RYosha
Archrock (NYSE:AROC) is riding strong compression market trends, and is cheaper than its top competitor.
Company Profile
AROC is an outsourced provider of natural gas compression services in the U.S. At the end of September, its fleet consisted of compression units with available horsepower (“HP”) of 3,773,000. Its fleet consists of mostly large compressors with 1,000 or more horsepower.
The company operates in basins across the country, with a heavier concentration in oil driven shale plays, such as the Permian, Eagle Ford, Scoop/Stack, and Niobrara. It also has units in other basins, such as the Marcellus, Utica, Bakken, and others.
The company serves both midstream and upstream operators, and its top-10 customers represent over 50% of its revenue. These customers include the likes of midstream companies Enterprise Products Partners (EPD), Williams Companies (WMB), and Enlink (ENLC), as well as E&Ps such as Chevron (CVX) and Devon (DVN).
AROC has fixed fee contracts, but charges reduced fees during periods of limited disrupted gas flow. Contracts generally have a 12-48 month initial term and then run month to month.
The company also has an aftermarket service business, where it sells parts and provides maintenance, overhaul and reconfiguration services to other companies that own their own compression units. This segment accounts for nearly 20% of its revenue.
It also owns a 25% stake in Ecotec International Holders, which manages and monitors ethane emissions.
Company Presentation
Opportunities & Risks
AROC is riding many of the same tailwinds as USA Compression (USAC), which I recently initiated coverage on in January. Similar to USAC, its main focus is on large compression units that serve the midstream space in the gathering and transport of natural gas. Only a small percentage of its units are smaller horsepower, which are used for gas lift applications by E&Ps.
As such, similar to USAC, AROC is also largely a play on natural gas volumes. On that front, natural gas production from natural gas focused E&Ps has been slowly growing in Appalachia, while other areas, such as the Haynesville, have cut back on production due to low prices over the past year. The Marcellus and Utica have very low breakevens, and with Appalachia E&Ps focused on cash flow and their balance sheets, they have been doing a good job navigating natural gas price volatility.
However, the big driver in natural gas production has come from oil-producing regions like the Permian, where with flaring regulations, now need to see much of the associated natural gas transported. This associated gas production is not dependent on natural gas prices, and instead is driven by oil prices, which have remained solid.
Also like USAC, AROC has also been benefiting from a tightening in the market as a result of a shortage in large compression units. With the cost of new units not as economically attractive to be purchased at current rates, something will have to give, which likely will lead to a continued increase in rates. Lead times for new builds is also around a year.
AROC noted in Q3 that it has seen increases for monthly revenue per horsepower for eight straight quarter. For Q3, it noted during this time monthly revenue per horsepower is up over 17%.
Discussing the market on its Q3 earnings call, CEO D. Childers said:
“Looking at the outlook for natural gas production, again, the biggest driver of our business, we expect to see consistent and modest growth rates in the low single-digits on an annual basis. This is being driven by 2 dynamics. First, we continue to see strong investment in associated gas plays in the U.S. like the Permian and the Eagle Ford, where the majority of our operating fleet is located. We also believe the recent U.S. Shell mega deals announced by major integrated producers reinforce the competitiveness and longevity of U.S. Shell. Second, our customers are [planning] critical infrastructure to support growing LNG exports from the U.S., further extending the attractive fundamentals for our industry well into the future. As natural gas demand and production grows, we’re experiencing unprecedented tightness in the compression market, which we believe is driven by structural and industry-wide changes to capital allocation practices.”
As far as utilization, based on horsepower, AROC was at 96% utilization at the end of Q3, a record for the company. That compared to 89% a year ago.
Unlike USAC, AROC seems more willing to add new compression units, even at elevated prices, which it noted are up about 40% since the pandemic. The company raised $55 million through the sale of nonstrategic equipment to help fund new build investments. Meanwhile, the company said its 2024 new-build capacity is already committed. Growth capex is expected to be about $160 million in 2024.
However, like USAC, AROC expects pricing to continue to rise on its installed base. However, it did say the rate of increases may start to flatten.
AROC also has its aftermarket service business. Given the high price of new units and lead times, this part of its business should also benefit from the current industry dynamics, as it should lead to more older units staying in the field that need more maintenance and overhauls.
AROC also has a longer-term opportunity with carbon capture. It has a 25% stake in ECOTEC, as well as partnership with Ionada, which has developed a post combustion carbon capture technology for small and medium-sized industrial emitter. AROC will serve as lead investor for the company’s Series A financing. AROC has also developed its own methane capture technology that it has successfully piloted in the Barnett. While not near-term drivers, these initiatives have long term potential.
As for risks, natural gas volumes is the biggest, which can be impacted by oil and gas prices. The company also pointed to LNG exports as a driver of natural gas demand and companies building out infrastructure to support that. However, the Biden administration recently did put a pause on new LNG export terminal permits to study the environmental and security impact of these facilities. This won’t impact new projects and expansion already approved by the Department of Energy, but it does add some risk to the facilities that were in the earlier stage of the process, including the large Venture Global CP2 LNG project.
And of course, there is still longer-term risk to fossil fuel volumes as the U.S. and other countries try to wane themselves off fossil fuels. This transition will likely take a long time, but it is a long tail risk.
Valuation
AROC trades at 8.5x the 2024 EBITDA consensus of $494.6 million. Based on the 2025 EBITDA consensus of $526.9 million, it is valued at 8.0x.
The stock has a distributable cash flow yield of about 8.5% based on my 2023 conservative projections of $225 million. And it pays out a dividend yield of about 4% after increasing it 6.5% in late January. Its dividend was covered 2.6x in Q3.
The company was leveraged 3.8x at the end of Q3.
AROC is less expensive than USAC even though the latter has lower leverage and a similar business. It has historically traded at a discount to USAC, perhaps because the latter is backed by Energy Transfer (ET). AROC has traditionally traded between 7-10x EBITDA.
I don’t think the consensus estimates look too commanding, as AROC should benefit nicely from price increases as well as additional HP. Given the strong market tailwinds, I’d value it between 9-10x ’25 EBITDA, which would be between $20-24.
Conclusion
While the Biden admin pause on new LNG facility permitting adds a bit of a wrinkle to the natural gas volume story, it shouldn’t have a big impact over the next two years. The move, meanwhile, looks more political in nature given the upcoming Presidential elections, so many of these projects could ultimately just get a bit delayed. A Republican President would also likely end the pause.
In the near term, expect the compression market to remain tight and for prices to continue gradually rise. A lot of natural gas has to get out of the Permian, and a number of projects have recently come online to help with that. Meanwhile, the MVP project is finally expected to come online in Q1, which along with extension projects, should bring much needed natural gas to southern utilities.
As such, I would expect a solid Q4 from AROC when it reports results later this month that sees high continued utilization with another quarter of sequential price increases benefiting its top and bottom lines. I anticipate 2024 guidance to be solid but conservative not straying too far from the consensus, with room for the company to raise its forecast later in the year if the market remains strong.
AROC is less expensive and has a better balance sheet than USAC and is riding many of the same trends. As such, I’m going to start the stock with a “Buy” rating and $22 target.
