2023-11-06 12:02:23 ET
Summary
- CHX's international businesses are expected to drive performance in Q4, benefiting from the momentum in the energy industry.
- The company turns to increasing shareholder returns as growth slows down.
- I expect CHX's EBITDA margin to strengthen, percolating into improved FCF and shareholder returns.
CHX Is On A Steady Balance
I have been discussing ChampionX Corporation ( CHX ) in the past, and you can r ead the latest article here from August where I rated them a Hold. A t the start of Q4, the energy industry momentum is gaining, primarily benefiting its international businesses. The company’s operating margin will also gain from the actions toward productivity improvements, cost management, and pricing realization. The company’s Production Chemical and Production & Automation Technologies segments should bear much of the fruit.
However, CHX’s drilling business can suffer a blow due to persistent pressure on the US onshore activity slowdown. To offset the cap on growth potential, it has earmarked shareholder return targets by improving its FCF. The increase in EBITDA will also help in achieving the goals. The stock is reasonably valued compared to its peers. I suggest investors "hold" the stock for moderate gains in the short term, with a possibility of returns rising in the medium term.
Industry Momentum
In Q3, most of the industry indicators weakened. From Q2 to Q3, the drilled and completed well count was lower (4% and 2.6% down, respectively), while the US rig count decreased by 8%. However, crude oil prices recovered sharply, declining by 29%. Natural gas prices, too, strengthened by 5% during the quarter.
Since the start of Q4, many of these indicators have shown positive signs, including a sustained and robust recovery in natural gas prices. The crude oil price, on the other hand, came under the garb of geopolitical uncertainty and lost some of the grounds gained in Q3.
Near-Term Outlook And Innovations
Given the momentum in the industry, I think international businesses will drive CHX’s performance strongly in Q4. The relatively weaker seasonal performance of the US onshore can partially mitigate the growth. Many US upstream operators will continue to constrain their working capital and free cash flow, given the lack of growth. The deceleration will primarily be seen in its drilling technology business, which can witness a sequential revenue decline.
To counter the possible US slowdown, CHX has been introducing new products. In Q3, it designed a continuous emission monitoring system, known as SOOFIE, for onsite methane emission detection. The other recent introduction was AURA optical gas imaging, which complements the SOOFIE system. The imaging system accurately detects and documents small methane leaks.
Q4 Outlook
It expects to record $192 million (at the guidance mid-point) in adjusted EBITDA in Q4, which would be 7% higher than a year ago. The Q4 adjusted EBITDA margin would be 200 basis points higher than Q3 2022. It plans to achieve a 50% FCF-to-adjusted EBITDA conversion ratio in Q4, which may improve to a 50%-60% ratio in the medium term.
Margin Expansion Strategy
CHX’s EBITDA margin has been on a roll. In Q3, it recorded an adjusted EBITDA margin of 20.2%. The adjusted EBITDA margin expanded sequentially over the past six quarters. In Q4, the company expects margin to grow by 370 basis points compared to a year earlier. It will likely expand further in 2024 through productivity improvements, cost management, and pricing realization.
Segments: Outlook And Performance
During Q3, CHX's Production Chemical Technologies (or OCT) segment revenues increased by 5% compared to Q2 because of solid international revenue. Although digital revenues declined, increased customer focus on digital and emissions technologies can push its sales higher in the coming quarters.
Revenues in the Reservoir Chemical Technologies segment grew nearly as much as the PCT segment due to significant improvement in the margin profile of this business. However, the exit of certain low-margin RCT product lines offset some gains. The Drilling Technologies segment was the weakest performer in Q3 (4.3% revenue fall) compared to Q2.
During Q3, the company’s revenues from the rest of the world were up by 3% sequentially, driven by solid growth in PCT and Production and Automation Technologies (or PAT) segments. The US revenues were flat quarter-over-quarter in Q3.
Cash Flows, Debt, And Dividends
In 9M 2023, CHX's cash flow from operations increased by 70%, led by robust cash collections in 2023. Free cash flows (or FCF) increased by over 80% during this period. In Q3, it converted 60% of adjusted EBITDA into FCF. Over the long term, it expects to convert 50%-60% of EBITDA to FCF.
CHX's leverage (debt-to-equity ratio) remained unchanged at 0.35x as of September 30, 2023. It had $954 million in liquidity as of that date. During Q3, it returned 74% of its FCF to shareholders through dividends and share repurchases. Since Q2 2022, it has returned $434 million of capital to shareholders, which equaled nearly 66% of the FCF. So, it aligns with achieving the objective of delivering 60% of the FCF to the shareholders.
What Does The Relative Valuation Tell Us?
CHX's forward EV/EBITDA multiple is expected to contract versus the current EV/EBITDA. Since the rate of contraction is less steep than its peers, it implies that its EBITDA will rise less sharply. This should typically result in a lower EV/EBITDA multiple. The company's EV/EBITDA multiple (8.8x) is lower than its peers' (WHD, FTI, and TTI) average. So, the stock is reasonably valued versus its peers.
Given the uncertainty in the energy sector, I do not see the stock improving sharply in the short term. However, if it trades at the past average, it can climb 44% from the current level. Given the near-term drivers, I think the stock may increase slightly (5%-10% upside potential), but with strengthened strategic positioning, it should back up to yield positive returns in the medium term.
Analyst Target Price And Rating
Ac cording to Seeking Alpha , nine Wall Street analysts rated CHX a "buy" (including "Strong Buy"), while one recommended a "hold." None of the sell-side analysts ranked it a "sell." The consensus target price is $38.3, which indicates ~22% upside potential at the current price.
Why Do I Keep My Take Unchanged?
In my previous article, I noted that CHX kept its pivot unchanged at providing value-added products and services, pricing re-adjustment, and productivity improvement. However, the industry tide was turning against any short-term growth potential. So, I recommended a “Hold.” I wrote :
"It looks to expand its operating profit margin through enhanced productivity in Chemical Technologies and Artificial Lift. Investors may note that its chemical business was boosted following the acquisition of Ecolab's upstream energy business. It is on course to achieve the 20% EBITDA margin goal in the near-to-medium term."
In Q3, the industry did exhibit signs of weakness, as expected. The deceleration will primarily affect its drilling technology business. But the situation appears to be easing as we sail through Q4. The company introduced new solutions, which will help its operating margin expand in 2024 through productivity improvements, cost management, and pricing realization. So, I continue to rate it a “hold.”
What's The Take On CHX?
At the start of Q4, the momentum in the energy industry appears to be shifting, which will provide a tailwind to CHX’s international business performance. It is on course to achieve the 20% EBITDA margin goal in the near-to-medium term. The company has also started generating positive cash flows in 2023. Along with the EBITDA goals, I expect it to achieve the 50%-60% FCF-to-adjusted EBITDA conversion ratio target in the medium term. Earlier in the year, its chemical business was strengthened following the acquisition of Ecolab's upstream energy business.
However, US upstream operators will operate under working capital restraint, adversely impacting CHX’s drilling technology business. Also, the exit of certain low-margin RCT product lines offset some gains. So, the stock underperformed the VanEck Vectors Oil Services ETF ( OIH ) in the past year. Given the relative valuation, I expect the stock to produce modest gains in the medium term.
For further details see:
ChampionX Corporation: Free Cash Flow And Shareholder Returns Take The Center Stage