Natural Gas Services Group, Inc.

Good morning, ladies and gentlemen, and welcome to the Natural Gas Services Group Second Quarter 2020 Earnings Call. At this time, I'll participate in a listen-only mode. Operator assistance is available anytime during this conference by President Starr Zero. Your call leaders for today's call are Lisa Datta, IR Coordinator, Steve Taylor, Chairman, President, and CEO. I'll now turn the call over to Ms. Datta. You may begin.

Thank you, Erica, and good morning, listeners. Please allow me a moment to read the following forward-looking statements prior to commencing our earnings call. Except for the historical information contained herein, the statement and this morning's conference call are forward-looking and are made pursuant to the safe harbor provisions outlined in the Private Litigation Reform Act of 1995. Forward-looking statements, as you may know, involve known and unknown risks and uncertainties, which may cause Natural Gas Services Group, Actual results and future peers to differ materially from forecasted results. Those risks include, among other things, the loss of market share through competition or otherwise, introduction of competing technologies by other companies, and new governmental safety, health, or environmental regulations, which could require Natural Gas Services Group to make significant capital expenditures. The forward-looking statements included in this conference call are made as of the date of this call. and Natural Gas Services undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances. Important factors that could cause actual results to differ materially from the expectations reflected in the forward-looking statements include but are not limited to factors described in our recent press release and also under the caption risk factors. In the company's annual report on Form 10-K follows the Securities and Exchange Commission. Having all that stated, I will now turn the call over to Mr. Steven Taylor who is President Chairman and CEO of Natural Gas Services Group.

Thank you, Alicia and Erica, and good morning, everyone, and welcome to NGSG's third quarter 2020 earnings review. Thank you for turning in to our call. In my nearly 40 years in the energy industry, I've never experienced a more challenging environment in which to work. Pervasive weakness in energy demand and volatile commodity prices have created unprecedented financial and operational challenges for oil and natural gas operators. and, as a result, the suppliers and service providers who work alongside them. While NGS is fortunate to have been well-positioned entering this period of extraordinary pain for the energy industry, no company is entirely immune from the impact of these sharp and protracted challenges. That said, and as we noted last quarter, our ability to act rapidly to reduce our cost structure and respond to our customers' needs have resulted in less impact than many of our peers on both our financial and operational conditions. While sales and service revenues declined in the quarter, our rental revenues were solid and grew on a year-over-year basis and were only modestly affected this quarter. Total adjusted gross margins came in at 50% and adjusted EBITDA was 35% of revenue. Although not unusual, especially not in downturns, we have seen a high degree of volatility in our compressor sales business. This is primarily due to customers' budget cuts and the current reluctance to restore them in any appreciable manner. Compressor sales, already at a relatively low level from last quarter, were severely impacted this quarter by customer redesigns, which delays the completion of compressor sales jobs, and capacity constraints due to committed higher margin rental contracts displacing sales projects. As noted in our financial statements, we did not have any material compressor sales in the third quarter, but we have not had any cancellations of work and our backlog carries forward. We are confident our compression sales business will strengthen as the market begins to firm. More important, in such a challenging operating environment, NGS continues to strengthen its balance sheet and liquidity position. The company generated positive net cash flow from operating activities of $13.1 million and a free cash flow of $12.1 million during the quarter. At the end of the September quarter, NGS had a cash position of $27.6 million compared to $15.5 million at the end of the second quarter. Our cash position continued to increase through October. We continue to be vigilant in protecting our financial strength during this period of remarkable industry stress, and our cash position provides NGS with significant flexibility and opportunity in any market environment. NGS continues to have one of the best balance sheets in the industry. While we are beginning to see initial signs of a trough in oilfield activity, commodity prices remain below a consistent level that will result in meaningful new oilfield activity. We expect the trend to remain choppy through the end of 2020 and into early next year as operators remain cautious in their approach to growth as they address capital constraints. In spite of that caution, or maybe because of it, As we said last quarter, we continue to see new opportunities for which we believe our fabrication capabilities, superior service, and strong financial position will allow us to capitalize, and we believe those are likely to materialize in the new year. As you are aware, we extended the time period to file our third quarter report to the impact of the COVID-19 pandemic on the Midland community and our firm. We remain vigilant in protecting the health of our team and, as a result, continue to work remotely when possible. We are operating our Midland headquarters with a severely reduced in-person staff and urge our team members to take steps to remain safe and healthy. Our field team continues to exercise appropriate distancing and health practices while working with customers on location. While these practices have added incremental cost and inefficiencies to our effort, we remain dedicated to protecting the health and welfare of our team and our customers in these unprecedented times. With that, let's move into the details. NGS reported total revenue of $15.8 million for the third quarter of 2020, a 24% decrease from the same quarter in 2019. This decline was driven by a decrease in sales revenues and, to a lesser extent, lower service and maintenance revenue. Conversely, NGS experienced an increase in real revenues of 3% when compared to the same quarter of 2019. Sequentially, total revenue decreased by 9%, driven primarily by a decrease in sales revenues by almost three quarters, as well as a decrease in real revenue of 2%. Our service and maintenance revenue exhibited strength this quarter, increased by over one-third due to a good increase in service and maintenance work we won this quarter. Our customers' capital budgets continue to be constrained due to the commodity price uncertainty surrounding the macroeconomic backdrop. Therefore, we expect total sales revenues to remain soft into the new year. Thank you for joining us today. In fact, rental revenue for the first nine months of 2020 is up 11% when compared to the same period of 2019. Given the unprecedented challenges in turmoil in the oilfield services sector, we are pleased with this performance, which provides support for our position as a leader in energy compression rentals. Total adjusted gross margin, which does not include depreciation, for the three months ended September 30, 2020, decreased by 18% to $7.9 million for $9.6 million for the same period ended September 30, 2019. Adjusted gross margin as a percentage of revenue for the three months ended September 30, 2020, was 50%, an increase from 46% year-over-year. Sequentially, adjusted gross margin for the second quarter of 2020 decreased 11% to $7.9 million from $8.8 million from the second quarter of 2020. Adjusted gross margin as a percentage of revenue slightly decreased to 50% in this quarter compared to 51% in the prior quarter. The predominant cause of the decline in gross margin dollars in both comparative periods is due to the unabsorbed cost of our fabrication facilities due to our lower volume of work going through those plants. Selling general and administrative expenses in the third quarter of 2020 were $2.5 million, a decrease of 11% when compared to the same period of 2019 and 6% lower when compared to the second quarter of 2020. SG&A as a percent of revenue for the third quarter of 2020 was 16%, slightly above our general run rate of 13% to 14%. Operating income for the third quarter of 2020 was a loss of $941,000,

and other members of the board.

Our operating income decreased from a loss of $148,000 last quarter to a loss of $941,000 in the current quarter. The operating loss this quarter is mainly due to lower total sales revenue and absorbed fabrication costs. NGS reported a net loss of $562,000 in the third quarter of 2020 compared to adjusted net income of $967,000 during the third quarter of 2019. Sequentially, net income reported in the second quarter of this year was $165,000. The decline in net income for the comparative periods is primarily attributable to the decline in total sales and the associated burden of unsolved costs. NGS reported a loss per diluted share of $0.04 for the third quarter of 2020 compared to adjusted earnings per diluted share of $0.07 in last year's comparative quarter and $0.01 in the second quarter this year. Adjusted EBITDA defined as earnings before interest, taxes, depreciation, amortization, and increases in inventory allowance for the three months ended September 30, 2020 was $5.6 million, or 35% of total revenue, a decrease of 19% from $6.9 million, or 33% of revenue for the same period in 2019. Adjusted EBITDA decreased approximately $940,000, or 14%, sequentially from $6.5 million in the second quarter of this year. Now, to break down the revenue components a little more, total sales revenues, which include compressor, flare, and product sales, decreased $5.3 million to $536,000 on a year-over-year basis. The year-over-year decline is predominantly attributable to a lack of compressor sales and, to a lesser extent, decreases in flare and parts sales. For the same reasons, Sequential sales revenue decreased to $536,000 from $2 million. Year-over-year total sales gross margins declined from $1.5 million to a loss of $461,000, with sequential gross margins decreasing from a positive $148,000 to the same $461,000 loss. Both comparative period losses were primarily due to lower sales revenues and margins, with the lower margins caused by a higher level of unabsorbed costs due to underutilized compression fabrication facilities. These underserved costs are largely due to the severe contraction in the industry, especially for custom fabricated capital equipment, and our need to maintain minimum operating levels at our underutilized fabrication facilities during these periods. Our compressor sales backlog for the third quarter increased to $1.7 million, slightly higher than the second quarter backlog of $1.4 million, but essentially flat with our backlog in August 2020. Now, this backlog was worked off in the current quarter for a couple reasons. A portion of the backlog was postponed due to a customer requested redesign of their equipment. and the balance was delayed due to limited fabrication throughput because of contracted higher margin rental bills. As such, in the third quarter 2020, we did not record any compressor sales. For comparison, compressor-only sales were $4.7 million in the third quarter 2019 and $1.4 million in the second quarter 2020. This is certainly not something we plan on, but it is not unprecedented and has happened before during severe downturns. Compressor-only gross margins were a little more than $1 million in the third quarter of 2019 compared to losses of $127,000 in the second quarter and $607,000 this quarter. As mentioned, losses on sales were exclusively caused by unabsorbed fabrication costs. Rental revenue in the third quarter of 2020 was $14.9 million compared to $14.4 million in the third quarter of last year and $15.1 million last quarter. Rental revenue decreased 2% sequentially. but significantly we are 3% higher this quarter than last year at this time. Year-to-date through September, rental revenues are 11% higher for the nine months in 2020 than the same period in 2019. This is remarkable considering the dramatic upheaval in our business and industry over the past year is much better than many of our peers. Compared to the second quarter of 2020, our average rental rates decreased two to three percent on a unit and horsepower basis. This is primarily due to the discounted rates given to customers in the second quarter when the industry felt the impact of lower crude oil prices and decreased activity. Reported rental gross margins this quarter were 55%, a slight decrease from the second quarter 2020 rental gross margin of 56%, but an increase from last year's third quarter gross margin of 54%. Our rental margins are exhibiting a strong base and would have been higher this quarter except for an increase in bad debt allowance of $180,000.00. As of September 30, 2020, we had 2,339 compressor packages in our fleet, up from 2,277 units at September 30, 2019. The company's total fleet horsepower increased by just over 10% to approximately 449,000 horsepower on September 3, 2020, compared to approximately 407,000 horsepower in the same period last year. This includes the addition of 37 large horsepower units to the company's fleet over the past 12 months. 41% of our utilized fleet horsepower and 30% of our total fleet horsepower is now classified as large horsepower compression equipment, with a utilization of 89% as of September 30, 2020. This has since increased to 93%. Our total fleet horsepower utilization in the third quarter of 2020 was 64%, which is a very small increase above the second quarter 2020 utilization of 63.6% and compares to 66% in the third quarter of 2019. Our unit-based utilization of 55% in the third quarter 2020 remained flat when compared to the second quarter this year and 62% in the third quarter 2019. For the first time this year, we have seen a positive utilization increase quarter to quarter. It is very slight that the fact that there is any is positive in this environment. For the first three quarters of this year, we spent a total of $12 million on capital expenditures, with $10.3 million of that dedicated to rental equipment. In last quarter's call, we anticipated another $8 to $10 million in capital expenses for the balance of the year. We spent $1 million on capital equipment this quarter and anticipated another $7 to $9 million in the fourth quarter, subject, of course, to customers following through on their projections and timings. From a balance sheet perspective, our total bank debt remains minimal at just over $400,000 as of September 30, 2020, and our cash balance is strong at $27.6 million. Our cash balance is up almost 80% from $15.5 million at the end of last quarter and has continued to increase through October. We have received $4 million of the $15 million tax refund we have been anticipating, and that is reflected in our cash balance. There is still another $11 million of total tax refund that is owed to us, although we are not certain regarding the timing of it. We generated positive net cash flow from operating activities in this quarter of $13.1 million, including the $4 million tax refund, which represents 75% of our quarterly revenue. Without benefit of the tax refund, our operating cash still ran 52% of revenue. This is an extraordinary conversion of revenue into cash. Free cash flow for this current quarter was $12.1 million. On a nine-month year-to-date comparison, we generated $27.9 million of operating cash in 2020 compared to $21.3 million in 2019. That's almost 30% more operating cash generated this year than last year in the comparative nine-month period. In summary, there are not many companies in the oilfield services space that have a recurring rental revenue stream, essentially no debt on the balance sheet, cash reserves in the bank, and the continued ability to generate cash. Before I take questions, I want to express my thanks to the entire NGS team for their continued dedication to making NGS one of the best energy services companies in the industry. 2020 has not been easy for any of us, yet the tireless work ethic of our team in the midst of a pandemic and the resulting uncertainty in our industry is something for which I'm incredibly proud and thankful. While shareholders measure our company by a series of impersonal financial numbers, each of those metrics is a direct result of the effort and care of the people that comprise the NGS family. So, thank you. We don't expect a lot to change in the final 45 days of 2020, except of course our capital expense. We expect and hope the year will finally end. We do believe that, while 2021 is likely to start cautiously, there are early signs of recovery on the horizon. More important, NGS is well positioned with a solid balance sheet, a strong customer base, and a team committed to providing uncompromised service. With a stable to modestly improving operating environment, we believe there will be opportunities for meaningful improvement in business prospects as we progress in the new year. Erica, that's the end of my prepared remarks, so if you would, please open the phone lines for any questions.

Ladies and gentlemen, at this time, we will conduct the question and answer session. If you would like to state a question, please press star 1 on your phone now, and you'll be placed into the queue in the order received. Once again, if you'd like to ask a question, please press star 1 on your phone now. Our first question comes from Rob Brown from Lake Street Capital. Please state your question.

Good morning, Steve. Hi, Bob. Hi, Rod. Nice execution in a pretty tough environment as you laid out, so thanks. My first question is really around the CapEx and Q4. Maybe characterize kind of what's driving that, the type of projects that you're filling in. I think it's my horsepower orders that comprise of it. Maybe just clarify the CapEx and Q4.

Yeah, it's made of primarily two components. One is we got a pretty good order for some 400 to 600 horsepower equipment. And, you know, that's what I mentioned, our high horsepower utilization was 89% at the end of Q3, but it's actually climbed to about 93% already because, you know, the stuff that was idle temporarily at the end of the quarter has now been were utilized and committed, and they were building some more. So it's primarily that. and then we've also got, I think I mentioned in the past, the potential for some leaseback purchases, purchasing some new equipment from customers and renting it back to them. So, you know, those two pieces are the biggest part of that. Yeah, and I think the leaseback is pretty interesting from the point that it provides some capital to a customer. It's equipment we actually built for them in the past, and we get to convert into rental revenue at good rates in long-term contracts. So it's interesting, especially in this environment, that there's at least one customer looking to monetize equipment they own and just lease it back. But those are the two biggest components. The biggest risk to that CapEx number is really timing. It's not that the projects will happen, but this is mid-November. We've got holidays coming up and everything else, and that's always a crunch you get into at the end of the year as to whether and, you know, Projects Get Done or, you know, whatever it is. So the number's pretty solid, we think. If there's any wavering to it, it'd be timing, not commitments. But those two components are the biggest part of that.

Okay, good. And then on utilization and kind of the bottoming of the industry, I think you said utilization was sort of stable quarter to quarter here. How much visibility do you have on units coming back and going out and maybe a sense of how the utilization plays out over the next few months? I know it's hard to predict exactly, but do you feel like it's bottom tier or is it still uncertain?

Yeah, I think it's Thank you for watching. The bias is positive in it. We've still got some shut-in equipment that we anticipate coming back on a little more. If you listen to analysts, read reports, everybody's fairly positive on oil price next year, but of course those reports are good the day they're written. Anything can change them. I think the bias for Positive utilization is good, but it's going to be some up and down to it. I think 2021 actually is going to be a fairly good year. I mean, this year's actually been a lot better than I would have guessed back in March when all this stuff happened because it was down pretty fast.

But, yeah, our guys have done a great job of it.

taking care of it, recovering it, and continuing on and watching the costs, obviously. So I think we'll see a trend up, but it's hard to say what that slope is.

Okay. And then last question is really on the competitive environment. Has this played through? Are you seeing any changes there, or is it about what you've expected and you're in very similar to historical cycles?

Yeah, it's what I expected and it is in line with historical trends and that we tend to see some questionable pricing in the market. So both those, you typically see those in downturns, especially from people that aren't as financially strong as we are. We're able to They can choose the jobs we want, the pricing we want, stuff like that. If we want whole pricing, we can. If we want to get aggressive, we can. But we've got the choice to do that. A lot of competitors don't have the choice due to debt or other issues. But we see some weaker pricing out there. It's probably not as much as you would have guessed six months ago as to what it might be due to just the fast downturn. But we still see select stuff. Now, I mentioned our price was down 2% to 3%. You'll get a little drag in pricing as you put more bigger horsepower out there because bigger horsepower costs less per car. and many more. and a number of other people. So, you know, we intend to, as things solidify, going into the next, into the new year, going back to those customers who gave some discounts too and asking for those back. So, you know, the two to three percent down is explainable and reasonable and expected, but, you know, I don't think that will continue, but we do see some weird pricing here once in a while. But again, overall, probably not as bad as you would have thought six months ago, but it's still a little more than I would like.

Okay, great. Thank you. I'll turn it over.

Thanks, Rob.

Our next question comes from Tate Sullivan. Please state your question.

Thanks. Thank you, Steve. Good morning. Can you talk a little more about the leaseback purchases? I was just looking at your sales. I mean, $60 million of sales of compressors and other equipment, understandably, since the end of 2016. Is this an active market historically in the natural gas compressor industry, or is this new? I have not heard you talk about this before. and are you uniquely situated to take advantage of customers that want to monetize some of their equipment?

Yeah, you know, I've mentioned it probably a little in the last couple quarters. We probably are uniquely situated to take advantage of it just because we've got money. Right. You know, when Thank you for joining us. You know, they want or, you know, worse shape or something like that.

So, most of these things just don't take very long to look at and say, you know, we're not interested.

You know, or they don't fit our fleet makeup, or they're smaller horsepower, all kinds of reasons. You know, this one came to us, you know, just a customer we've dealt with for a long time and, you know, do a lot of work with them over, you know, over the years and things like that. And with It's not really a situation of a customer having to have cash, I guess, from the point of being financially in bad shape or something like that. And this is good. It's more customers now looking at, you know what, I've got a finite amount of dollars today. I can spend it on drilling or I can spend it on equipment. Drilling makes me all the money. That's where my return comes from. That's my expertise. Why don't I go ahead and spend money on that and rent equipment? Rental provides some advantages, certainly not the capex you have to spend on it, but also operationally we take care of all the stuff. If you need to downsize, upsize it. Thank you for joining us. Thank you for joining us. Yeah, I think we've got $3 or $4 million dedicated to it. And as I mentioned, I think it'll happen. The only question is timing, you know, if the operator gets around to, you know, needing it quick enough and stuff like that. But, yeah, that's kind of the background of it. And we're comfortable with it because it's equipment we know.

Okay, thank you. And you answered my question earlier on sort of the timing of that CapEx in the quarter and the good order you mentioned for the 400 to 600 horsepower. If you can share roughly, I mean, that size horsepower, the average rental term lengths versus your larger horsepower. Have you talked about that before, Steve?

We're getting two to three years on those, you know, on the 400 and 600 horsepower. So we're getting good terms on them and, you know, market-leading rates on them too. So, you know, just like any other CapEx, we're not – We're not spending any capex on deals. We're not trying to use our money to go get market share or anything else. We're trying to use our money to make money. And so we want longer terms, and we want better rates, or we don't spend the money.

We don't have to.

So we know this, and that's what we look at from those standpoints. But that's the other $7 to $9 million this year. It's all pointed to and dedicated to longer terms and high rates.

The larger horsepower units, particularly the equipment that you built in the last year and a half, are they more than a year rental terms typically as well? And I understand that can change based on shutting down.

Yeah. Yeah, the biggest ones, say the 1,400 horsepower units, yeah, we typically go, you know, three to five years on those. We want a good long term on that stuff. And it's not too hard to get that sometimes. It is, you know, it depends on the customer obviously, but The equipment is so big and so expensive and takes so much time to install and operate. The customer is paying for a lot of this, right? The installation, the freight, and all this other stuff. I dare say you could rent it on a one-month term. It's going to stay out there a long time. Obviously, we like the security of of Contracted Rentals. So the bigger the equipment, generally, the bigger the equipment, the longer we go on terms. And, you know, then that kind of mid-horsepower will do some midterms, the two- to three-year stuff, and then the smaller stuff is, you know, it's 12-month terms nominally. We've tried to extend terms overall on all the equipment to get a little longer term. you know, rental period and security with it.

Thanks. And last one for me. I mean, I know the whole industry and, I mean, the balance between more people talking about renewables going forward. Have you ever talked about more utilities or mentioning trying to get renewable natural gas into pipelines? And I think some of that process needs compressors. Has that market ever been an opportunity for you or can it be going forward?

Yeah, I guess it hadn't been a big overt market in the past just because the emphasis hadn't been on the ESG part of it as much. Now, obviously, that's growing. And natural gas, just by virtue of being a cleaner fuel, is going to gain in some of that and obviously contributes, I think, to better environment, cleaner air, et cetera. But I think there are opportunities to capitalize on that. We feel like we've already got some real clean equipment from the point of the engines you know, very tightly controlled from an emissions standpoint, cat-eye converters, air-fuel ratio controllers, and actually every one of our engines in the fleet, the engines that drive the compressors, meet or exceed the worst of any state's regulations. I hesitate to say we exceed all the states, but it's the vast majority that we exceed. We decided to do that a while back. We've got real clean engines. The skid itself is different. It gathers fluids, etc. We've got some and some recycling components on the units to conserve oil, to capture gas and things like that. But I think there is more opportunity to do more, number one, mechanically and physically to the equipment and some of our practices in the field. and many, many more. taking a little more share out of that piece of it. But there's more to do, and I think you'll see more and more gains and certainly out of us more and more emphasis on that part of it.

Thank you, Steve, for all the comments. Have a great rest of the day.

Okay. Thanks, Tate.

Once again, if you'd like to ask a question, please press star 1 on your phone now. At this time, we have no further questions.

Okay. Thank you, Erica, and thanks, everyone, for joining me on the call. I appreciate your time this morning. Hope your holidays are healthy and happy, and wish each of you a more prosperous new year. I look forward to speaking with you about NGS in 2021. Thank you.

This concludes today's conference call. Thank you for attending.

The host has ended this call. Goodbye.