Enerflex Ltd

TSX:EFX

Earnings Call Transcript 2023-Q2

[Operator]

Good morning, ladies and gentlemen, and welcome to the Enerflex Second Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded.

I would now like to turn the call over to your host, Stefan Ali, Vice President, Investor Relations and Business Development Energy Transition. Please go ahead.

[Stefan Ali]

Thank you, operator, and good morning, everyone. Thank you for joining us on our second quarter 2023 earnings call. With me today are Marc Rossiter, President and CEO; Rod Gray, Senior Vice President and CFO; and Ben Park, Vice President, Corporate Controller. During today's call, we'll touch on highlights from our second quarter results and provide an update on how we are progressing our near-term strategic priorities.

Before I turn it over to Mark, I'll remind everyone that today's discussion will include non-IFRS and other financial measures as well as forward-looking statements regarding Enerflex's expectations for future performance and business prospects. Forward-looking information involves risks and uncertainties, and the stated expectations could differ materially from actual results or performance. For more information, refer to the advisory statements within our news release, MD&A and other regulatory filings, all available on our website and under our SEDAR+ and EDGAR profiles. All dollar amounts discussed today are in Canadian dollars unless otherwise stated.

I'll now turn it over to our President and CEO, Marc Rossiter.

[Marc Rossiter, President, CEO & Director]

Thanks, Stefan, and thanks to all our listeners for joining this morning's call. Last night, Enerflex reported results that reflect strong operational performance across our three core business lines and a continued focus on integrating Exterran and strengthening our financial position. In the second quarter, we delivered revenue of $777 million and adjusted EBITDA of $142 million, demonstrating the strength of our energy infrastructure and aftermarket services business lines as well as continued momentum in our North American Engineered Systems business.

The gross margin profile on our recurring businesses expanded from the first quarter. Our energy infrastructure platform benefited from more favorable terms on renewals and additional contracted revenues generated from the new energy infrastructure assets we brought online in the first half of the year. And our aftermarket services business benefited from increased activity levels, including continued global demand for spare parts.

Notably, our aftermarket services gross margin has increased by over 500 basis points from 2022 levels.

Our gross margin profile from Engineered Systems has also improved significantly from this time last year, up 400 basis points. However, operational delays on certain in-flight projects resulted in a lower gross margin percentage in the quarter versus the prior quarter. We are focused on regaining lost time experienced on those projects to improve their margins.

I'd like to quickly touch on some key activities across our business segments. Our North American business continues to perform exceptionally well across all product lines. Customer activity levels remain elevated, which has enabled us to capitalize on new opportunities and expand our booked margins. Our U.S. contract compression fleet is operating at high utilization rates, averaging 96% in the second quarter. And as a result, we are securing attractive pricing in this tight compression market. Our aftermarket services business is observing notable strength in gross margin improvements as customers continue to catch up on deferred maintenance activities and general parts and supply needs. And our Engineered Systems business continues to be a meaningful contributor, especially as we look to book -- sorry, especially as we book larger cryogenic natural gas processing plants, which I'll touch on later.

In Latin America, we are observing strong performance from our fleet of energy infrastructure assets and are focused on optimizing our contract compression business by redeploying idle units to meet rising local demand. We are also seeing solid activity levels in aftermarket services across the LatAm region.

In the Eastern Hemisphere, three of the four large in-flight projects that we -- that were being advanced through 2022 are complete and generating stable cash flows. We continue to advance the fourth in-flight project, the Cryogenic facility in Kurdistan, which we expect to complete in 2024.

We continue to focus our efforts on integrating Exterran. Since closing the transaction, we have captured most of the annual run rate synergies we identified at the time of the announcement, USD 50 million of the USD 60 million targeted and continue to expect that we will capture the remaining USD 10 million within 12 to 18 months of the transaction close. We are 9 months into our integration efforts and are actively streamlining our global operations to ensure we are shaping our business for long-term success and maximizing profitability and resiliency.

As we identify opportunities to optimize our global operations, we expect we will incur additional onetime restructuring and optimization costs, which should improve the overall efficiency of our business in the long term. An example of this is our previously announced plans to consolidate our global manufacturing capacity from five facilities to three. We have since identified further opportunities to simplify our geographic footprint and plan to execute on these initiatives over the next two years.

Lastly, turning to our Engineered Systems business, Enerflex secured $322 million of bookings in the second quarter, allowing us to remain -- to maintain a significant backlog balance of $1.4 billion that we plan to convert into revenue through the balance of this year and into 2024. Notably, our second quarter bookings included $120 million of electrified natural gas infrastructure and another $20 million for carbon capture and sequestration related projects as we advance our energy transition business strategy.

A strategic benefit from the Exterran acquisition that I'm particularly excited about is our expanded product offerings, which have deepened our ability to serve the energy value chain, and we have diversified our backlog composition. In the second quarter, we secured $80 million of bookings for two large cryogenic natural gas processing plants in the United States. This is in addition to the cryo plant we booked in the first quarter for an international customer. Today, we are better positioned to capture these larger scale opportunities, which should enable us to high-grade the margin profile of our Engineered Systems backlog.

I will now turn it over to Rod to speak to the financial highlights from yesterday's release and provide an update on Enerflex's outlook for the balance of 2023.

[Rodney Gray, Senior VP & CFO]

Thanks, Mark, and good morning, everyone. Enerflex delivered strong financial and operational results in the second quarter. Revenues generated by our energy infrastructure and aftermarket services product lines were largely flat from the first quarter while gross margins from these recurring businesses expanded. Our consolidated second quarter revenues of $777 million were down from the first quarter because of the noncash finance lease revenue we recognized in the first quarter when we brought a large natural gas infrastructure asset into commercial operation.

Enerflex's gross margin was $147 million or 18.9% as a percentage of revenue. And as Marc described, was influenced by solid quarter-over-quarter improvements in our recurring businesses. We did experience some delays on certain in-flight projects, which impacted our Engineered Systems margins. Still, we have expanded our gross margin on Engineered Systems through the first half of 2023 by over 400 basis points when we compare to the first half of '22 despite the lower margin on these particular projects during the second quarter.

Enerflex's SG&A of $100 million decreased $16 million from the first quarter, which was largely driven by a recovery of a $12 million bad debt receivable. We are laser-focused on reducing our SG&A, but do expect to see -- continued to be impacted by foreign exchange losses related to the Argentine peso as well as onetime restructuring and integration costs as we optimize our global operations to enhance long-term profitability.

In the second quarter, we incurred $10 million of SG&A related restructuring and integration costs and recognized foreign exchange losses of $12 million, which we partially offset with $8 million of interest income from associated instruments reported against our net finance costs. This brings me to our reported adjusted EBITDA of $142 million in the second quarter. Strong business performance and an expanded energy infrastructure portfolio resulted in adjusted EBITDA increasing by 16% from the first quarter. Enerflex generated distributable cash flow at $52 million -- $32 million in capital expenditures directed primarily at our contract compression fleet in the U.S.A. and Latin America. We recognized a small net loss of $3 million, which was the result of higher cash taxes and lower gross margin recorded in the period, partially offset by the decrease in SG&A.

Enerflex is focused on strengthening its financial position and prioritizing a conservative balance sheet over the long term. And in the second quarter, our long-term debt balance decreased by $50 million. The increase in net working capital resulting from the growth of our North American aftermarket services business as well as the timing of cash flows in our Engineered Systems businesses caused by our net debt balance to increase slightly from the end of the first quarter. Strong adjusted EBITDA generation allowed us to lower our bank adjusted net debt-to-EBITDA ratio to 2.8x, and we continue to expect this ratio to improve to 2.5x by the end of the year through strong cash flow generation from our reoccurring business and the execution of our large Engineered Systems backlog. Once we've reached our post-acquisition deleveraging target, we plan to continue strengthening our financial position through absolute debt reduction to ensure we have significant financial flexibility through the industry cycles.

With last night's release, we reaffirmed our full year 2023 financial guidance for adjusted EBITDA, year-end leverage, maintenance capital expenditures and expenditures to execute the cryogenic facility in Kurdistan. Enerflex is revising its guidance for other nondiscretionary expenses to a range of USD 180 million to USD 210 million, representing a USD 50 million increase from the midpoint. This is to account for the increase in net working capital associated with higher activity levels in our aftermarket services and Engineered Systems businesses as well as higher expected cash taxes in 2023. Enerflex is also introducing guidance for PP&E and growth capital expenditures for the year with a range of USD 80 million to USD 90 million.

This guidance largely reflects Enerflex's year-to-date results, which include the completion of two large water projects in the first quarter. We invested about USD 55 million in PP&E and growth capital in the first half of the year, with the remaining funds for 2023 planned to be directed towards modest customer-sanctioned investments in our U.S. and Latin America contract compression fleets, a small brownfield expansion in the Middle East and PP&E investments and some software and upgrades required on facilities that we acquired through the transaction.

Finally, Enerflex is committed to delivering a sustainable dividend to shareholders with our Board declaring a quarterly dividend of $0.025 per share last night. The dividend is payable on October 12 to shareholders of record on August 24.

With that, I will pass it back to Marc to deliver his closing remarks.

[Marc Rossiter, President, CEO & Director]

Thanks, Rod. Enerflex's primary focus for 2023 is to progress the integration of Exterran and strengthen our financial position. Our solid second quarter 2023 financial and operational results highlight our continued ability to execute on three core business lines on a global scale. We will continue to build on these strong results as we integrate Exterran with our near-term imperative of optimizing our business to be increasingly resilient and profitable to ensure maximum flexibility through the industry cycles.

I will now hand the call back to the operator for questions.

[Operator]

[Operator Instructions] Our first question will come from the line of Aaron MacNeil from TD Cowen.

[Aaron MacNeil, TD Securities]

I've had a couple of inbounds from investors on the revised guidance and suggesting that free cash flow generation implied by the guidance will be limited in 2023. I'm hoping you can sort of slice and dice this in a few different ways. So first, I'm hoping you can give us a bit of context in terms of what's reoccurring and what's more onetime and transaction-related, including -- I know you called out the legacy water projects that were announced with the transaction last year.

And second, I'm hoping you can give us a sense of what's first half of the year versus second half of the year? And if you think we should expect free cash flow generation in the back half of the year.

[Rodney Gray, Senior VP & CFO]

Sure. Aaron, it's Rod. I think when we look at capital spending, in particular, what you're referring to. So Canadian dollar terms, I think we had about $73 million of capital spending in first quarter -- or sorry, first half of the year, and we'd expect something in the order of about $40 million to $42 million in the second half. And so you've got about 2/3 of that spending that's already happened in the first half of the year. So it is skewed to the first half.

Secondly, when we look at working capital, we had an approximate $155 million use of cash in terms of overall working capital build in the business. We would see that moderating in the second half of the year by about $50 million, and that is incorporated in our overall guidance. which effectively gives us something in the tune of about $50 million of free cash flow for the year.

[Aaron MacNeil, TD Securities]

Understood. You've also implied a bit of a change in the disclosures in terms of your capital allocation priorities. Maybe I'm reading into it too much, but am I right to assume that debt reduction will be the focus now in 2024 over and above a more enhanced shareholder return? And where does sort of debt reduction, enhanced shareholder returns, organic growth in CIB, all the usual suspects rank in your opinion, from a go-forward capital allocation strategy.

[Marc Rossiter, President, CEO & Director]

Aaron, this is Marc. We feel that the best way for us to improve shareholder returns is through total debt reduction, and we will do that this year, and we will do that in 2024. That will be our primary mode of providing shareholder returns is through debt reduction.

[Operator]

Our next question will come from the line of Nick Corcoran from Acumen Capital.

[Nick Corcoran, Acumen Capital]

First, on the Argentina FX loss of $12 million in the quarter. Is there a way you can manage that cost going forward or is that just a cost doing business in the country?

[Marc Rossiter, President, CEO & Director]

I'll start and then maybe Rod will kick in. I feel that we did manage that in the quarter. We had the $12 million FX loss. We had the $8 million roughly gained by using our hedging instruments. That's roughly the same performance we had in Q1 on the topic. And so that will be our mode going forward.

Like I said in the last call in Q1, just about everything operationally and from a macroeconomic point of view with our customers in the business in Argentina is good. Our assets are good. Our people are good. Our customers are good. We're improving margins quite significantly. And our revenue streams are pegged to the U.S. dollar. Once we receive those revenues and they go into the bank, we've got a cash balance that has been devaluing over time. The sort of quarterly loss of $12 million, offset by the $8 million interest gain. That is a run rate that we would be aiming for, for subsequent quarters.

[Nick Corcoran, Acumen Capital]

That's good color. And then maybe moving on to the backlog is down from a record high last quarter. First question is, is there anything to read on what the backlog is doing at this point of the cycle? And then the second question is related to energy transition and whether you're seeing the pipeline for opportunities increase in that part of the business?

[Marc Rossiter, President, CEO & Director]

I think that the backlog or the bookings in the quarter of $322 million, that's a healthy level of bookings. In Q4 '22 and Q1 of '23, bookings of over $500 million were exceptional quarters. And I think investors ought to look at those quarters as exceptional and as sort of a rebound coming out of the pandemic-induced very low levels of bookings.

The reduction in backlog of $100 million, we rolled off about $400 million of revenue in the quarter. We booked $322 million and that net reduces backlog by about $100 million. $1.4 billion backlog is still an extremely healthy backlog, and it's still -- the record high was $1.5 billion last quarter, $1.4 billion is the second record. So we're not concerned per se about significantly reducing backlog in the business. And $1.4 billion of the business, I can tell you the margins in the backlog are getting better. The variety of equipment we're booking into the backlog is significantly different and improved, in my opinion, compared to where we were a stand-alone Enerflex a year ago.

And that will lead into your next question. Like we said, $120 million of bookings in the quarter related to electrifying natural gas infrastructure. That's a pretty significant theme for Enerflex in our sustainability journey and our energy transition business. Electrification has always been something that we've identified is in demand from our customers, and it's right in the middle of our wheelhouse from our capabilities point of view to deliver that. We did $20 million of carbon capture, carbon related orders in the quarter. And further, what I'm really quite excited about so far this year, we booked 3 cryogenic gas plants through our U.S. manufacturing hubs. And a lot of that business came from the reputation the Exterran cryo business had built over the last 30 years. So we're really excited about that.

Those projects are typically higher margin. They're with customers that we worked with before. It's more of a long-term infrastructure play. We don't feel that's quite as peaky as the compression business. So the backlog, I'm extremely excited about our Engineered Systems backlog and believe it will be quite positive going forward.

[Operator]

Our next question will come from the line of Keith MacKey from RBC Capital Markets.

[Keith MacKey, RBC Capital Markets]

Maybe just to follow on to the bookings line of questioning. If you look at the macro environment now, you kind of fold in the Exterran business and you see the improved bookings that you're seeing on the energy transition items. Marc, do you have a sense for what you think normalized bookings and revenue should be in the Engineered Systems business going out the next 18 to 24 months?

[Marc Rossiter, President, CEO & Director]

We don't provide specific guidance as to bookings, but I can tell you I'm quite optimistic that the $322 million of bookings we got this quarter, I'm quite optimistic that our global market can support such a bookings level going forward. Now as I think all of our investors know bookings is the most cyclical part of our business, but what's significantly different today than in the last 10 years of Enerflex as a public company, is that our global footprint is different, our suite of products is different. We're addressing the energy transition demand that is quite significant for us, and I think that's a differentiating point for Enerflex.

So it's -- we're not going to tell you that it's going to be x dollars per quarter for the next two years, but we know that having a healthy level of bookings that is capital -- essentially capital-free growth and cash flow generation, that's very important to us.

[Keith MacKey, RBC Capital Markets]

Got it. And just to follow up on return on capital employed. It was about 1% this quarter. Can you maybe walk through the top 2 or 3 priorities in improving the ROCE number and kind of where you think that number should ultimately go as you fold in the Exterran business and get to operating on a more more normalized basis.

[Rodney Gray, Senior VP & CFO]

I think, Keith, we've got a lot of noise in the numbers with transaction costs that are impacting that number considerably right now. And so we see run rate going forward. Obviously, our expectations are improving upon that. But the call it, margin hit that we had in the quarter, combined with the taxes that we're experiencing, it was definitely a drag.

The other thing, Keith, to keep in mind is the trailing 12 months doesn't have the full Exterran results in. It's only from the close date in October.

[Operator]

And our next question will come from the line of Tim Monachello from ATB Capital Markets.

[Tim Monachello, ATB Capital Markets]

First question, just around some of the accretion estimates that changed in the quarter. And I understand you won't be disclosing these metrics going forward, but those were revolved around 2023. I'm curious if you expect this acquisition to be accretive on 2024 within your internal models.

[Rodney Gray, Senior VP & CFO]

Accretive on 2024? We didn't post 2024 information, Tim. So we wouldn't have a basis to compare that against.

[Tim Monachello, ATB Capital Markets]

Okay. I guess asked another way, is it just things that are sort of transferring 2023 that are impacting your view on like EPS accretion that will reverse in future years?

[Rodney Gray, Senior VP & CFO]

When those numbers were as...

[Tim Monachello, ATB Capital Markets]

[indiscernible] That is the major thing, right?

[Rodney Gray, Senior VP & CFO]

Correct. And, we are providing information in terms of our combined results now. I think the premise that those -- that, that information was based on involved a lot of assumptions around the transaction and timing. And as we've integrated operations, those assumptions, half of those assumptions are built into the results. And so adjusting for them becomes very difficult.

[Marc Rossiter, President, CEO & Director]

Tim, this is Marc. I mean if I can answer it a different way, Enerflex still strongly believes in the strategic rationale for the transaction. We believe it's the very best thing to do. We think the combined company will be significantly stronger, more resilient, more profitable than either the individual companies on a stand-alone basis had we not done the transaction. There's like no doubt in my mind from that point of view.

So we do think that the deal was a good deal. We're working through it. There are definitely more restructuring costs this year that are using some capital, but we're doing that restructuring activity this year because it's going to set up this combined business to have the best opportunity to grow margins, grow revenue in the future.

[Tim Monachello, ATB Capital Markets]

Okay. Yes, that's really helpful. I think that there are some investors that are expecting a synergy update with the quarter related to the UAE and Singapore facility closures. You haven't chosen to update the synergies. But can you talk a little bit maybe about what you expect for cost savings and how that will come through?

[Marc Rossiter, President, CEO & Director]

Yes, sure. We'll do. And to give you an idea how we're thinking about synergies, to us, synergies is very specific transaction-related cost savings. The $50 million of synergies we've executed so far are almost 100% to do with personnel sort of reducing redundant -- executing on redundancies, reducing head count, minimizing overhead from that point of view. And the remaining $10 million really relates to software, supply chain, those kinds of things that you can draw a very direct line between the transaction and those savings. When we think about reducing our manufacturing footprint from 5 facilities globally to 3, we're thinking about that as a restructuring and business optimization expense, not synergy per se. And so we're sort of going to put a pin on the synergies of $60 million. We're going to execute on those within 12 to 18 months of October '22 when we announced -- when we closed the deal, but we are engaging in optimization efforts that we're going to kind of separate those two. We think that's the appropriate way of looking at it.

Closing the shops specifically, we think will save between $10 million to $20 million on an annual basis. And that's, in my mind, a pretty conservative estimate. And when you close shops, you save money. The flip side of that is when you really do your best to load up the balance of the shops, it's quite reasonable, it's proven by historical numbers, that your per unit costs and your COGS as a percent of revenue should go down when you focus a lot of work into a smaller number of well-managed shops.

So it's hard to say exactly, here's the upside to Enerflex by closing these shops, but we're pretty clear that between COGS and overhead, there's at least $10 million to $20 million worth of savings by closing those two facilities.

[Tim Monachello, ATB Capital Markets]

And what's the cost to close those?

[Marc Rossiter, President, CEO & Director]

Sorry, say that again, Tim.

[Tim Monachello, ATB Capital Markets]

Sorry, what would be the cost to close the facilities?

[Marc Rossiter, President, CEO & Director]

It's going to be roughly $10 million to $20 million, mostly realized this year, and we'll be out of both of those facilities this year. There's equipment being executed in both, and the jobs will be largely finished this year, maybe into Q1 of 2024.

[Tim Monachello, ATB Capital Markets]

Okay. Great. And then I guess another piece that isn't included in synergies because it's probably more of a revenue synergy was a couple of nice wins on the cryo side this quarter that I think you guys would have been extremely hard-pressed to achieve on a stand-alone basis. Can you talk a little bit about the market in cryo? Is that just sort of the tip of the iceberg that these been? Or is this something that's going to be lumpier? I mean it was about 25% of your bookings in the quarter. So I'm just curious how that looks on a go-forward basis.

[Marc Rossiter, President, CEO & Director]

We're quite optimistic about our ability to book cryo plants in future quarters. And it's probably -- you can look at the macro from a North America point of view and a rest of the world point of view when you think about cryo plants.

In the United States, it should be a pretty steady level of bookings for cryo plants as gas is added as sort of gas production has increased, and we've seen pretty significant gas production increase in the Permian Basin, and that's where these projects are going. They continue to add cryogenic gas plants to extract all the ethane for petrochemical use. So pretty steady. The global business will be a little bit lumpier and the projects will probably be bigger than the North American jobs.

One thing I'd like to point out is that in the bookings, the $80 million of bookings of these 2 projects, that's just the core cryogenic equipment. These are customers that we also sell a lot of other equipment to, compression, other gas processing equipment. And typically, the cryo plant is sort of the heart of the project. It's the first thing that's purchased. And then a lot of the other Enerflex products and services are purchased after that. So one of the, if you will, revenue synergy parts that have in the cryogenic business within the Enerflex family is that we know about projects earlier. We'll have differentiated relationships with those customers that could make a difference as we pursue the sale of the sort of ancillary equipment and the compression, if you will.

It was a core part of the strategic rationale for the deal, but it's not something we talked about a lot early because we really wanted to get the business, understand it better. And before we started talking to sort of positivity about revenue synergies in that point of view, but it's definitely something that we're focused on, and we see it's -- it could be a pretty big difference for Enerflex in the Engineered Systems business going forward compared to Enerflex the past years.

[Tim Monachello, ATB Capital Markets]

Okay. Great. And sorry to hog the mic here. But just one more on CapEx here. It talks a little bit about investing in some of Exterran's facilities that needed upgrading. Can you talk a little bit about that? What was the capital hit there? Second, was there any incremental economics?

[Marc Rossiter, President, CEO & Director]

Well, just in general about the CapEx, I would like to point out that as far as like pure growth CapEx sanctioned this year, it's only $12 million. And so when Enerflex entered the year and we're -- and we very much told investors that our priorities delevering the balance sheet, that's the priority. We've only sanctioned $12 million of new growth CapEx, and that's sort of modest investments in the Latin American and U.S. rental fleets to make sure that we stay as close as possible to our best customers.

Secondarily, the improvements to shops, that's largely a function of really increased workload. So you don't go from a backlog of $500 million to $1.5 billion without having to put a little bit of TLC into our facilities. The -- I wouldn't say it's -- the increased economics are the increased level of bookings and our ability to take on extra work at higher margins.

[Tim Monachello, ATB Capital Markets]

Okay. Great. That's a good clarification. I was confused. I thought you were talking about processing facilities that were in the project portfolio.

[Operator]

Thank you. I'm not showing any further questions in the queue. I'll turn the call back to Marc for any closing remarks.

[Marc Rossiter, President, CEO & Director]

So there are no more questions. Is that what you said, operator?

[Operator]

Yes. No further questions. I'll turn it back to you, Marc.

[Marc Rossiter, President, CEO & Director]

Okay. Well, with no further questions, I'd like to thank everyone for joining today. I would like to welcome Rod Gray to the team. His impact -- he's a very seasoned financial professional. His impact on the company has been felt already, and I look forward to even further impact with him as part of the team. We appreciate your interest in Enerflex and look forward to discussing our third quarter 2023 results with you in a few months' time.

[Operator]

This concludes today's conference call. Thank you for participating. You may now disconnect. Everyone, have a great day.