Cactus Corrects Course, But Energy Market Concerns Remain

WHD Stays On The Balance

In my previous article on September 13, 2023, I discussed Cactus, Inc.’s (NYSE:WHD) business and strategies. Due to the precipitous fall in natural gas prices, WHD faces a relatively uncertain energy market environment. The upstream operators will likely respond with rig reductions, which may weaken the company’s near-term outlook. It has also deferred its investments in the Middle East to lower costs and protect the margin. I think its outlook on the margin front has improved since my last article, although the topline remains slippery.

Recently, WHD has rolled out modified frac valves, reducing the number of repairs and leading to increased potential demand in the coming months. The spurt of inquiries for frac rental equipment is also encouraging for its prospects. The stock is reasonably valued compared to its peers. Backed by improving cash flows and robust liquidity, I suggest investors “hold” the stock for moderate medium-term returns.

Why Do I Keep My Call Unchanged?

I considered WHD a “hold” in my previous September 13, 2023 article. By the end of Q2 2023, I believed the stock would stay on the balance. Meanwhile, subdued US drilling activity would pressure its Pressure Control topline, lower input costs, and supply chain diversification would lower its cost structure, keeping the margin steady. I wrote:

The supply chain costs have been deflating, releasing the pressure of high-cost inventory on the working capital. It plans to diversify in the Middle East and expects to finalize its investment structure and record its first customer order in late 2024. To maintain a light cost structure, it has deferred its investments in the Middle East.

Given the consolidation in the upstream energy market and low natural gas prices, I still see some headwinds persist. On the other hand, the company witnessed increased inquiries for frac rental equipment. It also keeps its cost structure tight with efficient product introductions. Its cash flows and balance sheet remain robust as it pays dividends. So, I retain my “hold” take on the stock.

Strategies Explained

WHD is about to roll out new wellhead and valve products. The new products will replace its inventory in the following months and should improve its financial results. Because valves are torn down after a frac job, it typically involves large repair costs. The rollout is a modification of the existing frac valve, significantly reducing the number of repairs. WHD is also evaluating opportunities regarding its expansion plans in the Middle East.

After the current M&As of upstream operators, efficiency has become the primary focus of oilfield services companies. WHD primarily caters to relatively large-sized customers who invest through the commodity cycles. Although the near-term impacts of the consolidation are unclear, the management expects a reduction in the US land rig count by the end of 2024. Given the weakness in natural gas prices, operators will likely respond with rig reductions. However, I expect such a scenario will strengthen the importance of high-grade drilling and drilling efficiencies.

How Does The Q1 Look?

The company’s management estimates that the Pressure Control segment revenues can decrease by “mid-single digits” in Q1 compared to Q4 2023. It expects a similar fall in the Spoolable Technologies segment revenues. It also expects the adjusted EBITDA margins in the Pressure Control segment to decrease by 180 basis points (at the guidance mid-point), while the adjusted EBITDA margin of Spoolable Technologies can deflate by 360 basis points.

In my view, the segment’s performance will depend largely on the rig count. Since I expect a marginal drop in rig count due to low natural gas prices, I think the company’s management has made a fair estimate regarding the Pressure Control segment Q1 outlook. Starting Q2, the segment will likely improve following increased inquiries for frac rental equipment.

In the Spoolabe Technology segment, increased input costs will dent its margin in Q1. However, the company will have tailwinds following higher demand for FlexSteel’s products from international and midstream customers. Investors may note that WHD acquired Flexsteel in March 2023, which helped increase installation speed, reduce ownership costs, and improve efficiency.

Analyzing Q4 Drivers

From Q3 to Q4 (as released in its FY2023 earnings on February 28), WHD’s revenues in the Pressure Control segment decreased marginally by 1.1% due to the decline in US onshore activity. EBITDA margin expanded by 120 basis points due to lower rental equipment repair costs following the changes in frac valve design.

In Spoolable Technologies, revenues decreased by 10.4% as upstream activity decreased. However, higher expenses resulting from the remeasurement of the FlexSteel earnout liability improved its margin. The adjusted EBITDA remained steady from Q3 to Q4. However, lower sales volume resulted in reductions in operating leverage, partially offsetting some gains.

Cash Flows and Balance Sheet

Cactus’s cash flow from operations improved by 1.9x in FY2023 compared to a year ago. Higher revenues, lower inventory, and higher collections of receivables are the main reasons for the cash flow rise. Free cash flow also increased 2.3x in FY2023. Its FY2024 capex guidance ($45 million-$55 million) means capex will increase from FY2023.

As of December 31, 2023, WHD’s liquidity (cash balance plus available credit facility) was $350 million. Robust liquidity ensures few financial risks. In Q4, it paid a dividend of $0.12 per share and is authorized to keep the dividend unchanged for the March payment.

What Does The Relative Valuation Imply?

WHD’s forward EV/EBITDA contraction versus the current EV/EBITDA multiple is steeper than some peers. This typically results in a higher EV/EBITDA multiple. The company’s EV/EBITDA multiple (8.6x) is higher than its peers’ (CHX, THNPY, NOV) average (6.2x). The current multiple is below its five-year average EV/EBITDA of 13.2x. So, the stock appears to be reasonably valued compared to its peers.

If it trades at the past average, it can climb 29% from the current level. If it trades at the industry average, it can drop by 37%. Since my last publication in September, where I suggested a “hold,” the stock has declined (down approximately 8%). While the rig count was relatively strong when I last published, it has become uncertain recently. However, demand from international and midstream customers has improved. Overall, I think investors’ sentiments regarding the stock will remain unchanged. Therefore, I expect it to hover around the current price (within a $44-$48 band).

Wall Street Rating

In the past three months, four sell-side analysts rated WHD a “buy” (including a “strong buy”), five analysts rated it a “hold,” and one rated it a “sell.” The consensus target price is $52.9, suggesting a 17% upside at the current price. I think the sell-side investors are slightly more optimistic about the returns than its outlook truly reflects.

Risk Factors

From Q3 to Q4 2023, the crude oil price declined by 15%. During this period, the US rig count remained nearly unchanged. Since the start of Q1 2024, the crude oil price and rig count have remained steady. I think that natural gas prices will largely determine the rig count’s movement, but a steady crude oil price will act as support in the near-to-medium term.

Energy prices affect oil and gas industry activity and oilfield services’ performance. Natural gas prices have been volatile recently. Over the past year, natural gas prices have crashed by ~40%, while crude oil prices have remained steady (~2% up). A weakened natural gas price can further reduce energy operators’ capital budgets and drilling activity, keeping WHD’s topline and cash flow under pressure in the near term.

What’s The Take On WHD?

The introduction and renewal of wellhead and valve products and the company’s expansion plans in the Middle East have led to improved efficiency. Given the changing scenario in the energy industry, upstream operators will likely pay a premium for more efficient products. The increased inquiries for frac rental equipment will be encouraging for the company. It continues to benefit from the previous acquisition of FlexSteel in 2023 through improved speed and more efficient products. So, the stock marginally outperformed the VanEck Oil Services ETF (OIH) in the past year.

However, increased input costs will dent the margin of the Spoolabe Technology segment. The company’s cash flows turned positive with inventory cost reductions in FY2023. Its balance sheet is robust, with ample liquidity. Given the relative valuation multiples, investors might want to “hold” the stock.