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Oil and Gas Equipment Industry Outlook: Pain to Prevail

Zacks Equity Research

Oilfield Equipment industry is vital for drilling activities, thus making the domain heavily dependent on oil prices and the spending levels by producers. Upstream companies are reliant on superior equipment supplies including production machinery, drilling products, pumps, valves, et al to reduce their break-even prices and apply technology advanced fracking methods.

During the slump, the oil explorers slashed their capex and delayed drilling projects, leading to a decline in demand for equipment providers. While the oil prices have certainly rebounded from hitting the multi-year lows, the situation has not translated into a rosier scenario for equipment suppliers due to various factors.

Notably, North America is the leading market for oilfield equipment, accounting for above 40% of the global market. However, infrastructural bottlenecks especially in North America’s hottest shale play, Permian Basin, is forcing producers to lower their spending capacities as well as output levels of late. Even Canada is suffering the scarcity of takeaway capability, inducing receding drilling activities. The pipeline pinch is certainly hurting equipment providers, who can’t cash in on the crude recovery. Cost inflation along with labor and equipment shortages are further worsening matters for equipment providers.

Industry Lags in Terms of Shareholders Returns

Looking at shareholder value over the past year, it is quite evident that the crude price recovery has not been able to provide a much-needed impetus to mechanical and equipment industry as the industry is lagging both the broader sector and the S&P 500 market.

Capital discipline by upstream players, dearth of labor and pipeline crisis have weighed on the industry in recent times, reflecting disappointing results for the firms.

One Year Price Performance

Evidently, the Zacks Oil and Gas- Mechanical and Equipment Industry, a 15-stock group within the broader Zacks Oil and Energy Sector, has underperformed both the S&P 500 index and its own sector over the past year. While the stocks in this industry have collectively gained 8.4%, the Zacks S&P 500 Composite and the Zacks Oil and Energy Sector have rallied 16.6% and 9.5%, respectively.

Oilfield Equipment Stocks Trading Pretty Expensive

One might get a good sense of the industry’s relative valuation, looking at its enterprise value-to-EBITDA ratio (EV/EBITDA), which is the most appropriate multiple for valuing the capital-intensive mechanical and equipment stocks, given their significant debt levels and high depreciation plus amortization expenses.

Despite the industry underperforming the S&P 500 scale, the valuation seems high. Currently, the industry has a trailing 12-month EV/EBITDA ratio of 27.33 at a significant premium as compared to the S&P 500’s EV/EBITDA ratio of 11.93.

Enterprise Value/EBITDA (TTM)

Comparing the group’s EV/EBITDA ratio with that of its broader sector also shows that the industry is much overvalued. The Zacks Oil and Energy Sector’s trailing 12-month EV/EBITDA ratio of 6.02 and the median level of 6.69 for the same period are way below the Zacks Oil and Gas – Mechanical and Equipment Industry’s respective ratios.

Enterprise Value/EBITDA (TTM)

Earnings Outlook Does Not Evoke Much Optimism

With crude prices bouncing back — indicative of a major influential factor to drive the mechanical and equipment industry — one might expect the industry to pick up the pace. However, an early revival is not likely amid a pipeline crunch and labor paucity.

What really matters to investors is whether this group has potential to perform better than the broader market in the quarters ahead. While the valuation analysis shows that there is plenty of room to run, one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a turnaround in the near term.

One reliable measure that can help investors understand the industry’s prospects of a solid price performance is the earnings outlook for its member companies. Empirical research shows that a company’s earnings guidance significantly influences its stock performance.

The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for it as well as the industry's aggregate stock market performance. The red line in the chart represents the Zacks Consensus Estimate for 2019 earnings while the light blue line represents the same for 2018.

Price and Consensus: Zacks Oil and Gas- Mechanical and Equipment Industry

Please note that the industry’s -$0.14 EPS estimate for 2018 is not the actual bottom-up dollar estimate for every company within the Zacks Mechanical and Equipment Industry but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the industry’s earnings per share for the current year but how this estimate has evolved recently.

This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.

Current Fiscal Year EPS Estimate Revisions

The chart above clearly shows that the current earnings estimates for 2018 are down 250% from the year-ago tally, indicating the analysts’ current pessimistic view of the industry’s earnings growth potential. While the consensus mark for earnings with regard to the Zacks Oil and Gas — Mechanical and Equipment industry of -$0.14 per share shows a huge year-over-year deterioration, the EPS estimate has nearly remained firm since July.

Zacks Industry Rank Indicates Insipid Prospects

The group’s Zacks Industry Rank is basically the average of the Zacks Rank of all-member stocks, reflecting underperformance in the near term.

The Zacks Mechanical and Equipment Industry currently carries a Zacks Industry Rank #195, placing it at the bottom 24% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

In fact, the bearish view can also be established by the rising debt levels of the mechanical and equipment companies, which have sharply increased since 2016.

Another important indication of a lukewarm future prospect is the net cash from operations, which has been dwindling since the past six years.

Bottom Line

Notably, Mechanical and Equipment industry has been grappling with contraction of activities and decreased spending. Pipeline woes and labor inadequacy have aggravated the predicament of equipment providers. Pipeline concerns are escalating and operators are resorting to slowdown in production, which is likely to affect the industry. With infrastructural log jams likely to take another year to get in place, the short-term prospects of the mechanical and equipment industry look challenging.

Hence, the industry might not be an appropriate choice for investment going forward due to prevalent headwinds. Poor price performance, stretched valuation and south bound earnings estimate revisions mirror bleak prospects of the industry. Below we provide four companies with a weak Zacks Rank #4 (Sell) or 5 (Strong Sell) that investors should avoid for now.

(You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.)

Profire Energy, Inc. (PFIE): Utah-based Profire Energy carries a Zacks Rank of 4. The consensus estimate for current-year EPS has been moved 30% south over the past 60 days.

Natural Gas Services Group, Inc. (NGS): Headquartered in Texas, Natural Gas Services is a Zacks #4 Ranked stock. The Zacks Consensus Estimate for 2018 EPS has been revised 63.3% downward over the past 60 days.

Ion Geophysical Corporation (IO): Texas-based Ion Geophysical is a Zacks #5 Ranked player. The Zacks Consensus Estimate for current-year bottom line per share has been lowered 431% over the past 60 days.

Matrix Service Company (MTRX): Domiciled in Oklahoma, Matrix Service has a Zacks Rank of 5. The Zacks Consensus Estimate for fiscal 2019 EPS has moved 99% down/south over the past 60 days.

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Zacks Investment Research