Natural Gas Services Group, Inc.

Good morning, ladies and gentlemen, and welcome to the Natural Gas Services Group second quarter 2022 earnings call. At this time, all participants are in listen-only mode. Operator assistance is available at any time during this conference by pressing zero pound. I would now like to turn the call over to Mr. Michael Foster, Natural Gas Services Group's Chief Financial Officer. Mr. Foster, please begin.

Thank you, Luke, and good morning, everyone. Before I turn the call over to John Chisholm, our interim president and chief executive officer, I remind you that during this call, we will make forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, based on our current beliefs and expectations, as well as assumptions made by and information currently available to Natural Grass Services Group's leadership team. Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Please refer to our latest filings with the United States Securities and Exchange Commission for the factors that may cause actual results to differ materially from those in the forward-looking statements made during the call. In addition, our discussion today will reference certain non-GAAP financial measures, including EBITDA, adjusted EBITDA, and adjusted gross margin, among others. For reconciliations of these non-GAAP financial measures to our GAAP financial results, please see yesterday afternoon's press release in our forms 8K, 10K, and 10Q, furnished to the SEC. Now, I'd like to turn the call over to John Chisholm, Natural Gas Services Group's Interim President and Chief Executive Officer. John?

Micah, thank you, and thanks to each of you for taking the time to join us for today's second quarter 2022 Earnings Conference Call and Operational Review. In addition to Micah Foster, our Chief Financial Officer, with me today is Jim Hazlett, Natural Gas Services Group's Vice President of Technical Services. Micah, Jim, and I will be happy to answer your questions after our discussion of the company's second quarter results and some comments on the current operating environment. Every good plan is subject to the power or lack of technology. We apologize for the inconvenience this morning, but apparently our conference call provider's carrier had a massive outage at 7.59 a.m. Eastern Time, just in time for our call. We aren't telephony experts, so we aren't exactly sure what happened, but we will get to the bottom of it to make sure it never happens again. This after we had a practice run with the system last night. That said, here we are, about 90 minutes later than expected, but everyone is safe and we're ready to go. And in the big picture, if this is the biggest challenge of the week, we will all have a pretty good week. Now, as they say, on with the show. Yesterday, NGS released its financial and operating results for the three months ended June 30, 2022, in a press release and filed its quarterly report on Form 10-Q with the U.S. Securities and Exchange Commission. Financial details for the second quarter and first half of the year can be found in those filings. While we will not regurgitate all the data in those reports, we will discuss the highlights of the quarter, provide some additional context regarding the current operating environment, detail key initiatives at the company, and provide some conclusions and general comments about what we see in the coming months. When I agreed to step into the role as Interim President and Chief Executive Officer from the Board of Directors, I was quite comfortable with the financial position of Natural Gas Services Group. As I noted on the last call, Steve Taylor, our former president and chief executive officer and current chairman, was an exceptional steward of the company's financial position. He left NGS in a much stronger financial and competitive position than when he joined the company nearly 17 years ago. From that standpoint, Steve's shoes are hard to fill. As the transition process and responsibilities were developed, the board asked me to focus on accelerating the growth of the enterprise. evaluating and seizing appropriate opportunities available in the present energy market environment, and position the company and its culture for its next generation of leadership. While only just over two months in the process, I'm humbled by the acceptance of the NGS team of my new role and enthused by the opportunities that are ahead. As I get to know my colleagues, I've been impressed with their initiative and enthusiasm and believe we have one of the best operating teams in the domestic compression business. As noted in our press release last night, we reported total revenue $19.9 million for the three months ended June 30, 2022, including $18.1 million in rental revenue, a 6% sequential increase and a 16% increase when compared to the year-ago period. For the first six months of the year, rental revenue totaled approximately $35.3 million, an increase of nearly 14% from the first six months of 2021. As we've noted in the past, sales revenue can fluctuate wildly, and we saw a modest sequential reduction in sales in the second quarter. We should note that an emerging trend in the current acceleration in oil field activity is the continued reticence of exploration companies to commit capital for oil field equipment purchases when leasing options are available. As a result, at least for now, we expect sales to be rather subdued as most upstream participants continue to focus on compression rental opportunities. Before MICA provides additional color on our financial performance for the quarter, I'd like to share with you four key priorities as we work through the balance of 2022 and into 2023. As nearly anyone who's been around the oil field across multiple economic cycles will tell you, the current environment is certainly unique. In my nearly four decades in and around the oil patch, I have never seen variables converge to create more durable opportunities for energy service and technology concerns, including compression. It is our mission at NGS to seize those opportunities to create long-term value for our shareholders. First, we remain committed to our large horsepower strategy. While we're not neglecting smaller horsepower opportunities, there are plenty of them, we remain committed to growth in our large horsepower fleet. The vast majority of our capital is committed to large horsepower projects, and we expect that to continue for the foreseeable future. NGS has a key advantage over many of our peers in that our balance sheet strength allows us to more assertively but prudently take advantage of large horsepower new build opportunities. That said, we intend to be deliberate in our capital commitments and return requirements going forward. It is important that we receive appropriate consideration from our clients to commit capital for high horsepower projects that have longer-term payback parameters. During the challenges of the pandemic slowdown, we worked with our clients that required flexibility in deliveries and pricing. Today, with oil and natural gas prices near cycle highs, we expect our clients will understand our need to forge partnerships that have economic symmetry. Second, we are focused on new technologies and initiatives that can make compression more efficient and provide benefits to both our clients and our investors. Our recent announcement that we are accelerating the conversion of a meaningful number of combustion engine compression units to electric drive motors is just one example. As upstream clients seek ways to reduce emissions, demand for electric drive compression is accelerating. Moreover, electric compression typically operates more efficiently, can be incrementally more reliable than combustion engine packages, and as a result, generally is deployed at a better price point. Our proprietary SIP compression technology allows for ready, rapid, and relatively simple conversion from combustion engine to electric drive units. In addition, We continue to roll out proprietary smart system on most new units in our fleet and are retrofitting several existing units with this system. The technology provides real-time monitoring of gas lift compression surface and downhole pressures to ensure steady pressure levels and optimize production. This technology provides NGS with a competitive advantage with several key clients. We continue to look at a number of other technologies. from those that could enhance existing compression systems to some that claim to be the next great evolution in compression technology. While many will not pass the scrutiny of our technical team, we won't know unless we look. And in today's market, new technologies may be the difference between emerging as a future leader in energy service technology or losing your competitive edge in the market. Hence, we remain focused on innovation. While not directly a technology initiative, we've accelerated our swing program of comprehensive equipment overhauls and upgrades to make sure our deployed compression is operating reliably and at an optimal efficiency level. There is nobody better than our Jim Hazlett and his 40 years of compression experience to lead this initiative. Third, as the energy cycle continues to strengthen, we are focused on a rational pricing policy. Our team, led by Micah and Jim, is working diligently to ensure our pricing economics are fair for our clients and optimal for our investors. As anyone with oil field experience knows, oil field pricing is more art than science, and many times the art isn't terribly appealing. As mentioned earlier, Too often, energy service concerns providing pricing allowances as cyclical demands recedes but don't recover and maintain pricing when the cycle accelerates. With what now appears to be durable cyclical growth, we believe the value of our equipment and services should be recognized by our clients, which should provide benefits to you, our shareholders, as well. As demand for compression equipment exceeds supply, We do not expect our business to be an exception to pricing theories embedded in economic history. Fourth, we are acutely focused on operating in capital efficiencies. While there isn't a lot we can do about overall inflationary and supply chain pressures, we are fixated on what we can control. Internally, we are using technology to improve efficiencies. Whether it's automating hourly technicians' time clocks or moving toward real-time field inventory tracking, we are undertaking a major automation program for field services tracking and data analysis. While this won't happen overnight, the availability of real-time data and analytical capabilities combined with the elimination of the delay inherent in paper reporting should result in less time spent on paperwork, and more time on productive interaction with clients and their equipment. Another example, simply equipping service vehicles with GPS should help us be more responsive to maintenance calls, reducing downtime for clients and reducing unnecessary travel time and expenses for our technicians. In addition, in response to supply chain challenges, we are working with key supplier partners on preferred supply agreements and partnering with them to develop delivery schedules that help us ensure we can better meet the needs of our clients. Those agreements in many cases may also provide us with preferred pricing and reducing our overall capital costs, resulting in an opportunity for incrementally better returns on new equipment. We recognize there are a number of operating expenses and disposable items that are putting pressure on operating margins. We work daily to secure optimal pricing on disposables such as lubrication fluids. However, even with negotiated bulk pricing, lubrication oil prices have increased over 30%. We're working with our clients to recover those increased operating costs and will continue to push for fair expense recovery as appropriate. I would be remiss not to mention labor pressures as well. As activity continues to accelerate in the Permian Basin in West Texas as well as in other key energy markets, competition for quality people continues to grow. We are regularly benchmarking our wages to make sure we are competitive. We are also increasing and improving our training opportunities and enhancing benefits while in many cases holding the line on benefit costs. An example is a pending change in retirement plan providers. that will provide more robust options and accessibility features while reducing the overall administrative cost of the plan. Kudos to Mona Porras, our Human Resources Director for her leadership on these initiatives. With that, I'll turn it to Micah to provide additional color on our second quarter financial results. Micah?

Thank you, John. As John mentioned, total revenues for the three months ended June 30, 2022 increased to $19.9 million from $17.7 million for the three months ended June 30, 2021. Rental revenue increased 16% to $18.1 million in the second quarter of 2022 from $15.6 million in the second quarter of 2021 due to the increased deployment of rental units, primarily higher horsepower packages. As of June 30, 2022, we had 1,281 written units representing 311,379,000 horsepower compared to 1,245 units representing 287,365,000 horsepower as of June 30, 2021. Utilized horsepower increased by 8.4% in the second quarter when compared to the year-ago period. Sequentially, total revenue decreased 2% to $19.9 million in the second quarter of 2022 compared to $20.3 million in the first quarter of 2022, primarily due to a $1.6 million decrease in sales revenues, partially offset by a $1 million increase in rental revenues. As noted in our release yesterday, adjusted rental gross margin of $8.9 million increased 36% when compared to $6.5 million in the same period in 2021, and nearly 13% when compared to $7.9 million in the first quarter of this year. Adjusted growth margin as a percent of sales for the second quarter was 49% compared to 42% in the year-ago period and approximately 46% in the first quarter of 2022. Operating income for the three months into June 30, 2022 was $0.7 million compared to an operating loss of $2.3 million for the three months into June 30, 2021. Operating income increased due to higher rental margins. Similarly, operating income increased due to greater revenue and rental margins in the second quarter of 2022 and $0.4 million during the first quarter of 2022. Our net loss for the three months ended June 30, 2022 was $70,000 or a penny per basic and diluted share compared to a net loss of $1.9 million or 14 cents per basic and diluted share for the three months ended June 30, 2021. Improved rental margins helped reduce our net loss in the quarter. We had net income of $300,000 in the first quarter of the year, or $0.03 per basic and diluted share. The difference was largely the result of higher income tax expense in the second quarter. Adjusted EBITDA increased to $6.7 million for the three months ended June 30, 2022, from $4.5 million for the same period in 2021. This increase was primarily the result of higher rental margins. Sequentially, adjusted EBITDA decreased marginally from $6.8 million, primarily as a result of lower sales margins. SG&A in the quarter was approximately $2.3 million, a reduction of about $300,000 from the year-ago period and a reduction from approximately $2.5 million in the first quarter of this year. We expect SG&A to fluctuate somewhat in the second half of the year with an increase due to costs of the executive transition process and recognition of severance expenses related to Mr. Taylor's retirement. Our cash balance as of June 30th was approximately $9.8 million. In the first six months of the year, we realized cash flow from operations of $13.2 million and used $19.2 million for capital expenditures, $18.8 million of that on our rental fleet. We also repurchased 534,505 shares of our common stock for approximately $6.7 million. We currently have nothing drawn on our revolving credit facility with Texas Capital Bank. We are still awaiting a tax refund of approximately $11.5 million that is due from our 2015 to 2017 amended federal tax returns. While we cannot predict the timing of the refund, our tax professionals have escalated our inquiries into the IRS to determine the status. With that, I'll return the call back to John.

Michael, thank you. Before we take your questions, a couple of concluding thoughts. As noted in the press release yesterday, And in my earlier comments, the compression market remains strong and demand for equipment, especially high horsepower equipment, continues to exceed supply. As a result, we've accelerated our new equipment development program and increased our capital budget forecast to $40 to $50 million. The vast majority of that spending is for equipment that is already contracted with favorable pricing. The new budget also includes capital for our electric compression conversion program. While we are starting our conversion program with smaller horsepower equipment, our survey of the market suggests there is strong demand for those units, and we expect demand to build as we complete the initial conversions. We are excited to see where our commitment to electric compression will take us. While opportunities abound in the compression market, there are challenges to consider as your company prepares for the future. Whether it is the quest for improved energy technology from clients, the push for more environmentally responsible services from multiple stakeholders, or requirements resulting from regulations and legislation, including the recently passed Inflation Reduction Act, the operating environment, challenges, and future business opportunities have evolved significantly in recent years, with the evolution accelerating in recent months. creating the possibility of new initiatives in and around the energy compression market. I am privileged to have an opportunity to step into a daily leadership role with a group of women and men who come to work every day wanting to make NGS a better company for all its stakeholders, our clients, our vendors, our shareholders, and for each other. In today's frenetic oilfield market, There is a lot of work to do, and our professionals come to work each day with a mission to make your company the best compression concern in the business. It is hard not to be energized by that. I will continue to focus each day on smart growth, expanding our commitment to technology leadership, and creating efficiencies and opportunities that result in durable value for you, our shareholders. Execution is the key to turning opportunities into positive results. While we won't always get it right, our mission is to strive for executional excellence in everything we do. I of course want to thank all of our employees for their effort during this past quarter and the entire year. I want to thank you for your time, patience today, interest and confidence in all of us here at Natural Gas Services Group. We are now happy to take your questions, operator.

Ladies and gentlemen, at this time, we will conduct the question and answer session. If you would like to state a question, please press 7 pound. That's 7 pound on your phone now, and you will be placed in the order in the queue received. You can press 7 pound again at any time to remove yourself from the queue. Our first question comes from Rob Brown with Lake Street Capital Markets. Go ahead, please.

Good morning. Thanks for taking my call.

Of course, Rob.

First on the kind of the demand environment, you were pretty clear about the strength in the demand environment. How much visibility do you have in that continuing? And I guess, how do you sort of handle that at this point? Is it a function of pricing or does the CapEx increase kind of get you there as well? How long does that take to kind of play out?

Yeah, so our visibility, not just by us, but outside manufacturers that we use, Our financing institutions all believe through, at a minimum, the end of next year, this demand-supply situation is still going to be the way it is today. And our challenge, as we mentioned in our prepared remarks, is to equate that capital spend with the proper pricing and contracts in many, many of the cases before we even send out the money to build the equipment.

Okay, great. And then when you look to adjust pricing, how quickly do your contracts allow that to happen on average? I think you have a fairly quick turn on that, but just wanted to get a sense of how that pricing can start to flow through.

Sure. In most of the contracts, it's a 30-day notice. And we're working on that right now. We're not going to be overly specific due to competitive reasons, but as you can tell by the way we mentioned it in the call, it has our undivided attention. And Micah may want to say a couple of things on that as well.

Yeah, Rob, good question. You know, some of the contracts are newly issued contracts. You know, we believe those prices, the current price point is a fair price. A lot of our deployed units are on month-to-month basis, and so, you know, all we lack is a 30-day notice to get that pricing improvement pushed out.

Okay, great. Thank you. That's good color. And then my last question is electrification. I know you had a fair number of units that are starting that. Where is that at in terms of being rolled out, and are you seeing more units kind of falling into the electrification pool?

So it's in the early stages. We actually have a handful, probably more than that, of electric units already in the field generating revenue, and that's what gives us such a strong opinion of the returns from a margin standpoint on the electrification units. And Jim, you're welcome to add anything if you'd like to as to where we are on the initial build-out.

On the initial build-out, we are currently through the design phase. We're ordering equipment, the motors and the necessary equipment that we need, and it's well underway for the first 20 units scheduled for October.

Good. And then just to follow up on that, from a customer standpoint, what are their requirements? Are there certain locations that obviously have electrical power or, I guess, what's the field availability to electrify these units? Is it, you know, what percentage of the base or, you know, how do you sort of think about that?

Right. Great question that I'm sure other people are thinking about. So right now the limitation of electrification is the grid and then the stability of the grid. And so The clients themselves are trying to work on that to figure out how they can create greater stability in the grid. And this is going to be a crawl and a walk before a run. And everybody just needs to kind of appreciate that. This is not going to be a flip the switch and all of a sudden... A large percentage of compression in this industry goes electric. But clearly, all indications are that is a preferred way to provide this service, be respectful of the environment, and actually have, as we mentioned, lower operating costs for everyone involved.

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

Thank you very much. Our next question is From Tate Sullivan, Maxim Group.

Thank you. More on the electrification effort. Did you say that the initial waiver for the near future for the electrification will be on the smaller compression horse equipment?

We did, and we'll give you a little bit of definition on that in terms of horsepower. Jim, go ahead.

Okay, so the main thing with the The horsepower, there's a lot of it being used in the higher horsepower areas, but it's mainly the grid that John talked about. There's a lot more or a lot more available systems out there that runs on 480 volts instead of 4140, which is the higher voltage. So with that, we are seeing a successful entry into the 200, 250 horsepower market using those grids that have that voltage and that capability.

Okay. And then to convert the smaller horse, the 200 to 250, are these units that are already in your facilities and ready to go?

These are units that we actually have out there right now. If you'll remember that John in his program mentioned the capabilities of the SIP compressor. It allows us to go from a gas engine to electric motor in about three days if we have the equipment. So we have plenty of those style equipments in the gas side right now, and we're converting them to electric.

Great. And just one more on the smaller horsepower. Just, John, have you seen with this durable cyclical growth any indications of higher demand for the smaller horsepower?

Yeah, there's certainly... higher demand increasing, and, you know, we want to, again, provide some real good clarity. The vast majority of our capital is committed to the high horsepower market, but that's not in any way to say we're neglecting the smaller horsepower, and we think that'll really start to realize greater potential as more and more electric units are able to be applied into the smaller horsepower market. Hopefully that helps for you. Thank you very much. Sure. Thanks for the questions.

Thank you very much. Our next question comes from Mr. Kyle Kruger, Apollo Capital. Kyle, go ahead, please.

Thank you. Congratulations on a very nice quarter. Question as you significantly ramp up capex. You talked about 40 or 50 million, and we see that your cash balance is being drawn down in anticipation of that. What kind of an ROI can we expect out of that capex, incremental capex? You talked about sort of a build-to-suit scenario.

Sure, we'll let Mike handle that for you.

Yeah, Kyle, good question. You know, a lot of this capital, you know, there's long lead times on this. So, you know, we're expecting the bulk of the capital that we incur this year to be deployed, you know, first part of next year going into the middle part of next year. So you're looking at revenue realizations coming in the latter part of of next year. And on an ROI basis, you know, we kind of, when we look at CapEx and we look at pricing, we kind of factor in somewhere, you know, 15 to 20% range on return on that investment capital.

Yeah. Okay. So at 40 or 50 million bucks, which is $4 a share at 15 to 20%, that ought to take you to a solidly earnings positive position starting next year and be significantly accretive to earnings per share. Is that a fair view?

Yes, but I would point again, you know, that these are five to six year contracts, right? So that realization happens over time. You know, I would say absolutely it's going to be accretive to revenue. You know, we're forecasting, you know, continued, you know, inflationary pressures on labor costs and parts costs and all that kind of stuff. We think we've accounted for that appropriately in our expense models. But, you know, anything can happen. But that's so, we've got to keep expenses in line, but we think the revenue projections that we're going to get off of these incremental units will be very accretive to the bottom line.

Yeah, okay, last one for me. John, while you've only been there two months, you still have interim in front of your name, in front of your role, your title. What can we expect in terms of filling the CEO role on a permanent basis?

Yeah, it's a great question. I'm sure others are thinking about it. And the independent directors of the board are considering a number of options. We wanted to make sure that there was minimal turbulence in this transition. I think the quarter speaks to that of the character of our people and the leadership team that, you know, the adjustment from Steve to myself was very seamless. But in addition, between Steve, Jim, Micah, members of the board, we've got pretty deep Rolodexes in this industry and not just limited to compression. So we're looking at that as well. You know, that's a... winding answer I know, but I'd say stay tuned and we'll be able to give you more definition on that on the next call after the third quarter. Okay, thank you. No, thanks for the questions.

Thank you, everyone. That was our last question. Mr. Chisholm?

Sure. Thank you there, Luke, and thanks for hanging in there with these technical gremlins. And again, thank you everyone on the call for your time, patience, and interest. We look forward to visiting with you again after the third quarter, if not before. Have a great day and the rest of the week.

This concludes today's conference call.

Thank you everyone for attending.