Description

Summary: Step Energy (“STEP”) is a US$199MM market cap (~US$80MM free float) Canadian pressure pumping company. In 2018 STEP completed a debt funded acquisition which left it over levered heading into the following downturn. Since, STEP’s equity has traded at a discounted valuation. The Canadian pressure pumping market is reverting to mid-cycle and STEP’s equity should benefit from a combination of positive earnings revisions and multiple expansion as its balance sheet is de-risked.    

Background: STEP was founded in 2011 by ARC Financial (which still owns 60%) as a coil tubing company. In 2015 and 2016 STEP purchased two Canadian pressure pumping companies, Gasfrac Energy Services and Sanjel Energy Services, out of insolvency. In May 2017, STEP IPO’ed at $10 per share. In April 2018 STEP acquired Tucker Energy Solutions for C$350MM and entered the US pressure pumping market.

The Tucker transaction was funded with C$50MM of new equity and C$300MM of cash on hand and a new revolving credit facility. While management originally guided for Tucker to generate US$96.7MM (~C$120MM) of EBITDA the market turned in the second half of 2018 and earnings collapsed. STEP’s equity has been priced at option value since.

Today STEP has 365,000 HHP of active capacity and 16 active coil tubing units (out of capacity of 490,000 HPP / 31 units). This capacity is split ~55% Canada / 45% US. Both the Canadian and US markets have begun to turn. The Canadian market is the focus of this write-up as it has a clearer line of sight to recovery.

The primary commodity prices to watch for the Canadian market are, Western Canada Select Crude Prices (USCRWCAS Index) and AECO Natural Gas Prices (NGCDAECO Index). Additionally, Baker Hughes publishes a rig count for Canada (BAKECAN Index), which is the main driver of pressure pumping demand.

Trican Well Services (TCW) is the largest player in the Canadian pressure pumping market and provides high level commentary of supply and demand in its earnings calls and presentations. The below table is based on page 13 of their March 2022 Investor Presentation.

Page 15 of the same presentation provides an overview of demand. TCW estimates that the above 29 fleets are fully utilized with ~4,500 wells drilled per year and that in 2022 5,500 wells will be drilled, needing an additional six fleets. The 5,500 well estimate is in line with consensus estimates and a 25% YoY increase. During Q122 the Baker Hughes Canada Rig index was up 57.5% YoY and is the primary variable to watch.

While there is theoretically excess capacity, it is unlikely that most of this can return. A portion is older equipment which needs to be retrofitted. More importantly labor to man fleets has become increasingly scarce. TCW’s CEO discussed the topic on their Q421 earnings call:

“The good news on that is because labor is so tight, we will continue to see labor availability as a very significant bottleneck in crew additions, whether it's within the fracturing industry or the drilling industry. So I think the industry overall will be sort of operating at its max capacity from a people perspective and whether there is a discipline or not, probably won't matter because people just won't be able to add equipment like they used to.”

Combining these items, TCW - which holds the majority of the spare capacity - has said it will only bring one additional fleet back this year. Calfrac has said it will not add any capacity. The market does not expect STEP to add capacity as it does not have the balance sheet flexibility to fund the reactivation costs. This should lead to the market being short capacity during the second half of 2022 when activity seasonally picks up following the spring break-up.

Valuation

At C$3.7/share STEP trades at 3.84x FY22 consensus EBITDA of C$110MM and 5.35x EV/EBITDA – Capex. If the Canadian and US markets recover to 2017 levels there is upside to consensus estimates. In FY17 STEP generated EBITDA of C$117MM and Tucker adds C$120MM pointing to potential earnings power in excess of C$200MM.

On a relative basis the comps in Canada are TWS and Calfrac which trade at 7.4x and 6.7x FY22 EV/EBITDA and in the US ProPetro, NexTier and Liberty which trade at 5.8x, 8.6x and 10.4x FY22 EV/EBITDA.On an absolute value basis STEP trades at US$920 and 690 per active and total HPP versus replacement cost of US$1,000 per HPP (assigning no value to the coiling tubing assets). 

Risks

There are shortages across the OFS supply chain, including labor, sand, steel tubes, drilling equipment, parts etc. A shortage in another sub-segment may limit demand for pressure pumping equipment preventing a recovery.

Under current 2022 consensus estimates STEP will be marginally cashflow negative. The company is required to make C$28MM of debt repayments under its credit facility, has guided to capex of C$53MM and will likely need to invest in working capital as the industry is experiencing cost inflation.

STEP’s credit facility contains a 3:1 interest coverage ratio covenant, a 3.5x leverage covenant and a minimum liquidity covenant. At year end STEP was in compliance with these covenants.

STEP’s assets are likely underinvested.

STEP may issue equity to de-risk its balance sheet.

Catalyst

Continued recovery in US and Canadian pressure pumping markets.