Why Archrock Should Be In Your Portfolio – Archrock, Inc. (NYSE:AROC)

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I think that a long position in Archrock (AROC) makes sense. The company is adding more horsepower due to the increasing demand for its services. Also, the natural gas market outlook looks bullish. The company has had a reliable operational performance. I am not concerned about AROC’s long-term debt, and I believe that the dividend will be fully funded in 2020 when management slashes capital expenses by half.

AROC’s future

One of the aspects that I like about AROC is the fact that the company continues to add productive assets. For instance, Brad Childers, President, and CEO, mentioned in the 2Q 2019 earnings conference call that the company expanded the base of operating horsepower, by adding 50,000 hp in the quarter, totaling more than 3.6 million. The company increased the horsepower in areas servicing growing production, particularly in oil plays with substantial associated gas volumes.

Also, I like that the company improved the gross margin in the aftermarket service business to 19%, which is the high end of the full-year guidance range. Management can execute the strategy.

Brad also believes that the compression business has remained sound, primarily benefitting from the low and stable U.S. natural gas price experienced over the recent decade. Also, he believes that LNG exports and Mexico exports will be drivers for an increase in demand in the future years. Also, I think that the continuing conversion of coal power plants to natural gas power plants will continue to drive the demand for natural gas higher. Between 2007 and 2017, the number of power plants in the U.S. has declined from 351 to 219. Simultaneously, the number of gas-fired power plants have increased from 767 to 820. I believe that the trend will continue, provided that natural gas prices remain at current levels.

Image created by the author. Data gathered from the EIA.

AROC’s recent operational performance

Looking at the past operational performance is essential. My go-to analysis is the DuPont ROE summary because it provides a holistic view of the tax and interest burden, operating income margin, asset turnover, and equity multiplier. I am showing the inputs and summary in the following tables. All amounts are in 1000s unless ratios or otherwise noted.

Image created by the author. Data collected from the SEC EDGAR website

Image created by the author. Data collected from the SEC EDGAR website

First, it seems that the ROE is improving year-over-year. In other words, the company is generating more net income per dollar invested in equity. Now, I want to discuss each of the inputs and their implications.

First, I want to discuss the tax burden. Excluding the metric for 1Q 2018, the average is at 0.80. It is always good to see companies minimize their taxes.

I am slightly concerned at the interest burden. Typically, I want to see interest burden ratios above 0.5. In 2Q 2019, the interest burden was 0.24, meaning that the net interest expense is high compared to the operating income margin. I will speak further about the interest expense in the following section.

One positive aspect of AROC is the expanding operating income margin. The coefficient increased from 16.9% in 2Q 2018 to 21.6% in 2Q 2019.

The asset turnover is stable at 0.09, and there is not much to write home about.

Lastly, the equity multiplier has been stable, hovering around the 3.0 level. Usually, I start to pay close attention to leverage when the equity multiplier is above 3.0, and I get anxious when the coefficient is above 5.0. However, in AROC’s case, I am not too concerned because the operating income margin is expanding.

In brief, the ROE has expanded primarily due to increasing operating income margin, which is music to my ears.

Delving further into AROC’s long-term debt

Since the leverage is high, I want to delve further into the long-term debt to determine its sustainability. My preferred metrics are the interest coverage ratio and the D/E ratio. The former tells me if the company generates enough operating income to cover the interest expense. The later tells me if I should be concerned about overleverage.

From the interest coverage ratio lenses, the story looks appealing. While the ICR is still below 3.0, my line in the sand, the metric has been improving from 1.6 in 2Q 2018 to 1.9 in 2Q 2019. In the next earnings report, I want to see the trend to continue growing.

The story is also appealing when looked from the D/E ratio side. Leverage has increased meagerly from 1.8 in 2Q 2018 to 2.0 in 2Q 2019. While the long-term debt has grown, so has the equity.

Overall, I am not concerned about the leverage from the long term. I am comfortably provided that the operating income continues to improve.

Image created by the author. Data collected from the SEC EDGAR website

Image created by the author. Data collected from the SEC EDGAR website

Delving into AROC’s dividend sustainability

Since AROC pays a dividend, it is crucial to determine if it is sustainable in the long run. My preferred metrics are the dividend coverage ratios calculated from the net income and the cash flow from operations. From the net income perspective, the story does not look bullish. The company has not generated enough income to cover the dividends in the previous twelve months.

Image created by the author. Data collected from the SEC EDGAR website

From the cash flow from operations, the story also looks worrisome. The company has not generated enough CFO to cover capital expenditures and dividends. Therefore, I believe that AROC should focus its strategy on reducing capital expenditures so that it can cover the dividend sustainably. In the next earnings report, I will pay close attention to capital expenses with the hope to see it lower than in 2Q 2019.

Image created by the author. Data collected from the SEC EDGAR website

One of the positive aspects for AROC is that Brad mentioned in the 2Q 2019 earnings call that the capital expenses for 2020 will be half of the amount in 2019. Therefore, I am expecting CAPEX for approximately $210-230 million. If the company manages to deliver the expectations, AROC will have enough CFO to fund capital expenditures and dividends.

In brief

The outlook for natural gas seems bullish. The company is executing a strategy benefiting its shareholders. The operational performance is reliable, and I am not concerned about AROC’s long-term debt. Finally, although the company cannot fund the dividends from the CFO, Brad mentioned that capital expenses should be half of what they were in 2020. Therefore, AROC will fund capital expenses and dividends from CFO. In brief, I think that a long position in AROC makes sense.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The opinions expressed herein are the author’s sole views, and they do not constitute investment advice in any form. Past performance may not be indicative of future performance. Always do your due diligence, and determine if the investments mentioned here suit your risk tolerance and objectives, your return objectives, and your personal constrains.

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