Natural Gas Services Group, Inc.NYSE:NGS) has seen strong price movement over the past year due to improved future cash flows from strategic investments in rental units. I believe the stock is a liability to buy for undervaluing and optimizing core services, which will drive increased cash flows in the long term.
Natural Gas Services Group provides compression services and equipment to the US energy sector. This company specializes in the manufacture, rental, sale and maintenance of natural gas ignition systems and compressors. Its core business is the rental of compression units for various horsepower requirements in unconventional oil and gas production.
The 1,869 vehicles in NGS’s rental fleet have a combined 425,340 horsepower. In addition, the company designs and manufactures reciprocating compressor frames and parts, as well as compressor units and components. NGS also produces flare systems and flare stacks for gas combustion in onshore and offshore environments. In addition to offering compressor sales and flares, they also offer modest horsepower screw compressor replacement and rebuild services. NGS generally serves midstream businesses, exploration and production firms that use compressors to provide artificial lift, and those that focus on natural gas production.
With a market cap of $181.83 million, NGS has a 1% return on invested capital. Over the past 52 weeks, the stock has experienced a trading range from $16.25 to $9.41. Currently priced at $14.58, the company carries an EV/EBITDA ratio of 9. Notably, NGS’s EV/EBITDA ratio stands relatively high compared to industry peers, indicating relative overvaluation.
NGS also doesn’t pay a dividend, but that’s because of negative FCF from investing $128.7 million in leased equipment to boost future cash flows. With a current ROIC of 1%, management is trying to drive more growth with this FCF to create compound organic growth that can support other forms of value creation in the future, such as a dividend or share repurchase.
Performance Compared to the Broader Market
Over the past 3 years, NGS has outperformed the broader market with a return of 51.4% compared to 28.95% for the S&P 500. Although NGS’s share price has been fairly stagnant over the long term, this recent performance demonstrates the firm’s ability to create shareholder value through better leverage and performance, which can continue over the long term. I believe this recent good performance is due to the firm starting to expand its rental income, which will improve earnings and subsequently, future cash flows, thus justifying the higher price. high for NGS.
The NGS balance seems a bit expensive in terms of interest due to the interest coverage of only 1.73. But as the investment in more rental units begins to take effect, operating income will continue to grow resulting in a more stable financial position where debt can be repaid relatively easily. Also, with a current ratio of 1.49 and an Altman-Z score of 1.27, the firm should remain solvent in the short term until earnings recover.
NGS demonstrated strong financial success in third quarter of 2023 reported in November, with an increase in both sales and profitability. The company’s total revenue increased 42% year-over-year and 16% sequentially to $31.4 million. Rental income also rose 49% to $27.7 million. Adjusted operating income increased by over seven times as SG&A costs fell by over $2 million and gross margins also increased by 14%.
So far in FY2023, the firm has consistently beaten EPS-related estimates, indicating the firm’s ability to grow profitability during macro headwinds. This outperformance has resulted in solid earnings revisions over the past 6 months as the firm has demonstrated its ability to stabilize earnings and grow them over the long term.
These results are because NGS has made significant capital expenditures of $128.7 million in its rental fleet, which is providing a strong foundation for future growth. With steady revenue growth and a favorable hydrocarbon production and price environment, NGS provided optimistic guidance for 2023 and 2024 with revenues and EPS growing rapidly as shown below. To meet these trends, the firm will need to continue to increase profitability to de-risk the firm’s balance sheet in the long term to remain solvent and maintain FCF.
Analysts currently rate NGS a “Strong Buy” with a 1-year price target of $22.33 representing a potential upside of 52.95%. This is due to the expected increase in cash flows from the growth of the core business, which should give the firm more FCF to expand after the debt is paid off.
Before calculating a fair value for NGS, I decided to find an accurate discount rate by calculating the firm’s cost of capital using the Capital Asset Pricing Model. Assuming a risk-free rate of 3.9% based on current The 10-year Treasury yield, NGS has a cost of capital of 7.77%. This represents the expected return required by investors for the risk of holding NGS’s capital.
Based on the previous cost of equity, I calculated a 5Y DCF equity model based on net income. I decided not to use a risk premium for my discount rate of 7.77%, because although the firm has a larger than average debt load, they have the resources and income necessary to not disrupt cash flows. I also estimated that revenues and margins would increase in line with guidance and estimates with strong growth in the first few years due to the increase in rental units through leverage, thereby increasing revenues over time. This resulted in a fair value of $17.88 representing an 18% undervaluation.
Also, based on the valuation ratios below, we can see that the stock appears to be relatively overvalued. But that’s because the firm expects higher growth, thus adding a price premium compared to recent years and peers. With revenues expected to recover as mentioned in the earnings section, and with continued growth through rental unit investments, all of these ratios will improve significantly in the coming years, making the stock competitive for its upside.
Optimizing Product and Service Offerings
NGS has strategically positioned its product and service offerings to maximize financial benefits, primarily through its specialized compression equipment and related services. A key component of NGS’s strategy is the leasing of small and medium-sized compressors, which are necessary for natural gas production. For many natural gas companies, these compressors are not only more affordable than purchasing the equipment as a whole, but they also offer more operational flexibility. Customers can tailor their equipment requirements based on production requirements by leasing compressors instead of paying outright for new equipment.
Additionally, NGS adds value to its services by providing full maintenance and servicing for these compressors. This part of the service ensures that the machine runs effectively and reliably, saving customers money on maintenance costs and downtime. In the natural gas sector, where any operational delay can result in huge revenue losses, this kind of efficiency is essential. NGS offers its customers a compelling value proposition by combining reliable equipment with high-level service, which creates a competitive advantage.
For NGS, this plan also has obvious financial advantages. Lease and service contracts contribute to more stable and predictable income streams by providing a reliable source of income. In addition, NGS targets a specific market sector by focusing on small and medium horsepower compression equipment. This allows for more targeted marketing and operations efforts, which will result in cost savings and increased profit margins. This will create compound growth through stable cash flows, in which the firm can have a more stable financial position to take on debt and create shareholder value.
Regulatory changes: Risks may arise from environmental laws and policies affecting the natural gas sector, increasing operating costs or restricting specific operations. This would reduce the firm’s cash flows and change my valuation of the firm due to lower earnings. This could be a moderate risk for NGS as a decline in pipeline construction could affect future earnings if regulations become more stringent.
Technological advances: Rapid advances in technology can make NGS products or services obsolete, necessitating continued investment in new ones to maintain a competitive edge. This risk is quite low because their rental units meet the needs of their customers, which means that innovation from competitors would not take market share as quickly as it would in a direct distribution such as telephones.
To sum up, although NGS has seen a recent rally in price, I still believe the stock is a buy due to its undervaluation and optimizing core services, which will drive incremental cash flows over the long term. . I believe that observing future earnings will be important in determining whether the firm can continue to pay off debt and may change my overall thesis if the company does not perform well.