Select Water Solutions, Inc.

Greetings and welcome to the Select Energy Services Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Chris George, Senior Vice President, corporate development, investor relations, and sustainability. Thank you, Chris. You may begin.

Thank you, operator, and good morning, everyone. We appreciate you joining us for the Select Energy conference call and webcast to review our financial and operating results for the third quarter of 2022. With me today are John Schmitz, our founder, chairman, president, and CEO, Nick Zweika, senior vice president and chief financial officer, and Michael Skarkey, executive vice president and chief operating officer. Before I turn the call over to John, I have a few housekeeping items to cover. A replay of today's call will be available by webcast and accessible from our website at selectenergy.com. There will also be a recorded telephonic replay available until November 17, 2022. The access information for this replay was also included in yesterday's earnings release. Please note that the information reported on this call speaks only as of today, November 3, 2022, and therefore time-sensitive information may no longer be accurate as of the time of the replay listening or transcript reading. In addition, the comments made by management during this conference call may contain forward-looking statements within the meaning of the United States federal securities laws. These forward-looking statements reflect the current views of select management. However, various risks, uncertainties, and contingencies could cause our actual results, performance, or achievements to differ materially from those expressed in the statements made by management. The listener is encouraged to read our annual report on Form 10-K, our current reports on Form 8-K, as well as our quarterly reports on Form 10-Q to understand those risks, uncertainties, and contingencies. Also, please refer to our earnings announcement released yesterday for reconciliations of non-GAAP financial measures. With that, I'd like to turn the call over to our Founder Chairman, President and CEO, John Schmitz.

Thanks, Chris. Good morning and thank you for joining us. I'm excited to be discussing Selecta Energy again with you today. The third quarter's results, combined with our recent acquisitions, display our continued ability to execute on our core strategies of improving and bolstering our base business, advancing our technology, sustainability, and diversification efforts, and executing on strategic M&A. The third quarter saw strong sequential revenue growth, increasing 12% quarter over quarter, with all segments showing solid improvements during the quarter. Our water service segment saw quarterly revenues approach pre-pandemic peak levels, with gross margins increasing to 23%. Meanwhile, our infrastructure segment achieved record quarterly revenues, and our chemical segment achieved record high margins. Reinforced by steady activity levels, a challenging labor market, and a tight equipment supply environment, we continue to capture market share and see pricing improvements across each of our segments. Combined, these factors led to a strong 70% growth in net income and 32% growth in adjusted EBITDA. On the back of these strong financial improvements, I'm also pleased to have announced the acquisitions of Breakwater Energy Partners and the strategic infrastructure assets from Cypress Environmental Services, both of which closed this week. Select has a long and successful track record in M&A, and I continue to believe that consolidation remains an important way to drive efficiencies and further create value within our industry, and more importantly, for the select shareholders. Both of these acquisitions fit us extremely well and provide strategic growth opportunities at very attractive entry points. With these acquisitions, we are also bringing on skilled and experienced leadership and their strong operating teams who we are excited to partner with going forward. With Breakwater, we are acquiring one of the market leaders in advanced water recycling, infrastructure, disposal, and logistics solutions. Breakwater has broad capabilities across the entire Permian Basin with complementary water logistics operations in the Eagleford. With a core footprint of strategic commercial recycling facilities, serving the heart of the Midland Basin, Breakwater currently operates about 600,000 barrels per day of active recycling capacity at its four primary fixed facilities with an additional 1.4 million barrels per day of permitted capacity available for development. Breakwater also operates nine active modular recycling facilities with 1.5 million barrels per day of throughput capacity. Breakwater's facilities are supported by 46 miles of gathering and distribution pipelines, 70,000 barrels per day of disposal capacity, and 4.7 million barrels of storage capacity with an additional 3.7 million barrels of permitted storage capacity available for development. This footprint expands Select's recycling capabilities to nearly 3 million barrels of total daily capacity across fixed and mobile capabilities, while adding a number of new strategic customer relationships and strengthening existing relationships with new recycling opportunities. Through the Cypress acquisition, we added a portfolio of strategic wastewater disposal facilities in North Dakota and at attractive value. Further consolidating the Bakken region following our recent acquisition of Aqua Libre Midstream and Nevera, we believe there is meaningful opportunity to expand and network these assets with our existing infrastructure footprint. In addition to these strategic benefits, both transactions provide clear and immediate financial benefits as well. On a full year 2022 combined basis, the acquired operations from Breakwater and Cypress are expected to generate approximately $110 to $115 million of revenue and more than $30 million of adjusted EBITDA. The businesses have seen a strong trajectory through the year, and there remains meaningful opportunity for growth and network expansion in 2023. Importantly, both of these acquisitions further complement Select's rapidly growing portfolio of contracted and production-related revenues, adding incremental stability to our revenue base. Breakwater's recycling facilities and infrastructure operations are supported by a number of long-term customer contracts. while more than 60% of Cypress volumes are currently delivered by pipeline with long-term contracts. Supported by our strengthening revenue and earnings profile and recent acquisitions, we are also pleased that our board has initiated a regular quarterly dividend program during the third quarter, with the first dividend payment set to be made this month. Initiating a regular quarterly dividend program reflects our confidence and selects operating performance and strong balance sheet, as well as our commitment to generate multiple avenues of shareholder returns over time. These factors, along with our capital-wide business model and growing portfolio of contracted infrastructure and production-related revenue streams, enable us to return capital to our shareholders while maintaining a disciplined capital structure to support the growth of our business and continued expansion of our water recycling and infrastructure incentives. We strongly believe in the long-term earnings and free cash flow generating capabilities of our business and are excited to share the benefits of this cash generation with our shareholders. While the third quarter saw the U.S. onshore rig count increase by about 7%, completions activity continued to modestly lag during the quarter with low single-digit percent growth. Even with this disparity, we continued to accelerate our revenue wallet share on per completion basis as we saw strong demand from our customers for the integration of our comprehensive water and chemistry solutions. anticipate some modest seasonality during the fourth quarter, customer activity remains steady overall, underpinned by a solid commodity price environment. These two recent acquisitions, and breakwater especially, add additional scale and experience, further advancing Select's ability to offer innovative, integrated water and chemistry solutions. I believe we will continue to build on our recent success with more integrated offerings, along with additional long-term contracts and infrastructure development opportunities in 2023. We anticipate continual operational efficiency gains and growth opportunities from our acquisitions. And we expect to see further improvements to our financial performance, including meaningful free cash flow generation next year. 2023 is shaping up to be a very strong year for Select. With that, I'll hand it over to Nick to discuss the financial performance and outlook in more detail.

Thank you, John, and good morning, everyone. The third quarter exceeded our expectations from both the revenue and margin perspective, and with the acquisition of Breakwater along with the Cypress infrastructure assets, we're poised to continue this momentum. Revenue of $375 million grew by 12% for $39 million, and 59% of this revenue increase fell through to higher gross profits. All three of our segments increased their gross margins from second to third quarter, resulting in our highest quarterly net income in adjusted EBITDA since the third quarter of 2018. Net income increased by 70% to $24.7 million, and adjusted EBITDA by 32% to $62.8 million. Despite volatility in commodity markets and in the daily headlines, our customers are in the strongest financial position they've been in years, and demand for secure and dependable oil and gas production from the United States continues to grow. As we partnered with our customers to produce natural resources in a safe, cost-efficient, and environmentally friendly manner, we've also demonstrated the value of SoPlex's unique ability to connect chemistry with full lifecycle water management and share in the value this partnership creates. Produced water recycling is a prime example of this value creation, and the breakwater acquisition brings a substantial growth opportunity with a large footprint of new fixed recycling infrastructure in the Midland Basin. Along with consolidating certain Texas and New Mexico water logistics services, this infrastructure network furthers our goal to increase contracted and production-levered revenue streams and enhances our established commitments to growing our recycled produced water volumes. While we were already well on pace this year to exceed our 2022 target of 31 million barrels of recycled produced water through our fixed facilities, the breakwater acquisition with its current 600,000 barrel per day recycling capacity provides strong additional momentum in this area and puts us well on our way to meeting our 50 million barrel future annual commitment. With the addition of the Breakwater leadership team and over 300 skilled employees and the combined revenue and adjusted EBITDA run rate John mentioned earlier, we expect the Breakwater acquisition to generate considerable value for our shareholders in the months and years to come. The initiation of a regular quarterly dividend also marks the milestone in our corporate maturity and commitment to shareholder returns. Our phenomenal recovery and growth over the past two years Expansion of contracted and production-levered revenue streams, all executed while maintaining a net cash position, opens up new opportunities to create and return value. We will continue to make targeted investments to advance our infrastructure network while benefiting from the expansion of this more stable cash flow stream. Turning to the individual segments, the water services segment grew its revenues sequentially by 13% to $221 million, while advancing gross margins over three percentage points to 22.8%. This segment benefited from continuing pricing improvements, driving incremental gains of nearly 50% to gross margin before DNA. Our water services segment will be both benefited and impacted by the breakwater acquisition and integration in Q4, which makes forecasting the fourth quarter a little more difficult. We'll of course have a more fulsome forward view on our next earnings call in parallel with 2023 budget development. But for now, we see water services as generally steady in the fourth quarter, balancing out the integration and usual seasonality with continued momentum and recent outsized gains relative to general industry activity. Water infrastructure saw the most significant revenue gains in the third quarter, growing by 23% sequentially to $74 million in the third quarter. The recent investments we've been making around both acquired infrastructure assets and Greenfield recycling facility development are now generating meaningful revenue and profitability for the company, and we expect both of our latest acquisitions to continue this trend. With this revenue growth, gross margin before DNA increased to 27.2% in Q3, and we anticipate margins in the high 20s percentage range with low double-digit revenue growth in Q4, driven primarily by the acquisitions. While the chemical segment had seen tremendous organic revenue expansion over the last few quarters, the third quarter marked a consolidation of that higher revenue at a remarkable margin expansion. Quarterly gross margin before DNA increased sequentially from 14.6% to 18.8% as we reallocated manufacturing production and resources away from certain lower margin commoditized products into our more specialized proprietary chemistry. This segment will not be directly impacted by the acquisitions announced yesterday, but even with typical seasonality, we expect to be able to grow revenues by mid-single digits in the fourth quarter while maintaining margins around the Q3 level. Our SG&A as a percentage of revenue remained below 8% while increasing in dollar terms from $26.7 million to $29.8 million. This figure includes $700,000 of transaction costs in Q3 which we expect will increase in the fourth quarter due to the size and impact of the breakwater acquisition. Looking forward, we expect to maintain SG&A as a percentage of revenue at a consistent level prior to giving consideration to one-off transaction costs. Given that breakwater has historically been run as a lean private company with limited overhead and the Cypress assets do not come with any material corporate costs, we are not prioritizing cost synergies in these transactions particularly given the tight labor market for the specialized skill sets our combined teams wield. While the latest acquisitions will require some additional near-term integration efforts for certain back office functions, generating positive free cash flow through improved working capital management is a core priority. Driven primarily by our continued meaningful revenue growth, networking capital increased by $54 million during the third quarter, resulting in free cash flow of negative $10.7 million in Q3. However, we expect to advance into positive ground over the fourth quarter of 2022 and to generate considerable free cash flow during 2023. Gross capex of $19.8 million for the third quarter translated to net capex of $16.1 million after asset sales. $29 million of net capex year-to-date. We expect to finish the year between $45 to $50 million, reducing the top end of our previous guidance. Looking forward, we believe our low capital intensity business model provides further support for our ability to produce substantial free cash flow in 2023. We finished the quarter with a net cash position of $13.2 million and no bank debt, and have nearly $245 million of total liquidity when considering our sustainability-linked asset-backed lending facility, up from $221 million as of last quarter. The breakwater acquisition includes the repayment or settlement of approximately $13 million of net debt and other obligations in conjunction with closing. Before opening the call for questions, we wanted to welcome our new team members to the Select family. We are eager to harness their talents and capabilities to continue to fulfill our vision to be the recognized leader and trusted partner in sustainable water management solutions. Select's expanded footprint of water recycling and disposal infrastructure in both the Midland Basin and the Bakken, along with our other steadily improving base operations, provides us with a greater opportunity set both with individual customers and in managing multiple customers' needs across highly productive acreage. The growing momentum seen in the third quarter's results, combined with these valuable new partnerships, will bring exciting new ambitions for Select in 2023. Thank you, and with that, we'll open it up to questions.

Operator? Thank you. We will now be conducting the question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. The confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for your questions. Our first questions come from the line of John Daniel with Daniel Energy Partners. Please proceed with your questions.

Hey, guys. Congrats on the two deals. Probably might be a silly question, but when you look at breakwater with the 600, you know, 0.6 million barrels a day of capacity today, and you note the permits for another 1.4 Can you just walk me through the process to develop that capacity, the time required to develop it, and the cost? Just in criminal code, it would be helpful.

Sure, John. So this is Michael Skargi. So the permitting process, Breakwater has been very diligent. And to permit commercial recycling facilities, once you have kind of a track record in the permitting process and you do it the right way, it can be done as short as three or four months. But initially, you know, permits could easily take six months or more to just get them permitted. The construction is really going to depend on the size and the type of treatment being applied. But you're, you know, if I'm bookending it, on the low end, you're going to be, if everything goes smoothly, you have the equipment, you're moving quickly, you could get it done in four or five months. And on the longer end, I would say it's going to be not 12, but probably close to nine months. But one of the big problems is just commercializing it. So you're not going to put forth typically a large amount of capital for a project that's not underwritten and at least partially commercialized with the ability to expand beyond that. And so that's where the additional lead time could come into play. One thing I would note is I think Breakwater did a great job of going ahead and permitting this and setting up recycling facilities and storage. But they really didn't have the capital. And this was true with the other transactions that we've closed in the last 18 months, that the assets were underutilized and they didn't have the growth capital to expand. And so we're really looking forward to working with them, understanding their pipeline, comparing it with our backlog and key customer relationships to see how we can develop out these systems and really fully commercialize it.

Okay. Got it. And then just the transactions here, largely Permian, Bakken. Can you talk about what some of the other – M&A opportunities might be in other basins? Is that how, you know, are you actively looking today or is this keeping you pretty busy with these two deals?

Yeah, John, this is John Schmitz. You know, I would tell you that, you know, we know the market. I mean, we're actively in the market at all times. We try to stay as in tune to the market as we can. You know, as you've seen in the past, We remain open to business in this kind of transactions, and we believe there is still more opportunity across the United States in these unconventionals to do water and chemical solutions in these kind of transactions where we're adding asset base that really fits with our asset base, assets that need capital to really commercialize them or get them in a position that you can put contracts and long-term relationships around them, bring efficiencies and value to the customer. So we're active still, John, and we believe there's more.

Fair enough. Okay. And then the last one, just a housekeeping, Nick, I think you said the net CapEx for 22 is 45 to 50 million. That's correct. Heard that correctly. I mean, just a framework for next year, just, you know, given that your growth through acquisition, what that might look like potentially? Sure.

So, yes, you know, obviously we'll have more detail on our next policy budget, but I think we can go into some of the factors here. So as we acquire more assets, as activity increases, that's going to naturally take your maintenance capex up a little bit. So right now we're seeing $40 to $50 million increase. as a ballpark range for next year. We'll be adding to that some targeted growth opportunities, not only around the previously announced acquisitions, but as we get our hands around the breakwater and Cypress fields and understand the great opportunities there. You will have fewer asset sales than we had in the, you know, year-to-date period so far. But as far as the growth investment, really our third quarter infrastructure performance reflected putting a lot of money or the money to work on our previous acquisitions. And I think the infrastructure group has a healthy trajectory in front of it, not just from those, but on an ongoing targeted capital light basis here. Okay.

That's a good starting point. Thank you very much for letting me ask some questions. Thank you, John.

Thank you. Our next question is coming from the line of Tom Kern with Seaport Research Partners. Please proceed with your questions. Good morning.

Nick, I think this quarter's big working capital bill that consumes $54 million of CFO and then, you know, the related step down in cash on the balance sheet to just $13 million has spurred some consternation falling on the heels of your regular dividend introduction. Obviously, you know, as usual at this point in an OFS upcycle, Select's need to build working capital, you know, is a very high quality, positive challenge. But could you expound on how exactly you expect to reverse working capital's flow in 4Q? You know, with specific levers, are you planning to pull for it to become a source of CFO in 4Q? And then, you know, How do you expect to constrain it as you move through 2023? Sure, Tom.

So these are, you know, high-quality customers. We work for, you know, the biggest majors, large independents and very high-quality, smaller independents, private and private equity-backed customers as well. So as you're well aware, we've had a number of integrations recently. I'm going to try not to get too deep into the weeds here, but we're also upgrading various ERP systems into one consistent ERP across the whole company. Right now we have three. So each of those, you're operating separate groups, billing customers from different historical accounts. And that just provides a little bit of confusion and need to integrate teams and processes and accounts going forward. So, you know, we're disappointed by the working capital build in the third quarter. But we do see great opportunity, you know, not just in the fourth quarter to turn that around, but in 2023 to deliver substantial positive free cash flow. You know, we've been focused on these recent acquisitions to a large extent recently. We will have some, you know, working capital needs as it relates to that revenue that we're bringing on. However, we think for the entire company we have a large opportunity here going forward to unlock that. You saw in our liquidity number that was up $25 million that we are very well capitalized. We are still net cash positive, no bank debt. And so all those things provide us with a lot of opportunity here.

And as your team has had the chance to dig into the receivables that you've inherited via the acquisitions, are there any that – that have seen an increase in the risk profile where you've seen an increase in the possibility of not being able to collect to the extent you thought or potentially having to create a reserve?

No, Tom, no surprises. Our reserve is very conservative or it is appropriate for our ongoing business and our ongoing revenue. There are no surprises in any of these acquisitions. It's just getting everything connected on the same wire and pulling those in.

Got it. And then exiting 2Q of your seven existing recycling facilities, I believe six were still at utilization levels of less than 50%. Could you update us on how those six progressed over 3Q and where their utilization rates stand now?

Sure. So Tom, this is Michael. When we look at the fixed facility recycling facilities we have, all of them, this was the first quarter where we had all of them contributing for a full quarter. So we're certainly trending in the right direction from that standpoint. And as I look at Q4, I think we're going to continue to commercialize particularly the newer facilities and see utilization continue. As I think about kind of your more specific question I'd say about a third of the utilization for Q3 was higher across the board than it was for Q2, but half of our facilities are still really new and emerging and underutilized. So we have the ability to continue to commercialize really all of them, but at least half I would consider underutilized today.

Thanks for that, Michael. And then last one for me. Could you just clarify, did you enter into the negotiations with the Cypress creditors while it was still going through Chapter 11 restructuring? And, you know, did you close? I just don't know if it's actually emerged yet. So could you just share a bit of color on, you know, how you actually pursued and seized on that opportunity?

Yeah, Tom, this is John Schmitz. Yeah, we did have conversations prior to the transaction that did happen, which I believe was an out-of-court restructuring, but we actually did the transaction with the group that bought the whole Cypress. They were wanting the pipe inspection business out of it, and we were wanting the know the disposal assets that we ended up getting so we actually bought it from the prop you know the party that uh participated in in in restructuring the company got it thanks for that additional color john i'll turn it back thank you mr schmitz there are no further questions at this time i would now like to turn the floor back over to you for closing comments You bet. Thanks, everybody, for talking about Select today and look forward to the next quarter. And, again, welcome all the employees of the transaction as their team members. Thank you. Thank you.

This does conclude today's conference call. You may disconnect your lines at this time. Thank you for your participation and have a great day.