Liberty Positioned For Strong Growth In 2023 And Beyond (NYSE:LBRT)

Investment Hypothesis

Liberty Energy Inc. (NYSE:LBRT) reported a solid financial performance in 2022 and achieved new records in revenue, pump hours per fleet, frac stages, and tons of sand pumped while navigating tight supply and labour markets. The company’s diversified platform and technology portfolio contributed to its excellent results, and its profitability potential is expected to continue in the longer duration cycle ahead. In addition, the company is optimistic about the fundamental outlook for North American hydrocarbons, despite potential bumps in the road, such as softening natural gas activity and elevated recession risk. Liberty’s digiFrac pump technology, which combines low emissions with superior design, will help customers to have an optimized solution that matches their needs, including a fully electric backside, proprietary quiet fleet technology, and the lowest possible emissions footprint.

With the Discounted Cash Flow valuation, I arrived at the intrinsic value of $20.7 per share for the company against the current market price of $15.57 per share, making the share undervalued. Thus, at the current price, investors with Liberty shares in their portfolio can continue to hold and accumulate shares while new investors can add them to their portfolio.

Liberty Energy Inc Overview

Liberty Energy, headquartered in Denver, Colorado and founded in 2011, provides hydraulic services and technologies for onshore oil and natural gas production in North America. The company uses a hydraulic fracturing process to pump water, chemicals, and sand underground to crack open the rock and release the oil or gas. Liberty Energy has a fleet of equipment and personnel to perform the above services. The company also provide wireline services for connecting the wellbore to the target formation. In October 2021, Liberty Energy acquired PropX – A leader in last mile proppant delivery solutions. This acquisition helps the company transport and handle sand used in the hydraulic fracturing process. The company’s objective is to provide environmentally friendly solutions. In addition, the management has extensive experience in hydraulic fracture technologies that help them develop new technologies and processes to help their customers.

The company operates in a cyclical industry where demand for its services is linked to the volume of drilling in the market, which is influenced by the economic outlook for new well completions. This is affected by the global supply and demand for oil and the domestic and natural gas demand. In response to increases in commodity prices, companies in the industry may increase their capital expenditures. Conversely, higher production can lead to a higher supply of hydrocarbons and lower prices, which can drive companies to spend less on capital expenditures in response to lower demand for energy services. Thus, Liberty Energy will have a volatile performance that will vary from quarter to quarter, making it difficult for analysts to compare results across the periods.

Further, the company’s business is seasonally affected by holidays and weather conditions. For example, Liberty Energy’s operations get impacted during the winter due to snow and ice, making it challenging for them to move their equipment and provide services. Furthermore, adverse weather conditions impact Liberty Energy’s customers, affecting their exploration activities. In extreme drought conditions where the company operates, it finds it difficult to source water for its operations. These factors result in fluctuations in the company’s revenue and profits.

In recent years, Liberty Energy has made significant investments to improve its technology and research capabilities. For example, the company has developed databases of information on oil and gas wells to optimize drilling and fracking to reduce customer costs. To date, the company has filed 500 patents and has built processes to protect its trade secrets.

As of December 31, 2022, Liberty Energy had 4,580 employees and no unionized labour. The company has a trained and experienced employee pool in hydraulic fracturing services with a good employee management process. In addition, the company has made significant investments in hiring, training, and retaining the best employees by offering competitive compensation and benefits.

The company has developed good relationships with its customers, including major oil and gas companies like Exxon Mobil (XOM), BP (BP), ConocoPhillips (COP), and Occidental Petroleum (OXY), by addressing their business needs and ensuring timely quality deliverables on time within the expected costs. Liberty Energy’s approach of providing customized services using advanced technology and prioritizing safety and reliability has helped it to develop strong relationships with its customers. The company has low customer concentration, with no single customer accounting for more than 10% of the company’s revenues.

The company manages its supply chain effectively by employing a team that handles buying and transporting the materials they need to operate, such as sand and chemicals. The company has built good relationships with its suppliers of proppant, chemicals, and hydraulic fracturing equipment. It has also vertically integrated by acquiring suppliers of containerized sand and proppant logistics solutions to ensure a reliable supply of these materials and manufacturing equipment parts. The company predicts that any interruptions in supply or price increases in the future could hurt its ability to operate. To mitigate supply chain issues, the company has acquired two state-of-the-art sand mines in the Permian Basin to ensure they have enough sand to continue working.

Liberty Energy operates in a highly competitive industry and faces competition from companies of different sizes providing oilfield services in the United States and Canada. The company counts Halliburton, Calfrac Well Services, and ProFrac Holding Corp as its major competitors. Liberty Energy wins projects by bidding, where the projects are awarded on technical expertise, equipment capacity, workforce competency, efficiency, safety record, reputation, experience, and pricing. Thus, to stand out from the competition, the company aims to provide high-quality services and equipment, efficient operations, and a safe working environment.

In the last five years, the company showed volatility in revenues due to changes in the macroeconomic environment. For example, the company reported a decline of 51.5% in revenues in 2020 due to the Covid crisis, where there was a global lockdown policy. However, after Covid, due to Russia Ukraine war and rising inflation, an increase in oil and energy prices resulted in 155.8% and 67.9% growth for the company in 2021 and 2022. Thus, the company grew at 22.7% CAGR in the last five years and 27.7% CAGR in the last five years.

The company’s margin depends on global oil prices and the demand for oil and gas. Thus, the company reports a higher margin at higher revenue growth but shows a lower margin at lower volumes which is evident from its negative EBIT margin in 2020 due to the Covid crisis. However, the gross margin picked up in 2022 due to the higher oil and gas demand and higher energy prices.

The company’s asset turnover and efficiency have increased in the last two years from 1.3x to 1.8x and 6.9% to 23%, respectively, from a low of 0.6x and 5.4% in 2020. During this time, the company made investments in capital expenditures and efficiently used its assets to improve revenues and profitability.

In 2022, the company invested $451.9 million in Capital expenditures investing 10.9% of its revenues in capital expenditures. Higher investments in capex combined with higher asset turnover and efficiency have helped the company report more robust performance in 2022.

The company reduced its day sales outstanding from 107 days in 2020 to 52 days in 2021 and 44 days in 2022, implying that it was efficient in collecting cash from its customers. In addition, the improved efficiency in cash collection resulted in a lower cash conversion cycle from 85 days in 2020 to 35 days in 2021 and 28 days in 2022, implying that the company was able to generate cash more efficiently from its operations.

The company’s current ratio declined to 1.1x in 2021. Still, it rebounded to 1.5x in 2022, evident from its efficiency in improving collections and reducing current liabilities to meet its short-term obligations, thus showing a better liquidity position.

The company has increased its debt from $243.6 million in 2021 to $348.9 million in 2022 to fund its capital expenditures and acquisitions. However, the net debt-to-capital ratio has declined from 11.4% in 2021 to 10.2% in 2022 due to doubling its cash reserves from $20 million in 2021 to $43.6 million in 2022.

According to Michael Stock, CFO of Liberty Energy.

Net debt decreased by $55 million from the end of the third quarter, even with the execution of $55 million share buybacks and $9 million towards our recently reinstated quarterly cash dividend. Total liquidity at the end of the year, including availability under the credit facility, was $351 million. Earlier this week, we amended our ABL facility to provide a $100 million increase in net borrowing capacity to $525 million. In conjunction with our ABL expansion, we retired our $105 million term loan, reducing our effective interest rate. Net capital expenditures were $116 million on a GAAP basis in the fourth quarter, which included costs related to digiFrac fleet construction, capitalized maintenance spending and other projects. In 2022, we demonstrated the capital investment and higher rate of return opportunities and shareholder returns could both be achieved.

Despite taking a higher debt in 2022, the company’s interest coverage ratio improved from -10.9x in 2021 to 21.9x in 2022. In addition, its net debt to EBITDA declined from 1.5x to 0.3x due to the company reporting higher revenues and EBITDA.

The company has a higher operating leverage at 5.9, implying that its operating income is more sensitive to changes in sales due to higher fixed costs. Thus, higher sales volume results in higher operating margins because it can improve its efficiency and productivity to increase its operating income without increasing its fixed costs. However, higher operating leverage makes the company’s stock prices volatile as the revenues and profits will vary from quarter to quarter. Further, its financial leverage increased in 2022 as it used debt to fund its capital expenditures, increasing its return on equity. However, the financial leverage is not high to expose the company to bankruptcy which is evident in the higher interest coverage ratio.

The company reported its 2022 results on January 26, 2023, with its revenues in 2022 jumping to $4.1 billion, an increase of 68% year on year. Further, the company reported an adjusted EBITDA of $860 million and a net income of $400 million in 2022. The fourth quarter revenues increased 3% to $1.2 billion, whereas adjusted EBITDA grew 7% sequentially to $295 million. Due to higher free cash flow generation, the company decided to buy back 4.4% of its outstanding shares and 134 million shares for $500 million because it thinks its shares prices are trading at a discount.

According to Chris Wright, CEO of Liberty Energy.

Our 2022 financial performance illustrated the value created from our actions over the pandemic years, including transformative transactions, technology innovation and investment in the extraordinary talent at Liberty for future success. The Liberty team achieved new records measured by revenue, pump hours per fleet, frac stages or tons of sand pumped, all delivered while navigating tight supply and labour markets.

Despite challenges in the oil and gas industry, such as changes in natural gas prices and a higher risk of a recession, Liberty energy is optimistic about a strong outlook for North American oil and gas production in the coming years.

According to Chris Wright, CEO of Liberty Energy.

The multiyear outlook for North American activity is robust. Our customers and competitors are investing with discipline, keeping capacity flat to only very modest growth. For years, E&P operators, oil and gas alike, have invested in expanding metal inventory, understanding the geology and resource quality, optimizing drilling and completion designs and assembling their teams to execute development plans. Their hard work is now paying off with high rates of return, particularly in the oil, even as breakeven prices have increased from extreme pandemic lows. The majors are redirecting capital spending to attractive risk-reward opportunities in North America. Independents continue their robust shale programs at a minimum to offset natural production declines as the North American oil and gas portion reaches new heights.

The company believes there will be a high demand for its services due to limited production capacity and the transition to more environmentally friendly natural gas-powered fleets.

According to Chris Wright, CEO of Liberty Energy.

We see a multiyear cycle favouring service companies that offer differential technologies, fortifying strong customer engagement and competitive advantages. We enter 2023 with strong competitive advantages enabling further profitability expansion, including efficiency gains.

Liberty Energy aims to become a leader in the next generation of natural gas-powered fleets. Therefore, it wants to invest significantly in new technology and services to meet the industry’s high performance and quality requirements.

According to Chris Wright, CEO of Liberty Energy.

We enter 2023 with significant competitive advantages that enable strong relationships with the best producers and that drive demand for Liberty services far beyond our capacity to supply. These factors will likely deliver rising free cash flow and strong returns to our shareholders in the years ahead.

The company’s investment is to use debt to fund its growth by investing in projects that generate a high rate of return and leverage its strong balance sheet with strategic acquisitions that further improve its free cash flow.

For 2023, the company projects a 40% growth in adjusted EBITDA with minimal additions to the fleet count and wants to invest 50% of EBITDA in capital expenditures but like to reduce it to 30% of EBITDA in 2024. The higher capital expenditures are driven by strong customer demand for its next-generation low-emission frac technology. The company is confident its long-term strategy and operating model will yield solid returns for its shareholders.

The company’s ROA and ROE increased to 17.3% and 29.4%, respectively, due to higher turnover on its assets and funding those assets with debt resulting in a higher return on equity. In addition, the company forecasts higher ROA and ROE in the next year due to lower capital expenditures and a higher demand for its services.

The company reported a levered free cash flow of $78.4 million in 2022 due to higher revenues and energy prices. The company’s ability to generate cash from its operations is good, with a free cash flow to net income ratio of 19.6%. In addition, the company can use cash to pay off debt or return money to shareholders through dividends and buybacks.

In the last three years, Liberty Energy generated 88.7% returns to its shareholders against 21% return by S&P 500 index due to its robust operating model followed by solid execution aided by higher commodity prices.

I used the Economic value-added approach to assess if Liberty Energy is creating value for its shareholders. The result was a value of $134.9 million in excess returns generated over the cost of capital invested in the business. This indicates that the company effectively manages its assets and creates excess returns for its shareholders.

Risks

The most significant risk for Liberty Energy is a drop in commodity prices, especially oil prices, which could significantly impact its valuation. This was seen during the financial crisis when oil prices dropped from over $100 to $30. A deep global recession could also impact the company’s growth due to lower energy consumption. Additionally, since the company’s growth is tied to oil prices, any significant price drop from current prices to $40 could potentially hurt its valuation.

Valuation

Before I valued Liberty Energy using Discounted Cash Flow approach, I benchmarked the company against its competitors using multiple metrics.

I identified the following companies for my benchmarking.

1. Expro Group Holdings N.V. (XPRO)
2. NexTier Oilfield Solutions (NEX)
3. Tidewater Inc (TDW)
4. USA Compression Partners (USAC)
5. Oceaneering International, Inc. (OII)

In the last year, Liberty energy grew at 67%, which is better than its peers, except NexTier, which had a stellar growth rate of 128%. The company’s high growth is due to its innovative approach to developing a highly advanced frac fleet called digiFrac. digiFrac is designed to be the market’s most technologically advanced and cost-efficient fleet while having the lowest emissions.

At a gross margin of 24%, Liberty was commanding a better margin than its peers, but what differentiates the company is its high EBIT and net margin, which shows its better cost structure and efficient utilization of its assets.

Liberty has a better asset turnover than all its peers. In addition, its asset efficiency of 23% is the best, demonstrating how the company is efficiently using its assets to generate higher revenues and profitability.

Liberty Energy has a lower amount of debt than similar companies, which means it is at a lower risk of financial distress. Additionally, the company has enough cash to invest in projects that will generate higher returns than the cost of capital. If any extra cash is available after investment, the company returns it to shareholders through dividends and buybacks.

Liberty has the highest interest coverage ratio and lowest debt to EBITDA, indicating that the company’s financial health is good. In addition, at a 1.5x current ratio, the company does not face any short-term liquidity issues.

The company generates superior shareholder returns at 25.5% ROIC, 17.3% ROA and 29.4% ROE when benchmarked against its competition. In addition, the company has increased its return on equity by judicious usage of debt to fund its capital expenditures.

The company’s EV/EBITDA ratio is 3.6x, which is lower than its competitors, despite having higher revenue growth, lower debt to capital, and generating higher shareholder returns. This suggests that the company may be underpriced. Looking at the forward EV/EBITDA ratio, which is 2.4x, the company appears to be even cheaper and potentially even more underpriced than its competitors.

Further, I do a comparable valuation of Liberty, taking EV/EBITDA multiple as a metric and benchmarking it against its peers.

First, I analyze the company’s financials against its peers by looking at its income statement and balance sheet. Then, with a positive commentary from the management, I forecast Liberty’s EBITDA to increase from $820 million in 2022 to $1.2 billion in 2023 and $1.3 billion in 2024.

Liberty’s EBITDA grew at 44.5% CAGR in the last three years, much better than its competitors, and its EBITDA margin for 2022 was 19.8%. Therefore, I take the median EBITDA of the benchmarked companies and the median of Liberty’s historical EBITDA for the last five years to arrive at 4.6x as the EV/EBITDA multiple for my valuation. At this multiple, the implied value is $19.5, giving a 25.3% upside against the current price.

From the management commentary that provides an optimistic outlook for the company, I project the company’s EBITDA to increase to $1.2 billion in 2023 and $1.3 billion in 2024, at the fwd. EV/EBITDA multiple of 2.8x, the implied value is $19.11 per share, giving an upside of 22.7% against the current market price.

I average the implied price obtained from LTM EV/EBITDA and Fwd.EV/EBITDA to arrive at the implied price of $19.31, giving a 24% upside against the current price of $15.57. Thus, from the comparable valuation, the company looks underpriced.

For my DCF valuations, i use the following assumptions:

Next year’s revenues will grow by 20% as the management assumes an optimistic forecast. I expect the company will grow at 10.9% CAGR in the next ten years, and at the end of ten years, the company will report $11 billion in revenues.

The EBITDA margin will improve to 25% in the next year, as projected by the management but will converge to the industry average of 8.1% at the terminal year.

As the company’s growth rate slows down, the company invest less in capital expenditures, and most of the investment is to maintain the current capital expenditures. Further, I assume the net working capital will stay at 7% of the revenues in 2022.

To arrive at the cost of capital, i assume the 10-year U.S. treasury rate of 3.8% as the risk-free rate.

I assume the U.S. equity risk premium of 5.5% for the company.

At an unlevered beta of 1.54, a debt-to-capital ratio of 12.5% and a marginal tax rate of 15%, the levered beta for the company is 1.73.

I assume the company will maintain the debt-to-capital ratio in the future, resulting in a 3.83% cost of debt and 13.3% cost of equity, giving me a 12.1% cost of capital.

At the above assumptions and a terminal rate of 3.8%, I arrive at an Enterprise value of $3.97 billion.

Adding debt and subtracting cash, I arrive at the equity value of $3.6 billion and the current share count of 176 million, I arrive at the intrinsic value of $20.82 per share.

At the intrinsic value of $20.8, Liberty Energy stock is undervalued by 33.7% against the current market price of $15.57.

I conclude my analysis by stating that Liberty Energy looks underpriced and undervalued. With my comparables valuation, I arrived at the implied price of $19.3; with DCF, the implied price is $20.8.

To summarize, Liberty Energy has created unique advantages that help them charge higher prices while keeping their customers happy. This, in turn, drives up demand for their services beyond what they can currently supply. Doing so makes the company more likely to generate strong cash flows and deliver higher value to its shareholders.