Drilling Tools International Corp

NASDAQ:DTI

Earnings Call Transcript 2024-Q2

[Operator]

Greetings, and welcome to the Drilling Tools International Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation.

[Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ken Dennard. Sir, the floor is yours.

[Kenneth Dennard]

Thank you, operator. And good morning, everyone. We appreciate you joining us for Drilling Tools International, or more commonly referred to in industry as DTI. We welcome you to DTI's conference call and webcast.

With me today are Wayne Prejean, Chief Executive Officer; David Johnson, Chief Financial Officer; and Jameson Parker, VP of Corporate Development. Following my remarks, management will provide a high level commentary of the benefits of the SDPI acquisition, a review of the 2024 second quarter results and updated outlook, before we turn the call to you for your questions.

There will be a replay of today's call. It will be available by webcast on the company's website at drillingtools.com, and there'll be a telephonic recorded replay feature available until August 13. Please note that any information reported on this call speaks only as of today August 6, 2024. And therefore, you're advised the time sensitive information may no longer be accurate of the time of any replay listening or transcript reading.

Also, comments on this call will contain forward-looking statements within the meaning of the United States federal securities laws. These forward-looking statements reflect the current views of DTI's management. However, various risks and uncertainties and contingencies could cause actual results, performance or achievements to differ materially from those expressed in the statements made by management. The listener or reader is encouraged to read DTI's annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K to understand certain of those risks, uncertainties and contingencies.

The comments today may also include certain non-GAAP financial measures, including but not limited to adjusted EBITDA and adjusted free cash flow. These non-GAAP results for informational purposes, and they should not be considered in isolation from the most directly comparable GAAP measures. A discussion of why we believe the non-GAAP measures are useful to investors, certain limitations of the using these measures and reconciliations to the most directly comparable GAAP measures can be found in the earnings release, which is on our filings page or with the SEC.

And now with that behind me, I'd like to turn the call over to Wayne Prejean, DTI's Chief Executive Officer. Wayne?

[Wayne Prejean]

Thanks, Ken, and good morning, everyone. I will begin my remarks with a quick review of our Superior Drilling Products acquisition and synergies, observations on second quarter results, and discuss how we are dealing with the market softness in North America. After that, I will hand off the call to David to go through the financials and our revised 2024 outlook. Also on hand today is our VP of Corporate Development, Jameson Parker, available during Q&A for comments on our recent acquisitions.

Starting with SDP, we believe this acquisition, along with Deep Casing Tools completed in March, has created a step change for DTI to offer current and prospective customers, proprietary products into expanding markets, both domestic and international. These two transactions are outstanding examples of how we are showcasing DTI's growth opportunities with a particular focus on our presence in the Middle East.

Our rationale for the SDP acquisition is quite compelling. Over the next 12 months, we expect to realize an excess of $4.5 million in identifiable SG&A synergies and realizable NOL tax benefits. In addition, there are vertical and horizontal integration synergies that include approximately 60% CapEx savings on new DNR tools and 45% margin capture on Repair & Maintenance of our global Drill-N-Ream asset.

Superior is headquartered in Vernal, Utah. The team and state-of-the-art facility adds to DTI's offering additional engineering and product development, PDC cutter brazing and bit repair expertise, a substantial manufacturing facility with precision machining capabilities, and of course, our ongoing Drill-N-Ream repair center. In addition, after a significant investment and three years of trials and development, a fully staffed and operational PDC bit and Drill-N-Ream repair facility in Dubai, UAE, a local bit repair contract with ongoing revenues as well as several hundred fit-for-purpose DNR tools on the ground across the Middle East. This provides us fuel in the tank to serve our clients in the region.

While our vertical and horizontal integration synergies are activity and backdrop driven, we believe they will prove to be quite significant once market activity stabilizes and the rig count improves into 2025 and beyond. Adding to these synergies, we also gained an approximately $6.6 million receivable from the selling party to extinguish a note, which will accrue to DTI's benefit, effectively reducing the total purchase price of the transaction from $32.2 million to $25.6 million, subject to purchase price accounting adjustments. As you can see, the SG&A synergies of $4.5 million, the CapEx and cost reduction, the note due of $6.6 million and millions in previously invested rentable assets and infrastructure, add up to a very meaningful long-term accretive value to DTI.

Moving now to our 2024 second quarter operating results. The US rig count experienced continued softness in the quarter compared to our flat rig count outlook earlier this year. So what have we done to adjust to the softer market conditions and rig count decline. First, we have implemented a cost reduction program for annualized savings of $2.4 million in overall cost. We will continue to appropriately scale our operations to adjust for the activity levels in North America, but will continue with our growth initiatives in other markets where growth opportunities are available.

Currently, our cost adjustment decisions are focused more on the near-term environment, realizing that our current and short-term needs must be met with a lower cost structure while still keeping our eye on the long-term. Additionally, we were able to manage capital expenditures during the quarter and improved our adjusted free cash flow by $3.2 million compared to last year's second quarter. Our unique business model enables us to generate returns despite a decline in North American land activity. As a result, we are maintaining our adjusted free cash flow guidance range from $20 million to $25 million for the full year. David will add more commentary to our updated outlook shortly.

And now some observations of the market, and what has transpired over the last few months, as oil and gas customers have reduced activity. Our customers, the operators and oilfield service providers became very focused in improving efficiency and producing more with less. It appears E&P megamergers have begun to slow and operators have turned their attention to integrating, executing and rationalizing their drilling programs.

In essence, these operators are utilizing their best rigs as efficiently as possible by deploying their best crews to drill longer laterals with more producing footage, all with fewer rigs. Also important, they are much more efficient with a focus on minimizing drilling mistakes like loss in hole events. Operators will look to redeploy additional rigs when demand picks up, and we believe demand will eventually rise and should require more drilling and producing activity.

Certainly, things have changed over the last decade and although, oil and gas operations are much more efficient, producing wells typically peak early in their life, then decline year-by-year. If we believe demand will continue to rise, then more wells will be needed to meet that demand. For the next few months and likely through mid-2025, we expect a soft activity pace for North America and are confident rig counts and well counts should rise in 2025. International markets should be flat to upwards with less volatility.

Due to the current North America market softness, we have had to align our core rental tool business to remain more competitive as our customer landscape shifts with mergers, and our customers rotate oilfield service suppliers to find best cost and value, we had to be more flexible by adjusting commercial terms to meet our customers changing needs.

Although, we have strategic moats for these events, we are not immune to this type of request and have installed key initiatives to deal with this transitory trend. In some product lines, we have adjusted to pricing reflective of footage drilled as opposed to price per day. And yes, it's challenging, but we will prevail and be more vibrant coming out of this downturn like we have during so many other market downturns.

As we have previously stated, in a steady state environment, our business consistently delivers 30-plus-percent adjusted EBITDA margins and mid- to high-teens adjusted free cash flow margins. While we have taken measures to adjust to lower demand, we believe we will be well positioned to come out stronger when the market recovers.

Although, we have acquired some new revenue streams with product sales such as Deep Casing and service repair revenue, Superior Drilling Products, our business model has historically relied mostly on rental, repair and recovery revenues. Our customers count on us to maintain a relevant and sustainable fleet of equipment. The rental and repair income provides the basis for our rental model. The tool recovery revenue also known as lost and damaged equipment charges, allows us to sustain our fleet, which enables us to not only remain relevant but also generate positive adjusted free cash flow throughout the energy industry cycles. This is one of those cycles.

As I said previously, our blue chip customers prefer to rent downhole tools because it would not be efficient to own and maintain their own fleet due to the many exhausted configurations, hole sizes, geographies and engineering requirements. Bottom line, our customers rent tools from DTI because we provide high quality service and value along with our substantial fleet of tools to best serve their needs. This, along with our acquired new products and revenue opportunities, positions us to continue to capture a greater share of the industry on a global scale.

Longer-term demand trends remain robust. Agencies such as the EIA expect oil demand to continue to grow through 2050. In addition, many industry experts are forecasting that the medium- to long-term natural gas demand outlook is very strong, particularly with the new LNG capacity slated to come online in 2025 and 2026. And with electricity demand rising rapidly to accommodate the anticipated growth of data centers.

DTI is well positioned for this industry trend. We have been extremely active in the M&A market since going public in June 2023 as we work to position DTI for future growth, which is what we said we would do, and we continue to believe that there are meaningful consolidation opportunities that exist in our sector.

It is our stated goal to make thoughtful acquisitions a significant part of our growth strategy. We have established an M&A framework and robust M&A pipeline that will allow us to selectively and strategically consolidate numerous oilfield service, product and rental tool companies that meet the criteria for our growth plan.

With that, I'll turn it over to our CFO, David Johnson, for a review of our financial results and outlook. David?

[David R. Johnson]

Thanks, Wayne, and thank you, everyone, for joining us today. In today's earnings release, we provided detailed financial tables, so I'll use this time to offer further insight into specific financial metrics for the second quarter. DTI generated total consolidated revenue of $37.5 million in the second quarter of 2024. Second quarter tool rental net revenue was $28.3 million, and product sales net revenue totaled $9.2 million.

Second quarter operating expenses were $35.3 million, and income from operations was $2.2 million. Adjusted net income for the second quarter was $3 million or adjusted diluted EPS of $0.10 per share. Second quarter adjusted EBITDA was $9 million and adjusted free cash flow was negative $1.1 million, a $3.2 million improvement compared to the second quarter of 2023. As of June 30, 2024, we had approximately $6.8 million of cash, net debt of $17.4 million and an undrawn $80 million ABL credit facility.

As Wayne mentioned, we saw the US land rig count down sequentially during the second quarter. Rig count was down roughly 15% over the last 12 months. Despite this decline in rig count and activity, our revenues in the second quarter of 2024 were flat over the second quarter of 2023. Our acquisition of Deep Casing, our Tier 1 customer base, our wide distribution service and support network and new product offerings have been integral in managing this challenging cycle.

Moving to maintenance CapEx. As a reminder of what I have shared on previous calls, we are a downhole rental tool company and our maintenance capital is funded by tool recovery revenue. The customer is responsible for all lost or damaged tools while the tools are in their care, custody or control. This tool recovery component of our rental model helps keep our rental tool fleet relevant and sustainable.

For the three months period ended June 30, 2024, maintenance CapEx was approximately 7% of total consolidated revenue. This portion of our capital investments is trending lower due to the decline in rig count and our customers focus on efficiencies that have translated into fewer lost in hole and damage beyond repair events.

Now moving on to our outlook. We are updating our 2024 ranges, which include the estimated impact of Deep Casing Tools and Superior Drilling Products on full year results. We expect 2024 revenue to be in the range of $155 million to $170 million. We expect adjusted EBITDA to be within the range of $41 million to $47 million. Gross capital expenditures are expected to be between $21 million and $22 million. Adjusted net income for the full year is expected to be between $9.9 million and $13.5 million.

And finally, since a majority of our CapEx was incurred in the first half of this year and we have curtailed or deferred other planned CapEx, we are maintaining our adjusted free cash flow to be between $20 million to $25 million for 2024, which is more than double the adjusted free cash flow in 2023.

That concludes my financial review and outlook section. Let me turn it back over to Wayne to provide some summary comments before Q&A.

[Wayne Prejean]

Thank you, David. Before opening up the line for Q&A, I'd like to reiterate, we are extremely pleased to welcome SDP's talented team to the DTI family and add SDP's products, service and world class manufacturing expertise into our broad reaching and expanding global sales channels.

In conclusion, I would like to reemphasize that one, we are very pleased to have closed in our two acquisitions in five months, and we believe we will see significant cost synergies as well as vertical and horizontal integration synergies from the SDP acquisition that will lower our cost and improve our margins. Two, we have implemented an annualized $2.4 million internal cost reduction program to adjust to the softer market conditions.

Three, we are competitive and profitable despite the soft market and are well positioned to combat pricing pressures. Four, our RotoSteer technology continues to make positive commercial traction, but at a slower pace than we anticipated late last year, when the market outlook was flat to upward. We expect to have continued growth in this important technology, but have tempered our fleet development plans and deferred quarter-to-quarter increases to adjust our CapEx and fleet utilization.

I am highly confident this product line will continuously grow. Stay tuned for updates as this exciting opportunity develops. And finally, we believe additional thoughtful consolidation opportunities exist in oilfield services that will supplement our organic growth initiatives. Throughout industry cycles, our focus on safety, quality and reliability continue to be the hallmark of DTI.

I would, again, like to express my sincerest gratitude to every member of the DTI, Deep Casing and most recent addition, Superior team for their continued dedication to safety, customer service, and the successful execution of our strategic initiatives. The commitment of our employees has been critical in driving our success, and I extend my heartfelt appreciation for their contributions.

With that, we will now take your questions. Operator?

[Operator]

Thank you. We will now be conducting a question-and-answer session.

[Operator Instructions] Thank you. Our first question comes from Jeff Grampp from Alliance Global Partners. Go ahead, Jeff. Your line is open.

[Jeffrey Scott Grampp, Analyst, A.G.P. / Alliance Global Partners Corp.]

Good morning, everyone. I wanted to first start on the Superior integration here now that we've closed. I understand we're only in the first week here, but do you guys have any kind of preliminary estimate for when you could potentially see some traction or signs of success on the revenue synergies upside, particularly in the Middle East, and elsewhere internationally? Is that a 2024 event, where you guys could maybe see some green shoots of success? Or is that more of a 2025 event we should stay tuned for?

[Wayne Prejean]

Thanks, Jeff. This is Wayne Prejean. We expect to see some green sprouts starting to occur throughout the remainder of this year. We have – we've been slowly having discussions on between our team and their team on how we might integrate post-closing and now that, that has happened, we're ready to implement some of those initiatives and accelerate the efforts between our commercial team, and their teams and get things really ramping up in that market. Probably, more of a 2025 event to see the true traction. So quarter-by-quarter, we expect to make steady progress. So...

[Jeffrey Scott Grampp, Analyst, A.G.P. / Alliance Global Partners Corp.]

Great. Thank you. And on the revised guidance slide in your updated deck and you touched a bit on this in the prepared remarks as well, Wayne, on M&A, so five near-term priority targets as you guys kind of call it. Can you shed a bit more light on those perhaps in terms of, I don't know, geographic focus, product line, maybe size in terms of what size businesses these are to the extent you can kind of ring fence some of these opportunities in any broad strokes?

[Wayne Prejean]

Thanks, Jeff. I've invited Jameson, our Corporate M&A, VP to kind of comment on some of that. Jameson?

[Jameson Parker]

Yeah. So speaking of the pipeline, Jeff, we have everything from product specific tuck-ins that are identified and we're working on some kind of single product pipeline companies, all the way up to significant mergers of equal or even larger. So we're constantly coming in the depths of the market to find the thoughtful consolidation opportunities that we speak to in the deck. And I would say that funnel is very real when we speak to the opportunity set and the near-term opportunities that we're actively working on.

[Jeffrey Scott Grampp, Analyst, A.G.P. / Alliance Global Partners Corp.]

Okay, great. If I could just tack a follow up on that, Jameson.

[Jameson Parker]

Sure.

[Jeffrey Scott Grampp, Analyst, A.G.P. / Alliance Global Partners Corp.]

What's kind of relative to the last call a few months ago, how would you guys kind of characterize bid/ask spreads, seller sentiment? What is that overall market like today versus a few months ago?

[Jameson Parker]

Yeah. I think in one of our kind of introductory calls, spoke to valuations being very range bound still in oilfield service there is not – I think the bid/ask spread continues to narrow. And we have seen the complete departure of the private equity bidder in most of these processes. And some of these processes that we're doing are not the broadly marketed deals. These are individual founder driven companies that we've known or worked with for a long time. And the timing is right to take their products commercial. So I think the acquisition landscape for consolidation remains robust for oilfield service. We need to do what our customer base is doing and get larger and leaner.

[Jeffrey Scott Grampp, Analyst, A.G.P. / Alliance Global Partners Corp.]

Great effort to those comments. I'll turn it back. Thank you, guys.

[Wayne Prejean]

Thanks.

[Operator]

Thank you. And our next question comes from Steve Ferazani from Sidoti. Go ahead, Steve.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Good morning, Wayne. Good morning, everyone. Appreciate the detail on the call.

[Wayne Prejean]

Yeah.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Wanted to ask about the updated guidance because it now includes SDPI. Is there any kind of detail you can give us on the breakdown of what you're expecting the contribution for SDPI is on the remainder of the year?

[Jameson Parker]

So historically, we only speak to the percent contribution by the product lines at year end. I mean, they were public prior, and you can see some of the results, and we spoke to the kind of margin capture and improvement by being vertically integrated.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Okay.

[Jameson Parker]

So that's kind of where things are trending now.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Can you say if SDPI, your outlook on SDPI in terms of trends are similar to your legacy business?

[Wayne Prejean]

Yeah. We think they're – they have some bit repair business opportunities in the Middle East that are starting to get traction. So we anticipate that

[indiscernible] (00:24:48) contribution. And also, we have assets on the ground, renewable assets on the ground that we can put to work, we believe as things kind of continue to ramp up as we integrate our efforts.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Okay.

[Wayne Prejean]

We factored in an appropriate amount of what we believe is, sticky activity, so that we feel like we pretty – feel pretty good about our guidance of – there's certainly potential for more opportunity in the future. So we'll just have to gauge that quarter-to-quarter as we integrate these two businesses. So...

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Fair enough. When we think about the updated guidance, obviously rig count has continued to soften, but we're down about 20 rigs last quarter and I know, we're continuing to decline this quarter. But when I see the updated guidance and you touched on it in your comments, there seems to be maybe a more severe pricing impact or maybe it's utilization. And I'm trying to figure out how much consolidation is playing into that, even though you probably the incumbent of the acquirer in a lot of these cases. Are you getting more pricing pressure from consolidation or is it more just the slower rig count?

[Wayne Prejean]

So when the rig count, the slow bleed of the rig count over the last 18 months has been kind of an interesting phenomenon within our industry, where it didn't go down just rapidly, just kind of ticked away as a slow leak, if you will.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Yeah.

[Wayne Prejean]

And the industry's had to learn how to adjust to that, that slow burn rate of rig activity. And as those have – as that's happened, operators have had a chance to A consolidate B. What I spoke to in the press release was the rotation of different vendors trying different ways to cut costs and put compressive pricing on different service providers and so on. And that's affected us because we've seen some of our core customers get shuffled around from this operator to that operator and we've had to shuffle as well.

So we made those adjustments. As I spoke earlier, we have strategic moats built-in. Those strategic moats are having the proper fleet, the most relevant types of connections and things in the industry that gives us the strongest sticking power. But as I've said previously in calls and with the different investors, no one is immune to a compression of the market by our customers. So, yeah.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Does how much can this reverse as we start seeing I think you mentioned it and certainly, we all think there's some recovery next year with all the LNG export capacity coming? How positive are you on some recovery on pricing and margins, if we get that recovery?

[Wayne Prejean]

Well, I think it's just a matter of time that our customers do put more activity in play, because they have a desire to grow their business as well, being in the oil and gas customers.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Yeah.

[Wayne Prejean]

As far as pricing rising back up, what we've done, we've tried we make every effort to maintain our pricing points, but we modify our commercial terms with utilization, used tools and things like that and standby rates and things like that when you have extra tools unutilized. So our goal is to modify our commercial terms and then move our utilization efforts back to where the activity supports a better pricing model. And we think we'll be in a competitive position to offer better products and more relevant products for the future.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Perfect. Last one for me. I mean, the international outlook as we come out of the first half listening to some of the Bellwether conference calls, the international outlook remains really, really healthy. A lot of people calling for a multi-year cycle here with particular strength in the Middle East. Can you touch on how that's your strategy with SDPI, Deep Casing?

[Wayne Prejean]

Yeah.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Can you give a little bit of picture on how that affects your international strategy? And how that will play into sort of this international potential multi-year upcycle?

[Wayne Prejean]

So Deep Casing, for example, has a product line that's very contributory and beneficial to many of your Middle East and international offshore players. So that – we see that business slowly growing and evolving and making a more significant contribution. Now that we have the SDP acquisition, we've joined forces with them. We're no longer serving two masters. We're now aligned and working together in unison. I think we can help that platform rapidly expand and set up repair centers and other locations and expand that product line. So the opportunities are there and for – in addition to that where Jameson didn't give you any real color on because he's reserving his comments but I'll add to it is, one of the criteria for M&A strategies is to place a high emphasis on international impact and component these M&A deals can do for us.

So we pretty much look at that as a higher value proposition than maybe just some tuck-in and bolt-ons in the North American market, which many could be attractive, but we're focused and we're aiming more towards technology and – technology in Middle East and international expansion as far as when we make an M&A deal that needs to make a significant contribution to our long-term strategy.

[Steve Ferazani, Analyst, Sidoti & Co. LLC]

Fantastic. Thanks, Wayne.

[Operator]

And our next question comes from John Daniel from John Daniel (sic) [Daniel] (00:30:53) Energy Partners. Go ahead.

[John Daniel, Analyst, Daniel Energy Partners LLC]

Yeah. Wayne, your margins are already better than a lot of your peers and it was just noteworthy when I saw the cost reduction efforts, the $2.4 million. Can you elaborate on what you guys are doing?

[Wayne Prejean]

With regard to our cost reduction?

[John Daniel, Analyst, Daniel Energy Partners LLC]

Yeah. Is it regional or yeah, how are you approaching that?

[Wayne Prejean]

So one thing interesting about our business is, we can scale our business according to activity and that's very challenging, but some of its labor centric, some of its deferring certain aspirational cost. So we've made those appropriate adjustments in North America. We have a tenured management team in all of our facilities, which is unique. And they all understand, what is required of them quarter-to-quarter, year-to-year and how the industry ebbs and flows. So we made those variable cost adjustments and – but we are a public company now. So we've had to take on some public company burdens that we're all aware of. So we've been mindful of managing that escalation as we grow and build muscle to take on more and more M&A and larger broader enterprises.

So – but most of it's been the variable cost component in North America, where we see the lever of ebb and flow of activity. And if the activity raises or rises to a level that requires more support, we're prepared to those increases, if needed, to support the business. So...

[John Daniel, Analyst, Daniel Energy Partners LLC]

Okay. And then just a follow up unrelated but the press release calls out the bit repair facility in the UAE. I'm just curious, when you have a facility like that what's the opportunity for additional roofline there? And how quickly could you start taking other product services into a facility like that? If you could just expand, it will be helpful.

[Wayne Prejean]

Well, I think – okay. Yeah. Thanks. The facility that's set up now was simply located in the UAE and that serves our needs for now, but we're looking at how to put something possibly in Saudi. We could – the roof line that we currently have could add support for some of our other product lines in the Middle Eastern market. So it's expandable. There's the bit repair business can be expanded. The Drill-N-Ream repair business can be expanded. And we have some machining capability that's being loaded into there to add more repair capability to support rental fleets. So, we're good to go for a while.

[John Daniel, Analyst, Daniel Energy Partners LLC]

Good. Okay. That's all I had. Thank you for including me.

[Wayne Prejean]

Thanks, John.

[Operator]

Thank you. This does conclude – sorry. This does conclude the question-and-answer session. I would now like to turn it to management for any closing remarks.

[Wayne Prejean]

Well, thanks, everybody, for your interest in DTI. It's been a challenging year, but we've once again overcome those challenges and we see a pretty bright outlook going forward and we look forward to keeping you posted on those events. Thanks for your interest.

[Operator]

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