Enerflex’s Large Debt Burden Will Cut Into Growth Investments (EFX:CA)

Figures are in CAD unless otherwise stated.

Enerflex (TSX:EFX:CA) (NYSE:EFXT) is in a current state of flux in which bookings and backlog appear to be rising on strong energy economics only to be pulled back by a large debt burden as a result of the Exterran acquisition that has left the firm with a 5.26x net debt/EBITDA. On a trailing basis, Engineered Systems backlog booked a 23% increase from the previous year as new projects were being awarded to the firm through their facility expansions and upgrades in North America, Latin America, and in the Middle East. As Enerflex navigates through integrating Exterran’s business units by eliminating redundant personnel and less productive facilities, arising are higher costs that can burden the firm’s operations through the duration of FY23. Despite the near-term pain, management is adamant in deleveraging the balance sheet by limiting growth capital investment, which may hinder future growth opportunities. Combining my view of their strong revenue growth throughout the last year along with strong backlog growth and strong macroeconomic outlook in the growth of global natural gas demand, offset by their high debt burden and CFO turnover, I provide Enerflex with a price target of $2.48/share for a multiple 1.5x P/EBITDA, and assign a SELL recommendation

The underlying macro drivers for Enerflex’s business are robust, with the ongoing focus on global energy security and the growing need for low-emission natural gas resulting in strong demand for Enerflex’s energy infrastructure and energy transition solutions.

– Source: CEO Marc Rossiter

Financials

The big elephant in the room is Enerflex’s large debt burden. Their total debt sums to $1,408mm, nearly 3x their market cap. Their debt comes with a large aggregate price tag of 8.5%. Annualized, interest expense is $121mm, compared to the firm’s TTMq2’23 operating income of $68mm and EBITDA of $235mm. This provides just under 2x interest coverage when removing the non-cash expenses. Total liquidity, including their heavily drawn down revolver, runs at $468.6mm. One of the challenges faced in their debt burden is that the firm is in breach of their senior security net funded debt covenant and may need to prioritize deleveraging their balance sheet. Their first covenant states borrowings under the revolving credit facility & term loan, net of cash, to EBITDA ratio must remain between 1-2.5x. As of q2’23, this ratio is sitting at 2.2x, just below the limit. The other covenant tied to this term is a net-funded debt to EBITDA ratio ceiling of 4.5x. This figure currently sits at 5.26x. This is clearly a challenge management must prioritize and address before future business expansion can occur.

Management did voice on their q2’23 earnings call that deleveraging the balance sheet was their top priority. The downside to this initiative provides a mere $12mm for growth capex. Management is also in the process of closing 2 of their 5 global facilities located in UAE and Singapore with cost savings estimated at $10-20mm on an annual basis. These cost savings are going to net out for FY23 as the closing costs amount to $10-20mm per facility. With the acquisition of Exterran, management is seeking $60mm in synergies 12-18months post-closing. $50mm of these synergies are headcount eliminations, with the remaining $10mm attributable to software and supply chain-related expenses.

What alerts me the most, aside from these last points, is the exodus of two CFOs in the last year. Sanjay Bishnoi left Enerflex in April 2023 with Matthew Lemieux taking over in the interim prior to Rodney Gray taking over. Rodney took his leave October 1st, 2023 and has recently appointed Preet Dhindsa as interim CFO. Though there may be other factors involved with Rodney taking his leave given his short tenure, we cannot discount that there may be other challenges involved. Considering the higher than expected restructuring charges as a result of the Exterran acquisition, the facility closures, and headcount reductions, there may be some hidden operational challenges that haven’t become apparent on the operating statements as of yet.

There are a lot of positive aspects to the firm’s q2’23 results despite these apparent challenges. Revenue on a company-wide, TTM basis grew 18% from the previous year with engineered systems backlog up 23% for the same period. EBITDA margin contracted to 9% off of 11%; however, roughly 14% of the 1H23 cost difference between their EBITDA and a EBITDA is the result of transaction, restructuring, and integration costs.

With management’s statements on further restructuring charges into the duration of the year, reaching the targeted $380-420mm in eFY23 aEBITDA could be feasible given the strength of their backlog and higher than anticipated restructuring charges. On a TTM basis, these targets would be the result of a 42-57% growth rate (+314-388% y/y) for margins in the range of ~12-14% if we assume a topline growth rate of 15%. If we were to assume constant aEBITDA margins for this level of growth, topline revenue growth would be expected to be 114-136% on a year-to-year basis. I’m not going to completely write this goal off as it could be perfectly attainable given the increased activity in Canadian gas basins – see Hammerhead Energy (HHRS) and Logan Energy (LGN:CA).

Management does raise concerns relating to lower rig counts in q2’23. Since the call, rig counts have continued to decline in the US and will potentially trickle into Enerflex’s future operations. Bookings growth has slowed to 1% growth on a TTM basis as backlog slowed in q1’23 while being revitalized in q2’23. Given that bookings are expected to be recognized throughout the following year plus the $1,400mm in backlog management expects to convert to revenue (down from $1,500mm in their q1’23 call), we can expect a baseline of $3,000mm in revenue generation from bookings and backlog throughout FY24.

There are some positive catalysts to take note of for Enerflex. The energy industry remains competitive with oil prices remaining elevated in the mid-$80s/bbl and natural gas returning to over $3/mcf.

Industry consolidation in the E&P space will help relieve some of the production pressures and allow these higher commodity prices more breathing room. There also appears to be a lot of interest in offshore drilling per management at Transocean (RIG).

Enerflex also engineers solutions for pre-LNG natural gas processing. With an estimated 40mtpa of capacity expected to be built out along the Gulf Coast through 2035, Enerflex should be well positioned to capitalize on these projects. The IEA reported in March 2023 that an additional 7.3Bcf/d of LNG export capacity is under construction with an additional 18.3Bcf/d of capacity with full regulatory approval from the DOE and FERC.

Other catalysts include paying down their debt load and bringing the company back into compliance with their debt covenants. From a value perspective, this will not only cut down non-operating costs by $121mm but will also allow for more growth capital investments for future projects.

Valuation

Given the total financial outlook for Enerflex, I provide EFXT shares a SELL recommendation with a price target of $2.84/share for a P/EBITDA of 1.5x. Though the firm has many hurdles to overcome in the next few years, there remains some bright spots in the energy industry for them to achieve financial success. As I expect the share price to be cut down by -30% throughout the duration of the year, I believe an investment at the lower valuation can be appealing as this firm has many events that can drive shareholder value. In the near-term, the challenges outweigh the benefits. In the long-term, I believe Enerflex has the ability to deleverage the balance sheet and continue to achieve their operational growth.