Pason Systems Inc

TSX:PSI

Earnings Call Transcript 2019-Q1

[Operator]

Good morning. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the Pason Systems Inc. First Quarter Results Conference Call. [Operator Instructions] The contents on today's call are protected by copyright and may not be reproduced without the prior written consent of Pason Systems Inc.Please note, 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.Thank you. Mr. Marcel Kessler, President and CEO, you may begin your conference.

[Marcel Kessler, President, CEO & Director]

Thank you. Good morning and welcome to Pason's First Quarter 2019 Conference Call. With me here in Calgary today is Jon Faber, our Chief Financial Officer.I will start with the highlights of the first quarter. Jon will dive into the details of our financial performance. I will close with a brief perspective on the outlook for the industry and for Pason, and we will then take any questions.Pason continues to perform well in all geographies, and we are pleased with our financial results in the first quarter of 2019. We generated revenue of $82.1 million in the period, an increase of 11% compared to the same quarter last year. The main drivers of revenue growth were increased industry activity in the United States, significantly higher activity levels in all Pason's international markets and increased penetration of Drilling Intelligence and data delivery products.Adjusted EBITDA was $40.6 million, an increase of 17%. Adjusted EBITDA as a percentage of revenue was 50% compared to 47% 1 year ago. The driver of this improvement was an increase in revenue with high incremental margins. Adjusted EBITDA was also positively impacted by the adoption of IFRS 16 that is the change -- a change in accounting treatment of leases, and Jon will speak a bit more about that later.Pason recorded net income for the quarter of $19 million compared to $12.4 million in the prior year. At March 31, our working capital position stood at $258 million, including cash and short-term investments of $184 million. We are maintaining our quarterly dividends at $0.18 per share.As you know, we report our revenue along 5 product categories: Drilling Data, continues products and services associated with acquiring, displaying, storing and delivering drilling data. Revenue in this category increased 16% in the first quarter compared to the prior year and accounted for 53% of total revenue. This growth was driven by a 7% increase in U.S. land drilling activity, by market share gains in both the United States and Canada and by strong demand for our data delivery services, and was partially offset by a 32% decline in Canadian drilling activity.Internationally, drilling activity increased in all major markets with the largest absolute increases being in Australia and Argentina.Mud Management & Safety includes products such as the Pit Volume Totalizer, Smart Alarms, Gas Analyzers and Hazardous Gas Alarm. In the first quarter, Mud Management & Safety revenue increased 11% and generated 29% of total revenue.Communications include satellite and terrestrial Internet bandwidth, Wireless Rigsite and other services and accounted for 7% of total revenue.Revenue in this category is showing negative growth because of the transition from satellite to terrestrial bandwidth, allowing us to share cost savings with our customers while providing a better experience for users.Drilling Intelligence bundles Pason's products offerings targeted at enabling our customers drilling optimization and automation efforts. It contains products, such as AutoDrillers, abbl Directional Advisor, the ExxonMobil Drilling Advisory System and Pivot, a pipe oscillation system for improving slide drilling. Drilling Intelligence revenue increased 30% in the first quarter compared to the prior year and accounted for 7% of total revenue.Finally, Analytics & Other includes our Verdazo Discovery Analytics product suites, various reports and some other revenue streams. This category is not directly correlated to drilling activity, grew 14% and accounted for 4% of total revenue in the first quarter.And I am now turning the call over to Jon.

[Jon Faber, Chief Financial Officer]

Thank you, Marcel.As Marcel noted, we were pleased with Pason's first quarter financial results. Year-over-year improvements in U.S. industry activity, market share gains and higher revenue per EDR day, all drove strong U.S. results. The Canadian business unit managed to outperform the underlying drilling activity by 11%, seeing its revenue decreased by 21%, while drilling activity decreased by 32%. Our International business unit posted its strongest gross profit since 2014 on the back of a 46% revenue increase with revenue growth in each of its major operating regions. And we continue to prudently manage both operating costs and capital expenditures.Before I review the financial results in more detail, I'll remind you that Pason adopted IFRS 16 related to lease accounting effective January 1, 2019. As a result of this transition, our balance sheet includes additional noncurrent assets of $14 million, offset by a $14 million of additional lease liabilities. Details of the impacts of the adoption on IFRS 16 can be found in the MD&A, which was included in our first quarter interim report filed on SEDAR.Consolidated revenue in the first quarter totaled $82.1 million, up 11% from the same period in 2018 and flat sequentially from the fourth quarter. Increased U.S. industry activity, growth in U.S. market share, improvements in revenue per EDR day and growth across our international business all contributed to year-over-year revenue growth, offset by a significant year-over-year reduction in Canadian drilling activity.Drilling Intelligence again posted the largest year-over-year revenue increase of 30%, while communications revenues were down 24% reflecting both the significant reduction in Canadian drilling activity, where we typically have higher product adoption in the category, and the savings we're sharing with customers associated with the transitions to more terrestrial bandwidth.Adjusted EBITDA for the quarter of $40.6 million represented an adjusted EBITDA margin of 50%. This compared to $34.8 million and a 47% margin in the prior year period and was up 2% sequentially from the fourth quarter of 2018. Net income of $19 million for the quarter was up $6.7 million from the first quarter of 2018 and down $1.7 million sequentially.On a per share basis, earnings for the quarter came in at $0.22 per share compared to $0.14 per share in the prior year period. Capital expenditures of $10.3 million in the first quarter were up $4.5 million from the same period of 2018, and up 22% sequentially from the fourth quarter.We continue to expect to spend up to $30 million on capital expenditures, including the capitalized portion of our R&D and IT investments in 2019.Free cash flow for the quarter came in at $385,000, down from $18.9 million in the first quarter of 2018. The most significant driver of the decrease in free cash flow related to a $15.3 million payment, which related to our bilateral advanced pricing agreement with the CRA and the IRS. Note that we've been carrying offsetting withholding tax payable receivable amounts on the balance sheet, and this free cash flow impact represents a timing difference between the payment to the CRA and receiving the same amount from the IRS once they have reassessed prior year income tax returns.Free cash flow was also lower year-over-year, due to a change in the timing of payouts related to our short-term incentive program, the increased capital program in the first quarter and increased cash taxes now that historical [ net operating ] losses have been fully utilized in both Canada and the U.S.Financial results in our U.S. business unit reflected strong year-over-year activity growth as well as gains in market share and revenue per EDR day. In the first quarter, revenue of $54.5 million was up 23% compared to $44.1 million in the first quarter of 2018 and down 2% sequentially from the fourth quarter. Sequentially, industry activity was down 5% from the fourth quarter and revenue per EDR day increased by 3%. Segment gross profit for the U.S. business unit of $30.6 million in the quarter was a $7.2 million improvement from the prior year period and decreased 4% sequentially.We are continuing to invest in expanding our operational capacity in the U.S. business unit, in anticipation of expected activity increases as new pipelines come on stream in the Permian region later this year.The Canadian business unit managed to outperform very challenging industry activity in the first quarter. While activity was 32% lower compared to the first quarter 2018, Pason's revenue decrease was 21%. A 7% improvement in revenue per EDR day and market share gains helped to offset some of the revenue decrease. Sequentially, revenue increased 3%. Segment gross profit for the Canadian business unit of $8.2 million was down 30% from the first quarter of 2018 and down 3% 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 $9.2 million was up 46% from the first quarter of 2018. Sequentially, revenue increased 5% from the fourth quarter of 2018. Segment gross profit in the International business unit of $3 million improved by $2.3 million year-over-year and marked the highest gross profit for the business unit since 2014. Sequentially, International business unit segment gross profit was up 14%.To recap, we were pleased with our financial results in the first quarter. 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 prudently manage our fixed costs. We remain confident about our new product introductions, which are directly impacting drilling performance and facilitating increased use of data-driven technologies.Our balance sheet is strong with $258 million of working capital, including $184 million of cash and no interest-bearing debt. We are returning cash to shareholders through our regular dividend and our normal course issuer bid program. Our quarterly dividend is unchanged at $0.18 per share.And I'll turn the call back to Marcel for his comments on our outlook.

[Marcel Kessler, President, CEO & Director]

Thank you, Jon.From a macro perspective, we expect oil market sentiments to steadily stabilize and improve over the course of this year. There are clear signs that E&P investments worldwide are starting to normalize as the industry is moving towards a more sustainable financials stewardship of the resource base. This means that higher investments in the international markets are required simply to keep production flat, while North American land is set for a somewhat lower investments at least in the short term.We expect international drilling activity and rig count to further increase going forward. Conversely, in North American land, we see lower capital spending relative to last year as company seems to spend this in cash flow, repair balance sheet and improve shareholder returns.As a result, we expect U.S. land drilling activity and rig count to trend down slightly from current levels, before starting to increase again towards the end of this year. In Canada, infrastructure issues continue to weigh heavily on the outlook for the upstream sector. With drilling activity constrained by operator access to oil and gas markets, Canadian rig counts are expected to remain materially below last year's levels. In this environment, we are prudently managing our fixed costs and maintaining flexibility in our 2019 plans.This gives us the means and confidence to address any activity scenario. Our capital expenditures will be relatively modest going forward, with a larger portion of development efforts focused on software and analytics. We intend to spend up to $30 million in capital expenditures this year. 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.Our market positions remain strong, and we expect to be able to deliver growth in international markets and through higher product adoption and select market share increases going forward.And we will now be happy to take any questions.

[Operator]

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

[Greg R. Colman]

Congrats on a great-looking quarter, gentlemen. I wanted to start by talking about incremental margins. Your Q1 revenue, Marcel, as you mentioned in the opening comments, your Q1 revenue annualized is close to $330 million. And you still posted what we calculate as 70% incremental margins, but please correct me if I'm wrong there. Historically, in prior calls, we've talked about $300 million in annual revenue being at a level where incremental EBITDA contribution starts to drop as you have to add cost. What are your thoughts about incremental margin at this point going forward given now you're probably maybe 10% through the level of what we've talked about in the past? I realize it's nascent but I just wanted to get your thoughts about additional high incremental margins.

[Jon Faber, Chief Financial Officer]

Sure. Thanks, Greg. It's Jon. Maybe I'll just sort of give -- the 70% you referenced, I agree, I understand how you calculate that. There is an impact there from IFRS 16. So if you sort of net out the effect of the accounting it's about 60%, so it is a little bit lower than it would have been historically. We have talked about the increases in organizational capacity in the U.S., particularly around the Permian, and that putting some downward pressure on the incrementals. The other thing that's happened in the first quarter is we have sort of seen some cost reductions in the Communications space. So we've talked about the fact that there's been revenue reductions, but also cost reductions. And so -- so that has offset some of the muting effect, if you will, of the increases in spending on the U.S. capacity question. But I would suggest that we continue to think that 75% incremental is a pretty good number sort of in a medium term with some normal amount of revenue growth. But as the industry is going to continue to be somewhat sideways to down in terms of activity for the next quarter or 2, I think you should expect the incrementals to trend a little lower for the medium term.

[Marcel Kessler, President, CEO & Director]

And maybe just to add, I think as we mentioned in previous quarters, Greg, we do not really anticipate any kind of step function increase in costs.

[Greg R. Colman]

At current levels or modestly above or below?

[Marcel Kessler, President, CEO & Director]

Correct, yes.

[Greg R. Colman]

Got it. Okay. So that's my first one. Secondly, on day rates, your U.S. EDR, the U.S. revenue per EDR in local currency held up very well and Canadian was even better. And -- but it's now a bit above the U.S. $700 a day level for several quarters. Could you offer a little more color as to the details behind that? Is this rig mix? Is it new product penetration apples-to-apples price increases? And then the follow-on would be, should we expect this level of revenue per EDR day in the U.S. to kind of flatline around here? Or is there still room to move?

[Jon Faber, Chief Financial Officer]

Well, listen, the first answer is, yes, which is to say, it's sort of a little bit across all those buckets you would've referenced that we've talked in prior calls around having a little bit more pricing power in the U.S. than we would've had in Canada. And so some of that has been reflected in the first quarter through the U.S. We have seen some adoption of existing or, well, call it for a lack of better terms, some the legacy product, we've seen some of that adoption increase a little bit. And we have seen uptick for new products. Drilling Intelligence, that we've talked in prior calls around the Pason growth and that is somewhat limited by the integration efforts required based on the rig mix there. But the notion around data delivery and some of the new products and initiatives we have in the Drilling Data space are gaining quite a bit of traction in the U.S. as well. So it's sort of across all of those. So I would expect from here, we could expect to see revenue per EDR day continue to tick up a little bit or kind of hold flat subject to mix of where the activity is. Because that does sometimes draw -- which products get adopted at what times. And frankly, the nature of the industry is things slow down a little bit, people tend to sort of adopt a few less products as well. So there's a few more moving parts there, but I think it is a pretty sustainable number based on what we know today.

[Greg R. Colman]

And just on the last part of your comment there, Jon, when you were talking about how some of the Drilling Data is getting a little bit more of an uptick in the U.S. Could you offer us any more granularity on that? Is it a particular play type geographic region, big type that it seems to be getting more penetration, rather than less?

[Jon Faber, Chief Financial Officer]

No. It's not really driven by sort of the rig or the -- this particular sort of basin. It's really driven by increasing customer desire to use data around various analytics programs, and maybe looking to use different automation things they'd like to do. So there's just this growing need to feed data into multiple types of systems. And that is driving some product development in some commercial and [ monitor this ] sizable opportunities around how we see data in through -- and 2 other systems.

[Greg R. Colman]

And how should we think about the margin profile of those types of services versus the margin profile, let's say, all the rest of the company?

[Jon Faber, Chief Financial Officer]

Again, in the short term, it takes a bit of an R&D effort, right? So in the short term, the margin gets constrained by the efforts to build these things. But as those things are built, that will be a much higher margin business because it's essentially software type products again.

[Greg R. Colman]

Got it. And then just last one for me and sorry to hog the time. We've talked about the move from satellite to terrestrial communication for some time now. Marcel, in your prepared remarks you mentioned it again. I was wondering with 5G networks now starting to be rolled out in the U.S., I think AT&T came out in late '18 with the sort of first one and just a spotty way. Is there any impact? Is this something that's going to start to help, hinder? How should we be thinking about that for the communications part of your business?

[Jon Faber, Chief Financial Officer]

It's just a notion of going to anything terrestrial, it is certainly net positive in terms of the dollars per gigabyte that you pay in terms of bandwidth. The other advantage is that the capital intensity of terrestrial is much lower than the capital intensity of satellite, if you think about the devices that we need to deploy. So it's clearly too early for us to say what could happen in terms of 5G relative to our business. But should we sort of see the opportunity and the desire to move in that direction, it's a lower capital opportunity and it will clearly be a lower dollars per gigabyte type of opportunity as well.So the same factors that we would've seen going from satellite to terrestrial, I think, you'd see that same trending as you go to different types of terrestrial, maybe not quite as big of a step change. But it will be a movement in the same direction, both from OpEx and CapEx and presumably revenue as well if you [ get that way ].

[Operator]

[Operator Instructions] And your next question comes from the line of Daine Biluk from CIBC World Markets.

[Daine Biluk, Associate]

So for your Pivot oscillator product, can you give a bit of an update on how that commercial adoption is unfolding? And just thinking along the lines of, has the uptick progressed either faster or slower than what you would've expected, say, 6 months ago?

[Marcel Kessler, President, CEO & Director]

Well, Daine, we do not provide specific information on the individual products in the Drilling Intelligence suites. So we're not going to be -- I'm not going to be able to answer that question directly on Pivot, the oscillator. I think it’s very early days for that product though, and it would be where we expect it to be today. But it's not a material portion today of the growing intelligence product suite. It is what, I think, would be on the edge between R&D and commercialization, right, it's in that zone where we're haven't fully commercialized this offer yet.

[Jon Faber, Chief Financial Officer]

Just maybe the other thing to add there, Daine, is that particular product is another one of these products where there's integration work required. And so we need to do -- to address different portions of the market. We have to do with additional R&D work around integration. So what that does is limit the pace on that cycle, which is good.

[Daine Biluk, Associate]

Okay. That's helpful. I guess, maybe on, I mean, could you -- are you able to share how many active drilling rig installations there are now of new Drilling Intelligence software?

[Jon Faber, Chief Financial Officer]

Well, across the Drilling Intelligence suite, so I'm not going to sort of obviously go product-by-product. We think the last conference call talked about there being in the order of 200. That number is probably closer to 150 today because a large number of those Drilling Intelligence products were on the Canadian side because of that band brake dynamic that we've talked about many times. So with the 32% reduction in Canadian activity, obviously, a lot of the Canadian installations would be down in this quarter. The U.S. side will continue to see increase on the adoption, but slower mainly because of operational challenge.

[Daine Biluk, Associate]

Right, okay. That makes perfect sense. I guess just kind of last one for me because most of my other questions have been answered. Just thinking internationally, has, call it, your willingness or desire increased at all to enter new countries versus, I mean, prior apprehension?

[Marcel Kessler, President, CEO & Director]

I don't think there has been a change in our target countries, right? So the big drilling activity countries that we are not active in, Russia, China, India. I don't think that has changed. I think we have seen a bit of an uptick in activity in some of our peripheral markets. For instance, Oman, United Arab Emirates. But there's not been a fundamental change in our appetite to enter new markets. However, obviously, we're quite excited about the growth potential of our international portfolio that we are currently in.

[Daine Biluk, Associate]

Okay. Got you. And I guess maybe just one more to follow up on that. I mean with some of this growth you are seeing in those international markets. Will any of them require many more meaningful capital in order to get those to be able to serve kind of the higher activity levels? Or do you kind of have the capacity in place?

[Marcel Kessler, President, CEO & Director]

I think we'll be able to live within the $30 million capital budget that we highlighted for the year. Now if international growth was triple what we anticipate, maybe not. But as -- but how we see things today, we don't really expect a significant expansion of capital required.

[Operator]

[Operator Instructions] And there are no further questions at this time. I will turn the call back over to Mr. Marcel Kessler for closing remarks.

[Marcel Kessler, President, CEO & Director]

Thank you, everyone. And I would like to invite everybody on the call to our AGM, which will take place at 3:30 P.M. this afternoon at the Pason Office at 6120, 3rd Street Southeast here in Calgary. Thank you very much.

[Operator]

This concludes today's conference call. You may now disconnect.