Kodiak Gas Services: Too Constrained

Kodiak Gas Services (NYSE:KGS) is a recent IPO that offers contract gas compression services on a medium-term, fixed-revenue basis to large upstream and midstream customers. The company is primarily active in the largest US oil and gas shale play, the Permian basin, with 70% of its horsepower there. The company also has 14% of its horsepower deployed in the south Texas Eagle Ford shale.

In addition to the main job of transporting natural gas to end-use markets, Kodiak meets producers’ needs to limit gas flaring and gas emissions. These will grow as both dry and associated gas volumes increase in the Permian basin due to both increasing production of associated gas, dry gas, and the natural increase in gas-oil ratios as the field matures.

Despite the company’s growth prospects, I recommend Kodiak as a “sell” to most investors due to its heavy debt load, restrictive covenants, and majority non-public equity overhang. It may be of interest to very short-term traders and to “speculative dividend-hunters” based on its announced plan to offer a substantial dividend for 4Q23.

Initial Public Offering

Kodiak Gas Services began trading at the end of June 2023. Its initial public offering was originally priced at $19-$22/share, but the 16 million share issuance priced at $16/share for a capital raise of $256 million. Net proceeds for the company were $234.1 million.

On June 30, 2023, the 16 million shares represented about 20% of its equity. The remaining 80% is held by insiders.

Second Quarter 2023 Results and Guidance

For the second quarter of 2023, Kodiak Gas Services reported net income of $17.5 million ($0.30/share) compared to net income of $8.9 million in 2Q22. However, six-month net income for the first half of 2023 was smaller at $5.2 million or $0.09/share due to an unrealized loss on derivatives.

Adjusted EBITDA for 2Q23 was $107.9 million compared to adjusted EBITDA of $96.9 million for 2Q22.

Net cash provided by operating activities in the first six months of 2023 was $118 million; however, cash interest costs during the same period were $116 million.

Contract compression represented most of the revenue and earnings for the first six months of 2023.

Horsepower utilization at the end of 2Q23 was 99.9%.

Full-year adjusted EBITDA guidance is $425-$440 million.

Macro

Recent statements from the Federal Reserve suggest continued high interest rates. In particular, Fed Chairman Powell just recently said that the current US path is unsustainable. Such a warning could suggest “higher for longer” interest rates which would lead to lower stock and bond prices.

Gas Supply, Demand, and Prices

The October 20, 2023, Henry Hub natural gas futures price (November 2023 NYMEX contract) was $2.92/MMBTU.

The growth in shale gas supply, especially from the Permian, shows the importance of gas handling infrastructure.

Associated (with oil) Permian gas production grew 1.3 BCF/D to average 10.2 BCF/D in 2022; 56% of US associated gas production came from the Permian and volumes are expected to increase.

Total Permian gas production for November 2023 is projected to be 24.1 BCF/D. Total US gas production is expected to rise from 103.7 BCF/D in 2023 to 105.1 BCF/D in 2024.

U.S. Energy Information Administration - EIA - Independent Statistics and Analysis

Competitors and Customers

Kodiak Gas Services is headquartered in Montgomery, Texas, northwest of Houston. It is the third largest contract compression provider in the US with a fleet of over 3.17 million horsepower.

Among its nearest competitors are Archrock (AROC), limited partnership USA Compression Partners, LP (USAC), and CSI Compressco LP (CCLP).

Customers include EOG (EOG), Devon (DVN), Phillips 66 (PSX), Pioneer Natural Resources (PXD)—due to be acquired by Exxon Mobil (XOM)--and Targa (TRGP).

Governance

Shorts were 8.3% of float on September 29, 2023.

Insiders hold a very large 79.4% of the stock. While their interests may align with the minority public shareholders on dividends, they may diverge on other matters. And, as noted below, debtholders may also have substantial say due to the large amount of debt in Kodiak’s capital structure.

At June 29, 2023, in addition to the insider ownership of 13.8%, the four largest institutional stockholders with the largest holdings Ion Asset Management (2.1%), Citadel Advisors (1.9%), Goldentree Asset Management (1.8%), and Zimmer Partners (1.7%).

Financial and Stock Highlights

At the October 20, 2023, closing stock price of $17.21/share, market capitalization is $1.33 billion. Trailing twelve months’ (TTM) earnings per share (EPS) was $0.70 for a trailing price/earnings ratio of 25. The averages of analysts’ 2023 and 2024 EPS estimates are $0.54 and $1.37 respectively. These give a forward price/earnings ratio range of 12.6-31.9.

Average daily trading volume is 365,000 shares on float of 18.3 million shares, or 2.0%. This thinner trading volume could make the share price sticky compared to, for example, Archrock. Archrock’s average daily trading volume is 933,000 shares on float of 141,770,000 shares, or 0.7%.

The company’s stock price range since going public is $15.05-$19.79 per share, so its October 20, 2023, closing price is 87% of the high. The one-year target price is $24.25/share; the closing price is 71% of this level.

At June 30, 2023, Kodiak had $3.07 billion in liabilities, including $2.77 billion of long-term debt. With $3.26 billion in assets the liability-to-asset ratio was a very steep 94%.

Note that in its September investor presentation, Kodiak reported it had reduced debt by $1 billion in July 2023.

But reverting for a moment to the 10Q for the second quarter ended June 30, 2023, the company had a term loan of $1.0 billion and a $2.2 billion credit line (“ABL Facility” under which it has borrowed $1.8 billion) which appears to potentially restrict its activities, including the ability to pay dividends. From the most recent 10-Q (the applicable rate for ABL is the Secured Overnight Financing Rate (SOFR)):

“The ABL Credit Agreement also restricts the Company’s ability to: incur additional indebtedness and guarantee indebtedness; pay dividends or make other distributions or repurchase or redeem equity interests; prepay, redeem or repurchase certain debt; issue certain preferred units or similar equity securities; make loans and investments; sell, transfer or otherwise dispose of assets; incur liens; enter into transactions with affiliates; enter into agreements restricting the Company’s restricted subsidiaries’ ability to pay dividends; enter into certain swap agreements; amend certain organizational documents; enter into sale and leaseback transactions; and consolidate, merge or sell all or substantially all of the Company’s assets.

“The applicable interest rates as of June 30, 2023 were 10.25% (prime rate plus 2.00%) and 8.34% (Term SOFR rate plus 0.10% plus 3.00%).”

The rate on the $1.0 billion loan is 12.16% on June 30, 2023. It has similarly restrictive covenants.

Maturities for both the ABL and the term loan occur after 2027.

The ratio of enterprise value to EBITDA is 43: far above investor-friendly (bargain) territory of less than 10.

While Kodiak Gas Services does not pay a dividend now, in August 2023, the company anticipated offering a quarterly dividend of $0.35/share to $0.40/share ($1.40/share/year to $1.60/share/year) starting in 4Q23, subject to board approval. Annualized and at the current stock price, this dividend yield would be 8.1%-9.3%.

The company’s mean analyst rating is 1.9, or “buy,” from eight analysts. At least one analyst considers the stock overvalued.

Book value is $3.27/share, below market value and thus a positive investor signal.

Positive and Negative Risks

Since Kodiak Gas Services’ revenues are volume-based, it benefits from higher gas prices as companies are incentivized to expand their dry and associated gas production.

Like all hydrocarbon companies, Kodiak faces US political risk from a federal administration that is implementing an anti-hydrocarbon agenda.

However, renewed focus on reducing gas emissions and flaring increases the demand for compression.

And like everyone in the US, Kodiak faces increased inflation in its operational costs, including for financing. This is evident not just in the debt market—and Kodiak carries a large debt load--but in the company’s plan to issue a relatively large (on a percentage basis) dividend.

Recommendations for Kodiak Gas Services

Kodiak is well-positioned in the large Permian basin, which has not just big volumes of co-produced associated gas but also, like all basins, will get more gassy and less oily on a percentage basis as drilling activity matures.

Kodiak Gas Services may appeal to an oxymoronically named category of investors: speculative dividend-hunters, as well as to short-term traders.

Although Kodiak does not yet offer a dividend, it has publicly stated in its 2Q report that it will do so beginning for 4Q23 (so payable in 2024) and a rate of between 8.1% and 9.3%. Hence “speculative:” this company hasn’t paid dividends but announced it plans to, with board approval.

Due to restrictions of its high-cost credit facility, dividend payments do not appear certain.

The upside to the one-year stock target price is 40%. Should it retire debt, the equity could increase in value; however, there is also a big overhang (79%) of non-public equity that could come to market and depress prices via dilution. In the meantime, these equity owners could influence decisions that are not in alignment with the interests of public investors.

Because the public stock float is small, it does not take large trading volumes to pop the price up or down. This may appeal to short-term volatility traders.

The company’s price-earnings ratio is no bargain now (25) although it improves on projected 2024 earnings to 12.6.

With the exceptions noted above (speculative dividend hunters and short-term traders) I recommend Kodiak Gas Services as a “sell.”

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