Archedrock

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Archedrock is a leading provider of natural gas compression services in the U.S., which includes a variety of maintenance, operation, and engineering services focused on natural gas compression equipment.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Explanation

Archrock primarily focuses on natural gas compression, a critical step in the midstream energy sector, ensuring the smooth flow of gas from wells to pipelines. Their services are crucial for maintaining gas pressure throughout the gathering, processing, and transmission processes. Here are some other important aspects of the business:

  • Operations: They operate and maintain natural gas compressors for customers. This includes equipment maintenance, optimization, and the provision of necessary operational expertise.
  • Aftermarket Services: AROC also offers aftermarket services, which involves providing replacement parts, repairs, and equipment overhauls to extend the life of their client’s compressor fleet.
  • Technology & Innovation: They are heavily invested into innovative technology to provide better efficiency and reliability to customers.
  • Geographic Location: The majority of their assets are located in the US market, although they also have some operations in Latin America.
  • Natural Gas Demand: The demand for natural gas is expected to increase in the coming years, which will likely increase the need for compression. The increase in natural gas production by U.S. energy companies means more compression capacity will be needed in the future.
  • ESG Concerns: There are growing concerns about greenhouse gas emissions, which could affect the way that compressors are utilized in the future. The company is trying to capture more business from customers needing to transition to a lower-emission fuel alternative.
  • Technology & Efficiency: Customers are increasingly looking for efficient and cost-effective compression solutions to meet their economic and sustainability goals.

Competitive Landscape

  • Limited Number of Competitors: While there are numerous compressor companies in the world, they all work on small geographic areas. The number of companies of the same scale as Archedrock operating on a national or international level is much smaller. This indicates high barriers to entry.
  • Reputation: Customers care greatly about the safety, reliability, and efficiency of compressors. New companies entering the field will have a hard time competing if they don’t have a good track record.
  • Switching Costs: In this market the relationships and trust between the companies and the clients has a lot of influence. Some companies have been working for some of their clients for decades. Switching to a new compressor company can be a difficult and expensive process for the clients and thus, the switching costs are relatively high for the clients.

Financials

  • Revenues: Archrock derives revenue from contract operations and aftermarket services. Their income statement is complex, and a large portion of their revenue is actually an offset on their balance sheet from customers who provide performance guarantees, while many other aspects of the income statement will be tied to investments.
  • In 2023, 65% of revenues came from the US segment, and 35% from the Aftermarket services segment.
  • Margins: Their operating margins have been relatively volatile, with adjustments frequently made to account for impairments, restructurings and unusual or non-recurring items. While these adjustments impact the operating profit number, it is important to note they have no effect on free cash flow.
  • Return on invested capital (ROIC): The ROIC, which calculates how efficient the business uses capital, varies widely through the years.
  • Debt: Archrock’s debt is significant, mostly to finance capital expenses related to equipment operations. The credit agreement included covenant ratios limiting how much debt can be added. The company has managed its debt well historically.
  • Reinvesting in the Business: Archedrock reinvests substantial portions of their capital into their fleet, maintenance and improvements. In 2023 for example, the company’s capex was higher than the depreciation rate. This means they have more future potential, and it also shows a commitment to keeping the company’s assets up-to-date.
  • Acquisitions and Joint Ventures: Archrock has used joint ventures to try to expand its business reach in other geographic areas. This suggests the company is active in seeking new markets.

Moat Analysis

AROC has what I would characterize as a Narrow Moat (3/5), which means the company possesses some long term competitive advantages but might not be able to defend them in the face of long-term intense competition. Here’s why:

  • Network Effects: The more compressors a company has, the larger its reach will be. This makes it harder for smaller competitors to obtain the same operational efficiency, and it also makes the company more attractive for clients that need many locations to be serviced.
  • Switching costs: Customers typically have established relationships with compression companies, so, for the most part, they tend to stick to the ones that they’ve been using. Changing providers involves risks, the burden of having to deal with a new company, and potential problems with compatibility or maintenance. This makes the switching costs relatively high.
  • Size and Scale: Archedrock is one of the largest companies in its field, which gives them scale advantages regarding purchasing and operations efficiency. Also, they have a very large distribution network of maintenance and operation facilities.

  • Brand/Reputation: Clients care a lot about the safety and reliability of compressor maintenance. Long-standing relationships built on expertise and trustworthiness are important.

    However, these advantages are not indestructible as a competitor that can offer lower prices, superior technology, or a better service can erode the company’s moats. The company also operates in a cyclical industry, and its financial performance can suffer from economic downturns.

Moat Risk and Resilience

Here are the potential risks for AROC’s moat:

  • Technological Disruption: New technology in compression could cause the company’s fleet to become obsolete. New, more efficient methods of natural gas extraction can also alter the competitive dynamics of the field.
  • Economic Downturn: Declining demand for natural gas or a major recession can impact the company’s results as clients would reduce their expenses. Lower demand can cause equipment utilization to decline, reducing profits and cash flow.
  • Regulatory Changes: Changing environmental regulations and permits could increase the operating expenses of AROC or limit certain operations.
  • Aggressive Competition: Competitors could try to undercut Archedrock by offering a lower price, more convenient contracts, and better servicing agreements. They may also start their own operations and compete directly.
  • Geopolitical Events: Geopolitical events could disrupt natural gas supplies or drastically change natural gas pricing, which could significantly affect revenues, profits and business stability.
  • Lack of Innovation: If AROC falls behind in adopting and developing innovative technologies that are better and more efficient that the previous technologies of their fleet, they may begin to lose their edge, and make the business more vulnerable to competition.

Business Resilience: Despite these risks, AROC displays a relatively high degree of resilience due to some factors. Their large scale and established distribution network, combined with long-term client relationships, gives it a good degree of resilience. Also, since they focus on providing necessary services rather than the business being tied to the price of natural gas, they can reduce their reliance on economic upturns, since they’re a cost center to their clients. The company’s strategy of continuous investment in maintenance and improvement will also help protect the company’s market position.

Understandability Rating

I rate Archedrock a 2/5 in understandability.

  • The company’s business model of providing compression services is relatively straightforward to understand.
  • However, the way the company generates revenue, which involves some complicated offset and other accounting practices, makes it less understandable. Also, some of the terminology in the financial report is technical and not common with casual investors, making it difficult to understand all the details in it.
  • Furthermore, determining the durability and sustainability of the company’s moats takes some work to understand as well.

Balance Sheet Health Rating

I rate Archedrock’s balance sheet a 4/5, which means they are in a very stable financial position and are unlikely to face problems in the near future.

  • Debt: While AROC has substantial debt, their credit facilities are structured to be somewhat flexible, and are dependent on the company’s assets. The company seems to have been managing its debt well and the scheduled payments appear manageable. However, given that debt is a double-edged sword it is still something to be monitored closely.
  • Cash Flow: The company’s free cash flow is relatively volatile but generally positive, meaning the company is not likely to have problems keeping up with its debt payments.
  • Assets: AROC has a considerable amount of tangible assets (compressors). These assets are very valuable in the field the company operates, which can be a boon in case of economic downturns. Also, these assets mean that the company has a high degree of collateral and asset value.

Recent Concerns, Controversies, and Problems

  • Supply Chain Issues: The company has previously had problems in their supply chain, mainly regarding availability of parts and labor for their maintenance and operation businesses. However, they appear to have resolved this issue, and now their operations seem to be running smoothly.
  • Increased Operational Expenses: In 2023 their operational expenses increased due to wage inflation, increased use of technology, and other factors. While the management is making an effort to minimize these costs through pricing adjustments, they do present a challenge.
  • Increased Competition: While the company enjoys a prominent place in a highly competitive market, it could experience a shrinking market share due to a new competitor using more aggressive marketing strategies and more innovative technologies.
  • Debt Obligations: The company is highly leveraged and changes in interest rates could severely impact business operations and profitability. The management is making an effort to refinance debt under more favorable conditions to control costs, while maintaining sufficient credit capacity and operational flexibility.
  • Industry Cyclicality: The company operates in a highly cyclical industry with wide swings and peaks. The company’s earnings can fall quickly if its customers see a decrease in demand for their services.

The management is aware of these risks, and they are continuously looking to implement strategies to diversify revenue and mitigate potential downfalls. All of the latest reports and earnings call data suggests that they are handling these risks carefully and have a good strategy to move forward with. This also shows that the management is aware of the limitations of the business.