CHX - ChampionX: Short Term And Long Term Catalysts

2023-05-23 15:06:20 ET

Summary

• Offshore drilling activity providing roadmap for longer-term strength.
• Margins and cash flow inflecting higher before major new projects come online.
• Three-year anniversary of the Apergy merger opens up M&A possibilities.

The Basic Business of ChampionX

ChampionX ( CHX ) was formed three years ago through a merger of Apergy, a provider of oil well drilling and automation technology, and the oil well production chemicals division of Ecolab ( ECL ). The product offering is described well in the graphic below.

The merger was structured as a Reverse Morris Trust, which sounds complicated but is just a way for a large company to sell a division tax-free. Anyone who wants to understand the structure more can read about it here . The salient point for CHX is that the structure prevents a takeover of the merged company for three years after the deal closing. That three-year period ends on June 4 of this year. I'll get back to that point again below.

The company's revenue mix is below. PCT (production chemicals technologies) is the company's biggest segment by revenue and EBITDA. As you can see below, the company has about 30% market share.

Since the production chemicals segment services producing wells, it's a very steady business and industry trends of pulling more oil from existing well increase the need for these chemicals.

With increased need comes higher margins. The company exited 2022 at 19% adjusted EBITDA margins for PCT and 18.1% for the company as a whole. There is a seasonal revenue and EBITDA dip in Q1, but EBITDA margins still climbed quarter over quarter from that 18.1% to 18.6%. Also, during the Q1 '23 conference call management guided to exiting 2023 with company-wide margins exceeding 20%, implying continued improvement in PCT margins. This coincided with year-over-year revenue growth of 10%. Ratcheting that revenue growth to high single digits for the year and assuming 20% adjusted EBITDA margins implies over $4 billion and over $800 million respectively versus $608 million of adjusted EBITDA for 2022 and $456 million for 2021.

Since specialty chemicals are the biggest business, capex is relatively low, and cash flow conversion is high. Leverage is also very low, ending 2022 at 0.6x and ending Q1 at 0.5x. This combo is allowing the company to return the bulk of its free cash (80% in Q1) to shareholders via a dividend and buyback. In 2022, that return equaled about 5%. I expect it to go higher this year.

Valuation

The good news is that these numbers are interesting on their own. The better news is that industry trends point to an even better 2024 and 2025. Day rates for offshore drilling rigs are approaching $500k, and many of these new offshore wells will be drilled in the second half of this year. Offshore currently represents 40% of PCT's business, and offshore wells are "high calorie" in their use of production chemicals. I think high-single-digit average revenue growth (~8%) for 2023-2025 is not unreasonable. Using ~20% EBITDA margins (which I think could be conservative) implies ~$900 million and ~$1 billion of adjusted EBITDA for 2024 and 2025 respectively. Unless these rigs come off, $1 billion could be a conservative steady-state level for after 2025.

In that $1 billion scenario, I think 8-9x are conservative multiples, implying >50% upside to the stock factoring in continuous cash returns.

Potential Takeout

As I said above, the three-year anniversary of the RMT (Reverse Morris Trust) deal is June 4. After that, the company can be acquired without triggering any negative tax liabilities for Ecolab. I think this business would fit like a glove in either Schlumberger's ( SLB ) or Halliburton's ( HAL ) product offering. Both companies could easily acquire CHX without stressing their balance sheets and could drive revenue and cost synergies. I'm not saying it's likely the company gets bought, but it's not impossible either. I think $40 is about the right price for a takeover.

Risks

This company sells chemicals. All chemical producers, even specialty like them, are exposed to inflationary cost pressures. They have moderated for CHX but could roar back. Also, as we've seen with 3M ( MMM ) and Chemours ( CC ) which are shorts in the Catalyst Hedge Investing model portfolio, liabilities could pop up. There is nothing on the horizon right now with CHX, but again, a potential risk at some point. Lastly, if oil prices crash, this will likely trade down even if much of the revenue comes off existing producing wells and much of the growth is coming from wells that are major offshore projects. Still, energy-related names trade as baskets with big moves in oil.

Conclusion

I think CHX has a lot going for it. The business has good short and long-term prospects, and tons of flexibility for returning cash given a clean balance sheet and strong cash flow generation. A potential takeout is a lottery ticket catalyst that could happen any time after June 4. The best part is, you don't need that to play out for solid returns here.

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