CES Energy Solutions Corp

TSX:CEU

Earnings Call Transcript 2019-Q1

[Operator]

Thank you for standing by. This is the conference operator. Welcome to the CES Energy Solutions Corp. First Quarter 2019 Results Conference Call. [Operator Instructions] And the conference is being recorded. [Operator Instructions]I would now like to turn the conference over to Tony Aulicino, Chief Financial Officer. Please go ahead.

[Anthony Michael Aulicino, Chief Financial Officer]

Thank you, operator. Good morning, everyone, and thank you for attending today's call.I'd like to note that in our commentary today, there will be forward-looking financial information, and that our actual results may differ materially from the expected results due to various risk factors and assumptions. These risk factors and assumptions are summarized in our first quarter MD&A and press release dated May 9, 2019, and in our Annual Information Form dated March 12, 2019. In addition, certain financial measures that we will refer to today are not recognized under current general accepted accounting policies. And for a description and definition of these, please see our fourth (sic) [ first ] quarter MD&A.At this time, I'd like to turn the call over to Tom Simons, our President and CEO.

[Thomas J. Simons, President, CEO & Director]

Good morning. Thanks, Tony, and thank you to listeners for joining our call today.On today's call, we're going to focus on capital allocation by the business. I'm calling this the 80-20-16 call: 80% of free cash flow is going back to the balance sheet, 20% is going to buy stock back and $16 million is going towards a sustainable dividend. Cash CapEx in 2019 will track our modest CapEx spend in Q1, which was just below $10 million. We'll spend $50 million to $60 million in 2019. I'll expand further on that later in the call.On today's call, we'll also provide a detailed operations update and share some insights into new technology. We'll talk about leadership changes at the company. Tony will provide a detailed financial update. We'll share our outlook for the business, take questions and then provide a brief summary and conclude.In this new era for public energy companies where expectations are crystal clear, sustain, grow, create value from within cash flow, we believe CES is poised to outperform. Our customer base is blue chip and growing. Our technology offerings are unique and create measurable value for our customers. Importantly, our infrastructure is fully built out to support our next leg of growth across all of the major basins in North America. Our people are trained and primed to solve our customers' problems. Our chemical manufacturing capabilities are world-class with lots of running room to grow throughput, meaning our plants are not full. Our big capital spends are complete.We really like our existing ability to generate much more free cash flow than we need to reinvest in the business. Our substantial investments last year in the Permian and Canada helped the company stem the slide in EBITDAC margins. Business is up in both markets because of our new infrastructure as is profitability. We anticipate further new business and efficiency gains over the longer term. Between margin improvement, greatly reduced CapEx in the quarter of below $10 million and focus on working capital, we managed to reduce our line by $30 million in the quarter.The company plans CapEx in 2019 of $50 million to $60 million. Approximately $40 million will be rolling stock or trucks, about $15 million of it for maintaining the fleet and up to $25 million in growth capital, so for trucks that we put on the road to support new business that we're taking that meets financial tests in our business. $10 million to $20 million would go towards infrastructure at plants, yards and labs. We continue to assess ways to expand our barite milling capability in the U.S. in the most cost-effective manner. If we don't begin our Northeast barite project in 2019, expect CapEx to be closer to $50 million than $60 million. We will need expanded volume in the future and feel confident that we can find a way to generate a 20%-plus rate of return on that project.Now I'll get into the operations and technical update. I'll start with the U.S. which generated 68% of the quarter's revenue at almost $225 million. In drilling fluids, AES is now at 13% market share. Today, we have 124 jobs running, which is approximately the same as what we ran through the quarter. Our Kermit mud plant, which is a dusty little town in the middle of the Delaware Basin, was doubled in throughput with last year's capital program. That's now starting to repay the company. Our Permian job or rig count is at 85, with 60 of those jobs running out of that expanded Kermit mud plant. When trucks don't wait in a long line to load or return materials, it's a lot easier for us to win new work and make more money from that new work. At times in the past, we've been eating or paying standby charges for trucking. That's an example of one of the efficiency gains that's occurred through the quarter.We've also begun rolling out new technology for the intermediate hole section when our customers drill in the Delaware Basin. We're injecting a proprietary liquid polymer into our EnerLITE or direct emulsion system, which helps remove drill cuttings, which keeps the fluid density low enough that it doesn't induce lost circulation as you drill deeper in that hole interval. We used this -- we used technology from our Sialco plant in Vancouver to build the system in the first place. Now we're working in the field with our customers to further utilize chemistry we use in breaking emulsions in our production business to recover the diesel in this fluid system. The value proposition is pretty simple: use $5,000 to $10,000 worth of our chemistry to save drilling days by avoiding lost circulation in the intermediate section and save up to $50,000 in diesel through recovery and reuse when you recover the diesel out of the well or out of the fluid system when you're done drilling. We're in very early stages on this. I'll caution people that it takes time to train your field people on new technology. You want to ensure that you deliver what you promise so you don't sully the reputation of what you're selling. This type of innovation is a win-win for E&P and service company. They save days and costs, and we make more. And I believe we'll win more work longer term. And being the first to market in the oilfield is always very powerful. Overall, AES has 85 Permian jobs; 10 in the Mid-Con; 11 in the Gulf Coast, which includes the Eagle Ford; 13 in the Northeast; and a couple in the Rockies. We expect softness in Q2 in the Eagle Ford, with that being offset by gains in the Permian. With Permian takeaway expanding in the second half of '19, we feel very good about 2019 for AES.I'll move on to our U.S. production business. We continue to benefit from growing production for our customers. Our positions in the Rockies, Mid-Con, California and the mighty Permian are significant and growing. Our backstop for the business, our vertical integration as a molecular-level manufacturer, continues to drive margin, innovation, helps win new business and importantly, attracts top-tier employees as we expand our team. Jacam Catalyst benefited in the past from the explosive growth of the Bakken and now help sustain that production for our customers as water cuts rise and they bring associated problems like scale and corrosion. We've invested ahead of the inevitable massive production growth in the Permian. We've invested in people, infrastructure, trucking and now it's our time to realize that upside, which we think is just beginning.To support our production chemical business in the Permian, we've expanded yards that hold inventory and delivery trucks. We've expanded our Midland lab, we have built a 10,000-square-foot office building, we've expanded our trucking fleet and we continue to recruit top-level technical problem-solvers to service our customers. We expect to automate manufacturing of our solid chemistry line to meet growing demand for this novel product. In the face of terrible public policy in Canada towards energy, I can proudly say God bless Texas. To that end, I'll also note that I'll soon have a personal home in Houston, where I'll work alternating weeks.I'll now move on to Canada. I'll start by saying that the company has made a change in operational leadership in Canada. Ken Zinger, who was my partner when we started this privately in 2001, has assumed leadership of all Canadian operations, so Canadian drilling fluids and Canadian production chemicals. Ken is a working manager, meaning he sells, hires and fires and is actively in the details of the Drilling Fluids business. His success maintaining a market share of 30%-plus for about a decade, all while generating free cash flow for the company, emboldens our confidence in his expanded role. We remain committed and excited about the production chemical market in Canada. But with public policy headwinds in Canada, we felt it was necessary to consolidate leadership to drive needed efficiency gains.PureChem and CES are indebted to Jason Waugh, whose tenure at CS goes back to our IPO. Jason brought incredible drive and passion to the business. Thank you, Jason, and good luck in your future endeavors.For Q1, Canadian drilling fluids averaged low 80s for jobs in January and February and approximately 50 in March as breakup began. Today, we have 24 jobs running. Our highly variable cost structure should allow Canadian mud to generate positive EBITDA at that activity level in Q2. While the second half of '19 is hard to predict for drilling activity, we are confident we'll hold our leading market position and benefit from trends to drill deeper wells, which require more technical drilling fluids and larger volumes. We also benefit from the SAGD market as we have a leading position in that drilling space as well.Our production treating business is already benefiting from our Grand Prairie investment, where we built blending, storage, rail siding and lab capabilities. To date this year, our top 2 customers for PureChem are being serviced from Grand Prairie. As we build on that success and work into a bigger market position in the oil sands, we like our ability to increase PureChem profit margins.I'll caution listeners that Canada needs a change in public policy to really unlock Canada's potential both for industry and for CES. LNG will be a home run for us, but we need oil pipelines and out of the investment penalty box to really realize our potential in Canada, which is huge. Sialco and Clear continue to make modest financial contributions. We believe both have upside, specifically chemistry technology and supply chain improvements from Sialco, and Clear is always looking for angles to make money around water.I'll now turn it over to Tony.

[Anthony Michael Aulicino, Chief Financial Officer]

Thanks, Tom. Q1 represented compelling alignment with our financial areas of focus, including free cash flow generation, CapEx, margins, debt reduction and returns. Q1 revenue of $333 million represented a record first quarter for the company, with continued strong representation from U.S. operations at 68% of total revenue and the balance of 32% from Canadian operations. U.S. revenue of $224 million represented a 25% year-over-year increase and benefited from our completed infrastructure and operational investments in key markets, including the Permian, Eagle Ford, Bakken and Marcellus. U.S. revenue also benefited from increasing production levels and related chemical treatment requirements. Canadian revenue of $108 million represented a decrease of 11% year-over-year. This decrease was primarily driven by current industry challenges causing a decline in drilling activity, while government-mandated production curtailments and severe weather conditions affected our Canadian production chemicals business.Adjusted EBITDAC in Q1 demonstrated margin stabilization and improvement for the first time in 5 quarters. Adjusted EBITDAC of $43.7 million represented a 13.1% margin. And excluding IFRS 16, adjusted EBITDAC of $42.3 million represented a 12.7% margin. Both of these numbers demonstrated an improvement over the 12% margin in Q4 2018. Adjusted EBITDAC margin benefited from revenue mix, internal cost improvement initiatives and isolated price increases.During Q1, we incurred $9.4 million of cash CapEx compared to $15.8 million in Q1 2018 and $17.8 million in Q4 2018. CES completed significant CapEx programs in 2018 to support higher U.S. production chemical activity levels, increased blending capabilities in the Permian and the completion of our Canadian production chemicals business build-out. In 2019, we expect cash CapEx to be approximately $50 million and include key strategic investments of USD 1.9 million to complete our Permian-based drilling fluid plant and USD 8.8 million related to the expansion of our U.S. barite grinding capabilities.Draw on our senior credit facility fell to $132 million as at March 31 from $162 million on December 31, 2018. This significant decrease was primarily driven by strong free cash flow generation and a focus on returning working capital to the balance sheet, offset by opportunistic share repurchases through our NCIB program. In Q1, we repurchased 360,000 shares at a weighted average price of $2.89 per share. Subsequent to March 31, we repurchased 847,000 additional shares at a weighted average of $2.70 per share. Since the inception of our NCIB program on July 17, 2018, CES repurchased 6 million shares at a weighted average price of $3.81 per share, totaling approximately $23 million and representing 2.2% of shares outstanding on June 30, 2018.Having completed significant CapEx programs in 2018, we continue to focus on increasing free cash flow generation and return metrics through execution in key markets, prudent capital expenditures, improved working capital efficiencies and opportunistic margin expansion.In 2019, we expect that EBITDAC will materially exceed the sum of cash expenditures on interest, taxes and CapEx, allowing for surplus free cash flow to reduce debt, pay our dividend and continue our share buyback program. Our financial strategy remains aligned with prudent allocation of capital, including debt reduction, share repurchases, dividend payments and accretive investments in operations.At this time, this concludes our -- the formal part of the call. Operator, I'd like to open up the line to any potential questions.

[Operator]

[Operator Instructions] The first question comes from Greg Colman with National Bank Financial.

[Greg R. Colman]

Congratulations on a good-looking quarter. I wanted to start by focusing a little bit on margins and some nuances here. I think, Tony, you touched on this in some of your prepared remarks, but I might have missed on it. When we think about your 4 divisions, Canada and the U.S., production and drilling in each geography, what are the puts and takes that you're seeing on margin contribution right now? What were the ones that are really pulling the margins higher? And what are the ones that you still see some room for improvement?

[Anthony Michael Aulicino, Chief Financial Officer]

Yes. I'll start off, and we've been consistent in our previous calls talking about the fact that 3 of those 4 divisions continue to perform well, at or above that 15% margin threshold. We did -- the PureChem Canadian chemical production business still is lagging a little bit, but did pick up in Q1, which we were very impressed by. And we look forward to that continuing under Ken Zinger's leadership. The other part of the business that did show an improvement in margins was the U.S., and specifically, production chemicals in the U.S.

[Greg R. Colman]

So when I think about those different areas that were pulling things up, PureChem lagging but it did pick up, and then the U.S. specifically, what do you think was there -- or what was the larger contributor to the sequential margin improvement? Was it the Canadian PureChem or was it the U.S.?

[Anthony Michael Aulicino, Chief Financial Officer]

If I had to rank those, I would say it would probably be about 50% improvement in the U.S. due to an increase in the quality of the revenue that we incurred specifically out of production chemicals, a higher-margin business. And the balance would have been out of the improvement at PureChem.

[Greg R. Colman]

Do you see that trend continuing? I mean I know we're going in a breakup here so it's a little bit gnarly. We're probably going to get a bit of a check back in Q2. But absent that, do you see that margin profile trend continuing over the balance of the year?

[Anthony Michael Aulicino, Chief Financial Officer]

Well, I think you're bang on. Everybody knows that Q2 always is and we expect it to be softer from a seasonal perspective, especially when you combine that with the pressure that we're having in Canada. However, we have started seeing green shoots in production chemicals in Canada. And as I've said, we're really looking to ensure that those improvements are sustainable improvements. And as Tom mentioned, when we look at what Ken did in the very seasonal and cyclical drilling -- Canadian drilling operations, and if we can incorporate those practices into production chemicals in Canada by taking advantage of the people and the infrastructure we have and taking advantage of the expertise that we have in the U.S. with our production chemicals business there, we expect to mitigate the softness that we would otherwise see in Canada. And in the U.S., it's that same strategy. Where in the past, we have picked up significant levels of revenue for key customers, sometimes that revenue is a little bit lower margin for key customers because we will not refuse helping out our key customers with work requirements. However, as we saw in this last quarter, that type of work leads to higher-margin business. And that's what we're in the business of doing.

[Greg R. Colman]

The green shoots that you mentioned there, Tony, is that external green shoots in the sense that you're seeing demand pick up, which is something that you can't control and is -- it's [ dictated ] by the market? Or internal green shoots in the sense that the steps you're taking to increase the profitability of the division have further to go from here?

[Anthony Michael Aulicino, Chief Financial Officer]

It's the latter. It's a laser focus on the latter, on what we can do with what we have, the people and the infrastructure we have. Improvements in the external factors will just be gravy.

[Greg R. Colman]

Okay. Just moving over to the balance sheet for a second. We saw a small working capital release in Q1, which is good to see. Revenue did roll sequentially, so not too surprising to see that working capital come out there. What are your thoughts on additional release in working capital as you just try to increase that efficiency for Q2 and then over the balance of the year?

[Anthony Michael Aulicino, Chief Financial Officer]

I think in Q2, you may see a little bit of an increase. However, what you will see and what we are focusing on is maintaining cash conversion cycle days and individual receivable inventory and payables days around the level that we have now and potentially improving through the year.

[Greg R. Colman]

Why are we going to see an increase in Q2? It's typically, seasonally, a smaller period. Wouldn't we expect some of the Q1 receivables to come at you in Q2?

[Anthony Michael Aulicino, Chief Financial Officer]

It'll -- there'll be a little bit of a lag there.

[Greg R. Colman]

Okay. Fair enough. And then just lastly, on the U.S. side, on the customer mix side, when we're taking a look at capital budgets and progress out into later 2019, we're seeing a bit of a bifurcation of commentary from the E&Ps with larger IOCs looking to increase spending, put more rigs to use. But some of the smaller companies, the smaller public companies or mid-cap companies are focusing more on free cash flow and may not ramp spending. Can you give us some insights as to your customer base weighting, especially in the U.S., especially in the Permian? Is there a concern that any lift in spending could be at a customer group that's away from you or that you haven't historically been targeting?

[Thomas J. Simons, President, CEO & Director]

Greg, you've known the history of the business a long time. We built this business working for the bigger independents that are results focused, not process focused. But we are doing work at Shell and Exxon in Canada, and we think that can translate into work in the U.S. We're very conscious that the super majors may consolidate some of our customers. Things we've done to prepare for that possibility is that we got ISO certified in '15, '16. Our safety programs are satisfactory to those companies. Our customer mix is the bigger results-focused companies. But as the big super majors grow their share of the North American market, I think we've got a business here that can be on location for them, Greg, as they grow the pie or their part of the pie.

[Anthony Michael Aulicino, Chief Financial Officer]

Hey, Greg, just before we continue, I actually spoke too quickly when answering that delta in working capital from Q1 to Q2. Early on in the start of Q2, which is where we are, we were pretty flat. But when I look at where our numbers will be, you're absolutely right that Q2 will see a fairly significant reduction in working capital.

[Operator]

The next question comes from Aaron MacNeil with TD Securities.

[Aaron MacNeil, Analyst]

Tom, you mentioned in your prepared remarks that the plants weren't full. And so I guess aside from the barite facility, what would you say your effective utilization would be across some of your plants and infrastructure? Or maybe what you think you could increase throughput through some of your -- through your existing infrastructure would be today? And perhaps you could also mention, again, aside from the barite facility where future pinch points might be.

[Thomas J. Simons, President, CEO & Director]

Sure. I'll start with Kermit. That's our mud plant in the Delaware Basin. That plant was built to support 50 jobs. We were bumbling along at about 55 through Q4 as we completed or almost completed that expansion. We've got a little bit of work to do there now. We built that place, Aaron, that if enough people will hire us, we could run 100 jobs out of there without a mile-long line-up of trucks. So that's what we've done in terms of capability for growing that market. And we put about $5 million or $6 million into that expansion. In Kansas, the plant continues to run sort of 6:00 a.m. to 4:00 p.m. Lots of the kettles aren't even full when we run reactions. How that plant was built is that each reactor is its own ecosystem. It reduces the amount of waste that the plant generates because you don't need to wash the vessels to make different chemistry, so your retains go back into the next batch. I would put available throughput of that plant to be over 50%. Kettles aren't full. First thing would be to run bigger batches, and then the second thing would be to run a second shift. And the plant rarely works on weekends. It's 50 acres in size. We've got 2 rail lines in there, and we've got a 1/4 section of farmland around it. So we could double sales in the business before we probably need to put serious capital in that plant to expand it. In Vancouver, Monday to Friday, 8 to 5, same thing. If you can sell more product, just run an extra crew. You don't need to build more reactors.

[Aaron MacNeil, Analyst]

Okay. So fair to assume that this theme of generating free cash flow extends beyond 2019?

[Thomas J. Simons, President, CEO & Director]

I sure hope so. We spent a lot of money last year. And now we've got to fill these places. We've got to get these trucks that we bought to have fuller routes. I think that $40 million in capital towards rolling stock is probably a safe number for quite a while. We're going to have to maintain the ones we have. And if we get new work and it makes enough money, we'll put a new truck on the road. And then it's just the odd piece of infrastructure like a barite mill. For people that are familiar with the business, they'll know that a big way we win business is we solidify liquid chemistry on the production side. Or for frac to treat water, we can solidify biocides, scale inhibitors, paraffin dispersants. It allows you to get the chemistry into a place in the well that you can't circulate liquids. By automating manufacturing of that, we think we may be able to multiply throughput by almost 4x. So very little capital required. It's just taken years of work and some ingenuity to figure out how to do that. But we're going to be able to sell way more of that stuff, Aaron, and not be limited by manufacturing. And we're talking tens of thousands of dollars beyond what we've done to date to automate.

[Aaron MacNeil, Analyst]

Okay. And then maybe in the same vein of that question, for Tony, you obviously gave some fairly detailed guidance on capital allocation priorities for the year. But I guess longer term, can you share any specifics on what your debt reduction goals might be? And what sort of leverage ratios you're targeting before you'd start to reallocate that, call it, 80% of free cash flow in the year towards debt reduction towards other capital allocation priorities?

[Anthony Michael Aulicino, Chief Financial Officer]

Yes. I think we're going to revisit on the 80-20 plan that Tom outlined, depending on where our share price is and where our leverage level is. We would like to be in a position to pierce through into the low-2x level by mid to late next year.

[Aaron MacNeil, Analyst]

Okay. And then not to put you on the spot -- or, I guess, to put you on the spot. Is there a debt reduction target in 2019 you'd be comfortable throwing out?

[Anthony Michael Aulicino, Chief Financial Officer]

Not yet. We'd really like to see what happens in Q3 and Q4, especially in the U.S., as production levels pick up, egress issues get cleaned up with committed take-or-pay pipelines. I think we'll all have a better feel at that time.

[Operator]

[Operator Instructions] The next question comes from Mike Mazar with BMO Capital Markets.

[Michael Mazar, Equity Analyst of Oil and Gas Services]

Just kind of a quick housekeeping thing here. The effective tax rate was very high, the deferred tax. You mentioned derecognition of U.S. losses. Can you just give us a little more color on that? Was that just a matter of figuring out that you're never going to use those losses so they went away? Or is it a change in tax? What happened exactly?

[Anthony Michael Aulicino, Chief Financial Officer]

That's just a timing thing. That analysis is based on a forecast. In this case, it's a 2-year forecast. And there was a difference in the level of taxable earnings that we were forecasting in this forecast versus the last one. And that resulted in the derecognition. If you look back at the last 8 quarters, you will see us going back and forth on that. You shouldn't be surprised if you see us go the other way in the next couple of quarters as we roll forward our forecast.

[Michael Mazar, Equity Analyst of Oil and Gas Services]

Okay. So back to a little more reasonable rate, likely as we kind of look at Q2, Q3?

[Anthony Michael Aulicino, Chief Financial Officer]

Correct.

[Operator]

The next question comes from Matthew Weekes with Industrial Alliance Securities.

[Matthew Weekes, Analyst]

Just circling back a little bit to the margin improvement. You said about kind of 50% of that improvement in margin came from Canadian PureChem, roughly. I was just wondering if that was mostly due to the Grand Prairie facility being online or whether that was more revenue mix or some pricing gains there.

[Thomas J. Simons, President, CEO & Director]

I think you could attribute it to Grand Prairie being online. That's why I noted that our top 2 customers year-to-date are in that market. The Montney has paraffin in the condensate. As that condensate comes up the hole, it cools and comes out of solution and solidifies, plugging the well and creating shrinkage in the condensate. You don't get paid for the volume. That's a very technical problem to solve. We're successfully doing that. Those wells also have acid gas, so CO2 and H2S, which is highly corrosive. So as we've kind of become established in that market, it's changing revenue but importantly, bottom line for PureChem because their big-volume wells that take a technical solution. Treatment points aren't the only indicator for how we're doing in these chemical businesses. One multistage fracked horizontal could be like 100 old vertical wells. And you can imagine, it's better for the chemical company if your labor goes to one place instead of 100.

[Matthew Weekes, Analyst]

Okay. So given that trend then, would you say there's more improvement to come in the coming quarters as far as Canadian PureChem margins go?

[Thomas J. Simons, President, CEO & Director]

Yes. There is. But we'd caution people that this stuff doesn't change overnight. Back of the napkin, we think curtailment cost us $0.5 million of EBITDA on oil that was shut-in that we were previously treating. We need a change in politics here to unlock the value that's in this country for all of us. That will help. And if we don't have a change, we need to be relentless on the cost side of the business while being good enough on location to get the work.

[Operator]

This concludes the question-and-answer session. I would like to turn the conference back over to Tom Simons for any closing remarks.

[Thomas J. Simons, President, CEO & Director]

Sure. I'll thank listeners for their time today. I'm going to keep the outlook very succinct. We think 2019 probably looks like 2018 for us operationally as a company, with the U.S. up a little and Canada down a little. We'll look to continue to pay down the line using the approximately 80% of free cash flow to pay the line down and approximately 20% of free cash flow towards share buybacks. We will not raise the dividend, but we will maintain it as part of our commitment to return money to shareholders.With that, we'll conclude today's call.

[Operator]

This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.