Archrock, Inc.

Good morning. Welcome to the ArchRock second quarter 2023 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 Ms. Repine. You may begin.

Thank you, Julianne. 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 second quarter 2023, as well as updated guidance for the full year 2023. If you've 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 our current beliefs and expectations as well as assumptions made by and information currently available to our TRACS 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 and our Form 8K furnished to the SEC. I'll now turn the call over to Brad to discuss ArchRock's second quarter results and to provide an update of our business.

Thank you, Megan. Good morning, everyone, and thank you for joining our call. Exceptional execution drove ArchRock's outstanding second quarter performance. In our results, we see the long-term and hard-fought-for benefits of our Transform platform combined with and operating in a compression market that remains undersupplied. In the second quarter, our net income of $25 million was up nearly 50% compared to the second quarter of 2022. We generated adjusted EBITDA of $113 million, up 16% compared to the first quarter of 2023, and up 13% compared to the second quarter of last year. These increases were driven by positive momentum in unit start activity, pricing, and profitability in both our contract operations and our aftermarket services business segments. In contract operations, revenue increased 7% sequentially and was complemented by a strong contract operations gross margin as we saw record utilization and record pricing. In aftermarket services, performance meaningfully exceeded expectations for the second quarter in a row. We delivered a 42% increase in gross margin dollars compared to the same period last year. As we met strong customer demand, we concurrently continued to increase returns to investors, raising our dividend for the second time this year, while also maintaining robust dividend coverage of 2.1 times. In addition, we began repurchasing shares under our buyback authorization. Last, as we continue to embed sustainability in our strategy, I'm proud to share that we recently received recognition for our progress from Hart Energy by being named one of 12 energy companies to receive the Hart 2023 Energy ESG Award in the public midstream category. These are just a few of our second quarter achievements. These achievements are the direct result of our employees' outstanding efforts over the past several years to execute on our strategic transformation and to deliver a first-rate customer experience each and every day, 365 days a year. As we continue to raise the bar for our company, our employees continue to step up to deliver excellent safety performance outstanding operations, and strong financial results. For this, I'd like to pause and thank the incredibly hardworking women and men of R-TRAC. The step change in second quarter results is just the beginning for R-TRAC, and we believe we are set for an extended period of strong and sustained performance. I want to take a moment to reiterate what I said on our call last quarter. We believe our truck has never been in a better position than it is today. I'd like to expand on that statement and offer the reasons why we're in this position, which we believe is driven by three factors. First, natural gas production fundamentals remain durable and promising. Second, the compression industry is as tight as we've ever seen. And third, our competitive position is as strong as it's ever been, and our balance sheet offers distinctive flexibility within the compression sector. First, on the durability and promise of natural gas fundamentals. Let me reiterate and highlight a key differentiating aspect of our natural gas compression business, which is that our business is tied to natural gas production volumes and not commodity prices. U.S. natural gas production forecasts continue to show growth in 2023 and 2024 volumes, with most forecasts showing projected growth rates in the low single digits on an annual basis. And associated gas volumes in the Permian and other liquids rich shell plays, where the majority of our operating fleet is located, are expected to grow at an even faster pace. This is consistent with the elevated customer demand that we continue to experience for our large horsepower units, as compression infrastructure is required to transport these associated gas volumes to market. Second, the compression industry is as tight as we've ever seen, and we currently don't see a disrupter to tight market conditions. There is simply not enough equipment to satisfy current natural gas compression demand, much less to support the growth in gas volumes I just described. The industry is still catching up, following a period of significant underinvestment during and coming out of the COVID-driven downturn. In addition, ArchRock and other outsourced compression providers, like many companies in the energy industry, are responding to broader market demands for capital discipline and restraining the amount of growth capex being invested. And last, lead times for new equipment remained around a year. This brings me to my third and final point. Our competitive and financial position offer significant flexibility within the compression sector. As we've sold small non-strategic horsepower, we've quickly replaced this with higher quality EBITDA by investing in large and standardized horsepower in the more stable infrastructure segment of the market, high grading our customer relationships and enhancing our leverage to growth plays. As I step back and think about our position today, we have the most experience with over 68 years of operating expertise. We are the leader in large midstream horsepower. Our fleet has the most horsepower, the largest horsepower per unit, and the highest percentage of large horsepower. We have the best balance sheet and financial position. This includes the lowest leverage ratio in the space and As I will get to in a moment, we're moving our target even lower. With ArchRock's superior platform, we have strong visibility and confidence in our ability to generate free cash flow and allocate capital with discipline, and we are well positioned to create and return value to our shareholders. A testament to our conviction, we increased our financial guidance for 2023, which Doug will walk through shortly. In addition, today we're in a position to share some initial expectations for 2024 a lot sooner than we have been able to in the past. Based on our current outlook for 2024, we are set up to grow our dividend with a 2024 target of 5% and maintain a dividend coverage ratio of approximately two times. Concurrently drive our leverage ratio even lower to a range of 3%. to 3.5 times, fund our growth capital expenditures, which we currently anticipate to be in $160 million range in 2024, down 20% compared to 2023. And this capital plan preserves significant optionality to buy back additional shares. Moving to our contract operations segment. we're seeing unprecedented levels of tightness in the market. This is evident in key demand indicators, including utilization, booking activity, and pricing. Fleet utilization exited the first quarter at 95%, another record for our truck. We also delivered approximately 75,000 in horsepower growth, excluding non-core active asset cells of 7,000 horsepower. Our team continues to do a great job putting our remaining idle fleet back to work. We continue to see historically low customer stop activity. And when we do have equipment returns from the field, this horsepower continues to be promptly rebooked at higher rates. On booking activity, customer demand is unwavering. And in fact, in fact, extending in duration. With the compression market undersupplied, and customers cognizant of long lead times. Not only do we have an early and elevated order book for 2024, but booking demand for 2025 is already heating up. On pricing, with utilization at historic highs and continued strong booking activity, we've continued to move pricing higher. We achieved a record monthly revenue per horsepower during the quarter, reflecting a sequential increase of 5%. This is the largest sequential increase since the current up cycle began. Record spot pricing is holding and we expect to continue to make progress moving rates up on our installed base. Gross margin percentage increased 450 basis points sequentially based primarily on a couple of factors. First, make ready expenses have started to decline to more normal levels with our more fully utilized fleet. And second, the price increases we're implementing this year are catching up with the cost increases we experienced over the last few years. Turning to aftermarket services, we're seeing noteworthy performance. Trends on the service side of the business really stand out as customers continue to catch up on deferred maintenance. In addition to elevated activity, Results also reflect the outstanding effort by our team to high grade our AMS operations, both in terms of the quality of activity and the profit margins we are targeting. This has been really great work. In summary, our fleet transformation efforts over the past several years paid off in a big way during the second quarter, and we believe the best is yet to come. Trends continue to point to a multi-year run for natural gas and in particular compression, one with a longer duration than previous cycles. As the leading outsourced compression provider in the U.S., we are well positioned to capture significant value for our shareholders. With that, I'd like to turn the call over to Doug for a review of our second quarter and to provide additional color on our updated outlook for 2023.

Thank you, Brad, and good morning. We appreciate all of you joining us. Let's look at a summary of our second quarter and then cover our financial outlook. Net income for the second quarter of 2023 was $25 million. This included a long live and other asset impairment of $2.9 million and an unrealized change in the fair value of our investment and an unconsolidated affiliate of $1.7 million. We reported adjusted EBITDA of $113 million for the second quarter 2023. Underlying business performance was strong in the second quarter as we delivered meaningfully higher total gross margin dollars on both a sequential and annual basis. Results further benefited from approximately $1.2 million in second quarter asset sale gains. Turning to our business segments, contract operations revenue came in at $201 million in the second quarter, up 7% compared to the first quarter of 2023. Operating horsepower and pricing both increased sequentially. Compared to the first quarter of 2023, we grew our gross margin by nearly $17 million, or 16%, resulting in gross margin percentage of over 62%. This was up 450 basis points compared to 1Q lows. In our aftermarket services segment, we reported second quarter 2023 revenue of $46 million, up 10% compared to the first quarter of 23. Second quarter AMS growth margin of 24% was up from 19% in the first quarter of 23 and 16% in the year-ago period. Growth capital expenditures in the second quarter totaled $71 million as we continue to invest in new equipment to meet strong customer demands. Maintenance capex for the second quarter was $27 million compared to $23 million during the first quarter. Make ready capex was down sequentially, which was offset by higher overhaul spending. In May, we completed the extension of our $750 million revolving credit facility through 2028. I'm very pleased with the continued support from our lenders in the debt markets, an indication of the health and steadiness of our business. We exited the quarter with total debt of $1.6 billion and variable rate debt continue to represent 21% of our total long-term debt. In addition, we maintain strong available liquidity of $404 million. We reduced our leverage ratio to 4.2 times down from 4.4 times in the second quarter of 2022. As we execute our plan and our earnings power continues to build, We expect to achieve a leverage ratio well below four times by year end 2023 and currently anticipate taking that even lower in 2024 to a range of three to three and a half times. We recently declared an increased second quarter dividend of 15 and a half cents per share or 62 cents on an annualized basis. Our latest dividend represents a solid yield of around 6% based on yesterday's closing price. Cash available for dividend for the second quarter of 2023 totaled $52 million, leading to impressive quarterly dividend coverage of 2.1 times, even on the higher dividend level. In addition to increasing the dividend this quarter, we repurchased approximately 220,000 shares for $2 million at an average price of $9.33 per share. This leaves $48 million in remaining capacity for additional share repurchases. Turning to our 2023 guidance, we have tremendous confidence in compression market fundamentals in the execution we're seeing and in our financial outlook, both near and longer term. Taking into account solid first half performance and our enhanced outlook, we are raising our 2023 annual adjusted EBITDA guidance range to $430 million to $450 million from $400 to $430 million. This compares to $363 million in 2022. And after normalizing for 2022 net gains on asset sales totaling $40 million, 2023 adjusted EBITDA is projected to increase 35% year over year. Turning to capital, on a full year basis, we expect total 2023 capital expenditures to be around $295 million. Of that, we are holding the line on growth CapEx of $200 million to support investment in new-build horsepower and repackage CapEx to meet continued customer demand. As Brad mentioned, we believe 2023 is just the beginning. Our exceptional execution, the undersupplied compression market, strong backlog give us confidence to expect this robust market to continue well into the future. In the coming quarters, we look forward to build upon what we believe is a compelling value proposition for ArchRock through durable and enhanced earning powers and growing return of capital to shareholders. With that, Julianne, I think we'd now like to open the line for questions.

Thank you. If you would like to ask a question, please press star followed by the number one on your telephone keypad. To withdraw your question, please press star one again. Our first question comes from Jim Rolison from Raymond James. Please go ahead. Your line is open.

Good morning, gentlemen. How are you today? Good morning, Jim. We're great. Thanks. brad just to follow back up on the on the contract compression margins obviously you kind of got it coming from from both sides of the equation uh with higher pricing and then you saw costs come down on the cost part of that equation and we i think you've talked for a few quarters now about elevated make ready costs and as you kind of run out of close to full utilization uh obviously that that fades as we think about that part of the equation the cost side How sustainable is that kind of over the next handful of quarters? I mean, obviously, we know what the guidance is, but I'm just thinking even beyond this year is low 60s to 60, 62 percent type of number, a sustainable number. Do you see any inflationary things that are still lingering or just kind of how are you thinking about that side of the equation?

Thanks, Jim. On the good news side, we are very confident in the forecast, the guidance that we've laid out for 2023. That's definitely the best reference point for you to think about the profitability. Supporting that, we still see opportunities for pricing to continue to move based upon how tight the market is, how high utilization is. The long lead times for equipment remain very supportive on the revenue side of the equation. And then on the cost side, we've benefited from a more normalized make ready expense for sure, but we've also seen some inflationary pressures that previously pushed us abating a bit. And that includes not just the make ready expense, but also our overall management of the labor in the field. As activity levels come down, we can manage our labor better, and we've also gained some incremental downward momentum in a few categories, including notably lube oil. All of that suggests we're highly confident in our gross margin guidance, and you're right. It's definitely coming productively from both the revenue and the cost management side.

And curiously, I don't know if you'll answer this, but I'm going to ask it anyway. If you were to mark to market your kind of entire fleet today that's out there working to where leading edge pricing is, what kind of delta would that imply for your kind of average monthly revenue per horsepower, just from what you just posted in this quarter, if you don't know that number by perchance?

You're right on multiple fronts. We believe that one of the key things drivers and benefits of the market that we're in is the value of our compression fleet has increased significantly based upon the demand for compression in the space. So your hypothesis is a strong one, and as is your assertion that we don't have a number for that. No worries.

No, we do have a number. We do have a number, Jim. Unfortunately, that's not one we're going to share.

Yeah, that's fine. Understood. And then just one last follow-up on, I was going to ask you about growth capex. You obviously gave color next year at 160 million down from 200 million. Curious, the philosophy there, how much of that reduction is tied to kind of capital discipline versus your desire to return capital or reduce debt or what have you versus just customer demand delta?

Yes. The answer to those three points is yes. First, on just the demand in the marketplace today, which we see both at high levels and extending in duration, because we've also suggested we have bookings pressure already for 2025. I'll note that demand is strong, but we're now in August, and with one-year lead times, that leaves us only a portion of the year left to book more equipment and spend more CapEx, that reinforces the strength of that guidance. The second I point out is that that number is already substantially booked with customer commitments, which is really strong, setting up a really strong 2024. But finally, I want to emphasize we're very committed to generating free cash flow through the cycles. And that includes that we expect and target to have a very firm commitment to generate free cash flow and return of capital to our investors in 2024. Great.

Thanks for your answers. Appreciate it. Good quarter. Thanks, Jim. Thank you.

Our next question comes from Salman Akyol from Stifel. Please go ahead. Your line is open.

Thank you. I want to go back to, you talked about prices moving higher. You set it up 5% sequentially. So as we think about that, and I guess a little bit kind of going back to the last question, that would just be, I guess, for stuff you're placing newly into service and stuff that just recently came up for recontracting. So I guess how much further to go, number one, on the 5%, and then Can you say like in the next year you're going to be repricing 10% of your fleet, 15, 20% of your fleet, 25? Because it goes out there at a three to five year tenor?

Thanks for the question, Solomon. First, the pricing that we see in the market today does not just apply to spot pricing. While spot pricing is up significantly, like definitely double digits, on a year-over-year basis. We also are working hard to raise the pricing on our installed base, and that's justified for a few reasons. One, the super tightness in the market, but also we've been catching up to some of the price cost inflation that we experienced over the last couple of years, and that's providing a justification and a need for us to see pricing come up on the fleet in its entirety. Finally, to your question, on the good news front, About 70% of our fleet is either out of term or under contracts that have pricing mechanisms built into them and will be available for repricing within the next year. So we see a lot of opportunity and a lot of need and momentum given the market tightness that we're experiencing for us to continue to put the pressure on pricing.

This is Doug. I'll just add a couple more data points here. For us, revenue per horsepower per month is now up seven quarters in a row. Obviously, coming out of COVID and at a time when utilization was at a much lower number than it is today, you would expect that to continue. But as you look at not just ArchRock at 95% utilization, but the industry, as Brad talked about, so tight right now and no available equipment. I think while we'd love to pin us down and this will be the second or third question on pricing on where it can go, so long as lead times remain in this north of a year period and utilization remains in the 90s for everyone, we think that we're going to continue to see that trend and the pace and the size will be for further reporting on further quarters.

Got it, but that is certainly helpful. So we should be thinking about it as really the leading indicator is just the long lead times. If that starts to shrink, that says something.

Is that the way you view it? The one thing I'd add is it's a combination. We have so many strong indicators of market demand and tightness in the market right now. Historically, utilization... has been a key reference point. And when we've been in the mid to high 80s and positively inclined, that is a market that typically denotes tightness and pricing prerogative to the compression service companies, including our truck. So I would just add to that, it's the tight utilization in addition to the long lead times that are key indicators of that pricing prerogative. Got it. Very helpful.

And then, I mean, you You guys are the leader and you look out there and clearly you see the improvements in the balance sheet and you talk about commitment to free cash flow and returning capital to shareholders. But kind of given this multi-year period that you see, do you see any other opportunities for capital other than just either reinvesting in the business or lowering debt or increasing the distribution, i.e. are you going to maintain a very narrow focus or is there anything else you might look to do with capital in terms of expansion of the business?

Thanks for the question. So number one, we're actually pretty excited about the opportunity to deploy capital in the business and in augmenting our returns to our investors through an increased dividend as well as through the possibility of continued share buybacks. These are exciting opportunities for us, and we think those mechanisms will create a lot of value to our investors, especially as we attract new investors with a debt target and a leverage ratio down into the three to three and a half times for 2024. So we're excited about those possibilities. On the market itself, one of the things that is supportive of our overall strategy is we see natural gas production growth continuing in a very solid way. but at about a 2% to 3% rate per year, which is very supportive of the levels of CapEx that we're targeting and leaving a lot of room for free cash flow generation. So those are real indicators in the market that we're pretty happy to take advantage of and return value to our investors in the near term. As far as investing outside of the space or in adjacencies to us, We have new venture investments that we believe could really help the energy space manage their emissions better, reduce emissions, and we're very focused on that. But this is still in the early innings of those ventures. While we're excited about the promise and the possibility they bring, especially to being effective in helping to improve the sustainability of our business and our customers' businesses, Those are the investments that we're excited about right now. We're going to probably stay pretty tightly in our lane and exploit our existing core competencies and those adjacencies in the sustainability space going forward.

Got it. Thank you very much. Thanks, Salman.

Our next question comes from Steve Ferronzi from Sudoti. Please go ahead. Your line is open.

Good afternoon, Brad, Doug. Thanks to all the caller on the call. I want to ask about the 95% utilization. It seems like you're at peak every quarter, but the new peak is a little bit higher. Sustainability of 95%, and then are you seeing any pickup in, and I know clearly if you are, you're turning it around fast, but on relocations and rebooking, I know you have minimal assets in some of the gassier plays, but has there been any pickup there?

Yeah, thanks for the question. The 95%, we believe, is holding and holding well. I can share with you that we have probably less than 100,000 horsepower that we could book today, which is around 2% of the fleet, which means that if we were to have a pro forma number off of our 95% for what we could actually report today, that pro forma number of what we expect to be working is higher than 95 percent meaningfully and that's supportive of maintaining this high level of utilization going forward so we like the position we're in and we think that that level of utilization in this type market is likely to be stable for a period of time stated differently we don't see what is going to disrupt that right now as far as the returns on the good news front, as soon as we get any unit stop activity, it gets rebooked very promptly, usually before it stops. And our overall level of stop activity remains historically low levels. And we don't see that changing. And we don't see when and how that's going to change with the tight market that we have today. Last comment is, Equipment is so tight. Our customers appear very reluctant to give up equipment because they know it's going to be a challenge for them to get it back and relocated. So it's just an exceptionally tight market.

Perfect. In terms of the guidance, it's sort of implied that maintenance cap backs will be meaningfully lower in the second half. Can you just sort of cover the dynamics on that?

I think that's mostly around the make ready. We've, you know, we put a lot of idle units back to work. already this year. And so the expectation going forward is that you won't see that same level.

So when I think about how that plays into 24, then we could stay at a lower level compared to where we were for the six quarters when there was a lot of make ready. That start would imply that given the other sort of guidance you've given, that 24 can be a very strong cash flow year, unless I'm missing some other costs.

You're not missing it. We believe 2024 will be a strong cash flow year, and we will not have equipment that we can make ready. We'll be looking for growth at that incremental level I described a minute ago based on natural gas production, primarily from our new build horsepower and from restarting existing horsepower. It does not require the same level of investment as it did in 2023. Thanks, Brad.

Thanks, Doug.

Yeah, thank you.

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

Great. Thank you, everyone, for participating in our second quarter review call. As the results show, we're seeing the intersection of unprecedented market fundamentals and the fruits of our labor. Our track is no doubt firing on all cylinders, and we look forward to updating you on our progress next quarter. Thank you, everyone.

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