Earnings Call Transcript - AROC Q1 2022

Operator, Operator

Good morning. Welcome to the Archrock First Quarter 2022 Conference Call. Your host for today's call is Megan Repine, Vice President of Investor Relations for Archrock. I will now turn the call over to Ms. Repine. You may begin.

Megan Repine, Vice President of Investor Relations

Thank you, Rob. 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, we released our financial and operating results for the first quarter of 2022. If you have not received the copy, you can find the information on the company's website at www.archrock.com. 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's 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 to our discussion today, we'll 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, 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 first quarter results and to provide an update of our business.

Brad Childers, President and CEO

Thank you, Megan and good morning, everyone. I appreciate everyone joining the call today. It's certainly been an eventful start to 2022 for the energy industry, with all eyes now on North American oil and gas supply. For Archrock, fundamentals in our natural gas compression business strengthened during the first quarter. At the same time, we continue to prioritize and advance our long-term strategies, high grading our fleets, harnessing technology across the organization and increasing our focus on sustainability. First quarter highlights include, the contract operations revenue increased $4 million or 3% from the fourth quarter, as we grew our operating horsepower and benefited from the initial price increases we implemented late last year. Strong customer engagement drove bookings 40% higher on a sequential basis. This is providing us great visibility into new starts through the remainder of 2022 and well into 2023. Our team did an excellent job maximizing our profitability in an inflationary environment, delivering a 61% contract operations gross margin. This is consistent with our annual guidance range and meaningfully above historical levels in this phase of the cycle. Last, AMS revenue increased 14% on an annual basis, as our customers began catching up on major maintenance. We've also enhanced our free cash flow outlook for the year. When we laid out our 2022 capital program on last quarter's call, we indicated non-core asset sales would be an important financial tool for us during this reinvestment period. I'm pleased to share that in May, we closed the sale of an additional non-core compression horsepower package of assets for proceeds totaling $56 million and we now expect to generate positive free cash flow after dividends in 2022. This transaction, like others we've completed over the past few years, creates significant value for Archrock. We're selling horsepower at attractive multiples and redeploying the proceeds to help advance our strategic priorities and to fund our investment in new, standardized large horsepower. This new horsepower will be deployed in the more stable midstream segment of the market for decades to come. These strategic divestitures have improved our returns and position us well to continue to reduce greenhouse gas emissions from our fleet. Moving on to the market backdrop. The macro environment during the first quarter further reinforced our outlook for the year. Recent midstream under investment and limited spare capacity drove commodity prices higher during the quarter and resulted in strong booking activity as our customers implement their 2022 growth plans. U.S. natural gas production forecasts continue to tick higher with the EIA now forecasting an annual increase of 4% in both 2022 and 2023. We're even more excited about the longer-term outlook. Geopolitical tensions have quickly driven the realization that a more diverse energy mix is needed to satisfy global energy demand and preserve energy security. In particular, we're encouraged by the growing potential for another wave of LNG projects that would result in a meaningful call on U.S. natural gas production and therefore our natural gas compression services. These secular forces lay the foundation for a more robust and sustained upturn than previously anticipated. With the increasingly critical role natural gas will play to decarbonize energy, we now have the opportunity as an industry to further strengthen the case for natural gas by reducing emissions across the value chain. We intend to do our part and help our customers with low emission solutions. Powering a cleaner America is the right thing to do for our customers, our environment, and our shareholders as we seek to maximize the value of our Natural Gas platform. Turning to our contract operations segment. Our customers are proceeding with their growth plans for the year, as they also return cash to shareholders. Compared to the fourth quarter, we grew our operating horsepower by 28,000, as our customers take advantage of higher commodity prices. Horsepower spots are at historically low levels and we expect to start activity to accelerate as the year progresses. The recovery and our exceptional customer service drove a 40% sequential increase in horsepower bookings during the quarter and we've effectively sold out several horsepower categories. This is a great indicator of what lies ahead for Archrock, with strong visibility into compression demand and now reaching well into 2023. In the context of a high inflation environment, I'm proud of our gross margin performance. We expect inflationary pressures will persist at least through the remainder of the year, as a result, we implemented another pricing increase in April and are prepared to take additional commercial action as necessary to protect our margins. In addition to rate increases, we continue with tight cost control and are in the early stages of leveraging an upgraded technology platform in our field operations, recently installing expanded telematics across our fleet and launching a new suite of mobile tools for our field service technicians. We're just four months in and have more work to do to operationalize and integrate these enhancements into our business. Over time, I'm confident we will achieve increased asset uptime, improve the efficiency of our field service technicians, enhance our supply chain and inventory management, reduce the miles driven by our field service technicians and lower our emissions and carbon footprint. Moving to our Aftermarket Services segment. We saw improved performance for the third quarter in a row. Revenues were up 14% compared to the prior year period. Parts activity has been the primary driver of top-line growth since the recovery began, as our customers resume internal maintenance programs and more recently we've seen encouraging trends on the services side of the business as well. We expect the business to benefit from improving market conditions going forward and are focused on growing higher profit AMS business activity. In support of this, we implemented rate increases for our AMS business as well. In summary, our multi-year efforts to high-grade all aspects of our operating platform are reflected in our first quarter performance and I'm confident that these investments in our customer base, our fleet, our technology, and our talent will continue to pay dividends and differentiate us as the current upcycle continues to unfold. Our capital allocation remains clear. We intend to make strategic high-return investments in our fleet to grow prudently and profitably with our customers and continue our dividend commitment all while maintaining a healthy balance sheet and financial flexibility. In addition to returns, our commitment to helping the oil and gas industry decarbonize is a critical element of our investment strategy. Through work led by our internal sustainability, technology, and new ventures, we've already advanced our fleet high-grading strategy and accelerated investment in electric compression. And most recently, we agreed to acquire a 25% minority stake in ECOTEC, a company with impressive and tested technology that identifies and quantifies methane gas emissions. In addition to the strategic investment, we will also begin working with our customers to bring ECOTEC's suite of solutions to support their sustainability goals as many of them are committing to thoughtful ESG strategies to measure and reduce their methane emissions. ECOTEC provides a highly differentiated offering; it is proven technology that is already applied in the landfill, biogas utility, carbon credit, and air quality industries. It continuously monitors methane emissions, which is a competitive advantage given our expectation for the market to transition to a standard that requires measured and quantified emissions; it includes an integrated software compliance engine that provides auditable data. In addition to advancing our ESG strategy and helping our customers, this is a financially compelling opportunity that can create meaningful shareholder value for Archrock, as we work to connect ECOTEC's proven technology with our leading U.S. natural gas compression infrastructure and customer network. As for next steps, we intend to demonstrate this prudent suite of methane monitoring and mitigation products in oil and gas applications this year with a handful of customers and we look forward to updating you on our progress later in the year. Last, I'll mention, this is the first of what I hope to be an expanding set of products and services we can bring to our customers to help them produce, compress and transport natural gas in an environmentally responsible way. With that, I'd like to turn the call over to Doug for a review of our first quarter performance and to provide color on our 2022 guidance.

Doug Aron, CFO

Thank you, Brad, and good morning. Let's summarize our first quarter results and discuss our financial outlook. Net income for the first quarter of 2022 was $2 million, which included a non-cash long-lived asset impairment of $7 million. We reported adjusted EBITDA of $81 million for the first quarter, aligning with our internal expectations and keeping us on track to meet our full-year financial goals. Now, turning to our business segments, contract operations revenue reached $164 million in the first quarter, an increase of $4 million or 3% compared to the fourth quarter. Both operating horsepower and pricing saw sequential increases. We achieved a strong gross margin percentage of 61%, which is consistent with our annual guidance and impressive considering the inflationary pressures faced by our operating team. In our Aftermarket Services segment, first quarter 2022 revenue was $34 million, down from $36 million in the fourth quarter as expected due to seasonal softness. However, year-over-year revenue increased by 14% as customers addressed maintenance that was deferred during the downturn. The first quarter AMS gross margin of 15% matched fourth quarter performance and was 300 basis points higher year-over-year. Growth capital expenditures in the first quarter totaled $29 million, up from $13 million last quarter, as we invest in new equipment to meet customer demand. Maintenance and other CapEx amounted to $16 million, bringing total capital expenditure for the quarter to $45 million. We ended the quarter with total debt of $1.5 billion, down $14 million from the end of the prior year. Our available liquidity as of March 31 was $435 million, and our leverage ratio at the end of the quarter was 4.5 times. As Brad mentioned, the $55 million in asset sale proceeds expected in the second quarter effectively funds a third of our growth capital this year and allows us to repay a small amount of debt even with the acquisition of our stake in ECOTEC and while we invest in our fleet. I am confident that our ability to drive higher quality EBITDA growth is accelerating, and over time, we aim to reach our long-term leverage objective of 3.5 to 4 times. We recently declared a first quarter dividend of $0.145 per share or $0.58 on an annualized basis, which currently represents an attractive yield of 7%. Cash available for dividends in the first quarter totaled $41 million, resulting in a healthy dividend coverage of 1.8 times. As we reinvest in our business, our quarterly dividend will remain a key pillar of our 2022 capital allocation, reflecting our confidence in Archrock's strong cash generation capacity. Earlier this year, we provided our full year 2022 outlook, expecting our financial performance to gradually recover throughout the year and conclude in 2023. Year-to-date, our business performance is unfolding as planned. We anticipate that year-to-date asset sales will yield a net benefit of $15 million to our adjusted EBITDA, partially offset by $2 million to $3 million in increased SG&A related to the ESG ventures discussed by Brad. Consequently, we are raising the lower end of our annual guidance range and now expect adjusted EBITDA for 2022 to be between $330 million and $360 million. Our full year CapEx guidance remains unchanged, including our growth CapEx expectation of around $150 million.

Operator, Operator

And we have a question from Kyle May at Capital One Securities. Your line is open.

Kyle May, Analyst

Hi. Good morning, everyone.

Brad Childers, President and CEO

Good morning.

Kyle May, Analyst

Brad, I want to start off with the investment in ECOTEC and kind of a bunch of questions rolled into one here, so bear with me, but I guess first can you tell us the size of your investment in ECOTEC? And then secondly, how you anticipate the investment will change or enhance the underlying business? And then finally, I think you mentioned maybe a handful of customers are going to I guess get a trial run with it but anymore I guess thoughts on kind of when that gets rolled out to I guess a broader customer base?

Brad Childers, President and CEO

Sure. So number one, we're really excited about what this could do for not just our business, but also for the industry at large. We believe that producing gas in the most environmental and responsible way is a pathway to continue to improve the overall emissions footprint of the industry and candidly prolong the life of an amazing amount of investment that’s taking place over a decade to bring energy to the U.S. into the world. So we think this is going in the right direction. We're super excited to be a part of it. The ECOTEC solutions are really a unique offering and that they bring continuous monitoring, with the ability to pinpoint and quantify using the suite of tools and the compliance engine for reporting and data management. So it's a very strong integrated suite of services and products that compete very effectively with others that are in the market, helping today with methane monitoring and litigation. So we're really excited about the suite of products. Look, we're in the early stages of this investment. We have confidence in this technology that's been proven in other spaces, but we're moving into the phase where we'll demonstrate it and its success with some oil and gas customers over the coming, I think months maybe even quarters. And as we do that, we'll have more to talk about in the future. But what we believe it does is it allows us to enhance the service offering. We have very close proximity to our compression assets, to our compression service footprint and expand the suite of offerings of services that we can bring to our customers in what could be a very productive way. So Kyle, that's it's a really exciting development for us at Archrock and we look forward to talking about more in the future. But at this early stage, that's about what I want to share at this stage.

Doug Aron, CFO

I think, yeah, I think, Kyle, the only thing maybe I'd add on to one piece of your question was what would our investment maybe allow them to do. And I think, I would expand that certainly allows an opportunity perhaps to expand some equipment offerings and then notably our context in the oil and gas space to accelerate that for a team that hasn't spent much time there.

Kyle May, Analyst

I appreciate the additional information. I wanted to ask about the non-core assets sold in the second quarter. Can you provide more details on their contributions, such as EBITDA or any other specifics, so we can understand how this will impact the business moving forward?

Brad Childers, President and CEO

I'm just looking at Megan in terms of what we've done historically. I know what the numbers are, but we shared that on past transactions, Megan you're going to have to remind me.

Megan Repine, Vice President of Investor Relations

So what we can say, in our prepared remarks, we mentioned that there was a $15 million net benefit from the transactions that we've done year-to-date and you can look at the net gain or the gain in our financial statements for this quarter. And then on top of that there is about a $17 million net gain that we will realize in the second quarter that information will be in our Q, that we'll file later today. And then offsetting that gain is about $4 million of lost EBITDA from those assets. So that's probably at this point what we can share about the transaction. But there definitely were some assets that were operating and contributing EBITDA.

Brad Childers, President and CEO

Yeah.

Doug Aron, CFO

Look, I'd add to that, Kyle, again, thinking about as you guys plan then future $4 million of EBITDA for the remainder of this year, you would then sort of think about that as a main transaction and annualize that into next year. But again as we talk about that, that allows us to fund CapEx for newer larger equipment. The average horsepower size on the stuff we sold is sub-400 and back to Brad's point on these being sort of non-core assets for us and our focus being more on midstream newer larger horsepower this very much continues that strategy for Archrock.

Kyle May, Analyst

That's great. No. That's really helpful. And one more if I can sneak it in. Appreciate the comments, gross margin was on the contract upside, I think around 61%. Just curious if you can give us any more thoughts about kind of what you're seeing in the market currently with costs, labor, inflation, and the supply chain?

Brad Childers, President and CEO

Yeah. So across the board, inflationary pressures are in the labor market were in the mid-single digits from a percentage increase year-over-year. For parts and materials, we’re in the candidly low teens for a percentage increase on a year-over-year basis. And from a lube oil perspective, we’re close to 30% in a year-over-year increase scenario to give you a scale of what it looks like. So to come out with the gross margin that we did and that we plan to is going to continue to require both great revenue management, which we're committed to, as well as tight cost controls. So those are the ranges that we're experiencing overall. But we're also very optimistic that we reaffirmed our guidance that we can deliver, I think a very productive and very profitable year notwithstanding these headwinds.

Doug Aron, CFO

Yeah. Look, everybody is dealing with them in terms of inflation in every business. I suppose that we're thankful if you can be in this type of environment that utilization has gone back into sort of that magic 85% and we're expecting it to be higher, which does allow us with equipment tightness, long lead times on new equipment count, to do everything we can to push that through to our customers.

Kyle May, Analyst

That's great. I really appreciate all the time this morning and I'll leave it there. Thanks.

Operator, Operator

Your next question comes from the line of Selman Akyol from Stifel. Your line is open.

Selman Akyol, Analyst

Thank you. Good morning.

Brad Childers, President and CEO

Good morning.

Selman Akyol, Analyst

Couple of quick ones for me. So you guys referenced seeing bookings higher by 40%. Can you maybe talk about where you were seeing that by basin come from?

Brad Childers, President and CEO

Yes. Across the board, we saw great bookings in multiple plays. The lead for us as well as for others probably at the 70% of our bookings came out of the Permian or at least the increase in our bookings quarter-over-quarter. So that's, followed by still, the good productive bookings and activity in the Eagle Ford in the mid-continent, as well as the Niobrara and the Bakken. And then what was really pleasing is, we also saw a nice uptick in bookings in some of the conventional plays and with this kind of gas price that's to be expected was sort of positive about that for us is it really gives us a chance to reactivate and redeploy idle horsepower in those plays. And so we saw that as a really nice positive for the quarter, but broad-based increase across the board by play with a strong pull to reactivate idle horsepower.

Selman Akyol, Analyst

Appreciate that detail. If I could just ask, can you remind me on what your exposure to the Haynesville?

Brad Childers, President and CEO

We observed a positive increase in Haynesville, although it's still incremental. It is on my radar, but we have a modest position there. It's worth noting that Haynesville has a significant midstream presence, some ownership, and very strong initial production levels, as well as initial pressure levels coming from the production. We have a solid business of midstream assets in Haynesville, but they represent a relatively small percentage of our portfolio.

Selman Akyol, Analyst

Got it. And then also in your comments you talked about pushing through price increases. And I know you talked about aftermarket services there too, but I'm just sort of wondering where do you think margins could get to with price increases rolling through?

Brad Childers, President and CEO

On the very positive side, we're seeing, as Doug mentioned, utilization moving up past the mid-80s and as that happens, that pricing for audited really goes to us. Second, as I mentioned in my prepared remarks, we're virtually out of and we're completely out of horsepower in several categories and by the way, we believe the market is as well. And finally, we've implemented rate increases on a short-term basis and given commodity prices and the inflationary pressures, I described we think they're well justified. So that makes us optimistic that we can continue to defend our margins, but in this inflationary environment on a short-term basis, I think depending on margins with these moves is about what we should hope to achieve. Longer term, however, I would point out that we believe the investments we've made in our fleets and in our technology platform are going to give us a much better opportunity as we hopefully get to a balance of inflation and pricing to increase margins over time. We're not in a position to quantify that. It's just an ambition that we have to help realize some of the returns on the investments that we've made.

Selman Akyol, Analyst

Got it. And then just one last question on ECOTEC. You mentioned that you can bring contacts and introductions into the oil and gas industry. I'm curious about what other industries they are currently serving where they have a stronger presence. Could you tell me a little bit more about them?

Brad Childers, President and CEO

Yeah. So look, obviously it's a small company. The good news is, its technology that's been proven over a very long period of time and they have presence today and utility and in waste and biogas are a few of the areas where they've proven out their technology, and so that's just a good footprint to leverage. Also the technology they offer is demonstrated in the marketplace, it's not an uncommon technology, but the technology that they have perfected is to build a suite of integrated products for both the monitoring, the data management engine, as well as the pinpointing of the location and quantification of a leak to allow immediate elimination mitigation. And so it's that suite of products that we're most excited about going forward, but that's just a little bit more about them and we'll talk more about them in coming quarters after we've had a chance to really work with our customers and see how well we can apply this to several locations.

Doug Aron, CFO

Okay. I would maybe just add to that. Yes, a small company, but in speaking to the proven technology in the landfill space as an example, without mentioning any publicly traded companies by name, they do list customers that include among the largest in that space and folks that are very focused on ESG and good monitoring. So again, when we talk about proven technology and high-quality customers. While a small company, these guys have technology that we're very excited about.

Selman Akyol, Analyst

Great. Glad to hear. Thank you.

Operator, Operator

And there are no further questions at this time. Now I'd like to turn the call back over to Mr. Childers for final remarks.

Brad Childers, President and CEO

Great. Thank you everyone for participating in our Q1 review call this morning. As we noted, we continue to drive strong customer activity and believe we are well positioned operationally and financially to capitalize on opportunities in our business as the demand for our services increases. I look forward to updating you on our next call, next quarter. Thanks, everyone.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.