ARIS Water Solutions, Inc. (ARIS)

As we noted in our brief missive last week, A Penchant for Pain: A Search for Big Returns in Small Packages, we cannot recall finding more interesting stocks than we do today in small caps. Last Friday, we highlighted OSG Ship Holding Group, Inc. which we felt might offer highly asymmetrical risk and reward. In today’s piece, we are highlighting ARIS Water Solutions. KCR hopes you find the one-page summary below and the subsequent 12 pages of detail thought-provoking.

On Monday, KCR’s rankings across Large, Small & Mid, and Microcap will be updated with the recently released fundamental data from Q1 earnings releases.

Summary

Aris Water Solutions, Inc. (ARIS) provides full-cycle water handling and recycling solutions in the Permian Basin for some of the world’s biggest hydraulic fracturing, or fracking, energy companies. Sales to three oil giants comprised 62% of ARIS’ 2023 revenue. By itself, ConocoPhillips accounted for 33% of ARIS’ 2023 sales.^[i] ConocoPhillips is likewise a major shareholder in ARIS; it owns a 22% stake in the company.

Fracking requires huge and rapidly increasing quantities of water sourced from groundwater wells or aquifers. For every barrel of oil produced in the Permian Basin, about four barrels of this “produced water” comes out of the ground along with it.^[ii] After use, the water must be cleaned and recycled before redelivery back to customers for their reuse. This cleaning process is a core part of Aris’ business. ARIS also disposes of produced water that is not recyclable in saltwater disposal wells.

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To handle the water produced by customers, ARIS has created a huge network of water-gathering pipelines (745 miles as of December 31, 2023) and recycling facilities in the Permian Basin. Importantly, ARIS’ customers have little interest in wasting capital to build their own infrastructure that would perform the same function as ARIS’ network, so ARIS’ customers should be considered long-term customers.

Why We are Bullish on ARIS:

• ARIS sees “greater demand for water infrastructure in the Northern Delaware Basin [a key segment of the Permian Basin] than there are existing assets, and [they] have the opportunity to participate in further growth at attractive rates of return.”^[iii]
• ARIS’ future revenue and cash flows are highly predictable. About 84% of its 2023 revenue in its largest business, Water Handling, stemmed from long-term contracts.

• ARIS trades at only a 7.2x multiple of enterprise value (EV)-to-2023 adjusted EBITDA, about four multiple points below the overall stock market. A two multiple point improvement would cause ARIS’ share price to increase to more than $20.
• ARIS’ strong growth profile is paired with robust cash flows; the company should generate $45 to $65 million in free cash flow in 2024.
• Much of this free cash flow will be devoted to share repurchases.^[iv] Given its small float, an initiative to repurchase even $30 million of ARIS’ shares this year would cut its float by 8%.

What is the Bear Case?:

• If Permian Basin drilling were to slow markedly, or if oil drillers were to choose to build what would be mirror water infrastructure systems, ARIS would suffer.
• Neither scenario seems likely to us in a world defined by geopolitical turmoil and in which companies would make huge outlays for redundant capital stock.

Company Description

Aris Water Solutions, Inc. (ARIS) is a fast-growing company that provides full-cycle water handling and recycling solutions in the Permian Basin for some of the biggest energy companies in the world — more specifically, companies that engage in hydraulic fracturing, or fracking, to extract oil and natural gas from deep rock formations. In addition, ARIS is developing technologies to utilize this treated water in other industries and to extract high-value minerals from the treated water stream.

ARIS is in the enviable market position of supplying a service for which the demand exceeds the supply. Indeed, on ARIS’ 4Q 2023 investor conference call, ARIS Founder and Executive Chairman Bill Zartler said, “There is greater demand for water infrastructure in the Northern Delaware Basin than there are existing assets, and we have the opportunity to participate in further growth at attractive rates of return.”[v]

Hydraulic Fracturing (Fracking)

Fracking is used after a drilled oil or natural gas hole is completed. In the process, a high-pressure mixture of water, sand, and chemicals is injected into tight-rock shale formations as deep as 10,000 feet to create or restore small fractures in the configuration. The fluid cracks open the rock, releasing the oil trapped inside. When the oil gushes to the surface, some of the injected water and chemicals do as well, along with briny water that occurs naturally in the rock layers.

A fracking operation creates paths that increase the rate at which fluids can be produced from reservoir formations, in some cases by dramatic amounts. More than 1.7 million U.S. wells are fracked; they have produced more than 7 million barrels of oil and 600 trillion cubic feet of natural gas.[vi]

The rub in all this is that fracking requires huge quantities of water sourced from groundwater wells or aquifers. After use, the water must be cleaned and recycled before redelivery back to customers. This cleaning process is, of course, a core part of Aris’ business. ARIS also disposes produced water that is not recyclable in saltwater disposal wells.

For every barrel of oil produced in the Permian Basin, about four barrels of this “produced water” come out of the ground along with it.[vii] Located in the southwest part of the United States, the Permian Basin is the largest fracking region in the world.[viii] According to Emily Head, Senior Geologist at Enverus Intelligence Research, the Permian leads the U.S. in resource inventory, which can be profitable even at a WTI oil price of $50 per barrel.[ix]

According to a study by The New York Times, fracking a single well can use a remarkable 40 million gallons of water or more. In addition, fracking wells have increased their water usage by 700+% since 2011.[x] See Fig 1.

Phrased differently, the U.S. oil and gas industry produces over 24 billion barrels of water per year. The Permian Basin alone accounts for roughly a third of this total. Furthermore, the Permian produces about 5 billion more barrels of water annually than can currently be recycled.[xi] See Figure 2.

ARIS’ Assets

ARIS has created a huge network of water gathering pipelines and recycling facilities in the Permian Basin to address this issue. ARIS’ assets are primarily located in the Delaware and Midland sub-basins of the Permian Basin in New Mexico and in Culberson, Reeves, Midland, and Howard counties in Texas. About 550 miles of ARIS’ total 745 pipeline miles are large diameter (12” to 24”) pipelines.[xii] See Table 1 and Figure 3.

Beginning in the upper left corner of Figure 4, ARIS’ gathering system takes in produced water from its clients’ wells. This system acts as an important barrier to entry for potential competitors. Some of the water is treated and disposed of by ARIS (upper right part of the figure).

The balance of the water is recycled using ARIS’ technology and returned to the groundwater or used as a water source in the new wells of a customer. Given its operational history, ARIS has become a reliable supplier of recycled water to some of the largest energy companies in the world.

ARIS hopes to extract and profitably monetize high-value minerals from its recycled water output in time. Some commodities it may be able to isolate in that water stream are listed in Figure 5.

ARIS received a boost in this “value added” strategy in mid-December 2023 when the DOE gave the company a grant to continue to study the treatment and desalination of produced water as an irrigation source for non-consumptive agriculture. If successful, such a beneficial use of produced water would allow ARIS to diversify from clients in the oil and gas industry. ARIS is performing this study with Texas A&M’s AgriLife Center and New Mexico State University.[xiii]

Details of ARIS’ Operations

ARIS’ Produced Water Handling revenue stems from the volumes of produced water ARIS gathers from its customers. About 70% of that produced water is treated and disposed of by ARIS. The remainder, or about 30%, is treated further and recycled by ARIS. Revenue stemming from these additional processes is called Water Solutions revenue. Recycled water and groundwater produced from ARIS’ Water Solution segment are delivered to ARIS’ customers to support their well completion activities.

In 2023, about 450,000 barrels of produced water per day of the total 1.492 million barrels that ARIS gathered for customers was recycled and sold back to its customers. ARIS disposed of about 1.042 million barrels of the produced water gathered from its customers. See Table 2.

ARIS’ future revenue and cash flows should be considered quite predictable compared to most companies in the energy industry. About 84% of its 2023 revenue in its largest business, Water Handling, stemmed from long-term contracts. More specifically, Acreage Dedication Contracts, in which an ARIS customer dedicates all water produced from current and future wells it owns or operates in a certain region to ARIS’ system, have an average remaining length of nearly eight years. See Table 3. Furthermore, about 97% of ARIS’ Produced Handling volume in 4Q 2023 represented transactions covered under long-term, fee-based contracts.[xiv]

A risk for ARIS is that agreements with just a few customers comprise a very high proportion of ARIS’ revenue. Indeed, ARIS’ sales to ConocoPhillips, Chevron Corporation, and Mewbourne Oil Company, Inc. made up an aggregate 62% of its 2023 total revenue. By itself, ConocoPhillips accounted for 33% of ARIS’ 2023 sales.[xv]

ConocoPhillips is likewise a major shareholder in ARIS. According to marketscreener.com, the oil giant owns 12.9 million shares in ARIS, equivalent to a 22% stake in the company. ConocoPhillips’ significant relationship with ARIS as both a customer and an equity owner could suggest an appetite for an even larger ownership stake in ARIS over the long term — assuming ARIS continues to execute well in its operations.

Strong 2023 Operating and Financial Results

ARIS posted impressive gains in its operating metrics and financial results in 2023. Total water volumes handled rose 16%, and revenue grew at an even faster 22% pace. Furthermore, ARIS’ adjusted operating margin and adjusted EBITDA rose to $214 million and $175 million in 2023 from $181 million and $149 million, respectively, in 2022. ARIS’ adjusted operating margin was about $0.39 per barrel of water handled. See Table 4 in the Appendix.

Given the strong demand for its services and continued cost discipline, ARIS expects to achieve further gains in 2024. Indeed, ARIS’ adjusted operating margin per barrel should increase by about 10% to $0.42-$0.44 per barrel this year. Note that ARIS’ adjusted operating margin per barrel increased by $0.05 between 3Q 2022 and 4Q 2023. See Figure 6. In addition, the company’s adjusted EBITDA should reach $180 to $200 million in 2024 versus $175 million in 2023.[xvi]

Furthermore, and perhaps even more importantly, ARIS expects its capital expenditures to decline markedly from $85 million to $105 million in 2024 to $170 million in 2023. ARIS’ capital expenditures fell noticeably in 3Q 2023 and 4Q 2023. See Figure 7.

Lower capex and improving operating cash flow should allow the company to generate $45 to $65 million in free cash flow in 2024, up from $14 million in 2023. Management expects to utilize its 2024 free cash flow for share repurchases and a potential dividend increase.[xvii] A share buyback program could significantly impact ARIS’ share price as its float is only around 24 million shares (or about $360 million at ARIS’ current share price)[xviii]. An initiative to repurchase even $30 million of ARIS’ shares this year would eliminate about 8% of the company’s float.

ARIS’ annual dividend rate is $0.36 per share, which equates to a dividend yield of 2.4%, about twice the yield of a large cap Index. So, you have a rapidly growing company with a tremendous economic moat repurchasing shares and throwing off enough cash to pay double the dividend you receive as an owner of a large-cap index. See Table 4 in the Appendix.

Compelling Valuation

In Table 5, we present key valuation statistics for ARIS and compare them with the S&P 500 Index. If you are wondering why we are comparing a microcap stock with a large-cap index…That is the whole point we are trying to make. Our ranking tools are surfacing high-quality, high-growth stocks with long “economic runways” trading like value stocks or “melting ice cubes.” Hence the opportunity, in our view.

Stocks of growth companies early in their corporate lives typically trade based on multiples of cash flows more than earnings, and we believe this valuation framework is appropriate for ARIS. Notably, both methodologies imply that ARIS is significantly undervalued. We note the following specific points:

• Surprisingly, ARIS trades at an enterprise value (EV)-to-2023 adjusted EBITDA multiple of just 7.4x, about a 35% discount to the overall market’s ratio of about 11.7x. Given ARIS’ strong and predictable growth prospects, entrenched market position, and its transition to a significant free cash flowing entity, this EV-to-EBITDA discount to the stock market seems unwarranted.
• Every one-point increase in ARIS’ EV-to-EBITDA multiple would increase its equity capitalization by $180-$200 million, or more than $3.00 per ARIS share.
• Based on analysts’ consensus 2024 earnings projections of $1 per share[xix], ARIS trades at a P/E multiple of 14x. By comparison, the S&P 500 trades at more than 20x earnings. For all the reasons noted above, it is difficult to understand why ARIS shares should trade at a 30% valuation discount to the typical stock.

Investment Summary

ARIS is a uniquely positioned company: its water handling and recycling services seem likely to be in tremendous demand for the foreseeable future. In simple terms, the fracking process produces rapidly increasing quantities of water that must be disposed of or recycled. ARIS’ existing (and growing) infrastructure is an important part of the solution to this problem in the Permian Basin.

State governments understand the gravity of this environmental issue. For example, in December 2023, New Mexico environmental officials proposed a new regulatory framework for reusing produced water from oil and natural gas drilling.[xx] (New Mexico is one of the two states in which ARIS operates.) The state hopes that treating produced water for use in industrial applications will help stem the depletion of freshwater aquifers amid a drought. Hearings on the proposal could begin this spring.

This New Mexico initiative could become an element of ARIS’ plans to develop technologies to treat produced water for reuse in multiple industries, including agriculture (see pages 6-7). In addition, ARIS hopes to eventually be able to extract high-value minerals like lithium from fracking wastewater commercially.

ARIS’ close relationship with ConocoPhillips (both ARIS’ biggest customer and a very large shareholder), of course, entails some risk. However, we think this relationship should be considered more of a constructive partnership than a potential drawback. Indeed, the expenses (and headaches) that ConocoPhillips would incur to move away from ARIS’ gathering system by building its own network or contracting with another company to perform the same service seems too high relative to any benefit it would realize.

ARIS trades at unwarranted discounts to the S&P 500 on both EV-to-EBITDA and P/E multiples. Of the two valuation standards, we believe a cash flow measurement is more appropriate for a young growth company like ARIS. ARIS trades at about a 7.4x EV-to-2023 adjusted EBITDA multiple, more than four multiple turns below the overall stock market. If ARIS’ multiple can grow to cut this gap in half — in other words, attain an EV-to-EBITDA multiple of around 9.5x — ARIS’ share price would move above $20. In our view, such a move represents a realistic intermediate-term price target for ARIS.

Appendix