Archrock, Inc.

Good morning. Welcome to the ArchRock third quarter 2020 conference call. Your host for today's call is Megan Repine, Vice President of Investor Relations at ArchRock. I will now turn the call over to Mrs. Repine. You may begin.

Thank you, Doug. Hello, everyone, and thanks for joining us on today's call. With me today are Brad Childers, President and Chief Executive Officer of ArchRock, and Doug Aaron, Chief Financial Officer of ArchRock. Yesterday, ArchRock released its financial and operating results for the third quarter of 2020. If you have not received a copy, you can find the information on the company's website at www.archrock.com. During this call, we will make forward-looking statements within the meeting of Section 21E of the Securities and Exchange Act of 1934, based on our current beliefs and expectations, as well as the assumptions made by and information currently available to ArchRock's management team. Although management believes that these expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct. Please refer to our latest filings with the SEC for a list of factors that may cause actual results to differ materially from those in the forward-looking statements made during this call. In addition, our discussion today will reference certain non-GAAP financial measures, including adjusted EBITDA, gross margin, gross margin percentage, and cash available for dividends. For reconciliations of these non-GAAP financial measures to our GAAP financial statements, please see yesterday's press release and our Form 8K burnished to the SEC. I'll now turn the call over to Brad to discuss our truck's third quarter results and to provide an update of our business.

Thank you, Megan, and good morning. I appreciate everyone joining our conference call today. Last night, we posted solid third quarter results despite significant demand headwinds brought on by COVID-19. I could not be prouder of how well the ArchRock team has responded to the challenges we faced this year. Our standout third quarter results were driven by excellent execution in the field and an unrelenting effort to attack our cost structure wherever possible. Among the accomplishments in the quarter, we generated adjusted EBITDA, of $113 million, up slightly compared to the prior year period. We defended our strong contract operations gross margin percentage, driving more than a 100 basis point increase versus the prior year period after adjusting for a non-recurring tax benefit in this current quarter. We further reduced SG&A expenses by 12% in Q3 on a sequential basis and also adjusting for that non-recurring tax benefit. We continue to pay an attractive dividend, complemented by peer-leading dividend coverage. And finally, we continue to generate robust free cash flow, both before and after dividends in the quarter. Year-to-date, our free cash flow after dividends totals $117 million. This is the combined result of operating cash flow resilience, lower capex spending, and approximately $50 million in non-core asset sale proceeds. In total, this has enabled us to repay borrowings on our credit facility and reduce our leverage to 4.0 times. These positive quarterly outcomes demonstrate the impact of the aggressive cost reduction and operational improvement measures we've implemented over the last several months. The disruptions to our industry require sacrifices from everyone in our track, and I'm very grateful for the continued efforts of our employees everywhere. We've taken significant action to squeeze costs out of our business, and our efforts have cut across all segments and all geographies. We maintain disciplined capital spending across the board in growth, maintenance, and other capital expenditures. Year to date, our total capital expenditures were $130 million compared to more than $300 million at this point in 2019. We expect to reduce our full-year 2020 total CapEx budget by $250 million, or approximately 65%, compared to 2019. We reduced SG&A substantially on a run rate basis in both Q2 and Q3. We continue to tightly manage overtime hours and discretionary spending And the previously announced salary reductions for certain employees in the executive leadership team, as well as reductions to board retainer fees, all remain in effect. While we're focused on retaining our great talent as much as possible, we've also had to make difficult decisions to right-size the organization for the opportunity set. This has resulted in a headcount reduction of more than 20% since the end of 2019. We continue to invest in technology. Even as we manage costs tightly in this downturn, we've been investing both SG&A and capital dollars to lay the foundation for continued improvement in both our customer service delivery and our operating cost structure. These investments will also help us reduce our emissions and carbon footprint in the future. Finally, we continue to high-grade our business. Year-to-date, we sold 133,000 horsepower with an average age of 22 years. And in July, we sold a portion of our AMS business at an attractive multiple. These efforts to upgrade our fleet, invest in technology, and enhance our operations and our profitability will continue to support our commitment to deliver on our capital allocation objectives, including delivering significant full cycle, free cash flow. Now I'd like to turn to the market and outlook for our business. Overall, energy market conditions have improved over the last few months compared to the second quarter. U.S. natural gas and oil prices have stabilized at higher levels. The rig count grew modestly during the third quarter, and customers are beginning to draw down inventories of drilled but uncompleted wallets. At the same time, we're cautious about assuming an immediate and full recovery, which is ultimately dependent on highly uncertain external developments, including the path of the COVID-19 pandemic and the timing and magnitude of a future economic recovery. Looking into 2021, most natural gas forecasts show a modest annual decline in U.S. natural gas production as producers limit drilling and completion activity to achieve maintenance levels of production and cash flows. Accordingly, we're planning for softness in the compression market to persist into 2021 with the potential for improved conditions later in the year. Beyond 2021 and long-term, we remain confident in the positive fundamentals for the critical infrastructure we provide to our customers, particularly as natural gas provides an affordable, reliable, and cleaner burning solution to meet growing energy needs worldwide. We believe natural gas will play a prominent role in a cleaner energy mix even as energy generation from renewables increases. According to the U.S. EIA, natural gas has been the largest contributor to lower energy related greenhouse gas emissions in the U.S. electric generation sector as it continues to displace higher emission fuels such as coal. In fact, between 2005 and 2019, U.S. natural gas production increased by 88%, while energy CO2 emissions in the U.S. declined by 14%. We look forward to continuing to play an important role in keeping our customers' natural gas streams flowing, partnering with them to meet their safety and environmental objectives, and powering America well into the future. Turning to our operations and contract compression, we're focused on what we can control, including how we manage our cost structure, how we execute, and how we service our customers. Our third quarter results are evidence that our focus is paying off. Revenues fell by 7% sequentially, primarily due to the full impact of quarterly horsepower declines. Pricing decreased modestly and is overall holding up well. The 148,000 horsepower decline in the third quarter was a significant improvement compared to the losses we sustained during the second quarter. Our third quarter exit utilization declined to 83% from 86% at the end of the second quarter. We expect to see modest horsepower declines for the next few quarters but believe our multi-year fleet high-grading efforts will keep us on track to outperform our utilization performance in the last downturn. Even with the top-line pressures, Archerox operations teams drove excellent gross margin performance. We posted a 66% gross margin in the quarter, or 63% adjusting for the tax benefit. This is up nicely from 62% in the year-ago period and consistent with our annual guidance range. In our aftermarket services business, we're focused on maximizing profitability and performance through this challenging period. We believe that we have right-sized the business for our opportunity set and will continue to focus on maintaining gross margin levels through this period. And early in the third quarter, we made the strategic decision to sell a portion of our AMS business, bringing in additional cash, which were redeployed to debt repayment. From a capital policy standpoint, we remain committed to our well-defined capital allocation strategy, which focuses on two key priorities, shareholder return and reducing debt. While others have been forced to get dividends, our truck has been able to maintain an attractive dividend and prudent dividend coverage through this sharp downturn. Our dividend yield continues to compare well to other energy companies and other income-oriented sectors. Of equal importance, we will continue to execute all available measures to reduce our debt and protect our financial position. We strongly believe reducing debt and paying a dividend are key value drivers for our truck, and we're confident in our ability to do both in the current environment. Before turning the call over to Doug, I'll share with you that in September, our company celebrated the 66th anniversary of our founding as South Coast Gas Company in 1954. While other companies in this industry have come and gone, our company has endured and grown to become the industry leader in U.S. natural gas compression. With that, I'd like to turn the call over to Doug for a review of our third quarter performance and outlook.

Thank you, Brad, and good morning. Let's look at a summary of our third quarter results and then cover our financial outlook. Our third quarter performance strongly supports our financial goals of protecting liquidity generating free cash flow, and reducing debt. We reported adjusted EBITDA of $113 million, slightly higher than the third quarter of 2019. Our third quarter adjusted EBITDA included $9 million in net gains related to the sale of assets and an $11 million net cash benefit from tax audit settlements covering a three-year period. 60% of this tax benefit was recorded in SG&A with the remaining 40% reflected in our contract operations gross margin. We recorded net income for the third quarter of 2020 of $18 million, which included a few one-time items, the majority of which were non-cash. We recorded an $11 million long-lived asset impairment during the quarter and took a $3 million restructuring charge related to severance benefits and property closures. Turning to the business segments, contract operations revenue came in at $175 million in the third quarter, compared to $188 million in the second quarter, due primarily to lower operating horsepower. Looking at our gross margin percentage, we continue to benefit from a highly variable cost structure, a key advantage as we continue to make adjustments to align our business with market conditions. we remain on track to deliver a meaningful increase in our gross margin percentage compared to 2019, despite revenue headwinds. In our AMS segment, we reported third quarter 2020 revenue of $30 million, down from $32 million in the second quarter. Our AMS revenue reflected lower customer activity, given cost constraints and market uncertainty, as well as lost sales from the divestment of our turbocharger business. We drove our AMS gross margin percentage back up to our 2020 target, delivering a third quarter gross margin percentage of 15%. We continue to focus on higher margin business and optimizing our labor utilization during this slower period. SG&A totaled $19 million for the third quarter, compared to $29 million in the second quarter and $30 million for the prior year period. Excluding the $7 million tax benefit, our third quarter SG&A was still down over $3 million on a sequential basis. For the third quarter, we limited our growth capital expenditures to $6 million, down more than 70% from $23 million during the second quarter. Our last bit of new build spend for the year was completed in July with repackage and new unit startup costs comprising the remainder of the growth CapEx during the quarter. We also reduced maintenance and other CapEx during the third quarter of 2020 to $11 million from $18 million in the prior quarter. For the first three quarters of 2020, we completed nearly $50 million of asset sales, as we continue to prune our fleet and divest non-core businesses where it makes strategic sense. With the planned decline in capital expenditures and proceeds from asset sales, debt repayment accelerated in the third quarter. This continues to mitigate the expansion of our go-forward leverage ratio until the market recovers and we can deliver on our goal of 3.5 to 4 times. Our total debt of $1.7 billion reflected $77 million in net debt repayments in the third quarter and over $100 million since the beginning of 2020. Our leverage ratio of 4.0 times was down compared to 4.1 times in the prior quarter and 4.3 times in the third quarter of 2019. We exited the third quarter with ample available liquidity of $492 million. We recently declared a third quarter dividend of 14.5 cents per share, or 58 cents on an annualized basis, unchanged on a quarterly and annual basis. Our dividend payout continues to be supported by our internal cash generation, strong balance sheet, and robust dividend coverage. Cash available for dividend for the third quarter totaled $77 million. Our EBITDA is holding up well, and we further reduced our interest and maintenance capital leading to strong third quarter dividend coverage of three and a half times. We are proud of our ability to continue delivering value to shareholders through an attractive dividend yield even during this downturn. Based on solid third quarter execution and our current view of the market, we are tightening our full year 2020 adjusted EBITDA guidance range to $405 million on the low end and $420 million on the high end, from $380 million to $420 million as previously guided. At the midpoint, this implies a sequential decline in fourth quarter EBITDA as expected. This reflects modestly lower operating horsepower on a go-forward basis, normal seasonal Q4 softness, and $20 million in third quarter items that will not recur. Turning to CapEx, last quarter we lowered our total capital expenditure range of $130 to $155 million, and today we're tightening the range to between $128 and $140 million. With our cost and capital reductions, we've further enhanced our outlook for free cash flow and cash available for dividend for the year. To sum it up, with our strong base of cash flows, cost and capital reductions, and asset sales, we continue to maximize our free cash flow and cash available for dividends for the year. We now expect to deliver $150 million or more in free cash flow this year after dividends, which will support our goal of substantial debt repayment. It's simply too early to lay out detailed guidance for next year on today's call, but I think it's worth ending my remarks with how we are thinking about 2021. Booking activity remains low, which will drive capital reinvestment even lower next year compared to 2020, particularly as we work to satisfy customer demand with unutilized equipment where possible. While we expect our EBITDA to be down compared to 2020, This will be more than offset by a moderation in spending, positioning us to achieve substantial free cash flow after dividends once again in 2021. And with that, now we'd like to open up the line for questions. Doug?

Thank you. Ladies and gentlemen, at this time, we will be conducting a question and answer session. If you'd like to ask a question, you may press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. Our first question comes from the line of Kyle May with Capital One Securities. Please proceed with your question.

Hey, good morning, everybody. Good morning. I appreciate the preliminary look at 2021, and I realize that you don't have formalized guidance yet, but Brian, I wanted to follow up on one of your comments, and when you think about the next couple of quarters, how do you think about the trajectory or the rate of change in compression utilization compared to the 3Q rate?

Yeah, so look, Utilization is the output from the factors that drive it, which are bookings and stop activity. And let me talk about those without giving you a quantification just because it is too early, too preliminary. And candidly, the view right now into 2021, even through our customers' eyes, remains opaque. So what we do expect, however – is to see bookings continue to steadily pick up as we have seen in Q2, I mean, in Q3 compared to Q2. And we expect soft activity to continue to moderate as we saw also from Q2 to Q3. But for the lines to cross and have us see net horsepower growth, we're expecting still softness into the first part of 2021. with the opportunity to maybe see some regrowth, both in natural gas production and, of course, then horsepower in the back half of 2021. So that's my best shape of the curve that I can give you without trying to quantify it, which would just be guesswork, Kyle.

Totally understand, and that's helpful. Also, maybe switching over to cost control, it's nice to see the ongoing, you know, attention to detail there. Can you give us any color if there's more cost that you can take out, and also how sustainable are these cost reductions?

Sure. So on the good news front, one of the things we really like about the compression business is that a majority, a lot of our costs of our OpEx are highly variable. By the way, our CapEx also can be highly variable, and it gives us a chance to really respond quickly to right-size the business to both maintain profitability. And as you've seen in 2020, not just maintain positive free cash flow, but improve it. So it's just a real strength to the business model that we can pull costs out. The improvements you've seen in our profitability, we believe, will be sustainable. And we're going to continue to focus on expanding our gross margin over time. The teams in the field, both in contract operations and AMS have been just tremendously well focused on improving profitability in a way that is sustainable. Now, of course, if we hit too much pricing headwinds based on utilization, we may see some giveback and some erosion. But overall, the profitability improvements we've put into business we think are sustainable. And candidly, we expect to see them expand over time as we leverage our investment in our technology.

Got it. That's very helpful. Appreciate the time this morning, and I'll turn it back. Thank you.

Our next question comes from the line of Daniel Burke with Johnson Racing Company. Please proceed with your question.

Hey, good morning, guys.

Good morning.

Let's see. Brad, I guess you alluded to this earlier, but when we compare this downturn to, I guess it was 15 and 16, can you talk about the horsepower you've had sidelined? Is it Can you compare and contrast maybe the horsepower you had sidelined in 15 and 16 to what's occurred this year? I would imagine the horsepower that's been pushed to the sideline, or at least a portion of it this year, is pretty high quality, maybe more modern equipment than was the case five years ago.

Yes, I can. And I think your inclination is completely correct. The improvement into the fleet that we've put in over the last, you know, certainly three or five, but even 10 years is really paying off in that the idle fleet today is younger, larger, and higher quality than we experienced in past downturns. And that's going to put, give us the opportunity to put more of it back to work more quickly and at less cost than a reduced cost. So we like that aspect of what we have in the fleet today compared to what we experienced in prior downturns. So your inclination is right. The other thing I want to point out is that even as we hit this downturn, the equipment that we've been investing in, which is equipment that is, you know, large horsepower and newer and younger in our fleet overall, remains well utilized and pricing remains, you know, very solid. So we just see that aspect of our fleet performing really well. And it's just one of the strong points and results of the investments we've made over the last several years.

Got it. Okay. And then maybe one of the smaller points in the guidance update this morning, there's a reduction in maintenance cap expectations for this year. I was just wondering, is that sort of sustainable on a per active horsepower basis, or what's going on to drive that reduced expectation as this year is advanced? Does it reflect more the fact that utilization has fallen off more than you expected, or is it that you're managing that program more assertively?

Well, it's a combination. Number one, the team is absolutely doing a great job managing our maintenance capex. One thing I point out is that we do not manage the maintenance capex to the detriment of either customer service or to the equipment and standards that we have in place to maintain our equipment really well. So that's one. Second, however, you're seeing the benefit of both we have more new horsepower in the fleet, the average age of our fleet has decreased, as well as the fact that we've had some stock activity increase. And all of that is decreasing our maintenance capex. But it's a combination of those factors. It's not really any single factor.

Got it. And, you know, certainly given, last one for me maybe, but given what's going on with natural gas pricing, I wouldn't imagine there's still a meaningful component of standby horsepower. But I figured I'd look to mop that up as we look at where your utilization is now compared, or I guess that would be included in utilization, to be fair. Maybe an update on where you stand with standby horsepower.

Sure. You know, the vast bulk of the standby horsepower has gone back to work and been turned back on. We always maintain a small amount. Our customers maintain a small amount of standby horsepower just for operational reasons. And the delta between what we see as a traditional annual run rate of normal standby horsepower compared to that peak that we had back in the middle of the second quarter is down like 75%, so it's a significant improvement in the amount of standby horsepower that was used during that time.

Okay, great. Well, look, guys, I'll leave it there. Thank you for the time today.

Yeah, thanks, Daniel.

Our next question comes from the line of Selma McCoyle with Stiefel. Please proceed with your question.

Thank you. Appreciate the difficulty looking out into 2021, but I was just going to ask you, can you talk about maybe what you see out there by Basin? And I guess I'm a little surprised, at least when speaking with other companies, some sense of optimism with the strip over $3 and things potentially turning the corner, but I'm not sure I really heard that from you guys. So I was just kind of curious if you could just talk about it by Basin maybe a what you're hearing from your customers.

Sure. So, you know, in our dry gas plays, where we have customers that are more driven by that commodity price, that would include the Marcellus, the Utica, we certainly share that optimism. But for the balance of customers, including in associated gas plays or in oil plays with associated gas production, we have a much more moderate view And the expectation is that we've seen both from analysts looking at natural gas production levels, as well as in dialogue with our customers, is that we still expect to see aggregate softness moving into 2021 with optimism. And we're optimistic we're going to be able to pick up in the back half of 2021. But I think that maybe some of the discord you're hearing in the commentary is is looking at businesses that are driven by dry gas as opposed to businesses that include oil and associated gas production.

Appreciate that. Just one other one for me. Seen a lot of E&P consolidation, or at least starting to see it. Is there any thoughts on that in terms of relating to just sort of customer and customer concentrations, those kind of issues?

It doesn't throw up any concerns for us. We have a stable base of just of top grade customers that we get to do business with. And as they're looking at consolidating and bringing in more capital discipline and financial discipline into their operations and take costs out, candidly, longer term, we expect to be a beneficiary of that as one of the key outsource service providers that can help them do that. So, we don't see any flags or any reasons to not be supportive and optimistic that further discipline and consolidation overall in the sector It's good for the strong participants. We plan to be one of them.

Understood. And if I could just ask one more, and I'm sorry. Any more thoughts in terms of asset sales as 2021? Is that just always continuously under review? Should we expect more, or is there anything you can say there?

Yeah, it's been continuous. 2020 is certainly a higher level of asset sales than we've had in prior years, but in all prior years we've had it. We're going to continue to be very disciplined in looking at our fleet hard and moving out assets that we think are not strategic for our operations and our business. And so, you know, A-level of asset sales will be ongoing.

Thank you, Kelly.

Yeah, this is Doug. I'd like to maybe top up Brad's answer, too, on 2021 demand and outlook. And I think it's It's one of, you know, our caution is well-heated, and we're simply saying that the market is opaque. But I think longer term, and I don't want this to be lost in today's message, is really the longer-term impacts of natural gas on greenhouse gases, on what's transpired, you know, as Brad mentioned in his prepared remarks, on a major reduction in that area. And we do very much see natural gas as a fuel of the future, and we see demand being great. Our question just at this point is, is that back half of 21? Is it later in the year? Is it earlier in the year? And I think that's where we feel a little more reticent to get over our skis on trying to predict that.

Understood. Thanks again.

Our next question comes from the line of Thomas Curran with B Reilly Securities. Please proceed with your question.

Good morning. Good morning. Trying to understand how demand is tracking the trending completions relative to the typical lag we've seen in past recoveries. Did your operating horsepower sequentially decline each month through 3Q? Which month was the lowest? And then did operating horsepower decline from September to October?

So what we're seeing right now is a fairly steady, and that includes month over month, and it includes quarter over quarter, decline in horsepower as stop activity is higher than start activity. And it's pretty ratable to the quarter and to the midpoint of the second quarter to give us the exit utilization rate, exit horsepower rate that we had that we announced today.

Okay, so not quite at a clear bottom yet then.

Well, I think what we've said so far would indicate that we think the bottom is ahead of us as we still see softness for a couple of quarters. And then we do expect to see, candidly, some outpaced opportunity for growth in the back half of 2021.

Thank you. Yeah. Just, you know, again, further clarification, the rate of decline has slowed significantly, but still, in our view, you know, decline in horsepower ahead.

That all makes sense. Doug, two guidance follow-ups for you. For aftermarket's 2020 revenue guidance range, when it comes to the 5% reduction at the midpoint, does that cut solely reflect the disposal of the turbocharger business and then Could you give me the split between parts and services for 3Q?

On the guidance, yes. It's almost all the turbocharger. You know, Q4 also tends to be seasonally one of the weaker quarters. So that's a piece. And then was the question, I guess, historical on parts versus service? Just what it was for 3Q. Yeah, Q3. percent of revenue services was 59, parts 41. And that was like 17.9 on service and 12.4 on parts.

Great. And then on SG&A, you know, a nice reduction there in the guidance range from 113 to 116 to 105 to 108. What are the factors behind this latest step down? And Do you think of this current quarterly run rate as sustainable into 2021?

I think, you know, look, yes, on part of that, you know, I think we do see the gross margin improvements as being sustainable longer term. You know, I'll be candid and tell you that, you know, salary reductions, well, some of the headcount reductions are permanent, and we have cut, you know, SG&A at all levels in the organization. I would see less permanency at those overall lower levels into perpetuity because we do want to, you know, get our salary levels back at some point to be able to attract and retain high-quality talent.

Great. Thanks for taking my questions.

Thank you, Tom.

Thanks.

Our next question comes from the line of TJ Schultz with RBC Capital Markets. Please proceed with your question.

Oh, great. Thanks. So what are the major things you need to spend money on to bring some of that idle capacity back to market if it's younger and larger horsepower? Is it just cost in moving around the units or mobilization costs? And would you think maybe you're moving those units to more gas-directed or different basins, whereas maybe the mix wasn't as large there before? Or are there other – meaningful modifications that need to be made to re-deploy the idle units?

Sure. The primary expense in putting units back to work is just make ready. That is, if they've sat idle or if they've been on a location, then we do take the time to go through the units and make sure that the maintenance is up to date. And since it's been idle for a period of time, it gives us that opportunity to do so without interrupting our customers' gas production. So, that make ready expense is a part of it, just making the unit ready. Second is, yeah, shipping startup. And so, those are the main costs associated with that. If we have units that need some additional changes to their configuration, whether it's to the size or to the controls, to move to that next application, then we would potentially engage in some repackage activity. Some of that shows up in Growth CapEx. Some of that shows up in OpEx. But those are the primary expenses that are required to reactivate. And I'll point out that that's in our guidance, and that's a level of investment or spend that is always in our business, either in our gross margin or in our CapEx.

Okay. But make ready costs are OpEx?

Yes.

Okay.

Appreciate it. Thank you. Yep. Thank you. There are no further questions in the queue. I'd like to hand the call back to Mr. Childress for closing remarks.

Great. Thank you. Thank you, everyone, for participating in our call today. As our results demonstrate, we continue to take the right steps to differentiate our track and deliver value for our shareholders. I look forward to updating you on our fourth quarter call early next year. Thanks, everyone.

ladies and gentlemen this does conclude today's teleconference thank you for your participation you may disconnect your lines at this time and have a wonderful day