Archrock Inc (AROC) 2018 Q2 法說會逐字稿

Good morning. Welcome to the Archrock, Inc. Second Quarter 2018 Conference Call. Your host for this morning's call is Paul Burkhart, Vice President of Finance at Archrock. I'll now turn the call over to Mr. Burkhart. You may begin.

Thank you, Adrian. Good morning, everyone. With me today are Brad Childers, President and Chief Executive Officer of Archrock; and Randy Guba, Interim Chief Financial Officer of Archrock.

This morning, Archrock released its financial and operating results for the second quarter of 2018. If you have not received a copy, you can find the information on the company's website at www.archrock.com.

During today's call, Archrock, Inc. may be referred to as Archrock or AROC. I want to remind listeners that the news release issued today by Archrock, the company's prepared remarks on this conference call and the related question-and-answer session include forward-looking statements. These forward-looking statements include projections and expectations of the company's performance and represent the company's current beliefs. Various factors could cause results to differ materially from those projected in the forward-looking statements. Information concerning the risk factors, challenges and uncertainties that could cause actual results to differ materially from those in the forward-looking statements can be found in the company's press release as well as in Archrock's annual report on Form 10-K for the year ended December 31, 2017, and those set forth from time to time in Archrock's filings with the Securities and Exchange Commission, which are currently available at www.archrock.com. Except as required by law, the company expressly disclaims any intention or obligation to revise or update any forward-looking statements.

In addition, our discussion today will include reference to non-GAAP financial measures, including adjusted EBITDA, gross margin, gross margin percentage and cash available for dividend. For reconciliations of our non-GAAP financial measures to our GAAP financial results, please see today's press release and our Form 8-K furnished to the Securities and Exchange Commission.

I'll now turn the call over to Brad to discuss Archrock's second quarter results and to provide an update of our business.

Thank you, Paul. Good morning, everyone. I'm excited to share with you the progress we made in the second quarter, building on the strong results and momentum we delivered to start the year. Our focus for the second quarter remained on solid execution. This includes: increasing our operating horsepower base, tightly managing our operations and costs, providing excellent customer service and maintaining our backlog or contract compression orders at strong levels and optimal pricing.

This focus resulted in strong revenue and gross margin performance in our contract operations and aftermarket services businesses in the quarter. The outlook for the compression market and our business remains positive, both of which continue to benefit from realized and forecasted growth in U.S. natural gas production. This backdrop underpins Archrock's growth and profitability to date and will serve as a catalyst for continued strong results in the quarters to come.

Let's hit on a few of the highlights from the quarter. Second quarter adjusted EBITDA of $85 million exceeded expectations and was up $11 million or 14% compared to the same quarter last year. Contract operations revenue was up 9% year-over-year, while aftermarket services revenue was up 31% for the same period.

Both business segments delivered strong gross margins. Contract operations margin at 59% was within our guidance range and on par with the second quarter of 2017, while aftermarket services margin of 17% was up about 200 basis points from the second quarter of 2017.

We increased our operating horsepower for the fifth consecutive quarter. Over the past 12 months, we've grown our operating base by 236,000 horsepower, and we will continue growing as we deploy our sizable backlog.

In April, we closed the merger of Archrock and Archrock Partners, which initiated several positive changes. It simplified our structure, strengthened our financial platform and positioned Archrock well for our next leg of growth. The merger also accelerated our leverage improvement efforts, and we exited the quarter with a debt-to-EBITDA ratio of 4.9x.

And finally, consistent with our commitment to return capital to investors, we increased our dividend by 10% over the prior quarter.

Moving to our contract operations performance. Our second quarter 9% year-over-year revenue increase was driven by an increase in our operating horsepower and improved pricing dynamics. We grew our operating fleet by 40,000 horsepower during the quarter, predominantly in the Permian, the SCOOP/STACK, Marcellus, Bakken and Niobrara, all of these basins reflecting our diverse footprint. Our backlog of new business remained robust and at historic levels, providing us with good visibility well into 2019.

Improving utilization of our fleet and our customers' future growth expectations are being reflected in pricing. During the quarter, we booked new contract compression orders at strong rates and also pricing improvements across all horsepower ranges, including on our small horsepower units. Our strong position in the market enables us to selectively place assets in this field with strategic customers at prices that generate solid returns.

Looking at our expenses in the quarter, our cost per horsepower was relatively flat year-over-year. As I mentioned earlier, we remain laser focused on the prudent management of our expenses. Our operations teams worked hard to effectively execute on the start of the new units and maintain excellent customer service, all while delivering superior safety performance.

Moving to the aftermarket services segment. We delivered an exceptional second quarter. We're seeing strong activity in that business, which we attribute to a few factors. First, the total compression market is expanding, in line with natural gas production growth. Our aftermarket services customers are tapping into our parts and service offerings to maintain their expanding compressor fleets. In addition, aftermarket services customers are facing long lead times for new compressors, incentivizing them to search for alternative solutions, which includes refurbishing and reconfiguring their own owned compressors. And finally, many of our customers are addressing past deferred maintenance on their units and the outsourcing of this work also benefited our business in the quarter.

Turning to a review of our capital policy. We remain steadfast in the continued execution of our capital allocation plan, which seeks to balance 3 objectives: the first is to invest in capital-efficient, high-return assets that grow the business and meet our customer increasing needs; the second is to reduce our leverage with the goal to be below 4x in 2020; and third is to return capital to our shareholders in the form of quarterly dividends.

On our goal of strategically investing in the business, we're in a great position to capitalize on the growing demand for compression services. We're investing in large horsepower units to support stable midstream applications tied to natural gas production. The large horsepower segment remains a key focus for our business, representing about 2/3 of our operating horsepower today, and we expect this percentage to continue to grow over time.

On our goal of further reducing leverage, our solid financial performance further improved our leverage position to 4.9x at the end of the second quarter.

Lastly, on our goal of returning capital, we increased our dividend by 10% up to a new rate of $0.132 per quarter or $0.528 on the annual basis. Including this increase in our dividend, our coverage remains strong at 2.76x for the second quarter, allowing us to continue to self-fund our growth, while also offering an attractive level of cushion to our quarterly dividend. Looking forward, we reiterate our expectation to increase our dividend by 10% to 15% annually through the year 2020.

Earlier, I highlighted the recent completion of our merger transaction with our Archrock Partners. The completion of this transaction reflects our company's ability to remain nimble and proactive as we strive to maximize long-term value for our shareholders. This transaction is aligned with our capital policy in 2 ways: first, the transaction simplified our corporate structure and structurally lowered our cost of capital, resulting in improved returns for our capital investments; second, the transaction was deleveraging for our company and it accelerated the progress toward our goal of achieving leverage below 4x in 2020.

Turning to the market. The U.S. outlook for natural gas production remains robust. The EIA is forecasting an annual increase of 10% in 2018. Producers are focused on developing the United States' vast natural resources. An increasing amount of the natural gas produced in the U.S. is associated with crude oil production. Archrock has an extensive presence in plays driven by associated gas, including the Permian, SCOOP/STACK, the Eagle Ford, the Bakken and the Niobrara.

Natural gas demand is growing in both domestic and foreign markets. On the domestic front, demand we primarily supported by significant growth in power generation as the U.S. retires coal plants and switches to natural gas fired plants. While we expect the U.S. to continue to face attractive demand in the domestic market, demand outside the U.S. is supporting much of the production growth and is expected to consume even more of the United States' abundant supply of gas. By 2022, the U.S. is forecasted to become the world's second-largest exporter of natural gas.

Underpinning this level of exports is the growing base of LNG export facilities. To put it in perspective, the EIA forecasts that 2018 natural gas production will average about 81 billion cubic feet a day, compared to 74 billion cubic feet a day in 2017. LNG terminals are currently providing export capacity for over 3 billion cubic feet a day and are forecasted to provide an additional 7 billion cubic feet a day of export capacity by 2020. In addition, natural gas exports to Mexico are also expected to grow.

Now before I close and with our simplification now completed, I'd like to take a few minutes to discuss Archrock's market position, specifically, who we are and where we fit in the broader energy value chain. Simply stated, we're an energy infrastructure company focused on compression services, primarily supporting midstream applications. Four key characteristics that capture Archrock and our value proposition to our investors. First, we generate relatively stable cash flows, driven by a compression business to provide mission-critical equipment and services for the production and transportation of natural gas. And the demand for our services is increasing, driven by significant growth in natural gas production. Further, the stability in our business is supported by the geographic diversity of our operating footprints as we service customer demand in all major U.S. shale plays.

The second defining characteristic of Archrock is our focus on servicing the midstream segment. As I mentioned earlier, about 2/3 of our fleet is large horsepower, which is mostly used to support midstream applications primarily for natural gas gathering. This strategy aligns our business and its results most closely with the production of natural gas, establishing and supporting a relatively stable -- comparatively stable business model.

Third is our focus on multiyear fee-based contracts with a diverse portfolio of high-quality long-term customers. Our unit's average time on site is more than 3 years, demonstrating the stability and duration of our assets once they are operating for a customer. Further, we service many blue-chip customers and have a broad base of over 600 contract compression customers across the major U.S. plays. And our relationships are deep-rooted. Our top 10 customers have worked with us for an average of approximately 15 years.

Finally, as I discussed earlier, we are focused on returning capital to our investors and creating long-term value through disciplined investments and a growing dividend.

I believe this combination of attributes is highly attractive and uniquely positions us to profitably participate in the growing market and deliver value to our shareholders. We've accomplished a lot over the past several years and particularly over the last several quarters, and we're excited with how we're positioned and our path ahead. Now I'd like to turn the call over to Randy for a review of our financial results.

Thanks, Brad. I'll start with a summary of results for the second quarter of 2018 and then we'll cover guidance for the third quarter. Archrock delivered solid second quarter results. We generated adjusted EBITDA of $85 million for the second quarter, an increase of 14% year-over-year and 5% sequentially. Revenues were $227 million for the second quarter, up 15% compared to the second quarter of 2017 and 7% compared to the first quarter of 2018, driven by increased operating horsepower, price increases and robust aftermarket services top line growth.

Turning to our segments. In contract operations, revenue came in strong at $165 million in the second quarter, up 9% from the second quarter of 2017 and 3% from the first quarter of 2018. On a sequential basis, a little more than half of the top line growth in the quarter was driven by an increase in operating horsepower, with the balance of the growth due to a mix of rate increases and freight revenue. Gross margin percentage remained solid with second quarter margins of 59%, flat from a year ago and down slightly from the first quarter of 2018 and within our guidance range. The slight decline sequentially is due to more maintenance activity on our units, but we are pleased overall with the field's performance of managing cost pressure and labor in parts.

In aftermarket services, revenues of $61 million for the second quarter are up 31% from the second quarter of 2017 and 21% compared to the first quarter of 2018. This is the strongest quarter of aftermarket services revenue since the fourth quarter of 2014. Gross margin percentage of 17% remained solid in the quarter, up 200 basis points from the second quarter of 2017 and flat compared to the first quarter of 2018.

SG&A expenses were $27 million in the second quarter, down 3% compared to the first quarter levels. Second quarter SG&A benefited from lower compensation and bad debt expense. In the second quarter, Archrock's growth capital expenditures totaled $45 million, which combined with the first quarter growth CapEx of $54 million, resulted in a first half growth CapEx of $99 million. We remain on track with our full year growth CapEx budget of $230 million to $250 million as we continue to invest in new equipment to meet strong customer demand.

Maintenance CapEx for the quarter was $13 million, about 18% higher than the first quarter levels. Debt on a consolidated basis at the end of the second quarter was $1.5 billion, up $32 million from the first quarter levels. The increase in consolidated debt in the second quarter was primarily due to the continued investment in the fleet.

As Brad noted, we made strides in further reducing leverage with second quarter leverage of 4.9x as compared to 5.2x at the end of 2017, figured on a pro forma basis to the merger. Our available but undrawn capacity on Archrock's revolving credit facility at the end of the second quarter totaled $288 million, while consolidated cash stood at $4 million.

Archrock's second quarter dividend was $0.132 per share, a 10% increase from the first quarter. The second quarter dividend amount of $17 million will be paid on August 14 to all shareholders of record on August 7. Archrock's cash available for dividend coverage was strong at 2.76x for the second quarter.

Turning now to an outlook for the third quarter of 2018. In contract operations, we expect revenue of $166 million to $170 million as we continue to benefit from increasing operating horsepower combined with the price increases we implemented at the start of the year. We expect third quarter gross margin to be in the range of 58% to 60%.

For AMS, we expect revenue to total $50 million to $60 million, with gross margin between 16% and 18%. On SG&A expenses, we expect $28 million to $29 million for third quarter. Depreciation and amortization expense is expected to be in the mid-$40 million range, with interest expense in the mid-$20 million range.

For full year 2018, we are reiterating our total CapEx guidance of $300 million to $320 million. Maintenance capital spending for 2018 is expected to be $45 million to $50 million, up $5 million from our prior guidance. It does not affect our full year total CapEx guidance. Newbuild capital expenditures are expected to be $230 million to $250 million for the full year of 2018, unchanged from prior guidance as we continue to invest in high-demand large-horsepower units. We also expect the sale of equipment to raise roughly $30 million in proceeds for 2018, which supports our investment in new equipment.

Before I conclude, I want to remind everybody that beginning in the second quarter of 2018, we revised our adjusted EBITDA calculation to exclude noncash stock-based compensation. This change will put us more in line with how our peers report. And with that, we'd like to now open up the lines for questions. Operator?

(Operator Instructions) And our first question comes from Tom Curran from B. Riley.

I guess, I want to start, Brad, for contract operations, could you tell us for the larger horsepower class, where is pricing at this point relative to where it peaked in the last up cycle? And then do you see the potential for it to go on to actually set a new record high over the balance of this up cycle?

Sure. So the answer is relative to the peak of the prior cycle on our largest horsepower, pricing on a spot basis is back to those prior peak levels and maybe an increment more. And we do see that pricing is likely to have more legs in future periods for us as we absorb costs. Because what we're experiencing in marketplace today with increasing labor, cost pressures, increasing parts price pressures as our vendors are also getting into the mode of increasing their pricing, we do see that there's going to be both a need and an opportunity for us to think about how we share that with our customers through pricing in the future. But from a spot price basis, we're back to historic levels on large horsepower.

And that -- you touched on inflationary pressures and the costs you're grappling with, which I think provides a nice segue to margin. Could you just provide some color around the key swing variables in your gross margin expectation and moving from 2Q to 3Q?

Yes. So we gave guidance on what we thought revenue and margins would look like. So behind that guidance that Randy already gave, what we're seeing in the field right now is inflationary pressure driven primarily by labor, some by parts and some by lube oil. Those are the categories where we see the pressure currently, and we expect it to continue with labor at historically low unemployment rates, certainly across the country but especially in the oilfield, in parts of the areas where we all operate. But in the face of this cost pressure, I think it's important to just note, we have strong routines and initiatives in place to help mitigate. And that includes solid preventative maintenance practices in the field, a very disciplined system to manage service quality, balanced with the activity and maintain a high uptime for our customers but with efficient maintenance by us. So the thing I'd point out is that I'm actually really pleased with the current level of profitability at which we get to grow the business. And longer term, we're targeting maintaining this business in the 60% plus or minus level of gross margin. And we're on the lower side of that right now as we're absorbing a lot of inflationary cost pressures, experiencing rapid growth and putting a lot of horsepower to work. But trying to keep this business in that range seems like a really key objective for us.

So no change in expectation about your ability over time to hit that trend gross margin level of 60% then?

Yes. Working on that 60% plus or minus over -- on a quarter-over-quarter basis and year-over-year basis is where we're going to push this business.

Okay. Great. And then last one from me. If we were to see AMS -- nicely surprised relative to your guidance ranges for both revenue and gross margin in 2Q. If we were to see it deliver upside again in 3Q, of the 3 main drivers you highlighted, which would you expect to be the most likely source of that upside?

Well, we've seen growth that's been fairly ratable or fairly even across the main buckets of AMS activity, the main categories of AMS activity. So, they include an increase year-over-year in parts to support our customers' units as well as field maintenance activities and overhauls. So what we've seen is the spikiest growth in parts but the other 2 categories have also been at a comparable level of growth even if parts is leading it.

And our next question comes from John Watson from Simmons & Company.

A quick follow-up on AMS. I think we talked about last quarter, a change in how revenue would be recognized for that segment. Did that contribute to the really strong quarter in 2Q?

Incrementally it did, but it was not the only driver. The real driver of this is increased activity in AMS as our customers are just requiring more support and more work on customer-owned units. So it was an incremental contributor but the biggest driver was activity based.

Sure. Okay. And then secondly, we've talked about Gas Lift, and that being an incremental source of demand for you guys, especially with all the associated gas coming out of places like the Permian. When you're deploying new Gas Lift units, do you have any feel if it's because of a switch from other forms of artificial lift, or if it's just new wells coming online where customers have used gas lifts in the past and they're continuing to use it?

Thanks, John. I don't have a great breakout on that. I would tell you that based on what we see and the locations that include a lot of new installations that it's a lot of new Gas Lift being added. But I do know that several customers have switched away from alternative Gas Lift methods, ESP is pumpless, in favor of compression. But I don't have a good capture on the volume of that.

Right. Okay. And then lastly, the guidance for 3Q, is there any expectation that activity in the Permian potentially stalling that, that might affect your business, is that baked in into the guidance for the third quarter?

Sure. So the direct answer is yes, anything that we would have seen is baked into the guidance. But let me address the underlying point, and that is that we don't see the same risk of capacity constraints in our high-quality customer base. We believe that in our discussions with our customers that our customer base largely has access to committed capacity going forward. So we just don't see the risk materializing for us the way maybe some have asked or thought about it for other energy -- for sector participants. The other thing I'd point out is that even if that's the case, we really think that any flattening out or limitation on capacity is likely to be transitory. And longer term, the outlook for the play remains robust as capacity comes in. So I -- we just don't see it the same way. And part of this is just reinforcement of our market position because we're leveraged to production and with a very diverse high-quality customer base.

(Operator Instructions) And our next question comes from Daniel Burke from Johnson Rice.

So it looks like the growth CapEx spend this year is just a touch back weighted. And can we assume the same is the case for the newbuilds you're delivering to the field this year?

Yes. We do expect, based upon the scheduling that we have, that the CapEx spend is heavier in the back half and the start activity also is expected to be heavier in the back half and moving into 2019. That's a fair point, Daniel. The main thing I think I -- that, that expresses is just the market remains really strong and so we do expect to see good deployments against the record backlog going through the next 2 and certainly 3 quarters.

Okay. And then Brad, I don't know to what extent lead times for your primary components remain extended at this point, but I would imagine you're already internally thinking about a growth CapEx plan for 2019. Is there anything you can share at this point about maybe the scale of that program relative to the scale of the program you're sponsoring this year?

Sure. The market remains strong and the pressure for our customers to grow and to deploy equipment remains at high levels. So although it's too early to really have capital talks with our customers, that process will begin now as the budget season is beginning. And we're not giving any guidance on 2019. I will say that if 2019 remains as opportunity rich as we've experienced -- if 2019's as opportunity rich as we've experienced in 2018, then the level of magnitude and the opportunity for capital deployment will remain at a comparable level.

Okay. Great. And then maybe just one last one. Since we talked about kind of longer-dated targeting or management of margins on the NACO side, when we look at the aftermarket business, I guess, historically in the last up cycle challenges, we were staring at margins that embedded in international business as well but does -- and mix matters as well, parts versus services, but is there ability to get that business closer to a 20% margin over time with further top line growth?

In a long term, 20% is a great target for us to push that business back toward -- it is what we've achieved historically, and we'd like to see it move back. The offsetting pressure on that is that the parts business is an incrementally lower margin business in the overall mix, and we're seeing that grow as well. So as long as we can generate good profit on that very low overhead, the parts business -- we'll accept those gross margin dollars even if it appears dilutive to the overall AMS business margin.

Okay. And so getting to that type of 20% target is contingent upon seeing a level of service activity that mirrors what you saw in the past cycle?

Yes.

Is that then the conclusion? Okay. How far away are we from that, when we see a $60 million type top line figure?

Yes. We will aim to deliver a higher top line figure.

We have no further questions at this time. Now I'll turn the call back over to Brad.

Thank you, everyone, for participating in our second quarter earnings call. Our focus at Archrock remains on strong execution as we move forward with -- in this fast growing market. We are strategically deploying capital in the high-quality assets with attractive returns, and our operations teams are working to efficiently and safely put our large horsepower to work. Our team is world-class and to our employees throughout Archrock, I am grateful for your contributions and your ongoing success.

Before I conclude, I would like to take a minute and thank Randy Guba for serving as our interim CFO. Randy has done a fantastic job shepherding the organization through this transition, and we're grateful for his services. In a couple of weeks, Doug Aron will join Archrock as our new Chief Financial Officer, and we look forward to welcoming Doug on to the team at that time. I also look forward to updating you during our third quarter call. Thanks, everyone.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.