ATB Capital In a report previewing second-quarter earnings season for Canadian energy services providers, ATB Capital Markets analyst Tim Monachello said the sector is “oversold” and “a U.S activity bottom could unlock significant second-half upside.”
“Energy sentiment has weakened through 2023 on significantly lower natural gas prices (following an unexpectedly warm winter) and headwinds facing crude prices (as the market continues to weigh the relative impacts of a potential global recession on crude demand against OPEC+ actions to support price and the potential impact of relatively range-bound North American crude production),” he said. “Even with this relatively tepid macro backdrop and a moderate softening in U.S. activity levels, we believe the North American energy services complex remains well positioned for a significant and sustainable inflection in FCF generation in 2023; across our Canadian SMID-cap coverage universe, we forecast an aggregate 235 per cent year-over-year increase in FCF generation in 2023, with the aggregate net leverage ratio falling to roughly 1.0x by year-end 2023 from 1.9x at year-end 2022.
“Meanwhile, valuations remain near all-time lows, with the median FCF yields across our coverage at roughly 24%/28% in 2023/2024. Still, sentiment often directs funds flows in the service sector, which begs the question: ‘What’s the catalyst?’. We believe the largest and most visible catalyst for the service sector will be a bottoming in U.S. rig activity levels, which our channel checks suggest is likely to occur in Q3/23. We believe stabilizing U.S. rig activity would signify a meaningful reduction in the downside risk for investors, and it could unlock meaningful upside as the market turns its focus to pricing in the sizable and sustainable FCF generation of the industry in a relatively range-bound activity environment.”
After adjusting his estimates to reflect minor reductions in our U.S. rig activity forecasts, Mr. Monachello made a pair of target price reductions to stocks in his coverage universe:
* Cathedral Energy Services Ltd. to $1.30 from $1.50, below the $1.87 average, with an “outperform” rating.
* Enerflex Ltd. to $13.75 from $14 with an “outperform” rating. The average is $14.30.
The analyst also named three top picks in the sector. They are:
* Akita Drilling Ltd. (AKA.A-T) with an “outperform” rating and $3.75 target. Average: $3.75.
“AKT has been among the worst performing stocks in our coverage universe (down 27 per cent year-to-date) despite no material change to our full-year estimates since November 2022, when we raised estimates,” he said. “We believe AKT’s recent share performance is, in part, a reflection of weak sentiment and limited funds flow in the sector over recent months. With that in mind, we continue to believe that AKT is among the most undervalued companies in the North American energy sector and that it could also be among the best positioned for a laggard-to-leader trade in an improving sentiment environment, which we believe is likely to materialize in H2/23 as U.S. industry activity bottoms. While AKITA is not completely insulated from the recent softness in U.S. activity levels, its U.S. fleet is comprised almost entirely of tier-one assets in the Permian basin, and according to industry data, AKT’s Q2/23 average U.S. rig activity was up roughly 5 per cent quarter-over-quarter and remains at its highest post-pandemic level (14 rigs). Adding to AKITA’s insulation from U.S. activity weakness is its material Canadian operations, for which we anticipate increasing margins through H2/23 as its rigs roll onto higher market rates. Most importantly though, AKITA is now generating meaningful FCF from its operations (roughly $27-million in Q4/22 and Q1/23 combined before working capital investment), and we forecast it will generate roughly $39-million/$31-million of FCF before/after working capital investment in 2023.”
* CES Energy Solutions Corp. (CEU-T) with an “outperform” rating and $4.50 target. Average: $4.08.
“CEU shares are down 5 per cent year-to-date, which is roughly in line with the sector and slightly better than the average U.S.-drilling-cycle-exposed company in our coverage,” he said. “CEU has a diversified (drilling and production), low-capital-intensity exposure to the North American energy service complex, with just a roughly 10% (ATBe) weighting to dry gas drilling across its drilling fluids operations. In addition, CEU produces consumable products that are not as susceptible to industry surpluses as higher-capital-intensity, equipment-based businesses. Taken together, we believe CEU is relatively well insulated from U.S. activity declines, and we do not anticipate any material margin pressure. CEU’s operational exposures are supportive of our view that the Company is in the midst of a low-risk and sustainable free cash flow inflection. CEU’s free cash flow generating profile has a healthy track record, though it has been absorbed by the rapid pace of working capital investment required to support its roughly $1.0-billion in annual revenue growth since 2021. This pace of growth has materially slowed, and CEU is now in the early innings of excess free cash flow generation, having generated roughly $55-million in excess free cash flow in Q4/22 and Q1/23 combined ($0.22 per share), and we forecast it will generate roughly $175-million of FCF in 2023 (before dividends and repurchases, $0.69 per share).”
* Total Energy Services Inc. (TOT-T) with an “outperform” rating and $18 target. Average: $15.67.
“While TOT’s shares are down roughly 1 per cent year-to-date, it remains one of the best risk/return propositions in our coverage,” he said. “From a risk perspective, TOT’s diversified exposures to four primary business lines (contract drilling, well servicing, rentals and trucking, and gas compression and processing), including both cyclical drilling-exposed businesses and more stable production-exposed verticals within the energy services complex, and three countries (Canada, the USA, and Australia) helps to both diversify risk and provide opportunity for capital allocation optimization between service lines. In addition, TOT has a pristine balance sheet, with just 0.4 times net leverage at June 30, 2023 (ATBe), down from 1.1 times at June 30, 2022. TOT’s strides to deleverage its balance sheet have now shifted its focus on returning cash to shareholders, which has largely been comprised of share repurchases over recent years, with roughly 1.4 million shares repurchased YTD (3.3 per cent of outstanding at YE2022) and a reduction in its total share count of 13 per cent since 2017. TOT also reinitiated a dividend in Q3/22 and increased it by 33 per cent in Q2/23 to $0.08 per share quarterly ($0.32 annualized, 3.3-per-cent yield). Given TOT’s healthy track record of free cash flow generation and its strong leverage position, we believe TOT is well positioned to both allocate capital to high-return, low-risk opportunities and increase returns to shareholders, through both growing dividend payments and share repurchases.”