ChampionX Corp

NASDAQ:CHX

Earnings Call Transcript 2018-Q3

[Operator]

Good morning, and welcome to Apergy Corporation Third Quarter 2018 Conference Call. Your host for this morning call is David Skipper, Vice President and Treasurer at Apergy.

I will now turn the call over to Mr. Skipper. You may begin.

[David Skipper, executive]

Thank you. Good morning, everyone. With me today are [ Soma ] Somasundaram, President and CEO of Apergy; and Jay Nutt, Senior Vice President and CFO of Apergy. Yesterday, Apergy released its results for the third quarter of 2018. If you've not received a copy, you can find the information on the company's website at www.investors.apergy.com, including the slides referred to in today's call. During today's call, Soma will discuss Apergy's third quarter highlights and strategy. Jay will then discuss our third quarter results in more detail. And we'll be referring to the slides posted on our website. He will then turn the call back to Soma to discuss our growth initiatives and market outlook. And then we will open the call for Q&A.

I want to remind listeners that the news release issued yesterday by Apergy, the company's prepared remarks on this conference call and the related question-and-answer session include forward-looking statements. These forward-looking statements include projections and expectations of the company's performance and represent the company's current views and beliefs. Various factors could cause results to differ materially from those projected in the forward-looking statements. Information concerning risk factors that could affect the company's performance and other unforeseen challenges and uncertainties [ that ] could cause actual results to differ materially from those in the forward-looking statements, can be found in the company's press release as well as in Apergy's registration statement on Form 10 and those set forth from time-to-time in Apergy's filings with the Securities and Exchange Commission, which are currently available at www.apergy.com. Except as required by law, the company expressly disclaims any intention or obligation to revise or update any forward-looking statements. In addition, our discussion today will include non-GAAP financial measures. For reconciliations of our non-GAAP financial measures to our GAAP results, please see yesterday's press release and our Form 8-K furnished to the Securities and Exchange Commission.

I will now turn the call over to Soma to discuss Apergy's third quarter results.

[Soma Somasundaram, executive]

Thank you, David. Good morning, everyone. I'm pleased to report that we posted another solid quarter, and we are delivering strong results as a standalone publicly traded company. We executed well in the quarter and continued to achieve key milestones and made solid progress on our growth initiatives.

From maintaining our technological moat in polycrystalline diamond cutters to driving market share gains in ESP, to developing and delivering technology with impact [ with ] our digital products, Apergy is performing well. Our teams continue to remain focused on supporting our customers and delivering a differentiated performance.

Turning now to our financial results from the third quarter. Revenues increased by $58 million [ or ] 22% year-over-year. Our revenue growth was driven by solid results in both of our operating segments. Consolidated adjusted EBITDA increased by 34% year-over-year, reflecting strong execution and operating performance in both of our segments. As a result, consolidated adjusted EBITDA margin increased to 25% from 23% in the third quarter of 2017. Additionally, we paid down $20 million of debt in the quarter, which demonstrates our commitment to our capital allocation priority.

Both of our segments performed very well in the third quarter. In our Production & Automation Technologies segment, we posted strong growth, both in our artificial lift product line and our digital portfolio. All of our artificial lift product lines posted growth, with ESP posting another strong growth performance. We continue to benefit from our full suite of artificial lift products, which enables us to provide the right technology to our customers to efficiently produce at every stage of the well's life cycle. This capability helps us to produce revenues throughout the life of the wells.

Digital products recorded significant growth at 46% year-over-year, driven by strong market activity and increasing adoption of our new products. Growth in our digital portfolio was broad-based in Q3, led by [ downhole ] monitoring products.

In Drilling Technologies, revenues increased 27% year-over-year, significantly outpacing the year-over-year worldwide rig count increase of 8%. This outperformance was driven by market share gains in polycrystalline diamond cutters and continued adoption of our diamond bearings technology. We continue to advance our shaped cutter technology. The strong results in our diamond cutter business is driven by our teams collaboratively working with our drill bit customers to solve difficult drilling problems and achieve lower cost per foot of drilling.

International activity continues to improve. We are seeing improved activity in Latin America, particularly Argentina and Colombia where we are continuing to gain traction. Rod lift activity continues to improve in Middle East; however, pricing environment continues to be challenging. Improvement in activity in Australia is driven by growth in our progressive cavity pump and rod lift product lines.

Before I turn the call over to Jay to take you through the details of the consolidated and segment financial results, let me take a few minutes to recap our operating philosophy and culture. Our operating philosophy is built on 3 simple tenets. First, we'll always be relentless advocates for our customers. If our customers win, we win too. Second, we develop and deploy technology with impact that drives safety, efficiency and productivity. And third, we are driven to improve with a culture of continuous improvement.

Our strategy and the work we do are highly focused around providing products and technology that drives our customers' success. This customer-centric strategy allows for decision making that is closer to the customer and guides our operating philosophy. We believe focus, speed, quality, service and customer-driven innovation are clearly the differentiators that set Apergy apart. At the heart of Apergy is a highly motivated team of over 3,200 employees around the world, that are focused on a collaborative approach to solving problems for our customers. We have a deeply rooted cultural foundation, and we are driven to help our customers succeed. We clearly view our culture as a competitive advantage.

I want to share with you the recent proof point of our customer-centric culture. Frost & Sullivan, a global consulting and market research firm, recently recognized Apergy with the 2018 Global Customer Value Leadership Award. Each year, Frost & Sullivan, based on their independent research, presents this award to the company that demonstrates excellence in implementing strategies that proactively create value for its customers with a focus on improving the return on investment that customers make in its products and services. We believe this award is recognition of the success of our customer-centric strategy.

Now let me turn the call over to Jay.

[Jay Nutt, executive]

Thanks, Soma. As David mentioned earlier, I'll be referring to the slides posted on our website.

Beginning with Slide 4, Apergy maintained a momentum that was built coming out of the first half of the year and achieved another solid quarter of operational results. Revenue was $316 million for the third quarter, an increase of $58 million or 22% compared to the third quarter of 2017 performance and an increase of $11 million or 3% sequentially.

Year-over-year revenue growth in the U.S. was $53 million or 27%. And non-U.S. revenue growth was $5 million or 8%. Adjusted diluted EPS was up $0.11 or 42% year-over-year to $0.37, as both of our segments continue to perform well in the current operating environment. Cash flow in the quarter was lower than we achieved during the second quarter, as we experienced the billed and customer receivables late in the third quarter. As a result, we had a lower adjusted EBITDA conversion to cash from operating activities less capital expenditures in the third quarter. We view this as a temporary challenge, as we are already experiencing stronger collections during October. And we're working with our customers to reduce outstanding balances and ensure a more consistent and sustainable cash inflow going forward.

Turning to Slide 5. From a macro viewpoint, the longer-term industry fundamentals continue to be favorable for our businesses. Oil and gas prices have demonstrated some choppiness in response to geopolitical headlines and the typical variability caused by changes in supply and demand estimates. But commodity prices have maintained a steady upward improvement throughout 2018. Likewise, worldwide rig count is still expanding, up 8% year-to-date compared to the full year 2017 average worldwide rig count. And finally, global E&P spending is continuing to grow with increased spending in the United States, which is good for Apergy. Accordingly, we believe we are well positioned to take advantage of the favorable long-term market conditions, and we're determined to capitalize upon opportunities with our customers in both of our reporting segments.

Moving to Slide 6 and looking at consolidated third quarter performance. Net income in the quarter was $25 million, and diluted earnings per share were $0.33. After adjusting for the impact of spinoff-related items and restructuring and other related expenses in the quarter, adjusted net income was $29 million or $0.37 per diluted share in the quarter. We generated adjusted EBITDA of $78 million during the third quarter compared to $58 million in the third quarter of 2017. Sequentially, adjusted EBITDA improved $2 million on the $11 million revenue increase. As a reminder, second quarter adjusted EBITDA benefited by approximately $2 million, driven by lower expenses associated with Dover's continued ownership of Apergy through May 8. During the third quarter, our businesses continued to capitalize upon favorable market conditions and drove the improved profitability.

In the third quarter, net interest expense was $11 million, which was up sequentially from the second quarter. Once again, the previous quarter benefited from only a partial quarter of interest expense due to the timing of the spinoff. Our effective tax rate in the third quarter was 23%. Cash flow from operating activities in the third quarter was $34 million, and as noted earlier, was negatively affected by the late quarter billed and accounts receivable. As a result of the lower cash flow from operating activities, our adjusted EBITDA conversion to cash from operating activities less capital expenditures was 25% in the quarter. This is below our typical levels and viewed as temporary.

Capital expenditures in the third quarter of 2018 were just under $15 million compared to $17 million in the second quarter of 2018. Spending was in line with expectations as we execute on our internal investment plan for the year, including ongoing investments in organic growth and spending on our leased asset portfolio in support of further profitable ESP market penetration.

Jumping ahead to Slide 7. Production & Automation Technologies revenue came in strong at $241 million in the third quarter, an increase of $42 million or 21% from $200 million in the third quarter of 2017 and flat with second quarter 2018 performance. The year-over-year improvement was due to continued growth from our artificial lift offering, and in particular, further penetration of the U.S. onshore ESP market. Additionally, we experienced robust revenue growth from our digital products portfolio and capitalized upon improving international market conditions, which are supported by the higher current oil prices and activity levels compared to prior year. Adjusted segment EBITDA rose 41% to $52 million in the third quarter from $37 million in the year-ago period, driven by substantial revenue growth. Adjusted segment EBITDA declined slightly from $54 million in the second quarter of this year. The sequential decline in adjusted segment EBITDA was primarily due to the expected increases in material input cost and the anticipated higher corporate cost combined with increased investments in support of our growth initiatives around our ESP and digital technologies offerings along with some nonrecurring operational expenses.

Adjusted segment EBITDA margin was 21% in the current quarter compared to 18% in the third quarter of 2017 and 23% in the second quarter of 2018. Our year-over-year margin improvement reflects continued cost discipline and solid operational leverage on the increased volume. Our Production & Automation Technologies business has continued to have a healthy book-to-bill ratio at 1.0x compared to 1.05x in the third quarter of last year and 1.04x during the second quarter of this year. Book-to-bill will fluctuate from quarter-to-quarter, and we consider the current performance consistent with usual patterns.

Moving to Slide 8. Drilling Technologies posted robust revenue growth of $75 million in the third quarter, representing an increase of $16 million or 27% from $59 million in the third quarter of last year. The revenue growth was a result of higher year-over-year worldwide rig count levels compared to the prior year, which was primarily led by growth in the U.S. rig count combined with increased market share in the premium diamond cutter market and very strong growth in diamond bearings for drilling tools. Compared to the second quarter of 2018, Drilling Technologies revenue increased 15% from $65 million. The sequential revenue increase was again due to increased rig count, driven largely by the seasonal recovery in Canada. The benefited diamond bearings adoption also contributed nicely on a sequential basis.

Adjusted segment EBITDA increased 24% to $29 million in the current quarter from $23 million in the third quarter of 2017, primarily driven by the higher volumes. Sequentially, adjusted segment EBITDA increased 20% from $24 million in the second quarter, again driven by higher volume with good earnings conversion and inclusive of the impact of higher allocated corporate cost. Adjusted segment EBITDA margin was 38% in the third quarter of 2018 compared to 40% in the third quarter of 2017 and 37% in the second quarter of 2018. The slightly lower year-over-year adjusted segment EBITDA margin was primarily due to increased expenses required to scale up and support the growth of our diamond bearings offerings. In the quarter, our Drilling Technologies business continued to have a good book-to-bill ratio at 1.01x, which is consistent with our expectations. The quarter-end ratio compares to 0.95x in the third quarter of 2017 and 1.08x in the second quarter of this year due to stronger bearings order.

Moving to Slide 9. On the balance sheet, third quarter ending debt, net of debt discounts and deferred financing cost was $688 million. Cash at the end of the quarter was $18 million. During the quarter, we made a [ repayment ] to Dover Corporation of approximately $12 million related to tax liabilities associated with the spinoff transaction. We'll have one additional payment to Dover associated with tax liabilities occurring a bit later in the fourth quarter. In addition, as noted in our earnings release and Soma's prepared remarks, we repaid $20 million of debt on our term loan, consistent with our commitment to our capital allocation priorities, which include funding organic CapEx needs as well as reducing our leverage through earnings growth and debt reduction. At September 30, Apergy's total leverage ratio was 2.6x and our available liquidity was $263 million. In the third quarter, adjusted working capital, which is composed of accounts receivable plus inventory less accounts payable, increased $32 million. As I noted earlier, the increase was primarily related to the slow payment by a few large customers. And we are actively working with these customers to ensure timely payment. We do not expect any credit issues with these customers.

Turning to Slide 10. I'll take a moment to discuss our financial outlook for the remainder of the year. Based upon our strong year-to-date performance through September combined with a positive start to the fourth quarter through October, we're increasing our full year 2018 revenue growth guidance to approximately 20% year-over-year. We're also increasing our full year 2018 adjusted EBITDA projection to be in a range of $289 million to $294 million, up from our previous estimate of $280 million. Our adjusted EBITDA outlook reflects our current view of the market and takes into account the potential impact of further material input cost inflation, including tariffs, the risk of E&P capital, budget exhaustion and fewer working days in the fourth quarter. We've now substantially built our corporate infrastructure, and we're on track to exit the transition services agreement during the fourth quarter. Our activity and the associated costs around these initiatives are embedded in our earnings outlook.

With regard to other factors pertaining to our outlook, our tax rate is expected to be lower in the fourth quarter due to a onetime tax benefit that was recently achieved. Our full year tax rate should be between 23% and 24%. We anticipate interest expense of just over $10 million per quarter. Our full year 2018 capital spending forecast continues to be approximately 3% of revenue for infrastructure-related growth and maintenance plus an additional $25 million to $30 million for capital investment directed at expanding our portfolio of ESP leased assets.

I'm now going to turn the call back over to Soma for some closing comments before we open the lines for Q&A.

[Soma Somasundaram, executive]

Thank you, Jay. We delivered another solid quarter, and our portfolio and technology are well positioned to take advantage of the positive trends in the market. Our strong portfolio combined with our rigor and execution and cost discipline will help us deliver a differentiated performance in the industry.

Before we open the call to questions, I would like to update you on our progress on the key growth initiatives for 2018 and beyond. Our first growth initiative is on our ESP product line where we are driving significant growth and share gains by continued penetration of the U.S. onshore ESP market. We again achieved a solid growth in the third quarter, and our ESP product line continues to be our fastest growing artificial lift technology. Our strong product offering, industry-leading service and established relationship with customers is continuing to help us achieve deeper penetration in the market. We believe we continue to have a sustainable momentum in this business.

Our second growth initiative is focused on existing well conversions to rod lift as production declines. While it is hard to predict the precise timing, we are involved in increasing [ conversations ] and orders for rod lift conversion solutions. We are delivering these conversions to rod lift both from ESP and gas lift wells. Our rod lift revenues have grown sequentially every quarter since the beginning of this year. We continue to believe that conversions to rod lift will accelerate in 2019 and beyond. Rod lift remains the artificial lift technology of choice for low flow wells. We are a market leader in rod lift, and we believe we are well positioned to capture the growth that will come as a result of the conversions.

Our third growth initiative involves driving significant growth of our digital product revenues. We are increasing adoption of our digital products and services through our fit-for-purpose solutions designed to improve customer productivity and operational economics. We are continuing to invest in developing cost-effective smart edge hardware and software with improved analytics and optimization capability. Customers are increasingly interested in fit-for-purpose digital solutions that gives them higher granularity of downhole conditions, asset performance, failure prediction and analysis and optimization opportunities. Our investments and efforts are aligned around these areas. We are well positioned to benefit from continued digital adoption, given our deep domain expertise and strong presence in the production well site. Adoption of our technology combined with strong market activity resulted in 46% increase in year-over-year revenues in the third quarter. We expect to deliver continued strong growth in our digital product lines.

Our fourth growth initiative is the continued innovation and advancement of our technology in our polycrystalline diamond cutters to improve drilling productivity. To that end, our Drilling Technologies segment has had 42 new patents issued in 2018 so far, bringing the total issued patents since the beginning of 2008 to 715. We are continuing to advance our shaped cutter technology. We believe that is a strong trend towards shaping and customization of cutters to meet specific drilling requirements. And we are at the forefront of this trend, working closely with our drill bit customers. Customer adoption continued to remain strong for our new technology, and this resulted in 51% of our revenues in the segment in the third quarter coming from new products.

Our final growth initiative is focused on driving continued adoption of our diamond bearings in downhole applications, including rotary steerables, mud motors and power generators. Compared to traditional bearings, diamond bearings provide higher load capability, significantly longer life and lower repair cost. On a year-over-year basis, revenue from our diamond bearings was up over 63% in the third quarter. In the third quarter, revenues from diamond bearings business represented about 12% of our Drilling Technologies revenue. We are investing to expand our capacity to meet the strong demand. We expect the strong revenue growth in diamond bearings to continue, as there is more adoption runway in downhole applications and other applications where this technology can be applied.

We expect to finish 2018 on a strong note. We remain focused on our customers, strong execution, productivity improvements and cost discipline. While the industry is seeing some slowdown in completions, our portfolio is not directly exposed to completions. We continue to keep our attention on what we can control and on delivering a solid performance relative to the industry. Finally, I want to thank all of our employees for their continued efforts and passion in improving the lives of our customers, our employees, our shareholders and our communities. I'm proud of their accomplishments, and it is a privilege for me to lead such a great team.

With that, I would like to open the call for questions.

[Operator]

[Operator Instructions] We have a question from Dave Anderson from Barclays.

[John Anderson, analyst]

I was wondering if you could talk a little bit about the competitive dynamics you're facing right now in artificial lift. Artificial just come up in a number of prior calls. So I'm just wondering if you could talk about kind of maybe what you're seeing out there in the Permian, kind of how that differs from the other basins. And also kind of in particular, what's the differentiation that you are offering versus your competitors? You talked about gaining share. I'm just wondering if you could dig into that a little bit more in terms of those dynamics.

[Soma Somasundaram, executive]

Yes. So great question. So I want to kind of give a little bit color on artificial lift, like you pointed out. So if you look at -- if you segment the market as U.S. or North America versus international, the dynamics are [ somewhat ] different. So in U.S. market, we're continuing to see activity improving. In fact, we recorded in U.S. a sequential gain in artificial lift up about 2% from Q2 to Q3. And then year-over-year, our artificial lift growth was over 23% as a total. International tends to be a little more lumpy for us, because it tends to be more tender-driven, so it tends to be more lumpy for us. So if you look at what's happening with the basin, I also want to remind that if you recall, during our Q2 call and subsequent in our public conferences, we had mentioned our deliberate attempt to make sure that we are being prudent about capital deployment into our leased assets. If you recall, we said we have more demand than we can carry, so we actually did reduce our capital deployment in leased assets, given some of the industry uncertainty around completions and all that. [ So we could have grown more sequentially in artificial lift, but it was purposeful ] . In terms of competitive dynamics, the key to artificial lift, as we talked about, the 2 large technologies, which remains ESP and rod lift. In ESP, particularly in the onshore ESP, it still continues to be -- the winning companies tend to have very strong service, a good portfolio of product offering and an ability to apply and size the right pump along with superior controls technology for the ESP. So service and application know-how continues to be the key. And the way we share gain -- gained share in the marketplace is primarily through that and ESP. Now when it comes to rod lift, rod lift tends to be more of around -- because as customers go to rod lift, they tend to stay on rod lift for a long period of time. It could be 10 years, 20 years, in some cases, even 30 years. So they tend to choose technologies and brands that have a proven track record of success. So having the best brands in the industry with Harbison-Fischer and Norris rods really helps us in that regard. So -- look, the competition in the -- is continuing to be strong in the marketplace, but we focus on what we can control. And being a pure-play full suite artificial lift player, it really helps us to be fast, at the same time provide the right service and right response.

[John Anderson, analyst]

So Soma, on your guide for this year, you raised your full year guidance, but you've got a lot of pushback throughout the year. As these [ Permian ] issues have sort of come in, a lot of people have been pushing back and say, hey, ESP probably has to get pushed down. Even in system, you haven't seen any changes from your customer behavior. Can you talk about that? Now are you still kind of seeing the same thing that you still feel confident that kind of -- that the demand is still there for these products and that your customers, are they looking past these takeaway issues?

[Soma Somasundaram, executive]

Yes, when you look at the -- with respect to particularly ESP, I think the 2 questions that have come up is about possibly completion slowdown and possibly gas lift. So let's do both. As we just mentioned -- Jay mentioned in the prepared remarks, October has started off well for us. So again, we have not seen any demand decline in October. So Q4 has started off well for us. In terms of -- with respect to the gas lift, as I mentioned in previous calls, they both are relevant technologies, but it is -- but Permian is a large region, and each of them tend to be very distinct in their own way, whether they apply ESP or gas lift. So both will be relevant technologies. So if you look at -- for example, if it's a high water content well, they tend to use more ESP. But if there is a high gas content, then they tend to go a little bit more with gas lift. And there's also other things that drives the requirement of gas lift if they have a gas infrastructure, compression capabilities available, and so on and so forth. So being a full suite provider, we have the ability to offer what is the right solution for the customer base. And we really haven't seen the ESP demand for a slowdown and very solid growth in Q3. And Q4 started off well, and we actually have authorized some additional capital to be deployed in the leased asset, which will continue to help us. As you know, we've pulled back a little bit in -- so now we have authorized some additional capital, which will help us as we go into -- continue into Q4 and into 2019 as well.

[John Anderson, analyst]

Last question from me. It seems like it's a buyer's market out there for M&A right now. I'm sure you're getting pitched on a host of things. Can you just kind of help us understand what makes sense for Apergy? What are the things as you sort of comment on what are the trends from here? What makes most sense for you? What are the types of assets that make sense? Can you just kind of walk us through your thoughts or what you can say?

[Soma Somasundaram, executive]

Yes. So I think -- look, as we communicated as a capital allocation priority, we want to fund the organic growth initiatives. We want to make sure we are continuing our innovation investments. We want to make sure that we are looking at as an M&A opportunity in the near term more tuck-in type acquisitions, which either improves our technology position or geographic position or cost position. And we are more also very focused on making sure that we get our leverage down, which you saw, we paid $20 million towards that. So you will see us continuing to follow this process. There are large opportunities that keep coming up, but we are very focused on sticking to our discipline of capital allocation, and we want to get our leverage down. As we've communicated, we're comfortable somewhere between 1 and 2, as we had said before. Now as we've -- as we finish our leverage down, you asked a question, Dave, what kind of assets that would be of interest to us. As we think about those, the things which will be of interest to us is the ones which are consistent with the quality of our portfolio. And what I mean by that is if products or service that performs well through the cycle, because if you look at our portfolio, one of the key characteristics of our portfolio is it performs well through the cycle. So we want to make sure any product or service line we add to our portfolio is consistent and does not dilute the quality of our portfolio. So that is #1. And #2, the type of company we would want to consider would be companies that they have a consistent cultural behavior like us, which is a very customer-centric type of culture. So that kind of gives you a little bit of flavor of the type of companies looking -- we will look for once we get our leverage down.

[Operator]

The next question comes from Byron Pope from Tudor, Pickering.

[Byron Pope, analyst]

Just have a question. As I think about the implied EBITDA guidance for Q4. And -- could you just -- based on what you've said so far in the call, it sounds as though the guidance range is really a function of laying out some risks that could happen as opposed to what you've seen to start the fourth quarter. But as I think about Drilling Technologies versus Production & Automation Technologies, can you frame for us what's essentially implied in your overall guidance with regard to what the top line might [ do ] directionally in those 2 segments?

[Soma Somasundaram, executive]

Yes. So Byron, so talking about Drilling Technologies, so we expect the drilling activity to be continued to be stable in Q4. And -- so which means for Drilling Technologies, we believe the activity continues to be stable as we walk into Q4. And we have seen that in October. The only time we have seen -- the only thing we -- that could be -- if there is any impact on Drilling Technologies could be sometimes the [ bid plans ] of our customers may sometimes shut down for holidays, depending on what their planning process is, which means their ability to receive shipments can get affected either in the last week of the quarter. And we are right now in conversations with customers to better understand who is planning what type of shutdowns. But that's more of a function of if we don't ship it in end of Q4, it could -- it will be beginning of Q1. But it's not -- we don't necessarily see a market-related risk to that. Now when it comes to Production & Automation, typically what we have -- in our Q4 guidance here, what we have kind of assumed, if you look at the range we have assumed, what's assumed in the range is as you think about the lower end of the range, that could be because -- that can happen, because there is budget exhaustion that is starting to slow down some spending and particularly more as we approach Thanksgiving and beyond. Because the way we've thought about it is we've seen October start off well. So -- and we have some clarity into November based on our bookings. But truly -- so the risk tends to be more around the Thanksgiving and beyond, and how the budget slowdown can happen. And we just don't have a good visibility of it, hence the range. The second aspect of it is, sometimes you see in Permian in particular or West Texas, you see weather-related issue pop up. We have seen that before. So there could be some weather-related issues that can pop up. And particularly, that will impact our rod lift particularly, because most of our rod lift in West Texas is driven by existing wells. So other than that, as I mentioned, October started off well. So that's why we thought it's prudent for us to provide a range. So Jay, do you have any other?

[David Skipper, executive]

You've already commented on the other items that we're watching, Byron, are continued increases in material input costs, including tariff, as we started to see the initial implications of that in Q3. And of course, we're offsetting that to the best of our ability with price increases and supplier concessions as well as our own productivity initiatives. So the ramp up in higher material input cost is something else that we're just -- we prudently take and accounted for in our guidance.

[Byron Pope, analyst]

Okay, that's really helpful. And then I just have one quick additional question. And I realize these won't be big dollars involved. But just given the demand drivers for your diamond bearings, [ here's the rotary steerable systems and mud motors ], it certainly feels -- it sounds -- feels as though you're going to continue to see strong demand for those [ started ] service lines from your customers that are providing those downhole services. And so with regard to what's involved to increase the capacity on the diamond bearings side, again, I realize it's probably not big dollars, but what do you have to do there to increase that capacity to meet the demand growth?

[Soma Somasundaram, executive]

Yes, it's typically investment in manufacturing cells. So this will be CNC machines and that type of capacity. So Jay, do you want to give a color on what a manufacturing cell would cost?

[Jay Nutt, executive]

Sure. So order of magnitude, it's probably about a $1.5 million or more for the machines, Byron. We added some capacity that came online early in the third quarter, with additional investments that just got installed early in October and will start to contribute. So that will help us to bring some work in-house that's currently been outsourced. But the investments are not large with regards to the additional capacity that we've put in place.

[Operator]

The next question comes from Scott Gruber from Citigroup.

[Scott Gruber, analyst]

Jay, just another question on the 4Q outlook. And I may have missed it, so I apologize if I did. But would the overhead expense rise further in 4Q as you continue to build out the back office and if so by how much?

[Jay Nutt, executive]

Scott, so we're substantially done with the ramp up. There's just a couple of few positions that are being put in place, and we are really within the matter of a few days of being done with the transition service agreement. So we made great progress in building up the -- building out the corporate infrastructure in Q3. So you should not expect any material increase in terms of corporate cost from a run rate basis.

[Scott Gruber, analyst]

Got you. So $64 million, $65 million on a run-rate basis excluding the charges that fall off, is that how we should think about it?

[Jay Nutt, executive]

So I think you're thinking about just the total SG&A there. And I think that -- that's a reasonably good number. We did make some investment within the operations in support of the ESP growth in SG&A as well as digital offerings. So some of the increase in the quarter is from the ramp up of the corporate cost plus increases within the operating units themselves in support of the growth initiatives.

[Scott Gruber, analyst]

Got it. And then just a follow up to Dave's line of question earlier. Soma, just directionally, do you think production revenues -- are they trending higher in the first half of next year? Do they look more flattish? Does it dip some? Overall, the big question we get is will there be an echo that hits lift sales in the first half of next year, given the current completion slowdown in the U.S.?

[Soma Somasundaram, executive]

Great question, Scott, and it's definitely -- it's on our mind. So we are busy with our planning process for 2019. So I'm not going to be able to give specifics on that right now. But there are a couple things I would say. We definitely expect 2019 to be a growth year for us. So the question of progression through the year is what we are thinking through and doing more work on. I would also say that the relationship -- I mean, there is a lag between completions and artificial lift. But the relationship between completions and artificial lift is not quite 1:1. As existing wells also require ongoing maintenance and replacement and conversion to another form of lift, right? So it's not quite 1:1., but it does have an impact. When there is a completion slowdown, there will be some part of impact. The other part, which we are also thinking through is, as we enter into 2019, there is also reloading of customer budgets, right? So that can also -- customers may accelerate some spending since they have new budgets assigned. So those are the variables we are thinking through. So it's a -- just a question of how the progression is going to be. And we'll be -- we're not in a position to talk about it now. We'll talk about it more as we enter into the next year.

[Scott Gruber, analyst]

And it seems like the outlook for the international side of production is improving. Can you just remind us what percent of production are sales outside the U.S. and Canada?

[Soma Somasundaram, executive]

So on Production & Automation Technologies, if you look at Q3, it's roughly about 22%.

[Operator]

The next question comes from Blake Gendron from Wolfe Research.

[Blake Gendron, analyst]

The first one just digging into capital allocation, it seems like organic growth and build out is going to be an ongoing initiative here. But as we think about the deleveraging side of the story, do you have specific targets in mind? Or can you refresh us on those targets, the timing? And then as we think about the handoff between deleveraging and potentially shareholder returns, how do you think about those in relation to a dividend versus possible buybacks?

[Soma Somasundaram, executive]

Yes, I think what we have communicated on this is we are comfortable to get it down somewhere between 1 and 2. So if we kind of think about at that, say, 1.5, [ as ] a possible point. I think -- we think we may be able to get there by end of 2019 with -- by a combination of our continued EBITDA growth, the earnings growth as well as periodically paying down some of the debt. Now we are focused on a very balanced capital allocation beyond that, so which means you should expect us to think about a balance between returning cash for the shareholders as well as continuing to invest in our growth. And we are planning to communicate our full value creation framework and algorithm in our Investor Day, which we are planning to host sometime in March, you should receive information about that, where we are planning to communicate our full value creation framework along those lines as well. Jay, anything to add?

[Jay Nutt, executive]

No, Soma, you've kind of hit it. So again, we want to continue to chip away at the debt, but not at the expense of investing in the growth of the organization such as the bearings growth and the ESP growth as well as the other growth initiatives. As Soma talked about, that gives us technology or a cost advantage. And then excess cash flow in the meantime will be used to repay debt.

[Blake Gendron, analyst]

Okay, great, appreciate the color. And then moving to Drilling Technologies. You guys have advantage share in virtually every geo market that you participate in on the Drilling Technologies side. But if we think about potentially the rig count getting more stable in the U.S., perhaps growing internationally on land, are there regions internationally that you think you can outgrow the broader rig count? And is that going to be just share gains on the part of PDCs? Or is that going to rely more so on the organic build out of technologies within the portfolio?

[Soma Somasundaram, executive]

Yes, I think on the international side, there is still some room for adoption of PDC compared to the regular type cutters. So I think that opportunity is still there. Beyond that, it will be one of continued innovation in technology. As we have talked before, this is a product line where customers always adopt new technology if it is reducing the cost per foot of drilling either by increased rate of penetration or longer lasting of cutters. So I think -- but internationally, there is still some run rate for increased PDC adoption.

[Blake Gendron, analyst]

Okay, great. And then finally from me, the vintage of wells that were completed from 2013 to 2014, where are those in the life cycle on artificial lift side? And what are the opportunities -- I imagine it's mostly rod lift. But just if you don't mind refreshing us on where those wells stand from a lift standpoint?

[Soma Somasundaram, executive]

Yes, so as we said in our prepared remarks about some of the conversions we are starting to see are from that 2013, 2014 wells is what we are starting to see. And as a reminder, each customers, when they switch to another form of lift, is different within a band of production flow rate. So it's hard to predict exactly at what flow rate every customer -- and we have a -- we are doing a lot of granular work on understanding customer-by-customer at what threshold do they prefer to switch over. But the vintage of wells we are seeing currently are mostly the 2013, 2014 wells.

[Operator]

The next question comes from Marc Bianchi from Cowen.

[Marc Bianchi, analyst]

In the press release and in the commentary, you mentioned about conversion to rod lift and you had some orders to convert from ESP and gas to rod lift. Can you talk a little bit more about this? What's the magnitude of the opportunity here that you've seen in these orders? When would that start to show up in the business? And how is this changed from prior quarters from what you're seeing?

[Soma Somasundaram, executive]

Yes, Marc. I think as we talked about in the last quarter call, this is -- the way we think about this conversion is not as if it's one big group of wells suddenly all convert at the same time to the -- because each customer is different. So what we're seeing, as we mentioned in the call is, we're seeing sequentially rod lift getting better and better in revenues. We're seeing that top line growth continuing to grow. And if you look at year-over-year growth, it's continuing to accelerate since the beginning of the year. Every quarter, we have seen increased year-over-year growth on rod lift, and we attribute that to the continued conversion of the -- about -- they don't come like, here is 100 wells, all complete at the same time. The customers do it at their own pace. And so the way I would describe it is you should expect our rod lift product line to continue to provide increased growth.

[Marc Bianchi, analyst]

Okay. Is there -- can you share with us what the mix of rod lift was in the third quarter?

[Soma Somasundaram, executive]

The mix of rod lift in the third quarter, yes, I can -- give us a -- Jay, you have that number? Give us 10 seconds.

[Jay Nutt, executive]

It's about 36%. 35%, 36%.

[Soma Somasundaram, executive]

36%, yes.

[Marc Bianchi, analyst]

Of Production & Automation?

[Jay Nutt, executive]

It's of artificial lift, Marc.

[Marc Bianchi, analyst]

Of artificial lift, okay. And the tariff headwind that you have, can you just remind us where you're exposed there? I believe it's mostly on the ESP side. As I understand, there's some increase in tariffs in the beginning of next year. How is that -- how have you prepared for that? And what's the potential impact?

[Soma Somasundaram, executive]

So let me make some comments here and then see if Jay has additional color. So just to remind on the tariff impact, again, there are 2 types of impact. One is the Section 301, which is very specific to China. And then there is the Section 232, which is related to steel. And there is also a secondary impact of that. Because of U.S. steel mills getting a lot of demand placed because of Section 232, there's an impact of price increase because of that. So for us, the Section 301 -- and again, on the Section 301, everybody is very familiar with the lift 1, lift 2, lift 3, as each time each lift gets effective depending on where your product is lifted. So for us, Section 301, the primary impact for us on that is the ESP. As we mentioned, our ESP supply chain extends to China. On the Section 232 related, for us, it is more of not a direct 232 impact, but it is that inflation because of U.S. steel mills are running pretty full and there is inflation associated with it. And that primarily affects our rod lift product line, the [ sucker ] rod product line. So I would say, Marc, those are the 2 primary impact related to our material cost inflation. So how we are offsetting that? First we have put through price increases. And on the price increases, it's getting more traction every quarter. So we implemented it in the middle of Q3. So as we walk into Q4, there is more benefit we are getting from the price increases. And we are -- I also want to point out that we are being strategic about it. So in certain cases where we see and our ability to gain some share or strategically win an account, we may use that lever as well. But price increases, we have put in place both in our rod lift as well as our ESP product line. And we are starting to see that traction, particularly towards the end of Q3 and also we have started seeing in October. The other [ aspect ] we are doing is our negotiations with suppliers. So supplier -- there is this concessions from supplier, specifically because of the tariff-related items. So those 2 are very specific initiatives to offset the impact of tariff. Now on top of this, we have our ongoing productivity improvements, which we have talked to you about before. We target on a gross level roughly 4% of our cost of goods sold as a productivity improvement effort. And this productivity improvement efforts are not specific only to the tariff issue, but it is also to offset inflation in direct labor and other material type inflation as well. So that's how we're positioned. Now today, I can tell you that direct impact of the tariff and material cost inflation and just the price increase and the supplier concession alone is not offsetting yet the impact of the tariff impact. Now what is helping is our productivity improvements. So as our pricing continues to gain traction, we should get better and better help with that. So hopefully, that gives you some color.

[Operator]

We have Saurabh Pant from Jefferies.

[Saurabh Pant, analyst]

So I guess, I would like to focus a little on the artificial lift side of things first. So just to understand, first thing, third quarter numbers [ in place on the revenue side, right, because revenues were flat ] ? And based on the commentary, I think you said artificial lift was up 2%. And I think based on the press release, digital was up like 4%. So it sounds like other production equipment within that, so Windrock, and Wellmark, and Timberline and some of the other product lines were down sequentially, right? So I just wanted to understand what was going on in that small part of the segment?

[Soma Somasundaram, executive]

Yes. So specific to artificial lift, I think what we mentioned sequentially, I think since the commentary -- question is very specific to sequential. There are 3 elements. So the first one is our U.S. portion of the artificial lift grew sequentially 2%. Okay? So that is the first comment. So the U.S. grew 2%. Now we could have grown more, as I mentioned earlier. You remember that we earlier communicated that we are tapping the brakes on our capital deployment on leased assets, right? So we could actually grow more in sequentially, but it was purposefully we tapped the brakes just to be prudent about, given the uncertainty in Permian takeaway and completion. As I mentioned just now, we have actually authorized more additional capital in October [ into ] deploy into our leased asset, because we feel comfortable now. So that should give us more benefit in -- towards end of Q4 and beyond into 2019 -- getting ready for 2019. The third element in artificial lift is our international business tend to be lumpy. And the reason is because they are more tender-focused business for us. And so what happens is you may have a higher shipment in -- a big shipment in Q2 that may not repeat in Q3. So that tend to provide that. So I just want to say we are seeing the momentum in the artificial lift. In our U.S., we are continuing to see the momentum. We grew 2% sequentially. We could have grown more. So there's no slowdown we are currently seeing in the momentum of our artificial lift business, particularly in the U.S.

[Saurabh Pant, analyst]

Okay. That makes a lot of sense. So I'm just trying to think, right, I mean taking that forward, right, as -- it sounds like at some point in the third quarter, you went to your ESP customers, I'm guessing, primarily in the Permian, right, because that's where the leasing model is predominant, right? You went to your customers, and I guess you would've told them that, look, we want to transition more to the upfront, sale model versus the leading model, right? And it sounds like, customers don't want that, right? And maybe that's what you saw and that was structuring...

[Soma Somasundaram, executive]

That's not actually true. That's not actually true. I mean, we are seeing increased purchase as well. So there both models are being very, very relevant right now. I'm talking about Permian. Both models are being very relevant. Yes.

[Saurabh Pant, analyst]

Okay, okay. So there's nothing on those lines, right? Okay.

[Soma Somasundaram, executive]

No.

[Saurabh Pant, analyst]

Okay. And then quickly going back to rod lift, I think you said 36% of artificial lift was rod lift in the third quarter. And if I remember the Analyst Day presentation correctly, I think that number was 48%, and I think that was a 2017 number. So definitely, ESP has grown a lot. But if you can give us some placeholder on a year-over-year basis, what has rod lift done, right? So 3Q '18 versus 3Q '17, how much is rod lift up, because you did say that it's up?

[Soma Somasundaram, executive]

Yes, it's up high single digits year-over-year roughly. And it has grown every quarter for us.

[Saurabh Pant, analyst]

Yes, you said that. Right, right. You said that. Okay. And then final one from me is on the digital side. So I did make note of that comment in your press release that you just commercially released your next-generation rod lift controller. So as I think about that, right, because you specifically said rod lift, I would think that the customers are more price sensitive in that market just because rod lift are much lower volume, right, so there's just enough incremental product in to offset that cost of using that new controller, right? So from a pricing standpoint, where does this new product stand versus whatever the prior product was? Is it cheaper than the prior product? Or is this is just a better product?

[Soma Somasundaram, executive]

No, it's definitely cost-effective than the prior product.

[Saurabh Pant, analyst]

Okay. Okay. So we should think that it's not just better, but also cost effective, right? [ So it wouldn't make a meaningful dent, I guess, right? ] That makes it more attractive to the customer?

[Soma Somasundaram, executive]

That's exactly right. Yes.

[Operator]

We have no further questions at this time. I would like to turn the call over to Mr. Skipper for final remarks.

[Soma Somasundaram, executive]

Again, thanks, everyone. Again, I want to extend again our thanks to our employees for a terrific job in executing on a solid quarter for -- in third quarter. And we look forward to talking to you again in the next quarter. Thank you.

[Operator]

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