CES Energy Solutions Corp T.CEU

From Scotia this Morning

[savyinvestor333]

Oilfield Services

CES Energy Solutions Corp.

• CEU-T: C$3.01
• Target: C$3.60
• Rating: Sector Outperform

Marketing Highlights

OUR TAKE: Positive. We hosted an in-person non-deal roadshow with CES CEO Ken Zinger and CFO Tony Aulicino on June 6. To us, there are clear signs that the company is achieving increasing levels of success managing margins and cash flows, and generating value through the upturn. Recent traction on price pass-throughs saw 1Q22 margin exit rates of 12.5% to 13%. While 2Q is seasonally softer, we believe the operating environment is supportive of further margin expansion beyond the historical range of 13% to 13.5% in 2H22 and 2023.

Beyond the margin discussions, investor conversations centered on CES’s working capital, FCF capacity, and eventual return of capital. Given the counter-cyclical cash flows, its WC investments effectively serve as a “piggy bank” where it can harvest cash to deploy towards debt repayment and return of capital when activity levels normalize. In our view, increased visibility on margin improvement (and we might be there already) and eventual return of capital should act as a catalyst for a re-rate (closer to historicals).

KEY POINTS

Early bird gets the worm. Faced with significant cost inflation, management started negotiating additional price increases with its customers in December. Given the lead time between pricing discussions and flow-through to the P/L (about 6 to 8 weeks), the company started seeing pricing momentum in late March such that 1Q margins came in above the implied guide and exit rates approached historical levels. We believe CES can recover historical margins sooner than some of its peers who only announced price increases in April.

Entering a new phase. The current operating environment provides an opportunity to expand margins beyond the historical range of 13% to 13.5% in 2H and 2023. Rig counts in the U.S. and Canada continue to trend positively and the pace and scale of cost inflation has subsided. Management also noted a shift in customer behaviour whereby security of supply and service level have started to become a focus rather than simply taking the low bid. On the supply side, industry consolidation, a lack of new capacity, and a higher cost curve have established a more balanced demand/supply environment with competitors remaining rational on pricing.

Value hiding in plain sight. To us, WC investment represents “accrued free cash flow” given the counter-cyclical FCF characteristics of the business. We forecast aggregate FCF before WC of $270 million through 2023 (~35% of its market cap). Incremental investments remain highly accretive: assuming normalized EBITDA margins of 13% and WC investment of $0.30 to $0.35 per incremental revenue dollar, implies CES is earning >25% returns on incremental capital. In the context of expanding return metrics, we think shares are inexpensive at 5.0x EV/EBITDA (versus a historical average of 6.5x) and P/B of 1.2x (2.1x) on our 2023E.

• Quarterly Financials
• Yearly Financials

Historical price multiple calculations use FYE prices. All values in C$ unless otherwise indicated.
Source: FactSet; company reports; Scotiabank GBM estimates.

Qtly Adj EBITDA (M)	Q1	Q2	Q3	Q4	Year	Current EV/Adj EBITDA
2020A	$51	$8.2	$18	$25	$102	12.4x
2021A	$34	$32	$42	$48	$156	8.1x
2022E	$42A	$43	$56	$62	$204	6.2x
2023E	$61	$51	$62	$65	$239	5.3x

Given how working capital investments can mask the true earnings power of the business, we view book value as a better yardstick of how the company can grow intrinsic value through the cycle. Shares appear inexpensive trading at 1.2x P/B on our 2023E, which is below its historical average of 2.1x. In our view, CES’s P/B valuation will likely expand as its return metrics improve and come in above historicals. We forecast BVPS increasing to $2.55 in 2023 from $1.85 as at 1Q22.

Exhibit 1 - Margin Upside Could Drive a Re-rate

Source: Company reports; FactSet; Scotiabank GBM estimates.

Exhibit 2 - Out-Earning Its Keep

Source: Company reports; FactSet; Scotiabank GBM estimates.

Company Overview

Company Description

CES Energy Solutions Corp. (CEU) designs, implements, and manufactures consumable drilling fluids and specialty chemicals for the North American market.

 

Key Risks

Commodity prices and industry activity levels; customer bargaining power; industry competition; input cost inflation and availability; and foreign exchange risk.