Exterran Holdings, Inc. EXH
January 03, 2009 - 8:40am EST by
2009 2010
Price: 22.96 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,486 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Exterran dominates the business of leasing compressors to producers of natural gas. About 35% of the compressors used by natural gas companies in North America are leased as opposed to owned – and Exterran has a 60% market share of the leased compressors. Therefore, about 20% of the compressors in use in North America are owned and leased by Exterran.

            Compressors are needed at a well head to bring the pressure of produced gas to a level higher than that of the gathering system. Otherwise, the gas would not flow out of the well. Some compressors also are needed at the end of gathering systems to bring the pressure of the gas leaving the system to a level higher than that of the pipeline that receives the gas from the gathering system. 

            There are many reasons why gas producers might wish to lease compressors rather than purchase them. One reason is to reduce cash outlays. A second, and more important reason, is to eliminate the need for maintaining the compressors. Exterran maintains inventories of spare parts and has repair personnel available who can quickly repair broken compressors. Also, the personnel perform preventive maintenance, including lubrication. This is important because a broken compressor means a shut down gas well. A third consideration is that, after a well has been producing for a while, a more powerful (higher horsepower) compressor might be required (reservoir pressures decline with time). Exterran owns a large inventory of compressors and can quickly install a larger compressor for a customer that has been leasing a smaller one. Thus, in many ways Exterran, is more of a service company than a leasing company.

             Exterran was formed in August of 2007 when the two largest compressor companies (Hanover and Universal) were merged. In the course of merging the operations of the two companies, a number of problems developed. Some salesman and maintenance men disagreed over territories and left the company – and changes in personnel lead to a decline in service levels and to lost sales. As a result of these problems, earnings in 2008 were below expectation – and the shares reacted by declining from a late 2007 high of $87 to below $20 (of course, the weak stock market also was a reason for the decline). In reaction to the problems, a few high level management changes were made – and considerable attention was placed on re-hiring capable field personnel and on customer service. It appears that most of the problems have been solved and that earnings are beginning to recover.

            Our best guess is that Exterran earned about $2.00 per share last year and will earn $2.50 or so this year and $3.50 or more in 2011. I note that, a year ago, before the problems became apparent, common estimates were that Exterran would earn about $3.50 in 2008. 

            There are several reasons why Exterran’s earnings outlook should be bright (in addition to the solving of the problems):

1.      Given the tightness of capital, a greater percentage of gas companies are likely to lease compressors as opposed to purchasing them outright;

2.      As our nation moves to become greener and more energy self-reliant, the demand for natural gas should grow at an accelerated rate; this especially will be the case if a carbon tax encourages utilities to switch from coal fired power plants to combined cycle plants (which use natural gas as fuel);

3.      New gas wells tend to be less productive than old wells (the large reservoirs of gas already has been found and produced) and thus more wells (and more compressors) are needed to produce the same amount of gas;

4.      Exterran has promising opportunities to expand outside of North America.

Key assumptions behind our $3.50 EPS estimate for 2011 are that North American compressor revenues, International compressor revenues, and revenues from fabricating compressors and other equipment grow at annual rates of 4%, 17%, and 5%, respectively (note – Exterran has two fabricating businesses: one that fabricates compressor systems and one that fabricates pressure and other vessels). We also assume that gross margins for the above three segment are at their historical norms of 60%, 65%, and 14%, respectively (note – gross margins are before depreciation and any overhead costs).

With respect to finances, Exterran appears to be in good shape for a leasing company. Net debt on September 30th was $2,350 million vs. hard book value of $1,420 million:

Compressors and fixed assets            $3,690 million

            Net working capital                                620

            Net other items excluding goodwill         -531

            Net debt                                             -2,350

            Hard book value                                 $1,420 million

As indicated below, there are no material repayments of debt until 2011:

            Revolver due 2012                              $312 million

            Term loan due 2012                             800

            ABS facility due 2012                          800

            4.75% converts due 2014                    144

            Debt of LP due 2011                           217

            Less cash                                             118

            Net debt                                          $2,350 million

In the meanwhile, the company has a large cash flow that could, if so desired, be used to retire the debt. Net earnings ($2.50 per share on 65 million shares) would provide $160 million of cash – and depreciation this year should be $400 million. The company does not pay a dividend. Thus, before any other considerations (such as deferred taxes), Exterran’s cash flow should be about $560 million this year – sufficient to pay off 100% of the net debt in 4.2 years.

Given the large cash flow and the depressed price of the shares, Exterran has been repurchasing some of its shares.

Exterran’s hard book value is about $22 per share ($1,420 million on 64.7 million shares outstanding). Furthermore, compressors have a long life (25+ years) and Exterran’s compressors are worth materially more than their book value.

Sam Zell was a major shareholder in Hanover (one of the two predecessor companies) and remains a large (8.3% of the outstanding shares) holder of the new company and has a representative on its board. Last August, Sam Zell purchased 1 million additional shares at $49 per share. I was told by another large Hanover shareholder, who is an acquaintance of Sam Zell that, a few years from now, Exterran’s annual EBTDA should be about $1,000 million and that the company should be worth at least 8 X EBITDA. If these number prove correct, Exterran would be worth $5.6 billion (assuming debt at the time is $2.3 billion), or about $86 per share. This may be why Sam Zell was willing to pay $49 for shares in August.

Other large shareholders include Fidelity (14.4%), Franklin Resources (8.5%) and Baupost (4.5%). Franklin Resources purchased its entire position in the third quarter of 2008 and Baupost purchased about 600,000 additional shares in the third quarter. In the third quarter, the shares traded in the range of $32-72.

I value Exterran at 15 X earnings. Therefore, I believe that, in mid-2011, the shares should be worth at least $52 (15 x $3.50 per share), or 126% above their present price. 



Earnings should rebound now that a number of merger related problems largely have been solved. Over the longer term, increased interest in the importance of natural gas (becasue it is green and domestic) should create interest in companies that benefit from an increased demand for natural gas.
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