Pason Systems Inc

TSX:PSI

Earnings Call Transcript 2017-Q4

[Operator]

Good morning. My name is Jody, and I will be your conference operator today. At this time, I would like to welcome everyone to the Pason Systems, Inc. Fourth Quarter and Year-end 2017 Results Conference Call. 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, 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. [Operator Instructions] Marcel Kessler, President and CEO; and Jon Faber, CFO, you may begin your conference.

[Marcel Kessler, Chief Executive Officer, President and Non]

Thank you, and good morning, everyone. I will start with the highlights of fourth quarter -- of the fourth quarter, and Jon will dive into details of our financial and operational performance, and I will close with our perspectives on the outlook for the industry and for Pason, and we will then take any questions.Pason achieved a robust fourth quarter. We generated revenue of $66.2 million in the period, an increase of 36% from the prior year quarter and 3% from the third quarter. The main drivers of revenue growth were increased drilling activity in the North American land market and market share gains in the United States.As in the third quarter, revenue growth was again negatively impacted by a stronger Canadian dollar, relative to the U.S. dollar. Revenue from the International business unit was up 14% year-over-year, driven by activity improvement in Australia and the Andean region. Adjusted EBITDA was $27.8 million for the quarter, an increase of 83% from the prior year quarter and 6% from the third quarter. Adjusted EBITDA as a percentage of revenue increased to 42%. The drivers of this improvement were the significant increase in revenue with high incremental margins and cost-reduction programs that were executed during the downturn.Pason recorded a net income of $5 million or $0.06 per share for the quarter. Jon will speak to a full year 2017 performance, but I would like to highlight that the incremental EBITDA margin on revenue growth in 2017 compared to 2016 was 79%. At December 31, 2017, our working capital position stood at $193.7 million, including cash of $154.1 million. There is no debt on our balance sheet, and we are maintaining our quarterly dividend at $0.17 per share.And I now turn the call over to Jon Faber for a more detailed look at the financials.

[Jon Faber, Chief Financial Officer]

Thank you, Marcel. I'll begin with a look at the consolidated results for the year in the fourth quarter before briefly discussing the results of each of the business units.Pason's financial performance significantly improved in 2017 as compared to 2016, with performance improvements and cost reductions implemented during the downturn helping to deliver strong incremental margins, as industry conditions improved.As Marcel noted earlier, we delivered 79% incremental adjusted EBITDA margins on an $85 million increase in revenue, consistent with our stated expectation of achieving incremental margins in excess of 75%, as revenue grew from 2016 levels.The $85 million revenue increase to consolidated revenue of $245.6 million in 2017 represented a 53% increase over 2016 revenue of $160.4 million. The most significant driver of revenue growth was a 76% increase in industry activity in the U.S. and a 59% increase in Canadian industry activity as well as an improvement in U.S. market share. Adjusted EBITDA increased from $31 million in 2016 to $98.2 million in 2017, representing an adjusted EBITDA margin of 40%.During the fourth quarter, the company booked amounts related to a series of tax-related matters which impacted the tax provision. These included recognition of the expected outcome of an advanced pricing arrangement related to the company's transfer pricing methodology, impacts from U.S. Tax Reform legislation and a reclassification as other comprehensive income of deferred tax amount previously recognized on the income statement. Each of these matters is described in detail in our annual financial statements, which have been posted onto SEDAR. For the full year, the company recorded net income of $25.2 million or $0.30 per share, a $67 million increase from a net loss of $41.8 million in 2016. As a reminder, 2016 results were negatively impacted by a $17.5 million in impairment charges and $10.9 million of restructuring costs. Capital expenditures of $20.8 million in 2017 were up 62% from $12.9 million in 2016. In 2016, we achieved our goal of being free cash flow positive before the dividend during the worst of the downturn. In 2017, as the industry began to recover, free cash flow increased to $65.8 million, more than sufficient to fully fund the regular dividend at its current level. We ended the year with no debt on the balance sheet and positive working capital position of $193.7 million, including a cash balance of $154.1 million.Consolidated revenue in the fourth quarter of $66.2 million represented a 36% increase over fourth quarter revenue in 2016, up $48.8 million and was up 3% sequentially from the third quarter of 2017.The strongest driver of revenue growth was increased drilling activity, with U.S. activity up 59% year-over-year and Canadian activity up 12%. Growth in U.S. market share throughout the year also contributed to the revenue increase. Adjusted EBITDA in the quarter of $27.8 million was up 83% from the prior year and up 6% sequentially from the third quarter. Net income for the quarter of $5 million or $0.06 per share was impacted by the tax provision matters, previously referred to. Fourth quarter capital expenditures totaled $ 9.2 million.I'll turn now to the results of the U.S. business unit. Revenue for the year totaled $152 million, up 67% from 2016. Adjusted for the disposition of 3PS at the end of 2016, the U.S. business revenue increased 81% compared to 2016 levels. The U.S. business unit benefited from a 76% increase in drilling activity in 2017 and a 260 basis point increase in market share.Revenue per EDR day was consistent with 2016 levels. Quarterly revenue of $42.1 million in the fourth quarter was up 47% from $28.6 million in the same quarter of 2016, and up 4% sequentially from the third quarter. Fourth quarter industry activity in the U.S. was 59% higher than 2016, while market share increased to 61%, up from 58% in both the fourth quarter of 2016 and the third quarter of 2017.Revenue per EDR day of $645 was essentially unchanged from the third quarter and down from $667 in the fourth quarter of 2016. Operating profit in the U.S. business unit increased to $21.6 million in the fourth quarter from $8.7 million in 2016, as operating costs only increased by $2.2 million compared to a $13.5 million increase in revenue. Sequentially, operating profit increased 12% against the 4% increase in revenue. For the full year, U.S. operating profit of $70.5 million was $55.7 million higher than 2016. Industry conditions in Canada remain more challenging than those experienced in the U.S., as concerns around take away capacity continues to create challenges for Canadian customers. Notwithstanding the challenges, full year Canadian industry activity increased by 59% in 2017 from 2016. Canadian business unit revenue of $70.5 million was up 53% from 2016, as calculated market share decreased to 88% for the year, while revenue per EDR day is held relatively constant.Our competitive positioning in Canada remains strong, and our calculated market share remains consistent with levels we're accustomed to experiencing in more active industry environments than we experienced in 2016.Fourth quarter revenue of $17.7 million was up 21% from the same period of 2016, as a 12% increase in industry activity and an 8% increase in revenue per EDR day more than offset a reduction in quarterly market share to 85%. Sequentially, revenue was 3% lower compared to the third quarter. Operating costs were 41% higher in 2017 compared to 2016, owing to higher activity levels in 2017. Despite these increases in operating costs, Canadian business unit operating profit increased by $16.9 million from $4.5 million in 2016 to $21.3 million in 2017. Operating profit of $4 million in the fourth quarter was down from $6.1 million in the same period of 2016.The International business unit posted revenue of $23.1 million in 2017, essentially unchanged from 2016. Efforts taken to reduce operating costs in 2017 were successful in driving positive operating profit of $1 million, a $5.1 million improvement from an operating loss of $4.1 million in 2016.Fourth quarter revenue of $6.3 million was up 14% year-over-year from the fourth quarter of 2016 and up 14% sequentially from the third quarter of 2017.We experienced revenue growth in the fourth quarter in each of our major International markets on both a year-over-year and sequential basis. Operating profit of $552,000 in the fourth quarter compared to an operating loss of $446,000 in the same period of 2016. Finally, I'll briefly comment on our corporate cost centers. R&D expenses including IT totaled $25.2 million in 2017, up 10% from $22.8 million in 2016. We continue to increase our investment in R&D, driven by increasing confidence in the early stages of commercializing our new product efforts.Corporate services expenses decreased 10% year-over-year to $15.1 million in 2017, further reflecting the benefits of cost-reduction efforts taken during the downturn.In summary, our financial performance has been strong. As industry activity has increased, we have seen the benefits of cost reduction efforts taken during the downturn take hold and have seen strong incremental margin performance as a result. We continue to have a capital structure that allows us to defend against the volatility of our industry while deploying additional capital toward attractive product development opportunities. We are maintaining our quarterly dividend at $0.17 per share. I'll turn the call back to Marcel for his comments on our outlook.

[Marcel Kessler, Chief Executive Officer, President and Non]

Thank you, Jon. Our -- the past 3 years of market downturn, we have restructured all relevant parts of the company resulting in a leaner, more agile Pason. At the same time, we have continued to invest significant resources in R&D and IT.Our development efforts continue to be focused on strengthening our position as a key enabler of Big Data analytic strategies and of drilling automation efforts pursued by our customers. In addition, we continuously enhance the functionality and performance of existing products. Many of our products directly improve the efficiency, effectiveness and safety of drilling operations and of wellbore quality. Examples of this include our PVT Smart Alarms, our AutoDrillers, the abbl Directional Advisor and the deployment of the advanced ExxonMobil Drilling Advisory System.In response to the evolving needs of our customers, as Jon mentioned, we have increased our investment in R&D and IT by 10% in 2017. We have further growth of similar magnitude planned in 2018. 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 about $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. Led by a robust global economy, growth and demand for oil is projected to continue in 2018. On the supply side, with the extension of the OPEC and Russia-led production cuts is translating into significant inventory draws.As a result, U.S., E&P spend is predicted to grow 15% to 20% in 2018, while in the international markets, E&P spend is projected to grow for the 4 -- first time in 4 years by about 5%.As we've entered 2018, there is enthusiasm throughout Pason. Our level of confidence in the successful commercialization of new products and service steadily grows, as the number of successful technical and commercial trials increases.Pason's market position remain very strong. We are the service provider of choice for many leading operators and drilling contractors, with Pason equipment installed on almost 1,000 drilling rigs, or 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 of National Bank Financial.

[Greg R. Colman]

I just have 2 really quick ones here. I want to start by talking about U.S. market share. Can you give us some color on the market share growth in the U.S.? My calculation suggests 60% market share, which appears to be a record high. I was wondering if you could help us out to understand where that's coming from and how it's happening. Specifically, is there a play or operator or driller? Where you see your growth rate materially exceeding the market growth rate?

[Jon Faber, Chief Financial Officer]

Thanks for the question, Greg. Clearly, we've been encouraged by the growth we've seen on the U.S. market share side. I think we've talked the last couple of conference calls around the mix of operators and contractors, and we've certainly had some contractors where we've increased our penetration of their rig fleet, which has driven some of the market share growth. And if I reflect, sort of, on the just with some of the specific situation, some were led by industry consolidation, and as we, sort of, go under the same corporate umbrella, some are driven by customers increasing penetration of Pason on their rigs by virtue of certain products. I think some of the effects from the consolidation-related are probably behind us. And on those rigs, we'd expect to see some revenue per EDR day opportunity, as we layer on some operator revenue streams. And I think, with some other contractors, we still have running room within their rig fleets as well as the follow-on operator revenue streams.

[Greg R. Colman]

So if I could paraphrase back to you, some of the wins of contractor consolidation have propelled the market share gains, but there's still a little bit more of that to come. Not necessarily on the consolidation side, but as you continue to gain, sort of, the blend in market share of the fleets in the future?

[Jon Faber, Chief Financial Officer]

Correct.

[Greg R. Colman]

All right and then just, second, Marcel was talking about incremental margin contribution, which is obviously done a lot to take the margins up this year. Is it safe to assume that the vast majority of that margin expansion is behind us and absent some sort of step change in pricing or activity, this, sort of, circa 40% EBITDA margin on a full year basis is what should be looking at? Or is there any particular reason it should be trending down a bit or that's cost increase or a little bit higher as prices, maybe, moderate?

[Jon Faber, Chief Financial Officer]

Incremental margins is an interesting question, Greg, because the ones impact we've seen on the cost side, in particular, in 2017 was on the repair side. We would've seen an abnormal increase in repair expense because of the industry activity driving the need to get equipment refurbished and put back onto new rig installations. So arguably, incremental margins were a little bit compressed, actually, in 2017 by virtue of that repair expense. And may actually expand a bit in 2018, but I think on a blended 2-year basis, that north of 75% is still a very relevant, sort of, target that we'll be targeting.

[Greg R. Colman]

North of 75% adjusted operating margin?

[Jon Faber, Chief Financial Officer]

No, sorry, incremental EBITDA margins. So I think the EBITDA margins could expand a bit from current levels of -- because we'd expect the repair expenses to normalize.

[Marcel Kessler, Chief Executive Officer, President and Non]

So we would expect that the actual EBITDA margin trend up a bit here.

[Jon Faber, Chief Financial Officer]

Yes, correct.

[Greg R. Colman]

If you had normalized R&M in 2017, what would've been the basis point contribution?

[Jon Faber, Chief Financial Officer]

It would've been a couple of hundred basis points higher on EBITDA margin.

[Operator]

Your next question comes from the line of Mike Mazar of BMO Capital Markets.

[Michael Mazar, Equity Analyst of Oil and Gas Services]

Couple of things, you -- Marcel, in the prepared comments, talked about free cash flow and the balance sheet still obviously being very strong, no debt, et cetera. Jon, talked about maintaining free cash even through the trough and now expanding here in 2017. That is all, prefacing a question of, can you talk a little bit about what the dividend policy is? Is there a target payout ratio that you guys, kind of, look at? Is there a target cash balance that you don't want to fall below? This just feels like that the balance sheet is obviously typically conservative, but I would argue, maybe it's gotten to the point where it's, kind of, unnecessarily conservative. Is -- maybe just talk about your philosophy as far as the dividend goes?

[Marcel Kessler, Chief Executive Officer, President and Non]

So Mike, Marcel here. So there is no fixed policy around the dividend in terms of a payout ratio or a target yield. But the dividend has always been a high priority for the Board. And we agree with your assessment, I think at this stage, the balance sheet structure is very conservative, no question, and we have more cash than we need. I think going forward, the board will, on a quarterly basis, have to decide that to -- how to deploy that free cash flow and that cash. And I think, regular -- an increase in regular dividend would likely be the highest priority.

[Michael Mazar, Equity Analyst of Oil and Gas Services]

Okay. That's a great answer. I just wanted to see philosophically maybe something had changed. But -- well, that's great.

[Operator]

[Operator Instructions] Your next question comes from line of Ian Gillies of GMP.

[Ian Brooks Gillies]

Can you maybe just elaborate a little bit on your ability to grow software revenue if we were to assume both U.S. and Canadian rig counts were to stay flat, given that focus of growth right now?

[Marcel Kessler, Chief Executive Officer, President and Non]

So I think first maybe a high-level comment is here that most of our product today, even the ones we're associated with, let's call it the hardware blocks, are software. So any kind of improvements in functionality and most of our development efforts even for our legacy products, be it the EDR, the PVT, is going to the software space. So I think it's asking to say -- if your question, if I'm able to rephrase that, it's eventually asking, what's our expectation around the revenue per EDR day growth in a flat rig count environment? And I think, our best forecast today is, probably, qualitatively on the pricing side, we don't see pressure increasing, more easing. So we're probably roughly where we are likely to be on -- in the pricing environment over the next 12 months, so we don't expect much movement from that. We don't see any significant declines in any of the product categories here in 2018. I think the question comes down to the traction we gain with new products. And we have obviously talked for the last few quarters about our investments in the drilling intelligence and Big Data analytics space. I think, we have a more visibility than you would had 3 or 6 months ago into how well those products may be doing. I mentioned a significantly higher number of technical and commercial trials, so that gives us confidence that clearly, we have something there. In terms of the price points of those new products, the ones that have the most successful trials now, they're looking at probably a price point of $300 to $400 per day to Pason. Now the question is obviously how much traction are we going to gain?. Are we going to achieve a penetration of 10% or 15% of the rig fleet with those product? And quite frankly, we don't know. And we are not providing guidance around that. But we believe that, if you look at the price points of those new products, they're quite significant vis-à-vis our existing product suite. And if we gain some traction, there is reason to believe that revenue per EDR day, largely driven by software, is able to move up quite a bit here going forward.

[Ian Brooks Gillies]

That's very helpful, Marcel. I mean, perhaps, specifically to both abbl and the Exxon Drilling Advisory System, would you willing to provide us maybe how many customers have tried it now? Or how many customers maybe using each of those products relative to maybe 12 months ago? Just to get us a sense of what the rate of change is there? How the penetration, maybe, is going with just a number of customers rather than number of rigs?

[Marcel Kessler, Chief Executive Officer, President and Non]

So as the increase year-over-year will be very significant. I think, I can't give you a specific number, but in terms of currently active trials for the Drilling Intelligence built around the Exxon DAS technology, we're probably looking at somewhere between north of 50 and under a 100, currently active installations.

[Ian Brooks Gillies]

And Jon, with respect to R&D spending on the income statement this year. Are you able to provide us with some goal post of whether -- where that may come in at? Or should we be thinking about a further 10% increase year-over-year?

[Jon Faber, Chief Financial Officer]

Yes, I think it's safe to look at that 10% increase we talked about and, sort of, use that as a starting point. The question always becomes what ultimately shows up on the income statement versus capitalization. And given the amount of initiatives we're doing around some of these new products in the automation space and drilling intelligence space, it may be a little more capitalized. But as a starting point, I think that 10% is a good place to anchor yourself.

[Ian Brooks Gillies]

Okay. And then, one housekeeping item for me. The EDR per revenue day in the U.S., I mean, declined pretty materially from Q3, Q4. I think you highlighted a bit in the prepared remarks. But is it fair to assume that's just new customers not using as much product per EDR day and there's some room around there?

[Jon Faber, Chief Financial Officer]

I would go back to the initial comment. The one we had around, sort of, the contractor-led increases on market share with some operator revenues to follow.

[Operator]

There are no further questions in the queue. On behalf of Pason Systems Inc., we'd like to thank you for listening. This concludes today's conference call. You may now disconnect.