Natural Gas Services Group: Undervalued Even After The Recent Price Surge - Seeking Alpha

Natural Gas Services Group: Undervalued Even After The Recent Price Surge | Seeking Alpha

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Natural Gas Services Group, Inc. (NYSE: NGS) has seen strong price movement within the last year due to improved future cash flows from strategic investments in rental units. I believe that the stock is a buy due to its undervaluation and optimization of core services which will drive cash flows up in the long term.

Business Overview

Natural Gas Services Group offers compression services and equipment to the U.S. energy sector. This company specializes in the fabrication, rental, sales, and maintenance of flare systems and natural gas compressors. Its major business is the rental of compression units for different 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 ignition systems and flare stacks for gas incineration in onshore and offshore environments. In addition to offering compressor and flare sales, 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 concentrate on producing natural gas.

Business Overview (NGSG)

With a market valuation 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 holds an EV/EBITDA ratio of 9. Notably, NGS's EV/EBITDA ratio stands relatively high compared to industry peers, indicating a relative overvaluation.

NGSG EV/EBITDA Compared to Peers (Seeking Alpha)

NGS also does not pay a dividend but that is due to having negative FCF from investing $128.7 million into rental equipment to raise future cash flows. With a current 1% ROIC, management is attempting to foster greater growth with this FCF to create compounding organic growth that can support other forms of value creation in the future such as a dividend or share repurchases.

NGSG Cash Flow Statement (TradingView) Share Performance (Seeking Alpha)
NGSG Cash Flow Statement (TradingView) Share Performance (Seeking Alpha)

Performance Compared to the Broader Market

In the last 3 years, NGS has outperformed the broader market with a 51.4% return compared to the S&P 500's 28.95%. Although NGS's stock price has been rather stagnant in the long term, this recent performance demonstrates the firm's ability to create shareholder value through leverage and outperform which could continue in the long term. I believe that this recent outperformance is due to the firm beginning to leverage to expand its rental revenues which will improve income and subsequently, future cash flows thus justifying the higher price point for NGS.

Performance Compared to the S&P 500 3Y (Seeking Alpha)

Balance Sheet

NGS's balance sheet seems slightly expensive regarding interest due to only a 1.73 interest coverage. But, with investments into more rental units beginning to take effect, operating income will continue to increase resulting in a more stable financial position where debt can be paid off 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 income recovers.

Financial Position (Alpha Spread) Interest Coverage (Alpha Spread) Solvency Ratios (Alpha Spread)
Financial Position (Alpha Spread) Interest Coverage (Alpha Spread) Solvency Ratios (Alpha Spread)

Earnings

NGS demonstrated strong financial success in the third quarter of 2023 reported in November, with an increase in both sales and profitability. The company's total revenue increased by 42% year over year and 16% sequentially to $31.4 million. Rental revenues also increased by 49% to $27.7 million. Adjusted operating income increased by over seven times as SG&A costs dropped by over $2 million, and gross margins also increased by 14%.

So far in FY2023, the firm has consistently outperformed estimates regarding EPS, showing the firm's ability to enhance profitability during macro headwinds. This outperformance has resulted in solid earnings revisions over the last 6 months as the firm has demonstrated its ability to stabilize profits and grow them over the long term.

Earnings Revisions (Seeking Alpha)

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 sustained revenue growth and a favorable hydrocarbon production and price environment, NGS gave optimistic guidance for 2023 and 2024 with revenues and EPS growing rapidly as shown below. To meet these trends, the firm will have to continue enhancing profitability to remove the risk to the firm's balance sheet in the long term to stay solvent and preserve FCF.

Earnings Estimates (Seeking Alpha)

Analyst Consensus

Analysts currently rate NGS as a "Strong Buy" with a 1-year price target of $22.33 representing a potential 52.95% upside. This is due to the expected surge in cash flows from core business growth, which should give the firm more FCF to expand once the debt is paid off.

Analyst Expectations (Seeking Alpha)

Valuation

Before calculating a fair value for NGS, I decided to find an accurate discount rate by calculating the firm's Cost of Equity using the Capital Asset Pricing Model. Assuming a risk-free rate of 3.9% based on the current 10-year treasury yield, NGS has a Cost of Equity of 7.77%. This represents the expected return demanded by investors for the risk of holding NGS's equity.

Cost of Equity (Created by author using Alpha Spread)

Based on the previous Cost of Equity, I calculated a 5Y Equity Model DCF based on net income. I decided to not use a risk premium for my discount rate of 7.77% because although the firm has a larger debt load than average, they have the necessary resources and income to not disrupt cash flows. I also estimated revenue and margins to grow in line with guidance and estimates with strong growth in the first few years due to the increase in rental units through leveraging, thus increasing income over time. This resulted in a fair value of $17.88 presenting an 18% undervaluation.

5Y Equity Model DCF Using Net Income (Created by author using Alpha Spread) DCF Financials (Created by author using Alpha Spread)
5Y Equity Model DCF Using Net Income (Created by author using Alpha Spread) DCF Financials (Created by author using Alpha Spread)

Also, based on the valuation ratios below, we can see that the stock seems to be relatively overvalued. But, this is because the firm is expecting greater growth, thus adding a premium to the price compared to recent years and peers. With income expected to recover as mentioned in the earnings section, and continued growth through its rental unit investments, all of these ratios will improve significantly in the coming years, making the stock competitive for its growth.

Seeking Alpha

Optimization of Product and Service Offerings

NGS has strategically positioned its product and service offerings to maximize financial benefits, primarily through its specialized compression equipment and associated services. One key component of NGS's strategy is the leasing of small- to medium-sized compressors, which are necessary for the production of natural gas. For many natural gas companies, these compressors are not only more affordable than buying equipment altogether, but they also provide more operational flexibility. Clients can adapt their equipment requirements based on production demands by renting compressors instead of having to pay for new equipment outright.

Moreover, NGS adds value to its services by giving thorough upkeep and servicing for these compressors. This part of the service guarantees that the machinery runs effectively and dependably, saving customers money on maintenance expenses and downtime. In the natural gas sector, where any operational delays can result in large revenue losses, this kind of efficiency is essential. NGS offers its clients a compelling value proposition by combining dependable equipment with top-notch service, which creates a competitive advantage.

For NGS, there are also obvious financial advantages to this plan. Rental and service contracts contribute to more consistent and predictable revenue flows by offering a reliable source of income. Furthermore, NGS targets a particular market sector by concentrating on the small- to medium-horsepower compression equipment niche. This allows for more targeted marketing and operational efforts, which will result in cost savings and increased profit margins. This will create compounding growth through consistent cash flows, in which the firm can have a more stable financial position to take on debt and create shareholder value.

Risks

Regulatory Changes: Risks could arise from environmental laws and policies that impact the natural gas sector, raising operating costs or limiting specific operations. This would decrease the firm's cash flows and alter my valuation of the firm due to decreased income. This could be a moderate risk to NGS as a decrease in pipeline construction could impact future revenues if regulations become stricter.

Technological Advancements: Quick advances in technology could make NGS's products or services outdated, necessitating ongoing investments in new ones to maintain a competitive edge. This risk is rather low because their rental units cater to their client needs, meaning that innovation from competitors would not rapidly take over market share as it would in a direct distribution such as phones.

Conclusion

To summarize, although NGS has seen a surge in price recently, I still believe the stock is a buy due to its undervaluation and optimization of core services which will drive cash flows up in the long term. I believe that keeping an eye on future earnings will be important to determine if the firm can continue paying down debt and can change my overall thesis if the company underperforms.