Enerflex Ltd

TSX:EFX

Earnings Call Transcript 2021-Q3

[Operator]

Hello. Thank you for standing by, and welcome to the Enerflex Third Quarter 2021 Results Conference Call. [Operator Instructions] Please be advised that today's conference may be recorded. [Operator Instructions]I would now like to hand the conference over to your speaker today, Stefan Ali. Please go ahead.

[Stefan Ali, Director of Strategy, Risk & Investor Relations]

Thank you, operator, and good morning, everyone. Here with me are Marc Rossiter, Enerflex' President and Chief Executive Officer; Sanjay Bishnoi, Enerflex' Senior Vice President and Chief Financial Officer; and Ben Park, Enerflex' Vice President, Corporate Controller.During this call, we'll be providing our financial results for the 3-months ended September 30, 2021, a brief commentary on the performance of our 3 business segments, and a summary of our financial position. Today's discussion will include forward-looking statements regarding Enerflex' 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, please see the advisory comments within our news release, MD&A, and other regulatory filings.Approximately 1 hour following the completion of this call, a recording will be available on our website under the Investors section. During this call, unless otherwise stated, we'll be referring to the 3-months ended September 30, 2021, compared to the same period of 2020. We'll proceed on the basis that you've all taken the opportunity to read yesterday's press release.I'll now turn the call over to Marc.

[Marc Edward Rossiter, President, CEO & Director]

Thanks, Stefan, and good morning, everyone. The third quarter saw continued strength across global energy markets as economies continued their recovery from the COVID-induced downturn. Across each of our operating regions, market fundamentals remain very constructive. As global energy supplies tighten, commodity prices are responding, rig counts are accelerating, natural gas production is reaching new highs in key locations such as the Permian Basin, and demand for natural gas liquids is increasing.Concurrently, the industry's commitment towards maintaining capital discipline has further strengthened the bullish undertones for the energy complex setting the stage for another industry up-cycle. This dynamic was reflected in our third quarter financial results where for the fourth consecutive quarter, we saw continued improvement in activity, booking $191 million in new Engineered Systems project and increasing our backlog to $375 million, its highest point since the first quarter of 2020.Demand was broad-based with roughly half of these new projects being destined for end-users and international markets and half for North American markets. New bookings also benefited from emerging demand for low carbon solutions where we sold over 10,000 horsepower of electrified compression and multiple landfill gas handling applications. In addition, we successfully completed the construction of an important power and gas treating plant in Colombia. Once commissioned, the system will reduce flare gas and CO2 emissions through a uniquely engineered solution that leveraged our cross-regional experience and is a win for the environment.While bidding activity remains strong across each of our 3 segments, navigating to these challenges will be front of mind. The manufacturing business is in the early stages of the recovery in a very competitive environment, which may pressure margins until such a time as excess industry capacity is put to work. In addition, global supply chain constraints that emerged earlier this year may impact the price and availability of certain inputs. While we've successfully navigated supply chain constraints to date, our teams must remain vigilant in neutralizing the impact of escalating costs and materials such as steel.Our after-market services business saw improved activity in the quarter across all segments on improved demand for parts and components, as well as operations, maintenance, and overhaul services. We've also seen operational efficiencies captured through instrumentation and telemetry upgrades, which are maximizing uptime and value for our customers. However, despite improved activity, the AMS business remains very competitive and is also seeing supply chain constraints impacting the price and availability of OEM parts, pressuring margins in the AMS business across all regions.Turning to asset ownership. Our global fleet continue to perform as expected. Utilization over U.S. contract compression fleet improved to a third quarter average of 88% while exiting the quarter at 89%, its highest utilization rates since entering the U.S. contract compression business in 2017. With the drawdown in inventories of drilled but uncompleted wells to their lowest level since 2013, additional drilling will be required to replenish inventories and for producers to meet their production targets, particularly in locations with high well decline rates, such as the Permian Basin. Accordingly, if commodity markets remain constructive, we expect demand for our rental solutions to continue.We're also seeing increasing demand for electrified rental solutions as our customers turn their minds to managing their environmental impact and reducing scope 1 emissions. We expect that demand for e-compression will continue to strengthen in geographies where it can be readily deployed as clients continue prioritizing their decarbonization efforts. In addition to our contract compression fleet, our international rental assets continue their strong performance across all geographies. We are progressing the 10-year gas infrastructure project awarded during the first quarter of 2021, and subsequent to the quarter, we're awarded a new 10-year, roughly $200 million natural gas infrastructure contract for a customer in our Rest of World segment. We've dedicated resources over the years to increasing our capabilities and expertise in complex gas handling applications and are proud that our reputation for successfully delivering has assisted us in securing additional projects this year.Turning into our energy transition efforts. We continue our work in understanding how the transition could unfold and are already seeing a significant number of inquiries for lower carbon solutions, including in respect of e-compression, carbon capture sequestration, renewable natural gas, and hydrogen. With supportive oil and gas fundamentals and developing policy frameworks for the energy transition, we are modestly increasing our dividend, illustrating our commitment toward returning capital to our shareholders. Looking forward, we are focusing our attention towards supporting our global customers in their development plans while simultaneously building capabilities to capture opportunities within the energy transition landscape.I will now turn things over to Sanjay to review our financial results.

[Sanjay Bishnoi, Senior VP & CFO]

Thanks, Marc. Second quarter revenue of $231 million decreased versus the prior year period due primarily to lower engineering systems revenue on lower opening backlog and reduced contribution from some major projects that were largely completed by the third quarter of 2020. Despite lower engineering systems revenue, bookings of $191 million improved our backlog by over 150% relative to December 31, 2020, reflecting the improving conditions for the oil and gas industry and for our Engineered Systems business.After-market service revenue improved versus the comparable period. As the industry activity continued to improve, rentals revenue also benefited from a more constructive operating environment compared to the same time last year, when the COVID-19 pandemic took significant volumes of production offline. Rentals continued to benefit from the improved utilization of our U.S. contract compression fleet and contributions from our growing portfolio of international BOOM and natural gas infrastructure assets.Gross margins decreased over the comparative quarter on lower revenue but the decrease was partially offset by increased contributions from recurring revenue product lines, which yield a higher gross margin as a percent of revenue. Overall, gross margins as a percent of revenue was in line with the comparative quarter but may be pressured in the near term until excess manufacturing capacity is utilized and supply chain constraints are resolved. SG&A increased versus the comparative period driven by higher overall compensation costs and the wind-down of pandemic-related government subsidies.During the quarter, we invested $9.4 million of capital towards units in our asset ownership platform, the majority of which funded the organic expansion of our U.S. rental fleet, which has grown to approximately 385,000 horsepower. From a capital allocation perspective, we are seeing several opportunities to deploy growth CapEx globally at attractive returns and with counterparties, with whom we have deep relationships.As Marc mentioned, subsequent to the quarter, we were awarded another 10-year natural gas infrastructure contract with an international counter-party. This project will be recorded as a finance lease, such that cost related to its construction will be accounted for as work in progress rather than CapEx. Accordingly, we expect to remain in line with the growth CapEx range of $50 million to $100 million provided earlier this year.Our balance sheet has been managed well through the downturn by managing working capital, reducing debt, and capital discipline. We exited the quarter with a bank-adjusted net debt to EBITDA of 1.38x compared to a maximum ratio of 3:1. This bank adjusted net debt to EBITDA ratio relates specifically to the company's bank facilities and notes and excludes the new non-recourse credit facility, which had approximately $42 million drawn on September 30.With substantial undrawn credit capacity and cash on hand, we remain well-positioned to capture opportunities as the industry activity continues to recover. Our net debt decreased by $80 million versus September 30, 2020, as we continue using cash flow to decrease net leverage and strengthen our balance sheet. With respect to liquidity, Enerflex has $102 million of cash on hand and access to $664 million on our bank facility giving us significant flexibility to manage our resources as the industry recovers and to consider both organic and inorganic growth.Lastly, Enerflex Board will continue to evaluate dividend payments on a quarterly basis based on the availability of cash flow and anticipated market conditions, yesterday, increasing its dividend to $0.025 per share to be paid on January 6, 2022. This amount represents a 25% increase to our dividend and is consistent with our long-term strategy of maintaining a strong balance sheet and delivering sustainable returns to shareholders.This completes the formal component of the webcast. Additional details can be found in our November 4 press release. We will now be happy to take any questions.

[Operator]

[Operator Instructions] Our first question comes from Aaron MacNeil of TD Securities.

[Aaron MacNeil, Equity Research Analyst]

Sanjay, could you perhaps engage in a bit more handholding for us as it relates to the $200 million BOOM project and in terms of revenue recognition, funds flow, and any other notes on accounting treatment since it's being accounted for as a financing lease?

[Sanjay Bishnoi, Senior VP & CFO]

Sure. Yes, Aaron. So it is a finance lease and the number that was disclosed is sort of the lifetime revenue associated with the contract. It will be much like the other finance lease contracts that we've signed. It would not be counted as CapEx but there will be an upfront cash outlay on the deal. And then we earn back the revenue over a 10-year period. And it's a high-quality international counterparty, and we're pretty excited about the deal.

[Aaron MacNeil, Equity Research Analyst]

Can you give us a sense of like what kind of work-in-progress inventory build we should expect or any of the moving parts in terms of the materiality?

[Sanjay Bishnoi, Senior VP & CFO]

Yes. So really round numbers, let's call it, $100 million.

[Aaron MacNeil, Equity Research Analyst]

Okay. That's helpful. And then a bit more high-level for Marc. Assuming we can all agree on the merits of incremental BOOM projects, what would you say to investors that maybe would have liked to see the company prioritize other capital allocation initiatives, such as a dividend that represented a much larger portion of free cash flow, share buybacks or further debt reduction over and above growth in the -- growing the infrastructure?

[Marc Edward Rossiter, President, CEO & Director]

Aaron, I'd say that this investment in the Middle East is exactly the kind of thing that's been part of -- a core part of our strategy for a number of years now, and we've signaled to all of investors that investing in good return, steady projects with good counterparties is a priority. And so that's what I would say to them, that this is exactly the strategy we've been talking about for a few years. It's a great win for us, we like the business, and it falls well within our ability to fund it. And we've got low leverage. So I feel like this project is just a great project exactly what we're trying to do and in line with our strategy.

[Aaron MacNeil, Equity Research Analyst]

Great. Last one for me on the energy transition initiatives. I know it's early days but could you maybe give us an update on the types of business models you might pursue or a potential time line of when we might expect to hear a bit more?

[Marc Edward Rossiter, President, CEO & Director]

Yes, sure. I'll take that one, Aaron. We're really excited about carbon capture. It really plays off our modular equipment history and expertise. We'll play in carbon capture as owners or manufacturers and servicers of the equipment. It's uncertain how that market will shake out. And I think it will be different in Canada and the United States where we're currently looking at projects, whether there's asset ownership opportunities for us or if it will be mainly as equipment providers and service provider site equipment. Renewable natural gas, non-fossil fuel gas, we're a natural gas company, so we absolutely want to be in any new sources of natural gas, which is RNG and landfill gas. You'll notice in the quarter, we had a good win for some landfill gas opportunities in North America. We're excited about that. We're looking really closely into RNG and trying to understand the space. We think it's a critical component of the natural gas grid going forward although the market opportunity is quite a bit smaller than how we would evaluate carbon capture and storage. But it's interesting to us. It's modular, it's natural gas. It's something that we should be involved with, so we're looking pretty closely at that. I would say hydrogen is sort of third place for us. We think it's a little bit longer term. It may not play into our modular capabilities quite as nicely as CCUS and RNG. But we've got a long history of building equipment for hydrogen, mostly blue hydrogen manufacturers, and we're quite active in bidding equipment in that industry still. But it's not as much of a really differentiated ETX play it is participating with the clients that have always been in hydrogen. Timing, Stefan and Sanjay will be working on better disclosures and descriptions of our strategy for ETX. Early 2022, mid-2022, we'll come out with more clarity and what our strategy is there.

[Operator]

Our next question comes from Tim Monachello of ATB Capital Markets.

[Tim Monachello]

Market seems to be focusing, I would imagine, on the margin degradation in the Engineering Systems segment. So I'm wondering if you could speak a little bit to what you're seeing on the cutting-edge in terms of new bookings that are coming in. What does the margin profile look like that -- on that compared to what you have in your backlog?

[Marc Edward Rossiter, President, CEO & Director]

Tim, sector fundamentals are improving but the pricing pressures remain high, and there's a risk of supply chain disruptions further challenging the margins going forward. The Q3 and Q2 were great quarters for bookings, but there is a lot of margin pressure in those quarters. We're seeing maybe in the last 5 weeks since the close of Q3, the markets continue to tighten. We feel that our -- the one portion of our Engineered Systems business compression packaging, there is a lot of supply of packaging capacity, and we don't feel that that is so full that there's going to be a significant inflection in margins on that part of our business right away. International work, gas processing, process refrigeration is a different story, and we really hope that in the coming quarters, there'll be the ability for us to garner more traditional margins.

[Tim Monachello]

Okay. That's helpful. In the commentary, you'd also mentioned outside of that one large project that you've won subsequent to the quarter is encouraging. A few other projects that you won that I imagine are smaller in nature. Wondering if you could just speak to that.

[Marc Edward Rossiter, President, CEO & Director]

Sure. They're in our ROW segment and they're sort of a blend of re-contracting and moving idle assets to other locations, installing them, and getting them running. So sort of a combination of our ITK business where we do the installation, reactivating idle equipment, expanding certain facilities that we had operating. So let's say, around 6 -- a little bit less than 6 projects throughout the ROW region. Modular equipment, compression gas processing, right down the strike zone of what we're good at.

[Tim Monachello]

Okay. Would those be ownership opportunities?

[Sanjay Bishnoi, Senior VP & CFO]

Yes, they are. Yes, they're boom projects with existing customers.

[Tim Monachello]

Okay. How should we think about CapEx for 2022?

[Sanjay Bishnoi, Senior VP & CFO]

So Tim, usually, we talk about the capital program in conjunction with Q4 results. I guess what I would say is, philosophically, I wouldn't expect any change from how we've been managing the company, living -- roughly living within cash flow.

[Tim Monachello]

Okay. And then last one to me, just on supply chain. Can you speak to the lead time for new projects? Is there -- has that extended materially just given ability to source parts and critical inputs for compression processing facilities?

[Marc Edward Rossiter, President, CEO & Director]

It's longer lead times today than it was, let's say, a quarter ago. It's manageable and I still think the lead times for our equipment is within the normal planning cycle for E&P companies and midstream operators.

[Operator]

[Operator Instructions] Our next question comes from Cole Pereira of Stifel.

[Cole J. Pereira, Associate]

I just wanted to maybe start on the margins. You've kind of identified 2 factors here, call it a ramp-up of manufacturing and maybe some work mix. And then, on the other hand, you have supply chains. I guess, which one do you really see as being more material and more of a threat to forward margins? Because one kind of screams as more transitory, whereas the supply chain issue might be around a little longer term?

[Marc Edward Rossiter, President, CEO & Director]

Cole, this is Marc. I would say that the margin pressure sort of supply-demand was the more dominant issue the last 2 quarters. And going forward, it very well could flip over to the supply chain portion of it.

[Cole J. Pereira, Associate]

Okay. That's helpful. Thanks. I guess with that in mind, I mean, you kind of touched on it earlier but how should we be thinking about margin improvement into Q4 and maybe into Q1?

[Marc Edward Rossiter, President, CEO & Director]

It's difficult for us to predict. I expect the margin pressures will hang around for at least another couple of quarters as the supply side gets busy. But what's -- what we're optimistic about or what might bring that in is the fact that we all know the commodity macro is extremely positive. And customers have been showing a lot of capital discipline, they continue to do so. However, our bid pipeline is more solid. It continues to be quite positive on that side. And so if we're going into our third quarter after the inflection from the crisis and as people continue to buy stuff, then we expect the margins will come up. When we compare this down cycle to other ones, it definitely hasn't come up as fast as you may have modeled from 2015, '16, or even from the global financial crisis. And I think the thing that's making it less of a snappy rebound is definitely the capital discipline story amongst the operators in our main shale basins in North America. The good part of it is our exposure internationally. The international customers are not quite as cyclical as North America. And we've pointed out in our script that about half of our bookings were from international markets. And that's really positive for us. We're very happy to have that exposure. And there's one more thing I wanted to mention on that front. No, I guess that's it. Thanks, Cole.

[Cole J. Pereira, Associate]

Okay. Thanks. And as well, just your comments on the landfill gas project. I assume that's -- that was the non-fossil-fuel-based Engineered Systems work and are you able to just quantify exactly how much that was or maybe give some kind of goal posts?

[Marc Edward Rossiter, President, CEO & Director]

I mean we obviously know how much it was, but it's not something we would disclose. It was meaningful enough for us to mention, but we'll leave it at that.

[Operator]

At this time, I'd like to turn the call back over to Marc Rossiter for closing remarks.

[Marc Edward Rossiter, President, CEO & Director]

Since there are no further questions, I'd like to once again thank you for joining us on the call. We look forward to giving you our fourth quarter results in February.

[Operator]

This concludes today's conference call. Thank you for participating. You may now disconnect.