Natural gas is a highly volatile energy commodity that is traded on futures exchanges in the United States and Europe. U.S. natural gas futures (NGX24) declined on Friday, breaking a five-week winning streak due to a weaker demand outlook, despite a federal report indicating that utilities added a smaller-than-normal amount of gas to storage in the week ending Sept. 27.
Nonetheless, Mizuho analyst Gabriel Moreen recently expressed a positive view on the overall U.S. natural gas demand outlook, noting that there are also significant tailwinds benefiting the compression industry. For those unfamiliar with natural gas compression, it is a process that increases the pressure of natural gas to enable its transportation. This is essential for facilitating the movement of natural gas through pipelines and other infrastructure. The analyst said that strong demand for compression services, coupled with limited spare capacity, has pushed utilization metrics to unprecedented levels, thereby enhancing pricing power. As a result, Mizuho initiated coverage of two leading contract compression providers, Kodiak Gas Services (KGS) and Archrock (AROC), with “Outperform” ratings and price targets of $36 and $24, respectively.
In this analysis, we will explore why these two natural gas stocks are primed for strong performance, and why dividend investors should consider adding them to their portfolios this October. We’ll dive into their financial health, recent performance, and the key factors driving Mizuho’s bullish outlook.
1. Kodiak Gas Services
Kodiak Gas Services (KGS) is a notable company in the oil and gas industry, specializing in offering contract compression infrastructure services to clients throughout the United States. It currently has a market capitalization of $2.74 billion.
The company’s operations are divided into two main segments: Compression Operations and Other Services. In the Compression Operations segment, it manages both company-owned and customer-owned compression infrastructure. This vital infrastructure supports the extraction, collection, and transportation of natural gas and oil (CLX24), key elements of the energy sector.
Beyond its core compression services, the company’s Other Services segment provides a variety of contract-based solutions. This encompasses station construction, maintenance, overhaul, and various ancillary services frequently needed in the oil and gas industry. By offering a comprehensive range of services, KGS ensures its clients receive the necessary support and expertise across all aspects of their operations.
As global energy consumption is projected to keep rising, requiring expanded natural gas capacities and increased oil drilling, KGS is well-positioned to capitalize on this trend, likely resulting in steady revenue growth for the company. Moreover, the company recently pointed out that the ongoing expansion of artificial intelligence (AI) data centers is driving substantial demand for natural gas-fired power, presenting another tailwind for the business.
Shares of Kodiak Gas Services have rallied around 62% on a year-to-date basis, outperforming the Energy Select Sector SPDR Fund ETF’s (XLE) 11.1% gain over the same period.
Kodiak Gas Services recently started paying dividends, declaring its first dividend in the fourth quarter of 2023. On Aug.16, Kodiak Gas Services paid its shareholders a quarterly dividend of $0.41 per share, marking an 8% increase from the previous dividend of $0.38. Its annualized dividend of $1.64 per share translates to a dividend yield of 5.05%, well above the sector median of 4.21%.
“Returning capital to stockholders is a key element of our capital allocation strategy. The dividend increase we announced today reflects the enhanced cash flow generated by the industry’s largest contract compression fleet and our confidence in the outlook for the compression market,” said Kodiak’s President and CEO, Mickey McKee.
Kodiak reported its second-quarter earnings results on Aug. 12. Its total revenues grew 52.3% year-over-year to $309.65 million, missing Wall Street’s estimates by $1.76 million. The growth in total revenue was primarily due to a 52.1% year-over-year surge in Contract Services revenue, which reached $276.3 million. This increase was driven by strength in contract compression services, due to a higher average revenue-generating horsepower.
However, the adjusted gross margin for the Contract Services segment was 64.0%, a decrease from 65.9% in Q1 and 64.2% in the same quarter last year. During the Q2 earnings call, KGS’s CEO noted that the company had acquired a compression business with a historical margin in the low to mid-50s. In just 90 days after integrating the assets, selling costs, and reactivating idle equipment, the company managed to achieve nearly the same combined adjusted gross margin for Contract Services as it did in the year-ago quarter. Given the ongoing tightness in the market for large horsepower compression, the company anticipates margin expansion in that part of the business as it moves forward, driven by a mix of price improvement and cost management.
KGS reported a record quarterly adjusted EBITDA of $154.3 million, up from $107.9 million in a year-ago quarter. However, adjusted EBITDA margin came in at 49.8%, down from 54.6% in Q1 and 53.1% in the same quarter last year. It’s also worth mentioning that horsepower utilization, calculated as revenue-generating horsepower divided by fleet horsepower, was 94.3% in Q2, compared to 99.9% in the same quarter of the previous year. At the same time, management pointed out that the core group of large horsepower assets, which were central to the legacy Kodiak fleet and a key target of the CSI acquisition, remains at effectively full utilization, exceeding 98%.
Kodiak’s net income totaled $6.7 million, compared to $17.5 million in the second quarter of 2023. Its Q2 GAAP EPS was reported at $0.06, missing expectations by $0.49.
Notably, the company strengthened its balance sheet in Q2, reducing leverage to 3.9x, progressing well towards its target of 3.5x by the end of 2025. As of June 30, KGS’s debt stood at $2.5 billion, comprised of the $750 million in senior unsecured notes due in 2029 issued in February, along with borrowings under its ABL facility. The company had $411.4 million available on its ABL Facility.
For the full year, encompassing 12 months of Kodiak operations, but only 9 months of CSI and synergies, the company anticipates revenue to range between $1.12 billion and $1.18 billion. Also, management raised the lower end of full-year adjusted EBITDA guidance by $10 million, now forecasting a range of $590 to $610 million.
Despite delivering another record quarter, Kodiak shares tumbled nearly 11% on the report. However, Wall Street analysts largely deemed that pullback a favorable entry point, with Stifel, Truist, and RBC Capital all increasing their price targets on the stock.
Analysts tracking the company anticipate KGS swinging to a GAAP profit of $1.15 per share for fiscal 2024, while also projecting a 36.26% year-over-year growth in revenue to $1.16 billion.
In terms of valuation, the stock is currently trading at 27.04 times the consensus earnings estimate for 2024, more than double the sector median multiple of 12.18. Also, Kodiak’s forward EV/EBITDA ratio is at 9.08x, representing about a 50% premium over the sector median of 6.04x. However, I believe the premium is justified by its strong long-term prospects.
What's the Analyst Forecast for KGS Stock?
On Sept. 27, Citi analyst Douglas Irwin initiated coverage of Kodiak Gas Services with a “Buy” rating and a $35 price target. The analyst anticipates that the already tight compression market will gain from several ongoing macroeconomic tailwinds, most notably the rising demand for natural gas in the near to medium term.
On Sept. 19, Redburn Atlantic initiated coverage of the stock with a “Buy” rating and a price target of $35. Kodiak provides investors with an appealing opportunity to capitalize on the structural growth in domestic natural gas demand, the firm told investors in a research note. The firm noted that increasing demand for compression, as well as industry consolidation and capital discipline among providers, has led to a rise in the company’s utilization, pricing, and returns. It projects that Kodiak will achieve a 9% organic annual growth in underlying EBITDA over the next three years.
Analysts have a consensus rating of “Strong Buy” on Kodiak stock, with an average target price of $32.67, which is roughly flat with the stock’s current price. However, the Street-high price target of $36.00 suggests about 11% upside potential. Of the 11 analysts providing recommendations for the stock, seven suggest a “Strong Buy,” two recommend a “Moderate Buy,” and the remaining two advise a “Hold.”
2. Archrock
With a market capitalization of $3.83 billion, Archrock (AROC) is a Texas-based company that specializes in providing natural gas contract compression services and equipment for oil and gas production, processing, and transportation, alongside support for energy infrastructure.
The company’s primary business segment is Contract Operations, where it leases its fleet of natural gas compression equipment to energy customers. The other segment is called Aftermarket Services. This part of the company specializes in supplying customers with parts and components, along with services such as maintenance, reconfiguration, and more.
Shares of Archrock have climbed 41.6% on a year-to-date basis, outperforming the Energy Select Sector SPDR Fund ETF’s gain over the same time frame.
On Aug. 30, Archrock announced the completion of its previously announced acquisition of Total Operations and Production Services (TOPS). Through the TOPS transaction, the company acquired 580,000 horsepower, which includes about 500,000 operating horsepower and a significant, contracted backlog of new equipment. The acquisition of TOPS aligns with AROC's strategic focus and presents an excellent opportunity to expand its contract compression operations, earnings, and cash available for dividends.
Archrock boasts a steady dividend history, having paid dividends for nine consecutive years, which surpasses the sector median of three years. Earlier this year, AROC announced a 6.5% increase in its quarterly dividend to $0.165 per share. This results in a modest 3.03% forward yield at current prices, below the sector median of 4.20%. Notably, cash available for dividends in the second quarter of 2024 reached $72 million, leading to an impressive quarterly dividend coverage ratio of 2.6x. Management anticipates that the boost in pro forma discretionary cash flow resulting from the addition of TOPS will further enhance the company’s financial flexibility and ability to raise dividends for its shareholders over time.
Archrock released its most recent quarterly earnings report on July 30. The company’s total revenue expanded 9.3% year-over-year to $270.53 million in the period, in line with Wall Street’s expectations. The increase in total revenue was driven by its contract operations business. Revenue from the contract operations segment increased 12% year-over-year to $225.5 million, led by higher rates and an increase in average operating horsepower for contract compression in response to higher utilization at Archrock and throughout the industry. Importantly, the adjusted gross margin for the contract operations segment was 65%, an improvement from 62% in the second quarter of 2023. It’s also worth noting that by the end of the second quarter of 2024, total operating horsepower reached 3.6 million, with utilization at 95%, both in line with the figures from the second quarter of 2023. This all contributed to a further expansion of the company’s bottom line.
Net income grew 39% year-over-year to $34.4 million, or $0.22 per share, but fell short of expectations by $0.03. Operating cash flow increased from $30.5 million to $70.7 million. Lastly, adjusted EBITDA reached $130 million, a 15% increase compared to the same period last year, primarily driven by higher pricing and a strong focus on cost management, resulting in solid profitability. Adjusted EBITDA margin improved from 46% to 48%.
During the Q2 earnings call, President and CEO Bradley Childers noted that booking activity increased sequentially as the company continued to build its order book into 2025. Management anticipates continued strong demand for compression bookings in the future, as customers prepare for increased natural gas production to support growth in LNG export capacity and additional electric generation demand from AI and data centers.
The company maintained its sector-leading financial position, which includes a leverage ratio of 3.2x. It ended the quarter with a long-term debt of $1.6 billion. Notably, Archrock is on course to meet its financial goals, including maintaining a consistent leverage ratio of between 3x and 3.5x.
Regarding the 2024 fiscal year, management is optimistic. They anticipate net income to range between $139 million and $167 million. At the midpoint, the projected $153 million would significantly exceed the $105 million reported last year. Excluding TOPS, adjusted EBITDA is projected to be between $510 million and $540 million, marking a 17% increase from $450 million in 2023.
Analysts tracking the company forecast a 55.07% year-over-year increase in Archrock’s earnings to $1.07 per share for fiscal 2024. Also, Wall Street expects AROC’s revenue to grow 13.89% year-over-year to $1.13 billion.
In terms of valuation, the stock is trading at 20.24 times forward earnings, which is a premium relative to the sector median of 12.04x and its five-year average of 17.42x. The same trend is evident in its forward EV/EBITDA ratio. Archrock is trading at 9.99x, higher than the sector median of 6.04x and its five-year average of 8.05x. However, the premium might be justified given management’s assertion that the company is in the strongest position in its 70-year history.
How Do Analysts Rate AROC Stock?
On Sept. 27, Citi initiated coverage of Archrock with a “Buy” rating and a $24 price target. And just a couple of days prior, Evercore ISI analyst Durgesh Chopra initiated coverage of Archrock with an “Outperform” rating and a price target of $24.
“Archrock is a dominant player in the gas compression market serving top-tier energy companies,” wrote Chopra, who also noted that compression is “a must-run service for gas production” and typically involves fixed-fee, long-term contracts. The Evercore analyst told investors that demand for compression is aligned with strong growth in demand for U.S. natural gas.
On Sept. 6, JPMorgan initiated coverage of AROC stock with an “Overweight” rating and a $24 price target. The firm said in a research note that the company is well-positioned to benefit from the macro tailwinds fueled by rising demand for natural gas and required energy infrastructure. The firm stated that expanding liquefied natural gas (LNG) exports and rising electric load growth act as “noteworthy drivers” for the shares.
Overall, analysts have deemed Archrock stock a “Strong Buy.” Similar to Kodiak, the stock is trading close to its mean price target of $23.75, yet the Street-high price target of $25.00 indicates there could be about a 15% upside potential from the stock’s Friday closing price. Among the seven analysts covering AROC, five recommend a “Strong Buy,” and two assign a “Moderate Buy” rating.
