A significant acquisition weakens the balance sheet and has me looking for greener pastures.
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This is not how I wanted to start my Monday morning.
A perusal of my inbox this morning turned up an interesting looking announcement from Enerflex. They were merging with (acquiring) another company in the natural gas compression and processing equipment space in an all-share deal. Initially I was excited. A well-timed acquisition is often a good thing. In their news release and on their conference call, Enerflex sounded very upbeat. They’ve had their eye on this company for quite some time and they felt that now was a good time to pounce. They see orders in the gas industry picking back up and believe that the two companies together will have broad geographic diversification and economies of scale that will help steer them through their next phase of growth. They see the deal as “accretive” to shareholders with pro forma cash flow and EBITDA rising by 50% after the deal.
Which all sounds wonderful. The problem is, I don’t invest on the basis of cash flow and EBITDA. I invest based on actual earnings and by this metric the deal looks a lot less favourable.
The company they are buying, Exterran, has not been doing well lately. It’s lost money in 4 out of the last 6 years. The company also happens to be loaded down with debt, far more than I would usually feel comfortable with. As a result, the share price has been in a bit of a death spiral. Mounting debt in the face of ongoing losses is a nasty combination.
On the one hand, Enerflex swooping in, with it’s much stronger balance sheet, to save the day seems like it might be a shrewd move. It takes the risk of bankruptcy off the table and as a result, adds significant value to Exterran’s operations. Perhaps they are snapping up a valuable asset at a bargain price. It’s certainly a boon to existing Exterran shareholders who saw the price of their stock jump by 50% this morning. But for Enerflex shareholders, who reacted by immediately lopping 20% off Friday’s share price, the deal does not look as compelling.
Enerflex is taking all of Exterran’s debt on to its own balance sheet and in return is getting a company that has lost a significant amount of money over the last 3 years. On an EBITDA basis, the company looks better. If you can ignore all those depreciation expenses and the interest payments on the debt (the I, the D and the A of EBITDA) then “earnings before the bad stuff” might look okay. But those interest expenses aren’t going away and may even increase if interest rates are set to rise, and depreciation is a regular cost of doing business for this company. They are keen on their build, own, operate model where they enter into partnerships to build natural gas facilities but building these massive power plants requires significant capital. And you need to expense that capital somehow. Depreciation is how you do that. You can’t just pretend it doesn’t exist.
Knowing when to sell a stock is always hard. One reason to sell is because the story has changed. I believe with this acquisition, the story has changed significantly. Before the Exterran acquisition this was a fairly stable company with a strong balance sheet and a long history of profitability even in the face of the severe downturn in the industry over the last two years. After the acquisition, this is a highly indebted company with a more muted earnings history. I believe the potential for a robust recovery in profitability has been hindered by this move, not enhanced by it.
Wincing in pain, I sold off my shares this morning at prices around the $6.35 mark, not much above where I bought it a year and a half ago. At least the ESG crowd will be happy. I suppose my portfolio looks a little greener after today.
On the plus side, this has now plumped up the cash in the portfolio. As the Fed starts to tighten in earnest and stocks continue their nosedive of last week, having some extra cash on the sidelines may come in handy. I’ll be looking for something to replace Enerflex with eventually, but I can’t say I feel like I’m in much of a hurry at the moment.
Full disclosure: I do not own shares in Enerflex or Exterran.