Archrock, Inc.

Good morning. Welcome to the ARTROC second quarter 2022 conference call. Your host for today is Megan Repine, Vice President of Investor Relations at ARTROC. I will now turn the call over to Ms. Repine. You may begin.

Thank you, Brent. Hello, everyone, and thanks for joining us on today's call. With me today are Brad Childers, President and Chief Executive Officer of ARTROC, and Doug Aaron, Chief Financial Officer of ARTRAC. Yesterday, ARTRAC released its financial and operating results for the second quarter 2022. If you have not received a copy, you can find the information on the company's website at www.artrac.com. During the 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 Trust 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 made during this call. In addition, our discussion today will reference certain non-GAAP financial measures, including adjusted EBITDA, gross margin, gross margin percentage, free cash flow, free cash flow after dividend, and cash available for dividend. 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 track second quarter results and to provide an update of our business.

Thank you, Megan, and good morning, everyone. During the second quarter, we continued to see a significant acceleration of customer activity and a strengthening of supply-demand dynamics for large midstream compression. Our focus in the quarter was converting this growing customer demand into high-return bookings, delivering profitable growth and maintaining capital discipline. Second quarter highlights include that we generated adjusted EBITDA of $99 million, reflecting solid underlying business performance that was generally in line with our internal expectations. In addition, quarterly results benefited from a net gain on the sale of assets as we continue to advance our fleet high grading strategy. Strong customer demand and our well-positioned and configured fleet of large horsepower compression equipment drove an increase in operating horsepower of 100,000 horsepower, excluding asset cells, and an increase in our exit utilization of 300 basis points to 87%. This improving utilization of our fleet and the extremely limited supply of available horsepower in the market are also allowing us to drive spot prices to record levels broadly across asset classes. Year-to-date bookings have doubled compared to the first half of 2021. This is providing us great visibility into new starts for the remainder of the year and into 2023. Last, AMS revenue increased nearly 50% on a sequential basis due to a welcome resurgence in overhaul and maintenance activity by our customers after years of deferrals. Moving on to the market backdrop, U.S. oil and gas production continued to tick higher, and for both 2022 and 2023, the EIA projects solid annual increases of 3 to 4 percent for natural gas and 6 to 7 percent for oil. More recently, uncertainties around a potential for recession have emerged, sending oil and gas prices lower, albeit to levels that continue to stimulate increased investment by producers. Although impossible to handicap the risk of a recession, we think several mitigating factors are worth noting. For oil, OPEC spare capacity remains limited and its willingness and ability to use it in question. For gas, Europe is now facing severe natural gas shortages due to its dependence on Russian supplies. And the global tightness we're seeing in oil and gas markets is largely the result of years of structural underinvestment and issue without an immediate solution. The energy industry in our business may not be entirely recession-proof, but commodity demand has historically remained resilient in periods of economic weakness, and current supply constraints for oil and gas are likely to persist. As we navigate through this cyclical noise, we've become more excited about the long-term outlook for our business. We expect that U.S. natural gas will play a vital role in meeting clean energy demand. Our mission to help our customers deliver abundant, affordable, and cleaner natural gas to a variety of critical industries to generate electricity and to directly heat and power our homes is more critical than ever. Further, recent geopolitical events have quickly driven the realization that a more diverse energy mix is needed to satisfy global energy demand and preserve energy security. In particular, we remain encouraged by the growing potential for another wave of LNG projects in the middle of this decade that would result in a meaningful call on U.S. natural gas production and therefore our natural gas compression services. The powerful combination of these secular forces lays the foundation for a robust and sustained upturn. Now turning to our operations, in our contract operations segment, demand for our large midstream compression accelerated across geographies, customers, and horsepower categories during the second quarter. You can see the positive impacts of this demand in our results through increased horsepower growth, increased utilization, and increased pricing. The 100,000 horsepower of organic horsepower growth that we delivered in the quarter was driven by several factors, including strong customer demand, as seen in our bookings and start activity, as well as low levels of stop activity. Demonstrating how quickly the market has recovered and is growing we started a total of 155,000 horsepower during the second quarter, the highest level of quarterly start activity that we've seen since 2019. And more than 80% of that start activity during the quarter was met by our idle fleet. Similarly, equipment stop activity has fallen to historically low levels as customers take advantage of higher commodity prices, and as the market supply of available horsepower is extremely limited. Looking ahead, with year-to-date bookings up 100% compared to the first half of last year, we have good visibility into accelerating start activity over the next several quarters. Our horsepower utilization exited the quarter at 87%, up from 84% at the end of last quarter. We're effectively sold out of several horsepower categories, and based on our assessment of the market today, we expect to test new highs in total fleet utilization by the end of the year. During the quarter, we continue to transform and standardize our fleet with additional non-core asset cells totaling 97,000 horsepower, creating significant long-term value for our truck. We're selling horsepower at attractive multiples, and redeploying the proceeds to help advance our strategic priorities and to fund our investment in new, standardized, large horsepower. This new horsepower will be deployed in the more stable midstream segment of the market for decades to come. These strategic divestitures are accretive to our leverage, have improved our returns, and position us well to continue to reduce greenhouse gas emissions from our fleet. During the quarter, we incurred higher costs primarily due to two dynamics. First, the steepness of the current recovery is requiring significant make-ready and labor expense to meet higher customer demand. This short-term dynamic of incurring higher costs to reactivate the idle fleet is completely consistent with what we've experienced during the redeployment phase in past cycles. However, this has been a particularly difficult environment to quickly and efficiently shift into growth as we've only recently emerged from a downturn, a period where our field organization was operating as leanly as possible and as labor availability across the industry is exceptionally tight. Second, U.S. inflation hit a 40-year high during the quarter, and we experience the impact of higher prices across our major cost categories of labor, parts, and lube oil. Though due to the pace and magnitude of this current high inflation, we experience margin compression in the quarter, we are confident in our ability to mitigate these impacts. We expect capacity across the industry will remain limited in light of continued capital discipline and extending lead times for new large horsepower units, which has already allowed us to increase spot prices to record levels. In the coming quarters, we intend to reclaim the increasing costs we're currently experiencing as we raise pricing on our installed base of operating horsepower, which we expect to translate into improved financial performance in 2023. As the current upcycle unfolds, I remain confident that our investments in our customer base, our fleet, our technology, and our talent will continue to pay dividends and differentiate our truck. Moving to our aftermarket services segment, second core performance was sharply improved. Both parts and service revenue increased to levels not experienced since 2019 due to customers catching up on deferred maintenance work as well as a seasonal uptick in demand. Of note, we believe industry-wide labor scarcity is driving more outsourcing of maintenance, which is typically higher margin work for our AMS segment. In addition, given the nature of our AMS business, we're able to pass through cost inflation to our customers more quickly to protect our margins. We believe this trend should continue for the foreseeable future. Turning to new ventures, the second quarter was busy for the team. As you know, we acquired a 25% minority stake in Ecotech, a company with impressive and tested technology for continuous methane emissions monitoring and management. The partnership was off to a good start as we began the work to introduce Ecotech's suite of solutions to our customer base in support of their methane emission reduction goals. I'm excited to share that we have agreements in place to demonstrate Ecotech's proven technology in oil and gas applications with multiple customers and in multiple basins this year. The first installation for demonstration was recently completed and I look forward to sharing additional progress later in the year. Beyond Ecotech, our internal team has been tasked with exploring potential improvements in compressor operations and design, as well as evaluating potential partnerships with additional third parties with a goal of assisting our customers to achieve improvements in emission performance. These efforts to develop solutions to help our customers decarbonize further solidify our commitment to and support of the role we expect natural gas will continue to play as an environmentally, economically, and strategically sound energy source for America and for the world. Turning to capital allocation, We intend to make high return investments in our fleet to grow prudently and profitably with our customers, continue our dividend commitment, all while maintaining a healthy balance sheet and financial flexibility. First, customer demand is robust, and we are responsibly increasing our investment in our fleet as planned so that we'll have equipment available in configurations desired by our customers. We're doing so at high returns, and believe returns on our new build investments are poised to strengthen further as utilization increases, capital discipline in the industry persists, and lead times extend. Second, we remain committed to returning capital to our investors. As shareholders ourselves, the board and I recognize that our dividend is an important component to the overall value equation.