CES Energy Solutions Corp

TSX:CEU

Earnings Call Transcript 2017-Q4

[Operator]

Good morning, ladies and gentlemen. Welcome to the CES Energy Solutions Corp. Conference Call and Webcast with respect to the recently announced results for the fourth quarter ended December 31, 2017. Presenting for the company today will be Mr. Tom Simons, President and Chief Executive Officer; and Mr. Craig Nieboer, Chief Financial Officer. Please be advised that this call is being recorded. [Operator Instructions] Please also be advised that this conference call may not be recorded or rebroadcast without the consent of CES Energy Solutions. I would now like to turn the conference call over to Mr. Craig Nieboer. Please go ahead, Mr. Nieboer.

[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 fourth quarter MD&A and press release dated March 1, 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 description and definition of these, please see our fourth 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]

Well, good morning. Thank you, Craig. So thank you to listeners for joining us today from snowy Calgary. We're extremely proud of the fourth quarter and total results for 2017. The fourth quarter of '17 represents a record quarter for the company in our history for revenue, and we take particular pride in exceeding $1 billion in revenue for the first time in our history. On today's call, as is usual, we'll give an operational review of the fourth quarter. We'll provide a detailed update on current business line activity. We'll update listeners on strategic initiatives to improve and grow the business. So what are new sales channels, new technology, infrastructure that we're building out to grow growth or drive growth of our business? We'll share our outlook for our company and the industry. Craig will provide a detailed financial update. We'll do Q&A, and then we'll give a quick summary and conclude the call. I'll start by reviewing activity by business line for the fourth quarter and how that's translated into 2018 activity to date and our outlook for each business line going forward. The sequence will be our customary order. I'll start with how the company began, which is Canadian drilling fluids. In the fourth quarter, we're happy to report that we averaged 77 jobs through the quarter. Had a lot of particular success in deep plays where our proprietary brine fluids continued to outperform the industry competitors, allowing our customers to get more meters for their drilling days. Proud to note that we had a Canadian customer drill a well to 7,848 meters with our technology. Our technology controls or reduces lubricity, cleans the hole properly, controls metal loss on the pipe and allows that operator open up more rock and get more value for their drilling dollar. To me, our Canadian drilling fluid business is illustrative of what keeping a high-performance team together for a decade-plus and arming it with highly-experienced and working leadership can create. We've got a commanding position in the SAGD market. In Southeast Sask, we remained poised to take advantage of any increase in activity in Canada and are pleased with our leading position. We get work in the space because of technology, because we're vertically integrated in our products, which makes us price competitive but allows us to generate a profit. We've got a problem-solving culture that's backed up by capabilities from 8 labs, 60-plus scientists. The people at the field level are the best in the industry. Our account managers are technical, our operations people are fanatical, our engineering people are using analytics increasingly to give better advice and help people problem solve. And in our supply chain, our logistics is excellent. When you add it all up, we've got a leading market share in Western Canada. It sets up for us to build out other business lines with the same customers. It establishes a good reputation for CES with the E&Ps that they can entrust their work to us. So that's what's allowing us to build out from drilling fluids, frac stimulations and workovers, production of hydrocarbons and associated water, pipelines and tanks and increasingly pipeline construction. Activity to date for 2018 looks encouraging. We've averaged 105 jobs through January and February, peaking at 115. We expected it will be a softer breakup than last year because of commodity prices. I'll add personally if anyone on Ottawa listening. We ran 9 HDD rigs through much of the winter. That's our new initiative or technology where we're providing our EnerSEAL technology, so a mineral mixture that goes into freshwater that's being used by midstream companies to drill bore holes under sensitive environmental areas, under rivers. Now that we've scaled the technology and got a sense of what happens on a bigger scale, what we've seen is reductions of water use by about 55%. We're getting much less frac-outs, so that's where the fluid goes to surface through a gravel seam or a fault. The estimate we're seeing is that we're reducing the frac-outs by about 2/3. We had 11 of them on the project through the winter and all but 2 self-healed. So the fluid as it gets into the gravel seam or a fault gels or becomes like Jell-O and it stops the fluid from going to surface. All of that adds up to much less waste to be hauled. As I've said, over a 50% reduction in water use and faster drilling, which makes the operation, I think, more environmentally responsible and obviously cost less. The challenge for the market as we look to scale this business up further in Canada and go on into the U.S. is that a lot of the equipment on these HDD rigs doesn't have mud tank systems and solids control that complement that technology. So it's going to be a process even though we believe we have on the verge of disruptive technology -- it's going to be a process to get up to speed on these rigs, which have run technology from the '50s for mud forever. With HDD backfilling less drilling by industry in Canada for 2018 than '17, barring an improvement in commodity prices for Canadian customers, we see a similar outcome for 2018 as '17. But we are poised to grow with any positive turn for commodity prices or an approval of an LNG project in Canada that could increase gas drilling or open up equity or debt markets for our customers. At AES, which is our U.S. drilling fluid business, and I'll highlight again because it is our culture, is led by working management. Q4 averaged high 90s for job count. We're creating very nice operating leverage because the activity is concentrated in Texas, in Oklahoma, in the Northeast U.S. in the Gulf Coast. Very pleased to report that today, we have 118 jobs, so we are up to 12% of the market. We've got a line of sight to increase market share. We're doing it through technology, superior service, competitive pricing. And we're doing it off the same asset base that we were running half these jobs 18 months ago. Today we've got 72 jobs running in the Permian Basin, with 10 in Oklahoma; 15 in the Gulf Coast, which includes the Eagle Ford; we've got 18 in the Northeast U.S. We're expanding our throughput at our Kermit mud plant, which is in the Delaware Basin. So we're expanding rail, bulk barite handling. We're looking at putting -- we are going to convert existing land we have in Midland by the airport in Midland to be a dry product yard that will allow us, we think, to service about 10 rigs out of that yard and absorb returns of dry materials that would have otherwise gone into the Kermit plant. So we'll be able to do a bit of a reno on Kermit, expand throughput and make use of land that we already own in Midland. We're also considering milling capabilities for the Northeast U.S. or possibly even the Permian. That would allow us to dedicate if we go to the Northeast more of the capacity in Corpus to the Texas market, and it will allow us to diversify where we have our manufacturing of those materials. Not all of our eggs in one basket in Corpus. We're looking at setting up proprietary liquid blending at a new facility on rail in West Central Texas. We've had a long-standing facility. We've done that in but we're looking to put a non-rail so that we can enjoy sort of the margin benefit of volumes as the business picks up. Our EnerSEAL technology for HDD drilling for the U.S., we expect to have NSF certification sometime late in Q2. We can use this technology for midstream companies, for pipelines, for utilities drilling, to lay utilities similar to a pipeline. We see significant opportunity in the U.S. It will be pure operating leverage because it will exist over the top of our downhole business. Our clay plant in Kansas, we expect to commission that in March, hopefully early in the month there. It's an important part of our vertically integrated supply chain. Our barite mill in Corpus is putting out approximately 25,000 tons a month. And as I mentioned, we're looking to expand our capabilities likely into the Northeast U.S. In 2018, I expect that we can increase market share at AES. It will drive lots of our operating leverage because activity will happen where we've already got infrastructure and a fixed cost base, so the Permian, the Gulf Coast, Oklahoma and the Northeast U.S. And moving on to frac sales now. In Canada, we report as modest and steady. We've got 2 pumper customers in Canada. We've got 4 to 5 pumper customers in the U.S. Again, revenue is very modest. We have a frac polymer trial scheduled in the Northeast U.S. We'll run our cationic polymer, which is a friction reducer that works in high-brine and high-iron water. We've got a job scheduled in the Northeast that we're awaiting. We recently have product -- also tested that product tested by a very large independent U.S. pumper, and they report that it was the best performing FR for high-brine and high-iron that they've tested. We are now up to 100,000 gallons a month manufacturing capability through a third-party toller. Our plan long-term is to repurpose existing reactors in Kansas to manufacture these products ourselves. We'll continue to use the third-party toller, but we want to control our own fate in terms of making feedstock and then converting that into the emulsion polymer. As we've said before, our thesis on the frac market is that we think there'll be an increased focus on sustainability by industry, which means using produced water or frac flow back water instead of freshwater to build these enormous fracs. As customers go into manufacturing mode and generate more produced water, which we're happy, of course, to report that we're treating when the well produces, we think that this allows the industry to demonstrate sustainability. It will reduce costs by turning the waste stream into an asset. We think the frac polymer that we're starting to become primary as a manufacturer, can get us in the game in both countries. And what we believe will happen is that will pull chemical sales of what the customer would call a flow enhancer, so surfactants in nanotechnology, clay stabilizers, biocides and scale controls. And we are already primary in manufacturing all of these chemistries in Kansas and at Sialco in Vancouver. I'll move onto PureChem, which is our Canadian production chemical business. Our Treatment Points continue to expand through Q4. We integrated a small acquisition that added scale without adding much overhead. Our Grand Prairie blend plant rail siding warehouse and staging facility is on track to be operating in summer of 2018. We expect and are building this plant because it will improve our cost to goods across all of our business lines, and it delivers an important message to customers that we're committed to the deep basin. It will also allow us to move large volumes because we'll have our own rail siding. January was the best month for top line in PureChem history. StimWrx is making a nice contribution in Canada, adding new customers that benefit from our unique technologies in stimulations and workovers. StimWrx is growing their business from when we acquired them a year ago as a private business by using a bigger toolbox and our significant footprint. We think frac can grow with our Grand Prairie facility, and with our ability, it will now self-supply a reasonable amount of the frac polymer. I'll move on to U.S. chemicals, which is JACAM and Catalyst. And again, working leadership is based in Midland backstopped by our Kansas and Midland plants. Q4 Treatment Points like PureChem rose throughout the quarter. We're growing across the Permian, particularly in the Delaware. We're seeing good growth in Oklahoma and good growth in California. We had a recent win in the Permian with a major that only hire Tier 1 service providers. To us, this is a good indicator of verification that our investment in the downturn, in manufacturing, in our 8 labs, our 60 scientists, blend plants across the Continent, warehouses and rolling stock to move the product, those have elevated the company in the eyes of the customer. StimWrx is starting to make traction in North Dakota and the Rockies. It’s is very technical sale, and we want to be careful about how we ramp that up to maintain the good reputation and results that technology creates. We expect a major contribution from U.S. chemicals that can enjoy operating leverage by growing in already significant markets for us. Revenue, we believe, can grow off a relatively fixed cost base. As production rises across the U.S, we think we can grow market share. Clear Environmental continues to make contribution financially and strategically in Canada. For us, Gavin and his people are the point of the spear for water for the company. They're working with customers and regulators on how industry can become more sustainable, so back to the theme of recycling water. Sialco remains profitable. It's showing improving results as a stand-alone business, which is into the oilfield and non-oilfield. Importantly, it's an incubator for technology that we commercialize, so we can self-supply from either plant, Kansas or Vancouver. And we are excited to announce that we've added some very high-end talent that will work with both plants to take the products that our scientists build on the bench and take them to reactors to scale them up in large size, so that we can commercialize and sell them and make money. I'll now turn it over to Craig for our financial update.

[Craig Frederick Nieboer, Chief Financial Officer]

Thanks, Tom. As Tom described, what an amazing bounce off the bottom 2017 was. $1.03 billion in revenue exceeding our previous high of $972.7 million in 2014. As Warren Buffett says, the first billion is always the hardest. EBITDAC of $151.9 million is the second highest in our history and more than 3x our 2016's $45.6 million. Focusing on Q4, it was a very good quarter. It too was a record revenue quarter of $278.8 million and up 49% over Q4 of 2016 of $187.7 million. EBITDAC in Q4 was $41.4 million versus $23.1 million in Q4 of 2016, a big increase as well. As the results were improving, so was our balance sheet. We refinanced our 300 million senior notes in Q4, reducing the coupon by 1% to 6 and 3/8% and extending the maturities out to October 2024. We have plenty of liquidity as well in our senior operating line. We have drawn about 110 million of the aggregate $165 million line. We expect our working capital build to subside in Q2 and begin to harvest cash in the back half of 2018. This free cash will be prioritized as always to growth initiatives to fund our modest capital program, which was guided in the MD&A at about $50 million of expansion CapEx in 2018, but it also will be available to fund future M&A and shareholder returns. At this time, we'll turn the call over to questions.

[Operator]

[Operator Instructions] Our first question is from Benjamin Owens with RBC.

[Benjamin Edgar Owens, Associate]

So margins obviously recovered nicely and then stabilized during 2017. Just hoping you could maybe just walk through some of what you view as the key levers to improving margin going forward in 2018.

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

Well, it's continuing to self-supply products so that we can control cost of goods increases, and then it's volume, Ben. We need to sell more stuff in the same places, which we believe is very realistic because operators are doubling down on acres they've built. They're proving out plays. So we've got a line of sight to a lot more activity in the Permian, in Oklahoma, in the Northeast U.S. We're building infrastructure in Grand Prairie because we believe long-term, the deep basin is a world-class asset that will see markets. We're getting volume in the oil sands as the oil prices have recovered for Canadian producers. So it's not about pricing; it's about volume. We've seen customers report 20% to 30% increases in D&C costs. That's largely, I think, coming through equipment people, where there is a supply demand tug-of-war. For the consumable business, it's all about volume.

[Benjamin Edgar Owens, Associate]

Okay. And you said it's not about pricing. I just want to maybe get your opinion on something. One of your larger competitors in the chemical side recently gave some positive commentary on getting traction with pricing in the second half of 2018 to the point that it could be accretive to margins. Just wanted to maybe contrast that with what your guided view is on potential pricing recovery in your industry.

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

Are you referring to Ecolabs?

[Benjamin Edgar Owens, Associate]

That's right.

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

Yes. I mean, I read their transcript. I didn't take in their call. I think it was pretty confusing. I don't think they gave in clear messages on the oilfield. They were pretty evasive. We'll remind callers because we've already reported on that. They had announced, and everyone knows this with the press release, in the fall, the price increased -- I think it was 6% to 8%, 6% to 9%. And then that was going to be implemented. And our take is that very little or none of that has actually happened, a little bit in the U.S. Rockies and a little bit to small customers. So I read their transcript and I didn't get a clear indication from them they had any success on that. I think we all would like pricing to go up. I think we're just realistic that at this stage, we can't count on that. And we're going to run this business profitably and increase our revenue and earnings on volume. And when opportunity comes in the future, if it does on price, we're not going to say no. But I would think realistically, that's not a near-term outcome.

[Benjamin Edgar Owens, Associate]

Okay. That's helpful color. I guess just the last one for me. With some of these new product you guys have in the pipeline, with the frac chemicals and then the HDD, are those products accretive to our overall margins? Or would they be more in line with the average?

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

The pipeline crossing business, Ben, is nicely accretive because we've had to make no capital investments at all. It's minerals that we already used downhole. We just finally smartened up and realized that there was a perfect application there in the downturn as guys were scrambling to make a market for stuff. On the frac polymer business, that's a tighter business. But like barite in the mud business, you need that to be in the game. And with the size of the fracs, even lower-margin FR but by the truckload is a good-looking business to us. And without it, we don't think you can move material amounts of the chemistry that really makes the frac perform.

[Operator]

Our next question is from Steve Kammermayer from Clarus Securities.

[Stephen John Kammermayer]

Just wanted to touch on the production chemicals in both Canada and the U.S. So obviously, since you've reported treatment -- started reporting treatment points, we've seen some very strong growth, some of which can be attributed to your acquisitions along the way. I think looking into 2018, barring any further acquisitions, where do you -- what type of growth do you target in Treatment Points, if we call it that?

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

I'm glad to say we've done this long enough, Steve, not to take the bait on guidance. I think the number is going to be bigger because I think North American production is going to grow. There's going to be more wells to treat. And since we got serious in the business after acquiring JACAM 5 years ago, we've been steadily beating the market. So it's not easy, it's not like adding 10 rigs and suddenly there's $1 million more of revenue a month or whatever the number is. So we can't guide. It's all about whether the customer will hire us or not. But we're improving the team, we're improving the product lineup. The problems are becoming more complex as new formations become economic through multi-stage fracking. So I think people can expect us to have a bigger production chemical business year-over-year, and I think the proof is in the pudding, where we're getting hired by the majors, who only look at Tier 1 providers in that space sort of like how they evaluate pumpers. There's Tier 1, 2 and 3, and we've moved up to be Tier 1 with Baker and Nalco.

[Craig Frederick Nieboer, Chief Financial Officer]

And I think the other thing, and it's hard to quantify, it's not going to make it better for you for your modeling, but our guidance has kind of estimated that 90% of the current Treatment Points are what you'd call the old vertical wells, which are producing less fluid and require generally less production chemical. So we're on customers in the Delaware, as an example. And as they continue to bring new horizontal pads that we get to treat, those new wells are going to use severalfold times more production chemical in their life. So as that Treatment Points balance between old verticals and new horizontals changes over time, there's more revenue per Treatment Points going to up as well.

[Stephen John Kammermayer]

Okay. That's actually very helpful. Just moving to the free cash flow. I mean, it's certainly growing, and you noted in the MD&A that cash flow should more than offset your cash costs in 2018. You also noted in your comments you're harvesting some working capital in the second half of 2018. Is that when you would start to look at maybe increasing the dividend? Or do you still keep that back in hopes of acquisition or strengthening the balance sheet further?

[Craig Frederick Nieboer, Chief Financial Officer]

Well, we're always -- as I've said, we're always going to prioritize growth because we see opportunities. We have the good fortune of being in an asset -- relatively asset-light business, so from our own, call it, organic growth scenario versus other oilfields. And to these M&A in the past, on the smaller side just like the small production chemical company we bought at the beginning of this year. It's been funded out of cash flow. So I think that those are the things. our CapEx -- small M&A are going to be the priority. But I think we were getting back to a point where we can start looking at other ways to return to shareholders value. Will that increase the dividend or will that be looking at something like a normal course issuer bid? Those decisions have yet to be made. But I think what you said is true that we have the opportunity to start to execute on those things later this year.

[Operator]

Thank you [Operator Instructions] Our next question is from Ian Gillies with GMP.

[Ian Brooks Gillies]

With respect to the 2018 Capex, the $65 million, I mean, you talked about a number of different projects that you're going to be pursuing throughout the course of the year. Are you able to maybe just give us a hand and force-rank them by size for us just so we understand where some of the big chunks of capital may be going this year?

[Craig Frederick Nieboer, Chief Financial Officer]

Well, I mean, the biggest chunk is going to our Grand Prairie build-out and then followed by, I think, our investments in the Permian that Tom talked about, and in Texas on chemical blending on rail for joint fluids. So those will be the big 3 at this stage. And possibly a barite expansion, milling in the Northeast would come in #4 on that list from a top-down on the spend, I would say.

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

Yes, and some of that, Ian, is rolling stock not to replace stuff that's wore out, but the fleet gets bigger because you move more product.

[Craig Frederick Nieboer, Chief Financial Officer]

Yes and more people.

[Ian Brooks Gillies]

Okay. And as we think about it from a return perspective from the investment dollars, I mean, do you tend to think about it more from a volume growth perspective or getting it from margin accretion? Or is it some sort of mix? Just trying to get a sense of how you guys are thinking about it.

[Craig Frederick Nieboer, Chief Financial Officer]

Well, it's definitely a mix. I mean, we're not -- contrast us with the guy that's deciding to build a rig, and he knows what the day rate is and the return. We need to physically expand Kermit facility in West Texas because we're taking on all kinds of customers. I mean, the return on that investment is going to be instant in real time. Things like the Grand Prairie facility is something that's needed for the expansion of PureChem. That's probably got a longer payout, but it's extremely strategic decision that puts us in the right part of Canada with the right facility that will reduce -- or improve margin, reduce costs and give us presence and allow us to expand the business. So it is always a mix. I think we look at it very strategically. We're looking at where the money is going to be spent in the industry. And once again, the overall profile has been a sort of 6% of the top line revenue capital spend. And the business is $1 billion revenue year, 10 plus x the company was the day it went public with 3x the shares. I mean, the return on capital has been phenomenal. And so, I guess, we look at it strategically, we look at it from margin, we look at it from returns, and we can definitely check all of those boxes.

[Ian Brooks Gillies]

Okay. That's useful. And with the rapid growth experienced over the last 12 months in type of being basically vertical. On both the drilling fluid side and production chemicals side, what percent of inputs do you think you're doing on your own versus third party right now?

[Craig Frederick Nieboer, Chief Financial Officer]

That will be tough to fire off the top of your head. You've got to remember, there are still a lot of things like drilling fluids made out of hydrocarbon. That's a big part of the input, right? And there's a lot of still commodity products that come with the specialty products.

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

In the production treating business, other than methanol, Ian, if we don't react it, we blend somebody else's base chemicals. So almost everything in that business would be self-supply. And if I was back on a rig running mud, probably over half of the stuff in the mud van, we would have made or blended. And then some of it is commodities that you're buying offshore or even domestic.

[Craig Frederick Nieboer, Chief Financial Officer]

I mean, I would say -- it will be fair to say 95% of any specialty product we make that we sell.

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

Yes, the chemicals and most of the polymers have our fingerprints on their DNA. And then the stuff where there is no money in making it, we buy it from someone else.

[Ian Brooks Gillies]

Okay. That's helpful. And then just a quick housekeeping question for you. G&A in Q4 -- I mean, was up meaningfully quarter-over-quarter. Were there bonus accruals in the fourth quarter that [ you're going to ] accrue earlier in year? I mean, are you able to provide some context around how you're thinking about run rate acknowledging that pace of sales will probably play some impact as does FX?

[Craig Frederick Nieboer, Chief Financial Officer]

Yes, I mean, there were some year-end accruals across the board. There's always a little more if it goes into Q4. The businesses continue to expand, so there's more people. They were part of the cost of the debt refinancing in that G&A number as well. It's just how the accounting works. So those would be the three sort of contributors to that. I mean, if you look at the business historically when it's running at kind of call it capacity. And sort of from a cash G&A, it's like a 12%, 13% business. And I think to model something different or think that's going to be much different in the future is unlikely because we do have a lot of variable compensation because that's what drives success in sales. And there will be adding of people. So I just think we feel comfortable that we're in the right range as a percentage of revenue.

[Operator]

There are no further questions registered at this time. I would like to turn the meeting back over to you, Mr. Simons.

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

Thank you, and thank you to the listeners. In summary, all of our business lines are creating great results for the company. At $50 oil and $3 gas, our call was that North American oil and gas production is rising. We see our operators living within cash flow, which while it may take some of the peaks off the highs, we think it also pays the industry and shareholders and investors back on the downside. We think we can sell our consumable chemicals, polymers and minerals across all land plays for drilling, fracking, stimulation and treating of production and water. As those markets grow, as we expand our pipeline construction business, we think the company is poised to continue to create value for investors. We're going to maintain a disciplined approach to running the business. As Craig said, CapEx of around 6% of sales, we believe, based on our long history of building out a chemical business, can allow us to seize all opportunities while maintaining maximum flexibility for the company financially. We expect in 2018 to generate significant free cash flow. We're going to keep our options open on what we do with that money. All options are on the table -- returning it to shareholders, strengthening the balance sheet, reducing share count, small M&A. I'd like to wrap up by thanking our customers for their business, our employees for their outstanding service and our shareholders for their trust. Thank you.

[Operator]

Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.