Archrock, Inc. Q3 FY2023 Earnings Call

Good morning, and welcome to the Archrock's Third Quarter 2023 Conference Call. Your host for today's call is Megan Repine, Vice President of Investor Relations at Archrock. I will now turn the call over to Ms. Repine. You may begin.

Thank you, Nadia. Hello, everyone, and thanks for joining us on today's call. With me today are Brad Childers, President and Chief Executive Officer of Archrock; and Doug Aron, Chief Financial Officer of Archrock. Yesterday, Archrock released its financial and operating results for the third quarter of 2023. If you have not received a copy, you can find the information on the company's website. During this call, we will make forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934, based on our current beliefs and expectations as well as assumptions made by and information currently available to Archrock management team. Although management believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct. Please refer to our latest filings with the SEC for a list of factors that may cause actual results to differ materially from those in the forward-looking statements made during this call. In addition, our discussion today will reference certain non-GAAP financial measures, including adjusted EBITDA, gross margin, gross margin percentage, free cash flow, free cash flow after dividend and cash available for dividend. For reconciliations of these non-GAAP financial measures to our GAAP financial results, please see yesterday's press release and our Form 8-K furnished to the SEC. I'll now turn the call over to Brad to discuss Archrock's third quarter results and to provide an update on our business.

Thank you, Megan. Good morning, everyone, and thank you for joining our call. We delivered excellent financial and operational results during the third quarter, which included setting several performance records. This continues to be a tremendous market for compression. But more importantly, the results Archrock delivered in the third quarter and the consistency and execution we've delivered all year, reflect the changes we've driven across the business to enhance our fleet, customer service and profitability to drive improved returns for our investors. Let me hit a few of the highlights from the quarter. In the third quarter, we doubled our net income to $31 million compared to the third quarter of 2022. We generated adjusted EBITDA of $120 million, which was a quarterly record for Archrock and was up 7% sequentially. The increase was driven primarily by positive pricing and profitability momentum in our contract operations segment. I'm also proud to share that we achieved an important balance sheet milestone during the quarter, as we drove our leverage ratio to 3.8x, and we intend to drive leverage even lower next year. We continue to increase shareholder returns. We paid a quarterly dividend per share of $0.155, which was up 7% compared to a year ago, all while maintaining robust dividend coverage of 2.6x. In addition, we continued repurchasing shares under our share buyback authorization. I'd now like to share my perspective on the market. Archrock is positioned in a unique segment of the natural gas value chain. And we believe compression market fundamentals have never been better. Similar to pipelines, we're an energy infrastructure company, supplying a critical piece of infrastructure needed to move gas to market with the majority of our large horsepower equipment deployed in natural gas gathering applications. We run a fee-based business, which is closely aligned to natural gas production volumes and not natural gas prices, so we're not exposed to the shorter cycle volatility facing drilling, pressure pumping and completions-focused services. Looking at the outlook for natural gas production, again, the biggest driver of our business, we expect to see consistent and modest growth rates in the low single-digits on an annual basis. This is being driven by two dynamics. First, we continue to see strong investment in associated gas plays in the U.S. like the Permian and the Eagle Ford, where the majority of our operating fleet is located. We also believe the recent U.S. Shell mega deals announced by major integrated producers reinforce the competitiveness and longevity of U.S. Shell. Second, our customers are critical infrastructure to support growing LNG exports from the U.S., further extending the attractive fundamentals for our industry well into the future. As natural gas demand and production grows, we're experiencing unprecedented tightness in the compression market, which we believe is driven by structural and industry-wide changes to capital allocation practices. Priorities have changed. With capital discipline permeating the energy sectors, companies are looking to drive moderated and profitable growth as well as consistent free cash flow to return to shareholders. We're seeing this capital discipline from our producer and midstream customers, other compression companies and even our equipment providers. We believe this powerful combination of expected continued growth in natural gas production plus the commendable discipline we're seeing across the industry support a comparably steadier and more durable up cycle for compression and for Archrock. Moving on to our contract operations segment. We've positioned our compression platform, selling non-strategic assets and investing in highly standardized, large midstream compression units. The benefits are clearly beginning to pay off in our results. Fleet utilization exited the third quarter at 96%, another record for Archrock. We also delivered nearly 650,000 in active horsepower growth excluding non-core active asset sales of 35,000 horsepower. The growth was primarily driven by new build equipment deliveries as we have a few idle units remaining to redeploy and as we continue to experience historically low levels of equipment returns from the field. When we do receive a notice of a customer's determination to return units, most of that equipment is booked for its next job before it ever stops in its current location. On booking activity, robust customer demand is showing no signs of slowing down, and our 2024 new-build capital is fully committed. With lead times for new equipment still around a year, the window to order compressors for delivery in 2024 is closing, and our customers are beginning to plan for their 2025 horsepower needs. On pricing, we've now achieved sequential increases in our monthly revenue per horsepower for eight consecutive quarters. Over this time period, our monthly revenue per horsepower is up over 17%. The pricing trajectory remains positive, and we expect to continue to make progress gradually moving rates up on our installed base next year. We delivered an impressive third quarter gross margin percentage of 64%, which was above our annual guidance range and is now approaching peak performance during prior cycles. This is due to a few factors. First, as I just highlighted, we've repositioned our compression platform for a more stable and profitable future. Second, the price increases we're implementing this year are catching up with the cost increases we experienced over the last few years. And third, we've maintained a consistent and unwavering focus on cost management as we grow modestly and profitably with our customers. Turning to aftermarket services. We saw steady and strong performance. We observed solid demand and activity on the service side of the business during the quarter, and profitability remains substantially higher than 2022 levels as our team focuses on targeting higher quality and higher-margin activity. From a capital allocation standpoint, we remain on track to deliver the enhanced framework that we laid out on last quarter's call, which is underpinned by our commitment to generate free cash flow. Based on our current outlook for 2024, we remain set up to grow our dividend with a 2024 target of 5% and maintain a dividend coverage ratio of approximately 2x. We currently drive our leverage ratio even lower to a range of 3 to 3.5x. Fund our growth capital expenditures, which we currently anticipate to be approximately $160 million in 2024. And this capital plan preserves the ability to continue to buy back additional shares. In summary, 2023 is shaping up to be a banner year for our company, and we believe we are set up for an extended period of strong and sustained performance. Natural gas production fundamentals remain durable. The compression industry is as tight as we've ever seen due to capital rationalization by both the energy industry and our supplier, and Archrock's competitive and financial flexibility is as strong as it's ever been. With that, I'd like to turn the call over to Doug for a review of our third quarter and to provide additional color on our outlook for the rest of the year.

Thank you, Brad, and thanks to everyone for joining us this morning. Let’s review our third-quarter summary and discuss our financial outlook. Net income for the third quarter of 2023 was $31 million, which included a long-lived and other asset impairment of $3 million and restructuring charges of $600,000. We reported adjusted EBITDA of $120 million for the third quarter of 2023, marking a quarterly record for Archrock. Our underlying business performance was robust in the third quarter, delivering higher total gross margin dollars both sequentially and annually. Results were further enhanced by approximately $3 million in asset sale gains during the quarter. In terms of our business segments, contract operations revenue reached $208 million in the third quarter, an increase of 3% compared to the second quarter of 2023 and 22% compared to the same period last year. Both operating horsepower and pricing saw sequential increases. We grew our gross profit by nearly $7 million or 6% compared to the second quarter, achieving a gross margin percentage of 64%, up 150 basis points from the second quarter and nearly 600 basis points year-over-year. Our aftermarket services segment reported revenue of $46 million in the third quarter of 2023, consistent with the second quarter and up 6% compared to the third quarter of 2022. The gross margin for aftermarket services was 20%, which was down sequentially but in line with annual guidance and up 300 basis points compared to the third quarter of 2022. Growth capital expenditures in the third quarter totaled $45 million, consistent with our expectations that capital investment for the year would be more weighted towards the first half. By the end of the third quarter, we had deployed $175 million of growth CapEx in high-return projects to meet strong customer demand, particularly in associated gas basins like the Permian. Notably, we raised about $55 million this year through nonstrategic equipment sales to support our new build investment program. Maintenance CapEx for the third quarter was $24 million, compared to $27 million in the second quarter. Make Ready and overhaul CapEx decreased sequentially. We finished the quarter with total debt of $1.6 billion, with variable rate debt making up about 20% of our total long-term debt. We also maintained strong liquidity of $439 million. Our leverage ratio improved to 3.8x, down from 4.3x in the third quarter of 2022. Reducing our leverage ratio to below 4x has been a goal since before my time at Archrock, and we are pleased to achieve this important milestone. We still have progress to make and believe it’s sensible to set new goals, especially in the current high-interest-rate environment. As Brad mentioned, we currently expect our leverage ratio to decrease in 2024 to a range of 3 to 3.5x. We recently declared a third quarter dividend of $0.155 per share, or $0.62 on an annualized basis, consistent with the second quarter and up 7% year-over-year. Our latest dividend reflects a solid yield of nearly 5% based on yesterday’s closing price. Cash available for dividends in the third quarter totaled $63 million, resulting in a strong quarterly dividend coverage of 2.6x. In addition to increasing the dividend this quarter, we repurchased approximately 354,000 shares for $4.4 million at an average price of $12.49 per share, leaving about $43.5 million available for further share repurchases. As for our outlook, we continue to execute well against our plan this year, and we are confident in the fundamentals of the compression market, our operational capabilities, and our financial flexibility. For adjusted EBITDA guidance, we expect to approach the high end of our recent guidance range of $430 million to $450 million. This suggests relatively flat adjusted EBITDA in the fourth quarter, reflecting continued strength in our contract operations segment but offset by seasonal weakness in our aftermarket services business and the $3 million in third-quarter asset sale gains that are not expected to reoccur. For our capital expenditures, we still anticipate total 2023 capital expenditures to be around $295 million. Of that, we plan to maintain growth CapEx at $200 million primarily for new build horsepower to meet key customer demand. In summary, we are committed to finishing the year on a high note and aim for an even better 2024, expecting enhanced profitability, improved financial returns, and positive free cash flow while prioritizing shareholder returns. We hope you will join us for what promises to be an exciting and rewarding journey. Now, I’ll turn the call back over to Nadia for questions and answers.

And our first question goes to Jim Rollyson of Raymond James.

Congrats on another great impressive quarter moving forward. Brad, just maybe as we think about growth going forward, obviously, you're probably getting closer to maxing out on utilization. And as you mentioned, so incremental horsepower adds, which you're going to spend $160 million next year will be part of that equation. And the rest of the equation seems like from a top-line perspective will be how your pricing moves from here, and it's been a pretty steady trend upward. I'm trying to understand maybe as you sit today and look across the portfolio of the fleet at your most recent contracts and the implied pricing and some of your maybe older contracts that haven't repriced or moved up with an inflator basis, trying to understand the spread there to kind of figure out how much upside room there is just from today's market if you mark your fleet to the market today.

Thanks, John. We believe there is a substantial upside in the profitability to the business. And when you think about profits, you cited two of the three items that will continue to move the needle for our performance. The first is incremental horsepower growth as we grow our fleet responsibly with great investments at very solid returns for our investors. One that you missed, and I'll come to pricing third, one that you missed is we remain ambitious about managing our costs with the investments we've made in technology to improve the performance of our fleet. We believe it's also going to enhance the profitability of our fleet. We believe that this is an investment that's going to yield incremental improvements and returns for years to come, and we intend to exploit that aggressively in 2024, just as we have in 2023, but also in 2024 and beyond. And then finally, on pricing, we certainly have room to bring the installed base up to more current spot pricing over time. And we're ambitious about what we can do with those pricing moves. So we believe these are three solid levers that are going to be available for us to drive returns for our investors in this market.

Understood. I didn't miss the costs. That was going to be my next question. Is there anything that indicates there are still opportunities to enhance that aspect? Historically speaking, this seems like a different time compared to most of history, at least from my perspective in this field. Considering the current pricing trajectory and the momentum it has, along with your present costs and the potential for improvements you just mentioned, where do you envision margins going? We are nearly back to historical peaks. I'm curious if this approximate 64 percent margin can continue to gradually increase over the next few quarters, or how you view that situation.

We believe the investments we've made and the market we have ahead of us support a very sustained margin level like we're experiencing currently. And I'm ambitious that we can move margins higher. Stepping back and looking at the historic returns in the compression space and candidly, in the energy space overall, returns have to go up. When you step back and look at the cost factors to our business, acquisition of equipment, those costs are up, labor costs are up, lube oil is up, parts pricing is up. And we have to improve the profitability of the business to catch up with those returns and then exceed them because very critically, cost of capital is up. And in a space with extreme capital discipline right now to attract capital and to deliver returns that attract capital, our returns have to go up too. So we believe there is room in the energy industry and certainly in compression to continue to improve profitability to accomplish those improved returns.

That makes perfect sense. I have one last question. With leverage already approaching your original year-end goal, and as you plan to move the target down to 3 to 3.5 times next year, what are your thoughts after reaching that leverage level? This process is consuming some of your cash flow to achieve your desired leverage, and your dividend coverage is currently 2.6 times and appears to be increasing. I'm interested in how you plan to allocate capital beyond 2024 once you achieve your target leverage.

We are a returns-focused investor. We're going to look to return and invest our cash where we're going to yield the best return. That includes the increase in the dividend for the benefit of our investors. That includes looking at share repurchases for the benefit of our investors. And with the managed liquidity and the objective of maintaining a free cash flow objective through the cycle and year-over-year. As we grow that cash flow, we'll have more to invest in the market if the returns on the equipment are there also.

Our next question goes to Steve Ferazani of Sidoti.

Brad, appreciate all the color on the call. I feel like I probably asked this last quarter, but worth asking again. utilization rates now a new record didn't seem like it could go higher. Just a question as we get into a seasonally higher demand area, and I'm sure your asset turnover has to be at near record lows. Is it safe to say that utilization is sustainable because you're not going to be returning compression into the winter months? Is that a fair way to look at it?

Yes, it is. What we said in the past, I can say again, and that is that there is not enough compression market, a compression equipment in the market today to meet current production needs. Not to mention the growing production that we see coming from the expansion of LNG exports. So we see high utilization rates continuing, and we see incremental growth ahead to support that level of production. And so we think utilization can maintain and candidly can even continue to tighten from here based on the demand we see in the market today.

I think I know the answer to this, but I'll ask it anyway. Obviously, in more drilling-related sectors, we've seen smaller operators getting more aggressive pricing and pushing down margins. Clearly, the numbers show it's not happening here. Any pressure from smaller operators or is everybody to your previous answer, operating at such full capacity that there's - that's just not any kind of a near-term risk?

We've noticed pricing competition in the market. However, our high-quality customer base is focused on growth and expanding their compression operations. They recognize the rate increases we've implemented, especially considering past inflation. Our overall rate adjustments have been successful. While there is competition, the market's growth, recovery from inflation, and the need for improved returns suggest that the pricing we have achieved, along with our expectations for 2024, will be well-received and will enhance those returns.

Can I emphasize a portion of Brad's answer? If we look back to the end of 2019 and the end of 2020, we mentioned this on our last call: we've seen nearly a 40% increase in the cost of new large horsepower equipment, from about $900 a horsepower to nearly $1,200 a horsepower. This increase means that customers who are ordering their own equipment with foresight and long lead times, as well as potential new entrants that we haven't seen yet, will need to price their offerings at current rates to achieve any recovery. One of the attractive aspects of Archrock is our installed base of 3.6 million to 3.7 million horsepower, much of which was acquired during a different market period. We believe this allows us to command a higher price. As Brad mentioned, the upside for 2024 and beyond suggests that if someone enters the market and tries to reduce prices, it would lead to a loss of value or capital.

That's helpful. If I could just get one last one in. Just on maintenance CapEx came down this quarter. Is there much idle capacity left to make ready? Or what would you expect trends being that you're going to have to maintain a larger fleet going forward theoretically into next year?

We still have about 100,000 horsepower that could be made ready and go to work over the right time frame. But we will not, and we do not expect to have the same level of Make Ready expense flowing through maintenance CapEx that we experienced in the first half of 2023.

Our next question goes to Selman Akyol of Stifel.

So let me just start with in terms of spot pricing, if you were to characterize it versus 6, 9 months ago, how is that trending?

No, let me expand on that a bit. We find that we are in a very aggressive pricing posture now for reasons we've already discussed on the call, so I won't go into all of them, Selman. But just catching up with original equipment cost for new builds, catching up with parts, labor, lube and the fact that the cost of capital has increased has justified a significant amount of price reclamation in the energy space and in compression that we and you can see our competitors also are benefiting from. We do not see the ability to raise prices changing or abating. The slope of the curve may start to flatten a bit, but we still are very positive that we can see more pricing gains from our installed base in 2024, and that's still ahead of us. By the way, let me expand on one point, which is that one of the really interesting aspects of this high inflation phase that we just went through, that is yet not fully appreciated, and you can see it in the pricing and returns that we're going to achieve in the future, is the value of our investments that we made ahead of this inflationary period, the value of our fleet has gone up substantially and we expect to claim improved returns off of those great investments that we made before this high inflation environment kicked in.

Understood. And then if I think about how much of your fleet is left to reprice, how would you say that?

We estimate that still two-thirds of our fleet can be repriced over the next 12 months. Part of that comes in the form of units that roll off term. Part of it comes in the form of units that are under a major strategic alliance with our customer base and has pricing mechanisms in there, some of which are indexed and some of which are just negotiated. So that allows us to keep the pricing fresh on our fleet, and it's about two-thirds that will be repriced over the next 12 months.

Understood. So, given your emphasis on costs, how is it that your gross margin is not expected to expand from this point?

We are very ambitious about our ability to continue to improve our gross margin and the profitability of our business based upon both factors, price increases that we expect are ahead, as well as cost opportunities that we are attacking vigorously inside the company.

We are not providing guidance for 2024 today because we are still developing our plan. However, we have achieved eight consecutive quarters of sequential revenue growth, and based on our current discussions with customers, we expect this trend to continue. Additionally, we want to keep some exciting updates for our Q4 report early next year.

I wanted to shift the conversation to the balance sheet and your comments regarding it. You mentioned your goal of reducing to 3% or 3.5%, and I agree with your strategies in a higher interest rate environment. My question is, regarding interest expense, unless you reduce your debt levels, even with lower leverage, your interest expense may still remain significant. Are you planning to pay down additional debt, or do you anticipate that your leverage will improve through higher EBITDA?

So I have a few comments to make. During our time on the road together, Selman, you coined a phrase that I've adopted. We are not just planning to reduce leverage, as you described, by growing EBITDA. We have actually repaid around $230 million in debt since 2019, which has significantly contributed to reducing our leverage. As we look ahead to EBITDA growth next year and the use of free cash flow afterward, we have identified three key areas to focus on: new growth capital expenditures, increasing our dividend, and either reducing leverage further or executing share buybacks. We will continue to assess all these options. When we compare ourselves to other midstream companies and particularly to our compression peers, we stand out as a best-in-class provider. We have flexibility that many of our competitors lack, and we will strive to find the right balance in managing our free cash flow.

Understood. And I guess you mentioned conversations on 2025 are starting. Just how are those going? And I'm just kind of curious, meaning they're very open to seeing continued price increases out that far, still hearing things are going to be tight. Is there just any insight you can kind of give on what's going on there?

Demand is high for 2024. Demand signals overall, pricing and horsepower amounts and unit amounts, those discussions with customers are as strong at the beginning of '24 as they were in 2023. And in fact, I think in some cases, they are earlier because with the tightness of the market, our customers have become accustomed to planning further in advance than they ever have. So it's a robust market and it looks to be very demand and growth-oriented continuing through 2024.

We have no further questions. I'll now hand back to Mr. Childers for any final remarks.

Thank you, everyone, for joining our fourth quarter call this morning. Our performance was exceptional this quarter. And with Archrock's enhanced platform and financial flexibility, we are well positioned to capture opportunities presented by the current market. I look forward to updating you on our progress next quarter. Thank you, everyone.

Thank you. This now concludes today's call. Thank you all for joining. You may now disconnect your lines.