Cactus, Inc.

Ladies and gentlemen, thank you for standing by, and welcome to the CAPTUS Quarter 3 2021 Earnings Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star 1 on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star 0. I would now like to turn the call over to our speaker today, Mr. John Fitzgerald, Director of Corporate Development and IR. You may begin.

Thank you and good morning, everyone. We appreciate your participation in today's call. The speakers on today's call will be Scott Bender, our Chief Executive Officer, and Steve Tadlock, our Chief Financial Officer. Also joining us today, are Joel Bender, our Senior Vice President and Chief Operating Officer, Stephen Bender, Vice President of Operations, and David Isaac, our General Counsel and Vice President of Administration. Yesterday, we issued our earnings release, which is now available on our website. Please note that any comments we make on today's call regarding projections or expectations for future events are forward-looking statements covered by the Private Securities Litigation Reform Act. Forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond our control. These risks and uncertainties can cause actual results to differ materially from our current expectations. We advise listeners to review our earnings release and the risk factors discussed in our filings with the SEC. Any forward-looking statements we make today are only as of today's date, and we undertake no obligation to publicly update or review any forward-looking statements. In addition, during today's call, we will reference certain non-GAAP financial measures. Reconciliation of these non-GAAP measures to the most directly comparable GAAP measures are included in our earnings release. And with that, I will turn the call over to Scott.

Thanks, John, and good morning to everyone. During the third quarter, drilling activity continued to move higher against the backdrop of strengthening commodity prices. I was particularly proud of our incremental margin performance in both product and rental business lines. Cactus remains extremely well positioned to participate in what we believe will be a multi-year upcycle for the industry, and the third quarter provided evidence of that. We are preparing now with people and inventory for what is increasingly looking like a very busy 2022. In summary, third quarter revenues increased 6% sequentially with growth in each of our revenue categories. Adjusted EBITDA was up 11% sequentially. Adjusted EBITDA margins were 28% up 120 basis points sequentially. We paid a quarterly dividend of $0.10 per share and ended the quarter with $302 million in cash and no debt. And I'll turn the call over to Steve Tadlock, our CFO, who will review our financial results. And following his remarks, I'll provide some thoughts on our outlook for the near term before opening the lines up for Q&A. So, Steve. Thanks, Scott.

Q3 revenues of $115 million were 6% higher than the prior quarter. Product revenues of $75 million were also up 6% sequentially, driven primarily by an increase in rigs followed. Product gross margins at 34% rose approximately 200 basis points sequentially as cost recovery efforts offset inflationary pressures across the supply chain. Rental revenues were $15 million for the quarter, up approximately 4% from the second quarter of 2021, while gross margins increased 12 percentage points sequentially, due primarily to lower repair and equipment activation costs as well as lower depreciation as a percentage of revenue. Field service and other revenues in Q3 were $25 million, up 6% versus the second quarter of 2021. This represented 28% of combined product and rental-related revenues during the quarter, which was slightly above expectations. We expect field service revenue to be 27% to 28% of product and rental revenue during the fourth quarter of 2021. Gross margins were 23% down 320 basis points sequentially, with the reduction largely attributable to lower utilization associated with time spent on new higher training, higher fuel and remobilization costs, and overtime required to meet increased activity levels. SG&A expenses were $12.1 million during the quarter, up $800,000 versus the second quarter. The sequential increase was primarily attributable to higher salaries and wages, increased professional fees, and IT system upgrade costs. SG&A expenses were 10.5% of revenue compared to the same percentage during the second quarter. We expect SG&A to be approximately $12 million in Q4 2021, inclusive of stock-based compensation expense of approximately $2 million. Third quarter adjusted EBITDA was approximately $32 million, up 11% from $29 million during the second quarter of the year. Adjusted EBITDA for the quarter represented nearly 28% of revenues compared to 26.5% for the second quarter. Adjustments to EBITDA during the third quarter of 2021 included approximately $2 million in stock-based compensation. Depreciation expense for the quarter was $9.1 million. A similar amount is expected for the fourth quarter. We reported income tax expense of $3.3 million during the third quarter, which is inclusive of a $0.7 million income tax benefit associated with a partial release of a valuation allowance during the period and a half million tax benefit related to the finalization of our 2020 tax returns. During the quarter, the public or Class A ownership of the company averaged 77%, and it ended the quarter slightly higher at 78%. Barring further changes in our public ownership percentage, we expect an effective tax rate of approximately 22% for Q4. Gap net income was $17.2 million in Q3 2021 versus $14.8 million during the second quarter. We prefer to look at adjusted net income and earnings per share, which were $14.7 million and $0.19 per share respectively during the third quarter, versus $12.3 million and $0.16 per share in Q2 2021. The Q3 adjustments included the application of a 28% tax rate to our adjusted pre-tax income generated during the quarter. We estimate that the tax rate for adjusted EPS will remain at 28% during the fourth quarter of 2021. During the third quarter, we paid a quarterly dividend of 10 cents per share, resulting in a cash outflow of nearly $8 million, including related distributions to members. The Board has approved a dividend of 10 cents per share to be paid in December of this year. We ended the third quarter with a cash balance of $302 million. For the quarter, operating cash flow was approximately $9 million, and our net capex was $4 million. Given issues with the global supply chain and extended transit times, we have strategically increased inventory levels over the last two quarters. Our goal is to secure equipment on a timely basis in anticipation of greater customer activity. During the third quarter, we made our annual TRA payment and associated distribution of $12.5 million. As a reminder, this payment is reflective of cash tax savings that occurred in 2020 as a result of our corporate structure. The next such payment isn't expected to occur until mid-2022. Capital requirements for our business remain modest, and we will continue to exercise discipline with regards to growth CapEx. As such, our net CapEx guidance for 2021 remains in the range of $10 to $15 million. That covers the financial review, and I'll now turn you back to Scott.

Thanks, Steve. As previously mentioned, we reported sequential growth across all our revenue categories during the third quarter, while improving overall margins to their highest level this year, despite extraordinary supply chain challenges. Following recent conversations with customers, I'm more bullish on U.S. activity levels than I've been in some time. Assuming commodity prices remain supportive and key supplies such as OCTG are available, we would not be surprised to see the U.S. land recount grow by an additional 10% by the end of the first quarter of next year. Despite nearly all of the U.S. market rigged additions coming from private operators who have historically represented a smaller portion of our business, we reported market share at 42% during the period. In what was a testament to our sales operations and supply chain teams, we improved product margins by 200 basis points during the quarter, despite historic levels of material and freight inflation and the increased use of our higher cost Bossier City facility. Looking to the fourth quarter, we currently anticipate our rigs follow to increase by approximately 10%. We remain of the opinion that our publicly traded customers will respond to the improved commodity environment as we head into 2022 and would expect to see another double digit increase in the beginning of 2022. Fourth quarter product revenue is expected to be up at least 5% sequentially. Based on current expectations regarding the timing of our latest cost recovery efforts, we expect relatively flat EBITDA margins in Q4 despite continued inflation headwinds. Note that revenue generated per rig typically declines marginally during the fourth quarter as completion activity lags drilling around the holidays. Additionally, In a rising rig environment, product revenue per rig can lag as rigs are fully onboarded. Lastly, and importantly, we have noted a modest decline in wells drilled per rig, a trend that could continue into next year if overall third-party service execution wanes. Margin performance will continue to be a function of our ability to adjust prices to compensate for the intense inflationary pressures being experienced in labor, steel, and freight. While successful on this front today, further steps are underway to achieve incremental margins consistent with historical norms. In recent weeks, conversations with customers have increasingly focused on the ability to secure equipment to meet drilling plans. We've always excelled in our ability to timely and safely deliver. This competitive strength resulting from our unique supply chain model becomes even more important during times in which the industry struggles with overall shortages. Although cost inflation has been well telegraphed throughout our industry and beyond, naturally not all customers welcome cost recovery efforts. As we've stated previously, this organization is focused on returns and not market share. Regardless, it is our belief that 2022 will be a year of heightened pressure on delivery and execution, which will reward those of us with significant domestic infrastructure, best-in-class products, and differentiated service and execution. On the rental side of the business, revenues increased by less than we had originally anticipated for the quarter, but were still up 4% sequentially during a period of relatively flat domestic completion activity. Customers have been relying on their inventories of drilled but uncompleted wells for the last several quarters, but with ducts at their lowest level since early 2017, that trend appears to have ended. However, one positive of the more moderated growth is that it generally leads to slightly more favorable EBITDA margins resulting from reduced reactivation costs. Our rental business is witnessing some positive dynamics, which should lead to above-market growth during the fourth quarter. While the tail end of the fourth quarter is normally subject to some year-end budget exhaustion, we currently anticipate rental revenue to be up at least 10% during Q4. Rental EBITDA margins are expected to be in the low to mid-50% range during the period. This rental market remains highly competitive, but should activity move forward in 2022 along with the rig count, there may be line of sight to some improved pricing dynamics, something we haven't seen since early 2020. Our reputation for providing equipment safely and reliably should become an important point of differentiation in the coming year as some service providers struggle to execute. Regarding our expansion into the Mideast, we were extremely pleased to have generated first revenue during the third quarter. As previously disclosed, this has been in concert with NESR, who has been active in the development of unconventional fuels in Saudi Arabia. Our agreement with NESR was important for Cactus to quickly gain access to Aramco and has allowed us to prove our technology and reliability with a key customer. This represents an important first step for our entrance into the area, and we're excited about our overall potential in the region. We continue to evaluate the shipment of additional assets into the region given the increase in unconventional activity while we pursue product sales. In field service, revenues continue to be driven by both product and rental activity. Revenue as a percentage of product and rental revenue is expected to decrease marginally on a sequential basis. This segment typically witnesses lower margins during the final quarter due to seasonal elements And accordingly, we expect to see EBITDA margins in the low to mid-20% range during the fourth quarter. We would expect margins to approach more normalized levels in the first quarter of next year as labor utilization returns to traditional levels. I'd like to close our prepared remarks by highlighting a few key points. The supply chain issues that have plagued most manufacturing businesses have not abated. Increased costs will continue to represent a headwind for the next few quarters at least. The size of that impact will depend on the degree of further cost increases and our ability to continue working with our customers to compensate us for the challenges we face in ensuring on-time deliveries. That said, we remain advantaged due to our Bossier City manufacturing capabilities, unparalleled experience in the relationships of our operations team. We simply don't tolerate miscommitted deliveries, and no one is better prepared to handle these issues in the face of increased pressures arising from changes in the amount and timing of deliveries. On the labor front, the market continues to tighten. However, we believe that Cactus offers unique opportunities for our associates, and we've always been successful in recruiting key talent. There's been no change in our opinions regarding M&A. We continue to believe that consolidation within our industry makes sense, and this team will carefully monitor and evaluate opportunities to the extent they become available. As I remind you, regularly management are long-term investors in this business and are highly aligned with our shareholders. As activity rebounds, our team will continue to evaluate capital deployment with returns and free cash flow as our main priorities. In summary, we were extremely pleased with the cost recovery support from our customers in both our product and rental revenue categories. Additionally, our optimism regarding industry activity levels continues to improve. We remain ready to take advantage of our favorable positioning as the ongoing activity recovery continues. And so with that, I'll turn it back over to the operator, and we may begin Q&A. Operator?

As a reminder, to ask a question, you will need to press star 1 on your telephone. To withdraw your question, press the pound key. Please have one question and one follow-up question only. Please stand while we'll compile the Q&A roster. Our first question comes from the line of Chase Mulvihill from Bank of America.

Hey, good morning. Good morning, Chase. How are you?

Good. Good. How are you, Scott?

I'm great.

Thanks. I guess first question, you know, obviously you talked about the supply chain challenges. um and you know and other kind of frictional uh costs around uh inflation and things like that um so i guess maybe you know first question is you know i asked you this last quarter i'm going to ask you again um you know is today better or worse than yesterday um from a supply chain um you know friction and then you know what are you doing to continue to manage the supply chain and how easy is it for you to continue to push along price increases to offset kind of inflationary costs?

I think you snuck three questions in there, Chase.

They're all related. Okay.

So the first one is easy. It's worse than it was when you last asked the question. I think this quarter was – probably significantly worse than what we've seen in previous quarters. So that's why I'm particularly proud of the job the team did in increasing our incremental margins. What are we doing to address supply chain? And as much as our competitors have access to this call, you're probably not going to get much of an answer to that. But you know the secret sauce. We've talked about it before. We have Bossier City. We forecast. We just do a number of things, but it's sort of a, it's one of the things I prefer not to discuss openly. And then, what was your last question?

Did you also forget?

Oh, well, you know, I'm not going to discuss pricing, but having told you now that costs increase by more than we expected in the third quarter, but our margins went up, that should give you some indication that we've been successful.

That's kind of a smart-ass answer, I'd say. All right. And then, you know, when you think about activity, and I think you said up 10% on rig activity between now and kind of the end of the first quarter, you know, let's call it roughly 50 rigs, horizontal rigs.

Right.

So could you... Could you maybe kind of characterize what you're seeing of those 50 rigs? Are those more publics, privates? Just trying to understand the mix there between publics and privates.

Third quarter was mostly privates. Fourth quarter, we expect to see an increasing participation by publics.

Okay. All right. I used, I think that was four, so I will jump back in the queue. Okay, Scott.

Thanks, Chase.

Our next question comes from the line of Scott Cooper from Citigroup.

Hey, Scott.

Yes, good morning. Good morning. Good, good. So just to check, the product forecast is RIGS followed up 10% and revenues up at least 5%. Did I hear that correctly?

You did.

Gotcha. And just some additional color on the revenue per rig trend, obviously taken down a little bit. Is that a mix issue with more privates in the mix, and they just tend to drill a little bit slower? Is it supply chain issues starting to impact everybody, and is there any fluctuation with wellhead sales driving that number as well?

Yeah, so that's a very, very good question. Really, it's a straightforward answer, but it has many components. So let me start by saying that in general, we see fewer wells drilled per rig per month by privates than we do by publics. So that's not helpful. Number two, we monitor the well efficiency of our overall customers. and for the first time in I don't know how many quarters, I'm looking at my team, we actually saw rig efficiencies drop in Q3, and by that I mean fewer wellheads ship out per month per rig than we've seen the entire year, and maybe in the last two years as far as I know. It was a surprising drop. And then, of course, as the ducts, as the ducts began to deplete, the need for production trees also fell off. So it's that combination, I think, of really broadly rig efficiencies, which could also result from maybe the incremental rigs being added being less efficient, crews being less efficient, or it could be the, I think it's really a function of privates in the overall mix. But that really has more to do, the fact that we've seen the reduction in ducks have the most to do with the fact that our revenue per rigs have dropped. Now, what I expect and what the team expects and what our inventory levels reflect is our belief, based upon the conversations we've had with our core customer base, who are the publics, that we're going to see the publics reemerge going into 2021. Gotcha.

So, you know, just in terms of trends.

There's hope.

Go ahead. Thanks, Scott. Yeah, I was going to ask about, you know, the 2022 trend, you know, with publics coming back and, you know, do you have, you know, a stabilization in the production tree sales such that, you know, that revenue per rig trend, should start to stabilize, or do you expect it to potentially degrade a little bit more in 1Q and 2Q?

I think that fourth quarter will be challenging just because of seasonality. In the best of times, people just tend to put on fewer production trees in the fourth quarter. They take a couple days off as well, which is not helpful. I don't expect to see great results in the fourth quarter. I'm much more optimistic as we get into the first and second quarters of next year, seeing us return to our historic levels. But, you know, you're going to have the benefit of some cost recovery.

Gotcha. And then just one additional one. You and peers have been building extra inventory, just given, you know, the issues on the supply chain side. Is that coming to an end? Do you have some more build to go? And how do you think about managing inventory levels after we get past all these supply chain woes? Do you bring them down? Do you just kind of keep them as an insurance policy? How are you thinking about it longer term?

Right now, I can tell you that the industry is stressed with shortages right now. So, you know, we've always been sort of opportunistic. And because we have so much cash, it's a great place for us to put our cash. I think the second point is we have historically high levels of in-transit inventory. And by that, I mean inventory on the water that we can't get our hands on. And I'm looking at Steve Tablak. I think we're at three times. Three times, that's a huge amount of inventory that we have that's been on a cruise now for an extended period of time. So that has not been helpful. And we have to accommodate that. Your broader question is, do I see inventory levels coming back down? Yes. Once Joel gets more confident in the supply chain, once the transit times, and they will become closer to historic transit times, you'll see inventory levels drop back down to our normalized run rate.

Yeah, I would just add, obviously, inventory is based on prospective sales, not historical sales. And given our view for 2022, we are, like Scott said, taking advantage of that with what we expect to come. I think working capital as a percent of annualized revenues was pretty good this quarter. It was more in line with our normal, which is 25 to 27%. We were at 26% in Q3. I think in Q4, you would expect, we expect that to be more, you know, 27 and a half percent, maybe, of annualized revenues. Largely because of annualized revenues.

Thank you.

Thank you.

Our next question comes from the line of Stephen Canker from Stifel.

Thanks. Good morning, gentlemen.

Good morning, Stephen. How are you?

Good, thank you. Two things for me. Year to date, obviously, we've talked about this public-private mix, and I know historically your relationships tend to be very sticky. Are you seeing that same stickiness with the private operators as you have historically with the publics?

Yes, sir.

Okay, good. And then as we think about next year in aggregate, I know you gave some good color on the beginning of the year. Are you seeing the same type of expectations as we have been hearing from many of the frat companies, like looking at kind of a 20% plus rise in spending and probably a bit lower increase in activity? Or is your insight different than that?

So, you know, I have to – I have to be honest, I don't really listen to the pressure pumpers calls. I'm looking at my man John Fitzgerald here. Is that 20%? And I assume that includes what they consider to be inflation, doesn't it? So what's the real activity increase they're projecting? Have they said? Probably close to half of that. So 10%. I would be very surprised if our frack activity was only up 10% next year. That's crazy. It's going to be better than that.

Okay.

And I'm talking about excluding inflation. I think it would be better than that.

Great. Thank you. And just if I could slip in one final, the competitive landscape in the U.S. market, right, obviously has changed a little bit over the last couple of years. Are you seeing any material changes in the competitive landscape and the folks that are fighting against you?

I would say there are a lot of smaller players out there fighting amongst each other. But I wouldn't say that we're not really seeing the impact. They're clearly taking a disproportionate share of the privates that are drilling, which is what you'd expect. But I think in a market where we participate, we really haven't seen much of a change.

Okay, great. Thanks for the call, gentlemen.

Our next question comes from the line of Ian McPherson from Piper Sandler.

Hi, Ian. How are you? Good morning, Scott. Great, thanks. How are you? Great. It is, following Stephen's question, it is an emerging disconnect, I think, between expected rates of activity increase and E&P spending that There's not enough money in 20% E&P spend growth to accommodate the service and product cost inflation that's happening plus 20s activity. It just doesn't fit. So I'd be curious to see how that unfolds. But my question is different. Really, your market share has sustained in the low 40s for about a year now. You cited OCTG as a specific threat or bottleneck that could govern growth over the near term with casing, et cetera. But I was going to ask if shortages in your niche as well could emerge and if you could actually out-compete the other 60% or so of the market on deliverability in this tight supply chain market and actually take more market share, not just on the basis of premium differentiation and efficiency, but also just sheer availability and deliverability of wellheads? That's the plan. Okay. Do you see evidence of competitors stumbling on deliverability out there today? Is that an abstract or a real opportunity?

Yes, we are seeing some of that, Ian.

Okay.

And then I was going to ask also, you don't ask me too many more questions about competitors.

This one's only for cactus. Uh, Sally, uh, you're up and running. Uh, how are you thinking about the scalability of that opportunity going into 2022?

Um, you know, I think that, um, you're talking about just within the kingdom or beyond the kingdom. Yeah, sure. Total international. Yeah, I think that, as I've said before, our hope and our plans are to continue the expansion of the Mideast with NESR. We're using Saudi kind of as our test case, and the performance has been very good, very pleased with it. I think that we'll continue to deploy more assets in Saudi. I can't tell you exactly when, and I think you'll see us deploy assets in other areas of the Mideast in conjunction with NES. I also feel increasingly optimistic that we'll turn some of this exposure into product sales later next year.

Very good. Look forward to next steps on that. Thanks a lot. Thanks, Ian.

Our next question comes from the line of Taylor Zurcher from Tudor Pickering Homes.

Hey, good morning. Thanks for taking my question. My first one's on M&A. And you talked about the continued need for M&A and likely continuing to evaluate deals. And I guess my question is, in this commodity price environment, it feels like stellar expectations have probably gone up significantly. So I'm just curious if you could frame, just generally speaking, where bid-ask spreads sit today and if the commodity price environment is hindering the likelihood of M&A over a near-term horizon, maybe the next 12 months at all.

Well, we haven't had too many bid-asks, so I can't really speak to you from experience. I mean, it would be logical that sellers would want more, but it would also be logical that we could afford to pay more with our currency. So, honestly, I don't think that we're disadvantaged, given... the improving dynamics in the macro. In fact, I feel probably the opposite. Because as long as this company continues to perform, I think our investors will continue to reward us. And as long as they continue to reward us, I think we'll be in an excellent position to move forward on M&A. So, I mean, that leads me to answer a question that you haven't asked yet. and that is, why don't you give up some of this $300-plus million? You're going to have positive free cash flow in the fourth quarter. Why don't you release that to the shareholders? And I'm going to answer the way I normally do, and that is that we are the largest shareholders, and I personally love dividends. But I still see some opportunities to deploy that cash in an M&A situation. So I know I've asked all of you to be patient with us. We're just very careful about how we spend money, but don't misinterpret that to mean we're not willing to spend money. We are willing, and we're pretty actively looking.

Well, you answered both of my questions there, so thanks for that. Maybe I'll sneak one in on market share. 40 to 50 rigs being added through Q1 based on the 10% metric that you provided. I suspect as the public start to come back a little bit more in the coming months that market share probably has room to move higher, but just curious how you frame that for Cactus over the next couple quarters.

I think your conclusion was correct.

Awesome. Thanks for the answers.

Thank you.

There are no further questions at this time. Please continue, Mr. Scott Bender.

All right. Again, thank you, everybody, for your continued attention to CACTUS and interest in CACTUS. And, you know, we do look forward to seeing you, hopefully, in person over the next 12 months. Everybody have a good day.

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