, the company may face challenges in a specific segment of its business, particularly in the Haynesville segment, as natural gas pricing has declined significantly, and rig count has trended lower, specifically in the Haynesville basin. As of December 2022, the company held a market share of 7.4% in the total US onshore drilling market, encompassing both oil and gas. The US rig count serves as a decent proxy for the company's business prospects. Recent trends indicate a decline in the US rig count, with 113 natural gas rigs in the week of Sep 8th, 2023, vs beginning of the year at 156 rigs which was also close to a peak. In comparison, the lows in 2020 were 69 rigs, and the highs in 2019 reached 202 rigs. And for oil rigs the count now stands at 512 vs beginning of the year at 621 rigs which was also more or less the recent year's peak. However, the last three weeks (ending Sep 8, 2023) the count has been flat and with oil rallying and once again closing in on $90/barrel one can assume perhaps a bottom is in for US oil rigs.

The current market outlook suggests that we are still in the early stages of an oil upcycle worldwide, primarily driven by nearly a decade of underinvestment. While there has been a recovery since the lows experienced during the COVID-19 era in 2020, growth has somewhat plateaued, and the risk of higher oil prices looms. However, the US oil industry is in a much stronger position today due to extensive balance sheet restructurings and a focus on leaner operations and improved financial health. Shareholders have rewarded cost discipline and capital returns, resulting in many producers operating profitably with leaner balance sheets. This positions them favorably to reinvest in operations once market conditions allow. Projections indicate a high single growth rate in capital expenditure for US producers in 2023.

KLX Energy experienced significant pricing improvement in 2022 suggesting further upside may be limited, specifically as rig count has trended lower this year. However, as labor and equipment constraints continue to exert pressure on producers, companies like KLX Energy should continue to exert pricing power for their services. In the near term, we assume stable pricing for oil rigs as oil prices trade range-bound between a $75 and $85 per barrel for WTI (West Texas Intermediate).

Overall, considering the ongoing oil upcycle, the improved positioning of US oil producers, and the continued support from labor and equipment constraints, KLX Energy is poised to benefit from the favorable market conditions in the oil and gas industry.

Value Proposition

KLX Energy has witnessed a significant improvement in its earnings over the past 12-18 months. However, despite this positive development, the company's enterprise value remains remarkably low due to its outstanding debt and upcoming maturity. We perceive this as an opportunity for investors. Currently, the stock is valued at a mere 3 times the trailing twelve-month (LTM) EBITDA, but only 2.4 times at the mid-point of the company's EBITDA guidance for 2023.

The market, in our assessment, has not fully recognized the increased size of the company, which now boasts close to revenues of $1 billion. Furthermore, the diversification achieved through various acquisitions and the reduced debt balance relative to EBITDA generation, currently standing at 1.3 times, have not been adequately factored into the valuation. We believe a more reasonable valuation for this business would be closer to $1 billion, equating to 1 times sales or 6 times the $150 million EBITDA figure. This contrasts with the current valuation of $430 million. Thus, we believe the stock has the potential to reach $40 per share.

Major competitors includes Schlumberger (SLB) 14x EBITDA, Baker Hughes (BKR) 12.5x EBITDA, Halliburton (HAL) 9.5x EBITDA Nine Energy Service (NINE) 5.5x EBITDA, RPC, Phoenix Technology Services, Scientific Drilling International, NexTier, Liberty Oilfield Services, Ranger Energy Services, ProPetro Holding Corp, STEP Energy Services and other private competitors.

It is important to note that the stock is subject to significant short interest, with a 13% short interest ratio. Additionally, liquidity may be limited, with an average trading volume of 243,000 shares. This situation creates the possibility of significant short covering on positive news, potentially leading to multiple days of short squeezes.

Taking into consideration the company's improved earnings, attractive valuation metrics, service diversification, reduced debt burden, and the potential for short squeezes, we believe KLX Energy presents an appealing investment opportunity for our portfolio.

Risks

We believe there are two major risk factors for KLX Energy which are the oil price and the rig count in the US onshore shale. They are correlated and as the oil price is below profitability for the producers they will stop investing in drilling and the rig count will go down. We've been in a period of rising rig activity since the depths of Covid but since Feb/Mar of this year we've seen declining rig count. The other specific company risk is the refinancing risk of the debt maturing in Nov 2025.

Catalyst: Refinancing of Capital Structure

An imminent catalyst for KLX Energy lies in the upcoming refinancing of its capital structure. The company recently took steps to strengthen its financial position by amending the maturity date of its Asset-Based Lending (ABL) facility from October 2024 to October 2025. Furthermore, the Senior Secured bonds are set to mature in November 2025. KLX Energy has made considerable progress in reducing its debt burden while concurrently achieving robust earnings growth. Based on its net leverage ratio, which is below 1.5x, we anticipate the company's ability to secure favorable market terms during the refinancing process.

The $250 million Senior Secured bonds, originally trading at distressed levels, have experienced a significant recovery and are now at par levels. Currently carrying an 11.5% coupon rate, these bonds present an opportunity for potential rate reduction. In the fourth quarter of 2022, the company successfully executed privately negotiated debt-for-equity swaps, resulting in a reduction of $12.8 million in principal and the issuance of 777.8k shares. This strategic move not only decreased future annual cash interest expenses by $1.5 million but also left the company with $237.3 million in outstanding notes.

Given the reasonable leverage level KLX Energy has achieved, we believe the refinancing will be executed successfully. While the credit market has witnessed increased costs overall, it is noteworthy that the current bonds already carry an 11.5% interest rate. With a leverage ratio below 1.5x, we see an opportunity to further lower this rate during the refinancing process. Additionally, the company can opt to continue executing its business plan, generating cash in 2023 and 2024 to further reduce borrowing from the ABL facility. This, combined with anticipated higher EBITDA, has the potential to drive leverage down to below 1x.

Considering KLX Energy's proactive debt reduction initiatives, robust earnings growth, and favorable market conditions, we strongly believe the company is well-positioned to undertake a refinancing that will enhance its financial flexibility and reduce interest expenses. This catalyst, coupled with the potential to achieve even lower leverage, presents a compelling investment opportunity for KLX Energy.