Pason Systems Inc

TSX:PSI

Earnings Call Transcript 2018-Q1

[Operator]

Good morning. My name is Sarah, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Pason Systems, Inc. first quarter results call. [Operator Instructions] The contents of today's call are protected by copyright and may not be reproduced without the prior written consent of Pason Systems, Inc.Please note that the advisory is located at the end of the press release issued by Pason Systems yesterday, which describe forward-looking information. Certain information about the company that is discussed on today's call may constitute forward-looking information. Additional information about Pason Systems, including the risk factors relevant to the company, can be found in its annual information form.I would now like to turn the call over to your host, Mr. Marcel Kessler, President and CEO; and Jon Faber, CFO. Please go ahead, gentlemen.

[Marcel Kessler, President, CEO & Director]

Thank you. Good morning, everyone, and welcome to Pason's First Quarter 2018 Conference Call. I will start with the highlights of first quarter performance. Jon will dive into the details of our financial and operational performance. I will close with our perspectives on the outlook for the industry and for Pason, and we will then take any questions.Pason achieved good first quarter 2018 results. We generated revenue of $73.8 million in the period, an increase of 25% from the prior year quarter and up 11% from the fourth quarter of last year. The main drivers of revenue growth were increased drilling activity and market share gains in the United States as well as higher revenue per EDR day in both Canada and the United States. Revenue from our International business was also up, driven by activity improvements in Argentina and Australia.Adjusted EBITDA was $34.8 million for the quarter, an increase of 40% from the prior year quarter and up 26% sequentially. Adjusted EBITDA as a percentage of revenue increased to 47%. The driver of this improvement was the significant increase in revenue with high incremental margins.Pason recorded net income of $12.4 million or $0.14 per share compared to $6.8 million or $0.08 per share in 2017, an increase of 82%.On March 31, our working capital position stood at $212 million, including cash of $163 million. We carry no debt on our balance sheet, and we are maintaining our quarterly dividend at $0.17 per share.Starting this quarter, we are reporting our revenue along 5 product categories, which better reflects the changing nature of Pason's business and which are aligned with how we think about our investments in new products and services.The first segment is Drilling Data. It contains all products and services associated with acquiring, displaying, storing and delivering drilling data. This includes our core product, the Electronic Drilling Recorder, or EDR, and all its peripherals. It also includes Pason Live and the DataHub, various data feed services and the Electronic Service Recorder. The Drilling Data segment currently accounts for about half of Pason's total revenue.The second segment, Mud Management & Safety includes products, such as the Pit Volume Totalizer, Gas Analyzer, Hazardous Gas Alarm and the Electronic Choke Actuator. In the first quarter, Mud Management & Safety generated 29% of total revenue.Third, the Communications segment includes satellite and terrestrial Internet bandwidth, Wireless Rigsite, VoIP and intercom services and accounted for 11% of total revenue.The Drilling Intelligence segment bundles Pason's offers targeted at enabling our customers' drilling optimization and automation efforts. It contains products such as AutoDrillers, the abbl Directional Advisor and the ExxonMobil DAS, Drilling Advisory System. In the first quarter, Drilling Intelligence generated 6% of total revenue.Finally, Analytics & Other includes our Verdazo Discovery Analytics product, various types of reports and other, and accounted for 4% of revenue.I am now turning the call over to Jon Faber for a more detailed look at the financials.

[Jon Faber, Chief Financial Officer]

Thank you, Marcel. As Marcel noted, we were pleased with Pason's first quarter financial results. A significant improvement in U.S. industry activity, market share gains made throughout the past year and higher revenue per EDR day, all drove strong U.S. results. Despite a more challenging industry context, our Canadian business unit was able to post strong results by retaining a strong competitive position and increasing revenue per EDR day through increased adoption of new product offerings, particularly in our Drilling Intelligence category. We saw revenue gains in each of our international markets. Continued discipline around both operating costs and capital expenditures drove strong incremental margins and free cash flow.Consolidated revenue in the first quarter totaled $73.8 million, up 25% from the same period in 2017 and up 11% sequentially from the fourth quarter. Increased industry activity, growth in U.S. market share and improvements in revenue per EDR day, all contributed to year-over-year revenue growth while the seasonal nature of the Canadian drilling industry helped drive the sequential improvement.Adjusted EBITDA for the quarter of $34.8 million represented an adjusted EBITDA margin of 47%. This compared to $24.9 million and a 42% margin in the prior year period and was a $7 million sequential improvement from the fourth quarter of 2017.Net income of $12.4 million for the quarter was up $5.6 million from the first quarter of 2017 and up $7.3 million sequentially. On a per share basis, earnings for the quarter came in at $0.14 a share compared to $0.08 per share a year ago.Capital expenditures of $5.8 million in the first quarter were up $4.7 million from the same period of 2017 and down 37% sequentially. We continue to expect to spend up to $25 million on capital expenditures, including the capitalized portion of our R&D and IT investments in 2018.Financial results in our U.S. business unit continue to be strong. In the first quarter, revenue of $44.1 million was up 47% compared to $30 million in the first quarter of 2017 and up 5% sequentially from the fourth quarter. Year-over-year, industry activity increased 32%, while market share increased by 500 basis points. Revenue per EDR day increased 7% both as a result of higher adoption of a broader range of Pason products associated with recent market share gains and targeted price increases on some of our existing products. Sequentially, industry activity was up slightly from the fourth quarter and revenue per EDR day increased by 5%. Market share was down slightly compared to the fourth quarter due to the mix of customers who were active during the period. Segment gross profit for the U.S. business unit of $23.4 million in the quarter was a $12.6 million improvement from the prior year period and increased $1.7 million sequentially.The Canadian business unit managed to outperform challenging industry conditions in the first quarter. While industry activity was 9% lower compared to the first quarter 2017, Pason's revenue decrease was only 2%. A 10% improvement in revenue per EDR day driven by the rollout of products in our Drilling Intelligence suite and adoption certain additional communications offerings helped to offset much of the revenue decreases in other product categories. Sequentially, revenue increased 32%, driven by a 29% increase in industry activity and a 260 basis point increase in market share. Segment gross profit for the Canadian business unit of $11.7 million was down $548,000 from the first quarter of 2017 and up $7.7 million sequentially.In the International business unit, the first quarter delivered higher revenue in each of our operating geographies. As a result, first quarter revenue of $6.3 million was up 23% from the first quarter of 2017. Sequentially, revenue as stated in Canadian dollars was essentially unchanged as a significant devaluation of the Argentinian peso between the fourth quarter of 2017 and the first quarter of 2018, offset gains measured in local currencies. Segment gross profit in the International business unit improved by $770,000 year-over-year from a loss of $134,000 in 2017 to a profit of $636,000 in 2018. Sequentially, International business unit segment gross profit was up 15%.To recap, our financial results in the first quarter were strong. We saw significant revenue growth in the U.S. and International segments, while the Canadian business unit managed to outperform a difficult operating environment. We continue to see benefit from the operating leverage in our business and continue to post attractive incremental margins. Our balance sheet is strong with $212 million of working capital, including $163 million of cash and no debt. We are maintaining our quarterly dividend at $0.17 per share.And I'll now turn the call back to Marcel for his comments on our outlook.

[Marcel Kessler, President, CEO & Director]

Thank you, Jon. Our level of confidence in the successful commercialization of new products has grown through the first quarter of 2018. The number of successful technical and commercial trials have increased significantly. For example, during the peak of the winter drilling season, we had over 70 concurrent installs of new Drilling Intelligence products in Canada, resulting, as Jon mentioned, in a year-over-year increase of revenue per EDR day of 10%. We have increased our total investment in R&D and IT, with a particular focus on machine-learning algorithms. There is some further growth planned for the coming quarters.Our capital expenditures will be relatively modest going forward, with a large portion of development efforts focused on software and analytics. We intend to spend up to $25 million in capital expenditures in 2018. Our highly capable and flexible IT and communications platform can host additional new Pason and third-party software at the rig site and in the cloud.Finally, a quick look at the global energy picture. There were no more increases in global oil stocks during the first quarter of 2018, supported by OPEC- and Russia-led production costs. It appears that the oil market is coming into balance, and this has led to higher oil prices. In addition, after 3 years of underinvestment in global E&P spending, the worldwide production base has started to show signs of weakness, with year-over-year production declines in several countries. It is becoming increasingly likely that the industry will face supply challenges over the coming years and a significant increase in global E&P investment will be required to minimize the impending deficit.The only major sources of short-term supply growth to address global production declines are in the Middle East, Russia and the U.S. shale industry. Pason's market positions remain very strong. We are the service provider of choice for many leading operators and drilling contractors with Pason equipment installed on over 65% of all active land drilling rigs in the western hemisphere. We are uniquely positioned to participate in the industry's growth.And we would now be happy to take any questions.

[Operator]

[Operator Instructions] Your first question comes from the line of Greg Colman from National Bank Financial.

[Greg R. Colman]

Just a couple of questions here. Incremental margins, we saw a couple of hundred basis points ahead of what we were expecting, over 500 basis point gain from Q4. Is there still some more to go there? Or is this 47% EBITDA near the top of what we're looking for? And just to put it a different way, what are the incremental margins you're seeing from the added dollar of revenue? Are you near the top of the margin band before you need to step up costs on either bandwidth or regional basis or something? Or should we still see some more expansion from here?

[Jon Faber, Chief Financial Officer]

Greg, it's Jon. I think there is opportunity for some more incremental margins from here. I guess, I there's maybe 2 specific things I would point to. One is more and more of a revenue growth is coming from some of these more software-based or algorithm products, particularly in the Drilling Intelligence suite, where there isn't quite the same amount of repair expense, for example, because you're not dealing with the hardware product. And also some of the expense we would have incurred as the industry has been picking up has been more around the repair expense side. And we think we're in good position with our equipment now to sort of have more of a normalized repair expense going forward. So the -- both of those should help on the incremental margin basis.

[Greg R. Colman]

Any thoughts on quantifying incremental margins?

[Jon Faber, Chief Financial Officer]

I think I'll just say, we think there's still some room from here.

[Greg R. Colman]

Marcel, you were mentioning in your closing remarks there about potential for supply growth and you highlighted on a few regions, including Russia, the Middle East and the U.S. shale. Your position in the U.S. shale is strong with a 60%-plus market share depending on how you slice it. But in other parts of the world, your market share, I believe, is sitting a little bit lower. What are your thoughts on increasing Pason's exposure to that part of the world, if that's something that drives incremental production?

[Marcel Kessler, President, CEO & Director]

Yes. So you're right. Obviously, our exposure in the U.S. and specifically in the Permian is significant. In fact, our Permian market share would be above average for the U.S. So it's higher than 60%. We have not been present in Russia and have no plans to do so. But as you know, we have entered the Middle East market a few years ago, one through a joint venture in Saudi Arabia. And with the business development office in Dubai that serves the broader region, including Kuwait, Oman and the United Arab Emirates. We estimate that our market share today in the Middle East in terms of presence on rig is probably of the order of 10%. Obviously, a lot of room for growth there, but clearly, we intend to participate in any growth in that region.

[Greg R. Colman]

Okay, great. And then just 2 last quick ones for me. Specifically on the U.S., with the activity uptick -- or sorry, with the oil uptick here, are you seeing any activity uptick in some of the higher cost regions, like the Bakken, with WTI sitting firmly above $65 here?

[Marcel Kessler, President, CEO & Director]

We haven't seen much yet. Really most of the activity increase has been and still is focused in the Permian.

[Greg R. Colman]

Okay, good. And then just finally on the dividend. Minimal capital expenditures coming in this year, moving onto software stuff, which is lower CapEx, positive outlook on oil and your comments last quarter that an increase in the quarterly dividend would likely be the highest priority. What would your views be today on the dividend and the dividend growth probability?

[Jon Faber, Chief Financial Officer]

I think there's a couple of considerations when you look at the regular dividend. And so I probably need to sort of bifurcate the discussion around excess cash balance because I think we've been fairly transparent about the fact that we probably have more cash on the balance sheet that we need for the long term and then the question around the excess cash flow generation. Because we have pretty significant operating leverage in the business, obviously that helps us when things go up. But if the back half of the year was to be a little bit slower than what the forecasts are today, then pretty quickly that buffer of free cash flow generation could get absorbed. So that's one thing we sort of keep in mind, particularly as we come into the second quarter, which is of our slowest quarter typically because of the seasonality of the Canadian business. We probably want some clarity around what the back half delivery will look like in terms of the free cash flow side. And then the other thing you look at is while we don't have specific targets around yields and payout ratios and those sorts of things, I would note that in the first quarter, which is a strong quarter for us, we delivered $0.14 of earnings and the dividend is still $0.17 per share. So that would be something that we would be mindful of as well. But it is certainly one of the capital allocation questions that we look at regularly is what we're doing with the regular dividend.

[Greg R. Colman]

So Jon, would it be accurate to characterize those comments as you sort of dialing back a little bit the optimism on potentially a dividend increase in the near term?

[Jon Faber, Chief Financial Officer]

I think it's really around the question around the confidence on free cash flow generation kind of sustainably in the long run. So as that confidence continues to build and macroeconomic factors seem to be improving, particularly on the U.S. side, that would give more credence to looking at it. But there's nothing that we're announcing today in terms of the regular dividend.

[Marcel Kessler, President, CEO & Director]

I don't think our -- the -- it being the first priority or a high priority for the board or our optimism around future growth has really changed, right? I think what Jon has been saying here is just our free cash flow generation in the first quarter outpaced the dividend by a bit, by not that much. We have spent more on the dividend than we have generated in earnings. And going into the second quarter, which, as you know, is typically the slowest quarter for Pason in the year, it didn't feel like this was the right time to make that increase.

[Operator]

Your next question comes from the line of Ian Gillies from GMP.

[Ian Brooks Gillies]

In the release, you specifically highlight running the Drilling Intelligence product on 70 rigs in Canada. And with respect to that, I mean, is that really the focus area of growth right now and then you'll take that product and move it down to the U.S. and try and market it there when you have more data? Or can you just, I guess, provide a bit of an update around the strategy there? And why there was no specific mention of the U.S., I guess?

[Marcel Kessler, President, CEO & Director]

Yes, so it was in addition to essentially trial the product and refine it in Canada first. So that was a very conscious decision. And we felt that we wanted to do that in Canada now because the major activity is actually in the winter drilling season. We felt that it would be a missed opportunity to refine the product here close to our R&D base. We will have to wait almost until the next winter drilling season to have the numbers that we were able to have here. The idea clearly is to roll this out more broadly into the U.S. and internationally as well. It is not the reflection of our belief around where growth will come from in the future. It's quite the opposite. It's quite obvious that the growth has been and will likely continue to be in the U.S.

[Ian Brooks Gillies]

Okay. And with respect to, I guess, the Drilling Intelligence service line and what was working during the quarter, was there any particular products that stood out to you that customers wanted or seem to be particularly impressed with, just given, I mean, there's a number of different items in there whether it'd be abbl or the Drilling Advisory System and so forth?

[Marcel Kessler, President, CEO & Director]

There are several products and there's some of which we have talked about, a couple which we have actually not. Some of the customer pull is interestingly for some products we have not yet talked about. [ We feel ] it's not quite ready for making it public. I think the one product the really stood out that we have talked about is deployment of the ExxonMobil DAS algorithm combined with an AutoDriller. And that is -- has been the biggest number in the first quarter here.

[Ian Brooks Gillies]

And not to get too deep in the weeds, but why those 2 products together?

[Marcel Kessler, President, CEO & Director]

So the 2 products together is essentially ExxonMobil. That is available in 2 fundamentally different implementations. One is with the AutoDriller and one is without. And again, don't want to get too technical here, but there are 2 different implementations of that combination, too. One is on the more traditional mechanical rigs, and the other is on the modern AC rigs. So those are different implementations. So we have solutions for both. But we were able to demonstrate the biggest performance improvement and had the most customer interest here in the winter drilling season in Canada and then combining the algorithm, the Exxon DAS drilling algorithm within an AutoDriller.

[Ian Brooks Gillies]

Okay. And with respect to the U.S., I mean, the revenue per EDR day on a consolidated basis ticked up nicely sequentially. Was there any particular product adoptions there that helped to boost that number? Or is there anything we should be thinking about with respect to that, I guess, that data point?

[Jon Faber, Chief Financial Officer]

Sure, Ian. There's 2 contributors to the growth on the U.S. revenue per EDR day. One is, what we talked over the last couple of conference calls around pulling along some of these follow-on rentals alongside some of the revenue -- market share gains we'd had in prior quarters. And then we had also mentioned that we did have some targeted price increases on certain products that would have been implemented very late in the fourth quarter, so the effects would really show up in the first quarter. Probably north of 3/4 of the revenue per EDR day improvement actually comes from just adoption overall of some of these pull-through revenue items. And for a little less than 1/4 from the price increase side. But there's no one specific product. It's really that suite of follow-on rentals that's come alongside.

[Ian Brooks Gillies]

Okay. And are you able to provide a bit of an update on what's happening in Saudi Arabia? There is obviously -- it looks like there's been some rigs changing hands, some rigs being laid down. And so could we maybe just get a bit of an update on market share? And what you're seeing from a customer demand standpoint in that region? And perhaps even what you're hearing from your customers or from our rig count growth perspective moving forward?

[Marcel Kessler, President, CEO & Director]

So the rig count in the Kingdom has been surprisingly constant over the last several years, and they hover around the low 200s. We don't have much insight into the plans. I think, there's some modest growth plans, but I haven't seen anything that will be a game changer in terms of growth plans. In terms of our market share, we have been of the order of 10% as in the broader Middle East region. As you know, we announced that last year, we had our first direct contract with Saudi Aramco. That was awarded last summer. And we are now in the process of trialing some of our new Drilling Intelligence products with Saudi Aramco. Now obviously, we hope that some of those will gain traction, I think, that would be very important for Pason's future with Saudi Aramco. But it's early days. So I don't want to give you an outlook of how that might play out.

[Ian Brooks Gillies]

Okay. And last one from me, Jon. You spent some time talking about what you call the regular dividend and perhaps I'm just reading too much into it. But is there going to be some contemplation around a special dividend at some point, given the cash position and just rather than having that quarter-to-quarter, I guess, cash commitment?

[Jon Faber, Chief Financial Officer]

Well, I think there are different ways of dealing with the excess cash balance side, right, if we didn't separate those 2. So one way was, of course, maintaining the regular dividend through the downturn, which we'd done and we did take a little bit of cash off the balance sheet to do that a couple of years ago. The other kind of 3 available sources of capital for capital allocation, really M&A opportunities, as they become available, and that's an opportunistic question, the special dividend concept or share buybacks, I don't think we would necessarily immediately gravitate to the special dividend as first among those 3, but those would be the 3 that would be contemplated if we're looking to remove some of the excess cash balance.

[Operator]

Your next question comes from the line of Jon Morrison from CIBC Capital Markets.

[Jon Morrison]

I realize it might be hard to communicate or you don't want to communicate at this point. But what would be the upside revenue potential on a per day basis for a rig that was running a high suite of call it traditional Pason products that then moved to a high level of incremental new Drilling Intelligence products, call it, the Exxon DAS, the abbl and maybe even an AC AutoDriller?

[Jon Faber, Chief Financial Officer]

So I probably don't want to quantify that, Jon. There are 2 factors, as you know. There's the question around what the price points are for these products, and there's a question on what that adoption rates are for the products.

[Jon Morrison]

If you could answer both of those, that would be good.

[Jon Faber, Chief Financial Officer]

Yes, you're right. Actually the thing is -- look, it's fair to say that if you had the price points, it would be in excess of what we would have today, but then the adoption obviously is the big question mark that frankly we can't predict what that would be, right? So...

[Marcel Kessler, President, CEO & Director]

Yes, so I think on the price point, I think we could for a fully outfitted rig, it would be a significant increase in revenue for EDR day. Now again, the penetration, your estimate is as good as ours at this point.

[Jon Morrison]

Okay. Is it fair to assume that we're talking hundreds of dollars per day is the upside potential one versus the other?

[Marcel Kessler, President, CEO & Director]

Absolutely. Some of the new items we have here would be significantly higher priced than our traditional products.

[Jon Morrison]

Can you share how many customer trials that were going on in Q1 were paid versus essentially free just for a trial basis?

[Jon Faber, Chief Financial Officer]

Yes, very few are actually free trials...

[Marcel Kessler, President, CEO & Director]

[indiscernible] Canada...

[Jon Faber, Chief Financial Officer]

On the Canadian side, which is where much of this activity was coming from, in fact, the customer interest was so high that simply in order to meet the demand, we weren't able to do free trials because we're too busy on the paid side. So we were only able to accommodate those prepared to pay.

[Jon Morrison]

Okay. And when you talk about potential pricing on the back end of it, were any -- did any customers come back and say, "I think it's a unique product, but from a pricing perspective, it just doesn't make sense?" Or that doesn't appear to be a pinch point at this stage?

[Marcel Kessler, President, CEO & Director]

By and large, it doesn't appear to be a pinch point. I mean, the Canadian situation, as you know, is quite disconnected from the U.S. and certain Canadian operators feel more of a pinch than others. So it will be at a range of conversations. But overall, pricing was not really an issue.

[Jon Morrison]

Okay. Is there anything taking hold in the international markets where you operate from a customer perspective that would lead your performance to trend out of line with the rig count growth in those markets? Specifically, has there been any large customer wins or losses that we should be thinking about in any geographies?

[Marcel Kessler, President, CEO & Director]

Not at this point, no.

[Jon Morrison]

Okay. On the dividend, not to harp on it for the entire call, but is it fair to say that stability is king at this point and the fact that you partially funded it out of the balance sheet in the downturn leaves you less likely to increase it for the coming period, then you'd have to be very confident with the forward market to really think about permanently increasing the dividend?

[Marcel Kessler, President, CEO & Director]

Yes, I think we want to be confident on the outlook for our free cash flow generation for the following 18 months, maybe. I don't think you ever have much more visibility than that anyway. But as Jon mentioned, I think, our cash flow -- free cash flow forecast here for 2018, it's a little bit more heavily weighted to the back end than the front end. So we would like to see how that plays out over the next couple of months before making a decision.

[Jon Morrison]

Okay. Marcel, is it fair to assume that the modest market share slippage we saw in the U.S. was just customer mix related this quarter and there was no notable customer losses in Q1?

[Marcel Kessler, President, CEO & Director]

That's correct, yes.

[Jon Faber, Chief Financial Officer]

Absolutely.

[Jon Morrison]

Last one just for me. Can you give any more color on pricing conversations in both Canada and U.S. right now? And I'm thinking more on your traditional product suite? You just mentioned that there was some pricing gains in the U.S. And I'm wondering if you expect more of that to unfold or it's fairly static from here?

[Marcel Kessler, President, CEO & Director]

I don't expect more to unfold in terms of actual price increases. But as Jon mentioned, in terms of the selective price increases that were made in The United States, it would not have seen that fully come into the financials. So I think you will see more of that or some more of that in Q2.

[Jon Morrison]

So on an average basis, it goes up, but probably nothing left in the balance of the year from a price [ book ] perspective?

[Marcel Kessler, President, CEO & Director]

Yes, I think that's right, yes.

[Operator]

[Operator Instructions] Your next question comes from the line of Elias Foscolos from Industrial Alliance Securities.

[Elias A. Foscolos, Equity Analyst]

Most of my questions were asked, but I do have one to sort of throw out on Drilling Intelligence. So clearly, we should keep our eyeballs on Drilling Intelligence. And correct me if I'm wrong here, and clearly, we should keep looking at it in the U.S. Is that correct?

[Jon Faber, Chief Financial Officer]

Well, I think you'd look at it in both now. Maybe the one thing to note, Marcel made reference to the sort of the difference between the mechanical rigs and the sort of AC rigs in terms of how some of these products operate. So the mechanical rig installations are a little easier to scale. So that mechanical market, if you will, would be kind of a smaller addressable market, easier to scale and probably a little less incremental revenue opportunity, whereas the more AC market would be a larger addressable market, a higher incremental revenue opportunity and likely slower to scale because there's more engineering work to be done. So if you just look at the relative mix in the U.S. versus Canada, because you have less mechanical rigs in the U.S., you probably see a longer time line to revenue delivery because of the incremental engineering effort in the U.S. market by virtue of the rig mix.

[Elias A. Foscolos, Equity Analyst]

Okay. And if you were testing a lot of new products out in Canada before the U.S., can we expect to see U.S. sort of rolling out in the second half of this year? It might not be visible, but is that kind of your -- from the financial or the disclosure, but is that kind of the time frame we should be looking at?

[Marcel Kessler, President, CEO & Director]

Yes, I think that's the correct time frame, yes.

[Operator]

And I'm showing no other questions at this time. Ladies and gentlemen, that does conclude our conference call today. Thank you for your participation. You may now disconnect.