Pason Systems Inc

TSX:PSI

Earnings Call Transcript 2018-Q4

[Operator]

[Audio Gap]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.[Operator Instructions] It is now my pleasure to turn today's call over to Marcel Kessler, President and CEO; and Jon Faber, CFO. You may begin your conference.

[Marcel Kessler, President, CEO & Director]

Good morning, and welcome to Pason’s Fourth Quarter and Year End 2018 Conference Call. With me here in Calgary city is Jon Faber, our Chief Financial Officer. I will start with the highlights of fourth quarter performance. Jon will dive into the details of our financial performance. And I will close with a brief perspective on the outlook for the industry and for Pason, and we will then take any questions.Pason achieved strong results in the fourth quarter of 2018. We generated revenue of $82 million for the period, an increase of 24% compared to the same quarter last year. The increase was driven by a 16% increase in total U.S. land drilling activity and partially offset by a 15% decline in Canadian land drilling activity.Internationally, drilling activity increased in all major markets with the largest increases in Argentina and Australia. Revenue also increased as a result of significant uptake of new Drilling Intelligence product for Pason.Adjusted EBITDA was $39.3 million for the quarter, an increase of 41%. Adjusted EBITDA as a percentage of revenue was 48% compared to 42% 1 year ago. The driver of this improvement was the significant increase in revenue with high incremental margins. Based on recorded net income for the quarter of $20.7 million compared to $5 million into prior year quarter.Capital expenditures for the quarter were $8.5 million and free cash flow was $16.6 million. At December 31, 2018, our working capital position stood at $256 million, including cash and cash equivalents of $204 million. We are maintaining our quarterly dividend at $0.18 per share. At the beginning of 2018, we began reporting our revenue along 5 product categories to better reflect the changing nature of Pason’s business.Drilling Data contains all products and services associated with acquiring, displaying, storing and delivering drilling data. Revenue in this segment increased 29% in the fourth quarter compared to the prior year period and accounted for 52% of total revenue. Mud Management & Safety includes products, such as the Pit Volume Totalizer, Smart Alarms, Gas Analyzer, Hazardous Gas Alarm, and the Electronic Choke Actuator. In the fourth quarter, Mud Management & Safety revenue increased 16% and generated 28% of total revenue.Communications include satellite and terrestrial Internet bandwidth, Wireless Rigsite and other services and accounted for 8% of total revenue. As we indicated on prior calls, revenue in this segment is showing no growth as we shared cost savings with our customers that have been achieved through the transition from satellite to terrestrial bandwidth. This allows us to provide a better user experience for our customers at the lower price, while maintaining our profitability from delivering this service.Drilling Intelligence bundles Pason’s product offerings targeted at enabling our customers' drilling optimization and automation efforts. It contains products, such as AutoDrillers, the ExxonMobil Drilling Advisory System, abbl Directional Advisor and Pivot, a pipe oscillation system for improving slide drilling. Drilling Intelligence is currently our highest growth segment as revenue increased 74% in the fourth quarter compared to the prior year and accounted for 8% of our total revenue.There currently are 200 active drilling rig installations of new Drilling Intelligence software. Lastly, Analytics & Other includes our Verdazo Discovery Analytics product suite, various reports and other revenue streams. This segment is not directly correlated to drilling activity, grew 9% and accounted for 4% of total revenue in the fourth quarter.I will now turn the call over to Jon.

[Jon Faber, Chief Financial Officer]

Thank you, Marcel. We were very pleased with Pason’s financial results in the fourth quarter of 2018. In both, the Canadian and United States business units, year-over-year revenue growth outpaced the change in the underlying drilling activity in their respective markets by approximately 15%. In The United States, drilling activity increased by 16%, while revenue increased by 31%.The Canadian business unit held revenue flat compared to fourth quarter 2017 despite a 15% reduction in drilling activity. Our International business unit also saw impressive year-over-year revenue growth with a 38% increase. Year-over-year incremental adjusted EBITDA margins for the quarter of 73% remained in line with our expectations of midline contribution from revenue growth.Consolidated revenue of $82 million represented a 24% increase from the fourth quarter of 2017 and was flat from the third quarter of 2018. For the full year, revenue totaled $306 million, a 25% increase from 2017. Adjusted EBITDA in the fourth quarter of $39.3 million was up 41% from the $27.8 million in the fourth quarter of 2017 and was down 7% sequentially from the third quarter. Adjusted EBITDA for the year of $146 million represented a 49% increase from 2017. Adjusted EBITDA margins for the fourth quarter were 48%.Full year adjusted EBITDA margins improved by 760 basis points from 40% in 2017 to 48% in 2018. Depreciation and amortization expenses were down 24% from 2017 and totaled $34.9 million. After coming in at elevated levels over the past few years as a result of significant capital expenditure program in 2014 and the capitalized R&D expenses associated with those products, current levels of depreciation and amortization expenses are starting to become more reflective of our expectations of annual capital expenditures going forward.Net income for the quarter of $20.7 million was up $15.7 million from the fourth quarter of 2017 and down $3.7 million sequentially from the third quarter. 2018 net income of $62.9 million was 150% higher than 2017. Capital expenditures in the quarter, including capitalized portions of our R&D and IT investments, totaled $8.5 million, bringing full year CapEx to $23.9 million, in line with our previous expectations of spending up to $25 million in CapEx for the year.Free cash flow for the year totaled $85.5 million, including $16.6 million in the fourth quarter. Full year free cash flow was up 30% from 2017 levels. At the end of the year, Pason had positive working capital of $256 million, including $204 million of cash and cash equivalents. Pason paid aggregate dividends of $59.8 million during the year, representing 95% of net income and 70% of free cash flow.Late in the fourth quarter, the company announced the implementation of a normal course issuer bid. During the final weeks of the quarter, 50,000 shares were repurchased through the program at an aggregate cost of approximately $920,000. I will briefly review the results of each of our operating segments.Our U.S. business unit posted fourth quarter revenue of $55.3 million, up 31% from the same quarter of 2017. Measured in US dollars, quarterly revenue increased 27% year-over-year, sequentially revenue increased by 2% from the third quarter of the year. For the full year, revenue of $204 million represented a 34% increase from 2017 revenue of $152 million.Full year revenue growth in the U.S. was driven by a 19% increase in industry activity, an 8% increase in revenue per EDR day and a 343 basis point increase in market share. Drilling Intelligence saw the strongest growth and was up 78% year-over-year in the quarter and 61% for the full year. Operating costs in the U.S. business unit increased by 12% in 2018 compared to the 34% growth in revenue.As a result, segment gross profit increased 64% from $70.5 million in 2017 to $115.6 million in 2018. Our operating costs have increased, particularly in the Permian basin as we expand our capacity to absorb additional work. We expect to continue to build out our service operations in the area, even as the industry is currently slowing while it works through pipeline constraints.As a result, we expect margins will compress in the first half of 2019 as we better position ourselves for further market share and revenue growth. Our Canadian business unit represents our second largest segment. A significant decline in the oil price in the fourth quarter resulted in lower activity levels than anticipated in Canada in December. Fourth quarter industry activity was 15% lower in 2018 compared to 2017. Despite the full backing activity, our Canadian business unit managed to hold revenue flat from 2017 fourth quarter levels at $17.9 million.For the full 12 months, revenue grew by 2% to $72 million despite an 8% decrease in industry activity. The successful introduction of products in our Drilling Intelligence category has been the largest contributor to a 12% increase in revenue per EDR day. Fourth quarter revenue from the Drilling Intelligence category was 92% higher than the fourth quarter of 2017.For the full year, Drilling Intelligence revenue increased 57% compared to 2017. Our competitive position in Canada remains strong with 2018 market share coming in at 88%, consistent with prior year levels. Reported market share for the fourth quarter was more than 600 basis points higher than the same period of 2017. I would point out that as oil and gas drilling slows, the contribution from non-oil and gas rigs has a disproportionately positive impact on reported market share. At the same time, however, as the daily revenue from those rigs is typically much lower, there is a corresponding downward pressure on reported revenue per EDR day.Full year segment gross profit for the Canadian business unit was 43% higher in 2018 compared to 2017 due to a 38% decrease in depreciation and amortization expenses. Our International business unit had strong financial results in 2018. Full year revenue of $30.5 million was up 32% from 2017. Fourth quarter revenue of $8.7 million was up 38% year-over-year from the same quarter of 2017, and up 7% sequentially from the third quarter of 2018.We saw revenue growth in each of our international regions on both sequential and year-over-year basis. Our international teams have managed to exert strong discipline over costs as revenue has grown. With the 6% growth in operating costs in 2018 compared to the 32% revenue increase, segment gross profit for the International business unit was up 655% year-over-year to $7.8 million.In summary, Pason posted strong financial results in 2018 and is well positioned to maintain its strong position even as industry conditions have, again, become more challenging. In the U.S., our market position is strong. Interest in our newest product offerings continues to grow and our capacity to respond to customer demand is increasing.Our Canadian business has significantly outperformed the declines in industry activity. We have retained and grown our market leadership position, while delivering significantly increased value to our customers, particularly through our Drilling Intelligence product suite.Our International business unit continues to post strong revenue growth in each of its operating regions and has returned to much higher levels of profitability. The investments we have made over the past few years in developing new technologies are coming to fruition. We are commercializing new and less capital-intensive technologies. We have worked to reduce our cost base and are maintaining appropriate discipline over both operating and capital costs as revenue increases.Our cash flow generation capabilities remain excellent. Our balance sheet remained strong with over $200 million in cash and no debt. We are maintaining our quarterly dividend at $0.18 per share. We have returned additional cash to shareholders through the implementation of a normal course issuer bid, and we expect to continue to use this mechanism as part of our capital allocation strategy to offset dilution from the exercise of stock options.I will now turn the call back to Marcel for his comments on our outlook.

[Marcel Kessler, President, CEO & Director]

Thank you, Jon. We have increased our investments in R&D in 2018 compared to the previous year, and we expect some further growth in 2019 through run rate effect. IT expenses also increased as we are transitioning towards a more cloud-based IT infrastructures.Our capital expenditures will be relatively modest going forward with significant share of development efforts focused on software and analytics and the larger portion of IT expenses being OpEx rather than CapEx. We intend to spend up to $30 million in capital expenditures in 2019.From a macro perspective, the significant fall in oil prices in the fourth quarter was driven by U.S. shale production surprising to the upside as well as geopolitics negatively impacting sentiments around demand/supply-balance for crude oil. This has introduced more uncertainty for the E&P spending outlook for 2019, with operators generally taking a more conservative approach at the start of this year.This will once again push out in time a broad-based recovery in E&P spending. For North American land E&P operators, this means that the investments will likely be close to the level that can be covered by free cash flow, making the outlook for drilling activity more uncertain. Conversely, in the international markets, after 4 years of underinvestment, the national oil companies and independents are starting to see the need to invest in their resource space simply to maintain production at current levels.Based on what we can see today, we expect industry activity in North America to trend lower in 2019, with declines of about 5% in the United States and much steeper declines in Canada. Drilling activity in most international markets, on the other hand, should continue to pick up. In this environment, we have built flexibility into our plans for 2019, which gives us the means and confidence to address any activity scenario.Our market positions remain strong, and we expect to be able to deliver growth through higher product adoption going forward. 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.And we now be happy to take any questions.

[Operator]

[Operator Instructions] Your first question comes from the line of Daine Biluk.

[Daine Biluk, Associate]

So considering the ongoing headwinds in Canada right now, can you share how the pricing conversations have unfolded to begin the year? Has there been a lot of push back in pricing? And what is your willingness to engage in discounts?

[Marcel Kessler, President, CEO & Director]

So pricing conversation has not really picked up significantly, but it's probably fair to point out here that never really is since the 2015 -- 2016 downturn. So, I think, our Canadian customers have always engaged -- have always been very, very price sensitive, but we have not really seen a significant uptake since that time. And from our history, our willingness to engage in steep discounts is quite limited and continues to be very, very limited.

[Daine Biluk, Associate]

Okay. That's good color. Do you anticipate the new product adoption for the new Drilling Intelligence softwares will flow through the year on the softer market activity in North America? Or is the rig addlements you're currently seeing largely concentrated in rigs that would not be candidates for some of these newer products?

[Marcel Kessler, President, CEO & Director]

So I think that the newer products are applicable to both the more traditional mechanical rigs, which still have a significant portion of market share in Canada as well as internationally and they're also implementations of the new products of the new Drilling Intelligence services for the modern AC rigs. So I think, we are quite -- we're probably somewhat indifferent to the rig mix at this point. It's probably fair to point out that the initial increase in adoption of the ExxonMobil DAS Drilling Intelligence was quicker on the mechanical rigs in Canada and is now essentially spilling over to the U.S., while obviously, the big prize there is the adoption of those products on the AC rigs, which is slower, but essentially proceeds at the drilling contractor by drilling contractor pace.

[Daine Biluk, Associate]

Okay. That's helpful. Internationally, was there any large customer wins in the quarter?

[Jon Faber, Chief Financial Officer]

Though it was really broad based across kind of existing customers and, I guess, we would always have some measure of customer wins and losses in any of those regions and so there'll be no significant outlier in that respect.

[Marcel Kessler, President, CEO & Director]

I think that the big win regionally internationally would have been in Oman.

[Jon Faber, Chief Financial Officer]

Correct.

[Daine Biluk, Associate]

Oman. Okay. And then just last one for me. Could you perhaps throw some financial goal posts around Pason Power. How should we be thinking about that from a spending and revenue perspective over the next few years? I fully recognize it's very early days still, but just trying to get a sense of how we should be thinking about that business?

[Marcel Kessler, President, CEO & Director]

I would suggest that you try not to model anything on the revenue or cost side. We don't -- as you know, we are very conservative and we don't really believe that it's going to be material in the short or medium term.

[Operator]

[Operator Instructions] Your next question comes from the line of Michael Robertson.

[Michael Storry-Robertson]

You had mentioned the NCIB was active to the tune of just under $1 million during the quarter. I understand NCIB activities depend on where the shares are trading, but is this a sort of activity level that you would expect as a quarterly run rate when shares are in the price range that we saw in Q4?

[Jon Faber, Chief Financial Officer]

Well, Michael, I'd point out that the NCIB only when in place in mid-December and, of course, the very end of December, there is very little liquidity in the market generally over the holiday season. So we've talked about using the NCIB as a mechanism to offset dilution from the exercise of stock options. So I think you should expect that we would do that in a somewhat disciplined, consistent manner, not necessarily trying to kind of time the market specifically. Now we see, sort of, unique opportunities in the market to maybe do a little more based on market conditions, we would consider that. But I think we're looking at it more as a measure of capital discipline over time as opposed to looking at the spot price in the market at any given day.

[Operator]

Your next question comes from the line of Ian Gillies.

[Ian Brooks Gillies]

Marcel, in your prepared comments you talked about the ExxonMobil Drilling Advisory System seeing pretty strong uptake on the mechanical rigs in Canada and now you are starting to see some of that in the U.S. as well. I guess, twofold question, can you just remind us why this product is better suited for mechanical rigs? And two, whether you are actually seeing any uptake at this point in time from some of the AC super spec rigs? I guess, probably more so on the U.S., just given some of your commentary.

[Marcel Kessler, President, CEO & Director]

Yes, absolutely. Good question. The ExxonMobil DAS algorithm or product suite, I should probably call it, is suited to all types of rigs. The implementation of it is simpler and, therefore, the commercial success is quicker with mechanical rigs. In the case of mechanical rigs, the ExxonMobil DAS software package is bundled with our existing AutoDriller, and is essentially a simple bolt-on through the rig and it's a turnkey operation. And that's why it was so quick in Canada and it's going to be reasonably quick now for the mechanical rigs that still exist in the U.S., in The United States. For the AC implementation, it requires more software integration by ways of middleware, I don't want to get too technical here, with the rig control systems. So there is more development work required, which essentially proceeds on a -- as I mentioned, on a drilling contractor by drilling contractor basis. There is adoption, and I think probably of the 200-or-so installs of new Drilling Intelligence software, I think close to 50 of those would be on the super spec AC rigs. It just progresses more slowly.

[Ian Brooks Gillies]

Okay. That's helpful. And maybe because it seems like you're getting pretty good uptake there. Maybe something else that would be helpful is, when you are in talking to customers about this, I guess, this product, I mean, is the competitive landscape -- is there a lot of people trying to do the same thing you are? Or if this is a very unique product and that's why it's getting such strong uptake?

[Marcel Kessler, President, CEO & Director]

I think there are several players trying to achieve the same objective. So increasing the rate of penetration, minimizing the damage to downhole tools and, ultimately, landing and drilling a better well, I think those are objectives that many people pursue. In terms of ExxonMobil DAS, that's obviously exclusive to us at this point. So nobody else has the ability to really use this specific technology. Now that being said, our large competitors who are the same ones that we would have competed in EDR space have comparable offerings. Now we believe that ExxonMobil DAS is clearly superior at this time. And some of the -- some drilling contractors are also making efforts to try to do some of this on their own. So it's not completely a white space.

[Ian Brooks Gillies]

Yes, okay. And if we take a step back and think about Drilling Intelligence, I mean the revenue growth year-over-year was obviously robust. Moving off a larger base of revenue now though as we move forward into future years, do you think that growth rate inevitably starts to slow just because we are working with larger numbers at this point? Or is the uptake in fact picking up and growth rates could in fact increase?

[Jon Faber, Chief Financial Officer]

Well, there is 2 pieces Ian, right. To your point, the growth rates are always large on small numbers in terms of absolute dollars or smaller numbers. So that will obviously drive contraction in the growth rate. The other and more important element is what Marcel was referring to, which is simply that the next leg of adoption in that space is going to require more integration work with the contractors, and so while I think the interest in that is increasing, the timed implementation is going to be quite elongered in some cases and so that will slow that pace of revenue growth. But clearly, the interest growth rate is increasing.

[Marcel Kessler, President, CEO & Director]

An additional point on this as well. So this product suite, the Drilling Intelligence product suite is not static, right? We continued to invest significant resources in R&D in that space, and we expect to round out that product suite with additional products and services. The next one really being a more automated offering for directional drilling. Now whether or not that's going to have commercial impact in 2019 probably not the case, probably more of a 2020 product. But I think that there will be additional products here that will generate growth as they're only in the medium term.

[Operator]

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

[Elias A. Foscolos, Equity Research Analyst]

I've got a couple of questions. I guess, the first one would be directed towards Jon. And it's a comment you made about as rig counts in Canada decrease you would see some downward pressure on EDR -- revenue per EDR day, of course, you mentioned the market share sort of a potential pickup. But the question I got is that inclusive or exclusive of peripheral adds?

[Jon Faber, Chief Financial Officer]

Well, the market share is measured on an EDR basis as you know, and that's why when we have these non-oil and gas rigs contributing disproportionately, it tends to drive the market share up. Now these types of rigs take less peripherals and that's why we have the downward pressure on revenue per EDR day when you have disproportionate contribution from those rigs.

[Elias A. Foscolos, Equity Research Analyst]

Got it. I appreciate the clarity. The last question I've got is on the R&D investment in the cloud-based infrastructure. First of all, I'll ask the question, might this be like Pason Power where it's kind of nonmaterial? Or is this something that would eventually enhance margins, contribute to revenue or maybe even neither? Just some clarity and I said only if it's material or you see it as material at some point.

[Jon Faber, Chief Financial Officer]

Well, I think the reason we sort of highlighted is that it does bring more of the spending to the income statement versus investment in capital equipment servers, et cetera. So it does have a financial impact in terms of where some of that spend shows up in the financial statements. But the real business purpose towards the move to cloud-based infrastructure, it really comes down to questions around disaster recovery business continuity types of things where you have sort of auto replication and so much faster recovery times in the event of disaster scenario. It also facilitates quite a bit faster velocity of software development, because you can sort of essentially spin up the required servers and infrastructure to experiment much more quickly than if you had to order those boxes as physical devices and configure them. So I think, the real win from a revenue perspective is velocity of product development and our ability to experiment and try things quickly and get them in front of customers quickly. And then there is, obviously, some just the core backbone infrastructure enhancements that you get as well.

[Elias A. Foscolos, Equity Research Analyst]

Okay. I appreciate that. That does help. And maybe just following up with that point that we made on how the spending is sort of shifting from capital to an income statement item. Clearly, the EBITDA margin gains on a year-over-year basis, as you said, were trending about right based on incremental revenue. Could that, what you just mentioned, be sort of a contributing factor to why it looked a little different on a quarter-on-quarter basis? Or should I just ignore that question because I'm really micro marring the brick a little too finite?

[Jon Faber, Chief Financial Officer]

No. I -- that would have been a contributor because we did shift quite a bit more in the fourth quarter so that would have -- we would have some cost there in the fourth that wasn't in the third. The other is probably bigger driver of the compression on the EBITDA margin in the fourth quarter is the investments we're making in the Permian area where -- and we're going to continue those investments as we said in the call, Elias, around building our capacity in that region, notwithstanding the fact that we've seen some slowdown due to these pipeline constraints. We still really feel our biggest constraint in that region remains our capacity to deliver service at a level that we deem appropriate, not customer demand. And so we think if we can continue to grow that capacity which will compress margins in the short term, there is additional demand there that's ready and waiting for us to pursue.

[Operator]

We have no further questions at this time. I will turn the call back to our presenter.

[Marcel Kessler, President, CEO & Director]

Thank you, everybody. Have a good day.

[Operator]

Thank you, everyone, for joining us today. This concludes today's conference. And you may now disconnect. Have a great day.