WTTR - Select Energy Services: Fundamentals Support A Higher Price

Summary

• Select Energy Services, Inc. turned in solid number for Q3 2022, with EBITDA showing a 60% rise quarter-over-quarter.
• The company made two accretive transactions in 2022 without busting the balance sheet.
• I think investors with a modest risk tolerance may take an interest in Select Energy Services, Inc.

Introduction

We are in pre-earnings period for a lot of companies we've covered. Select Energy Services, Inc. ( WTTR ) is one we've covered on multiple occasions, and you should give those earlier articles a read for deep background on the company.

I've generally been positive on Select Energy Services, Inc., but am finding it hard to keep the faith. Over the last year, the company peaked at $10 at the height of the Ukraine war oil price spike, and fell to the low $6's as the air came out of that balloon. The stock price historically seems to be purely a child of the whims of the oil price, and the futures curve, with little or no relationship to the generally strong fundamentals driving its core water treatment business.

In this article, we will have a look at Q3 results and management's commentary to see if we can find a catalyst for the stock. WTTR will report Q4 on or about February, 23rd 2023. Is there a reason to buy in?

Some general commentary about the OFS sector

There is a dichotomy between the big three service companies, or maybe, the big four if you want to count Weatherford ( WFRD ) as big, and the billion dollar and under microcaps. The small companies have not responded to sustained oil prices above $80 for most of the last year. At least part of the reason is there is so much competition at this level, the little guys - although they have and are continuing to raise prices - do not have the pricing power of Big Blue, Big Red, or even Big Aqua.

The point of this note is we need to be especially careful about entry points for stocks like Select Energy Services, Inc.

Contrarily, I expect 2023 is going to be a growth year in the frac water management business. Horizontal legs are getting longer, and rock quality is becoming marginal. This all means more inputs will be required to generate the same or grow the amount of oil produced. This is bullish for WTTR.

The thesis for WTTR

On a high level, water is required for fracking and must be reused for this process to remain viable. Much of the shale basins are in water-challenged regions, at least as regards fresh, surface water and the demands of fracking-20-30 million gallons per well, are too great otherwise. Fortunately water reclamation is a high art and actually still improving with desalination on the horizon. Another point I've made repeatedly, there's no onshore oil or gas-to speak of, without fracking, so the water business is a long term play.

Select is in the business of managing frac water used to stimulate the reservoir upon completion of shale wells. It also handles the cleanup or "flowback" sequence that follows after the plugs are drilled out between frac stages. In addition to the automated monitoring and treatment of clean and spent frac water, WTTR sources new water from surface sources, builds empoundments for water storage, and constructs pipelines to move water long distance to work site. They also provide chemistry for various in situ treatments to enhance the flow of oil to the wellbore. Here is the link again if you want more color on their business model.

WTTR is present in all major shale basins and is one of the dominant companies in this category.

They have a strong balance sheet with no long-term debt, and rising revenues and earnings. WTTR has also recently reinstituted a small dividend as a sign of financial health, and improving market conditions.

A catalyst for Select

The company has been a long-term business agglomerator, gobbling up competitors and merging their operations-without taking on a lot of debt. Since 2017 they have completed a number of strategic acquisitions without destroying their balance sheet. They include: Rockwater, Complete Energy Services, Agua Libre Midstream, Nuverra Environmental Solutions, and most recently Breakwater Energy Partners and Cypress Environmental Solutions.

Privately held Breakwater was one of the market leaders in advanced water recycling infrastructure, disposal and logistics solutions. Breakwater overlapped Select's broad capabilities across the entire Permian Basin with complementary water logistics operations in the Eagle Ford. Its core footprint consists of strategic commercial recycling facilities serving the heart of the Midland Basin. Breakwater brought about 600,000 barrels per day of active recycling capacity at its four primary fixed facilities with an additional 1.4 million barrels per day of permitted capacity available for development.

Breakwater also operates nine active modular recycling facilities with 1.5 million barrels per day of throughput capacity. Breakwater's facilities are supported by 46 miles of gathering and distribution pipelines, 70,000 barrels per day of disposal capacity and 4.7 million barrels of storage capacity with an additional 3.7 million barrels of permitted storage capacity available for development. This footprint expands Select recycling capabilities to nearly 3 million barrels of total daily capacity across fixed and mobile capabilities.

The Cypress acquisition added a portfolio of strategic wastewater disposal facilities in North Dakota. Further consolidating the Bakken region following their recent acquisition of Aqua Libre Midstream and Nuverra. In addition to the strategic benefits, both transactions provide clear and immediate financial benefits as well.

On a full-year 2022 combined basis, the acquired operations from Breakwater and Cypress are expected to generate approximately $110 million to $115 million of revenue and more than $30 million of adjusted EBITDA.

The catalyst is the successful pickup of active facilities with long-term supporting contracts, trained personnel, ongoing business relationships, and of course, taking out a competitor. Source .

Q3 2022 for WTTR

Revenue of $375 million grew by 12%, and $39 million and 59% of this revenue increase fell through to higher gross profits. All three segments-water, chemicals, infrastructure, increased their gross margins from second to third quarter, resulting in their highest quarterly net income and adjusted EBITDA since the third quarter of 2018. QoQ, Select Energy Services, Inc. saw 70% growth in net income and 32% growth in adjusted EBITDA, $24.7 mm and $62.8 mm respectively.

The Water Services segment grew its revenue sequentially by 13% to $221 million, while advancing gross margins over 3 percentage points to 22.8%. net working capital increased by $54 million during the third quarter, resulting in free cash flow of negative $10.7 million in Q3. Gross CapEx of $19.8 million for the third quarter translated to net CapEx of $16.1 million after asset sales.

Select finished the quarter with a net cash position of $13.2 million and no bank debt. Total liquidity stood at $245 million when considering their asset backed lending facility, up from $221 million as of last quarter.

In Q3, Select began paying a small dividend of $0.05 quarterly. Not much, but it's a sign of confidence in their business outlook for 2023. Source .

Risks to our thesis

I don't see much downside risk in Select Energy Services, Inc. at its present price. Sure if oil goes to $40, the business will tank. Short of that, I think they have a clear field to grow revenue and margins as the year goes on.

The real risk is dead money in this one. The fact the business is well-run and carries a solid balance sheet and has excellent growth prospects, appears to be meaningless at present. Will it be meaningless forever? Let's hope not, but at the same time acknowledge it's been a long slog in the single digits.

Your takeaway

When the acquisitions of Breakwater and Cypress are added in, earnings for Select Energy Services, Inc. should be in the neighborhood of $0.35-40 per share. A 60% bump from Q3. Let's keep our feet on the ground and acknowledge bad weather in December may cut into this a bit. A modest safety factor puts consolidated earnings at $0.30 per share, or $29.4 mm for the quarter, a 15% bump QoQ.

Revenues on an annual basis should come to $1.3 bn, and EBITDA should be in the range of $280-300 mm on a full year run rate basis. EV/EBITDA currently is 4.3X, in a fairly comfortable range. Competitors Aris Water Solutions, ( ARIS ), and TETRA Technologies, ( TTI ) are trading at 9.8X and 11.3X this metric, respectively. (Note-TETRA is not a pure play water company as is WTTR and ARIS.)

Analysts are calling for growth in Select Energy Services, Inc. stock price to $11.8 per share on an average basis, with a low of $8.50 and a high of $15.00 . How do we get to that $15 figure?

I think Select Energy Services, Inc. could surprise to the upside when earnings are released, and expect a bullish tone in the call that could lead to estimate revisions-higher. It wouldn't take much to get to that $15 figure, actually. A multiple of 5X at the consolidated EBITDA I've projected, gets you to that $15.00 share price and doesn't seem outlandish given the strength of the business and supportive macro environment.

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