Natural Gas Services Group, Inc.

Good morning, my name is Dennis, and I will be your conference operator today. At this time, I would like to welcome everyone to the Natural Gas Services Group, Inc., third quarter 2022 conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. To withdraw your question, press star one again. I would now like to turn the conference over to Micah Foster, Chief Financial Officer. Please go ahead.

Thank you, Dennis, and good morning, everyone. Before we begin, I need to 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 Gas Service 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 this 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 and our forms 8K, 10K, and 10Q furnished to the SEC. I will now turn the call over to John Chisholm.

Thank you, Micah. As most of you likely read in our press release last night, I resigned as interim CEO for NGS, but will remain as a director until March 1, 2023. My focus over the past 15 years as a director with NGS has always been on what creates the most shareholder value for NGS. But I concluded that with my other growing obligations, some of which are international, the time required that I could provide would not be sufficient. I want to thank the employees of NGS and my fellow directors for this last six months leading the company. I trust that I have extended the foundation of NGS and contributed to our value creation. Now, my longtime friend and colleague, Steve Taylor. Steve?

Good morning, everyone, and thank you, John, and thanks for your contributions to MGS. We all value your knowledge and insight and look forward to your continued guidance. And thank you for the assistance you've given me during this transition. Before I get to my prepared remarks, I do want to reiterate and reinforce that the company will continue our search, which is ongoing, for a permanent CEO. We will provide updates as required. I would also like to note that in addition to Micah Foster, our Chief Financial Officer, with us today is Jim Hazlett, our Vice President of Technical Services. Micah, Jim, and I will be happy to answer your questions after our discussion of the third quarter results and our current operating environment. To turn our attention to the business, as we noted in our second quarter earnings call, the current macro environment for the energy industry is unique in my career. Upstream operating customers have typically continued with their capital restraint, which supports higher commodity prices. There is clearly a weak supply-strong demand dynamic in play that has been influenced by traditional natural gas demand, declining pressures and volumes in existing basins, an increase in LNG consumption, and a continued strength in crude oil commodity prices, with a large amount of crude oil produced through gas compression-assisted techniques. It's a unique dynamic that demonstrates that gas compression demand is presently divorced from appreciably higher capital spending. Absent a large-scale geopolitical event, we believe that we are at the beginning of at least a couple of years of higher commodity prices. NGS, with our past financial discipline, is well-positioned to take advantage of these opportunities beginning this year and into 2023 and beyond. But we haven't been. and will continue to be focused on operational efficiencies, our visibility of organic growth opportunities in the large horsepower market has never been stronger. We have worked diligently with our customers to understand their needs in 2023 and beyond, and have started discussions with our financing partners to provide us with the needed liquidity to build out significant new large horsepower additions at highly accretive rates. We have always been protective of our balance sheet, We have the financial ability to execute on opportunities, and we are now in a land of opportunity. While the ultimate amount of capital required for our 2022 program has not yet been finalized, we are working with our board and bank to complete the process. Along with this, we have already begun work on meaningful amounts of new large horse car compression that is already committed under long-term contracts. In addition, our previously announced electrification conversion project on a number of our 250 horsepower units is well underway, and we anticipate that we will complete the conversion of 60 of these units by mid-year 2023. Additive to this are our plans to deploy our first 2,500 horsepower electric units in next year. For most of our capital is committed to traditional gas-fired engine additions, we are seeing more demand for high horsepower electric units from our customers, and we do think there will be more opportunities in this realm. Turning to our quarterly results, we are pleased to report our seventh consecutive quarter of increased rental revenues. Rental revenue increased 15% to $18.6 million from $16.2 million in the third quarter of last year, and 3% over the second quarter's rental revenue of $18.1 million. T3 saw a slight decline in operating margins on our rental business after consecutive quarters of improved margins. Inflationary pressures, primarily in labor, labor and parts, drove this decline. During the quarter, we worked with our customers to increase our rental pricing given these inflationary pressures. The price increases we rolled out will impact approximately half of the active rental fleet in the fourth quarter, with the balance of the fleet seeing increases beginning in January 2023. These price increases will need to not only recapture operating costs due to inflation, but to roll back through the negotiated price concessions we've seen over the last two to three years and during the pandemic. These will have a positive and sustained impact on revenues in EBITDA. We believe these price increases are appropriate given the current cost environment and will restore our margins to the levels needed to continue to invest in the business and bring on new compression to support our customers' activities. As you are all aware, we began our strategic shift towards the higher horsepower market nearly five years ago. It has been and continues to be an excellent source of cash, margins, and returns. Our asset mix, however, by unit count, is still heavily weighted towards small to medium-sized compression. Our large horsepower assets comprise approximately 14% of our current utilized fleet by unit count, but these units provide approximately 45% of our current rental revenue streams. As a small to medium-sized compression market is the most competitive and thus the most price-sensitive, we anticipate that our unit utilization will experience some volatility over the coming months, but it will not have a meaningful impact to our revenue stream. However, we anticipate that our horsepower utilization will continue to grow, reflecting our large horsepower growth. With that, I'll turn the call over to Micah to discuss our quarterly results in more detail.

Thank you, Steve. As previously mentioned, total revenue for the three months ended September 30, 2022 increased to $20.7 million from $18.2 million for the three months ended September 30, 2021. Rental revenue increased 15% to $18.6 million in the third quarter of this year from $16.2 million in the third quarter of last year due to the increased deployment of rental units, primarily higher horsepower packages. As of September 30, 2022, we had 1,196 rented units representing 305,953 horsepower compared to 1,221 rented units representing 288,706 horsepower as of September 30, 2021. We ended the third quarter with 60.5% utilization on a per-unit basis and 72.2% utilization on a horsepower basis. Utilized horsepower increased by 6% in the third quarter when compared to the year-ago period, while revenue per horsepower increased 6.8% when comparing the same periods. Sequentially, total revenue increased 4.1% to $20.7 million in the third quarter of 2022, compared to $19.9 million in the second quarter of 2022, primarily due to a half a million dollar increase in sales revenues and a half a million dollar increase in rental revenues, partially offset by a $200,000 decrease in service and maintenance revenues. As noted in our release this morning, adjusted rental growth margin of $8.6 million increased 17% when compared to $7.4 million in the same period in 2021, with a marginal decline of 300 basis points when compared to the 8.9 million recognized in the second quarter of this year. Adjusted rental gross margin as a percent of rental revenues was 46% for both the third quarter of 2022 and 21 and 49% for the second quarter of 2022. Operating loss for the three months ended September 30th, 2022 was 1.5 million compared to an operating loss of 1.6 million for the three months ended September 30th, 2021. Operating loss improved primarily due to higher rental margins, partially offset by increased G&A, primarily driven by severance costs related to the retirement of our former Chief Executive Officer, Steve Taylor. Sequentially, we reported operating income of $700,000 in the second quarter of 2022. The decline in operating income during the current period was a product of severance charges and, to a lesser extent, increased rental expenses. Our net loss for the three months ended September 30th, 2022 was $80,000 or a penny per basic and diluted share compared to a net loss of 3.6 million or 27 cents per basic and diluted share for the three months ended September 30th, 2021. Improved rental margins combined with a 1.3 million gain on the sale of certain assets from our rental fleet were the primary contributors to the decreased net loss. We recorded a net loss of $70,000 in the second quarter of the year or a penny per basic and diluted share. Adjusted EBITDA increased to 7.7 million, or 44%, for the three months ended September 30, 2022, from 5.4 million for the same period in 2021. This increase was primarily the result of higher rental margins and gains recorded on asset dispositions. Sequentially, adjusted EBITDA increased 13% from 6.7 million, primarily as a result of asset dispositions. SG&A in the quarter was approximately 4.1 million, a 1.4 million increase from the year-ago period, and an increase of approximately $1.8 million in the second quarter of this year. These increases were primarily attributable to severance expenses related to the retirement agreement between the company and our former CEO, as well as other costs related to our executive transition process. While we anticipate fluctuations in SG&A with our heightened activity, we anticipate severance and executive transition costs to be temporary in nature and do not expect them to impact our business beyond the midpoint of 2023. Our cash balance as of September 30, 2022, was approximately $2.6 million, with $2 million outstanding under our revolving credit facility. In the first nine months of the year, we realized cash flow from operations of $18.8 million and used $35.4 million for capital expenditures, $34.6 million of which was expended on our rental fleet. As noted in our second quarter earnings call, the compression market remains strong, and we are fielding calls daily from our customers inquiring about the availability of new compression, primarily higher horsepower. During the second quarter, we accelerated our new equipment development program and anticipate we will end the year at the high end of our previously forecasted $40 million to $50 million of capex spend. With that, I will turn the call back over to Steve. Thanks, Micah.

In my opening comments, I mentioned that we will be fabricating and installing some 2,500 horsepower liquid drive units, our first. That's significant. But I also want everyone to understand that this is only part of a new phase in our large horsepower strategy. We started on this shift to remake our fleet about five years ago, and we have been quite successful, as evidenced by the fact that today 45% of our rental fleet revenue is associated with our large horsepower assets. We're now embarking on another complementary phase, and that is moving into the 2,500 horsepower asset size. Besides providing an additional growth avenue, we will be able to leverage our existing large horsepower compression infrastructure that has already been established. In the past, we have been fortunate in being awarded rental contracts at a longer term at a higher price than the general market. These positive aspects continue as we contract equipment in the 2,500 horsepower arena. With our entry into the very large compression horsepower market, we anticipate that our utilized fleet horsepower will see double-digit growth by this time next year. Supply chain disruptions and customer delays can certainly impact that, but in general, we anticipate this level of activity. Besides the problems we see in our traditional business, we think we also have the optimum type of gas compression packages to capitalize on the methane reduction initiatives that continue to be legislated, as recently evidenced in the Inflation Reduction Act. Combined with our technological prowess and experience, our e-comps, e... Small E, capital C-O-M-P, compression package will not only reduce the carbon footprint of our equipment, but will simultaneously reduce the taxes operators pay related to those emissions. If you've followed NGS for any time at all, you know I'm pretty conservative when it comes to predicting the future, but it certainly looks like we are uniquely positioned to take advantage of this positive cycle. I did not expect to be coming back into NGS in a daily operating room, But through John's efforts and the contributions of the NGS team, we're in an excellent position to grow the company. Our focus will continue to be on capital execution, deployment of new compression equipment, and maintaining our service quality. I will, of course, provide further updates on our end-of-the-year call. Now, we're happy to take any questions. So, Dennis, if you'll open up the lines.

At this time, I would like to remind everyone, in order to ask a question, simply press star, then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. And your first question is from the line of Rob Brown with Lake Street Capital. Please go ahead.

Good morning, Steven. Good to be talking again.

Hey, Rob.

On the demand environment, you said it's quite strong and you're seeing customer activity increasing. I guess is that strength across the board or is it really focused on the high horsepower market or really what's driving demand and where are you seeing it?

Well, we're getting some increase across the board, but, you know, I mean, after gas prices are good. But it's primarily big horsepower that we're seeing. And, you know, the majority, I think the number was, 80% or 85% of our CapEx is spent on large horsepower, which has been pretty indicative the last few years anyway. But overall, we're concentrating and seeing large horsepower demand. Jim, do you want to add anything to that?

Well, Steve, you're absolutely correct about that. Most of our build-out or planned build-out will be in the large horsepower, 1,500 horsepower, 2,500 horsepower size units. As you know, there are some small ones, but not very much.

Yeah, thanks, Tim. You know, Rob, this is just after gas prices have been good. Of course, you know, volatile, but I think still pretty decent compared to the last decade. There is uplift everywhere. I mean, in traditional, just pure natural gas basins, you know, Barnett, San Juan, South Texas, places like that. But really, what's driving the large horsepower demand are oil commodity prices and gas lift techniques, which require compression. So it's kind of an indirect activity, but you know, the, the gas lift market is really the one that's driven our engine to the big horsepower last four or five years. So it's, you know, I don't want anybody to think that's a transient thing. Um, it's a high oil prices are driving the vast majority of the horsepower demand.

Yeah. Okay, great. Thank you. And then, uh, and then on the methane reduction kind of market, that's, that's opening up and the government support, how, um, How do you see that, you know, in terms of opportunity for you and kind of growth drivers next year and beyond?

Well, you know, it's a double-edged sword, right? It's an opportunity, but it's also driven by legislation. And, you know, that legislation, I mentioned the Inflation Reduction Act, you know, quite the misnomer. You know, it's having some portions of it directed towards methane reduction. I think... Even Biden the other day kind of doubled down a little bit on some of that stuff. So, you know, we're seeing that from a legislative standpoint everywhere. But certainly it is an opportunity from the point that the cleaner the machine you've got, you know, the more popular you're going to be. You know, you're going to be the girl that gets all the boys because all that stuff's coming along. And one of the things I think was in the Inflation Reduction Act and Jim Craig if I'm wrong but I think you know there is a tax regime in there based on carbon emissions methane emissions stuff like that and so when you start looking at that and and particularly the equipment as I mentioned that we're using whether it's the engines or you know going to electric drives or you know the e-comp phase of our type equipment you know we can reduce operators taxes quite a bit just due to taxes imposed on methane emissions. So, you know, there are, there's all kinds of opportunities around it, you know, whether it's, you know, environmental, whether it's a financial, we're getting to get started on it. Um, and, uh, you know, it's just going to grow. So Jim, I don't know if you got anything else about that actor or, um, the, our equipment. Now, don't give away any secrets.

Oh, I won't. It involves capturing the escaping methane from a traditional package, and we do it by changing our end devices and things like that. And we can get it down quite a bit. On the electric drives, we can move it down pretty close to zero. Steve, you're right. Also, I would like to mention that I heard yesterday even that New Mexico was increasing their Quad O restrictions on methane. So it's coming down to who can do more and better. So you're right. It's the girl at the dance. Yeah.

Yeah. So... Yeah, and Jim mentioned New Mexico, you know, it's part of the Permanent Basin. So, you know, it's a Permanent Basin that's driving a lot of this big horsepower, a lot of the concentrated sun emissions, et cetera. So, you know, we're going to be well positioned in that. And I think we start testing some phases of the equipment in about a month or so. But, you know, we're going to be able to offer to the operator a pretty –

cleaning machine. Okay, great.

That's a great color. Thank you. And then I guess last question is on the pricing environment. You talked about increasing pricing and then maybe a second round for the rest of your fleet. What sort of the degree of pricing places you can get and how long does that take to flow into the average?

Well, as I mentioned, about half the fleet will see price increases fourth quarter than the other half first quarter of next year. I'm not going to go into how much the increases were. I mean, they varied, you know, and, you know, depending on the current price of equipment and, you know, over time in the rental business, you know, for the same size and type of equipment, you know, different rental rates on them. with the same customers or certainly among customers because, you know, depending on when you put that stuff out and, you know, the environment, you know, with the high activity or low activity environment, things like that. And, you know, and your cost in certain areas are higher than other areas. So you've got different rental rates out there. And one of the things you've got to do is obviously get everything up to, you know, a decent return profile. So The increases were all different. Generally, they were, instead of a shotgun, broad approach, like we did in March, which just flat across the board, 7% to 8%, this was more surgical. And to that, and sort of give John some credit there for leading that effort. And that'll come in. I don't know if you've got anything else to say on the price increases.

Yeah, no, I think you hit it, Steve. You know, this was, you know, this is, when we say 50%, we're really looking at that from a revenue basis, right? So half our revenues will see a price uplift in the fourth quarter with the balance rolling into the first quarter. You know, and... A big piece of that, you know, we've got one, you know, large customer whose equipment is primarily still under contract terms. And so, you know, negotiating price increases there, we can't just do that unilaterally. It's a real negotiation there where we've got to prove out, you know, here's the cost burden we're bearing and kind of prove that out to them. So that's what we're expecting to come in in the first quarter. But, you know, in the fourth quarter, you know, this was across the rest of our customer base. And as we kind of intimated within the script, a lot of this was on small compression that is obviously the most competitive in the market as far as price is concerned. And so we anticipate, Rob, a little volatility in our utilization going forward as some of these units come back to us. We also have on several occasions when we've talked with the customer and said, here's the price that we need to, you know, to realize to keep operating this machine in the field for you. You know, this is some older equipment that, you know, isn't really part of our core strategy going forward. And those customers at times have kind of raised their hand and said, hey, you know, would you sell that to us and then maintain it for us? And so we've done that as well. So, you know, we're – We're working through all the options available to us to help our customers continue to, you know, with their operations, but at the same time help us, you know, realize the margins we need to go forward to continue to invest in the business.

Yeah, Rob, as you know, a lot of inflationary pressures, a lot of supply chain issues still. I mean, supply chain is getting a little better in some respects and in other respects it's not. certainly price, you know, inflation-driven pricing has not abated in spite of what the government says. Obviously, excuse my digression, you know, Biden hasn't been to a grocery store or hadn't bought a compressor part in a while because they're all still advancing in cost pretty significantly. So as I mentioned in the narrative, you know, a lot of this is to recover some costs, and certainly get our margins to where we need them to continue to provide equipment. There's a lot of demand out there. And it is unique. It's pretty high. And we're fortunate that we're in the meat of the market right now. The 1,500 to 2,500 horsepower realm is pretty active. So we think we're We're going to be in good shape. And the new contracts we're getting, as I mentioned on the bigger equipment, is excellent too. So I think you'll see that flow through certainly into 2023. And as long as we don't have some disruption in the market, that pricing should hold for a bit.

Okay, that's excellent, Collin. Thank you. I'll turn it over.

Once again, if you would like to ask a question, simply press star, then the number one on your telephone keypad. Your next question is from the line of Tate Sullivan with the Maxim Group. Please go ahead.

Hey, Steve. Good to hear your voice again. You commented earlier on maybe seeking other financial partners to finance building larger compressors. I mean, in this type of market, I mean, just is the customer demand enough to rationalize using more debt than you have historically? And how comfortable are you with using more debt to build a higher horsepower?

Well, it's not going to be too hard to use more than we have more debt than we have traditionally because traditionally it's been zero. And, yeah, we're, as I mentioned, we're talking to – know others about you know additional liquidity and things like that but the issue you get in we saw it moving into the 1500 horsepower you know you and say the medium horsepower you run into equipment that runs brand new you know maybe 250 300 000 you move into the 1500 horse realm and you've got stuff that's one half two million dollars start moving into 2500 horsepower and you get and it's two and a half to three million dollars you know so the magnitude of the expenditures grows even though the number of equipment doesn't. So yeah, we're going to have to, and that's what we're doing, and Mike is leading the charge on that. We're going to have to have some other sources outside of our operating cash. Certainly that's still going to be stronger by it, but we're going to have to supplement just because Number one, you've got the higher cost of the equipment and you just have such a demand that our cash flow just can't take advantage of it right now. Michael, you want to go a little more on that?

No, I think you hit it right on, Steve. It's something, as we've said numerous times, we've been very protective of the balance sheet, waiting for the right opportunity. And the market that we're seeing today with the wide gap between supply and demand is The rates we can secure with this new large horsepower additions are very accretive and something that, you know, we don't – it doesn't bother us to take on leverage in this kind of operating environment. You know, it's just the rates that you can get and the returns you can achieve on those investments is too good to pass up. So it's something, you know, we're working on diligently, talking with our banks and others today. to make sure that we have the financing lined up so we can go execute on the opportunities available to us. And just thank you.

Tate, I will mention that we're keeping an eagle eye on the balance sheet. We're not going to go out there and get five to six times even leverage and stuff like that. So we're going to keep it in the reasonable realm while still being able to grow the fleet pretty vigorously.

And then related to the larger, the 2,500 horsepower, is it not an element of the industry for customers to do installment payments or any upfront payments as they go to the larger horsepower? Or do you have to finance the whole construction until the rental, receiving rental income?

Well, yeah, on rental, it's all on us. Now, if we're building something for somebody, certainly we typically get upfront payments, progress payments, things like that. But that's not a capital expense. That's just a bill and sell the margin so you know we're not too worried about that stuff right there um that won't you know impact our capital profile too much it's a rental equipment that you know we've got to put the whole bill and then we turn around and you know rent it for that return okay great thank you steve thank you okay thanks tate at this time there appear to be no further questions i will now turn the call over to steve for any closing remarks okay i appreciate everybody um calling in certainly want to again um thank john for his contribution to the company and continued um insight and uh appreciate jim and micah join the call and certainly all the ngs employees we've got a you know a lot of opportunity in front of us so thanks everybody and we will see you next quarter thank you

This does include the Natural Gas Services Group, Inc., third quarter 2022 conference call. We thank you for your participation. You may now disconnect.