ENERFLEX LTD EFX
April 20, 2013 - 10:40am EST by
afgtt2008
2013 2014
Price: 13.00 EPS $1.06 $1.15
Shares Out. (in M): 78 P/E 12.3x 11.3x
Market Cap (in $M): 1,101 P/FCF 0.0x 10.9x
Net Debt (in $M): -49 EBIT 115 133
TEV ($): 962 TEV/EBIT 8.4x 7.2x

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  • Natural gas
  • Manufacturer
  • Industrial Equipment

Description

Enerflex is a leading global fabricator of natural gas compression and processing equipment as well as power generation engines. They focus on design, manufacturing, installation and after market support for their clients and are located around the world with a focus on North America, Australia, Middle East and North Africa (MENA). Future growth will be driven by:

  • The globalization and increased use of natural gas as a clean energy resource
  • A focus on higher margin processing equipment including new cryogenic offerings
  • A greater focus on service and aftermarket revenue

Enerflex is valued at 6.5x analyst 2013 EBITDA estimates, but only 4x, when using a more normalized EBITDA number that I believe is achievable and will elaborate on below, and could represent a return of 50%-150% based on several scenarios.

An investment in Enerflex is a prudent way to express a view that natural gas usage will grow over the next decade and provides a larger margin of safety than most E&P companies. They have a solid balance sheet with net cash as of the end of 2012, several growth opportunities to exploit and a tail wind at their back from the proliferation of increased natural gas consumption.

History

Historically the Canadian compression market was controlled by a division of Toromont and “old” Enerflex.  In early 2010 Toromont purchased old Enerflex for a total enterprise value of $860 million and in June 2011 spun out “New” Enerflex, which combined the compression division of Toromont with the old Enerflex business at an enterprise value of $1.106 billion.  The larger combined entity was now a pure play natural gas compression company.

Toromont is a large Canadian Caterpillar dealer. Caterpillar also manufactures engines that are installed on natural gas compression fabrications, many of which were sold to Toromont’s compression division as well as old Enerflex. Waukesha makes a competing natural gas engine and was sold to GE in 2010. GE has publicly stated that they want to invest in the Waukesha business and further penetrate the market. After the spinout Enerflex became the authorized distributor and aftermarket support provider for Waukesha in Canada, the Northern US, Alaska, Australia, Indonesia and Papua New Guinea. This should provide an opportunity for Enerflex to grow their aftermarket sales and service business and an agreement would not have been possible if the Toromont/Enerflex relationship still existed due to the channel conflict between Caterpillar and GE.

  

Product Segments

 

Revenue by Product Line

 

Revenue Breakdown 2010 2011 2012
Engineered systems           772,806       906,093              843,610
Service           238,600       262,217              207,144
Rental             56,377          58,827                29,340
Total Revenue       1,067,783    1,227,137          1,080,094
       
Engineered systems 72.4% 73.8% 78.1%
Service 22.3% 21.4% 19.2%
Rental 5.3% 4.8% 2.7%
       
Canada and Northern US           453,757       524,235              509,359
Southern US and Latam           364,273       342,335              512,145
International           249,753       360,567              480,180
        1,067,783    1,227,137          1,501,684
       
Canada and Northern US 42% 43% 34%
Southern US and Latam 34% 28% 34%
International 23% 29% 32%

Engineered Systems

Natural gas fields require compression to extract gas at a higher rate from the well and to transport gas from the well to pipelines or storage facilities. Enerflex supplies gas compression packages for these applications to customers that include E&Ps, midstream companies, and third party processing facilities. They are located in every unconventional gas play across North America with a focus on high rate compression that is suited to the new style of well and gas basin development. 

Increased natural gas development requires the use of compression and as new basins are developed more compression is required to establish the appropriate infrastructure. Mature basins also require compression to counteract the natural decline rate that all wells experience as they produce over time.  This provides a stable base as it is very capital efficient for producers to install additional compression on declining reservoirs rather than drill a new well. Massive new resource developments like the Marcellus and Eagle Ford in the US and the Montney and Horn River in Canada will require large amounts of compression infrastructure to extract and transport gas.  New basin development will drive growth as infrastructure is built and new horsepower is required to maintain maturing fields.

I think that there is an opportunity to increase margins in the compression business from their new distribution relationship with Waukesha engines as they should be purchasing higher volumes. This relationship also gave Enerflex the distribution rights to Jenbacher engines in Canada. These engines are used for power generation. Although I don’t believe it to be a primary area of growth, management has made comments that they are evaluating opportunities to grow this business along with the aftermarket service that could be cross sold in the new segment.

Engineered systems also includes processing equipment that is used to treat natural gas by removing impurities like water, carbon dioxide, as well as separating out natural gas liquids (NGLs). While the reduction in dry gas drilling has affected Enerflex’s business in 2012, they have begun to concentrate efforts on developing more specialized processing equipment that is used to treat the associated NGLs that are produced when drilling in wet gas plays and tight oil formations. In 2011 ~20% of engineered systems revenue was from processing equipment and the segment has higher margins than the compression business. The focus in 2012 has been to develop more specialized processing in the form of deep cut cryogenics. This is essential for producers looking to strip out the full chain of NGLs from their gas stream and has been a hole in Enerflex’s past service offering.  They built a team organically and to date have 2 orders set to deliver in late 2013/ early 14. Management has stated that this is their largest growth priority over the next several years and should provide an area for revenue growth and margin expansion.

The Engineered System’s operations are generally fabrication operations and capital investment is relatively small, typically only intensive when setting up or expanding facilities. Their Houston facility was recently expanded to take advantage of the areas relatively lower costs (20%) when compared to Canada. Capacity was doubled in this facility for a cost of $20mm and will be used to fabricate US and international projects. I don’ anticipate any further expansion plans in the near term.

Services

The service division covers the life of a facility/compression package from the time it is commissioned until its mothballed. It supplies aftermarket parts, maintenance contracts, and plant turnarounds.  It allows for more stable cash flow in all commodity price environments and many contracts are multiyear recurring revenue streams. For every $1 spent in equipment, another $1 needs to be spent in service over a 20 year time period. The Canadian market represents an annual opportunity of $300-400 million and the US is ~$1.5 billion. Over 60% of service revenue is derived from Canada, leaving a large opportunity in the US and internationally. They have the ability to remotely monitor plants, recommending preventative maintenance, allowing the owners to completely outsource all servicing needs.  Management has stated that they want to increase service revenue from 20% of the top line to 40% over the next 3-5 years. Service margins are higher than fabrication margins. At old Enerflex Service gross margins were 600-850 bps higher than Engineered Systems gross margins.

As a distributor and after sales support provider for Waukesha engines, Enerflex should be able to gain market share in the Northern US. They will be able to provide a one-stop shop for customers looking to buy, maintain and service compression or power generation equipment.  The relationship will also see smaller fabricators purchasing equipment from Enerflex, allowing them to garner a more detailed view of the competitive landscape. Their understanding of competitor’s spare capacity could lead to better bidding opportunities.  Enerflex could also lose a job to a smaller competitor and still supply the equipment.

 

Backlog

Historical Backlog  Q2/10 Q3/10 Q4/10 Q1/11 Q2/11 Q3/11 Q4/11 Q1/12 Q2/12 Q3/12 Q4/12
Canada and Northern US 102 169 136 103 151 195 177 165 136 117 107
Southern US and Latam 174 212 146 190 211 307 285 297 331 252 228
International 117 131 362 379 360 331 524 466 455 406 349
Total 393 512 644 672 722 833 986 928 922 775 683
QoQ % -6.2% 30.3% 25.8% 4.3% 7.4% 15.4% 18.4% -5.9% -0.6% -15.9% -11.8%
                       
Engineering Revenue 172 180 276 233 164 197 302 281 273 289 335
% of backlog 44% 35% 43% 35% 23% 24% 31% 30% 30% 37% 49%

Enerflex entered 2012 with a very strong backlog of almost $1 billion. It included the largest project the firm has won with a $228 million gas processing facility in Oman. 2012 was a very volatile year for any company involved with natural gas especially in Enerflex’s primary North American market. Gas prices in North America dropped below $2 /mcf in H1 and although prices are trending higher it is still low compared to historic standards. Dry gas spending has been reduced dramatically in the region and will likely be volatile in the short term as 2013 E&P budgets are set. In the long term massive basin exploitation is expected as LNG becomes a reality in both the US and Canada. Large compression infrastructure will be required to establish and maintain the feedstock for LNG facilities and should help North American gas prices converge towards a global level.

The Southern US business has been driven by liquids rich developments as the liquids in these plays can be stripped to realize value that is more influenced by oil pricing. If oil and NGL pricing remains at levels that allow producers to earn a return, the wet basins should remain active. I won’t get into the details of what level is required in each area, as that has been written about extensively, but I believe we can generalize by saying WTI above $75 should allow condensate rich gas plays to remain active despite gas being around $4/ mcf. Regional differentials and individual NGL pricing will drive well-site economics but I believe that is a decent rule of thumb.

International business has been quite strong over the last 2 years and provides a considerable long term opportunity. Activity is mainly being driven by Australia and MENA. The LNG facilities in Australia will require large development of their coal seam gas fields for decades. Additional LNG trains are in the proposal stage as well. Domestic and LNG demand for natural gas in the Middle East and North Africa is strong and Enerflex continues to win contracts in the region. Larger processing contracts like the Oman win could become more frequent and management is expecting larger projects to include service contracts to drive recurring revenue.

  

Future Growth Drivers

An investment in Enerflex is predicated on my conviction that natural gas demand will grow over the next several decades around the globe and will require a large investment in compression and processing infrastructure.  In Exxon’s latest energy outlook they forecast natural gas to play an increasingly significant role over the next 30 years and think that natural gas could overtake coal as the second most consumed fuel by 2025. Exxon forecasts gas growth of 1.7% p.a until 2040 resulting in a 65% increase in gas demand.

 Near term supply growth will be driven by the unconventional resources in North America but Africa and Asia have trillions of cubic feet of untapped resources that have no existing infrastructure.  Natural gas has been the fastest growing fossil fuel in China’s energy mix. Forecasts have it growing to 8% of their energy mix in 2015, resulting in annual gas consumption to grow to 246bcm from 151bcm in 2012. This increase will be supplied by LNG imports and local gas production, both of which will require increased compression infrastructure. Enerflex does not sell into China currently but in Q3 2012 they opened an office in Singapore to target South East Asia.

LNG development is looking like a reality in North America with both the US and Canada proposing numerous projects to get gas onto the global market. There are many positive signs in Canada with Chevron recently acquiring a 50% interest in the Kitimat LNG project in British Columbia and Petrona’s acquisition of Progress Energy. The big news out of the US was the DOE study suggesting that the US would experience net economic benefits from increase LNG exports, highlighting a growth scenario that forecasts exports rates as high as 12 bcf/d. It is impossible to know what level of LNG exports will be achieved in North America but it is probable that gas exports will benefit Enerflex over the long term.  While not participating directly in LNG facilities they will benefit from the increased development needed to supply LNG plants.  Globally there are over 25 LNG plants in some stage of planning. A fraction of them will likely be built over the next decade but it is likely that gas production will be materially higher in 10 years, and greater infrastructure will be needed to supply the feedstock for the plants as well as transport gas at the send and receive locations.

Natural gas used for transportation purposes is also accelerating faster than most would have anticipated. Clean Energy Fuels has made progress installing natural gas filling station in the US and helping to promote the development of gas powered cars and commercial vehicles. On their Q3 call they described that they will have 70 filling stations by year end an announced a number of commercial test being done by Fedex, Frito Lay, Staples, taxi companies, garbage trucks and municipal vehicle fleets. Again the greater the domestic gas demands the more energy infrastructure that will be needed.

Demand of floating production, storage and offload vessels (FPSOs) is growing at a very rapid pace and I have read reports forecasting over 130 vessels in the next 5years. Although Enerflex has not participated in this market in the past management believes that they now have capacity and capability to begin bidding in this market. The compression and processing equipment is fairly similar to that required on land but is larger in scale and customized to the specific configuration required.

 

Competition

Exterran is their largest global competitor and competes with them in almost all regions. Exterran business model is much more focused on renting compression assets and 75% of their gross margin comes from this segment. That being said their fabrication business is about the same size as Enerflex. They have stumbled in the past and have spent the past 2 years focusing on deleveraging to fix their balance sheet. They made good progress in 2012 but are still 3x levered forcing them to accept lower margin jobs to cover their interest payments.  Exterran’s abilities in the processing segment are superior to Enerflex but it is my understanding that Enerflex has built a team that will be able to compete at the same level going forward.

Biddell Compression, which is a division of Total Energy Services in Canada has developed a decent compression business that competes with Enerflex in smaller jobs. After the combination of Toromont and Enerflex producers needed a new competitor to keep pricing inline and Biddell has benefited from being a solid alternative for less complicated jobs.

Forecast

It is very difficult to forecast what backlog and revenue levels will be in the short term.  The sell side is focusing on the fact that 2013 E&P capex budgets could be volatile and may decline from 2012 levels.  The timing is quite uncertain but if you take a longer term approach it is clear that there are many growth drivers in place for Enerflex to exceed their previous revenue highs and generate higher margins than we have seen in the past.

Management has guided that bookings in Canada and the Northern US will remain suppressed unless we see an uptick in North American gas prices. Over the long term any definitive LNG developments will require large increase in the pace of Montney development and higher commodity prices could also see large investments in the Horn River and Duvernay formations. It is also important to note that although we have seen recent weakness in Canadian Engineered Systems revenue in Q4, service revenue remained at a high level which is likely due to their new distribution relationship and highlights the stability of the segment.

Southern US and Latam revenue were very strong in 2012, but the backlog showed a 20% decline. Management commented l that orders picked up into Q1 but near term performance will be influenced by commodity prices.

International projects are larger in size generally and lumpier than North America. The backlog is at a strong level but has declined over recent quarters. They likely have just over a year’s worth of revenue in backlog and it would be great to see another large project in MENA or Australia.

Although the timing is uncertain I have confidence that at some point Enerflex’s North America compression and processing business will exceed its previous high water mark. The growth drivers are far greater than they were in the past and US market share gains are possible with the focus on processing and increased service revenue. International drivers are just as compelling.  In 2008 the combined revenue of Toromont’s compression business and old Enerflex was $1.874 billion with EBITDA of $208 million and EBIT of $174 million. There are many reasons why I think that they should be able to greatly exceed this level of revenue but I think it is conservative to start here. Management has also stated that they have taken $30 million in costs out of the business after the merger, equating to an EBITDA level of $230 million. At today’s stock price, Enerflex enterprise value is $960 million and the stock is trading at just over 4x.

Revenue 2012 2013 2014 2015 2016 2017 2018 2019 2020
Canada and Northern US 509 525 540 567 596 626 657 690 724
    3% 3% 5% 5% 5% 5% 5% 5%
Southern US and Latam 512 538 554 571 582 594 605 618 630
    5% 3% 3% 2% 2% 2% 2% 2%
International 480 504 514 525 535 546 557 568 579
    5% 2% 2% 2% 2% 2% 2% 2%
Total               1,502            1,567                  1,609            1,662         1,713         1,765         1,819         1,875         1,933
    4.3% 2.7% 3.4% 3.0% 3.0% 3.1% 3.1% 3.1%
                   
EBIT             114.56          133.29                142.75          153.62      164.69      176.49      181.89      187.50      193.32
  7.63% 8.51% 8.87% 9.24% 9.62% 10.00% 10.00% 10.00% 10.00%
                   
                   
EBITDA              158            180                191            203         215         228         236         243         250
  10.5% 11.5% 11.9% 12.2% 12.6% 12.9% 12.9% 12.9% 13.0%
                   
Earnings                77             91                101            110         119         127         131         135         139
   per share  $         1.17  $       1.17  $            1.29  $       1.41  $    1.52  $    1.63  $    1.68  $    1.73  $    1.78
                   
CFO 134 137 150 160 171 181 186 192 198
Net Capex (after rental disp) -32 -40 -51 -55 -60 -64 -69 -73 -78
Free Cash 103 97 99 104 111 117 118 119 119
                   
Dividend -22 -22 -22 -22 -22 -22 -22 -22 -22
Debt Reduction -25 -50 -25 -19 0 0 0 0 0
Addition to cash 56 25 52 64 89 95 96 97 98
                   
Free cash per share  $             1.32  $          1.24  $                1.27  $          1.34  $       1.43  $       1.50  $       1.52  $       1.53  $       1.54
                10.21            10.85              
Net Cash 8 78 150 227 311 400 489 580 671
   per share  $             0.10  $          1.00  $                1.92  $          2.91  $       3.98  $       5.12  $       6.27  $       7.43  $       8.60
                   
EV/EBITDA 5.76x 4.68x 4.04x 3.42x 2.83x 2.28x 1.83x 1.4x 1.x
P/E 12.6x 9.6x 7.9x 6.5x 5.3x 4.2x 3.4x 2.6x 1.9x

We can debate over the geographic contribution and timing of growth but my above estimates equate to a revenue CAGR of 3.2%, with EBIT margins building towards management’s stated goal of 10%. Management thinks that they can achieve 10% margins by 2015, and I have waited until 2017 to reach the target. In my model I do not increase the dividend from today’s level and do not utilize the buy back, I simply let the cash build. Currently I am not sure if management is more likely to do tuck-in acquisitions with the cash or increase the dividend. I suspect that they are monitoring the dividend trend among other Canadian oilfield service stocks and will likely increase the dividend in 2013.

If management achieves its goal of doubling service as well as processing revenue in the next 3-5 years, EBIT margins should be able to exceed the goal of 10%.  In my upside scenario I have an EBITDA level of just over $300 million and multiple expansion could come as a result of the increased recurring service revenue.  For my valuation purposes I use 6x EBITDA as a base case target and 8x in an upside scenario.

 

EBITDA  EBITDA Multiple 
        31.92 5x 6x 7x 8x
230         14.80         17.76         20.72         23.68
250         16.09         19.31         22.52         25.74
270         17.37         20.85         24.32         27.80
290         18.66         22.39         26.13         29.86
310         19.95         23.94         27.93         31.92

Balance Sheet

Enerflex low capital intensity has allowed it to de-lever from $200 million in debt at the end of 2010 to a net cash position in Q4 2012. They currently are paying a dividend of $0.28/2.4% which was raised in Q3 by $0.04 per share last quarter. Management seems to be shareholder friendly and has just renewed their buy back for up to 10% of the float.

I believe they will earn strong returns on their capital as cash flow ramps up. Management has confirmed that hitting $1.8 billion in revenue will not require additional capacity and have historically been decent allocators of capital.

At a recent conference management noted that they are seeing opportunities to deploy capital. They have had interest from customers in renting compression equipment in the Bakken and Northern US. Historically this has not been a good business, and Enerflex has only operated a small rental fleet in Canada. Management's new interest stems from consolidation in the industry with the combination of Hanover and Unversal compression o form Exterran. Exterran management has been much more disciplined since the crisis with their pricing and Enerflex thinks that there could be an opportunity to enter several under-penetrated basins.

Management is also looking to expand its service offerings globally which would help achieve their growth targets and should be achievable with minimal capital investments. Again service margins are much higher than fabrication.

I believe that Enerflex can generate strong free cash going forward. The path will likely not be smooth in the near term due to volatility in North American gas prices but the infrastructure spend required to grow with global gas demand will eventually come.

Risks

Natural gas and oil price volatility

Sharp increase in natural gas pricing that spurs more investment in alternatives

Sustained low levels of drilling activity in North America

Failure to execute on large fixed price contracts profitably

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

 Continued build out of natural gas infrastructure in North America and internationally.
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    Description

    Enerflex is a leading global fabricator of natural gas compression and processing equipment as well as power generation engines. They focus on design, manufacturing, installation and after market support for their clients and are located around the world with a focus on North America, Australia, Middle East and North Africa (MENA). Future growth will be driven by:

    Enerflex is valued at 6.5x analyst 2013 EBITDA estimates, but only 4x, when using a more normalized EBITDA number that I believe is achievable and will elaborate on below, and could represent a return of 50%-150% based on several scenarios.

    An investment in Enerflex is a prudent way to express a view that natural gas usage will grow over the next decade and provides a larger margin of safety than most E&P companies. They have a solid balance sheet with net cash as of the end of 2012, several growth opportunities to exploit and a tail wind at their back from the proliferation of increased natural gas consumption.

    History

    Historically the Canadian compression market was controlled by a division of Toromont and “old” Enerflex.  In early 2010 Toromont purchased old Enerflex for a total enterprise value of $860 million and in June 2011 spun out “New” Enerflex, which combined the compression division of Toromont with the old Enerflex business at an enterprise value of $1.106 billion.  The larger combined entity was now a pure play natural gas compression company.

    Toromont is a large Canadian Caterpillar dealer. Caterpillar also manufactures engines that are installed on natural gas compression fabrications, many of which were sold to Toromont’s compression division as well as old Enerflex. Waukesha makes a competing natural gas engine and was sold to GE in 2010. GE has publicly stated that they want to invest in the Waukesha business and further penetrate the market. After the spinout Enerflex became the authorized distributor and aftermarket support provider for Waukesha in Canada, the Northern US, Alaska, Australia, Indonesia and Papua New Guinea. This should provide an opportunity for Enerflex to grow their aftermarket sales and service business and an agreement would not have been possible if the Toromont/Enerflex relationship still existed due to the channel conflict between Caterpillar and GE.

      

    Product Segments

     

    Revenue by Product Line

     

    Revenue Breakdown 2010 2011 2012
    Engineered systems           772,806       906,093              843,610
    Service           238,600       262,217              207,144
    Rental             56,377          58,827                29,340
    Total Revenue       1,067,783    1,227,137          1,080,094
           
    Engineered systems 72.4% 73.8% 78.1%
    Service 22.3% 21.4% 19.2%
    Rental 5.3% 4.8% 2.7%
           
    Canada and Northern US           453,757       524,235              509,359
    Southern US and Latam           364,273       342,335              512,145
    International           249,753       360,567              480,180
            1,067,783    1,227,137          1,501,684
           
    Canada and Northern US 42% 43% 34%
    Southern US and Latam 34% 28% 34%
    International 23% 29% 32%

    Engineered Systems

    Natural gas fields require compression to extract gas at a higher rate from the well and to transport gas from the well to pipelines or storage facilities. Enerflex supplies gas compression packages for these applications to customers that include E&Ps, midstream companies, and third party processing facilities. They are located in every unconventional gas play across North America with a focus on high rate compression that is suited to the new style of well and gas basin development. 

    Increased natural gas development requires the use of compression and as new basins are developed more compression is required to establish the appropriate infrastructure. Mature basins also require compression to counteract the natural decline rate that all wells experience as they produce over time.  This provides a stable base as it is very capital efficient for producers to install additional compression on declining reservoirs rather than drill a new well. Massive new resource developments like the Marcellus and Eagle Ford in the US and the Montney and Horn River in Canada will require large amounts of compression infrastructure to extract and transport gas.  New basin development will drive growth as infrastructure is built and new horsepower is required to maintain maturing fields.

    I think that there is an opportunity to increase margins in the compression business from their new distribution relationship with Waukesha engines as they should be purchasing higher volumes. This relationship also gave Enerflex the distribution rights to Jenbacher engines in Canada. These engines are used for power generation. Although I don’t believe it to be a primary area of growth, management has made comments that they are evaluating opportunities to grow this business along with the aftermarket service that could be cross sold in the new segment.

    Engineered systems also includes processing equipment that is used to treat natural gas by removing impurities like water, carbon dioxide, as well as separating out natural gas liquids (NGLs). While the reduction in dry gas drilling has affected Enerflex’s business in 2012, they have begun to concentrate efforts on developing more specialized processing equipment that is used to treat the associated NGLs that are produced when drilling in wet gas plays and tight oil formations. In 2011 ~20% of engineered systems revenue was from processing equipment and the segment has higher margins than the compression business. The focus in 2012 has been to develop more specialized processing in the form of deep cut cryogenics. This is essential for producers looking to strip out the full chain of NGLs from their gas stream and has been a hole in Enerflex’s past service offering.  They built a team organically and to date have 2 orders set to deliver in late 2013/ early 14. Management has stated that this is their largest growth priority over the next several years and should provide an area for revenue growth and margin expansion.

    The Engineered System’s operations are generally fabrication operations and capital investment is relatively small, typically only intensive when setting up or expanding facilities. Their Houston facility was recently expanded to take advantage of the areas relatively lower costs (20%) when compared to Canada. Capacity was doubled in this facility for a cost of $20mm and will be used to fabricate US and international projects. I don’ anticipate any further expansion plans in the near term.

    Services

    The service division covers the life of a facility/compression package from the time it is commissioned until its mothballed. It supplies aftermarket parts, maintenance contracts, and plant turnarounds.  It allows for more stable cash flow in all commodity price environments and many contracts are multiyear recurring revenue streams. For every $1 spent in equipment, another $1 needs to be spent in service over a 20 year time period. The Canadian market represents an annual opportunity of $300-400 million and the US is ~$1.5 billion. Over 60% of service revenue is derived from Canada, leaving a large opportunity in the US and internationally. They have the ability to remotely monitor plants, recommending preventative maintenance, allowing the owners to completely outsource all servicing needs.  Management has stated that they want to increase service revenue from 20% of the top line to 40% over the next 3-5 years. Service margins are higher than fabrication margins. At old Enerflex Service gross margins were 600-850 bps higher than Engineered Systems gross margins.

    As a distributor and after sales support provider for Waukesha engines, Enerflex should be able to gain market share in the Northern US. They will be able to provide a one-stop shop for customers looking to buy, maintain and service compression or power generation equipment.  The relationship will also see smaller fabricators purchasing equipment from Enerflex, allowing them to garner a more detailed view of the competitive landscape. Their understanding of competitor’s spare capacity could lead to better bidding opportunities.  Enerflex could also lose a job to a smaller competitor and still supply the equipment.

     

    Backlog

    Historical Backlog  Q2/10 Q3/10 Q4/10 Q1/11 Q2/11 Q3/11 Q4/11 Q1/12 Q2/12 Q3/12 Q4/12
    Canada and Northern US 102 169 136 103 151 195 177 165 136 117 107
    Southern US and Latam 174 212 146 190 211 307 285 297 331 252 228
    International 117 131 362 379 360 331 524 466 455 406 349
    Total 393 512 644 672 722 833 986 928 922 775 683
    QoQ % -6.2% 30.3% 25.8% 4.3% 7.4% 15.4% 18.4% -5.9% -0.6% -15.9% -11.8%
                           
    Engineering Revenue 172 180 276 233 164 197 302 281 273 289 335
    % of backlog 44% 35% 43% 35% 23% 24% 31% 30% 30% 37% 49%

    Enerflex entered 2012 with a very strong backlog of almost $1 billion. It included the largest project the firm has won with a $228 million gas processing facility in Oman. 2012 was a very volatile year for any company involved with natural gas especially in Enerflex’s primary North American market. Gas prices in North America dropped below $2 /mcf in H1 and although prices are trending higher it is still low compared to historic standards. Dry gas spending has been reduced dramatically in the region and will likely be volatile in the short term as 2013 E&P budgets are set. In the long term massive basin exploitation is expected as LNG becomes a reality in both the US and Canada. Large compression infrastructure will be required to establish and maintain the feedstock for LNG facilities and should help North American gas prices converge towards a global level.

    The Southern US business has been driven by liquids rich developments as the liquids in these plays can be stripped to realize value that is more influenced by oil pricing. If oil and NGL pricing remains at levels that allow producers to earn a return, the wet basins should remain active. I won’t get into the details of what level is required in each area, as that has been written about extensively, but I believe we can generalize by saying WTI above $75 should allow condensate rich gas plays to remain active despite gas being around $4/ mcf. Regional differentials and individual NGL pricing will drive well-site economics but I believe that is a decent rule of thumb.

    International business has been quite strong over the last 2 years and provides a considerable long term opportunity. Activity is mainly being driven by Australia and MENA. The LNG facilities in Australia will require large development of their coal seam gas fields for decades. Additional LNG trains are in the proposal stage as well. Domestic and LNG demand for natural gas in the Middle East and North Africa is strong and Enerflex continues to win contracts in the region. Larger processing contracts like the Oman win could become more frequent and management is expecting larger projects to include service contracts to drive recurring revenue.

      

    Future Growth Drivers

    An investment in Enerflex is predicated on my conviction that natural gas demand will grow over the next several decades around the globe and will require a large investment in compression and processing infrastructure.  In Exxon’s latest energy outlook they forecast natural gas to play an increasingly significant role over the next 30 years and think that natural gas could overtake coal as the second most consumed fuel by 2025. Exxon forecasts gas growth of 1.7% p.a until 2040 resulting in a 65% increase in gas demand.

     Near term supply growth will be driven by the unconventional resources in North America but Africa and Asia have trillions of cubic feet of untapped resources that have no existing infrastructure.  Natural gas has been the fastest growing fossil fuel in China’s energy mix. Forecasts have it growing to 8% of their energy mix in 2015, resulting in annual gas consumption to grow to 246bcm from 151bcm in 2012. This increase will be supplied by LNG imports and local gas production, both of which will require increased compression infrastructure. Enerflex does not sell into China currently but in Q3 2012 they opened an office in Singapore to target South East Asia.

    LNG development is looking like a reality in North America with both the US and Canada proposing numerous projects to get gas onto the global market. There are many positive signs in Canada with Chevron recently acquiring a 50% interest in the Kitimat LNG project in British Columbia and Petrona’s acquisition of Progress Energy. The big news out of the US was the DOE study suggesting that the US would experience net economic benefits from increase LNG exports, highlighting a growth scenario that forecasts exports rates as high as 12 bcf/d. It is impossible to know what level of LNG exports will be achieved in North America but it is probable that gas exports will benefit Enerflex over the long term.  While not participating directly in LNG facilities they will benefit from the increased development needed to supply LNG plants.  Globally there are over 25 LNG plants in some stage of planning. A fraction of them will likely be built over the next decade but it is likely that gas production will be materially higher in 10 years, and greater infrastructure will be needed to supply the feedstock for the plants as well as transport gas at the send and receive locations.

    Natural gas used for transportation purposes is also accelerating faster than most would have anticipated. Clean Energy Fuels has made progress installing natural gas filling station in the US and helping to promote the development of gas powered cars and commercial vehicles. On their Q3 call they described that they will have 70 filling stations by year end an announced a number of commercial test being done by Fedex, Frito Lay, Staples, taxi companies, garbage trucks and municipal vehicle fleets. Again the greater the domestic gas demands the more energy infrastructure that will be needed.

    Demand of floating production, storage and offload vessels (FPSOs) is growing at a very rapid pace and I have read reports forecasting over 130 vessels in the next 5years. Although Enerflex has not participated in this market in the past management believes that they now have capacity and capability to begin bidding in this market. The compression and processing equipment is fairly similar to that required on land but is larger in scale and customized to the specific configuration required.

     

    Competition

    Exterran is their largest global competitor and competes with them in almost all regions. Exterran business model is much more focused on renting compression assets and 75% of their gross margin comes from this segment. That being said their fabrication business is about the same size as Enerflex. They have stumbled in the past and have spent the past 2 years focusing on deleveraging to fix their balance sheet. They made good progress in 2012 but are still 3x levered forcing them to accept lower margin jobs to cover their interest payments.  Exterran’s abilities in the processing segment are superior to Enerflex but it is my understanding that Enerflex has built a team that will be able to compete at the same level going forward.

    Biddell Compression, which is a division of Total Energy Services in Canada has developed a decent compression business that competes with Enerflex in smaller jobs. After the combination of Toromont and Enerflex producers needed a new competitor to keep pricing inline and Biddell has benefited from being a solid alternative for less complicated jobs.

    Forecast

    It is very difficult to forecast what backlog and revenue levels will be in the short term.  The sell side is focusing on the fact that 2013 E&P capex budgets could be volatile and may decline from 2012 levels.  The timing is quite uncertain but if you take a longer term approach it is clear that there are many growth drivers in place for Enerflex to exceed their previous revenue highs and generate higher margins than we have seen in the past.

    Management has guided that bookings in Canada and the Northern US will remain suppressed unless we see an uptick in North American gas prices. Over the long term any definitive LNG developments will require large increase in the pace of Montney development and higher commodity prices could also see large investments in the Horn River and Duvernay formations. It is also important to note that although we have seen recent weakness in Canadian Engineered Systems revenue in Q4, service revenue remained at a high level which is likely due to their new distribution relationship and highlights the stability of the segment.

    Southern US and Latam revenue were very strong in 2012, but the backlog showed a 20% decline. Management commented l that orders picked up into Q1 but near term performance will be influenced by commodity prices.

    International projects are larger in size generally and lumpier than North America. The backlog is at a strong level but has declined over recent quarters. They likely have just over a year’s worth of revenue in backlog and it would be great to see another large project in MENA or Australia.

    Although the timing is uncertain I have confidence that at some point Enerflex’s North America compression and processing business will exceed its previous high water mark. The growth drivers are far greater than they were in the past and US market share gains are possible with the focus on processing and increased service revenue. International drivers are just as compelling.  In 2008 the combined revenue of Toromont’s compression business and old Enerflex was $1.874 billion with EBITDA of $208 million and EBIT of $174 million. There are many reasons why I think that they should be able to greatly exceed this level of revenue but I think it is conservative to start here. Management has also stated that they have taken $30 million in costs out of the business after the merger, equating to an EBITDA level of $230 million. At today’s stock price, Enerflex enterprise value is $960 million and the stock is trading at just over 4x.

    Revenue 2012 2013 2014 2015 2016 2017 2018 2019 2020
    Canada and Northern US 509 525 540 567 596 626 657 690 724
        3% 3% 5% 5% 5% 5% 5% 5%
    Southern US and Latam 512 538 554 571 582 594 605 618 630
        5% 3% 3% 2% 2% 2% 2% 2%
    International 480 504 514 525 535 546 557 568 579
        5% 2% 2% 2% 2% 2% 2% 2%
    Total               1,502            1,567                  1,609            1,662         1,713         1,765         1,819         1,875         1,933
        4.3% 2.7% 3.4% 3.0% 3.0% 3.1% 3.1% 3.1%
                       
    EBIT             114.56          133.29                142.75          153.62      164.69      176.49      181.89      187.50      193.32
      7.63% 8.51% 8.87% 9.24% 9.62% 10.00% 10.00% 10.00% 10.00%
                       
                       
    EBITDA              158            180                191            203         215         228         236         243         250
      10.5% 11.5% 11.9% 12.2% 12.6% 12.9% 12.9% 12.9% 13.0%
                       
    Earnings                77             91                101            110         119         127         131         135         139
       per share  $         1.17  $       1.17  $            1.29  $       1.41  $    1.52  $    1.63  $    1.68  $    1.73  $    1.78
                       
    CFO 134 137 150 160 171 181 186 192 198
    Net Capex (after rental disp) -32 -40 -51 -55 -60 -64 -69 -73 -78
    Free Cash 103 97 99 104 111 117 118 119 119
                       
    Dividend -22 -22 -22 -22 -22 -22 -22 -22 -22
    Debt Reduction -25 -50 -25 -19 0 0 0 0 0
    Addition to cash 56 25 52 64 89 95 96 97 98
                       
    Free cash per share  $             1.32  $          1.24  $                1.27  $          1.34  $       1.43  $       1.50  $       1.52  $       1.53  $       1.54
                    10.21            10.85              
    Net Cash 8 78 150 227 311 400 489 580 671
       per share  $             0.10  $          1.00  $                1.92  $          2.91  $       3.98  $       5.12  $       6.27  $       7.43  $       8.60
                       
    EV/EBITDA 5.76x 4.68x 4.04x 3.42x 2.83x 2.28x 1.83x 1.4x 1.x
    P/E 12.6x 9.6x 7.9x 6.5x 5.3x 4.2x 3.4x 2.6x 1.9x

    We can debate over the geographic contribution and timing of growth but my above estimates equate to a revenue CAGR of 3.2%, with EBIT margins building towards management’s stated goal of 10%. Management thinks that they can achieve 10% margins by 2015, and I have waited until 2017 to reach the target. In my model I do not increase the dividend from today’s level and do not utilize the buy back, I simply let the cash build. Currently I am not sure if management is more likely to do tuck-in acquisitions with the cash or increase the dividend. I suspect that they are monitoring the dividend trend among other Canadian oilfield service stocks and will likely increase the dividend in 2013.

    If management achieves its goal of doubling service as well as processing revenue in the next 3-5 years, EBIT margins should be able to exceed the goal of 10%.  In my upside scenario I have an EBITDA level of just over $300 million and multiple expansion could come as a result of the increased recurring service revenue.  For my valuation purposes I use 6x EBITDA as a base case target and 8x in an upside scenario.

     

    EBITDA  EBITDA Multiple 
            31.92 5x 6x 7x 8x
    230         14.80         17.76         20.72         23.68
    250         16.09         19.31         22.52         25.74
    270         17.37         20.85         24.32         27.80
    290         18.66         22.39         26.13         29.86
    310         19.95         23.94         27.93         31.92

    Balance Sheet

    Enerflex low capital intensity has allowed it to de-lever from $200 million in debt at the end of 2010 to a net cash position in Q4 2012. They currently are paying a dividend of $0.28/2.4% which was raised in Q3 by $0.04 per share last quarter. Management seems to be shareholder friendly and has just renewed their buy back for up to 10% of the float.

    I believe they will earn strong returns on their capital as cash flow ramps up. Management has confirmed that hitting $1.8 billion in revenue will not require additional capacity and have historically been decent allocators of capital.

    At a recent conference management noted that they are seeing opportunities to deploy capital. They have had interest from customers in renting compression equipment in the Bakken and Northern US. Historically this has not been a good business, and Enerflex has only operated a small rental fleet in Canada. Management's new interest stems from consolidation in the industry with the combination of Hanover and Unversal compression o form Exterran. Exterran management has been much more disciplined since the crisis with their pricing and Enerflex thinks that there could be an opportunity to enter several under-penetrated basins.

    Management is also looking to expand its service offerings globally which would help achieve their growth targets and should be achievable with minimal capital investments. Again service margins are much higher than fabrication.

    I believe that Enerflex can generate strong free cash going forward. The path will likely not be smooth in the near term due to volatility in North American gas prices but the infrastructure spend required to grow with global gas demand will eventually come.

    Risks

    Natural gas and oil price volatility

    Sharp increase in natural gas pricing that spurs more investment in alternatives

    Sustained low levels of drilling activity in North America

    Failure to execute on large fixed price contracts profitably

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

     Continued build out of natural gas infrastructure in North America and internationally.
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