Innovex International Inc (INVX) 2022 Q1 法說會逐字稿

Good day, and thank you for standing by. Welcome to the Dril-Quip First Quarter 2022 Fireside Chat.

I would now like to hand the conference over to your speaker today, Mr. Tom Curran from Seaport Research Partners. Sir, please go ahead.

Thank you. Greetings everyone. Welcome to Dril-Quip's first quarter fireside chat. I am Tom Curran, the senior energy technology analyst at Seaport Research Partners. And joining me this morning from management are CEO, Jeff Bird; and CFO, Kyle McClure, I'm going to pass the mic to Jeff, who will provide a brief summary and touch on some highlights of the results released last night, and then we'll turn to what will be a deep and expansive discussion. Jeff?

Thanks, Tom, and thanks for hosting the fireside chat this morning. Looking forward to a robust conversation. Before I jump in, I'd like to say thanks to the global team for continuing to execute in the quarter. Specifically, our new business leaders, our new product line business leaders, Don, Bruce and Steve, as they started to lead their respective teams and moving from what's largely been a functional organization since the founding of the company to a more product-oriented company.

We continue to be very pleased with the opportunities we see as a result of this reorganization. We believe in the second half of the year, we'll start to see specific improvements in our ability to service our customers and also an improvement in our cost position as we go into the second half of the year and really, we exited 2022 and head into 2023. So just thanks to those 3 people and their respective teams as well.

Looking at the quarter, Q1 was really middle of the fairway quarter with what we had talked about a couple of months ago. Bookings were in line, continued strong bookings, definitely larger than what we saw in the middle of the pandemic. So pleased with that.

Revenue and EBITDA, met expectations. Free cash flow was a headwind, but we always knew that was going to be a headwind going into the quarter. We've got some onetime payments that always happen in the first quarter of the year. So that's always a challenge. We'll see that bouncing back, I think, later in the year. if you step back and look geopolitically, obviously, a challenging environment for a lot of people in Ukraine and Russia right now.

So as we look at the resulting inflation, story continues to be an -- inflation continues to be an area of keen focus for us and our business leaders as we try to match price increases with inbound inflation. And it's really hand-to-hand combat right now if we think about inflation and what we're seeing there. And despite the inflation headwinds, though, the environment overall is very constructive for increased spending. So we're still very optimistic about the order intake over the balance of the year and look forward to a more robust discussion with you, Tom. Thanks.

Great. Let's start with a few questions on this quarter's results and then pivot to a market update on other topics. So the top line came in at $83 million, as you said, essentially straight down the fairway. But the company realized the gross margin on that revenue of just 23%, which was below expectations.

The first question on that margin is on mix. Does the margin shortfall partly reflect that you did hit the top line target, but perhaps with a less favorable mix than anticipated?

Yes. Tom, it's Kyle. All of it can be drummed up to mix in the quarter. Coming out of Q4, we had a 21.5% gross margin, 23% in Q1. We would expect, going forward, the orders mix has much improved versus what we saw coming out of Q4, which had a really heavy lean towards pipe and fabrication. We saw that play out in Q1. We would think for the rest of the year, if we look at the orders mix going into Q2 and beyond, you're going to see a much better mix of SPS, wellheads, et cetera. And so we would continue to see gross margins get up into the mid- to high 20s in the back half of the year.

Got it. And so if it was all entirely on the mix side, looking at the cost of sales it sounds as if you were able to control and manage the challenges you've been confronting there at least in 1Q. In general, both over 1Q and through to the present. How is Dril-Quip managing inflationary pressures and just the supply chain and logistics challenges that are afflicting the whole industrial world?

Yes. So as Jeff mentioned, sort of hand-to-hand combat to some degree on inflation. We do have MSA where we can ratchet up based upon certain indexes. It's what I call a fluid situation. We are sort of day-to-day thinking about this, whether it's price increases across the board based upon list and certain of our business units or if it's just we're dealing with a customer-by-customer situation.

In addition to supply chain issues, we are certainly looking at additional productivity that we've announced in the prior earnings call back in February. So it is sort of a very fluid situation. Inflation continues to be -- depending on the business we're looking at, whether it's downhole tools or the subsea business, the sort of 2 different interfaces happening there. Downhole tools a little bit more real time in terms of what they can do subsea a little bit longer-term contracts, but the MSA should continue to help us.

But it is a real-time situation that we are doing our best just kind of manage in Q1. I think we did a really good job of that. As the year goes on, we're probably going to continue to see inflationary pressures and we'll continue to pull price as we can, and we'll continue to pull cost as we need to.

Got it. So 2 levers there that do you expect to be able to continue to use. On the bright side, for expenses, SG&A did come in 12% lower than consensus. Engineering and product development expense was right in line. How much of this year's target for productivity and efficiency savings did you harvest in 1Q? And sequentially, how do you expect the remainder to be achieved over the rest of 2022?

Yes. So we talked about the $15 million. Back in February, we've got about $3 million of that in the quarter. We expect to pick up another $5 million of that in Q2 on an annualized basis. And the remaining piece of that is going to be largely supply chain savings and operational efficiency improvements and productivity.

So I think as we see the year play out, I would probably target around maybe $5 million to $7 million that will pick up this year. It will be split though between cost of goods and G&A. G&A will continue to be focused for the organization. I think we're sort of laser-focused on that, especially as revenues continue to come back, we want to make sure we get as much of that fall through of the incremental revenue. As you know, we saw when things came down, how quickly decremental margins went with it. As revenues come back, we expect the incremental margins probably to overshoot what our expectations are here internally. But as we continue to pull those 2 levers, whether it's cost or price, we're keenly focused on both right now.

Got it. Turning to bookings. Let's zero in on product orders. Inbound orders for products totaled $63 million, which was within that new higher stepped up guidance range of $60 million to $80 million. But closer to the floor, you've just reaffirmed annual bookings guidance for growth of 20% this year and clearly continue to think that forecast has potential variance, it's skewed to the upside. So did you just experience some standard slippage in 1Q in which the timing of certain orders or a large award simply slid out a few months? And what does your impact full year 2022 bookings guidance imply for a new expected quarterly product orders range, both for 2Q and then what we should see sequentially over the second half?

Yes. So still very optimistic about the 20% year-on-year and believe that's well within hand. I think if we looked at it, Tom, on the way into the pandemic, we had more misses to the downside. I think as we exit the pandemic, what we're starting to see now is more opportunities to the upside.

So if you look at specifically Q1, the $63 million number there, as I've said before, it doesn't take much to move the needle on that. A tree order of 3 trees is $15 million and suddenly moves that to the upside and that 1 order as an example. So I think we'll see some lumpiness quarter-to-quarter depending on how those orders play out. But we would expect to see continued increases Q1, Q2 and throughout the balance of the year.

What we're really seeing right now in the market is 2 things. One, a lot of the conversations that we didn't think were going to happen until Q3 and Q4 are being pulled into the first half of the year. So we're optimistic about that. And furthermore, there are some items that candidly were cap 2 items, lower probability items this year that we just didn't expect to have real meaningful conversations or see orders for those this year. And those drop-in orders are starting to materialize now in Q2. So we're very optimistic about the 20% and believe there's more likely than not upside to that number.

Yes.

Got it. You just mentioned how much of a swing factor subsea trees can be from 1 quarter to the next. I know that you are anticipating a big year for subsea trees with 17 to 19 orders foreseen. And the indicated timing of those awards was underpinned your original expectation for how product orders would fall by quarter, which was at -- initially 2022 is expected to have a barbell shape with a bigger 1Q and then 4Q. How many trees did you book in 1Q? And it's the latest visibility on how the remaining order should be distributed?

Yes. I believe there were about 3 trees booked in 1Q. And the -- we see a chunkier level of that in really Q2 and Q3 right now. And that's really on the back of 2 things, really, to be honest. One is concerns from a supply chain standpoint from a number of these customers and also just the underlying economics that you had as well. But I believe the number was 3 trees in Q1.

And then similar question when it comes to the latest multiyear Petrobras awards you've inked. What was the 1Q order contribution? And then what level of call-off orders should those awards yield this year?

Yes. So we had -- so a total of 87 development and exploration wellheads under that MSA, about 30% of those have already been placed in terms of purchase orders, and we're in the bookings in Q1. That's well ahead of the schedule that we would have expected to see. And candidly, we now expect that probably sometime first half of '23, there will be another tender where we'll see another renewal, if you will, or a flip over, if you will, of that MSA. So pretty optimistic that's a significant improvement to what we would have expected. Those 30 well heads will really deliver starting September this year and probably through the first 3 quarters of next year.

And just broadly, Jeff, you just touch on this to a degree, but it's worth, I think, revisiting and delving into a bit more. But what sources are fueling your confidence that there is this positive bias to your 2022 bookings guidance? Is it a combination of customer conversations? What you're seeing in certain geographic regions. You've already touched on both the acceleration you're seeing for certain projects and the rising probability of materialization for others. Just what all is behind your conviction that any surprises are likely to be upside now?

Yes. So just a couple of things here. It's a little bit of everything that you said. We -- first, myself and the business leaders have been having a number of what I'd characterize as a very fruitful customer discussions. And almost every one of those discussions that we have with customers is all about pulling things in and doing things earlier than we had originally expected. And some of that's pricing, but some of that is also, hey, we're worried about supply chains.

We want to get the early lead items out there and get that done. So that's 1 also a little bit more anecdotal probably. The other thing is we have a very robust process where every 2 weeks, we have what we call a war board meeting with each of our regional leaders, with each of our product leaders. We go through literally order by order with an update on what was the last conversation. The customer said it was going to be Q4, now it's Q2.

So those conversations are literally every 2 weeks. The customer conversations with myself and the business leaders are really once every quarter or so. So as an example, I did a European trip in Q1, got a lot of positive feedback from that. In Q2, we'll be doing an Asia tour and expect to get some positive comment there. The one area that's kind of weak right now that we see at least is Asia Pac. Europe seems strong. Brazil is very strong. Gulf of Mexico is picking up. LATAM is picking up. It's really Asia Pac, so I'll be interested to see the feedback we get when we're on that tour out there.

I know you just went through Europe, and that was a very encouraging trip. It sounds like moving on to the pillars of your growth strategy, you made impressive headway with the collaboration approach since you first introduced a concept a few years ago. How have the collaborations with Proserv and OneSubsea respectively performed so far. And what portion of 2020 bookings are you counting on them to deliver?

Yes. So let me divided it between Proserv and OneSubsea. If I think about Proserv, those are obviously the controls that go on the trees that we sell. We'll book, as you said, 17 to 19 trees this year. About half of the trees that we will book will have Proserv controls on them. So that's a very strong statement, I think, about that collaboration agreement. In some cases, we're bringing Proserv to the table.

But look, in some cases, Proserv is bringing us to the table as well. So we really view that as a mutually beneficial relationship. So about half of those trees -- if you think about the OneSubsea collaboration agreement, that really gives us exposure to EPCI and development wells. The challenge is that deal quips portion of the overall EPCI contract is pretty small when you look at the total scope there. So we'll probably won't target anything specific around that OneSubsea collaboration agreement. Right now -- I won't talk about it right now. We'll probably talk about those things as they happen because to be perfectly honest, it's all about 1 subsea winning. We're a small portion of that overall EPCI.

The other thing I'd say is that we talk pretty openly on the legacy side, we talk pretty openly about Proserv and OneSubsea. There's a number of other, what I would characterize as quiet collaboration agreements that are happening at the same time, specifically around the wellheads. And we believe those will start to materialize last 3 quarters of this year as well. We're careful about putting a target out there just because of the relationship with OneSubsea and how dependent we are on their win, to be honest.

Got it. The newest collaboration that Dril-Quip has entered with Aker Solutions was actually formed for the new energy side, specifically CCUS, carbon capture utilization and storage. Through that collaboration, you'll be participating in the Aker led consortium that's been selected as one of 2 co-finalists asked to provide a fee package for the Northern Endurance partnerships, East Coast cluster and U.K. North Sea. Between that opportunity and my understanding of some other prospects you have traction with it, it seems as if 2022 could be a breakthrough year for Dril-Quip's emerging role in CCUS. What's the estimated offshore CCUS TAM for Dril-Quip? And how much of that do you aim or aspire to eventually capture?

Yes. So if we think about -- first, let me talk a little bit about the agreement and then I'll give you a side -- a market size and kind of what we think about. Obviously, very pleased with the Aker Solutions collaboration agreement. And to be honest, the minute we announced that it was somewhat surprising. We've got 2 or 3 other large inbound calls asked about that collaboration agreement and asking us to participate in a joint bid with Aker Solutions.

The other thing that was somewhat surprising we had some other OFS companies that called us and said, "Hey, we really believe we can work with you as well in a collaboration agreement around that same segment." So we're very, very, very pleased with that. If you think about the size of the market, and it's all about a slow ramp-up to this number. But by 2030, it's easy to see where you'd have 200 -- annually 200 CCUS wells and then ramping from there.

If you look at what is Aker share and if you just assume that Aker subsea tree share is similar in CCUS, you'd be around a 15% to 20% share, could be higher than that, it could be lower than that. Could be a little higher, to be honest, just because you think about their European influence and where CCUS is likely to take off first.

But just think about it as 15% of those 200 by 2030. We've started the feed. The feed started 2 weeks ago. We've ring-fenced the resources around that. I joke a little bit, our director of energy transition has now gone from a team of 1 to a growing team as we jointly work on that fee with Aker Solutions. We probably won't see orders from that, Tom, until 2023 because the feed is going to take some time this year. The bid will happen later this year, and I don't think the award will happen until next year. So you'll likely see this in terms of bookings in 2023 and real revenue starting in probably late '23, '24 time frame.

Okay. So we'll stay tuned for that, but that was a very helpful overview. And I can't believe I actually used to capture that, that bad pun was not intended in terms of future share win. You've previously spoken to focal areas for additional collaborations Liner Hangers, the VXTe, just maybe revisit those and provide an update on where you're at in pursuing them and perhaps a distinction between big theme -- a potential big theme additional collaborations? And then what you just clarified for us, which is these quieter emerging collaborations around the wellhead, just should we think of those as 2 different categories or perhaps just an overall update on how collaboration should evolve from here?

Yes. So let me go through the 3 segments, and I'll kind of explain the quiet collaboration agreement versus more of a what I'd characterize as a headline collaboration agreement. So if you start with our downhole tool business, we do a lot of work, a lot of work with all the major service providers around the world. So that would include your normal cast of characters in a Schlumberger and Halliburton and Weatherford and a Baker. And depending on the region of the world, we just have a better kit and better availability than they might have internally. So there's a number of cases where in all -- with all of those major service providers, we're providing Liner Hangers today.

It's not a head of line collaboration agreement. It's more country-by-country, region-by-region, we're working with them. And candidly, those are very successful, and we see those growing right now. So that's really that downhole tool business. Where we're starting to, say, approach how we think about it in subsea wellheads and by approach, I mean, on the OneSubsea side, we literally sit down and jointly have a review of all the open tenders and how we're approaching it. We're starting to get down that path as well with Liner Hanger. So -- and we're expecting that growth in Liner Hangers to come this year as a result of that.

If I think about other areas for collaboration outside of that, the most likely right now is really around our connector. And if you think about that, there's some major pipe providers that don't have a connector. And obviously, we buy and pass through the pipe. So there's really some opportunities there, and we're constantly looking at those opportunities. It likely wouldn't be a global collaboration agreement. It would likely be a regional-specific depending on the pipe supplier collaboration agreement, but we're constantly looking at that.

As it relates to VXTe, I don't think you'll see a collaboration agreement specifically on VXTe until we likely get that first installation. And unfortunately, we had expected to have an installation in Q1 of this year. That was a dry hole. So we're kind of back to square one on that first installation. Realistically, now, we're probably looking at the middle of next year at the earliest for that first installation.

So we still continue to have conversations with some of the majors that are very excited about it. Still continue to have conversations with other tree providers that are very excited about it. But really step 1 in getting those people to move in a more meaningful way is really about that first installation. So I suspect on a collaboration agreement there, you wouldn't see one until probably late '23 after a first installation.

All right. So that next milestone will look for this progress towards a potential collaboration we'll be getting the first tree wet, right?

That's exactly right, yes.

Turning to another pillar of your strategic growth plan, downhole tools. I know that's one of your highest margin product lines, and it seems, therefore, given where gross margin came in on a consolidated basis in 1Q that downhole tools might have had a bit of a light start to the year in 1Q relative to your expectations for the full year. Do you still see double-digit growth for downhole tools this year? And what should be the drivers of that growth rate?

Yes, yes. We're still very optimistic about double-digit growth for downhole tools this year. The drivers are really 3 categories, XPak De continues to be a nice growth driver for us, a new product. As you're aware, we won an OTC award on that, I think, a couple of years ago, continue to see growth there.

We expect to start to get back some of the share that we have lost in the Middle East. If you think about the original TIW, they had a very strong presence in the Middle East lost that. over time. We're starting to see that return right now. So there'll be some share gain in the Middle East.

And then really just Latin America in general, inclusive of Mexico, Latin America in general, is just a very, very, very strong market right now. So that's not so much share as a rising tide. So think about it as XPak De starting to share penetration there. Think about it as Saudi share gains there, and then think about it as Latin America, inclusive of Mexico, really a rising tide, if you will, in just a very strong market.

Yes, they did have a tough Q1, Tom, but they do expect to grow pretty nicely in Q2 and maintain that growth throughout the rest of the year. So that will be a helpful margin tailwind for us heading forward.

Got it. You just touched on VXTe. We talked about timing expectations for that first VXTe installation. How about just an update on further installations than adoption of your new technology suite? Where are some of the other offerings at this point?

Yes. Look, so the -- while VXTe is a discipline right now from an installation standpoint, the track record for the E-Series continues to build. I just talked about the XPak De, as you mentioned, and we just installed our BigBore IIe 20K system in the Gulf of Mexico. That will actually be featured next week at OTC.

And then if you think about BigBore IIe in general, we would expect, as we get to the end of the year to probably have 60% to 70% of our orders, our wellhead orders around that specific product. So you'll recall, we went from 15 wellhead systems to 4 wellhead systems. We'll now even inside those 4 wellhead systems that we've got, BigBore II is the dominant system that we're seeing ordered right now. So still very optimistic about that as a standard system, and that's really been until XPak De started to get the installs now. That's really been a very, very nice surprise for us from a new product standpoint.

Shifting gears now to the company's ongoing transformation you've had underway. You do continue to implement changes to the organizational structure, how are you progressing at this point in -- at the high level, the changes you're making in terms of leadership and teams?

Yes, yes. So if I think about it in teams, and I mentioned the 3 current business leaders to you. So in terms of subsea products, we've now got very specific business unit managers around wellheads around our SPS franchise and surface equipment/connectors, those gentlemen are all doing a great job of starting to build out their teams. And we've really now communicated to every individual in the organization, what team they're on.

And as we start to divide and think about those teams, we're finding real opportunity there. We're breaking barriers where handoffs might have created problems either in terms of cost inside the system or in terms of just customer responsiveness and ability to improve our on-time delivery. Right now those are teams sitting in separate areas on the campus. So the communication is improving.

Over the course of the next 3 to 6 months, you're going to see those teams start to co-locate on the campus. And I'm optimistic that as those teams co-locate, we're just going to see even more benefits in the back half of the year, both in terms of improved on-time delivery, improved customer responsiveness and really just margin improvement as we start to attack costs in a meaningful way.

And in last quarter, in the fourth quarter, you did take a $53 million charge related to restructuring in sort of a big initial step towards the product line rationalization you'll be executing. Could you expound on where you're at with that? Have you already identified some of the product lines you'll be exiting? And will you be giving us updates on how that should run its course?

Yes. So as far as product line exit, we went through a grow harvest kill plan with every single product line, we're executing on that right now. The $53 million charge that you saw in the fourth quarter was a result of that.

The example I would give on an update on that, as I said earlier, we had 15 wellhead systems and went to 4 wellhead systems. Obviously, when you eliminate 11 wellhead systems, there's a lot of inventory and assets that go along with eliminating that. And that's just an example of what we've done. You're not going to see us say, hey, we're exiting one of the products line we've got today either in terms of wellheads, SPS, surface products, downhole tools. We're very confident, and we like those products, and we like our position there. This was more around pruning within those respective product lines as opposed to, hey, we're going to do a wholesale exit of 1 of those product lines.

Do you foresee wholesale exits as a potential or already planned next step?

No, no. We think we prune these product lines to the right level, and that -- and it's just more focused. I mean, I keep coming back to that 15 to 4. It's just much more focused. Candidly, it helps our customers a great deal, especially in the supply chain world that we live in today, we can be much more thoughtful around stocking programs and things like that. And that allows us to bypass perhaps some of the supply chain and logistics issues that we've seen before. So it's really more of that type of consolidation than it is really exiting one of those product lines.

Understood. Another aspect of the transformation underway is the rightsizing of your footprint. How much of the eventual expected $40 million to $60 million in targeted property divestiture proceeds do you expect to achieve in 2022?

Yes. So we've got the project in flight right now to attack the $40 million to $60 million. The $40 million to $60 million is probably over a longer -- much longer period of time, if you will. I would think probably by year-end or somewhere in the 9-month horizon, we should be in a position to at least announce perhaps our either closing or somewhere around there our first piece of that property reduction.

But in terms of how much we think we're going to pull in this year, it's a little bit tough to tell right now with what's going on in the market and different pieces of the property have different values and so forth. So I'd hate to put a number out there at this point in time.

I think what you will see, though, is you'll see that we'll have for sale signs, if you will, on probably around 85 to 90 acres of the Houston campus within the next 30 to 60 days. if not already, by the way, some of it's already there, but more to come there.

Yes. But predicting the cash and when that's going to happen, it's a bit tough right now.

Yes.

Okay. And in general, should we think about these restructuring and rightsizing improvements as separate from your targeted productivity and efficiency savings goal for 2022 of $15 million?

Yes, it's independent of that. I think -- yes. So that's one more extreme we've got, which is the $15 million in productivity. The property is a completely different work stream. But the $15 million to $20 million we would talk about in terms of longer-term savings as a part of the property reductions, getting our footprint smaller, overhead goes down significantly, things like property taxes and fixed cost, we anticipate somewhere in the neighborhood of $5 million in savings with that.

Beyond that, we're going to take the cash likely from the proceeds of the sale of getting campus a little bit smaller. We're going to put that towards our manufacturing. We think making a nice investment in manufacturing around sort of $20 million-ish right now. We'll have roughly a 2-year payback for us. So we think that $15 million to $20 million is both in combination of fixed costs. We think we'll see a reduction of about $5 million in addition to productivity that we'll see with the manufacturing investments, somewhere in that $15 million to $20 million range.

We will pick up annually, but that probably won't kick in probably until late '23, beginning at '24. But those are longer-term productivity goals for us associated with the campus reduction and then subsequent investment in manufacturing.

And when it comes to the transformation, we've talked a lot thus far about where you're pruning, shrinking, looking to monetize, but there's also growth enhancement side to it, right, where the new organization should have benefits in terms of where you'll be concentrating and hopefully, more effectively pursuing growth opportunities, specifically for the new energy transition team. In addition to the CCUS products that you'll be pushing through the Aker collaboration, are there other areas of transition you are interested in exploring?

Yes, there are, and we're actively engaging and evaluating those markets right now. It's really about matching up our core competencies. So if you think about high pressure, high temperature, metal-to-metal seal, things like that, it's really about evaluating those core competencies and seeing where those match in a number of energy transition areas.

We've got some of those identified right now. But to be honest, it's a little too early to start to have those conversations right now. Because we're still in the very early stages of evaluating our ability to win in those markets. There is a lot of white space in the markets we're looking at. It's just making sure that we've got the right match and the right formula, if you will, for success. And probably be talking more about those in the coming quarters, but just not ready -- evaluating doing a lot of work, but not ready to talk about it yet.

Got it. Maybe you've reaffirmed all of the prior guidance you've provided for 2022. But returning to how 1Q came in and the resulting effect on expectations for 2Q and the sequential progression over the remainder of the year. Could we just clarify both margin expectation for Q2 and then top line as well for revenue still expecting to achieve 10% year-over-year top line growth. But just where should we see 2Q now come in both in terms of the margin inflection expectations and then its contribution to that full year 10% growth?

Yes. So we would see revenues in Q2, probably a minimum growth of about 10%. Our expectation is revenue is going to start with the 9% in Q2 and beyond, which will put us back in the '90s for the first time since really for the middle part of 2020. The teams, I think, very optimistic about the remainder of the year, and I think we'd see margins continue to tick up to, call it, somewhere between 25% and 30%, depending on the mix that comes through next quarter. But I think we're pretty optimistic that we'll at least see 10% growth in Q2 and then gross margins would continue to tick up, call it, 450 basis points Q-on-Q is what the expectation is.

And as I said earlier, we'll continue to keep a pretty close eye on SG&A and we want to see that margin flow through. We think, as we've talked about earlier on the way up, just like we saw on the way down, we're probably going to overshoot some of the incrementals just because of the cost that's been taken out in addition. Now we're getting to a certain revenue threshold or a level that we're picking up on the fixed cost base here. And so for every dollar, we kind of bring in an incremental revenue standpoint, I think we're going to see some pretty nice flow-through.

And longer term, once you have completed these reorganization and rightsizing modifications, where do you think products gross margin should normalize?

I think overall gross margins, we'll talk to that and then come back to product, but overall gross margin is probably somewhere in the mid-30s. If you take a look at the productivity we're targeting and getting revenues much further north than here, we would think that the gross margins on products or overall would be somewhere in the mid- to high 30s is kind of what we would take a look at from a historical standpoint in addition to sort of the math we've done internally. On the product side of the house, you look across both downhole tools in addition to subsea products, again, I think you're probably going to see that probably in the low to mid-30s with service bringing us up to that kind of mid- to high 30s.

You had warned, Kyle, that the free cash flow would be negative for 1Q, and it came in at a negative $13 million. And yet as part of the reiterated guidance, you remain confident in the ability to achieve a positive free cash flow margin for 2022 of 3% to 5%. What does give you the conviction that over the next 3 quarters, you'll be able to reverse that and ultimately end up in that positive range for free cash flow for the year?

Well, I think just underlying improvement in the business is obviously helpful. The lack of onetime payments that we typically have in Q1 will dissipate into Q2. So I think as we think about Q2, getting us back to what I'd say is free cash breakeven in the quarter. And then as Q3 and Q4 happen, I think we expect to see a nice tailwind around various components of working capital.

In addition, we have perhaps some tax refunds from time to time flowing through and so forth. That will probably help bridge that gap. But I think we're pretty confident that, that $10 million to $15 million number is achievable if we do the math on the sort of 3% to 5% free cash. And you talked about Q1, it actually came in much better than our internal forecast. So I think we're pleased we're off to a good start.

DSO is down nicely Q4 to Q1 by about 17 days or so. We're going to try to hang on to that as we move throughout the year. As you know, when the business is growing here, we are going to be consuming cash and working capital functions, inventory and AR. We are going to obviously continue to -- we've made great improvements in 2021 as it relates to DSO and inventory. We're going to continue to hang on to those and try to improve those further.

And homing in on working capital, what's the likely evolution of it quarter-by-quarter. What should we expect in terms of draw versus contribution to cash flow in 2Q and then over 3Q and 4Q?

I'd say Q2, we'll call it working capital breakeven. And then beyond that, we should see some pickup in the back half of the year, probably sizing that somewhere in the $10 million range from working capital for Q2 probably breakeven on the working capital lines and then picking up about $10 million in the back half of the year.

And when it comes to your priorities for capital allocation in descending order of importance, they've been non CapEx that has been and will remain the top priority where you just reaffirmed an annual budget of $15 million to $17 million. Two would be M&A, which -- where you described being open to both energy and energy adjacent transactions. And then three would be share repurchases. Let's start with 2. Could you elucidate on what you mean by energy adjacent and what all we might see you consider in terms of M&A on that front?

Yes, sure. So I think when you look at the EV OFS landscape that's there today, and you will get in a very traditional sense, whether it's public companies or large private companies that we're all familiar with. They have large, almost 100% OFS exposure, in some cases, challenged balance sheets, challenged markets, challenged situations.

I think what we're really looking for, if you think about an ideal acquisition for us, if you open that aperture and say, "Hey, I want something that has energy exposure, and that most likely be our core OFS business, if you will." That's great, but it'd be ideally, we're finding something that has that OFS exposure, but also has non-OFS exposure as well that gives us just better -- a little bit more diversity, if you will, around products, but still plays to our mechanical engineering and manufacturing and footprint strengths that we've got around the world.

So we're in process of starting to evaluate what those end markets would look like. We're being very thoughtful about that. We really want to look out. We understand OFS very well. What we want to make sure is we're just as thoughtful about the non-OFS side of the business as well. So that's likely going to develop over the next 2 or 3 quarters, a more thoughtful communication around what our guiding principles are there and how we're thinking about it.

Got it. And on the energy side, could we see you potentially execute a transaction with a focus on new energy opportunities. Are there any technologies or products that you already have identified that ideally you would add as part of your pursuit of CCUS, for example?

Yes. I think CCUS is the obvious. We've got a kind of a robust product development plan on what we think we need to do around CCUS to make sure that's a fulsome offering for us. There may be cases as we look at that product road map where we say, "Hey, you know what, a lot of smarter to go out and buy this as opposed to try to develop it internally and be very thoughtful around how we approach that.

So that's the most likely acquisition and it'd probably be a little more technology related as opposed to a large business or something like that. The challenge candidly, that I see as you look out at new energy right now, is infinite multiples in some cases. So I think that's probably a challenged market for us right now. As we expand outside of CCUS, we may find some opportunities. But right now, if you think about new energy, it's more likely to be something from a product standpoint on the CCUS side.

Got it. And then Jumping now to the top priority, CapEx, the reiterated budget of $15 million to $17 million. Kyle, could you just refresh us on how that $15 million to $17 million should break down?

Yes, hang on 1 second here. It's largely going to be in the rental tool space associated with the previously announced work in Brazil. We've got quite a bit to build out there. Let's see here. Yes, it's largely rental tools, followed by we have a small piece of IT, we're going to be taking on this year in addition to just normal maintenance CapEx, but it's going to be sort of heavily weighted towards rental tools this year.

That's primarily a combination of downhole tools, and I think some big BigBore IIe tools as well. So if you think about where we're growing, those are really growth CapEx projects, if you will, for us, Tom. And the other thing to keep in mind, by the way, about that $15 million to $17 million is that it does not include or contemplate manufacturing investment, the $20 million manufacturing investment that Kyle spoke about. It does not contemplate that. Now obviously, given the lead times of those products and things like that, it's impossible that all $20 million would happen this year, but you could have an initial down payment or something like that this year for that.

Yes.

And once that $20 million spend does get underway, what sort of time frame should we assume it will happen over?

Yes. So I can talk about delivery of equipment. We haven't negotiated, obviously, terms and things like that. We're looking at a number of machines. First delivery, I think, on that first machine is 48 weeks once we place the order. There's been no order placed yet. And then you'd see every couple of months 1 more machine coming in, total of 7 machines, I believe, total coming in. So think about that as once we hit go 48 weeks, first delivery of machine and then every 2 months after that.

So most of the spend on that would likely happen and would bleed into '23 and maybe even to '24, depending on the timing of the approval of that $20 million.

Yes. So as we get that approved entirely, then we'll update our guidance on cash flow and CapEx accordingly.

Okay. We'll stay tuned for more on that. And then concluding the discussion of capital allocation priorities with the third priority, the buyback. In 1Q, you spent $5.8 million on the repurchase of just under 274,000 shares. If my math is correct, that would leave you with $102 million remaining under the existing authorization. Could you tell us just should we expect that there should just be continual refreshments of the authorization as that remains your third priority for capital allocation and go to for excess cash flow here or there?

Yes. I mean, so I think it's -- the authorization is, I think, $118 million at this point in time with the re-upping of $100 million at the end of last year. I mean, I think we've chatted internally about this. I think we -- there's a lot of uncertainty in the marketplace right now with the geopolitical stew that I think Jeff touched on earlier. We're going to continue to look at it. And depending on how cash flows are trending and so forth, we will continue to support the stock. It will just be -- if you look historically, as the company has done this, it's been what I'd call perhaps opportunistic at times. Did so in Q4 in the beginning part of Q1, but we'll continue to keep this as part of our capital allocation policy. There is a lot of uncertainty in the marketplace right now. So I think we're taking a pause here for the time being.

Got it. Thanks for that correction. I guess I had an additional $10 million there. So there is $118 million remaining under the current authorization.

Yes, yes.

Got it. And then is -- the approach there is expected to remain opportunistic. It sounds like you don't plan on putting any kind of 5B or program in place for algorithmic buying?

Yes. So just to clarify, I mean, when we say opportunistic, I mean, we do put formulas and grids and things like that in place when we take that approach. I think the thing that we're monitoring very closely right now, it's tough to understand the market right now and you've got the challenge in Ukraine, the challenge in Russia. The shutdowns that we see kind of spreading through China, it's just making sure that we understand the underlying environment when we're making that decision. And obviously, that's a challenge right now.

We're certainly not afraid, as we've shown in the past, to pull that trigger. And when we do pull that trigger, it will be in the form of a thoughtful grid that will roll out. And what we typically do in those cases, we roll out a grid and roll out a dollar amount and roll through it that way. But to Kyle's point, we tend to match free cash flow and buyback just as a philosophical point.

Sure. Makes sense. And then returning to the subsea tree order expectations for this year, I know the high degree of reliable visibility you've had, partly stems from specific projects such as BHP, Shenzi North, Harbour Energy's Catcher field. Could you perhaps split how those 17 million to 19 million tree should fall between major projects that are either greenfield or moving into a new phase of development versus incremental trees on established installed production host?

Yes. I'm going to say about 75% of them are probably build on from existing projects. So it would be a tree, 5, 6, 7 8 or in the case of Catcher, tree 20 somethings. We're in the 20s there. There's a small portion that are new one-off trees. Those are large greenfield projects. We tend not to participate in those large greenfield projects, we tend to participate well with what I'd characterize as the independence and larger independents as opposed to the major IOCs.

The nice thing about, by the way, the fact that those are largely knock on trees from previous orders is that what you find is that serial #1 tree is always challenging from an operational standpoint. You're learning a lot. When you get to trees 3, 4, 5 or in the case of Catcher trees, 20-something, you can be a lot more efficient from an operating standpoint. So we're pretty pleased about that actually as we progress through the year.

Got it. Yes, it's consistent with sort of how we've seen the overall subsea tree market up cycle progress in terms of where the majority of the demand is originating from. Why don't I wrap up with my questions here, turn it back over to you, Jeff and Kyle, and allow you to use these last few minutes to share some concluding remarks.

Yes, sure. So if we look at Q2, we're very optimistic about orders. As Kyle stated earlier, we would expect our revenue number to start with a 9. We believe that's going to have some strong incrementals with it as we start that March back up. We believe once we hit that number, we'll only see a rising number from there for the balance of the year. Very pleased with where the order trend is and believe that 20% is strong from an order standpoint year-on-year.

Very focused on our growth pillars. We've talked a lot on this call about collaboration and we're very pleased with those and see a lot of success for those. In some cases, it's laying the foundation now and orders next year in the case of CCUS, and in some cases, in the case of what we see with downhole tools and wellheads, it will likely mean real orders this year.

We're focused on our cost base and focused on executing with our customers. We've talked about shrinking that footprint and getting the organization aligned. We're well on our way to doing that. I am pleased that I think in the back half of the year that we'll start to see even further upside from that, but not quite ready to talk about that. Overall, middle of the fairway quarter, I understand it might have been a wide fairway, but a middle of the fairway quarter, but opportunistic about Q2 and beyond.

Great. I think we'll conclude there. Thank you to Jeff and Kyle for joining me for the first quarter fireside chat and to all of you for listening in.

Okay. Thanks, Tom.

Thanks, Tom.

This concludes today's conference call. Thank you for participating. You may now disconnect.