Archrock, Inc.

Good morning. Welcome to the ARTRAC third quarter 2021 conference call. Your host for today's call is Megan Repine, Vice President of Investor Relations of ARTRAC. I will now turn the call over to Ms. Repine. You may begin.

Thank you, Charlotte. Hello, everyone, and thanks for joining us on today's call. With me today are Brad Childers, President and Chief Executive Officer of ARTRAC, and Doug Aaron, Chief Financial Officer of ARTRAC. Yesterday, ArchRock released its financial and operating results for the third quarter of 2021. 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 meaning of Section 21E of the Securities and Exchange Act of 1934. based on our current beliefs and expectations, as well as assumptions made by and information currently available to our truck management team. Although management believes that the 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 during this call. In addition, our discussion today will reference certain non-GAAP financial measures, including adjusted EBITDA, gross margin, gross margin percentage, cash available for dividend, and free cash flow after dividend. For reconciliations of these non-GAAP financial measures to our GAAP financial results, please see yesterday's press release and our Form 8K furnished to the SEC. I'll now turn the call over to Brad to discuss R-Track's third quarter results and to provide an update of our business.

Thank you, Megan, and good morning, everyone. The positive trends in our top line drivers that we saw in the second quarter accelerated in the third, bolstering our confidence that the industry is in the early stages of recovery and setting the stage for a significant increase in activity as we move into 2022. During the quarter, we grew our operating horsepower slightly after adjusting for the non-core asset cells. Horsepower bookings exceeded second quarter levels. We're driving bookings at levels similar to early 2019, providing us greater visibility into new starts through the remainder of 2021 and into next year. And finally, our AMS revenue increased sequentially and on an annual basis, and our customers began catching up on major maintenance. Turning to our financial performance, the second half of the year is proving to be the transition period we'd expected and that we've experienced in the past as a late-cycle market participant. As we discussed last quarter, our revenue is at cyclical lows, and at the same time, we're beginning to invest to meet the expected growth ahead. And we're starting to face inflationary pressure from a tightening market. Despite the near-term challenge this presents, we're seeing the benefits of our actions to maximize our profitability, cash flows, and returns for our shareholders. Our total revenue of $195 million was down just $450,000 sequentially. Our contract operations gross margin percentage of 61% was within guidance expectations and above prior cycle lows, even in the face of sharp cost inflation. We generated impressive free cash flow after dividend of $98 million for the quarter and $179 million year to date, driven by disciplined capital allocation and proceeds from the sale of non-core assets. I'd also like to highlight that since the end of 2019, we've repaid a significant amount of debt together with returning a significant amount of capital to shareholders. In the midst of a global pandemic and through one of the most severe downturns in the energy industry's history, we've reduced our debt by $328 million and returned $156 million to our shareholders through dividends. At the same time as we've repaid debt and maintained our well-covered dividend, we've also continued to advance our multi-year strategic initiative to reposition our compression platform for a more efficient and sustainable future. We've done this through non-core asset cells, investment in large midstream compression units, and continuing our investment in technology on our existing fleet. Today, our truck's fleet is larger. As a percentage of our fleet, large horsepower has increased from 74% at the end of 2019 to 81% today. Our trucks fleet is digitized. We're just beginning to leverage the expanded telematics capabilities on our compression units to drive an enhanced and more efficient response to downtime events. We'll complete the planned installation of telematics across our fleet by the end of the year. And our trucks fleet is standardized. We've reduced the number of configurations in our fleet by 65% from the highs in 2011. Taken together, I'm excited about the benefits still to come as we deploy our enhanced fleet in steady midstream applications in the most critical US bases. These benefits include that our efforts will enhance our customers' experience and increase their uptime. Equipping our compression fleet with technology allows us to remotely monitor performance across our entire fleet and diagnose potential issues earlier. Our efforts will optimize our cost structure. Our vehicle telematics provide the data necessary to manage vehicle idle time and miles driven. Combined with our initiative to equip our entire compression fleet with telemetry, we expect improvements in how we supply the parts necessary for maintenance to decrease response time and reduce the number of trips our mechanics will make to the field. Finally, Our efforts have and will continue to reduce our emissions and carbon footprint. As we detail in our latest sustainability report, our compression fleet has become newer and more efficient for horsepower basis, and emissions have been reduced as a result. Reducing the number of trips required to the field will similarly reduce our miles driven. Turning now to a deeper review of the market backdrop. Oil prices have reached over $80 per barrel, and U.S. natural gas prices have exceeded $5 per MMBTU, levels we haven't seen for some time. This commodity price breakout is being driven by the concurrence of an accelerating vaccine-driven recovery and years of underinvestment by EMPs. Producers and midstreamers continue to hold the line on 2021 spending levels as investors remain focused on free cash flow generation and payout ratios. As a result, natural gas production, the largest driver of our compression business, has remained relatively flat this year. Looking into next year, we're increasingly optimistic. Based on our conversations with customers, we believe supportive commodity prices will drive higher reinvestment rates in 2022, though the magnitude of this expected increase will be solidified over the coming months. The EIA's forecast for natural gas production has increased since last quarter's call, with natural gas production now expected to exit 2022 at 99 BCF a day compared to 96 BCF a day previously. This represents a 10% increase from the low point experienced in the second quarter of 2020. This latest EIA forecast, combined with the additional perspective of rapidly increasing European gas prices due to constrained hydrocarbon investment and growing reliance on renewable energy, both reinforce our long view on structural natural gas demand growth in the U.S., even as the entire world works through energy transitions. Moving on to our segments, our contract operations top line performance was steady and compression demand signals continued to be encouraging. Compared to the second quarter, our third quarter exit fleet utilization was flat at 82%. And excluding the 101,000 active horsepower we chose to sell as part of our fleet high grading strategy, we grew operating horsepower slightly for the first time since the onset of the pandemic. We saw higher costs due to an increase in make-ready and freight expenses as we prepared to meet higher customer demand, and like others, also faced rising parts, lube oil, and labor expenses. Although we believe additional inflationary pressures are ahead for the entire industry, I can assure you that our supply chain and operations teams are doing their best to mitigate these cost headwinds through tight cost control, supply chain inventory management, and efficiency gains. We also began taking necessary action to implement our own price increases during the fourth quarter and expect these to be broad-based next year as the market continues to tighten. We expect this momentum to carry forward at a pace that should enable us to deliver horsepower growth in 2022. Taking a step back, Over the last two years, we've divested a significant amount of non-core compression horsepower based on size, age, or geographic location. We've strategically engaged in these transactions to drive concrete operational benefits for our truck. These benefits include that we've enhanced our competitive position and improved our returns, especially as we focused on a more stable large horsepower segment of the market and midstream compression applications. These actions have also made our fleet more durable as we approach energy transition and look to position the company to reduce greenhouse gas emissions from our fleet. And our high-grading efforts have ensured that we've retained the right equipment as we invest in telemetry and remote monitoring capabilities across our entire installed base. Finally, when it comes to safety, our employees can We've achieved great safety performance with zero recordable safety incidents recorded so far in 2021. In aftermarket services, revenues were up $5 million sequentially and $6 million on an annual basis, driven by both higher part sales and service activity. This is a walk of development following years of maintenance deferral by our customers. Turning to capital allocation, it's simply too early to lay out detailed guidance for next year on today's call. Just like our customers, we're in the early stages of planning for our 2022 budget. However, I can speak more broadly about how we're thinking about our capital allocation framework for next year. With the steady and modest growth in demand for national gas compression forecast ahead, The opportunity to deploy capital at premium pricing under multi-year contracts is beginning to unfold. This includes the growing potential to set new electric motor drive units for our customers. We're focused on redeploying existing idle compression units and responsibly investing in our fleet as necessary so that we have the equipment available in configurations desired by our customers. At this time, we expect that in order to meet the needs for our customers, higher growth capital will be required in 2022 compared to 2021. As we selectively invest in high profit, large midstream compression units, make no mistake, we will remain steadfast in our commitment to both maintain a solid balance sheet and return capital to shareholders. In summary, we're experiencing the lag effect typical of our business at this point in the cycle, but believe we're seeing the bottom of what has been an exceptionally challenging period for our truck and for others. We've performed remarkably well, and we've advanced the strategic priorities critical to our long-term success. I'm excited about the recovery that lies ahead, and I'm confident we're prepared to deliver value for our customers and shareholders in 2022 and beyond. With that, I'd like to turn the call over to Doug for review of our third quarter performance and provide the latest on our 2021 outlook.

Thanks, Brad. Good morning. Let's look at a summary of our third quarter results and our latest financial outlook for the year. Net income for the third quarter of 2021 was $9 million and included a few one-time items, the majority of which were non-caste. We recorded a pre-tax $5 million long-lived asset impairment and $2 million in depreciation expense from the write-off of compression and other assets damaged during Hurricane Ida. We reported adjusted EBITDA of $92 million for the third quarter of 2021. Higher net gains on the sale of compression and other assets, as well as improved AMS gross margin dollars, contributed to the $5 million increase in adjusted EBITDA compared to the second quarter. Turning to our business segments, contract operations revenue came in at $159 million in the third quarter, down only $5 million compared to the second quarter, primarily due to the previously announced strategic divestment of smaller and older horsepower. Our gross margin percentage of 61% was down 200 basis points sequentially, as expected, due to the higher cost Brad reviewed earlier. In our aftermarket services segment, we reported third quarter 2021 revenue of $36 million compared to $32 million in the second quarter and $30 million in the prior year as our customers began to catch up on long overdue maintenance activities. Better top-line performance helped with the segment's cost absorption, driving an increase in AMS gross margin percentage to 15% from 13% last quarter. SG&A totaled $29 million for the third quarter compared to $26 million last quarter and $19 million in the prior year period. We had higher technology spending as well as an increase in the compensation expense as we reinstated pre-pandemic salaries for our employees. In addition, the year-over-year comparison was impacted by the $7 million net benefit from tax audit settlements in 2020, with no comparable settlements in the third quarter of 2021. We maintained capital discipline during the third quarter, spending $71 million in total CapEx year-to-date in 21, compared to $130 million at the same point last year. For the third quarter, total capital expenditures of $32 million included $15 million of growth capex for equipment modifications and repackages, as well as delivery of a small amount of new horsepower. We exited the quarter with total debt of $1.5 billion, reflecting the repayment of $97 million in debt during the quarter. Our leverage ratio as of September 30th was 4.3 times, unchanged from the second quarter, but up from the 4.0 times in the third quarter of 2020, as debt reduction only partially offset the impact of lower adjusted EBITDA. We had available liquidity of $518 million as of September 30th, giving us plenty of financial flexibility. We recently declared a third quarter dividend of 14.5 cents per share or 58 cents on an annualized basis. Our dividend is stable and was unchanged compared to the prior quarter. Our dividend is competitive with a yield of 7% based on yesterday's closing price. And our dividend is well covered. Cash available for dividend for the third quarter of 21 totaled $50 million, leading to healthy dividend coverage of 2.2 times. Moving on to our latest view on 2021, given solid third quarter performance and our outlook for the fourth quarter, we expect to achieve 2021 adjusted EBITDA above the midpoint of our $340 to $355 million guidance range. This implies a sequential decline in fourth quarter EBITDA as expected. This reflects normal seasonal Q4 softness in AMFs, continued inflationary pressures, as well as $15 million in third-quarter items that we do not expect to recur. Similar to CAPEX, it's too early to provide formal EBITDA guidance for next year. Brad covered the success we've had with our divestiture program and the resulting operational benefits for our truck. These divestitures have also helped us manage our balance sheet and aggressively repay debt through the downturn, a tremendous outcome made possible by numerous people across our organization. Please keep in mind, however, that the expected EBITDA sold in these transactions was approximately $18.5 million on an annualized basis. We remain focused on optimizing our performance through the end of the downturn and until the positive trends in our bookings and price increases give way to a meaningful improvement in our financial results. With that, we'd now like to open up the call for question and answers. So, Charlotte, can you please take over?

Sure. As a reminder, to ask a question, you will need to press star 1 on your telephone keypad. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Again, as a reminder, if you would like to ask a question, you will need to press star 1 on your telephone keypad. That's star 1 to ask a question. Your first question comes from the line of Daniel Burke from Johnson Rice. Your line is now open.

Hey, good morning, guys. Good morning, Daniel. Let's see. Brad, in your overview, you noted the IEA's forecast for U.S. dry gas production essentially returning in 2022 to pre-COVID 2019 levels. Of course, back at that time, your utilization was in the upper 80s. Right now, you're in the lower 80s. Is it reasonable to think your utilization walk would mirror that expected upturn in gas production, or what are the factors we need to consider?

So we cannot predict utilization level for a period of time, but I'll share with you that we are absolutely focused on restoring our utilization into the upper 80s and beyond as a goal. How fast we can get there, the market will dictate in pace. Our customer activities will dictate in reality, but it absolutely is our ambition to keep this business, especially during a recovery or as a result of a recovery, up into the high 80s or better utilization range.

Okay. I'll stay with that for just one more question. You highlighted fleet mixes, if anything, or is a bit more weighted towards large units. Does that make it easier to get to sort of that 90% effective utilization cap, or do you still have the same amount of friction in the system even with a fleet mix that's more aligned or weighted to large units?

We believe that the improvements we've made into the fleet that have produced a fleet that is younger, that is more competitive, composed primarily of larger horsepower, and in configurations more desired by the market, should give us more momentum to increase our utilization rate compared to the fleet that we operated in the past.

Got it. Okay. And then I guess to pivot maybe as a follow-up, you mentioned the beginning of some price increases being implemented in Q4 and maybe more widespread increases early next year, maybe the more typical pricing season. Can you talk about the mechanics of implementing price increases, the timeline to see them across the fleet, and then How do we think about the ability to achieve net pricing gains when you guys are contending pretty successfully, at least in Q3, with rising costs?

Sure. So the mechanics to increase prices are, you know, we have a number of units that have automatic indexing built into them. That covers approximately one-third of our operating fleet. that's subjected to index-based or automatic price increases inherent in the contract structure. And then for the other two-thirds of the fleet, it's for those units that are out of term, we have the ability to ensure that we've repriced those units at market. And as contracts expire and units roll off, we similarly have the ability to increase pricing to bring it up to market. And so the mechanics are just that communication to the customers to what we're doing and what lies ahead, and that price increase that was implemented for Q4 will continue rolling for every quarter forward until we've accomplished getting the units that are available for price increase back, the two-thirds that are open for price increase back to market.

Got it. I appreciate that. I guess we'll stay tuned for 2020. to guidance in a quarter or so to get a sense for what you can achieve on the margin side into next year as you balance pricing and costs. Okay, I'll leave it there. Actually, maybe one small last question. Doug, you made reference to the sale of $18.5 million in annualized EBITDA. Was that Is that all horsepower sold year-to-date, or was it specific to the July transaction? I guess I just want to make sure I had the right clarity on that.

Yeah, Daniel, it's all horsepower sold year-to-date, and that's obviously annualized. So we're trying to help. We're not yet, as we talked about, ready to give 22 guidance, but also want folks to be cognizant of that. We absolutely believe operationally, and for all the reasons Brad described, that was the right decision, and our fleet's getting younger and more standardized. But in the near term, that's also EBITDA that we'll be looking to replace with new horsepower in 2022.

Understood. Okay, guys, I appreciate the time this morning. Thank you. Thank you.

again as a reminder if you would like to ask a question just press star 1 on your telephone keypad again that's star and then the number one on your telephone keypad for you to ask a question there are no more questions now i'd like to turn the call back over to mr childers for final remarks thank you operator

Thank you, everyone, for participating in our third quarter earnings call. As we noted, we continue to drive strong customer activity and believe we're well positioned operationally and financially to capitalize on opportunities in a compression market as the demand for our services increases. I look forward to updating you again on our fourth quarter and year-end 2021 calls.