Apergy Corporation (APY), a provider of engineered equipment and technologies to the upstream energy companies, has a near-term growth catalyst and some long-term growth drivers. APY's proposed combination with its geographically diversified peer can potentially create one of the leaders in the production-related oilfield equipment & service providers. Because the integrated company will derive revenues from a wider geographic base, investors should benefit from a more stable top-line. I think the company offers robust growth opportunities, and investors can look to add it to their portfolio.
On a standalone basis, APY is managing its business well. While the energy market goes through a rough patch, the company is strengthening the legacy business. With positive free cash flows and has no near-term debt repayment, it is relatively free of financial risks.
In December 2019, Apergy disclosed an agreement to combine with ChampionX, which is the upstream energy business of Ecolab (ECL). The combined entity, after the proposed merger, will become a leader in production-related product lines. It will have an expected enterprise value of $7.4 billion, of which the existing Apergy and Ecolab shareholders will own 38% and 62%, respectively.
The new entity will offer artificial lift equipment, chemical solutions, and digital technologies. According to the company's estimates, it will provide proforma revenues of $4.5 billion and adjusted EBITDA of approximately $615 million. The benefits of the combination, in terms of cost synergies, are expected to be $24 million annualized. Expected synergies would accrue from SG&A reduction opportunities, efficiencies in supply chain procurement, and leveraging of facilities.
While Apergy generates most of the business in the U.S., Ecolab has an operational presence in over 55 countries. Since Ecolab's revenue sources are more geographically diversified than APY's, the combined entity will generate less revenue from the U.S. (59%) compared to APY's 76% exposure to the U.S. Conversely, its exposure to the Middle East and Africa will increase from 6% to 11%. In other words, it will be less dependent on the stagnant U.S. onshore market and will get a better pie of a fast-growing market.
The other key benefit of the combination would be the addition of chemical and technology applications to Apergy's product suite. In the past five years, revenues from specialty products have grown by 60% in ChampionX, backed by 1,700 owned and licensed patents. It offers solutions across the reservoir, production, and midstream capabilities. Specifically, it is considered to be a leading provider in the category of corrosion management, bacteria management, and control, Oil and water separation, wax and asphaltene management, among others. Since both APY and Ecolab are relatively established brands, the combined entity can extract synergies from highly differentiated products without having to spend too much on marketing efforts.
The other key aspect of the new business will be the revenues and cash flow stability because it will derive ~80% of the revenues from production-related products and services. Typically, energy production lasts for more than 20 years in the life cycle of a well. In comparison, drilling and completions activity would last for four to six weeks. However, I think the current headwinds in the upstream energy industry will not allow APY to gain significantly from the transaction. In Q3, Ecolab's Global Energy business segment saw a ~3% revenue decline compared to a year ago. Nonetheless, the segment did improve operating margin (17% up) during this period. Although the upstream performance breakdown was not available, the energy business will likely be earnings accretive for the combined company.
The merged company's net debt-to-EBITDA will decline to 1.5x (including synergy) compared to ~2x for APY. So, the balance sheet will be less leveraged, supported by strong and stable cash flows. No wonder, APY's stock price climbed up by 6% as the news broke. But the stock has fallen since, raising some doubt over the realization of the gains from the merger.
APY looks to integrate its digital monitoring solution with the pumps and remote monitoring capabilities. During Q3, the contract began generating revenues for the company. Also, it has resolved the issues relating to ESP installation in the Bakken and has started to earn revenues from that region by the end of Q3. APY's electric submersible pump (or ESP) started gaining market share in the U.S. onshore unconventional market in Q2 2019 after the company received an order for ESP installations with an integrated oil company.
In the unconventional share resources where the production decline rates are high, APY field its rod-lift product offerings. Rod lift is a part of the artificial lift technology for the low-flow valves. In the past year until Q3 2019, rod-lift revenues increased by high single digits despite the weakness in the onshore E&P activity. The upstream customers seldom view the artificial lift as a full lifecycle solution. So, an ESP installation doesn't automatically guarantee a rod lift conversion. In this scenario, the quality of a product and the strength of the brand matter to the customers in making a choice. The management believes that with an established brand, it can capture a higher market share for the upstream companies that are increasingly adopting rod lift conversion.
The company's digital products are also expected to boost growth. Along with the company's premier fit-for-purpose digital solutions, it is developing Smart Edge hardware and artificial intelligence models. During Q3, its revenues from digital technology increased by 10% year-over-year. Along with the company's focus on growing digital revenues, it also looks to increase its share in the downhole applications market through investment in diamond bearings. It currently holds 22 patents in the Diamond Sciences Technology, including the polycrystalline diamond cutters (or PDCs), which shows its competitive strength in the market.
In the past year, the U.S. rig count declined by 26% until January 3, 2020, following the upstream companies' decision to reduce E&P capex. As drilling activity fell, the upstream customers reduced demand for a drill bit, which lowered the drill bit rate and led to a readjustment of inventories. Gradually, the companies started cutting down on the cutter inventories, including reducing safety stock levels and increasing the use of reclaim of the cutters from old bits. Destocking typically happens during an industry downturn. So, revenues from Drilling Technologies declined by 22% in Q3 2019 compared to the previous quarter. Similarly, the companies, during the restocking period, the revenue build-up would exceed the rig count growth. So, we can continue to expect lower revenues from Drilling Technologies in Q4, although with increasing crude oil prices, the operators will have incentives to increase drilling activity in 2020.
During Q4 2019, the West Texas Intermediate (or WTI) crude oil price increased by ~14%. So, if the crude oil price stays steady, there will be restocking of drill bit equipment. The company's management expects a sharper recovery activity improves. However, we can expect a relatively underwhelming recovery in revenue during the period of recovery, as the companies typically stick to the inventory plan.
By the company's internal estimates, on approximately 28% occasions in the past five years, the variation in the destocking-restocking cycle has been significant (>15%). Only two times in the past, there were sequential declines in two consecutive quarters. However, following two sequential decline quarters, we note a sharp recovery. What this means is during Q4, revenues from Drilling Technologies will continue to fall, while in early 2020, we can expect some improvement. Although the past trend suggests a sharp recovery in Q1, the company's management does not count as the recovery to be as intense as the fall witnessed in 2H 2019.
The steady rig count in the international markets was a bright spot in for APY in 2019. Its revenues outside of North America grew 13% year-over-year in Q3, led by the Middle East region. Buoyed by the activity improvement in South America, it made a strategic investment in a sucker rod manufacturer in Argentina during Q3.
In Q4 2019, the North American onshore activity is likely to remain low as the U.S. upstream continues to exercise spending restraint and the effect of seasonality (i.e., lower drilling activity in winter). During Q4 (October to December), the U.S. rig count decreased by 6.4%. I have already discussed how the lower rig count can affect the PDC drill bits in Q4.
On the other hand, the Production & Automation Technologies (or PAT) segment can remain resilient in the U.S. in Q4. The international geographies will offer growth opportunities as the rig count has stabilized in the past quarter. However, the overall effect will be minimal, and due to lower-than-normal performance in the Drilling Technologies segment, we can expect a quarter-over-quarter decrease in revenues and adjusted EBITDA in Q4.
In 2020, the company's growth initiatives, cost discipline, and productivity improvements can lead to higher free cash flow. Investors should remember that APY's business caters primarily to the short-cycle onshore drilling business, and as such, is prone to uncertainty due to customer destocking. The short-cycle business renders revenue visibility lower in the long-term.
The company expects the reduction in US drilling activity, and the customer destocking of PDCs would result in $5 million additional revenue fall in Q4. While the capex rationalization is expected to affect the Drilling Technologies segment revenue, the PAT segment is expected to remain relatively steady. So, in Q4, the management expects revenues to range between $255 million to $270 million, which, at the guidance mid-point, represents ~6% fall. In Q4, the adjusted EBITDA is expected to range between $53 million to $63 million or decrease by 13% sequentially.
In 9M 2019, APY generated ~$129 million in cash flow from operations (or CFO), which 32% higher compared to a year ago. Despite a fall in revenues in the past year, the company's working capital improved in 9M 2019, leading to the CFO increase.
The company's free cash flow (or FCF) also increased in 9M 2019. APY's management expects a free cash flow conversion ratio from adjusted EBITDA of 45% to 50% in FY2019.
APY's debt-to-equity ratio is 0.56x as of September 30, 2019. Its peers like Superior Energy Services (SPN) have significantly higher leverage (~9x), while TechnipFMC (FTI) has lower leverage (0.38x). Read more on the company's debt structure in my last article on APY here.
Apergy Corporation is currently trading at an EV-to-adjusted EBITDA multiple of 10.4x. Based on sell-side analysts' EBITDA estimates for the next four quarters, the forward EV/EBITDA multiple is 11.3x, which means sell-side analysts expect the stock's EBITDA to fall in the next four quarters. Between Q2 2018 and now, the stock's average EV/EBITDA multiple was 18.6x. So, it is currently trading at a discount to its past seven-quarter average. I have used estimates provided by Seeking Alpha in this analysis.
According to data provided by Seeking Alpha, nine sell-side analysts rated APY a "buy" in January 2020 (includes "very bullish"), while two recommended a "hold." None recommended a "sell." The analysts' consensus target price is $33.5, which at the current price, yields 8% returns.
Apergy's outlook can change dramatically if the combination with Ecolab's upstream energy business goes through successfully. The new entity can become one of the largest in the energy production-related servicing space by gaining from ChampionX's reservoir, production, and midstream capabilities. Besides, it will become less vulnerable to North America's onshore E&P activity slowdown.
Apergy's focus on integrating digital monitoring solution with the electric submersible pump (or ESP) and remote monitoring capabilities would augur well with the anticipated combination of Ecolab's upstream servicing business. Investors, however, should keep in mind that ESP installation may not lead to rod lift conversion. The quality of a product and the strength of the brand dictate demand. In the current scenario, when upstream capex continues to dwindle, and sales are not encouraging in the PDC market, the company may have to strengthen its brand to increase market share. With positive free cash flows and has no near-term debt repayment, it is relatively free of financial risks.
So, we have two drivers working for APY. One is the combination with its geographically diversified peer that has midstream and specialty businesses. Two, strengthening the legacy business. The company's long-term prospect relies on the sustenance of the U.S. shale oil production. I think the company will offer robust growth opportunities, and so, investors may want to add it to their portfolio.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.