Kodiak Gas Services, Inc.

Greetings and welcome to the Kodiak Gas Services third quarter 2023 conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Graham Sohns, Vice President of Investor Relations. Thank you. You may begin.

Good morning. We appreciate you joining us for the Kodiak Gas Services conference call and webcast to review third quarter 2023 results. Participating from the company today are Mickey McKee, President and Chief Executive Officer, and John Griggs, Chief Financial Officer. Following my remarks, Mickey and John will provide a high-level commentary on the company, our market, third quarter financial results, and our updated 2023 outlook before opening the call for Q&A. Before I turn the call over to Mickey, I have a few housekeeping items to cover. There will be a replay of today's call available via webcast and also by phone until November 16, 2023. Information on how to access the replays can be found on the Investors tab of our website at kodiakgas.com. Please note that information reported on this call speaks only as of today. November 9th, 2023, and therefore you're advised that such information may no longer be accurate as of the time of any replay or transcript reading. In addition, the comments made by management during this conference call may contain forward-looking statements within the meaning of the United States federal securities laws. These forward-looking statements reflect the current views, beliefs, and assumptions of Kodiak's management based on information currently available. Although we believe the expectations referenced in these forward-looking statements are reasonable, various risks, uncertainties, and contingencies could cause the company's actual results, performance, or achievements to differ materially from those expressed in the statements made by management, and management can give no assurance that such statements or expectations will prove to be correct. Solicitors are encouraged to read Kodiak's prospectus and quarterly report on Form 10-Q, available on our website or at sec.gov, to understand those risks, uncertainties, and contingencies. The comments today will also include certain non-GAAP financial measures. Additional details and reconciliations to the most comparable GAAP measures are included in the quarterly press release, which can be found on our website. And now I'd like to turn the call over to Kodiak CEO, Mr. Mickey McKee. Mickey?

Thanks, Graham, and thank you all for joining us today. I'll start by discussing our recently announced inaugural dividend payment to our shareholders. Then I will share some highlights from the third quarter and ultimately provide some commentary on the industry and our company. When I'm finished, John will provide additional financial details from the third quarter and discuss some updates to our 2023 outlook. We are excited to have announced our first quarterly dividend on October 24th. Our board declared a dividend of 38 cents per share for the third quarter of 2023 or $1.52 per share on an annualized basis. The stable, positive cash flow provided by our resilient business model supports returning capital to shareholders through a well-covered dividend. We believe that with the initiation of our dividend, Kodiak represents one of the most compelling yields in midstream energy today. It is an important part of our capital allocation strategy that also involves reinvesting a portion of our cash flows to grow our fleet, given the attractive returns we see in the current market environment. To be clear, we intend to generate positive free cash flow after growth capital and dividends are funded while driving towards our long-term leverage target of three to three and a half times. Now turning to yesterday's earnings release. We are very pleased with our third quarter results, which reflect the continued execution of our strategy, focused on deploying large horsepower compression infrastructure assets in high quality basins with the best customers. The compression market remains tight, as many of our competitors are near full utilization of their deployable assets, and we are well positioned as the compression provider of choice for our customers. To touch on a few highlights from the third quarter, We maintained our industry-leading utilization rate, ending the third quarter at 99.9% utilization. We have maintained this high utilization rate for years, and now this has allowed us to deliver record revenues of $186.7 million from compression operations and consolidated adjusted EBITDA of $110 million for the third quarter. Both are the highest figures on record in Kodiak's history. As we have discussed many times, our methodical and intentional deployment strategy of our equipment and contracts generates highly visible, steady cash flows that create a very compelling infrastructure investment opportunity. As we look forward to the fourth quarter and next year, our new unit deliveries are completely contracted and are exclusively large horsepower units. As I mentioned on our last call, We know the cost of the equipment, the customer it will be deployed with, and the contract rate it will earn. And because equipment lead times remain extended at about a year, we're already in discussions with our customers related to new equipment orders and customer contracts into 2025. We're also pleased to be in a position to update some of our previously disclosed guidance ranges for the full year 2023. We are raising the low end of our guidance and now anticipate record adjusted EBITDA of $430 to $440 million. John will cover a few other guidance updates. I provided a detailed background on Kodiak on our second quarter call for those of you not familiar with our story. I won't rehash that in full, but I do want to cover a few things that differentiate Kodiak. Our purpose-built fleet of over 3.2 million horsepower of predominantly large horsepower compression equipment is the youngest, most emissions-friendly fleet in the sector, specifically engineered and built to operate in rich gas environments like the Permian Basin, where over 70% of our horsepower is deployed. We have seen additional consolidation in the Permian Basin from our customer base this quarter. This dynamic is ultimately creating more contiguous acreage positions and allowing for longer drilled well laterals and ultimately larger infrastructure build out, creating more demand for services of a company like Kodiak specializing in large horsepower. We view this consolidation in the industry as a positive as our customer base continues to trim costly overhead and drive down ongoing cash production costs. At Kodiak, we strive to deliver the highest level of service and mechanical availability in the industry, also contributing to the superior utilization of our fleet. We charge a fixed monthly revenue rate for our services and ended the third quarter with less than 7% of our horsepower on month-to-month contracts. These factors combine to help insulate our business from short-term commodity price cycles. Natural gas prices have ticked above $3 recently but remain low by historical standards. However, our customers, which operate primarily in liquids-rich, oil-directed basins, continue to exhibit strong demand for compression services. We continue to be excited about the tremendous amount of LNG export capacity being constructed on the U.S. Gulf Coast and the resulting growth in natural gas production that's needed to provide feed gas to these plants. FERC data indicates that there's almost 14 BCF per day of LNG liquefaction capacity under construction on the Gulf Coast today, with about 15 BCF per day of approved projects behind that. Our view remains that the incremental gas will largely come from the Permian and Engleford basins, and we are well positioned as the leader in those basins to capitalize on this growth. as every incremental cubic foot of gas produced out of these basins will need to be compressed multiple times over. Additionally, our industry as a whole has shown tremendous capital discipline. While new unit deliveries have extended out over a year, with the lack of idle horsepower available to be deployed, this means that the supply side of our industry will remain very tight with little relief in sight. So to quickly recap, We are pleased with our third quarter results and continue to believe in a supportive energy market with a multi-decade runway for conventional energy and particularly large horsepower compression to feed the growing LNG export base on the Gulf Coast, providing clean, secure supplies of natural gas to the world. Our strategy is to continue to provide compression services safely and sustainably in the best basins with the best customers while providing investors with an attractive return on their investment through steady growth in cash flows and a compelling dividend. Now I'll hand the call over to John to discuss our financial results for the quarter and 2023 outlook. And I'll come back with some closing comments before we move into Q&A.

John? Thanks, Mickey. As Mickey emphasized, it's a wonderful time to be in the contract compression business and an even better time to be at Kodiak. Here are some of the results from the quarter. Total revenues for the third quarter were approximately $231 million, up about 14% sequentially, and 27% compared to the third quarter of last year. Adjusted EBITDA for the quarter was $110 million, up over $2 million, or 2% from Q2, and up over 8% versus the same quarter of last year. Both metrics exceeded our expectations. And since you'll see it in our team queue later today, I'll mention it now. Adjusted EBITDA for the quarter included an approximate $2 million allowance for doubtful accounts related to a particular compression customer in the midst of a restructuring. Excluding the impact of that reserve, adjusted EBITDA for the quarter would have been about $112 million. Looking at our segments, compression operations revenues were nearly $187 million, up about 14% year over year. Revenue generating horsepower grew by about $112,000 on a year-over-year basis. Consistent with last quarter, revenue growth in this segment was a function of growth in revenue generating horsepower combined with higher overall fleet pricing. In our other services segment, 2023 third quarter revenues were up substantially compared to both last year's third quarter as well as the prior quarter. This was driven mostly by quality execution and faster than expected progress on some project completion schedules, in particular on one relatively large job. From an adjusted gross margin perspective, our compression operations segment generated just shy of a 65% margin, up 70 basis points compared to the second quarter. Our operations team continues to focus on containing costs that are within our control. We continue to chip away at some of the margin compression we experienced in the last couple of years. from acute inflationary pressures. On a dollar basis, adjusted gross margin in our other services segment was about $5.5 million, up nicely from the prior quarter. From an adjusted gross margin percentage basis, the margin came in at 12.4%. As we've discussed, each project is different, and our third quarter margin percentage reflects a couple of larger projects that carry lower than normal margins. As a reminder, while the segment has a lower margin profile than our core compression operations segment, station construction projects are synergistic with our compression business, and they require no capital. Every dollar of incremental cash flow adds to both our overall return on capital employed and discretionary cash flow, which in turn allows us to pay more dividends and invest in high-return growth projects. So long as we manage our contractual and operating risks in project-related working capital carefully, this work is beneficial to Kodiak and our investors. In terms of capex, for the quarter, our maintenance capex was about $12.3 million, a bit higher than the prior quarter. Growth capex was $56 million for the quarter, and $3.5 million of that amount was non-new unit capex. We've mentioned in the past that growth capex in 2023 would be back in loaded. So you saw that in Q3 and you'll see it again in Q4. Moving to the balance sheet. So as a quick reminder, we received the proceeds from our IPO on July 3rd and simultaneously completed the pay down and novation of the term loan we described in our S-1. That reduced our debt by $1 billion. At the end of Q3, we had debt of 1.78 billion consisting entirely of borrowings on our $2.2 billion asset-based loan. Our credit agreement leverage was 4.07 times, and we had about $396 million in borrowing capacity at quarter end. With our IPO and associated deleveraging complete, we think we're well on our way to achieving our long-term leverage target of three to three and a half times during 2025. we continue to benefit from our interest rate swaps on a little less than 70% of our debt that fixed our interest rate well below prevailing floating rates. Now let's move to our updated 2023 outlook. Given the clarity that we received from our third quarter results and our expectations for Q4, we included updated four-year 23 guidance in our earnings release yesterday. For the year, we estimate adjusted EBITDA will range between $430 to $440 million. In our core compression operations segment, we're sticking with our prior revenue and margin guidance. Bottom line, given the constructive market dynamics alongside our crisp execution, we're highly confident in our segment outlook, and we're laser-focused on growing long-term, high-quality cash flows. In our other services segment, We now forecast full year revenue of 95 to 115 million and segment margins of 15 to 17%. We're providing a pretty wide range to account for some of the things that we can't control but can have an impact on outcomes, particularly in the fourth quarter. Things like weather events, customer budget exhaustion, and customer or subcontractor holiday season work schedules. If we have smooth sailing on those items, then we'll likely be at the high end of our range on both revenues and margins. And though we're not giving official guidance for 2024 until we deliver our full-year 2023 results, we do think this year is an outlier to the high side in terms of station construction projects and revenues. For adjusted SG&A, we're leaving the guidance as is. But we noted in our release that we're not including the $2 million allowance for uncollectible accounts that we took this quarter, since that was an isolated non-cash event and we wanted to keep the guidance focused on normalized expenses. Turning to CapEx. For the year, we now see maintenance CapEx coming in between $34 and $38 million. Our maintenance CapEx spend is largely predicated on the age and hours of our units. So the slight move up in guidance is related to the timing of when our team tackles the scheduled overhauls. We're working to get a few more things done this year in that area than we previously anticipated. On the gross side of CapEx, we're leaving our prior guidance alone. Included in the forecast is about $15 million in non-new unit related CapEx, which, at the midpoint of our updated guidance, would suggest that we'll be adding just shy of 140,000 of new horsepower during the year. Last thing on CapEx. Recently, our landlord, on a few of our more significant operations facilities, approached us with a compelling package deal to buy them out of the properties. It's got a few moving parts, but assuming everything comes together as planned, we would incur an incremental $10 million in real estate-related CapEx during the fourth quarter. We've not included that in our updated guidance, but should it occur, we'll still be free cash flow positive for the year. We believe the deal is compelling, and we are faced with imminent and disruptive moves in the near future to accommodate our substantial plan growth. So this opportunistic purchase allows us to control our own destiny in terms of facility and expansion in our most important growth regions and enables our operations leaders to stay focused on taking care of business. To wrap things up, as Mickey noted, our board declared an inaugural dividend payment of 38 cents per share, and we'll pay that tomorrow. This equates to an annualized dividend of $1.52 per share, yielding nearly 9% at our recent price range. Our capital allocation framework is a crucial aspect of the KGS investment thesis. Measure growth alongside attractive return of and return on capital while living within cash flow and deleverage. That's it for my prepared comments. Thanks again for your participation and support. I'll turn it back over to Mickey.

Thanks, John. In summary, we've built a market leader in contract compression infrastructure with a focus on large horsepower compression and its critical role in the energy value chain. We've concentrated our purpose-built fleet in the most economic, cost-advantaged basis with the best customers under long-term fixed revenue contracts that are resilient to short-term commodity price cycles. And we've built Kodiak with a commitment to sustainability. We're very pleased with our third quarter results, our initiation of a meaningful dividend, and we look forward to continued profitable growth in 2023 and beyond. I'd like to close the call by thanking the extraordinary women and men of Kodiak Gas Services. Their hard work and dedication to safety and our customers are what makes Kodiak special. And we wouldn't be an industry leader without their commitment to excellence. At this point, we'll open up the line for questions. Operator?

Thank you. Ladies and gentlemen, we'll now conduct our question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate that your line is in the question queue. You may press the star key followed by the number two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we pull for questions. And our first question comes from Jeremy Tenet with JP Morgan. Please state your question.

Hi, good morning. Hey, good morning, Jeremy. I just wanted to start off, if I could, with capital allocation, maybe expanding a bit more. I realize there's probably more to come on this topic. But insofar as there's a market with a lot of growth for compression, a lot of needs there, you have the healthy dividend yield as it is, yet it seems like the market's not necessarily giving as much credit as it could for this yield. And so when you think about further growth, growth capex in the future or if you think about raising the dividend or even possibly buying back stock, just wondering at this juncture, any high level thoughts you could provide with how you view these different options?

Yeah, Jeremy. This is Mickey. I think all of those things are possibilities going forward and things that we will be discussing with our board more over the next couple of quarters. I think right now we're focused on executing the business and making sure that we have a good yield and a return on capital of shareholders and increasing discretionary cash flow so that we can continue to grow CapEx and dividend over a long period of time.

Got it. That makes sense there. And then kind of pivoting towards the compression market as a whole, you know, very tight market. We've heard about it across the industry, how tight it is and the needs there. Just wondering if you could expand a bit more on how you're dealing with supply chain challenges out there, servicing your customers, securing large equipment, fulfilling these orders here, you know, given some of the disruptions in tightness as we see out there. Just wondering if you could talk a bit more about that.

Yeah, I mean, it's an ongoing management that we have to do with not only our customers but with our suppliers as well to make sure that, A, our customers are planning out well in advance to secure equipment. At this point, with Caterpillar engine deliveries out longer than a year, it's a challenge, but it's something that we work on pretty much daily with our customers and making sure that they're in the right position. as well as with our suppliers and making sure that deliveries and the ability for them to produce equipment for us and make sure that it's ready when they say it's going to be ready is something that's an ongoing supply chain management process that we do every day too. So, you know, we are out into, you know, discussing Q1 2025 potential equipment needs with our customers right now and, you know, looking at a very productive and fully subscribed kind of 2024 year already. So it's a challenge that we deal with on a daily basis, but it's something that we're used to managing and been doing this a long time. So we know how to handle it.

Got it. Makes sense. Thank you for that.

Yeah, thank you, Jeremy.

And our next question comes from Teresa Chen with Barclays. Please state your question.

Good morning. Thank you for taking my questions. First, I'd like to touch on the comments about 2024, understanding that you're not giving guidance today, On that fully subscribed asset level trajectory, can we get some color on the puts and takes on risks to the upside and downside from here as to how you see both pricing and margins evolving relative to 2023 and even some of the base IPO materials for the 2024 year?

Yeah, Teresa, good morning. Thanks for the question. Again, going back to what we discussed a minute ago with Jeremy, we've worked with these suppliers for a long, long, long period of time, and we know really what's coming down the pipeline from them from the standpoint of price increases and when it's going to happen from our suppliers. And so, you know, we're able to plan that out ahead of time and make sure that, you know, as we price our equipment into 2024 and even early 2025, that we're getting in that equipment. you know, return on capital investment that we're planning and making sure that we have to continue to maintain and hopefully expand margins over time.

Got it. And on capital allocation, related to the small real estate transaction, are there other opportunities similar to this that you see, you know, within the realm of possibility within the near term? Or should we think about the free cash flow primarily going towards returning cash to shareholders?

I think that we're going to stick to our kind of stated capital allocation policies that we've had where 35% to 40% of our discretionary cash flow is planned to pay a dividend. And the majority of the balance of that discretionary cash flow to go to growth capex, I think this This specific real estate transaction was one that was just pretty opportunistic that came along and we said, we looked around and said, man, this is a really good opportunity for us to control our own destiny and make sure that we don't have any kind of unforeseen interruptions in our operations group out in the Permian Basin. So it was something that we wanted to take advantage of. We were in a position to where we could execute on the transaction and still remain cash flow positive, which is one of our stated goals, and still take advantage of that opportunity and save some money in rents along the way. We decided to take advantage of that, but I don't foresee too many significant opportunities like that popping up over time. But if they do, we'll evaluate it and make sure that we're making the right decisions for the business.

Thank you.

Thank you, Tracy.

Thank you. And our next question comes from Neil Dingman with Truist. Please state your question.

Hey, morning, guys.

Thanks for the call.

Nice quarter. Mickey, I'm going to ask just a demand maybe question another way that, you know, you all have one of the best demand pitchers out there, you know, obviously talking to customers in 25. I'm just wondering, because of that, are you able to potentially structure contracts longer? Are you able to What are the benefits given, again, I see you all as having, as I said, one of the best sort of demand pitchers out there. I'm just wondering what are the sort of benefits or changes you might be able to take advantage of this?

Yeah, thanks for the question, Neil. Good morning. You know, I think you hit on it. There are some things that we've been pushing on. We have been able to secure longer contract tenors. throughout the last year. We've seen our average contract tenant move up a little bit over time, so that's a quality thing that we like to see. As I said in the prepared remarks, we're below 7% of our contracts on month-to-month contracts right now, so we really are pushing to have everything contracted up that we can have contracted up. We think that's the right thing to do to really secure the visibility of our cash flows going forward. As well, we're able to push some renewal increases that we've seen some rate increases along the period of time over the last couple of years that have gone to kind of combat the inflationary pressures we saw last year and maintain margin where we expect it to be in that kind of that 64% to 65% range. And we expect that we can hopefully continue to expand on the positive margin expansion we had this quarter.

No, that's great. Great to hear. And then maybe taking that demand over to John's question, John, because this sort of long-term, you know, demand picture you have, does that give you all more confidence? You obviously really materially raised your distribution, you know, 9%, again, obviously stocks too cheap, and that should readjust. But I'm just wondering, does that give you confidence to continue to raise that? Or when you think about the shareholder return, You know your coverage seems more than ample so john just wonder does it factor in when you're seeing this demand and sort of this certainly around there what what drivers sort of help shape that.

yeah yeah so thanks as it relates to the dividend you know it's all part of that big capital allocation framework that Nikki described a couple times, we obviously regularly discuss the strategy on capital allocation framework with our board. For the foreseeable future, we like that 35% to 40% of our discretionary cash flow being paid out in the form of the dividend. You just roll our business model forward based on 24, 25, and kind of the demand picture that we see. You know, we see the ability to grow EBITDA in that upper single-digit range for the foreseeable future. That would translate into increases in discretionary cash flow. So, you know, we will evaluate growth in the dividends over time, but we do think we'll see growth in the discretionary cash flow to afford it.

Awesome. Thanks, guys. Well done.

Thanks, Neil.

Our next question comes from Jim Rollison with Raymond James. Please state your question.

Good morning, guys. And again, congratulations on a good quarter. Mickey, just kind of circling back to the roughly 140,000 horsepower being delivered this year, and you obviously mentioned that you're pretty well fully committed for what's on order next year, just As we think through just trying to understand how much incremental horsepower you think gets delivered next year, and based on the way conversations are going for 25, just kind of thinking about that incremental growth rate on horsepower additions beyond 23, maybe some color around that.

Yeah, I mean, thanks for the question, Jim, and good to talk to you. You know, we are not quite... finished up the whole budgeting process yet for 2024 and not ready to provide guidance yet. But I will tell you that the horsepower deployment for 2024 will look a lot like what 2023 looked like and maybe a fraction more. And I think that you'll see that same kind of trend towards 2025. Again, just like John was saying about our capital allocation strategy here already today, If we can grow EBITDA by that upper single-digit percentage mark and that grows discretionary cash flow by that same amount, then I think that you could translate that into being able to allocate that both out to dividend and growth capital growth over time.

That's helpful. And then since no one else asked, I figured I'd ask. One of your largest customers is getting taken out here early next year and just kind of curious about how you see that from a potential opportunity standpoint going forward, given their kind of growth plans?

Yeah, I mean, look, Exxon is buying Pioneer, and Pioneer is one of our biggest customers, one of our longest tenured relationships, but we're excited about the opportunity to work with Exxon going forward. They've got great plans for the Permian Basin. They wouldn't be making this investment in the Permian unless they had a pretty long-term outlook about the opportunities in the Permian, which we think bodes really well for our business. As well as, I mean, Exxon's already a customer of ours on a smaller scale, so we already have a relationship with them, and so we're excited to get to move forward working with them and becoming one of their bigger providers.

Fantastic. Thanks, Mickey.

Our next question comes from Jackie Colettis with Goldman Sachs. Please state your question.

Hi, good morning. Thank you for taking my questions. Just wanted to start more on the cost side. So as we're seeing pricing continue to rise, could you comment on what you're seeing more so on the cost side and how inflation pressures have been abating and how you see that going into 2024? Yeah, Jackie, thanks for the question.

You know, I think we've dealt over the last couple of years with pretty significant inflationary pressures hitting us kind of left and right. And we've combated that as much as we could. And I think done a pretty good job of keeping margins pretty flat. So looking towards, you know, 2024, I think that we expect those inflationary pressures to kind of abate a little bit and remain pretty flat going into 2024. I think obviously you'll have some some increases from a labor perspective, as you do every year. But I think that we're kind of expecting our cost of operations metrics to stay relatively flat next year from the standpoint of costs from our suppliers and lube oil providers.

Okay, great. Thanks for the color there. And then lastly, just as a follow-up, I note that the CAT engine availability overall is now over a year plus. Is it specifically worse than what you saw during the second quarter? And has there been any update from CAT on that easing at all, either in the near or long term?

Haven't had any updates on that easing anytime soon. So we expect to keep having to deal with that. And it's kind of typical for these kind of up cycles that those deliveries get out to be that long. Although we expect for this up cycle to last longer than traditionally you've seen them in the past, just because we think that the supply side is so depressed and as well as such incremental high demand for compression services with the dynamic of the fact that the Permian Basin is providing a lot of the gas production growth in the United States, and it requires so much more compression to just produce that Permian Basin gas to get out of their feed LNG plants. So like I said, high, high demand that we foresee for a long time and really tight supply for a long time. So we expect this to continue on, and I don't foresee much relief in delivery times from Caterpillar anytime soon either.

Okay, great. Thank you so much.

Thank you. And there are no further questions at this time. I'll hand the floor back to Mickey McKee for closing remarks. Thank you.

Okay, thanks, Operator, and thanks to everyone for participating in today's call. We look forward to speaking to you again in the new year and with our fourth quarter and full year 2023 results. Thanks.

Thank you, and we conclude today's conference. All parties may disconnect. Have a good day.