CES Energy Solutions Corp

TSX:CEU

Earnings Call Transcript 2020-Q2

[Operator]

Thank you for standing by. This is the conference operator. Welcome to the CES Energy Solutions Corp. Second Quarter 2020 Conference Call. [Operator Instructions] and the conference is being recorded. [Operator Instructions] I would now like to turn the conference over to Tony Aulicino, CFO. Please go ahead.

[Anthony Michael Aulicino, Chief Financial Officer]

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 information, 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 13, 2020, and in our annual information form dated March 12, 2020. 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 second quarter MD&A. At this time, I'd like to turn it over to Tom Simons, our President and CEO.

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

Good morning. Thank you, Tony, and thank you to listeners for calling in to the second quarter CES call. On today's call, we'll provide listeners with an update of what actions we've taken within the business to ensure that the company survives COVID and muted energy demand. We'll talk about activity for the company in the different business lines in the quarter and probably more importantly, talk about how we're going to take the company through the balance of COVID, through the overhang of excess oil supply in the world and be positioned to be able to benefit shareholders, employees, customers in a recovery. That will be the focus of today's call. Basically, the philosophy we're taking to run the business, what that will look like economically for the business through COVID and how we're going to maximize upside on the other side of this. So I'll get into operations for the second quarter and activities to preserve the business's ability to get through COVID. The second quarter for CES, like all energy services providers, like most businesses in the world, saw sales volumes collapse. And unique to the oilfield is real-time pricing. So all service providers were required to provide discounts on work to customers that ran through the quarter, and that's how it's going to be for oilfield service providers, I would say, until oil breaches $50 or pretty close. In spite of lower volume and lower pricing, CES effectively broke even in Q2. We reported adjusted EBITDA of about CAD 8 million, CAD 6 million of that was payroll help from the federal government. So we think we've got the business at a point for cost structure where it can pay for itself at the very worst point of energy, which was Q2. We've done what's required to ensure the company survives COVID and muted demand: by converting receivables to cash. That's evidenced by us extinguishing our line and building a $40 million Canadian war chest over the summer. We've reduced operating costs by unfortunately needing to reduce headcount. We've reduced compensation for everyone that continues to work at the company, including Tony and I. We've reduced inventory and we've reduced CapEx. But we've done that while retaining what I'm calling our human capability, our culture, which is a sense of urgency, a sense of problem-solving. We're maintaining our physical assets so that we can ensure we benefit when energy demand grows as the world gets past COVID. Our strategy overall as a business is to get through COVID and preserve our ability to maximize the upside in the recovery. We need to preserve our human capacity and maintain our physical assets. We need to keep working on our relationships across with our customers. We're looking to add talent every day that could bring on work in the normal energy demand market. We're still focused on solving our customers' problems, and we're constantly looking to reduce our own cost structure as we see that's the common trend in any industry in the most successful businesses. Upon our recovery, we hope to have a smaller share count, a smaller bond and have the financial flexibility to be able to build working capital as required. We hope to have better pricing over our sales than we have today by making these discounts more transient for tracking artificially low oil prices. And we hope to have an increased market share in all the different verticals that we sell our chemicals into. I'll now get into the 4 main parts of the business, talk about how they did through the quarter, where they're going today and how we're going to take them through COVID and then what they would do in a recovery. I'll start with AES. It's our U.S. drilling fluid business. We averaged in the second quarter 51 jobs. We started to come down in March, like the whole global economy did. In April, we averaged 67, May was 48, we bottomed out in June at 39 and today, we're running 41 jobs. We've got a line of sight, 2 more rigs as oil has sort of stabilized in the low to mid-40s. What we need for AES to be able to print black numbers for the company and generate free cash flow is another 5 to 10 jobs, and it appears like those jobs will come with our expanding customer list through Q3. We expect those jobs to come from super majors and big independents that we've had long-standing relationships with. What we see for the U.S. drilling fluid market on the other side of COVID, less competition. We've got a major PE competitor that's in bankruptcy. We've seen one of the big integrateds wind down their mud business. And we've seen a couple of the big integrateds not allow their mud businesses to be loss leaders of bundled service offerings. They're making those business only take work if they can make cash, which later we think benefits AES and the people on this call. For U.S. production chemicals, business was down a lot in the quarter. We had a lot of shut-in production in the Rockies in Oklahoma and in Texas, and it continues to be very customer-specific. Most of the production we treated in the Permian is either back on or there's indications that it's coming back on, a little less so in the Rockies. So volume was down in the quarter and pricing was down. That business today has got enough production back on that it's able to make money for the business. But what will sort of turbocharge those results are when our operators go back to drilling new wells, completing them. The new flush production that the chemical companies treat are high volumes, it's technical work. So it's lucrative and not part of the sort of product mix of sales. The absence of that is going to mute financial results for all chemical companies in Canada or the U.S. until operators have a reason to bring new production on. We think we'll be better than we were before the crash because we've leaned out the business. We continue to invest in bringing in talented people that can get new business or solve outstanding problems. We've expanded our customer list through the crash and we're almost done building our tech center in Midland, which we think will give Bern and his team another tool to work for bigger companies and solve their problems and expand our business. We'll move on to Canadian operations. Canadian drilling fluids in Canada in Q2 averaged 7 jobs. I would say it's a result of 6 years of Ottawa standing on our chest and then the immediate collapse of oil and our customers' need to preserve cash and shut down operations. Today, we're running 17 drilling fluid jobs in Canada. We've got a strong market share position. The work we are doing is deep, it's long-reach or it's SAGD work. So it's technical. The volumes are higher, the margins are higher because the work is complex, but we needed to discount to our customers while we go through COVID, and oil is sub-50, with the understanding that you can revert to pre-COVID pricing as the operators get better pricing for their oil or condensate or gas. Our market in Canada though, through COVID, is becoming more competitive. We're seeing mom-and-pops looking to do work just to be able to move inventory and keep their business running. So that's going to be a drag on margins. We're going to need to continue to outperform. We're going to continue to need to bring new technical solutions that those mom-and-pops can't or the big shops, the integrateds that are not focused on Canada as a core market don't apply their best people to solving problems. I'll move on to PureChem now. That's our Canadian production chemical business. PureChem saw a lot of production shut-in in Q2, enough that again, the business was basically able across the board to break even. What we've had happen as productions come back on is volumes are increasing in sales to the point where we expect to be able to make money in PureChem in Canada even with the very low rig count for the industry. So much like Jacam Catalyst in the U.S. kind of being an anchor for the business. Even when drilling is down, completions are down. PureChem offers that to us in Canada. We just completed a SAGD trial, treating the production. That went very well. We believe we're going to be awarded business out of it. It's not material in dollar amounts, but it does give us sort of a flag on the board to try to penetrate more and more of that market. That market is huge for the chemical companies in Canada. As Keystone gets built out, as Trans Mountain gets built out, and the oil sands operators have a financial reason to grow their businesses, that's a part of the market that we need to be active in, and we're increasingly winning business there. Overall, how I would characterize PureChem is, from a year or 2 ago, better management is equaling better financial results while continuing to do a great job for the customer and treating our employees with respect and fairness. Before I turn it over to Tony for a financial update, what I would advise people is as we're looking at what to do with this cash war chest of $40 million, we're mindful that the share price is around $1, the bonds are around $0.90 and we're going to need about $0.30 on the dollar as we rebuild working capital and recovery. So we're going to weigh all of those things together as management and Board and try and maximize the value of that money. I believe we need 12 to 18 months of sort of operating costs, meaning covering our bond in our pocket, before we consider doing anything with money beyond that. And that will sort of be the goalpost that we'll use as we look at what to do with that money. Tony, I'll turn it over to you now.

[Anthony Michael Aulicino, Chief Financial Officer]

Thanks a lot, Tom. Our Q2 results demonstrate the company's financial resiliency and balance sheet strength in a very challenging economic environment. As Tom mentioned, the effects of COVID-19 had a drastic impact on our industry, global commodity prices, and greatly reduced demand into end markets that we service. In May, to address the deteriorating industry conditions, we announced our proactive approach with cash preservation and cost reduction initiatives as it relates to our dividend, NCIB activity, cash, CapEx spend and cost structure. We also provided the market with an expectation that we would harvest a significant amount of working capital and use the associated cash inflows to reduce leverage as we did during the last downturn in 2015 and '16. Our second quarter results demonstrate our strong execution of these strategies and initiatives, and I'm very happy to report, as Tom discussed as well, that our overall liquidity position and balance sheet strength actually improved significantly in the quarter as we once again displayed our defensible business model and countercyclical balance sheet during low points of the cycle. During the quarter, the net draw on our senior facility declined by $92.6 million from a net draw of $92.9 million at the end of Q1, to end at a net draw of $300,000 at the end of June driven primarily by strong free cash flow generation through working capital harvest and then continued inventory management and cost containment measures. CES exited the quarter with total debt of $328 million, representing a very significant reduction from $427 million at Q1, of which the majority of the company's $290 million principal outstanding on our 6.375 senior notes not due until October 21, 2024. Of note, subsequent to June 30, our discipline around working capital has continued to benefit us and resulted in material cash inflows through working capital harvest. And as we stand here today, we are sitting on a net cash balance of $40 million and 0 on our -- 0 drawn on our senior facility. Our focus on company-wide working capital optimization even before this, during 2019 and into 2020, and has positioned the company extremely well to maximize working capital cash inflows through the second quarter as activity levels declined. In the quarter, CES saw a working capital reduction -- a reduction in working capital surplus of $116 million. We continue to remain diligent and focused on strong AR collections, minimal bad debt expense and inventory management. We believe that this established focus on working capital optimization will allow us to further maximize free cash flow generation as industry conditions stabilize and eventually recover. During the quarter, CES generated approximately $159 million in revenue, down from $312.9 million in the second quarter of 2019. Revenue generated in the U.S. was $121.8 million, representing 76% of total revenue for the company; while Canadian revenue was $37.7 million. Both of these revenue results represented significant decreases over prior year comparative periods, which was primarily driven by unprecedented reduced activity across all business lines as the low-commodity price environment resulted in temporary production shut-ins, deferred completions and significant declines in drilling activity. Of note, both production and drilling fluids segments appeared to trough in the middle of the quarter. So during April of 2020 during the doldrums of the industry meltdown, that's when we experienced the worst results and the toughest conditions. However, we did see some stabilization begin in June, and that seems to have continued into July. For example, U.S. drilling fluids market share troughed at below 13% in April, but continue to climb with high-quality customers, and we currently are at approximately 17% market share. In light of the unprecedented industry conditions and associated initiatives we took to rightsize the business, we record the following nonrecurring items: a $1.2 million write-down of certain petroleum-based inventory products to net realizable value driven by the significant decline in the price of oil, resulting in an associated increase to cost of sales; a $1.5 million increase to bad debt allowances driven by isolated uncertainty around some collections; and a $1.3 million severance charge. Excluding these items, CES generated adjusted EBITDAC of $8.2 million in the quarter, down from $41.5 million in the second quarter of 2019. Included in these results is a $6.3 million benefit recognized from -- by CES from the Federal Government's Canada Emergency Wage Subsidy program, which has been instrumental in allowing CES to mitigate further Canadian personnel reductions during this downturn. Of note is the fact that the majority of our cost reduction measures that we announced in May really only became effective by the middle of the quarter, thereby resulting in a higher cost base in April and May in comparison to the estimated run rate of June and going forward. In May, we announced that in light of deteriorating industry conditions, we were eliminating all nonessential CapEx spend and reducing projected 2020 spend by approximately 40%, from $50 million to $30 million. In the second quarter, CapEx spend was only $5.1 million, bringing the year-to-date total to $17.4 million. And we believe we will be able to exit the year having spent less than $30 million. We continually monitor our capital allocation options in the context of market conditions, outlook and the levels of surplus free cash flow generation. In Q1 2020, we made a difficult yet calculated decision to reduce our dividend. And as industry conditions continue to worsen, we announced that our monthly dividend was suspended on April 16, 2020. This decision will conserve approximately $16 million in cash on an annualized basis. In Q1 2020, we spent $4.8 million under our NCIB program and repurchased 2.3 million shares while NCIB activity was suspended during the second quarter. We remain responsibly cautious on our outlook for 2020 and beyond in this low oil price environment. However, we came into this downturn from a position of strength, with an excellent first quarter and a very strong balance sheet and with a proven countercyclical leverage model in the second quarter. We will continue to assess bond repurchases and share buybacks in the context of our assessment of market conditions, certainty around our surplus free cash flow levels and market prices on our bonds and shares, as Tom alluded to. However, make no mistake about it. Our primary financial goals for this downturn continue to be the preservation of our strong balance sheet and optimization of our industry-leading operations and critical employee base to withstand the downturn and maximize our potential for when conditions improve. So at this point, operator, I'd like to turn it back over to you to open up the call to questions.

[Operator]

[Operator Instructions] There are currently no questions at this time. I will turn the call back over to Tom Simons for any closing comments.

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

Thank you, operator. To summarize our call, our intention on the other side of COVID is to solidly be the #1 drilling fluid provider in North America on land. That may mean #1 across the U.S. and Canada for market share, but what we really are targeting is #1 provider of technology, the best customer list, so the super majors, the big independents, the PEs that are drilling to sell. And we can achieve that by having the lowest cost structure, married to a culture that brings a sense of urgency, a sense of pride to location, faster drilling times and better execution on location and in well planning than our competitors. Our intention for North American chemicals is to be a very strong #3. We've got the ability to do reaction chemistry in Kansas and Vancouver by commodity chemicals, cook them, formulate those into intermediates and then blend them in definite products to be used to drill the frac, to stimulate, to treat production and pipelines, to treat tanks. We think off of the manufacturing base, we've got manufacturing capacity, logistics capacity and warehouses to double the business from where it's out on a trailing basis. So that's what we're looking to do with this business as COVID passes and energy demand normalizes. We think we've got the business today in a position where we can sustain our people, sustain their training, sustain their health, maintain our physical assets. And when our customers can get $50 for oil, they're going to go back to building their businesses. And they're going to hire services that are best-in-class, and we're going to be able to be that by having the people, by having maintained our assets. We're not going to get through COVID by selling things, by exiting business lines that we shouldn't have been in the first place. We didn't make any of our business lines loss leaders. We get into businesses to make 15% EBITDA and turn inventory fast enough to generate free cash flow. If we need to make further adjustments in the business to be able to at least break even in the business, we'll do that. But we think we've got the business in a place now where it can sustain itself, not consume that $40 million of cash for operations, but use it to sustain good value in the bond and maybe create value by buying bonds or shares. We're close to our customers. We're going to have the same sense as everyone on the call when things may normalize, and that's when we can all move around again. So from now to then, we're going to run this business prudently and let everyone benefit through it in a recovery.With that, I want to thank our employees -- for trying times and sticking with us. And really want to thank our customers for keeping us on location through this. And I will talk to everyone on the next call. Thank you.

[Operator]

Pardon me. There is actually one questioner now. We have a question from Matthew Weekes of Industrial Alliance Securities.

[Matthew Weekes, Equity Research Associate]

Sorry it's a bit late joining the queue.

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

It's good. We're happy to have a question.

[Matthew Weekes, Equity Research Associate]

Yes. No problem. I just -- I wanted to ask first about margins. So you kind of -- you mentioned that cost-cutting started to happen a little bit later in the quarter. So going forward, and considering you're still expecting to see some pricing pressure and activity levels in Canada and the States remain pretty depressed at this point, are you expecting the margin, say, in Q3 and Q4, to be an improvement from Q2 when you account for the Canada wage benefit?

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

I think, Matthew, for us, and probably all service providers, margins are going to be really tight. Every time you talk to the customer, they're looking for a price concession. So the point to the question is understood. We had costs happening in Q2 that will have went way, but I wouldn't expect to see margins getting better. If anything, they might get a little worse. What will improve margins is higher oil prices, meaning that the COVID discounts will either go away or be reduced. And that's what it's going to take to actually change things.

[Matthew Weekes, Equity Research Associate]

Okay. And being almost a couple of months through the third quarter right now. In terms of the Canada wage benefit, and you mentioned that the government is extending it to the end of the year, it's something that you're applying for at this point and expect to receive. Do you have line of sight to what that's going to look like going forward? Do you expect that you will see the similar benefit kind of going through forward to the end of the year as you did in Q2?

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

Tony, could you take this one?

[Anthony Michael Aulicino, Chief Financial Officer]

Yes, for sure. So we try being very transparent. And you have a number of Canadian employees as we have in our AIF. So you can actually sort of do the calculations, which some have done. So to answer your question directly, the contribution that we're expecting from that program in Q3 will be a little bit lower than the $6.3 million that we realized, probably somewhere in that a $5 million-ish range. And we're still waiting for some of the rules to be ironed out for Q4. But we'd expect based on what we see right now, that contribution to be somewhere between $1.5 million and $2 million.

[Matthew Weekes, Equity Research Associate]

Okay. That's helpful. Switching over to capital allocation a little bit. And I just want to make sure that I kind of understand this and maybe clarify some of the things that were said earlier on the call about bonds and that. Is sort of your focus right now as far, as the war chest and liquidity you have, as I understand it, I guess the top priority would be funding current operations. Number two, would you say is growth initiatives? And number three, kind of buybacks, looking at the shares and looking at the bonds. Once you've kind of looked at the growth first with the opportunities you've got out there, would that be kind of the correct order of capital allocation?

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

I would say we don't need to deploy capital to chase growth. We just need people to bring production back on oil prices to go up. And that growth will be organic with people we already work for. We don't need more physical assets to grow. So we don't have to risk capital on that. It would be our judgment on how much cash do we want in the tail to sort of be able to pay the bond and know that we've got good liquidity in muted demand for our service because the world is using less oil. So 12 to 18 months of kind of money in our pocket seems, I think, responsible to me. And what we would have above and beyond that, we might put the work either on shares or inventory. Those are the 3 places that we'll spend the money. We're not going to buy our competition out of bad markets. We're not going to help private equity get off an investment they need to monetize. If anything, we can just spend on ourselves. But what we don't need to do is spend money on capital, to be clear.

[Operator]

The next question is from Aaron MacNeil of TD Securities.

[Aaron MacNeil, Equity Research Analyst]

Tom, you kind of touched on it a bit, but I think it was last quarter that you talked about maybe strategic hires, instead of deploying capital or rescuing private equity, as you say. But I guess I'm wondering if you took a survey of your competitors over the last quarter, obviously, there's people cutting costs in people. But do you see an opportunity to start hiring good people from some of your competitors? And have you made any progress on that front yet? I assume not just with COVID distancing restrictions, but figured I'd ask.

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

Yes. That's a good question, Aaron. We picked up a good frac person for Canada. There's no frac market to sell to today, but there will be one day. We're poking around constantly. I mean we're all -- I call us working managers. The next time the oil field can come up with a social event, so service people can hang around with operators, we'll all be there ourselves. And we're trying to get the word out that we're looking for good people. So we'll have picked up a few people through this. And -- but nothing that moves the needle today, nothing that puts us in a new business line. It's not dilutive, though. It's not like M&A. So yes, we're just -- I'd say, steady state for that, Aaron.

[Aaron MacNeil, Equity Research Analyst]

Okay. Perfect.

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

Maybe the answer that's of value for listeners is that our focus is on running the business, not on doing M&A or rolling people up because prices are down. We're going to put our head down, stay close to the customer, keep as many people as humanly possible in the company so that later, the customer can put all of us back to work.

[Operator]

The next question is from John Bereznicki of Canaccord.

[John Mark Bereznicki, Analyst of Oil and Gas]

Apologies, I guess we're all a little slow on the phone this morning. But a couple of quick ones for you here. Just circling back on U.S. specialty chemical, interesting dynamic where the treatment points really were relatively resilient yet revenues, obviously, were off a bit more than that. Just wondering if you could talk a bit about the dynamic between pricing, chemical intensity, maybe revenue mix and maybe what's behind that?

[Anthony Michael Aulicino, Chief Financial Officer]

I can start off with just level setting on exactly how that metric works and the fact that it's not a perfect metric, especially in volatile periods like we're in right now, and Tom can definitely speak better to the pricing and customer dynamics. So to be crystal clear, treatment points is the measure of the number of wells that are treated in any given month. So for example, if we go out and treat that specific well 3x in a month, it counts as a single treatment point. We had a very strange dynamic during the quarter, particularly in the middle of the quarter, where we had a bunch of customers that decided to shut in wells in early to mid-May after we treated those wells at least once. So they shut them in during that month and they would stay shut in through the month. And in many cases, in June, they brought them back on. So if you were to look at the number of wells that we treated, it would have been the same as it would have been in previous period. Although the number of times that we visited that well would have been lower, thereby, the amount of volume or -- that we delivered to that well would have been lower than in previous periods. So that should help you understand the fact that the decline in the treatment point figure, specifically for the U.S., was not as pronounced as you would have expected to see it given the lower overall production levels, and thereby delivery of production chemical volumes by our company.And Tom could probably speak to the pricing dynamic that was being experienced during that period.

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

Yes. There'd hardly be a drop of product that went out the door, John, that didn't have a discount applied to it through April, May, June. And we're starting to, just in little ways, unwind some of those discounts as oils went up. But our customers were on a mathematical path to bankruptcy. So were we -- so as everyone when those transactions, call it, were happening, so we were watching storage because if it had filled, I think it could have been a blood bath for the industry. We all dodged that bullet. And we're not selling stuff at a loss, but we're also prepared to make a lot less to stick with the customer that when oil is 50, we get to charge more and they go back to building their business. So margins are going to be weak, while oil sells at 50 for us anyways.

[John Mark Bereznicki, Analyst of Oil and Gas]

Got it. That's great color. I appreciate it. And it kind of leads to my next question. In Canada, you obviously have a good vantage point across the basin. Kind of what's your sense of where shut-in peaked and kind of where we've moved forward today on a kind of a play-by-play basis?

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

I'm pausing, John, because I'm -- I think Canada was off 1 million barrels, and the U.S. might have been off 3. And maybe half of that's back in Canada, and 2/3 is back in the U.S. What happens in these times is everyone tries to use a little less product. And obviously, when they're shut-in, they're using none. So there's a lot of variables. We think probably by September, anything that's going to come back on, I would think, is probably back on, John.

[Operator]

There are no more questions at this time. I'll turn the call back over to Tom Simons.

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

Okay. Well, I'll sort of quickly repeat the summary. We're running the business for the mid- to long term. That means we hope to keep as many of our talented people as we can. So we may leave a few pennies on the table for what we could do for EBITDAC through COVID. But we think that we benefit many times over on the other side of this because our chemicals don't make themselves, they don't apply themselves in the field, they don't mix themselves on the rig. We need people to do all of that stuff and make a market for our products. So we need our people in a recovery. And we've got the business at a point where it won't lose at this headcount. And with even a slight bump in upstream activity, we can make a little bit of money as a business. Our production businesses, as production is getting turned back on, are back to being very steady and reliable, albeit at lower pricing. So listeners can expect us to protect our people, run the business for the recovery and maintain a strong financial position.And with that, we'll conclude the call.

[Operator]

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