Archrock, Inc.

Good morning. Welcome to the ArchRock First Quarter 2021 conference call. Your host for today's call is Megan Rapine, Vice President of Investor Relations at ArchRock. I will now turn the call over to Ms. Rapine. You may begin.

Thank you, Celine. 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, R-TRAC released its financial and operating results for the first quarter of 2021. If you have not received a copy, you can find the information on the company's website at www.RTRAC.com. During this call, we will make forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, based on current beliefs and expectations, as well as assumptions made by, and information currently available to our TRACS management team. Although management believes that 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 metrics, 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 results, please see yesterday's press release in our Form 8K furnished to the SEC. I'll now turn the call over to Brad to discuss our truck's first quarter results and to provide an update of our business.

Thank you, Megan, and good morning, everyone. I'm happy to be with you today to discuss our financial results for the first quarter of 2021. A solid performance reflects the continued actions we're taking to maximize our profitability and cash flows in a volatile and evolving market. We're controlling what we can, including our operational execution, our cost structure, and our capital allocation. I'm proud of the results and pleased to share that during the quarter, overall economic trends improved and we saw continued signs of stabilization in our compression business. First quarter highlights include revenue declined less than 2% from the fourth quarter, a significant improvement from the larger sequential declines we experienced throughout 2020. We delivered a strong contract operations gross margin percentage of 63%. This was consistent with guidance and up 100 basis points compared to the first quarter of 2020. We maintain capital discipline, spending $12 million in total CapEx in the first quarter versus $72 million in the first quarter of 2020. In addition, our first quarter 2021 net capital expenditures were negative when taking into account asset sell proceeds of $27 million generated during the quarter as we continue to transform and standardize our fleet. We continue to enhance our financial flexibility, robust free cash flow generation handily funded our quarterly dividend and keeps us on track to deliver at least $100 million in debt reduction during 2021. The downturn has been a true test of the durability of our business and is evidenced by the stabilization and performance of our operations during the first quarter. We are no doubt realizing the beneficial returns we had targeted in our multi-year efforts to hydrate our fleets, operations, geographic footprint, and customer base. Based on our strong first quarter performance, today we are reaffirming our guidance for the full year 2021. And consistent with the expectation laid out on the fourth quarter call, we believe that the second half of 2021 will offer ARCHROC an opportunity to resume revenue growth as we focus primarily on deploying existing idle compression units. The first quarter was a positive one for commodity prices, with oil prices in the range of $60 per barrel. We believe commodity prices are providing the necessary cash flow visibility for our customers and are beginning to translate into responsible increases in U.S. onshore activity levels, even as producers prioritize capital discipline, moderate growth, and free cash flow generation. Upstream capital spending is expected to increase gradually, and the U.S. rig count currently stands at about 475 rigs, up more than 80% from the trough last summer. Most U.S. forecasts show natural gas production steadily increasing throughout the remainder of 2021, with year-over-year production growth anticipated to resume in 2022 and beyond. In fact, the EIA's 2021 Annual Energy Outlook predicts that U.S. natural gas production will return to pre-pandemic levels in 2023 and then continue to grow during the entire forecast period 2050. Even at a time when much of the focus in energy is on renewables, we believe that U.S. natural gas will continue to play a critical role in helping to power America well into the future. and so will our truck. Turning to our contract operations performance during the first quarter, we recorded the smallest sequential decline in our operating horsepower and contract operations revenue since the COVID-19 driven downturn began. Compared to the fourth quarter, our first quarter exit fleet utilization was flat at 82%, and operating horsepower declined by just 59,000 horsepower $29,000, about half of which was attributable to operating horsepower that we sold as we continued to prune our compression fleet. Pricing on our active fleet remained steady compared to the fourth quarter, the result of our contracting strategy and standby units returning to full monthly service rates. Booking activity ticked up towards the end of the quarter, and though it remains below pre-pandemic levels, we're hopeful to carry this momentum as the year progresses. We plan to satisfy much of this demand from existing units in our idle fleet. Our gross margin percentage expanded on an annual basis, driven by our proactive and aggressive efforts to align our cost structure with the market environment. I also want to highlight the incredible response by our team following the week-long extreme freezing temperatures across Oklahoma, Texas, and other states that severely impacted many of our customers. Our field team had the majority of our units back in operation in short order once it was safe to do so. Once again, we showed our customers what excellent customer service is all about. I'm proud to say the team exemplified great safety performance with zero weather-related safety and vehicle incidents recorded during this challenging period. In aftermarket services, performance during the quarter was softer than our internal expectations. Revenues were down 4% from the fourth quarter of 2020. First quarter is a seasonally low quarter for the AMS business, and due to the pandemic, in many cases, customers are choosing to leverage internal resources rather than outsource their service needs. Further, we experienced a meaningful setback to activity with the severe winter weather. We did see some more encouraging trends during March. First margin percentile is 12%. but low guidance due to the revenue pressure and higher than expected costs, including some that were more one-time in nature. In summary, we're off to a solid start in 2021, and I'm excited about what lies ahead for our truck as we move closer to the upcycle and as the longer-term secular and steady growth in demand for natural gas becomes as clear to others as it is to us today. We'll continue to maximize our near-term performance during this uncertain period, As we do so, we'll remain focused on providing exceptional and safe service for our customers, protecting our balance sheet, liquidity, and leverage position, and maximizing our free cash flow. At the same time, we'll also continue to prioritize and advance our long-term strategies, high grading our fleet, investing in technology, and increasing our focus on sustainability. I'm confident that our truck has the right people, assets, and financial strength in place to drive differentiated and enduring value for our customers and our shareholders within the compression industry and the broader energy landscape. With that, I'd like to turn the call over to Doug for a review of our first quarter performance and provide the latest on our 2021 outlook.

Thanks, Brad, and good morning. Let's look at a summary of our first quarter results and our latest financial outlook for the year. Net income for the first quarter of 2021 was $4 million and included a few one-time items, the majority of which were non-cash. We recorded a non-cash $7 million long-lived asset impairment, a $5 million write-off of unamortized deferred financing costs, and nearly $1 million in restructuring costs. These items were partially offset by a non-income-based tax benefit of $2.5 million. We reported adjusted EBITDA of $98 million for the first quarter of 2021. Adjusted EBITDA was up from the fourth quarter as the impact of lower operating horsepower was offset by $11 million in net gains related to the sale of compression and other assets. I want to emphasize that the ongoing sale of non-core assets based on unit size, age, or geographic location is an important strategic choice for our truck and does more than just generate gains. These transactions improve our operational efficiency and profitability, bring forward future EBITDA, and bring in cash for debt repayment at a time when that's our focus. Turning to our business segments, contract operations revenue came in at $166 million in the fourth quarter, down only $3 million compared to the fourth quarter, due primarily to lower operating horsepower. We delivered strong gross margin percentage of 63%, up 100 basis points compared to the first quarter of last year, and consistent with guidance as our operating team maintained disciplined cost management. In our aftermarket services segment, we reported first quarter 2021 revenue of $29 million compared to $31 million in the fourth quarter. The decrease reflected the continued deferral of maintenance by our customers as well as lower parts and service activity as a result of the severe winter weather. First quarter AMS gross margin of 12% was below expectations. We had a few cost items come in above our forecast for the quarter, including higher workers' compensation and warranty expense. SG&A totaled $25 million for the first quarter. Even excluding the $1.6 million tax benefit during the quarter, SG&A was down 13% compared to the $31 million in the prior year period. For the first quarter, growth capital expenditures totaled just under $1 million, similar to last quarter, and were largely for equipment modifications and repackages. Maintenance and other CapEx for the first quarter of 2021 was $11 million. We exited the quarter with total debt of $1.6 billion. Through debt reduction, we maintained a leverage ratio of 4.1 times compared to 4.2 times last quarter and flat compared to the first quarter of 2020. Debt reduction continues to be a primary focus for our truck, and we are committed to at least $100 million of repayment this year and to bringing down our leverage ratio over time as our EBITDA recovers. We had available liquidity of $414 million as of March 31st, giving us plenty of financial flexibility on top of the free cash flow we are already generating. Yesterday, we declared a first quarter dividend of 14.5 cents per share, or 58 cents on an annualized basis. Our latest dividend represents a compelling yield of 6% based on yesterday's closing price, especially given the protection provided by our industry-leading dividend coverage. Cash available for dividend for the first quarter of 2021 totaled $62 million, leading to healthy first quarter coverage of 2.8 times. Earlier this year, we provided our full year 2021 outlook, including the expectation that our earnings will stabilize in the first part of the year and begin to recover in the later part of the year and end of 2022. As Brad mentioned, our first quarter results keep us on pace to achieve our guidance of adjusted EBITDA of between $335 to $375 million. We expect we will be able to tighten our guidance range as the year progresses. For the full year 2021, total CapEx is unchanged and expected to be in the range of $80 to $106 million. This represents a decline of $47 million on the heels of the impressive $245 million reduction we delivered in 2020. We continue to expect growth CapEx to total between $30 and $50 million, down from the $79 million in 2020 and the $300 million in 2019. 2021 growth CapEx includes repackaging CapEx and investments and a small number of new build units. To sum it up, we are maximizing our cash flow and still expect to drive approximately $100 million in free cash flow this year after dividends. With that, operator, we'd like to go ahead and open the floor to questions.

At this time, I would like to remind everyone, in order to ask a question, press star, then the number one on your telephone keypad. Again, that is star, then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. We have our first question coming from the line of Kyle May with Capital One Securities. Your line is open.

Hi, good morning, everyone. Good morning, Brad. Brad, in your opening remarks, you highlighted some of the economic trends and how that's overlaying with compression stabilization. Just wondering if you can give us any additional color on kind of your perspective on where we are with the economic recovery as it pertains to our truck and the compression business. You know, really just trying to get a better idea if we could see the compression business and perhaps AMS as well see improvements sooner than previously anticipated.

Yeah, thanks, Kyle. Look, what we see going on the market right now is steady improvement both in the data and also in the perspectives of our customers, which has been very encouraging that the guidance that we gave and the basis for it is candidly being reaffirmed. But I would suggest it's not being changed. As we see these indicators pick up, we know that our customers, though encouraging and encouraging, bringing to us discussions of projects that they're going to invest in, are still exercising a decent amount of restraint on new investment activities. They continue to focus on their own capital discipline, balance sheets, and free cash flow. So we, as I said in my opening remarks, and I think this is consistent with what we said last quarter as well, we believe that the back half of the year remains the opportunity for us to see growth in revenue in both AMS and contract operations.

Understood. That's helpful. And, you know, it appears that horsepower pricing actually stepped up a little bit in the first quarter. Just curious if you can share any color on the change that occurred in the first quarter and thoughts about pricing for the balance of the year. Sure.

What I would suggest is that pricing is essentially flat, which we're really happy to see on that level of maintenance of pricing stability in the market that we have today, and that stability overall has been great. The increment you're seeing is somewhat influenced by just quarter-over-quarter noise, but also including that we've brought some more standby units online, increasing the revenue on a per-horsepower basis per month. pretty nicely. The other thing I'd suggest that we're really pleased to see is that we really think that some of the long-term investments and strategic moves we've made are paying off in the stability of our business. The efforts we've had over the years to hydrate our fleet and focus on large horsepower and more stable applications to upgrade the location of our units and the basins in which we operate and are focused on, to work with our strategic customers, as well as to invest in technology, are really starting to show up and pay off in the stability of this business. And we really think a downturn can test a business much better than an upcycle. And we're pleased with how well we're coming through that right now based on that focus and the strategic work that we've done in the past.

Got it. That's helpful. Thanks for taking the questions this morning. You bet.

Thanks, Kyle.

We have our next question coming from the line of TJ Schultz with RBC Capital Markets. Your line is open.

Great, thanks. Good morning. So as you look at that compression market improving, what's your usable idle capacity and how much of that is larger horsepower variety? What would you expect to retire over the next one to two years? I'm just trying to get some indication of reacting to better demand. without a lot of new capex and where you do spend, what would the growth capex be for getting some of that IO capacity ready versus spending on new units into the fleet?

Yep, TJ, great question. Good news, we look at the overall fleet and from a kind of capacity, a way to think about it is highest utilization that we've experienced in the past has been right around that 90% level, 89% to 91%. The remaining amount of a fleet is then units that are coming off application, being made ready and going back to work. So we typically think about capping out utilization on a fleet as large and as diverse as ours at that 90% range. And we're at about 82% now, and that gives you a proxy for 80%, 8% of the units that would be basically good to go back to work. That's one perspective. The second perspective is that for the 1,300 horsepower and below range, we have lots of idle capacity, lots of idle units that are well equipped to go back to work within that 8% range, and we're working to put those back to work now. We do expect the bulk of our start activity in 2021 to be from that idle fleet and not require a significant investment in new horsepower units. At the 1,500 horsepower and larger range, however, the market remains pretty tight and very stable. And demand in that category is going to require us to start reinvestment. And we do think that that's likely starting in the back half of the year and moving through 2022. Okay, cool. And then on

Selling horsepower and realizing some gains, understand there are operational benefits, and it sounds like that will continue to be a tool to bring some EBITDA forward for you all. I'm just trying to think about how that progresses or quantifying that. Maybe if we think about the rest of this year, how much of your EBITDA guide range reflects some of those expected gains from some of these high-grading efforts?

Yeah, TJ, it's Doug. So, look, I think these transactions are – particularly if they come in any size, are pretty tough to execute. There are some counterparties that we're out there talking to, but from a forecast perspective, and I think I'd point you back, maybe not word for word to the Q4 transcript, but the midpoint of our guidance range for this year sort of reflects flat horsepower year over year, right? So we really aren't baking in any additional asset sales, certainly gains on asset sales into this guidance range, unless you start pointing towards the upper end. And, you know, I think there's a number of things we could point to that would get us to that. From a tailwind, possible tailwind perspective would be more large horsepower starts, more AMS activity, you know, a possible purchase leaseback transaction that we talked about, or, you know, those non-strategic asset sales. Those would would, you know, I believe get us more to the high end of the range. And then, you know, some of the headwinds that we're working to try to offset are, you know, higher oil prices have meant higher lube oil prices. And as more assets, idle assets go back to work, You know, those could – that just means more lube oil that we've got to put in, a little higher make-ready cost. And then, as Brad talked about, on some of that, you know, less than 1,000-horsepower stuff, that environment, while the large-horsepower stuff is really tight and we're seeing that pricing be very good, on some of the smaller horsepower, it could be a little tighter, meaning pricing is a little tougher and more competitive. So – I know that's a long-winded way of answering the how's it coming on asset sales. The answer is really there's a lot of things, obviously, that go into our guidance, but nothing further at, you know, again, the midpoint of that range, and hopefully that gives you a little bit of direction.

That's great. Thanks, everyone. I'll just leave it there. Sure. Thank you.

We have our last question coming from the line of Selma and actual with people. Your line is open.

Thank you. Good morning. I just wanted to continue along sort of the last answer you gave there. You referenced higher lube oil prices and make ready costs. I guess. Can you specifically maybe talk about what you're seeing in the labor markets as well in terms of just inflationary pressures?

Sure. We are definitely seeing the labor market is surprisingly tight at this part of the cycle, where we think we are flattening out and stabilizing. We typically would expect to see the labor market tightening and inflationary pressures ahead of us. But the dynamic in the field right now is that we are restarting, I think, some of the labor pressures of a a steeper part of the up cycle earlier in this cycle than we've had in the past. So we will see some inflationary pressures on labor, but we think they're in hand. We have a tremendous labor force and great management team to help us both recruit, develop, and dispatch and, you know, retain and have our workforce work with our customers. So we're optimistic that we can navigate this well. But we are seeing earlier inflationary pressures than we would have expected otherwise.

Got you. And then in your opening comments, you talked about and you were pleased with seeing how gross margin was sequentially flat. So I'm hearing you're saying the inflationary pressures are under control, but should we kind of still expect or are you seeing anything that might be a detriment to the gross margin?

Well, look, quarter over quarter, the gross margin may fluctuate a bit. We're definitely facing the headwinds we just described. And, you know, let's give you the easy summary on those headwinds. It's incrementally in labor. We're going to see it in lube oil and fuel usage. We're also going to see some spend as we invest in making units ready to go back to work. And all of those will provide pressure. Our goal is, however, to use the improved sort of operations that we've invested in over the years to help offset some of those inflationary pressures and still deliver a gross margin target within the range of our guidance. But quarter over quarter, you may see minor fluctuations in what actually gets delivered. But for the year, we're very comfortable with our guidance.

Gotcha. And then just the last one for me. Can you just remind us, I mean, as you go back into the upside cycle, what you expect your leverage or what your leverage goal is?

Yeah, sure. Look, I think really the only thing for us that's uncertain is the timing. And I'm not at all trying to be elusive about this. But, you know, again, right now what we're focused on is using free cash flow after dividend to pay down debt. And, you know, getting EBITDA back to sort of a pre-COVID level, I think we would obviously be inside of our four times target. I think what we've talked about as a management team and I think have brought support from the board long term is – but I long – that depends on who you're talking to, right? For hedge funds, that's a week. For long-term holders, that's a couple of years. But for us, three and a half is really that medium, long-term goal. And we'd love to get there by the end of 2022, but that's very dependent on what's the recovery look like. And so, We'll continue to be in debt repayment mode. Obviously, that's only half the equation, getting EBITDA back to the levels that we experienced prior to the downturn. The timing is a bit uncertain, but our philosophy has not changed.

Got it. Thank you guys very much for the time. Thank you. Thank you.

There are no more questions at this time. Now I'd like to turn the call back over to Mr. Childers for final remarks.

Thank you, Operator. We appreciate everyone's interest in our truck. I want to close by extending my thanks to our dedicated employees as we navigate the evolving market environment and focus on the elements of our business that we can control. I'm proud of our first quarter performance and look forward to updating you on our progress next quarter. Thank you.

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