Enerflex Ltd.

Ladies and gentlemen, thank you for standing by, and welcome to the first quarter 2020 Interflex earnings conference call. At this time, all participant lines are in listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star, then 1 on your touchtone telephone. Please be advised that today's conference may be recorded. If you require any further assistance, please press star, then 0 to reach an operator. I'd now like to hand the conference over to your speaker today, Mr. Stephen Alley, Director of Investor Relations. Please go ahead, sir.

And thanks for joining us. Here with me virtually are Mark Rossiter, Enerflex's President and Chief Executive Officer, Sanjay Bishnoi, Enerflex's Senior Vice President and Chief Financial Officer, and Ben Park, Enerflex's Vice President, Corporate Controller. During this call, we'll be providing our financial results for the three months ended March 31, 2020, a brief commentary on the performance of our three business segments, and a summary of our financial position. Today's discussion will include forward-looking statements regarding Enerflex's expectations for future performance and business prospects. Forward-looking information involves risks and uncertainties, and the stated expectations could differ materially from actual results or performance. Please see the advisory comments within our news release, MD&A, and other regulatory filings for more information on forward-looking statements and associated risk factors, including those related to potential impacts of the COVID-19 pandemic. Approximately one hour following the completion of this call, a recording will be available on our website under the Investors section. During this call, unless otherwise stated, we'll be referring to the three months ended March 31, 2020, compared to the same period of 2019. We'll proceed on the basis that you've all taken the opportunity to read yesterday's press release. I will now turn the call over to Mark.

Thanks, Stephan, and good morning, everyone. Before discussing the quarter, I want to first thank Interflex employees who have worked tirelessly to maintain a high level of operational integrity and for both Enerflex and its customers. I'm proud of their resilience, performance, and positivity in an otherwise challenging environment. Our quarter is a reflection of their strength. Enerflex's first quarter results reflected the continued execution of high margin engineered systems projects in our backlog and growing contributions from our asset ownership platform. Like most others in the sector, the COVID-19 pandemic has created much uncertainty in the market. The health and safety of our employees is of paramount importance, and I'm happy to report that we've yet to experience a COVID-19 case among all of our employees who operate across 17 countries. Each of our facilities and assets under contract continue to operate without disruption, and we remain vigilant in our health and safety efforts. We've implemented several business continuity measures to mitigate potential impacts of COVID-19. including social distancing measures to dilute personnel density in our shops and in the field, implemented additional cleaning measures for communal spaces, instituted additional PPE protocols, requiring certain people to participate in temperature checks and health questionnaires, and installed additional hand washing stations. For office employees, we've also implemented work from home strategies to minimize physical presence in our offices. Globally, The challenge we're currently seeing is around maintaining unrestricted access to active construction sites, particularly within geographies where governmental restrictions on movement are impacting site access. We have two sites in Canada that are still progressing and remain relatively unaffected, but we are more closely monitoring our international boom sites that are under construction. Our work site in Argentina was restricted for a few weeks, and we are now back on site. Similar access restrictions occurred at one of our Brazilian sites, which has slowed our progress, but which we continue to advance. Most impacted has been a site in the Middle East as a result of restrictions on in-country logistics and trucking. Overall, the three previously announced boom projects that we anticipated would commence operations through to mid-2020 are now more likely to commence operations in mid to late 2020, provided that no additional restrictions are imposed. In addition to COVID-19, the sector is also impacted by the severe downturn in oil prices. Typically, our business lags commodity price action and associated impacts at the drill bit by four to six months. We are still in the early stages of assessing adverse impacts from this downturn. That said, while we had a relatively healthy first quarter, we've seen continued pressure on engineered systems business in North America, where the big pipeline is not as strong as what we were seeing two months ago. Earlier in the year, we were cautiously optimistic that we would see an improvement in bookings as the year progressed, but that sentiment has changed in lockstep with current macro picture for energy. As a result, we expect Engineer Systems in Canada to be very quiet, while the USA will also be slow, but somewhat better. Ultimately, Engineer Systems is a business that is tied to the CapEx of our customers. So with reductions across the space, we expect this business to be pressured for at least the remainder of this year and until we see an improving supply and demand picture for oil and gas. For our global asset ownership platform, revenues and utilization were strong during the quarter, and we entered 2020 with a healthy demand indicators for the U.S. and the rest of the world regions. In the USA, clients' demand signals were tempered as the macro picture deteriorated. Consequently, we anticipated a reduction in that demand and halted capital spending appropriately. This decision prioritized balance sheet strength during a time of great uncertainty. As the macro picture remains uncertain, our teams have been actively engaging with customers to gain visibility on how fleet utilization might change going forward. In the current commodity price environment, rentals will see pressure as oil wells are shut in and associated gas volumes are reduced. The positive is that our rental fleet is mostly fungible and can be directed towards gas play and cost-advantaged shale basins throughout the U.S. and the rest of world regions. LATAM and MEA have a different set of drivers. In LATAM, many of our natural gas projects and assets are focused on domestic electricity demand and are not directly correlated to Brent or WTI crude pricing. Similarly, Middle East projects are developed by customers mostly NOCs and IOCs, specifically to increase the role of natural gas in regional electricity generation. Our clients continue to indicate that our natural gas projects and assets are critical to their overall development plans. The investments we made in our asset ownership platform are sound and will continue adding stability and predictability to our financial profile. But the current macro picture has driven the industry into uncharted waters, and we would be remiss to speculate as to what the ultimate ramifications to our rental business could be. We will instead focus our efforts on what we can control, taking action to protect returns on our investments, maintain customer relationships, preserve fleet utilization, and keep our customers' assets performing as promised, all of which can assist in mitigating pressure to our asset ownership business. Aftermarket service, AMS for short, has performed well for the past several quarters, and has been resilient in the early stages of the pandemic. AMS is an OPEX-oriented business and will be most impacted by production shut-ins. If wells are flowing, equipment needs to be serviced to run reliably. We have service personnel in all major basins in North America and all of our operating regions globally. This diversification should provide defensiveness through the remainder of the year. The current operating environment has created challenges the likes of which few industry participants have seen. It will be a difficult year for the engineered systems business, and the demand destruction for crude oil has created uncertainties for other Enerflex products and services. We expect 2020's financial performance to be underpinned by our asset ownership and AMS businesses, both of which may see some pressure, but which we anticipate will carry us through this downturn. Our focus is to maintain a defensive balance sheet as we navigate the cycle. We've run several analyses to plan for a broad range of industry activity and will continue to monitor and make cost reduction decisions accordingly. Being proactive in this regard should keep us well positioned to weather this downturn and succeed as the industry recovers. I will now turn things over to Sanjay to review our financial results. Thanks, Mark.

Fourth quarter revenue of $366 million decreased versus the prior year period due to lower engineering systems revenue on weaker bookings through 2019 and lower services revenue on decreased activity and part sales. This decrease was partially offset by increased contribution from our growing contract compression fleet. Our U.S. contract compression fleet totals approximately 325,000 horsepower with an 87% utilization rate at March 31, 2020, compared to approximately 310,000 horsepower with an 87% utilization rate at December 31, 2019. Although revenues decreased, gross margins increased over the comparative quarter driven primarily by high margin engineered systems projects that were booked near the end of 2018. Certain of these projects were completed during the quarter, while change orders have extended the project scope and duration for which others will contribute to revenue. We expect to complete these high-margin projects during the second quarter. Quarterly consolidated gross margins of 26% represent the highest quarterly gross margins in the company's history. But again, as these high-margin projects are completed in 2020, gross margins from our engineered systems business will decrease and margin contribution from our other product lines will make up a larger portion of total gross margins. As Mark mentioned, engineered systems bookings activity is anticipated to be slow for the remainder of 2020, while the market navigates the impact of COVID-19 and global demand destruction for oil and gas products. Selling, general, and administrative expenses decreased over the comparative quarter due to lower compensation costs associated with the share-based compensation, partially offset by unfavorable foreign exchange movements. We remain vigilant in controlling costs across the platform to align with expected activity levels. Cost savings initiatives include a combination of workforce reductions, temporary leaves of absence, unpaid time off, planned shop shutdowns, and reduced travel and other discretionary budgets. EBIT increased versus the comparative period as a result of the increased gross margin and lower SG&A costs. while adjusted EBITDA, including the impacts of share-based compensation, was consistent with 2019. Growth of our asset ownership platform continued in the quarter, with rental revenues of approximately $54 million, representing a 12% increase over the comparative quarter. During the quarter, $63 million of capital was deployed towards U.S. rental fleet and international boom projects at an approximately 60-40 split, As described in our operational update during the quarter, we are committed to 2020 growth capital expenditures of approximately $90 million to fulfill obligations for the completion of five- and ten-year boom contracts in our rest-of-world segment and for our USA contract compression fleet. With the capital plan being front-loaded in the first half of 2020, Maintenance CapEx across our platform is estimated to be approximately $15 million for 2020. Exact values for expenditures will depend on foreign exchange rates and final project scope. Working capital in the quarter saw a net increase of $44 million since December 31st. We entered 2020 with what appeared to be a robust backdrop for U.S. contract compression and an improving view of the engineered systems order book. but we have since slowed our supply chain transactions to align with current market conditions. Inventory levels increased during the quarter due to purchases of major equipment with long lead times which were ordered in prior periods and delivered during the first quarter. The company expects inventories to have peaked in Q1 and will realize these goods into engineered systems projects and new contract compression units as demand for these products returns. Notably, these items are non-perishable and fungible across our engineered systems and rental offering, so we can consume them in either business line globally. In addition to inventory, receivables become a more salient topic in this environment. While it's still early days, we have not seen material challenges in our pace of collections and our local finance teams and treasury groups are engaging in weekly updates to ensure that we are staying on top of this. In addition, our assets are spread across a global footprint and across multiple basins, which assist in mitigating counterparty credit risk that can result from customer concentration. While the current environment may stress AR, in the coming months, we do ultimately expect to harvest cash out of AR as the year progresses. As Mark mentioned, the COVID-19 situation has created some operational challenges for in-flight construction projects as a result of government instituted restrictions on movement in and out of countries and or worksites. The ramifications of these restrictions have resulted in scheduled slippages for the expected start dates of three of our previously announced boom projects, which in our last earnings call, we anticipated would commence operations and begin generating revenues in mid-2020. That timing has been pushed out, and we expect the respective boom projects to begin generating revenue by mid to late 2020. The most significant of these three boom projects is located in the Middle East, where government restrictions on access to sites have resulted in transportation delays to and from sites. We fully expect that work will continue as expected once these restrictions are relaxed. For other rental assets, namely the U.S. contract compression fleet, we do expect some softness to hit this segment as the year progresses, driven by a reduction in produced oil and gas volume. Prolonged commodity price weakness is likely to reduce demand for Enerflex's products and services. Ultimately, we are watching fleet utilizations closely and working with customers as best we can to find mutually agreeable arrangements to maximize our interests and theirs. The majority of our U.S. rental fleet is located within the Permian Basin, where we have maintained a presence since 2005. We believe in the long-term potential of the Permian and anticipate that it will be a significant part of our operating footprint going forward. Demand for Enerflex's products outside of North America is more constructive than within North America, and we continue to assess opportunities that would be accretive to our asset ownership platform. From a capital allocation perspective, our priorities in 2020 are focused on two areas, completing those capital expenditures as required to fulfill obligations related to our organic rental fleet addition, and preserving balance sheet strength to weather the current downturn, the latter of which was reflected in our proactive dividend reduction of 83%. Interflex's board will continue to evaluate dividend payment on a quarterly basis based on the availability of cash flow and anticipated market conditions, yesterday declaring a $0.02 per share dividend to be paid on July 2, 2020. With respect to liquidity, we exited the quarter at net debt to EBITDA of 1.2 times, which represents a slight increase from our net debt position of 1 times EBITDA at December 31st. The $70 million increase in net debt is attributable to, first, foreign exchange fluctuations between the U.S. dollar and Canadian dollar, where the strengthening U.S. dollar during the quarter contributed to approximately 30% of this increase, and second, previously mentioned expenditures on inventory and CapEx commitments, which, again, are front-loaded for the year and will see a significant slowing as the year progresses. With available liquidity of $530 million, our debt position remains healthy and leaves us flexibility to manage the business through the current downturn. This completes the formal component of the webcast. Additional details can be found in our May 7th press release We will now be happy to take any questions.

As a reminder, ladies and gentlemen, if you would like to ask a question at this time, please press the star, then the number one key on your touchtone telephone. Again, that is star, then one, if you'd like to ask a question at this time. Please stand by while we compile the Q&A roster. Our first question comes from Greg Coleman with National Bank Financial. Your line is now open.

Hey, guys. Congrats on a solid-looking start to the year. I know it's going to change a little bit, but at least we see some good numbers in Q1. I wanted to start by focusing on the engineered systems bookings and that side of the business. I was wondering if you could give us a little bit more detail on the cadence of the bookings that you saw in the quarter. The $155 million was more than we were expecting. It was actually an uptick sequentially. You know, in your prepared remarks, you talked about how you entered the year optimistic and that's kind of trailed off as we've seen the impact of COVID and demand destruction come through. Was that the sort of thing where those bookings were very much the beginning of the quarter and we should probably look for bookings to slow aggressively from that level into Q2 and beyond? Or is that sort of a reasonable level for us to be thinking about in the next couple of quarters, which was quite frankly better than we were expecting in Q1?

Hey Greg, this is Mark Rossiter speaking. Thanks for the question. The first quarter, January, February was good, and once the COVID situation hit, not surprisingly, there was a real slowdown in purchase orders. And I would say that our pipeline, the quality of equipment in the pipeline for new orders going forward softened after the COVID pandemic started roughly the middle of March. I think anybody that's looking at the macro in North America would be expecting the rest of the year to be soft on engineered systems, and that's what we're preparing for.

Got it. That's good color. And you touched on geography there, which is sort of leading to my next part. You know, you give us nice geographic segmentations for the bookings. I think we saw 100 million in the U.S., then the balance was split between sort of rest of the world and Canada somewhat evenly in, in historic quarters, the bookings location, like the a hundred million in the U S is where it's manufactured, but not necessarily the end market is that a hundred million, definitely a U S focused market there, or is, or is a component of that actually targeting the rest of the world? Just looking for that color.

Well, we don't provide that, that level of detail for competitive purposes. Um, I would say in the first quarter, we definitely saw a resurgence of North American activity, you know, January, February, like I said, after four quarters of relatively low bookings in North America. So we're not going to give you details on how much is going to the U.S. and how much is going internationally, but it was sort of a little bit of a reawakening in the North American land market for new orders in the first quarter.

Got it. No worries. Okay. And then, Sanjay, You started talking about the working capital there, and, you know, it sounds like reading through your comments, you're pointing to a working capital release beginning in Q2. I'm just wondering, am I reading those tea leaves correctly?

Yeah, that's a good question, Greg. I think, you know, that's certainly, you know, what a lot of the external models, I believe, including your model, is predicting, and we've got reason to believe that that's a good way to think about it and a good way to model it. We haven't seen any real concerns yet in terms of customers that are going to extend payments or be challenged to pay. I mean, we continue to watch those very closely. But by and large, yes, we are anticipating through the year to see some modernization of working capital.

And just in terms of the magnitude, I know it's a dynamic situation there, and I don't want to hold you to a specific number. However, the current working capital surplus is record high, $360 million. When we look at the company's history, it's sort of been between $120 million to $160 million of working capital surplus, which is sort of a delta at $200 million. Understanding, of course, that this is a unique time. Inventories probably aren't going to come down that much. but can you give us an idea as to what your target working capital surplus would be over the balance of the year so we can have some kind of idea of how much of that working capital will be released and can go towards net debt reduction?

Yeah, it's a tough thing for us to give guidance on, right? Especially in this industry setting is tough to predict, and so I think we're just not comfortable kind of putting out guidance on that number right now. I would say qualitatively, I think your statement is correct. We actually do anticipate that we'll have more luck with the ARAP side of working capital than we will with inventory. And I think it really is, you know, we're going to have to see a turnaround in the engineering systems order book before I think we have a chance of significantly digging into inventory and monetizing that.

Okay, that's good, Keller. Sanjay, thank you. And then last one for me before I turn it back, just on the rental market and shut-in risk, can you talk about how that's manifesting now as we're in April here? You know, we've got 2.2 billion cubic feet a day shut-in. The EIA is talking about that ramping to 11 billion in the U.S. What kind of returns have you seen in your rental market now? Are you likely to move in line with the U.S. shut-in average, or is there a reason that your shut-ins might – your returns might be either higher or lower than the average there based on your size of compression packages and the geographic location.

Hey, Greg, this is Mark. We're going to be very careful to not predict utilizations going forward. It's a dynamic situation. Our fleet is relatively small, and so I would caution against any direct correlations between big picture macro and the impact on our particular fleet. We've got good customers in basins that are challenged to different degrees, and we'll just have to see how it's shaped up.

That's a really valid part, Mark. Just talking about what we're currently seeing now, can you give us, not forecasting at all, but can you talk about sort of today we're seeing a low single-digit percentage of U.S. natural gas shut in. Because your fleet is so small, that percentage could be wildly different from what you're seeing. To your point, and is it, or is it at least at the moment reasonably close to the macro numbers?

Greg, you're just going to have to wait for our Q2 numbers to come out on that front. It would be a little bit too dangerous for us to start giving vague indications of our utilization. We have to be quite strict on just saying we don't provide guidance on that, and you'll know when Q2 numbers come out.

Understood. I'll give it one more shot, which is some of your peers have talked about sort of a 6% to 10%. decline in activity, and I'm just wondering when you look at your peers' commentary, were you surprised by that commentary or not surprised by it?

Well, I would say that if we can leave our peers out of it for a moment, when we look at the last couple of big cycles in the rental business, which we looked at very closely before we invested in this business and decided to invest in it as a new business line, specifically in the lower 40 of the United States, We saw pretty clearly where the utilizations went in 2015-16, and again, during the mortgage crisis. And if those are the downside cases in the rental thesis, then we were comfortable with that. And, you know, I've obviously read the quarterly results of our peers or companies that we admire, and the numbers that they're talking about in their predictions very much look back to 15 and 16 as four examples. But it's very, you know, we really have to point out that every downturn is different. And the downturn in this situation is different than it was in 2015, and so it's difficult to draw a direct conclusion. What I can tell you, you know, and our investors is, we've spent a lot of time stress testing our business with a variety of potential downside cases, and we're comfortable with our investment. You know, we're comfortable with our ability to manage through and to be a strong company on the back end of it.

Thanks for that. I will pass it back.

As a reminder, ladies and gentlemen, if you would like to ask a question at this time, please press the star, then the number one key on your touchtone telethon. Our next question comes from Keith Mackey with RBC Capital Markets. Your line is now open.

Good morning. Thanks for taking my questions and hope everybody's doing well. Just first question here for you guys. Talked about your medium-term goals as a 10% EBIT margin with 10% annual growth and recurring revenue. You know, this year obviously going to be different. So just what are your targets for managing this year? Are you thinking about the business in terms of free cash flow neutrality? Do you think that's achievable? Or, you know, how are you thinking about getting through 2020?

Yeah, thanks for the question, Keith. I think you're right. Like it's, you know, the growth metrics especially are things that I think we really need to, you know, put on the shelf for a bit, right? I think it's just appropriate given the severity of this downturn that we focus on balance sheet strength. And that's really how we're reprioritizing our goal. You know, I would say that, you know, free cash flow neutrality I believe is absolutely possible. And a lot of that is going to depend on what Greg was asking us about, which is monetizing our working capital. And I think as long as we do a decent job of that, I think we can certainly manage within free cash flow neutrality.

Got it. Makes sense. Thank you for that. And last question for me is just – In the backlog, just can you give us an idea maybe of the split between projects that are underway versus projects that have yet to be started?

Sorry, can you repeat that one, Steve?

Yeah, so I'm just curious about the backlog, you know, roughly 400 million. Is a lot of that, you know, projects that may be halfway through completion or partially through completion versus projects that, are in the queue to be delivered and haven't been necessarily started yet.

Yeah, I think that's a fair statement. I think, um, a big, a big chunk of our, um, of our backlog is certainly stuff that's in flight.

Okay, got it. Thanks. That's it for me. I'll turn it back.

We have a follow-up question from the line of Greg Coleman with National Bank Financial. Your line is now open.

Sorry, I found more, uh, frustrating questions. Um, Just on the CapEx program, just want some clarity here. You call it 90 million growth, 15 million maintenance, front-end weighted. You spent 67 million in Q1. I just want to make sure that I'm not messing this one up. You know, simple math. There's 38 million to be spent in the rest of the year, except probably mostly in Q2, or is it kind of weighted throughout the rest of the year?

It's... It's weighted throughout the year, Greg. I think the X factor here for us is the delays on some of the international boom projects. And so we were anticipating that those projects would be online in the first half of 2020. And we're managing access to those sites. We still feel really good about all three of those projects, but probably coming online second half of 2020 as opposed to first half of 2020. So, you know, when that CapEx gets realized is a little bit of a function of what timeline we're on on those projects. Got it.

The projects you were mentioning in your earlier comments.

Yes.

And then lastly for me, and related to the CapEx, you know, the $63 million in the quarter was deployed towards rentals. This is getting a little cute here, but can you give us an idea of the cadence during the quarter? Did that get blasted out at the beginning and we saw the full benefit of that capital during the quarter? Was it at the very end of the quarter and we didn't see any contribution from you as those rentals went to the market or sort of evenly weighted? I'm just trying to get a feel for the, I guess, lift from that capital as it's being deployed in Q1.

Yeah. You know, I'm not even sure that I know that to that level of detail. Greg. I think it was pretty flat and pretty rateable across the quarter. And again, I guess I would point to that CapEx spend was, again, split pretty equally, rest of the world versus United States rental fleet. And so the rest of the world stuff was definitely just on a schedule. And so I think it really comes down to digging into the U.S. numbers and You know, just gut feel. They felt pretty rateable to me, but honestly, I'd have to dig into detail to really get you an answer.

No worries. We'll follow up offline. That was it for my follow-ups. Thank you.

I'm showing no further questions in queue at this time. I'd like to turn the call back to Mr. Rossiter for closing remarks.

Since there are no further questions, I'd like to thank you once again for joining on the call. I'd like to point out that on the 75th anniversary of Victory in Europe Day, I'd like to thank all those employees who had family members that were part of the Allied Forces during that time. Just thank you for your service. And all of our employees and clients that have family members that are currently serving in the Armed Forces, thank you to them for their service as well. We look forward to giving you our second quarter results in August. Have a good weekend.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.