FA Alpha Daily

You need water for drilling and this company is here to help

As the EU seeks reliable energy sources in the aftermath of Russia’s invasion of Ukraine, the U.S. has a strategic opportunity to meet this unmet energy demand. In today’s FA Alpha Daily, we take a deeper look at Select Water Solutions to understand why this company is positioned to gain substantial benefits from the shifting global energy landscape.

FA Alpha Daily:
Thursday Uniform Accounting Analysis
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The conflict in Ukraine has drastically changed the global energy landscape.

For decades, Europe relied heavily on Russia for its natural gas supply, with Russia accounting for around 40% of EU gas imports prior to the invasion.

However, in late February 2022 Russia invaded Ukraine, prompting swift sanctions from Western nations targeting Russia’s critical oil and gas exports.

With Russian pipelines no longer a reliable source of energy, the European Union has been scrambling to find alternative suppliers of natural gas.

The United States has stepped up to help fill the gap left by Russia, with liquefied natural gas exports to Europe nearly tripling in the first half of 2022 compared to the previous year.

This increased demand for U.S. oil and gas comes at an opportune time, as producers in America are ramping up shale production utilizing technologies like hydraulic fracturing that have unlocked vast reserves of unconventional resources in recent years.

As U.S. oil and gas output rises to meet the needs of global allies while lessening dependence on Russia, one company that stands to benefit substantially is Select Water Solutions (WTTR).

Select provides water management and chemical solutions to onshore oil and gas producers throughout the United States. Their portfolio of services includes produced water handling and recycling, freshwater transportation, and well site fluids handling for hydraulic fracturing operations.

Hydraulic fracturing is a water-intensive process, requiring millions of gallons of water per well to unlock oil and gas from tight rock formations like shale.

As drilling and completion activity increases across U.S. basins to satisfy growing demand, more and more water is needed to sustain these operations.

This translates directly into higher demand for Select’s integrated water solutions, which help producers efficiently source, transfer, reuse, and dispose of produced and freshwater resources.

We can see the surge in drilling has already become beneficial for Select…

The company has managed to increase its profitability in the last year. While it struggled in 2020 and 2021, the Uniform ROA recovered fast and reached around 5%.

With the demand for energy coming from the U.S. not slowing down, we can expect the company’s Uniform ROA to reach above 8%.

However, the market is underestimating the ability of domestic shale production to bridge global supply gaps in the near term.

We can see what the market thinks through our Embedded Expectations Analysis (“EEA”) framework.

The EEA starts by looking at a company’s current stock price. From there, we can calculate what the market expects from the company’s future cash flows. We then compare that with our own cash-flow projections.

In short, it tells us how well a company has to perform in the future to be worth what the market is paying for it today.

At the current stock price, the market expects the company’s ROA to fall from 5% in 2022 to 4%, completely neglecting the high organic growth and increasing profitability potential.

The market thinks the surge in the demand for U.S. energy is not sustainable in the long run.

With the E.U. not backing out of sanctions for Russian gas imports and ramping up imports of U.S. LNG instead, we can expect U.S. shale production to rise substantially in the coming years.

More drilling will drive the need for increased water handling, playing right into Select’s core business.

As a premier provider of sustainable water management services for the energy industry, Select is well positioned to capitalize on this multi-year growth opportunity and deliver increased value for shareholders.

SUMMARY and Select Water Solutions Tearsheet

As the Uniform Accounting tearsheet for Select Water Solutions (WTTR:USA) highlights, the Uniform P/E trades at 11.7x, which is below the global corporate average of 18.4x but above its historical P/E of 7.1x.

Low P/Es require low EPS growth to sustain them. In the case of Select Water, the company has recently shown a 225% shrinkage in Uniform EPS.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Select Water’s Wall Street analyst-driven forecast is a 24% and 63% EPS growth in 2023 and 2024, respectively.

Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Select Water’s $7.59 stock price. These are often referred to as market embedded expectations.

The company is currently being valued as if Uniform earnings were to grow 4% annually over the next three years. What Wall Street analysts expect for Select Water’s earnings growth is above what the current stock market valuation requires through 2024.

Furthermore, the company’s earning power is below its long-run corporate average. Moreover, cash flows and cash on hand are 1.6x its total obligations—including debt maturities, capex maintenance, and dividends. Also, the company’s intrinsic credit risk is 460bps above the risk-free rate.

All in all, this signals low dividend risk.

Lastly, Select Water’s Uniform earnings growth is in line with its peer averages but below its average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

The Uniform Accounting insights in today’s issue are the same ones that power some of our best stock picks and macro research, which can be found in our FA Alpha Daily newsletters.

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