Description

Investment Thesis (Long): North American Energy Partners (ticker: NOA)

North American Energy Partners (NYSE: NOA, Price: $7.75) has 50-100% appreciation potential over the next 6-18 months and several near-term events (starting June 10-11) should jumpstart the process. Driving the performance is significant and underappreciated earnings growth, which should translate into $2/share of cumulative FCF over the next two years. Additionally, the company could receive earn-outs and option payments worth almost $4/share over the next three years, beginning with a $0.60/share payment due in Q3. We think the stock is worth $12-15/share and the CEO seems to agree as he has purchased nearly $2.5mm of stock and $1mm of debentures in the open market.

The situation becomes even more compelling as the stock sold off 10% since March 9 due to a botched “bought” secondary (priced at $7.85) that created a technical overhang. NOA broke deal price and participating banks are trying to unload the stock, creating selling pressure. To further convolute the issue, the deal coincided with Q1 earnings. With 4 of 6 analysts now restricted from updating numbers, the magnitude of consensus revisions off a strong Q1 report is somewhat elusive (our 2014 EBITDA and EPS estimates are 20% and 100% higher, respectively). As technical selling pressure abates and 2014 estimates are revised upward, NOA should quickly migrate back to post-call levels and eventually towards $12-15/share over time.

Situation Overview

NOA is the market leader in the highly competitive Canadian Oil Sands construction services industry. The company operates 516 pieces of heavy equipment and has a long history servicing the existing mines in the region. The Edmonton-based, $270mm market cap company is NYSE-listed (there is a Toronto listing as well) with a predominantly US shareholder base.  Canadian investors’ distaste stems from a history of management led disappointments (2006 IPO at $16/share), as growth strategies not only failed to meet expectations but superseded profitability. As excess equipment sat idle, low utilization reduced profit margins by 65% driving the stock from a peak of $23 in 2007 to below $2 during the financial crisis. 

Based on current estimates, the stock would appear fairly valued (6x 2014 consensus EBITDA). However, this assumes 1) NOA will operate at trough revenues (the current run-rate), and 2) depressed profit margins are the “new-normal.”  We disagree on both fronts and have visibility to sustained top-line growth and a reversion to prior normalized margins (with potential to hit peak margins).

Brief Industry Overview

The Canadian Oil Sands construction services industry is driven by development from both existing and new mines (there are five active mines), which in turn is driven by factors such as oil prices, capex budgets, transportation infrastructure, the differential between WCS-WTI, and the regulatory environment, among many other factors. For industry background data, we suggest reviewing Morgan Stanley’s Canadian Energy Initiation (3/19/14) and the Canadian Association of Petroleum Producers web site (http://www.capp.ca/Pages/default.aspx).

At a very high level, the current consensus seems to conclude: 1) Energy is not in favor, 2) Canadian Oil Sands are structurally disadvantaged due to price differences between Western Canadian Select (WCS) and Brent, and 3) US shale growth is further exacerbating this pricing impairment. Additionally, for those investors seeking Energy exposure, US E&P projects seem to offer more favorable economics. A June 5th WSJ article entitled “Canada Aims to Sell Its Oil Beyond U.S.” provides a high level overview of the competing dynamics.

Many investment themes we have seen highlight these structural disadvantages in their top-down analyses and conclude Canadian Oil Sands are an inferior investment in an unloved sector. However, it is prudent to highlight some advantages that are often overlooked (which benefit companies like NOA):

1. Existing Mines Have Long Lives: Canadian Oil Sands mines have lives that extend 40+ years and costs of shutting them down is prohibitive. Unless oil falls below operating costs (which experts peg around $30/bbl for most mines) mines are not shut down and even at lower prices, operate at full capacity since the goal is to ensure the lowest per barrel cost. It is important to note, the majority of NOA’s revenues comes from existing mines.
2. Geography and Capital Costs: Like other construction services providers, the Oil Sands players need to provide a large fleet of reliable equipment. However, given the harsh weather in Alberta and its remote location, on-site equipment and skilled labor provide a barrier to entry.

Key Investment Points

NOA has reached an inflection point in fundamentals – driven both by cyclical and structural improvement – which should translate into significant earnings growth and cash generation. A new CEO (with a demonstrable track record of success) has already deleveraged the balance sheet, repurchased shares, and instituted a dividend. We expect the $2/share of cumulative FCF generated in the next two years to be used for similar shareholder friendly initiatives. Our key investment points are:

1. Technical pressure is capping the stock at $7.85. As selling pressure abates, sell-side analysts resume coverage, and their estimates are revised upward, we expect 10-15% near-term upside. 
2. A confluence of improved fundamentals and sentiment should re-rate the stock from depressed to normalized levels. The majority of improvement is driven by structural not cyclical gains.
3. Roughly $4/share of “free options” based on earn-outs, put options, and refinancing offer upside.

**Please note the majority of our thesis is predicated on fundamental improvement in the business. The technical environment has created a near-term buying opportunity so we have decided to discuss it first.

A confluence of technical events (non-fundamental related) has presented a compelling near-term buying opportunity for NOA shares. The botched secondary involves roughly 20%+ of shares outstanding and occurred right after the Q1 earnings release (results were very strong). Due to the timing, sell-side analysts at participating banks are restricted from updating their estimates. The current consensus estimates are essentially stale and not reflective of the most recent data. To further convolute the story, management does not provide formal guidance in the earnings release but does provide qualitative guidance on the earnings call. All-told, we have a situation where technicals are pressuring the stock and the magnitude of earnings-revision remains elusive. As these abate, we expect 10-15% of near-term price appreciation, which will eventually lead to far significant gains (see investment point #2).

Background: In the week prior to May 6 earnings, the stock rallied 10% from $7.75 to $8.55. The stock then fell to a low of $7.43 after the secondary and has settled in at around $7.75.

Botched “Bought” Secondary: On May 6 (post-close), NOA’s largest shareholder announced a secondary for 7mm of the company’s 35mm shares. The “bought” deal was led by 4 of the 6 banks covering the stock. Here is a chronology of the week’s events:

1. May 6 (post-close): NOA reports strong Q1 earnings; stock rallies 10% through the report. Management does not give formal guidance in press release.
2. May 7 (9am EST): NOA holds its conference call. Management provides bullish quantitative and qualitative guidance on the call (to be discussed).
3. May 8 (post- close part I): largest shareholder sells 7mm shares in a bought deal at $7.85, or 6.5% discount to closing price.  At the time of the announcement, our intel suggested appetite was quite strong and brokers had orders for 85% of the deal.
4. May 8 (post-close part II): Analysts that participated in the deal become restricted. Typically, analysts would be updating their numbers at this point with the Q1 report and commentary from the call. Four of the six banks that cover the stock participated in the deal and are hence restricted from updating their models. Of those four, three were unable to update their numbers post-call. A fifth bank (Stern Agee) did not participate and decided to downgrade the stock on the news (I guess that’s payback for you!).
5. May 9 – stock trades down 10%, below $7.85 deal price, buyers cancel orders. Technical selling pressure ensues.

As of June 9, we believe the majority of stock has been placed. Management is on the road meeting with investors and we expect the deal to close in the next few days.

Consensus Need to Increase Substantially: Due to the transaction, consensus numbers have not been updated for the strong Q1 and more importantly bullish commentary made on the call. Before we review the details, the current consensus estimates are below:

We believe 2014 EBITDA estimates need to increase by at least 20% and EPS estimates by 100%. Since management does not give formal guidance in its earnings releases, this is not readily apparent. However, management gives plenty to work with in the commentary. While at times ambiguous (which creates the confusion and hence opportunity) we have extrapolated the necessary commentary that gives us confidence in our above consensus forecasts.

1. Q1 call (2/20/14): Management states they have already replaced all non-recurring work from 2013, which we estimate at $100mm. All bookings after this date are purely growth.
2. Q2 call (5/7/14):
   1. EBITDA Margin: “…hope to land the right mix and timing of work to improve upon our recent EBITDA margin run rate [14% in Q1]”
   2. Management says they won $100mm of awards on the Ft. Hills mine. When asked about how this would translate into a revenue ramp, management responded “I would add that $50 million to Q2 and Q3, is the way I look at it.”

Revenue Revision: Even if NOA did not book any further awards, 2014 revenues should be at least $50mm higher than 2013 per management’s comments (revenues of $520mm vs. consensus of $473mm). However, we know this is conservative since other contracts have already been awarded and through our research of RFPs (see investment point #2).

EBITDA Revision: Management expects EBITDA margins to improve from Q1 (which was very strong). For the remaining three quarters of 2014, consensus EBITDA margin estimates are 12.3%, so we know those have to go up as well. Even if one were to assume margins would stay at consensus levels, overall EBITDA numbers would have to come up by a minimum of $6mm with the added revenues alone. Using a $65mm 2014 EBITDA estimate and the pre-Q1 multiple of 6.5x would translate into a $9 stock.

Investment Point #2: Fundamental Improvement Should Drive Stock to $12-15 

While we believe the technical environment provides a near-term buying opportunity, we expect structural improvements and some cyclical gains to drive 40-80% of stock appreciation in the next 6-18 months. Based on current valuation, the market expects NOA to operate at trough revenues and margins (the “new normal”) for the foreseeable future. In order for the stock to work, investors need to believe industry growth will materialize and profitability will improve. While one issue is cyclical and another is structural, we have conviction both are working in our favor.

Cyclical Issues: Increased Bidding Activity Provides Visibility Into Revenue Growth

NOA’s revenues are currently operating at cyclical troughs and last year’s 21% revenue decline provided further evidence to bears that Oil Sands growth would not materialize. We project 12% annual growth this year (our estimates are considerably higher than consensus). Our conviction is based on diligence calls with industry participants and customers, as well as our bottoms-up analysis of the five major Oil Sands sites. Additionally, approximately 70-80% of NOA’s revenues are derived through Master Services Agreements, which provide a recurring and visible revenue base. As increased bidding activity translates to an improved growth outlook (not just for 2014 but beyond since many contracts are 5+ years), we expect both estimates to rise and sentiment to re-rate.

Our conviction in revenue growth relies on the following:

1) Recurring Revenue: Based on Q1 commentary, NOA already replaced the $100mm of last year’s revenue that was non-recurring leaving any future awards to provide growth. Our diligence has already identified $80mm of new opportunities we believe NOA has secured.

2) Ft. Hills Mine: this is the newest of the “existing” mines having been sanction in October 2013. The total planned capital investment is $13.5bn and RFPs for site preparation work have already been released. Our research suggests NOA is bidding on an additional $200-300mm of work (beyond the $100mm already won). Since their equipment is already on site, NOA is a “preferred” contractor, which should enable it to win a sizable amount of tenders.

4) Kearl Mine: NOA signed a 5-yr MSA for the project in late 2013. The contract was slow to ramp but should now be a strong contributor to 2014 growth.

4) Road/LNG Work: Management is competing for road and LNG work, business the company has historically not bid for. Management’s strategic plan is to pursue these end markets for additional growth, diversification, and operating leverage. It is a similar strategy Mr. Ferron successfully executed while COO of Helix (discussed in detail below). Our diligence has identified several large RFPs NOA is bidding on, which we believe will translate into 2015 revenues. Management is targeting $100mm of non-Oil Sands revenue in 2015.     

Structural Issues: Dynamics Support a Reversion to Normalized Margins 

Several structural dynamics – both industry and company specific -- support our thesis that margins should revert to normalized levels (which averaged 18-20% for years). We believe the company could get to 15% margins by 2015 (compared to 9% in 2013). While our estimates are slightly more conservative, those margins could lead to $1 in EPS and a $15 stock based on the current multiple.

Industry Dynamics: We believe the following structural improvements at the industry level will improve margins for NOA:

1. Fleet Rationalization: after years of excess growth destroyed profitability, there are signs the fleet is shrinking through attrition and lack of growth capex, which has started to produce improved utilization and pricing.
2. Competitor in Financial Distress: Our diligence suggests NOA’s largest competitor is under financial duress and a bankruptcy could add nearly 5-points to industry margins. Even should the competitor survive, we believe it has deferred maintenance capex and will be much less of a competitive threat to NOA.
3. Outsourcing: In an effort to reduce costs, Oil Sand customers began to insource work that would have traditionally gone to contractors. Our diligence suggests that the negative effects of this have bottomed and work flow has started flowing back to the contractors.

Company Dynamics:  We believe many of the structural issues NOA is plagued with can be solved by the new management team led by CEO Martin Ferron. Our confidence lies in his track record, his insider purchases ($2.5mm of stock and $1mm of debentures in the open market), and his implementation of a proven strategy.

In order to appreciate the current strategy, it is necessary to understand the prior strategy, which stressed growth and size, regardless of risk (from our understanding, there was no formal risk management process in bidding awards). This became evident during the meteoric rise in revenues and subsequent collapse in margins from 2005-2012.  The strategy was led by a private equity backed management team of financial professionals not operators. With the appointment of Mr. Ferron in June 2012, the strategy changed to focus on price discipline and risk management. The company’s results reflect the willingness to sacrifice revenues for profitability (2013 revenues declined by 21% but EBITDA margins increased from 4.7% to 9.2%).

We believe the following structural improvements at the company level will improve margins for NOA:

1. New awards are being bid at higher margins
2. Management has identified $5mm of cost savings, in addition to the $15mm already slashed
3. Improved utilization should drive operating leverage

A Case Study at Helix: Prior to joining NOA in June 2012, Martin was the COO and then CEO of Helix Energy Solutions (NYSE: HLX, market cap: $2.5n) from late 1998 to 2008. At the time of appointment, HLX was a subsea contractor focused on the Gulf of Mexico earning around $50mm a year in EBITDA. The company had both an asset utilization issue as well as a singular end market (just like NOA). Martin tackled both issues, and by the time he left the company was a diversified energy services contractor generating almost $800mm of EBITDA. The stock had also increased from $6 to $40 (before falling during the financial crisis). Martin has employed a similar strategy at NOA by addressing the underutilization of assets, and increasing margins. Additionally, he has paid down $220mm of debt, repurchased 5% of shares outstanding, and instituted a dividend. We expect Martin to continue focusing on margins and enter the second leg of the strategy which is diversifying end markets away from the Oil Sands.

Investment Point #3: Optionality Provides $4/share of Upside

Several options offer shareholders both near and long-term benefits. We do not believe any of these are reflected in the current share price.

1)      Earn-out Payments Could Total $93mm ($2.60/share including use of NOLs): As part of the company’s restructuring, it sold is Piling division to Keller (LSE: KLR) in July 2013 for $225mm and a potential earn-out.  There are three annual measurement dates for the earn-out (starting 6/30/14) and NOA is due a multiple of the businesses EBITDA (details on the calculation are listed in the filings). The first payment is calculated based on performance from closing to 6/30/14 and NOA receives $2 for every $1 in EBITDA greater than $30mm (with a maximum payout of $30mm this period). We estimate $20mm for the 6/30/14 payout ($0.60/share).  Raymond James put out a note expecting $30mm on March 20 but we believe that is too high.

2)      Put Option Could Be Worth $50mm ($1.10/share). We believe that one of NOA’s contracts contains a put option allowing NOA to sell its equipment to the customer should its contract not be renewed. We believe the value of this put option is roughly $50mm greater than the book value of the equipment.

3)      Refinancing Could Save $5mm. NOA’s cost of debt is nearly 10%. The company is actively reducing its debt balance and we believe is exploring various alternatives to reduce the rate. A combination of debt and interest rate reduction could reduce interest expense by $5mm in 2015 ($0.10 to EPS).

We believe NOA is worth $12-15/share based on normalized earnings.  While we look at a variety of valuation metrics, sell-side analysts prefer EV/EBITDA.  We currently use a target multiple of 6.5x EBITDA, which equates to an 11x FCF multiple. Every ½ pt change in the EBITDA multiple changes our 2015 target price by $1.15/share.

Risks:

1. Key man: we attribute much of NOA’s fundamental improvement to Mr. Ferron. If he were no longer with the company, our thesis may become impaired.
2. Macro-economy: Oil sands expenditures are driven by global economies, prices, and price differentials that could impact NOA’s business and may be difficult to predict. Any shocks could have a material impact on financials.
3. Customer concentration: NOA only has a few customers. If a mine were to mothball, business would be adversely impacted. Diversification into alternative markets partially mitigates this risk.

Catalyst