Kodiak Gas Services, Inc.

Moat: 1/5

Understandability: 4/5

Balance Sheet Health: 3/5

Kodiak Gas Services, Inc. is a leading provider of contract compression services for natural gas production and midstream transportation in the United States, mainly the Permian Basin, Eagle Ford Shale, and Haynesville Shale formations.

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 Overview

Kodiak Gas Services, Inc. (KGS) operates in the energy infrastructure sector, providing contract compression services. These services are critical for maintaining pressure in natural gas pipelines, facilitating the efficient transportation of gas. KGS primarily serves upstream and midstream customers, focusing on natural gas gathering and processing facilities, where compression is vital to drive gas through pipelines. This is a highly specialized field, with significant barriers to entry and long-term contracts, making the business somewhat sticky with existing customers.

KGS primarily operates in three regions which includes the Permian basin, Eagle Ford shale and Haynesville shale.

  • Compression Operations: These operations involve the use of large reciprocating compression equipment, which is very expensive and requires large amounts of capital investment.

    • KGS operates at scale in large horsepower compression and has invested heavily into compression infrastructure and equipment.

  • Other Services: This business provides a portfolio of services in connection to compression operations. It includes field services, site construction services, and gas measurement and analysis services.

Revenue Distribution

KGS generates revenue through long-term contracts with customers. It’s revenue is broken down into:

  • Contract Services: Primarily from large horsepower contracts.

  • Other Services: From provision of services related to compression operations. This business segment makes up a smaller part of the total revenues.

While contract compression operations are typically very stable, these contracts can include volume guarantees as well as commodity price components and thus create a variable revenue base.

Industry Trends and Competitive Landscape The natural gas compression industry is highly specialized and capital-intensive with high barriers to entry. Companies must operate with scale and efficiency to keep pace with the competition. The industry is undergoing consolidation, with larger players acquiring smaller players and is also increasingly impacted by the energy transition, with a greater emphasis on emissions reduction and operational efficiency.

KGS faces competition from several large companies, but also from regional competitors and a few in-house operations. However, KGS’ focus on high-horsepower compression is a significant advantage.

What Makes KGS Different

  • Focus on Large Horsepower: KGS primarily operates in high-horsepower compression, which makes them distinct from other players in the market and allows them to operate a specialized business.

  • Long Term Contracts: They focus on acquiring companies that offer long term relationships and contracts, resulting in some stability in the cash flows.
  • Geographic Focus: By focusing on high-activity basins in the US, KGS has positioned itself in areas of growing demand with strong regulatory support.

Recent Concerns and Management’s Response

  • Debt Concerns: KGS has been leveraging its financial structure heavily to fund acquisitions and operations. Management has outlined plans to deleverage the balance sheet using proceeds from sales of non-core assets and free cash flow, but the leverage is still high. This can increase financial risk and also decrease the potential for growth. They aim to reduce net debt to below 3.5x adjusted EBITDA.

  • Integration Challenges: After a period of hyper-growth by acquisitions, they are focusing on integrating those acquisitions. This could result in cost-cutting, optimization, and improved processes.

  • Operational Efficiencies: Some shareholders have questioned their ability to handle a fast-growth environment. Management continues to highlight their focus on operational efficiency improvements.

  • Contracting Concerns: Despite operating under long term contracts, a significant portion of their customers are natural gas producers. Due to high volatility in gas prices, it is possible that some of these contracts could be renegotiated or abandoned. They have reiterated that this is not a significant factor in the short term.
  • Short-Term Performance: Given their high amount of debt, an expected slow down in the macro-economy and higher financing costs will impact their ability to repay debt.

Financial Deep Dive

  • Balance Sheet: KGS has a lot of debt which is concerning. This is used to fund their acquisitions. Their intangibles and goodwill are worth over $2B which is a large component of their total assets.

    • KGS has a debt to equity ratio of over 4, which is quite high.
    • They have a quick ratio and a current ratio both at 1, implying that they have sufficient liquid assets to meet its immediate obligations. But this is a minimum requirement and not necessarily an indication of health.

  • Cash Flow: Their cash flow from operations was $317M for the year ended 2023 which has been steadily increasing. Given the large debt pile and capital investments they have, its important to follow the FCF which was $158M in 2023 and $170M in the trailing 12 months.

    • They had an adjusted free cash flow of $125M in Q3 of 2024 (TTM) .

  • Profitability: While their revenue has been increasing, their profits and margins need further scrutiny as they have very large operating and interest expenses that can severely effect profitability.

    • They have a gross profit margin of 55.1% in Q3 2024, which is quite stable. -Their Adjusted EBITDA margin for 2023 was 56% with a target of 57.5-60%.
    • Net income margin for Q3 2024 was 9% which has been improving.

Moat Assessment: 1/5

KGS has minimal moat due to its capital-intensive business and the large number of competitors that are present. While KGS has certain advantages, they cannot be defined as a wide moat, or even a narrow moat. Their dependence on long-term contracts and specialized high-horsepower operations is not a strong barrier to entry.

  • No Pricing Power: While they do provide a crucial service, they can’t have increased pricing power in the markets they operate.
  • Limited Switching Costs: There are some implicit switching costs, but they are not a material driver for moat. Customers can typically switch to other options in the market with relative ease.
  • Lack of Network Effects: This is a very straightforward pipeline business and does not benefit from network effects.
  • Weak Intangibles: They have no strong branding or recognition from the average consumer as their end customer is another business, and not an individual.
  • Cost Disadvantages: While they can achieve economies of scale as they get larger, they can’t use unique and hard to copy processes that could lead to a sustained competitive advantage.

Risks to the Moat and Resilience

  • Technological Disruption: New technologies that reduce the need for compression or provide cheaper alternatives could harm the business.
  • Regulation Changes: Changes in environmental regulations may force additional spending on their operations. Government policy might also create barriers to entry that could result in lower overall returns in the industry.
  • Economic Downturn: Lower oil and gas prices, along with economic recessions, could negatively impact KGS’ customers, leading to reduced production, and increased financial risks.
  • Customer Concentration: The loss of several large clients could have a dramatic effect. While they try to diversify their base, key players make up a large portion of their overall revenue.

  • Leverage: The high level of debt makes KGS particularly vulnerable to macroeconomic factors, such as a recession and rising interest rates, thereby making it difficult for them to pay back their obligations.

  • Integration Risks: Integrating new acquisitions into the overall business poses numerous risks as well as creates challenges for future growth. These acquisitions have created a high degree of complexity in their operations and this can negatively impact operations.

Business Understandability: 4/5

KGS’s business model is relatively straightforward: provide compression services for gas transportation and production and is not hard to understand. The core concepts of their operations are easy enough to grasp, and their value proposition is quite simple to understand. However, the complexity lies in their operations, which includes long-term contracts and many customers which may be hard to analyze by a retail investor. But given the context, the understandability is not complicated at all.

Balance Sheet Health: 3/5

KGS’ balance sheet shows some strength but also considerable weakness and thus I’d give it a rating of 3.

  • High Debt: The company has accumulated substantial debt due to acquisitions. It does make it harder for the company to raise further capital at good prices and increase their chance of going into financial distress.
  • Intangible Assets: A huge chunk of assets are made up of goodwill and other intangible assets which could lose value. This makes their balance sheet less secure.
  • Liquidity: They have a good quick and current ratio which shows their ability to meet obligations.
  • Equity: Is relatively small compared to its debt and its assets.

The main thing concerning the balance sheet is the high debt and the amount of intangible assets. A deleveraging plan might take some time before the balance sheet becomes truly healthy.

Conclusion

KGS is a company in an important, yet competitive field. It has many of the characteristics that a good company should have, but does not possess a strong competitive moat. They are exposed to numerous market and industry level risks, but possess some inherent stability in its operations and value provided to customers which helps with resilience. Given that they operate in a complex industry, it is still reasonably easy to understand, but a detailed analysis of their financials, especially with their new operations, must be performed.