Pason Systems Inc

TSX:PSI

Earnings Call Transcript 2019-Q2

[Operator]

Good morning. My name is Karina, and I will be your conference operator today. At this time, I would like to welcome, everyone, to the Pason Systems Inc. second quarter results conference 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 describes 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 Marcel Kessler, President and CEO; and Jon Faber, CFO. Please go ahead.

[Marcel Kessler, President, CEO & Director]

Thank you. Good morning, everyone. I will start with the highlights of our second quarter performance. Jon Faber 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 despite the fact that we have witnessed decreases in industry activity in the second quarter in both the United States and in Canada. Drilling industry days declined 6% and 24%, respectively compared to 2018. The company generated revenue of $72.9 million in the period, an increase of 7% compared to the same quarter last year. The main drivers of revenue growth were higher activity levels in all of Pason's international markets and higher market share and an increase in revenue per EDR day in the U.S. and Canadian business units. Adjusted EBITDA was $30.7 million for the quarter, an increase of 4%. Pason recorded net income for the quarter of $9.2 million, an increase of 69% compared to the prior year quarter. Second quarter revenue, EBITDA and net income were down from the first quarter 2019 due to the seasonality of Canadian drilling activity as is the case every year. At June 30, 2019, our working capital position stood at $250 million, including cash and short-term investments of $189 million. Consistent growth in our regular dividend remains a priority for us, and we are increasing our quarterly dividend to $0.19 per share. Key developments in the second quarter in our 5 product categories were as follows: Revenue in the Drilling Data segment increased 11% and accounted for 54% of total revenue. This increase was driven by growth in international drilling activity with the largest absolute increases in Australia and Argentina, EDR market share gains in North America and strong customer demand for data delivery products. Mud Management & Safety revenue increased 10% and generated 29% of total revenue. Drilling Intelligence bundles Pason's product offerings enabling our customers' drilling optimization and automation efforts. Drilling Intelligence increased 5% in the second quarter and accounted for 6% of total revenue. Revenue in the Communications segment accounted for 6% of total revenue and is showing negative growth because of the ongoing transition from satellite to terrestrial bandwidth with lower pricing, but better user experience for our customers. Finally, the Analytics & Other segment, which includes Verdazo Analytics and Pason Power is not directly correlated to drilling activity, grew 8% and accounted for 5% of total revenue in the second quarter. R&D and IT expenses grew 16%. The drivers of this growth were a greater proportion of project costs being expensed, rather than capitalized, and the ongoing transition to a more cloud-based IT and infrastructure. I'm now turning the call over to Jon.

[Jon Faber, Chief Financial Officer]

Thank you, Marcel. As Marcel noted, Pason posted solid financial results in the context of challenging industry conditions in the second quarter. While drilling activity was at lower levels in both Canada and the United States in the second quarter compared to 2018, continued market share gains and strong growth in revenue per EDR day in North America, coupled with ongoing strength in our International business unit, drove increased revenue year-over-year. The revenue change in both the U.S. and Canada, again, outperformed the change in underlying drilling activity by 10%. We continue to prudently manage both operating costs and capital expenditures, making targeted investments in areas where we see opportunities to achieve additional growth as industry conditions stabilize and, ultimately, improve. Before I review the financial results in more detail, I remind you that Pason adopted IFRS 16 related to lease accounting effective January 1, 2019. Details of the impact of the adoption of IFRS 16 can be found in the MD&A included in our quarterly report filed on SEDAR. Consolidated revenue in the second quarter totaled $72.9 million, up 7% from the same period in 2018 and down 11% sequentially from the first quarter. Growth in North American market share and revenue per EDR day and growth in our International business unit contributed to the year-over-year revenue increase, offset by a significant year-over-year reduction in Canadian drilling activity. The sequential revenue decrease was largely driven by the seasonality of Canadian drilling activity and a sequential decrease in U.S. industry activity. Revenue grew in all product categories with the exception of Communications where the continued shift towards terrestrial technologies has allowed us to share cost savings with our customers, while providing a better customer experience. Revenue for the first half of the year totaled $155 million, up 9% from the same period of 2018. Adjusted EBITDA for the second quarter is $30.7 million represented an adjusted EBITDA margin of 42%. This compared to $29.5 million and a 43% margin in the prior year period. On a year-to-date basis, adjusted EBITDA of $71.3 million is up 11% from the first half of 2018. Net income of $9.2 million for the quarter or $0.11 per share was up 69% from the second quarter of 2018 and down 51% sequentially. 6 months net income of $28.3 million or $0.33 per share was a 59% improvement from 2018 levels. Capital expenditures for the first half of the year totaled $14.5 million, up 38% year-over-year, including $4.2 million in the second quarter. We continue to expect to spend up to $30 million on capital expenditures in 2019. Pason generated free cash flow of $32.5 million in the second quarter, up 41% from the second quarter of 2018. Year-to-date, free cash flow of 3 -- $32.9 million was down $9.1 million from 2018. Recall that year-to-date free cash flow was negatively impacted by a $15.3 million payment related to our bilateral advanced pricing arrangement with the CRA and the IRS. We continue to carry an income tax recoverable of $15.3 million related to the offsetting refund due from the IRS once they reassess prior year income tax returns. Free cash flow was also lower year-over-year due to an increased capital program in 2019 and increased cash taxes, now that historical net operating losses have been fully utilized in both Canada and the United States. Our U.S. business unit posted a 7% increase in revenue or 4% measured in U.S. dollars in the second quarter despite a 6% decrease in drilling activity. Market share was slightly higher in 2019 at 62%. Revenue per EDR day increased 9% year-over-year in the second quarter. We have seen particularly strong adoption among data delivery products in our drilling data category as customers continue to advance their data-driven analytics and automation efforts. For the first half of the year, U.S. revenue of $108.1 million is up 15% from 2018. Operating costs increased 16% year-over-year in the U.S. and 15% on the year-to-date basis, as we increase our operational capacity in the Permian basin to better meet additional activity through market share gains and anticipated improvement in industry activity as additional pipelines come on stream. As a result, segment gross profit for the U.S. business unit decreased by 1% to $28.3 million in the second quarter, while first half gross profit of $58.9 million was up 13% over prior year results. The Canadian business unit managed to again outperform very challenging industry conditions in the second quarter. Pason's revenue for the quarter was 14% lower than in 2018, while industry activity was 24% lower. On a year-to-date basis, Pason's 19% revenue decrease compared to a 29% decrease in industry activity. Revenue per EDR day increased 9% in the second quarter and 8% on a 6-month basis. Reported market share of 87% was up from 85% in the second quarter of 2018. With Canada's seasonally low rig activity in the second quarter of each year, Pason's market share is typically more sensitive in Q2 than other quarters. Given that we expect drilling activity levels to remain low in the upcoming quarters, market share will continue to be more volatile than in years past, owing to the proportionate impact of the gain or loss of any 1 rig. Given those lower activity levels, combined with a greater proportion of cost-focused operators in the active customer mix, we expect we will see some downward pressure on reported market share in Canada in the upcoming quarters with more volatility to follow. However, revenue per EDR day should improve with increasing growth of Pason's newest product and service offerings. Sequentially, revenue decreased 50% owing to the seasonality of Canadian drilling activity. Operating costs were down 21% in Canada on both the second quarter and year-to-date basis, largely as a result of reduced purchasing cost in our Communications category. Segment gross profit for the Canadian business unit of $518,000 was up $212,000 from the second quarter of 2018. And for the first half of the year, segment gross profit came in at $8.8 million. Our International business unit saw continued strong performance in the second quarter, delivering higher revenue in each of our operating regions. Second quarter revenue of $10 million was up 37% from the second quarter of 2018 and up 10% sequentially from the first quarter. Segment gross profit in the International business unit of $3.4 million improved by $1.7 million year-over-year and was up 15% sequentially. Year-to-date, gross profit from the International business unit stood at $6.4 million. Pason's second quarter results represent continued outperformance in the context of challenging industry conditions. Revenue growth in the U.S. and international segments offset declines in the Canadian business unit, which again managed to outperform a difficult operating environment. We continue to prudently manage our fixed costs, and we're strategically investing in areas that grow our capacity to absorb additional work. We maintain -- remain confident about our new product introductions, which are facilitating increased use of data-driven automation and analytics technologies. Our balance sheet remained strong with $250 million of working capital, including $189 million of cash and no interest-bearing debt. We are returning cash to shareholders through our regular dividend and through our normal course issuer bid program. During the quarter, we deployed a further $9.1 million towards the normal course issuer bid. Continued growth in the regular dividend remains an important part of our capital allocation programs, and we are increasing our quarterly dividend to $0.19 per share. At this point, I will turn the call back to Marcel for his comments on our outlook.

[Marcel Kessler, President, CEO & Director]

Thank you, Jon. From a macro perspective, short-term oil demand forecast has been reduced slightly on global trade fears and geopolitical tension, but there is no change for the medium-term outlook. This, combined with the recent decision by OPEC and Russia to extend production cuts through the first quarter of 2020, are likely to keep oil prices around current levels. However, a paradigm shift is underway in North American land, leading to a further probably about 10% decline in E&P investments, which ought to temper any enthusiasm around growing E&P capital expenditures in the near term. North American E&P drilling plans will likely be restrained, as they focus on keeping capital spending within operated cash flows. In contrast, international land E&P investments is expected to continue growing about 10% annually, leading to further increases in international rig counts. Pason's leading market positions in Latin America and Australia and our growing presence in the Middle East will allow us to generate profitable growth in our International business units. We are keeping our fixed cost low and maintain flexibility for our plans for the next year, which gives us the means and confidence to address any activity scenario. As Jon mentioned, our capital expenditures will be relatively modest going forward with a significant portion of development efforts focused on software and analytics. 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 our international markets and through higher product adoption going forward. We are the service provider of choice for many leading operators and drilling contractors with Pason equipment installed in over 65% of all active land drilling rigs in the Western Hemisphere. And we'll now be happy to take any questions.

[Operator]

[Operator Instructions] The first question is from Michael Robertson with National Bank Financial.

[Michael Storry-Robertson]

Congrats on the solid quarter.

[Marcel Kessler, President, CEO & Director]

Thanks, Mike.

[Jon Faber, Chief Financial Officer]

Thank you.

[Michael Storry-Robertson]

On the dividend raise, I understand the goal of long-term consistent dividend growth, but is there also a target range for the payout ratio that helps inform that decision of where you're comfortable increasing the regular dividend?

[Jon Faber, Chief Financial Officer]

Mike, it's Jon. When it comes to payout ratio, it's awfully tricky to have a target ratio given the volatility of the results we have. We, obviously, have volatile underlying industry exposure with drilling activity and pretty significant fixed costs. So that creates very volatile earnings base, so it really is thought of more in the context of that steady growth in the regular dividend. If you think about capital allocation, slightly more broadly, we, of course, have the combination of the regular dividend and the normal course issuer bid. And our view has been the normal course issuer bid gives us flexibility to sort of flex the amount of cash returned to shareholders based on that volatility in the industry and maintaining a dividend with kind of slow and consistent growth is the more appropriate approach to the regular dividend.

[Michael Storry-Robertson]

No, that makes sense. Of the 4 major international segments, is there a particular region that stands out the most within your sort of 10% overall annual growth expectation?

[Marcel Kessler, President, CEO & Director]

So international, as always, is a bit of a mixed bag. I think we expect the most robust growth to come from a combination of Argentina, Australia and the Middle East. And Argentina is, obviously, a very sizable and strong market per share position for us. Australia a bit smaller, but very strong market share and very, very high margin. And the Middle East will be, of course, newer for us in terms of market entry and the more emerging position. So these are the 3 regions that stand out. Others, the rest of Latin America, including Brazil as well as Mexico probably less of a positive outlook.

[Michael Storry-Robertson]

Got it. Regarding the 100 basis point year-over-year increase in U.S. land market rig share, would it be fair to assume that the majority of that gain is occurring in the Permian?

[Marcel Kessler, President, CEO & Director]

Yes, I think that's right. That will be a good assumption.

[Michael Storry-Robertson]

And lastly, do you expect a significant impact moving forward, as you search for the new tenant for the remaining lease term in Colorado? And how long is the remaining lease term?

[Jon Faber, Chief Financial Officer]

Well, there's still a few years remaining on the lease term. We're not particularly concerned about the ability to find a tenant. It is a fairly attractive building in a nice part of the town. The challenge we have, of course, is when you're into a bankruptcy process with the tenant, there's just a bit of a standstill while the court works through that process. So we're just not able to sort of find a tenant immediately, we probably have a few months here where we won't be able to put somebody else into the building, but we do feel pretty good about the prospects of being able to get that real estate occupied again.

[Operator]

Your next question is from Daine Biluk with CIBC World Markets.

[Daine Biluk, Associate]

So maybe just a bit of a follow-on to the U.S. market share gains. Was that largely a function of a specific client win? Or was it more of your existing client work programs and just some work mix there?

[Marcel Kessler, President, CEO & Director]

It was not 1 specific customer win, it would have been a mix of increases in market share with several large contractor customers as well as some operator expansions.

[Daine Biluk, Associate]

Okay. Okay. Makes sense. And then maybe just kind of as a follow-on, if you were to look forward in a context of a weakening rig count in the U.S., do you expect that to have any effect on your market share, either positively or negatively, based on the current client list?

[Jon Faber, Chief Financial Officer]

I think the question for us, Daine, always becomes where the market is actually weakening, right? So to the extent that the weakening happens in areas of the U.S. other than kind of northern regions or Permian for example, where we have significant strength, that would help us. If it was the Permian that would be a little bit less positive for us, but we feel pretty good even in a declining rig count about our ability currently to have pretty meaningful conversations with some customers we haven't necessarily had quite the same ability to talk to in the past on the basis of some of these new products that we've been rolling out. So there's a little bit more of a motivated customer base based on the technology stack today.

[Daine Biluk, Associate]

Okay. Okay. Yes, that's very helpful. Could we get a bit of an update on how you're thinking about research and development spending? Going forward, is the expectation for that line item to remain in the $7 million to $8 million range per quarter? And is there any reason that you could foresee materially dialing up or down that number?

[Jon Faber, Chief Financial Officer]

I think where we're at in terms of run rate for total spending, right, if you take a look at the R&D IT, including the deferred development costs on the cash flow statement, that is sort of run rate where we would be. Now I would say it's probably about $1 million or so higher than it would have been this quarter based on some tax credits that would have come through in the quarter, but that sort of $8-ish million a quarter is pretty good run rate on R&D total spending.

[Daine Biluk, Associate]

Okay. Okay. Got you. Nice to see the continued strength in your international platform. How much of that year-over-year growth would have been a function of activity recovering in a region versus, say, new product adoption and market share capture?

[Marcel Kessler, President, CEO & Director]

The bulk would have been driven by the increase in activity. I think market share has been fairly high and steady, especially in Latin America and Australia. Some increase in new product adoption, but not at the same level as North America.

[Daine Biluk, Associate]

Got you. Okay. Then maybe -- I mean based on that, is there any regions or countries where you see a more modest rate going forward given if a recovery has largely taken place already? Or is it kind of expected to remain kind of the steady 10%?

[Marcel Kessler, President, CEO & Director]

Well, I think based on what we see and hear today, at least over the next year or so, we expect the further 10% increase roughly in underlying E&P capital spending, which should directly translate into higher rig counts. I think the areas where we see weaker or more challenging environment, internationally, would include, as I said earlier, countries like Brazil, Mexico and the Andean region.

[Daine Biluk, Associate]

Okay. Got you. Okay. That makes perfect sense. And then just last one for me guys, and then, I'll turn it back. So considering the cash on hand, what is the current thoughts around potential acquisitions? And have you seen an increase in the number of companies putting the for-sale sign up given kind of maybe the more softer market in the U.S.?

[Jon Faber, Chief Financial Officer]

Well, I think anytime you have a challenging industry, you probably have a few more acquisition opportunities you can look at, that doesn't necessarily mean that they're more attractive opportunities. But I would say that we talked fairly openly in the past too about using M&A potentially to kind of reinforce initiatives that we're active in, not directly tied to North American land drilling and I would say that we are seeing sort of some opportunities that look interesting. Whether or not we'll do something, we obviously, don't know today, but I would say we probably feel a little bit more interested in a few things, none of which will be significant if we were to do them, but I think we see some opportunities there to deploy some capital on that side potentially.

[Operator]

[Operator Instructions] Your next question is from Matthew Weekes with Industrial Alliance Securities.

[Matthew Weekes, Analyst]

Just a little bit more on the international outlook. As far as kind of drilling rig count go, I was looking at those and we're seeing some modest growth in Latin America and the Middle East, sort of, in the first half of this year over last year. And we're seeing some pretty good growth in European rig counts as well. I was wondering in the near term, if you see any opportunities for expanding into new international markets given the growth outlook, such as more into Europe or is that more sort of something that might happen in the longer term?

[Marcel Kessler, President, CEO & Director]

Well, there are no plans at this stage to expand into Europe, but Europe has traditionally been obviously, primarily, an offshore market that has not shown much growth. And our products and services, as you know, are a lot less applicable in the offshore market. Beyond that, the 2 or 3 big markets that we are not in: Russia, China as well as to an extent India, are markets that we have decided not to enter for different reasons. And I don't think there are any plans to do so at this point.

[Operator]

[Operator Instructions] There are no further questions at this time. This concludes today's call. Thank you for your participation. You may now disconnect.