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This $3 Stock's Rally Could Deliver Up to 59% Returns

David Sterman

The phrase "fracking" -- referring to the hydraulic fracturing of rock formations to tap into deeply submerged seams of natural gas -- has surely been controversial. Consumers have expressed concerns that fracking may cause groundwater contamination, and regulators are closely studying the issue.

The good news: Proper safeguards can help fracking unlock our vast trove of natural gas in ways that don't despoil the environment, and several companies are gearing up to help the cause. Oil services giant Schlumberger (SLB), for example, is now selling fracking fluids that have a much more benign environmental footprint, and rivals are coming up with their own solutions as well.

Still, for these fluids to work effectively, fresh water needs to be trucked in and post-fracking wastewater needs to be trucked away from drilling sites. One of the leading companies in that effort also happens to be one of the most unloved stocks in the market right now. That's largely due to a major acquisition made nine months ago that has weighed on recent quarterly results. Yet that deal should start to generate more solid results in coming quarters, and when that happens, this stock should pivot back into investor favor and deliver solid upside.

A New Name to Clean the Slate

I'm talking about a company known as Nuverra Environmental Solutions (NES), though due to its recent name change, you may know the company by its former name, Heckmann Corp.

In a bid to become a one-stop shop for environmental remediation services at energy drilling sites, Nuverra has pulled off a string of acquisitions. The September 2012 purchase of Power Fuels helped to virtually double the company's size, and though the deal was initially greeted with a sharp spike in the stock price, investors have grown frustrated as recent quarterly results have lagged consensus profit forecasts.

Still, it's hard to ignore this company's impressive industry footprint thanks to the myriad recent acquisitions. Highlights include:

-- Operations in eight shale formations across the United States, in vibrant areas such as the Bakken Shale in North Dakota, the Eagle Ford in Texas and the Utica in Ohio.

-- A fleet of nearly 1,500 trucks and railcars, a network of water delivery and wastewater collection pipelines, and 4,200 frack tanks and 46 liquid waste disposal wells. More recently, it has been constructing facilities designed to treat and recycle used fracking fluids.

-- A sales base that is likely to double in 2013 (to more than $750 million), and grow roughly 10% organically in subsequent years.

However, the slate of deal-making has left Nuverra with a messy balance sheet. The company has more than $550 million in debt and will need to ensure that cash flow stays higher than interest payments. How is the company doing on that score? Not well.

A Lousy Financial Picture

Looking solely at reported financials, Nuverra barely generates enough gross profit to cover interest expense, let alone general operating expenses. Yet that view is misleading as the recent acquisitions were still in the process of being integrated, generating a short-term spike in expenses. Moreover, Nuverra has roughly $125 million in annual depreciation expense, so EBITDA is much firmer than those above-noted operating profits would suggest.

Looking ahead to the current and future quarters of 2013, results should be much better.

Roughly speaking, look for:

-- Sales of around $200 million to $210 million in the June, September and December quarters
-- Quarterly gross profits in the $40 million to $50 million range
-- Operating profits in the $15 million to $20 million range
-- EBITDA in the $45 million to $55 million range

That should be solidly higher than the $12 million to $13 million in quarterly interest expense and leaves ample room for cash to build, even after accounting for capital spending plans.

It's hard to overstate the importance of more robust quarterly results to help resuscitate this flagging stock. Investors have grown rightly concerned that high levels of debt load and weak cash flow are a recipe for trouble. The task for management is to stick to its current guidance and deliver the quarterly trends outlined above.

Once the debt service concerns begin to abate, perhaps as soon as Nuverra's early August earnings release, investors can again focus on just how inexpensive this stock has become. As investors digest the upcoming quarterly results, they will start to focus on the rest of 2013, as well as projected 2014 results.

And as noted earlier, sales should rise around 10% on an organic basis in 2014, which should yield solid operating leverage. EBITDA appears on track to rise from around $190 million this year to around $280 million next year. This company's stock market value of $811 million is less than three times that projected 2014 EBITDA run rate.

I ultimately see shares rising from a recent $3.14 to $5, representing 59% upside. That price implies a forward EBITDA multiple of just 5.5. It will likely take a year or more for investors to fully trust the EBITDA trends in this business model, so in the near term, look for a move up to $4, representing a more modest 27% near-term price appreciation potential.

Recommended Trade Setup:

-- Buy NES at $3.60 or less
-- Set stop-loss at $2.75
-- Set initial price target at $4 for a potential 11% gain in three months

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