CES Energy Solutions Corp

TSX:CEU

Earnings Call Transcript 2018-Q2

[Operator]

Thank you for standing by. This is the conference operator. Welcome to the CES Energy Solutions Corp. Second Quarter 2018 Results Conference Call and Webcast. [Operator Instructions] And the conference is being recorded. [Operator Instructions]I would now like to turn the conference over to Craig Nieboer, Chief Financial Officer. Please go ahead.

[Craig Frederick Nieboer, Chief Financial Officer]

Thank you. And good morning, everyone, and thanks 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 second quarter MD&A and press release dated August 9, 2018, and in our annual information form dated March 1, 2018.In addition, certain financial measures that we will refer to today are not recognized under current generally accepted accounting policies. And for a description and definition of these, please see our second quarter MD&A.At this time, I'd like to turn it over to Tom, our President and CEO.

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

Good morning, and welcome to the CES Q2 Earnings Call. On today's call, we'll provide a detailed update on operations, a thorough financial update, we'll share our outlook for our industry and for our business, we'll take questions, we'll provide a brief summary and conclude the call.I'll start the call by talking to 2 things. One, I'd like to speak to the announcement of Craig's retirement from the business and also talk about margins.I'm going to start, Craig, by saying it's been a great ride together. And I think you can be very proud of what you helped build here. Like I committed to Jim and Gene when they retired from the business, we got this. And we're going to honor what you helped build by taking it to the next level. I want to personally acknowledge that you've made me way better as a manager and as a man. You brought financial sophistication to our business, and I'm personally grateful for spending 10 years with you running this business. So thanks, Niebs.

[Craig Frederick Nieboer, Chief Financial Officer]

Thanks, Tom.

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

I'll move on to margins. So we want to talk about margins because we're very pleased with the quarter, and we know that there's quite a bit of concern coming out of Q2 -- or out of Q1 about margins.The U.S. and Canada both made solid contributions in the quarter. The U.S. generated $201 million in revenue, which is a record ever in a quarter. Canada contributed almost $83 million, which is a record in our long history in Canada for second quarter. Very importantly, I'd like to note that bottom line results as a percentage across the company improved each month in the quarter. This is owing to some very modest price increases on certain products and accounts as the quarter progressed. It's also owing to growing volumes over the quarter. We feel confident that we can continue to make good EBITDA percentage as we complete our infrastructure expansions in the Permian and in Grand Prairie, Alberta. I'll give some granular color on margins throughout our business.CES is primarily 4 business lines: Canadian drilling fluids, Canadian production chemicals, U.S. drilling fluids and U.S. production and specialty chemicals.The Canadian production chemical business, for us, PureChem, was a green shoots, new upstart business that we started 9 years ago. We're still in build-out mode, meaning, we expect over the next couple of years to see meaningful EBITDA percentage expansion as we increase sales and volume over a stable fixed cost base. As the new kid on the block over the last 10 years in basically a duopoly, so Baker and Nalco treat most of the production in Canada, PureChem's won business through a combination of needing to be better and cost the same or less as the 2 big incumbents. And we've taken work away by doing those things. We've taken it from large established companies. As we add additional scale to PureChem, we expect good increasing results for shareholders. Today, PureChem is our lowest EBITDA percent of our main business lines. We're very committed to PureChem. That's why we're building our Grand Prairie facility. As that improves, our overall EBITDA percentage as a company has room to improve.I chose to speak to margins at the beginning of the call because we understand concern exists after Q1 '18 showed revenue growth but EBITDA percentage fall slightly. While our business remains highly competitive, we remain confident that our unique business model can generate solid EBITDA percentage and very significant free cash flow over the full cycle. Our model remains decentralized sales and service, shared manufacturing labs, logistics and professional services platform.I'll now start with the operations update, and I'll begin with Canadian drilling fluids. Through Q2, we ran an average of 39 jobs and made money. Today, we have 82 drilling fluid jobs running. We continue to be dominant in all the deep plays. Our unique ability to run brine-based fluids, which accelerate penetration rates in certain geology, is owing to our ability to control corrosion far better than competitors. We believe we have the leading SAGD drilling fluid technology, and our strong market share reflects that. Our manufacturing and Canadian infrastructure gives us a significant edge in the oil-based drilling fluid market. We crush our own weight material, which is barite. We make our own viscosifiers, organophilic clay. We make our own emulsifiers and oil-wetters and lost circulation materials.Being vertically integrated creates superior technology and creates margin. There's no middlemen to steal the margin or resell your innovations. Our outlook for Canadian drilling fluids remains strong regarding our market position but modest for overall drilling fluid activity -- or drilling activity in Canada. Catalysts could include LNG or heavy oil takeaway finally getting built. We also have a strong order book in Canada for our new HDD drilling fluid technology. The work looks to start in the fall. So that's around pipeline construction.At PureChem, Treatment Points are heading up, as are overall sales. We continue to make great headway in conventional production across the basin, and we built a great team for the deeper horizontal market, which is paying off for us. It's why we built our facility for blending and storage, which includes rail in Grand Prairie. That market is the next big leg up for PureChem, big volumes of production to treat, complex downhole problems to solve, a big and growing market that we believe we can build a meaningful position in.We also continue to chip away at heavy oil, the SAGD market for treating. We believe operators want more than 2 reliable and competent chemical suppliers. The market is huge, and we have our foot in the door. Over time, this can become a meaningful part of PureChem's sales.Our Grand Prairie facility will open in late Q3. It will help us, we believe, generate top line and lower cost of goods. Over time, we feel PureChem can be a major contributor to our overall results. We've built the team, the products, the infrastructure, which include 2 blending facilities, world-class problem-solving lab in Calgary, a very significant lab in Carlisle. This part of the company is on the come and can drive bottom line results higher in time.Now we need to do what we're the best in town at: sell product. At Clear, our environmental group in Canada, they continue to generate positive EBITDA on an annual basis. Q2 was very quiet for Clear because of wet conditions in the field. But Clear operates with a highly variable cost base, so when things are quiet, they kind of lock down the hatches and then come back to work when you can get out in the fields. Clear is also becoming more active in water management for fracs, which we believe can help boost Clear's contribution over time.At Sialco, which is our reaction plant in Delta, British Columbia, it contributed positive EBITDA in Q2 and is really starting to get traction for internal supply and innovation. The rest of 2018 looks good at Sialco.StimWrx is our Canadian stimulation, or workover, group. They had a good quarter, continue to win new business, and they've expanded into the Rockies, treating over 200 wells.I'll now move on to the U.S. At AES, which is our U.S. drilling fluid business, we averaged approximately 120 jobs through Q2. Today, we're running between 120 and 123, depending on rig moves. We're happy to report that we were able to secure a long extension on the contract with our largest customer for drilling fluids in the U.S. This base fluid business is powerful for us as it allows us to use those wells as offsets to get work at offsetting operators, and it helps drive volume needed as a manufacturer. In AES today, we've got 76 jobs running in the Permian, 12 running in Mid-Con, 17 in South Texas and the Gulf Coast. We've got 14 in the Northeast and 3 in the Rockies.Our Kermit, Texas, expansion will allow us to take new work in the Permian, particularly the Delaware, and win back some of the operating leverage. I can report that the mud plant has doubled its capacity to 12,400 barrels and will go live actually this weekend. We're working on defining the scope of the rail sighting with the railway company and expect the completion of that would be in December.We expect completion of handling bulk barite in mid-October. Tanks arrive next week to build a diesel tank farm that we'll share with one of our largest customers, and we've got a warehouse going into Midland to handle returns of sacks that will be complete in September. These are all in anticipation of expanding our part of the business and then retaining the work that we have there already.For the balance of the year at AES, we expect to hold our market position in the year but also continue to fight for new business. We're remaining disciplined and taking new business where the operator allows our technology and service to drive better results and not just be on location because of lowest line item pricing to create value. We know how to make money in this segment, and we're going to remain focused and disciplined.In U.S. production chemicals, Jacam Catalyst had a great Q2. Permian's leading the charge, but the Rockies is also coming on strong. We're seeing gains in market share in both markets, and we're being able to recruit high-end talent that in time can bring work. As production rises for our customers in those markets, we think we can get a bigger piece of a growing market. We've purchased land adjacent to our Permian blending facility to allow for expansion there, which will require modest CapEx. The plant has lots of room left to make product, but we need more room for inventory and rolling stock for delivery trucks.I can report that we're working to automate our solid chemistry manufacturing in Kansas. This will allow us to increase throughput and elevate safety for our workers. Our frac polymer initiative is going slowly. We've perfected making the molecule and now remain focused on doing trials in brine water with our FR. I'll advise that we're choosing to exhibit discipline in the frac market. Margins for products have been crushed during the industry collapse. I believe this will be a long process as we don't work for free, and we don't work for practice.We continue to hold the view that this market holds good upside for us. Fracs have got dummied down to water, a little bit of FR and a lot of sand. As better chemistry becomes affordable again in the eyes of the customer, we expect science to prevail and formation damage to be addressed through chemistry. These are the same products or chemistry that we make in our reactors that we already have. It's the same chemistry that treats the well when it produces to prevent corrosion, scale. You don't want to create H2S in the zone by fracking water into the zone that was -- or bacteria in the water into the zone. We can treat for emulsions, for water-wetting sensitive clays. We continue to sell into frac, but we haven't had the big breakthrough that we all want. I can commit that we'll remain disciplined and take a technical but practical approach to building out this market. We do believe that there's operating leverage for sales in that market because it can happen off our existing infrastructure in manufacturing.I'll touch on the Permian before I turn it over to Craig. We expect customers to continue to live within cash flow. I'm personally excited to see takeaway projects being sanctioned and starting construction. Up to 3 million barrels a day of additional takeaway is being contemplated or built in the Permian. In the fullness of time, this emboldens our view of this market. To fill those new pipelines, upstream activity will be strong and, I believe, fairly continuous. And our position as a local production chemical company with world-class capabilities bodes well for our future there. Our biggest Permian customers are growing through the drill bit and through consolidation. So we believe, in time, as production rises in that market, we can benefit by being at the rig and at the well header pump jack in that market.I'll now turn it over to Craig.

[Craig Frederick Nieboer, Chief Financial Officer]

Thanks, Tom. And as Tom noted at the beginning of his presentation, Q2 results reflect a very impressive financial performance for the business: A record revenue Q2 for the company of $284.3 million, up 20% over Q2 2017 of $237.6 million; a record revenue quarter for our U.S. business, and not just for Q2 but for -- a record revenue quarter for all time of $201.5 million, an increase of 24% over Q2 2017 of $163 million; also a record revenue Q2 for our Canadian business of $82.8 million, which is an 11% increase over Q2 2017 of $74.6 million.For fear of sounding like a broken record, these impressive record revenue results are reflective of our growing business across North America and has translated into a record Q2 EBITDAC print for CES of $37.5 million versus $34.9 million in Q2 2017.Reflective of our very positive business outlook during Q2, we also doubled our monthly dividend to $0.005 per month and announced the implementation of a normal course issuer bid.Subsequent to the quarter end, the normal course issuer bid was started, and we have bought over -- just over 1% of our outstanding float already. Specifically, to date, we've purchased 2.7 million shares at an average price of $4.57 a share for a cash outflow of $212.4 million.Our balance sheet remains in great shape with over $300 million of unsecured notes termed out to 2024 and ample liquidity under our senior operating facility.At this time, I'll just indulge myself by just saying a few words about my departure. It's been a fantastic ride, 10 years. Amazing people. This company's culture is second to none, which is why it will always thrive and survive and do very well in the business. People might question why this would be a time that someone like myself would look to exit the business. I think, at the end of the day, there's no better time to leave this business. It's in its best shape it's ever been financially with the most opportunity in front of it that it's ever had. And I've had a great time helping build this business. But it's time for me to take on new challenges in my life. I want to thank Tom and the Board of Directors and all the fantastic employees that I've worked with over the last 10 years.So at this time, we'll turn it over to questions.

[Operator]

[Operator Instructions] Our first question comes from Greg Colman of National Bank Financial.

[Greg R. Colman]

Craig, just wanted to say you'll be missed. It's been a great run. I've got 2 questions, first on margin and then on Permian takeaway capacity. On the margins, I'd like to discuss your capacity growth, not the takeaway capacity but CES' capacity growth in the Permian. When do you think, from a timing perspective, we could see the next leg up in operating leverage in the Southern U.S. from your supply standpoint as you expand the facilities that you were discussing, Tom? And in the meantime, while you are going through those capacity upgrades, would it be reasonable to expect some modest margin pressure? Or am I reading that wrong and we're still looking at sort of unchecked -- like not aggressive margin growth, but still these margins shifting higher even through the expansion period.

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

It's a chicken and egg thing, Greg. We've got to complete the expansion. And then, unlike equipment companies, just because you have it doesn't mean it's going to work. So we've got to go make a market for our products, but we're not going to leave operating leverage on the table like we have been down there, particularly for drilling fluids initially. We'll start to, with the same job count, put a little bit more money to the bottom line, inch-by-inch, effectively, this weekend when that mud plant gets -- when the doubling at the mud plant is live this weekend. So it will happen over the balance of the year for drilling. And around production treating, it hasn't really compressed anything yet, but it's very tight in our facility in Gardendale. And Vern and his people don't take work that they're not very confident they can keep by doing a great job. So I think maybe you double down on being aggressive to go after new work. We bought the land surrounding Catalyst's facility. We've already built an office building, already expanded the lab 2 times there in 2 years. So I think it's just a slow march up on production treating in the market. There's probably more torque on the drilling side, and watch for updates on job count and Treatment Points. And hopefully, we're dragging along more money with it.

[Greg R. Colman]

That makes sense. Okay, we'll watch that -- watch for that closely. And then just on the basin-wide takeaway capacity. Mentioning the 3 million barrels a day of potential projects coming in, we're all following that very closely. I'm just wondering what you're hearing in terms of timing from a project start to a project completion on that takeaway capacity. When do you think the relief valve is available to be opened?

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

Oh, probably in fits and starts over a couple of years, and maybe the first stub's 18 months out. I mean, we're not in that business, but we talk to our customers and ask them all the time, are you going to lower your rig count? Or are you going to hold it, and why? Every customer of any size says the same thing, that they have seen this coming, and they have managed takeaway for their oil and gas. They think it's the smaller guys that can't commit on volumes or private equity companies that aren't sure how much they are going to grow production before they sell it. So a lot of our customers claim to have workarounds and may not get a lot busier but indicate they don't expect to get quieter, either. My personal view is this just delays the market thinking the Permian's flooding North America. And if they just keep running the 500 rigs they have there, it's pretty good for us. And I don't know if the industry there could have delivered much more drilling anyways because you can't get anyone to drive a truck. I was there last week. It's flat out and tight. And to contrast that to Canada, as we all know, that delay is going to be measured in months in the United States versus years and decades in Canada.

[Operator]

[Operator Instructions] Our next question comes from Tim Monachello of AltaCorp Capital.

[Tim Monachello, Analyst of Institutional Equity Research]

Congratulations, Craig. It's exciting. And my questions just have to do with pricing. You talked about extending the contract with your largest customer in the U.S. drilling fluids. Did that come with any pricing escalation? And what are you seeing for pricing generally in the specialty chemicals business in the States? I know that Ecolabs, on their second quarter call, said that they've been having some success passing out pricing increases to their customers.

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

Yes, we're -- new business that we're winning in production or specialty chemicals, the market's a little different than it was 2 years ago, so you go in maybe a snick higher than you would have 18 months ago. That business is accretive to our bottom line percentage, I'd call it, already. And so any wins above that are positives. On our drilling fluid extension with our largest customer, we were able to get increases on products that we could show we needed it and on some products that have really delivered some great sort of problem solving attributes. We've had some good success in the Eagle Ford managing losses to the hole. We've had some good results in the Delaware with some technology, same concept. It's working great. How fast can you make more of it, and what it's going to cost. So a combination of innovation and showing you need the increase. And with that contract extension, every 6 months, we can go in and ask for a look at certain products if there's been input cost increases. So if tariffs in the States hit input costs, then you go in with your hat in your hand and you point to the facts. And we feel confident that people will be fair on that. I'll note that we made some significant sort of investments in working capital to drive cost of goods down, which people can expect to contribute through the balance of the year, and also to get in front of, possibly, some of these tariffs. We bought $11.4 million of barite ore to crush. We're ordinarily buying those, but we accelerated the timing a little bit. In Canada, we bought $6.5 million of base oil, so distillate, to make oil-based mud out of and some products to get better pricing, knowing that we're going to put those products in the ground this fall. And then we spent $12.4 million on NCIB. So we've spent some money in the last 60 or 90 days, but it's reducing dilution and it's creating margin. And it turns into a receivable and then cash, in time.

[Tim Monachello, Analyst of Institutional Equity Research]

Okay. Yes, that's helpful. Has your outlook for the trajectory of your margins through the back half of the year changed at all from what you know today versus what you knew sort of at the time of the first quarter conference call?

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

Well, I never thought we were in trouble in the first quarter. My back of the napkin math was, as recently as December, we had 15 rigs that customers planned to run on deep wells in Canada that they canceled. If those rigs work 60 days, you run out $10,000 or $15,000 a day of higher-margin product because the systems are complex. We were over 15% with that contribution if it didn't go away in that quarter. So I knew that all the businesses were on good footing. What we couldn't predict is when the customer would be in a mind frame where you could get some increases. But we've seen big competitors trying to get increases. You mentioned Ecolabs. Hal is not trying to use mud at the moment as a loss leader to get work from other service lines. They want to make money off the market share they bought with cheap pricing in the crash. So people should not expect us to go up a point or 2 every quarter. This isn't going to be a hockey stick. But the bottom line percentage, we're all over it. The trick is to be in the weeds and in the details and get increases on stuff that you're going to be successful getting them on for a variety of reasons, and then keep the business lean and mean.

[Tim Monachello, Analyst of Institutional Equity Research]

Okay. Great. And then my last question here, just on PureChem and the trajectory of that business. Could you quantify at all what you think your market share is today? And the growth, potentially, that you see maybe over the next year?

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

We think in conventional, we're 10% to 20% of the market, maybe teens. And in the deep market, it would be single digits, maybe low. And in heavy oil, we're barely scratching the surface. I don't know what discounting did to the number, but CAPP, 3 years ago, promoted the idea that the oil sands spends $800 million a year on chemistry. So that's obviously the 1,000-pound gorilla we want to get in on. And 2 companies, basically, divide that market. So the next leg up for winning business for PureChem, we think we're #3 by a long ways in Canada. But to #1 and #2, they've got the gravy. They've got the deep work and the heavy oil market. It's more complex. It takes more problems. Our strategy all along is show them that we're competent on the conventional stuff to get a chance on the complex stuff. And we think that's coming, and coming soon, because we're getting the people that can do the work. And to me, that's an indicator that people go where they can have success personally and professionally. And we're getting the people for those kinds of markets now. It's why we put a stake in the ground in Grand Prairie. And if LNG happens, that won't just be a boon to our drilling business. In time, it will be the same for PureChem.

[Operator]

[Operator Instructions] Our next question comes from Mike Bowcott of TD.

[Michael Bowcott]

I'm wondering if you can just clarify the normal course issuer bid that was just approved and the dividend policy. I'm just trying to get a sense as to what the priority is here. And, obviously, I know that you had a higher dividend at one point and cut it down. You just doubled it, which, maybe it's to $0.06. But I'm just trying to get an understanding of what your priority is, what you're going to be doing here going forward.

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

Over the next handful of years, Mike, we'd like to use the free cash flow that comes from the production treating part of the business to be able to cover bond debt and cover the dividend, which makes it sustainable in a crash. When we raised it 11x in the past, most of that was coming out of our upstream chemical businesses, which is why we had to cut it in half and then almost eliminate it in the crash. So we learned that we want to fund that out of the part of the business that is more robust in a down market. Unless you shut a well in, you're still treating it forever. You -- what we did learn in the crash is you had to discount that work to keep it because of the severity of the crash. So our view on the dividend is to keep it modest, to maybe look at it once a year and make sure that we're paying it out of free cash flow. I'll maybe ask Craig to talk to the NCIB.

[Craig Frederick Nieboer, Chief Financial Officer]

I mean, I think where we're at is that based particularly at the current share price, we felt the best use of current free cash flow was to focus on the NCIB. I think we came out of the gate and bought 1% back of the shares in under a month. We've signaled to guys that it's a 10% potential buyback, but we're probably looking more at, on an annual basis, at least trying to absorb the stock-based comp dilution that we have, which is round 1.5% to 2% a year, and then opportunistically look at times like this where we feel the shares are significantly undervalued and we have free cash flow. So I think it's going to be a balanced approach going forward. Obviously, those decisions get made at points in time. I think the dividend is going to be modestly increased over time, and the NCIB will be something that is going to be turned up and turned down based on market conditions and based on cash flow.

[Michael Bowcott]

I'm just trying to get a better understanding of this, because I look at it, and I look at the insider trading, and I see more insider selling. Then I look and you're, obviously, buying it back to offset your stock-based compensation. But it just seems to be a bit of a disconnect here, and I really struggle with this on a go-forward basis as to what the priorities -- where the better use of capital is, whether it's the dividend or some other...

[Craig Frederick Nieboer, Chief Financial Officer]

Well, I mean, the best use of capital is what we do, which is focus on growing the business. So our first use of capital is funding our expansion CapEx, which has been our entire history. So unlike 90% of the oilfield services companies that you might invest in that raise capital to expand their business, we have funded all growth CapEx internally. The only capital we've ever raised in the market is to do significant M&As. We've also funded most small M&A out of cash flow. So the priority has always been grow the business, make it more profitable, and we're continuing down that path. The next priority, obviously, is manage your debt load, which we think we've done a good job of through all the cycles. And, obviously, if you have debt, you've got to pay your interest. Now we're talking about free cash flow beyond that, which very few companies in the oilfield have ever got, even if they are buying back shares over the long-term cycle. So now what we're talking about is whether you're depositing that free cash flow back to shareholders in the form of dividend or back to shareholders in the form of share count reduction. And at this current stock price, I'm repeating myself, our view is the best return to shareholders is to buy back these cheap shares.

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

Yes. My view on it, Mike, is 5% or 6% CapEx, that's been our historical. That will come out of free cash flow, allow us to keep growing the business, get the dividend up over time but at a sustainable level, use free cash flow to buy shares depending on the value in the market, but we do want to buy a set-off to stock-based comp. And then remaining free cash flow, we'll strengthen the balance sheet by paying down the line.

[Operator]

[Operator Instructions] We currently have no questioners in the queue. I would like to turn the conference back over to Mr. Simons for any closing remarks.

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

To summarize, as I just sort of ran through with Mike, we aim to strengthen the balance sheet in the business, build on a sustainable dividend. We want to retain our culture. We have 200 drilling fluid jobs running in the company today. Production chemical, Treatment Points are growing. We've had some very modest but important price improvements. Wells in the industry continue to get deeper and longer. Fracs continue to get better. I believe, in time, in certain geology, operators will start looking at formation damage again, and that'll open the door for us to have the breakthrough we want in frac. Production from new horizontals gets bigger and bigger with these other advancements, which means that there's more production chemical required to treat that production. When we blend this all together, we feel like the business is on excellent footing. We look forward to the balance of 2018 being very strong for the company.I'm going to conclude by saying, Craig, it's been awesome, buddy. We're going to keep this going. You're going to be proud of us. To callers, thank you for your time today.

[Operator]

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