Archrock Inc

NYSE:AROC

Earnings Call Transcript 2021-Q2

[Operator]

Good morning. Welcome to the Archrock Second Quarter 2021 Conference Call. Your host for today’s call is Megan Repine, Vice President of Investor Relations of Archrock.

I will now turn the call over to Ms. Repine. You may begin.

[Megan Repine, Vice President of Investor Relations]

Thank you, Katrina. Hello, everyone, and thanks for joining us on today’s call. With me today are Brad Childers, President and Chief Executive Officer of Archrock; and Doug Aron, Chief Financial Officer of Archrock. Yesterday, Archrock released its financial and operating results for the second quarter of 2021. If you’ve not received a copy, you can find the information on the company’s website at www.archrock.com.

During this call, we will make forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934 based on our current beliefs and expectations, as well as assumptions made by and information currently available to Archrock’s management team. Although management believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct. Please refer to our latest filings with the SEC for a list of factors that may cause actual results to differ materially from those in the forward-looking statements during this call.

In addition, our discussion today will reference certain non-GAAP financial metrics, including adjusted EBITDA, gross margin, gross margin percentage and cash available for dividend. For reconciliations of these non-GAAP financial measures to our GAAP financial statements, please see yesterday’s press release and our Form 8-K furnished to the SEC.

I’ll now turn the call over to Brad to discuss Archrock’s second quarter results and to provide an update of our business.

[Brad Childers, President and Chief Executive Officer]

Thank you, Megan, and good morning, everyone. Let me start by saying that I’m pleased with Archrock’s performance in the second quarter of 2021. We executed on a number of strategic priorities and they’re driving value in this transition year. With our fleet of large horsepower assets, solid operational performance and continued financial discipline, we delivered meaningful free cash flow during the first half of 2021.

Highlights for the second quarter include that we saw further stabilization in our operations in revenue. Compared to the first quarter, our utilization was flat at 82% and our contract operations revenue was down just 1%. We captured our highest level of horsepower bookings since the second quarter of 2019, reinforcing our confidence in this recovery. We delivered a solid contract operations gross margin percentage of 63%, largely unchanged compared to the first quarter of 2021. We maintained capital discipline, spending $39 million in total CapEx in the first half of 2021 compared to $113 million at the same point last year. We continued our commitment to return capital to shareholders. We paid $22 million in dividends with internally generated cash flow and maintained a robust dividend coverage ratio of 1.9 times.

Finally, we progressed our multi-year fleet hydrating strategy. In total, we’ve divested 279,000 horsepower year-to-date, including 108,000 horsepower during July. These transactions improve our operating efficiency and profitability, bring forward future EBITDA and allow us to accelerate debt repayment. I’m proud to share that the proceeds from these asset sells and strong year-to-date operational execution has accelerated our targeted debt reduction from the expected $100 million to $150 million or more during 2021, and from $250 million to $300 million or more since the end of 2019.

As a late-cycle participant, we expected 2021 to be a transition year as the current cycle turns from contraction to expansion. The pace of this recovery is proving to be more measured than we initially anticipated, however our utilization pricing are at or near cyclical lows. At the same time, we’re beginning to invest to meet the expected customer growth plans, and they’re starting to face inflationary pressure from the tightening market and from shortages. This concurrence in lower revenue and accelerating investment is typical of the transition in our business from the end of the down cycle to the beginning of an up cycle.

As with fast cycles, our focus is now moving to the growth we expect to see ahead as we convert our growing backlog of compression demand to revenue and get set up to raise pricing to align with our cost structure. We expect this period to be transitory as it has been in the past cycles and we expect to leverage the market opportunities presented by the steady, multi-decade growth cycle for natural gas that we believe is now underway. We expect increasing booking activity to continue through the balance of the year, which for Archrock should translate into a robust outlook for 2022 and beyond.

Turning now to a deeper dive and review of the market backdrop. Commodity prices strengthened further during the second quarter. Oil prices remain above $70 per barrel, supporting the existing 2021 activity plans across the oil patch. The North American rigs now currently stands at approximately 470, up more than 100% from the trough. Our conversations with customers around 2022 plans are increasing in frequency and optimism, and we believe future activity is biased higher, setting the compression industry up for a stronger 2022.

In the EIA’s latest forecast, natural gas production remains in the 93 to 94 Bcf a day range for the second half of the year with a 2021 average of 93 Bcf a day, essentially flat from 2020 levels. From there, it’s expected to reach 96 Bcf a day by the fourth quarter of 2022 above pre-pandemic levels and 7% higher than the low point experienced in the second quarter of 2020. Beyond the cyclical recovery currently unfolding, the positive long-term fundamentals for natural gas and therefore our compression business remain in place. Natural gas remains a cornerstone fuel through a worldwide energy transition in the multi-decade forecast, published by major energy agencies.

And as the oil and gas industry increases its commitment to reducing its own greenhouse gas emissions, this could further strengthen national gas’ value proposition and provide upside to long-term demand. For Archrock, we believe the opportunities presented by energy transition outweigh the risks. Our strategy includes a growing commitment to our ESG performance and disclosure. We plan to publish our third sustainability reports in the next few weeks with 2020 data and additional disclosure enhancements. As you know, we already provide electric power compression to certain customers, this represents a small portion of our fleet today, but a key growth opportunity ahead.

Moving on to our segments. Contract operations revenue declined by just $2 million or 1% in the second quarter, a significant improvement from the larger sequential decline we experienced throughout the pandemic. Compared to the first quarter, our second quarter exit fleet utilization was flat at 82%. Excluding the 12,000 active horsepower we chose to sell as part of our fleet hydrating strategy, operating horsepower declined by just 22,000 compared to the first quarter. So in the second quarter, we divest at 63,000 total horsepower and in July sold another 108,000 horsepower to compression providers with small horsepower strategies. This required a tremendous effort from numerous people across our organization, and it was a win-win for all parties involved. Including the benefit of these transactions, our large horsepower equipment as a percentage of our operating fleet has increased from 74% at the end of 2019 to 80% today.

Pricing on our active fleet remains steady compared to the first quarter, the results of our contracting strategy and standby units returning to full monthly service rates. Revenue for horsepower was flat on sequential basis. Booking activity during the quarter was robust and reached levels we’ve not seen since the second quarter of 2019, which should enable us to zoom horsepower growth.

Our gross margin percentage was roughly flat from the first quarter of 2021 and was down on a year-over-year basis. During the second quarter, we started to see higher costs due to an increase in make-ready expenses as we prepare to meet higher customer demand and are also facing rising parts with oil and labor expenses. The team has and will continue to optimize gross margin and work to offset inflationary pressures with tight cost control, efficiency gains and future price increases.

I also want to thank our employees for their continued hard work and commitment to safety. We achieved great safety performance with zero safety incidents recorded so far in 2021. In aftermarket services, revenues were up $2 million sequentially of a seasonally low first quarter. However, results were softer than our expectations as the resumption of major maintenance by our customers has largely lagged our experience in prior cycles. This is especially true for our field service activity.

I’d like to touch on our capital allocation framework, particularly as we move closer to the upcycle. As always, we will remain focused on balancing appropriate levels of investment, leverage and return of capital to shareholders. Over the past several years, we’ve worked hard to build a platform that will profitably support the consistence, the relatively modest growth and demand for natural gas compression forecasted ahead. We’ve modernized our fleets, invested in technology and standardized practices in the field and across the organization. With this solid foundation, we’re focused primarily on redeploying existing active compression units and we’ll responsibly increase investment in our fleet as necessary so that we have equipment available and in configurations desired by our customers.

In summary, we’re confident, a recovery is developing. We have a lot of reasons to be excited about 2022, and we have the right people, assets and strategy in place to optimize the results during this transition period and as this recovery takes hold.

With that, I’d like to turn the call over to Doug for a review of our second quarter performance and provide the latest Archrock 2021 outlook.

[Doug Aron, Chief Financial Officer]

Thanks, Brad, and good morning. Let’s look at a summary of our second quarter results and our latest financial outlook for the year. Net income for the second quarter of 2021 was $9 million and included a few one-time items, the majority of which were non-cash. We recorded a non-cash $3 million long-lived asset impairment and nearly $1 million in restructuring costs. We reported adjusted EBITDA of $87 million for the second quarter of 2021 compared to the first quarter horsepower declines and smaller net gains related to the sale of compression and other assets resulted in a decline in adjusted EBITDA.

Turning to our business segments. Contract operations revenue came in at $164 million in the second quarter, down only $2 million compared to the first quarter due to lower operating horsepower. We managed to defend our gross margin percentage of 63% relatively flat compared to the first quarter, but down 300 basis points year-over-year. Our year-over-year margin decline was due to fewer units on standby and additional make-ready expense.

In our aftermarket services segment, we reported the second quarter 2021 revenue of $32 million compared to $29 million in the first quarter as activity recovered from a seasonally slow first quarter. Revenue was down on annual basis, primarily due to the July 2020 disposition of our turbocharger business. Top line pressure weighed on the segments gross margin, which came in below annual guidance at 13%.

SG&A totaled $26 million for the second quarter, down 9% compared to $29 million in the prior year, as we improved our bad debt expense and tightly managed corporate overhead. For the second quarter, growth capital expenditures totaled $8 million. We invested in equipment modifications and repackages and took delivery of a small amount of new horsepower. Maintenance and other CapEx for the second quarter of 2021 was $19 million and reflects higher levels of make-ready and overhaul spending as well as technology investments.

We exited the quarter with total debt of $1.6 billion. Our leverage ratio as of June 30, kicked up slightly to 4.25 times from 4.1 times in both last quarter and the second quarter of 2020, as debt reduction only partially offset the impact of lower adjusted EBITDA. However, we redeployed process – proceeds from July asset sales towards debt reduction and pro forma for these actions. Our leverage ratio as of June 30 was 4.05 times. Debt reduction continues to be a primary focus for Archrock. And as Brad mentioned, we are committed to at least $150 million of repayment this year, and to bringing down our leverage ratio over time as our EBITDA recovers. We had available liquidity of $420 million as of June 30, giving us plenty of financial flexibility on top of the free cash flow we are already generating.

We recently declared a second quarter dividend of $0.145 per share, or $0.58 on an annualized basis. Our dividend represents a compelling yield of 7% based on yesterday’s closing price, especially given the protection provided by our industry-leading dividend coverage. Cash available for dividend for the second quarter of 2021 totaled $42 million leading to a healthy dividend coverage of 1.9 times, even after making our semi-annual interest payments during the quarter.

Moving on to our updated outlook. We are tightening our full year 2021 adjusted EBITDA guidance range to $340 million and $355 million. Full revenue and gross margin detail of the segment level can be found in the earnings press release we issued last night. For contract operations, we still expect full year 2021 operating horsepower to be flat year-over-year with the horsepower growth assumed in the high end of our guidance, now expected to materialize in 2022. Relatedly, as we absorbed the cost of start activity and inflationary pressures to discuss today, we anticipate our gross margin percent will step down during the second half of the year. We are also revising our annual AMS revenue and gross margin guidance to account for week or year-to-date performance and to reflect our latest view of a recovery.

Finally, our updated guidance incorporates the $18 million net effect of the year-to-date asset sales, both the $10 million in lost EBITDA, as well as the $28 million in net gains from asset sales. For the full year 2021, total CapEx is unchanged and expected to be in the range of $80 million to $106 million. This represents a decline of $47 million on the heels of the impressive $245 million reduction we delivered last year.

With that, I’ll now turn the call back over to you, Katrina, and we’ll take questions from those on the line.

[Operator]

Thank you, sir. [Operator Instructions] We have our first question from Kyle May from Capital One. Your line is open.

[Kyle May, Capital One]

Hi, good morning, everyone.

[Brad Childers, President and Chief Executive Officer]

Good morning.

[Kyle May, Capital One]

Maybe, Doug, just a quick question to follow up on the guidance. Looking at the contract operations segment, it looks like revenue is set to decline in the back half of the year. Is this really primarily driven by the loss in EBITDA that you mentioned or is there something else going on in the segment?

[Doug Aron, Chief Financial Officer]

Yes. So it is two things, Kyle. It is very much that EBITDA that goes away, offset obviously by the game that we saw, but we also are experiencing the inflation that you’re hearing about, gosh, all throughout the country and likely globally. Higher parts expense for us is forecasted in the second half of the year. Lube oil expense, in addition to the higher commodity price, you’re seeing some shortages frankly, and availability of lube oil and lubricants in the U.S., which is driving into really what was the equivalent of sort of $100 oil price previously. So we’re dealing with that. And after labor and parts, that’s our third highest cost.

And then again on labor, which is in fact our largest costs, we’re starting to see some pressures in certain basins, particularly the Permian, which you would expect. I think seeing that inflation happened faster than we’re going to be able to pass some of that through. And so that’s really what’s leading to the lower forecast that gross margin for second half.

[Kyle May, Capital One]

Got it. Okay. That’s helpful. And maybe for Brad, based on what you’re seeing with recent bookings and kind of the outlook for activity, can you help us frame up how to think about the growth for Archrock next year?

[Brad Childers, President and Chief Executive Officer]

Thanks, Kyle. It’s too early to really know what and how firmly 2022 is going to materialize and develop. But I will show that I’m optimistic. The activity that we’re seeing in bookings already for starts in new activation on locations in 2022 is taking place at a nice rate. By translating that is what the net growth is going to look like with normal stop and start activity. And that growth on top of it, it’s just too early, but it’s a good outlook that’s developing. So we’re excited about it.

[Kyle May, Capital One]

Understood. Great. Well, appreciate the color this morning. I’ll jump back in the queue.

[Brad Childers, President and Chief Executive Officer]

Thanks, Kyle.

[Operator]

[Operator Instructions] Our next question is from Selman Akyol from Stifel. Your line is open.

[Selman Akyol, Stifel]

Thank you. Good morning,

[Brad Childers, President and Chief Executive Officer]

Good morning.

[Selman Akyol, Stifel]

Couple of quick ones. So you talked about electric compression as a growth opportunity. Can you maybe talk about pricing strategies on that and what difference you’re seeing for electric compression, if any?

[Brad Childers, President and Chief Executive Officer]

Sure. On the good news front, as our customers and as we, and the entire industry, all turn our attention to being the best corporate citizen that we can be including on our ESG efforts and managing emissions that continual migration to more electric motor drive compression, where we have electrification in the field is inevitable.

And what I can share with you is that, number one, that the amount of opportunities that we’re seeing for that with our customer base are to double or triple what they would have looked like this time last year, which is really great to see. And then number two, from the margin contribution perspective more than pricing, we really make the equivalent amount of margin contribution and profitability and returns on investment in the electric motor drive compression that we put out in the field as we do with our reciprocating natural gas operating engine. So, overall it’s an equivalent contribution.

So it’s exciting to see it developed, it’s something we have experienced in, and we’re looking forward to meeting our customer’s growing needs with electric motor drive compression for the future.

[Selman Akyol, Stifel]

Appreciate that. Thank you. You mentioned you’re optimistic in bookings for starts in new locations and things for next year. Is there, I don’t know, sort of a percentage we could just think about in terms of bookings turning into eventual revenues? Or is there anyway, I guess we can just kind of think about that?

[Doug Aron, Chief Financial Officer]

Selman, this is Doug. I’d say part of the trouble with that is, is going to be a little bit dependent on what our capital, our ability or our desire, I guess, to spend on new equipment will be for 2022. That’s the discussion we just had with our board preliminarily for the first time looking at 2022. And so as much as I’d love to start getting into the 2022 guidance, we’re just not there. We’re still kind of a quarter away. I mean, I think, again, what you can see is particularly in that larger horsepower class, but 3,606s and 3,608s, preliminary discussions are very much that 90-plus percent utilization as an industry. There’s not much if any available idle equipment in those horsepower classes. And so, the fact that we’re having several customers already calling and inquiring about availability for that next year is all goes into sort of the formula of what will bake our 2022 plan, but give us 90 more days to come back to you on what that’s going to look like, if you don’t mind.

[Selman Akyol, Stifel]

No, not a problem. I understand, I appreciate the commentary. Let me just see if I can ask this in more of a general question. Is there anything you can talk about in terms of like basins? I mean, okay, we all know Permian from that standpoint. But is there any other basins that we should be looking for particular strengths coming?

[Doug Aron, Chief Financial Officer]

So, you’re right. And I think the conventional perspective in the industry is that the Permian will be the dominant player, especially with a buoyant oil price. It’s prolific, it’s profitable and it still attracts more capital than other places. But after the Permian and there’s some producers that don’t have such a large Permian position that have invested in their fields in other locations, we still expect to see some good activity in the Northern Rockies. We are seeing some good incremental activity in a couple of dry gas places, including in the Northeast. And we’re also hearing and seeing some opportunities developed in Aumsville. Nothing at the same scale as the Permian, but all of which are important to our customer base and still provide good markets for our compression services.

[Selman Akyol, Stifel]

All right. Thank you very much, and it does it for me.

[Doug Aron, Chief Financial Officer]

Thank you.

[Operator]

[Operator Instructions] We have a question from Eric Hess from Newfleet Asset Management. Your line is open.

[Eric Hess, Newfleet Asset Management]

Good morning. Just on the compression you sold in July, was that smaller horsepower stuff? And any comments on demand trends across the small, medium, large fleets?

[Brad Childers, President and Chief Executive Officer]

Sure. The answer is yes. The horsepower sales we’ve conducted are primarily around our smaller horsepower fleets. The average size was definitely in the small horsepower range and all of the asset sales that we’ve conducted on year-to-date. And as for demand across the horsepower ranges, I’d say that the tightest demand remains in the largest horsepower categories. So the 1,775 horsepower above, where utilization is very tight in the 90-plus percent range. Generally above 1,000 horsepower is also relatively tight utilization is pretty good, close to the mid 80% range. And then in the smaller horsepower range, it’s really down in the – we see utilization in the lower 80% range. And demand is a little bit softer, but there’s still demand in the market across all ranges of horsepower.

[Eric Hess, Newfleet Asset Management]

Thank you.

[Brad Childers, President and Chief Executive Officer]

You’re welcome.

[Operator]

There are no further questions. Now I’d like to turn the call back over to Mr. Childers for final remarks.

[Brad Childers, President and Chief Executive Officer]

Well, thank you everyone for participating in our second quarter earnings call. I’m proud of our results and I’m thankful to our employees for their continued contributions to our ongoing success. We’re executing well, and I’m confident we will profitably and safely deploy assets as we put our growing backlog to work in the future. Thank you, everyone.

[Operator]

Thank you, presenters. Ladies and gentlemen, this concludes today’s conference. Thank you for your participation and have a wonderful day. You may all disconnect.