Friday, August 3, 2018

KLX Inc: Boeing Merger, KLX Energy Services Spin

KLX Inc (KLXI) is familiar to many special situation oriented investors, it was a December 2014 spinoff of BE Aerospace (BEAV), BEAV has since been acquired by Rockwell Collins (COL) in April 2017.  KLXI combined two unrelated businesses, Aerospace Solutions Group ("ASG") which is a distribution business to the aerospace industry and Energy Solutions Group ("ESG") which is an onshore oil and gas services business.  Both segments were rollups designed with the underlying theme of providing mission critical products/services that were relatively low cost in the context of the overall project, but for which the cost of failure is high enabling higher margins for KLXI.

Fast forward to today, Boeing (BA) is purchasing the ASG business for $63 per share in cash.  KLXI originally wanted to sell both the ASG business and ESG business to separate parties but couldn't come to agreement with any buyers for ESG.  As an alternative, KLXI is going to spin off ESG as KLX Energy Services (KLXE) simulatenously with the closing of the ASG deal with Boeing (guided to a Q3 close).  I have zero expertise in energy related businesses, most of the time I've dipped my toe into the sector I've gotten my face ripped off, but this deal reminds me quite a bit of LaQuinta/CorePoint (LQ/CPLG) that I've decided to give it another try in hopes to expand my circle of competence marginally.

How is it similar?  First, the deal will be taxable to KLXI shareholders, thus removing the tax-free two year safe harbor on a business that management clearly wanted to sell in the first place.  Second, the management team is moving to the spinoff and in this case, foregoing cash compensation to take stock in the spin which will likely trade poorly initially due to typical spinoff dynamics when management knows that they'll be looking for a buyer.

A little more on KLXE, the form 10 can be found here, it was formed as a rollup of 7 regional players, all the deals were done in the 2013-2014 timeframe before oil prices collasped for a combined price tag of ~$700MM.  The business did $100MM EBITDA in 2014 before the bottom fell out completely, with oil prices rebounding the past year, they're guiding to $110MM for 2018 which is significantly more than the $27MM in EBITDA in 2017.  During the sale process, they received bids for the ESG business in the range of $250MM to $400MM, the leading bid was a SPAC, so mostly financial buyers were interested.  The proxy pointed to the poor trailing twelve months results and a lack of credit available to finance energy deals as reasons for the disappointing bids for ESG.  The management team is interesting here as well, Amin Koury is 78 years old, lives in Florida (no major onshore energy basins there as far as I know), he's getting cashed out of ASG and was already cashed out of BEAV, his son runs his family office and isn't involved in the energy business, this is the last and smallest piece of his empire, all signs seem to point to KLXE not being a public company for long.

KLXI trades for $72.75 today, backing out Boeing's $63 cash offer and KLXE's implied market cap is ~$500MM, it will have no debt and KLXI is gifting KLXE $50MM in cash immediately prior to the spinoff.  So the implied EV is about ~$450MM, using the $110MM EBITDA estimate, and we come up with a 4.1x EV/EBITDA multiple, certainly cheap for any viable business.  Most oil services businesses trade a lot higher, I don't know of a perfect comp, but a similar setup to look to could be Dover's recent spinoff of Apergy (APY) which has done well since the spin.

Of course the problem with these types of ideas, they're hard to size up, even if we assume KLXE is worth 8x EBITDA, then the pre-spin KLXI is worth $81 or about 11% higher than today's trading price, not a home run, but I think it's an interesting short term idea that gives you a toehold position in KLXE at a cheap price.  After the deal closes you can decide to sell or add to the stub, that's my plan at least.

Other thoughts:
  • As far as I can tell, the taxable piece is fairly straight forward at this point, similar to LQ you'll receive cash and shares in the spinoff, the taxable amount will be $63 + KLXE's share price on day one over your original basis.  At the corporate level, KLXE has a tax basis of $600MM, if the day one value of KLXE is above this amount, then KLXE will be on the hook for any taxes.
  • KLXE will have a tax shield of approximately $32MM per year due to amortization of intangible assets, if you want to get cute on the valuation you could put an NPV on the tax attributes and KLXE would look even cheaper.
  • Cash at KLXE will also likely be higher than $50MM, KLXE is entitled to any free cash flow generated from 5/1 to the closing date.
  • KLXI is not an S&P 500 component, but it is in aerospace indexes and not in energy indexes, so along with dropping down in market cap indexes, it'll be removed from industry ones as well, potentially creating some forced selling from ETFs.  I would imagine there are few holders of KLXI that were involved for the energy business.
Disclosure: I own shares of KLXI

18 comments:

  1. Hi MDC, Thanks for he idea.I owned this until recently as well. One tough part of trade is that it is capital intensive, ie., have to put up a lot of cash.I need to look at the business more. The valuation is less compelling now given the sell off in the OFS space. For example, PTEN and FTSI are high quality names trading roughly 5X 2019 CF and are much higher quality businesses. Paying 1 turn for these seems to make more sense. I also wonder about KLXI's asset quality. Many in the space have guided down so i wonder if the 110 EBITDA guide is still good.

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    1. I might be wrong but i doubt KLX's business is as capital intensive as the examples you named. Those are drillers and pumpers which are the most capital intensive energy related businesses. KLX seems to be servicing those guys whith tools and other expertise which is probably(?) less capital intensive.

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    2. I think the capital intensive comment was related to the trade itself, not necessarily the business, today this is more of a merger arb as you need to put up a lot of money to "create" a normal sized position in KLXE's implied price. Might be better to wait for after the deal to occur.

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  2. There is also a spac MPAC that announced an OFS deal at 2X EBITDA. I plan to take a look but I am sceptical of these small OFS names. There is lot going in the Permian with take away problems, transportation and wage issues. Small players lack the scale to compete and need to have differentiated services to succeed. There seems to be excess capacity in certain services like pumpimg.

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    1. Thanks for the feedback, I'll take a look at those names you mentioned. There's certainly a risk the $110MM isn't good anymore, seems like a swag, but the Form 10 confirms a significant ramp through 4/30 that makes it seem feasible. Agreed on the capital intensity of the trade, for me it's just creating a tracker position in KLXE and I'll decide what to do with sometime after the deal closes.

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  3. Thank you for the write-up. As you said, at this point, it is a capital intensive trade, so I'm actually waiting for the spinoff for a possible entry point. Have you looked at Linn Energy spin off? Thanks.

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    1. I have a little bit, owned it LNGG for a quick second before reversing and deciding I was outside of my comfort zone, just don't know how to value either side (I was more interested when they were splitting into three with one being an MLP). If you have a view, I'd be interested in hearing it.

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    2. I got into RVRA yesterday. It's currently trading at $24 vs my fair value estimate of at least $30/share. I value Blue Mountain at 10x midpoint EBITDA ($1.125B) and value mature assets at $1B plus $260mm in cash. BM's capex is projected to go down from $120mm this year to $23mm next year, debt-free BS, possible uplisting, shareholder friendly management with Elliott representative on the board.

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  4. Where in the materials is the detail on forgoing cash for spin stock? Or is this simply implied given management stays with spinco?

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    1. Several places but you can see it in the pro forma BS.

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    2. See page 124 of the Form 10, "Compensation Going Forward"

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  5. MDC is right when i referred to capital intensive I was referring to the amount of cash tied up in the trade since KLXI is a stub.

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  6. Firstly I'd like to say thank you for such an enjoyable and thoughtful blog! I was just wondering if 1) there is any risk that the deal doesn't close in your view? 2) After going through the form 10 I still have no idea whether this is a "good" business, I know management talk about having higher EBITDA margins than other comparables, but it still doesn't seem to generate any cash? would be really interesting to hear your view here. Thank you.

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    1. Not a risk/merger arb expert, but I believe most of the hurdles to this deal closing have been met at this point, fairly confident it closes.

      It's a bit of a leap of faith in taking management's 2018 guidance, although the 4/30 numbers seem to back up the quick ramp, $110MM of EBITDA, $40MM of maintenance capex, minimal taxes and no interest payments, should generate some cash if those estimates are correct. Over a full cycle, maybe its a different story. Thanks for the kind words.

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  7. Interesting idea. According to the proxy Boeing expected the ESG sale to fetch $400m in Feb 2018 (based on an estimate of $73m EBITDA). And, as you pointed out, they received bids in the $250 - $400 range. Add the extra cash, some value for the tax shield and you end up ballpark around $400 - $500. Which is pretty much what the market is implying.

    Are you confident that the company is suddenly worth much more than what these private buyers were bidding? Is it reasonable that the EBITDA estimate is suddenly up 50%? Will the public market value this company at a higher multiple?

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    1. I wouldn't say I'm confident its suddenly worth a lot more, but management sure seems to think so? I'm more following the incentives here, I think they'll try to sell it again in the next 6-24 months once they have a full twelve months of good results behind them. As I tried to point out and others did too, probably best to just wait for the spinoff to happen, less capital committed and maybe you get some forced index selling.

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  8. Off topic...but have u looked into the servicemaster spin ? they filed the prospectus recently

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    1. Someone else asked that in comments of my Perspecta post, I read through the Form 10 and it sounds interesting, very growth oriented, but so far struggling with why the business is being spun off in the first place? Doesn't initially strike me as a different business model that should be run separately for the typical reasons, but I want to spend more time on it.

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