Earnings Call Transcript - EFXT Q3 2020

Operator, Operator

Greetings, and welcome to the Exterran Third Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the presentation. Please note that this conference is being recorded. I will now turn the conference over to our host, Blake Hancock, Vice President of Investor Relations. Thank you. You may begin.

Blake Hancock, Vice President of Investor Relations

Good morning, and welcome to Exterran Corporation’s third quarter 2020 conference call. With me today are Exterran’s President and Chief Executive Officer, Andrew Way; David Barta, Exterran’s Chief Financial Officer. During this conference call, we may make statements regarding future expectations about the Company’s business, management’s plans for future operations or similar matters. These statements are considered forward-looking statements within the meaning of the U.S. securities laws, and speak only as of the date of this call. The Company’s actual results could differ materially due to several important factors, including the risk factors and other trends and uncertainties described in the Company’s filings with the Securities and Exchange Commission. Management may refer to non-GAAP financial measures during this call. In accordance with Regulation G, the Company provides a reconciliation of these measures in its earnings press release issued earlier today, and a presentation located in the Investor Relations portion of the Company’s website. With that, I’ll now turn the call over to Andrew.

Andrew Way, President and CEO

Thanks, Blake, and good morning, everyone, and thanks for joining the call today. First, I’ll discuss the third quarter highlights, then some recent developments and wins along with what we’re seeing across our global footprint before I turn it over to Dave. The third quarter came in line with our updated guidance from September, as we had originally guided to the mid-$30 million EBITDA range. This was driven by improved ECO revenue, along with continued focus on our cost structure as SG&A continues to move lower. COVID-19 continues to challenge logistics globally for many of our customers and suppliers. But during the quarter, we saw a slight improvement in our ability to move people around the world, which is continuing so far into the fourth quarter. We remain cautiously optimistic, but are closely monitoring the potential impact of renewed COVID cases around the world. During the quarter, we signed an $80 million six-year extension in Latin America that requires no incremental CapEx. This puts renewals for the region over $200 million for the year, continuing to highlight the mission-critical nature of our equipment globally. During the third quarter and nearly in the fourth quarter, we were also awarded two small ECO contracts in the region, further enhancing our commercial success. While new product bookings and new ECO orders were slow during the quarter, we are seeing a pickup in interest in tender activity gradually increasing outside North America. We continue to work on several large water projects and remain hopeful that at least one of these projects will get awarded during the fourth quarter. Water is an integral part of our transition story, not only because it does not require incremental demand to drive growth, but also it’s important in delivering enhanced environmental solutions to our customers and provides us multi-industry applications over the medium to long-term. While this year pulls the growth in this business more than we would’ve liked, as our customers stepped back to find the new normal, we continue to see new projects come onto our radar and have started to see customers look beyond the short-term and plan for their future needs. We have a strong pipeline of both large and smaller projects with a majority of the mix related to our Middle East region. As the dust settled in the U.S., we are beginning to have a more constructive dialogue with our customers on starting additional pilots and trials to further prove our technology. The commodity supply-demand imbalance and COVID-19 pandemic have certainly impacted our customers’ production and their cash flow, ultimately leading to many looking for ways to adjust spending over the near term. Over the past nine months, we’ve had numerous conversations with our customers on helping them navigate these challenging markets. The outcome of these discussions has resulted in solutions to mutually benefit both Exterran and our customers taking into consideration the short-term uncertainty while balancing the longer-term needs. A net result of these negotiations to date is roughly a $40 million reduction in long-term backlog, largely tied to one specific contract with the term of the agreement we’ve modified. The reduction in backlog impacts the second half of 2022 through 2028, and Dave will provide more color on this in his comments. Looking across our regions and starting in North America, clearly product bookings continue to be slow, but we are starting to see more positive conversations. It’s a little early to say things will pick up next year as our customers are going through their budgetary cycles right now, but we are all hopeful a few of these will turn into opportunities next year. We’re also extremely focused in the region on building out our AMS service offering to help generate revenue and continue to enhance our margins. In Latin America, despite all of the difficulties, the regional space between COVID-19, geopolitical challenges, and currency headwinds, we continue to have commercial success. On top of the more than $200 million of extensions so far in the region, we have had a couple of small ECO wins, and we still see additional opportunities for important renewals within the coming months and quarters. Turning to the Middle East region, we continue to execute well on the projects in backlog. However, with travel limitations, it has caused certain project schedules to move further to the right. Commercially in the region, we see the de-boom structure gain additional traction, which should set us up well for additional opportunities in the coming years. There are also other large countries in the region, where we have not had a significant presence that we are currently focused on expanding in a few years to help drive additional revenue and profitability. For the Asia Pacific region, we are seeing a breakthrough for Exterran in new processing and treatment equipment, enabled by the many years of successful service support our AMS team has performed in the region. Overall, despite the industry challenges, we continue to have constructive dialogue with our customers and see a healthy pipeline of opportunities for our products and services. And with that, I’ll now turn it over to Dave.

David Barta, CFO

Thanks, Andrew. For the quarter, we delivered EBITDA of $36 million, which was in line with the updated guidance that we provided in September, on revenue of $170 million. You’ll see in the earnings press release and in our 10-Quarter, which will be filed soon, that we have now reclassified our U.S. compression fabrication business into discontinued operations. So, all these offers are now have been restated to exclude this business from our recurring numbers. For the past year, we have talked about becoming a company with EBITDA margins greater than 20%. As we reported in this quarter, our adjusted EBITDA margin was 21%. This achievement is not just a function of the mix of higher margins from more recurring businesses, but also results from the focus of the organization to drive productivity. As one example, we’ve taken out almost $30 million in SG&A costs from our structure since 2018. We also have had strong OpEx productivity that’s reflected in gross margins. The Q3 adjusted EBITDA margin of 21% compares to 15% for 2018. While some variable costs have benefited from lower volumes, we’ve had margin rate pressure from fixed costs due to these lower volumes as well. These results and our transformation have been accomplished in what could possibly be the most difficult business environment in the past 70 years. Exiting compression was the last significant adjustment to our product portfolio. And we’re now focused on higher margin, cash-generating, and returns-enhancing businesses. Back to the Q3 results from a segment perspective. Revenue for contract operations was $82 million, while gross margin was $57 million, resulting in the gross margin rate of 70%. Revenue increased sequentially, as a result of the contract adjustments which Andrew mentioned, the full quarter’s impact from the Q2 contract start-up and more overall activity during the quarter. I will add, the contract term that was adjusted resulted in the acceleration of deferred revenue and appreciation for the project, which will continue over the next two years. This may be a good time to point out and remind everyone that when we receive upfront cash reimbursements for ECO projects, we amortize that over the life of the project as deferred revenue. ECO backlog at the end of the quarter stood at $1.21 billion. The backlog was down as the new contract extension was partially offset by the contract adjustment. For AMS, revenue was $30 million and gross margin was $7 million. This resulted in the gross margin rate of 24%. The revenue increase was driven by increased activity in the Asia Pacific region and Latin America. Revenue in the product sales segment was $57 million and gross margin was $3.1 million, resulting in the gross margin rate of 5%. Revenue increased sequentially driven by incremental activity in our international location. Margin increased for the quarter due to better absorption of fixed costs with increased factory activity. We continue to make strategic decisions to hold certain engineering and manufacturing costs that we deem critical going forward. This was roughly a $1.1 million drag for the quarter. Our product sales backlog was $497 million at the end of the third quarter compared to $547 million at the end of the second quarter. SG&A expenses were $30 million, down from $32 million in the second quarter. Moving to the balance sheet. Net debt at the end of the third quarter was $488 million. Our leverage ratio is 3.5 times and compares to 3 times at the end of the second quarter. I'll also remind you that we have no near-term maturities. Our next maturity is our revolver in 2023. Turning briefly to the fourth quarter. We expect adjusted EBITDA to be in the high $30 million range. We have included guidance for CapEx and cash taxes in the earnings presentation deck. While there remains a great deal of uncertainty and variability in the business environment, we are also well into the 2021 planning process. While we're not in a position today to provide quantitative guidance, we are confident that EBITDA in 2021 will improve from the 2020 level. This will be driven by the strong ECO and product backlogs, along with the productivity and efficiencies that we've achieved over the past year. EBITDA margins will remain above 20% as well. And with that, I'll turn the call back to Andrew for his closing remarks.

Andrew Way, President and CEO

Thanks, Dave. As we look beyond 2020 and into next year, we continue to see the year as a growth year driven by backlog execution, additional productivity, and cost controls. We are strongly focused on building additional momentum in our water business, growing aftermarket services, and expanding our new product development to help enable and enhance our total product offering. We will control what we can control and will adjust quickly and swiftly if needed, as we have shown we are capable of doing over the past couple of years. All of this leads to the focus on protecting the core of our business, which means managing our cash flow to protect our balance sheet while allowing us to continue to invest in the business in the coming years. As we near the completion of the compression divestiture, the cleanup of our portfolio will largely be complete from this leg of our transformation. The areas of focus I laid out for 2021 will drive improved backlog, enhanced margins, and better returns over the medium to long term. Our strong backlog gives us visibility heading into 2021, and the opportunities we see in the coming 12 months provide confidence for the years to come. And with that, I'll now turn the call back to the operator. Thank you.

Operator, Operator

Our first question comes from Kyle May with Capital One Securities.

Kyle May, Analyst

Hi. Good morning. I have a two-part question about the contract operations business to get started. One, can you give us any color about how the renewal in Latin America compares to the previous rate in terms? And then, two, you had mentioned some contract adjustments and an increase in activity. Just wonder if you can give us any more details around the changes there and how we should be thinking about that?

Andrew Way, President and CEO

Yes. Good morning, Kyle. First of all, the renewal that we saw during the quarter was pretty consistent with the renewals that we've had year-to-date. In terms of the commercial terms of those contracts, we see no changes to our current outlook. As you can see in the last few quarters, we've seen a fair amount of productivity and a lot of great work done by our teams in the regions to continue to enhance our margins in ECO. We really don't see any changes going forward, and the contract renegotiations were very, very successful as it pertains to that particular contract that you referred to. In terms of the other contract that you referred to, it's very clear that not just for ourselves but the whole industry has been through a multitude of challenges this year. Early in the March-April timeframe, we had a lot of customers throughout the industry, not just from ECO but generally asking if we could work through their particular profiles of hydrocarbons that they're producing and see if we could come up with ways to either produce them more productively or if there are opportunities to change some of the construction of the facility to produce different types of output from maybe less dry gas and more liquids. We’ve had a lot of discussions throughout. I’d say a very strong outcome for Exterran and a good outcome for our customers. Our teams around the world, both in Latin America and the Middle East, really worked hard during the last few months in difficult times to navigate and help customers. We have been able to negotiate and work with our customers to make sure that the projects are still flowing adequately. Our engineering teams have embraced a lot more technology to provide solutions real-time with customers. So, we've had a lot of activity where we've been able to keep pace with all the engineering deliverables, whereas in the past, you would have required people to be in offices together. So, just a lot of changes, a lot of challenges that we've successfully navigated. We feel very good about the overall outcome going into the fourth quarter and into 2021.

Kyle May, Analyst

Got it. Okay. That's very helpful. For my next question, Dave, I appreciate your preliminary thoughts on 2021. I understand there's still considerable uncertainty ahead, but I'm curious if you can share any additional insights or benchmarks on how we should approach next year, and perhaps some initial thoughts on capital expenditures?

David Barta, CFO

Yes. I think, again, you're exactly right, I think, there's a lot of variables right now that we are working through and hope that some of those things are settled in the coming months. Obviously, COVID being one, as Andrew said, it impacts projects. We had a big project we announced in the first quarter that heavily depends on our people getting to that site. So, COVID is a challenge. Hopefully, we'll get more clarity and provide you more guidance around revenue and margins and EBITDA. From a capital standpoint, we're being, as you can imagine, very thoughtful about our investing. We're focused on investing in high-quality opportunities, whether that’s capital or working capital type investments. At this point, we have very little capital that's committed for next year, and I think in terms of our final view on capital, it will depend on any attractive project opportunities that we see between now and the start of next year. We have mentioned some water projects that are out that we're involved in, and some of that may come down to our final guidance for how those projects are awarded.

Kyle May, Analyst

Okay, got it. And, maybe one more for me. I believe you mentioned that you're nearing the exit of the U.S. compression fabrication business. Can you give us an update on the timing of the close for that and the use of proceeds?

David Barta, CFO

Sure. Kyle, we've had a great working relationship over the past few months during this transaction with Compass. We're pleased to say that actually, as we speak, we're in the middle of closing today. By the end of the close of business this evening, the business will be closed. The transaction will be complete, and Compass will be the proud owner of Exterran's compression manufacturing business here in North America. So, it's pure timing that it happened today. We're hoping that by the end of play today, it will be moved on, and the team will be in great hands with Compass. We certainly look forward to working with them and transitioning here over the next couple of months as we support their needs. But today is the planned closing date.

Operator, Operator

Our next question comes from Doug Becker with Northland Capital Markets.

Doug Becker, Analyst

Andrew, you mentioned one of the Middle East water services contracts is still expected to be awarded by year-end. Would this be for services or equipment? And just any color around the remaining hurdles from getting those across the finish line?

Andrew Way, President and CEO

Yes. Good morning. We actually have a number of contracts that we're currently negotiating. The pipeline for our water business is still strong. I would say that during the summer timeframe, there were a number of contract negotiations that stalled, mainly because of the challenges that came with our customers coming together with their decision-makers and our ability to get face-to-face with our customers. I wouldn’t say there's any hurdles or stumbling blocks. We need to do a lot of work upfront on ensuring that we have the right technical profile of the actual water profile and what actually needs to be done. All of that technical evaluation certainly took place during late spring and early summer. I really hope that in the fourth quarter here, in the next couple of weeks, one of the projects out of the few that we're negotiating will come through. They're both equipment and services, and we're very hopeful that will happen. As soon as it does, we look forward to communicating and letting you all know.

Doug Becker, Analyst

Perfect. Dave, maybe just to follow up on cash flow or free cash flow thoughts as we think about the fourth quarter and next year. I appreciate that the Middle East project is going to be a use of working capital, but net debt still increased a little bit more than I was expecting. Can you just give a little more color on what you're thinking for free cash flow in the fourth quarter? And is it fair to say that barring something really unforeseen that free cash flow is positive next year?

David Barta, CFO

Yes. On wrapping up this year, and Kyle had asked the question, proceeds from the sale of the compression business, obviously, we'll take that and pay down the revolver. We also have our interest payment in the fourth quarter as well. We’re focused on cash flow in a major way. In the third quarter, the increase in debt was primarily due to capital investment in a couple of the projects in the Middle East that we're in the process of wrapping up. At this point, we don't have a significant amount of committed capital in terms of growth capital for next year. We just have the residual of a few of the project awards where we're completing those projects, and then it will depend upon where some of these other projects go. We aim to use the revolver to initially fund these projects and make decisions from there. And, as we move forward, we're also focused on finding ways to continue being successful.

Doug Becker, Analyst

I appreciate that. Is it fair to say that you'll be free cash flow positive, barring some unexpected issues?

David Barta, CFO

Again, this project is significant, and it has evolved from a hybrid project. It includes some AMS and product sales. The schedule will be crucial in shaping our cash profile for next year. Since it primarily involves a product sale, there is a working capital aspect to consider. Therefore, it will depend on the timeline and how everything aligns before I can offer detailed specifics.

Doug Becker, Analyst

Sure. And then, just one last one on the guidance. I think, it was for upper 30s in terms of EBITDA for the fourth quarter. Just any particular variables we should be keeping an eye on for the business?

David Barta, CFO

No. I would say it's normal business. We've been able to get people into certain regions and countries easier than we had. That's helped the AMS and some of these projects we're working on. There are definitely some pluses and minuses in there, but it all leads us back to that similar zone.

Operator, Operator

Our next question comes from Tim Monachello with AltaCorp Capital.

Tim Monachello, Analyst

Hey. Good morning, everyone. Just a couple of questions. I guess, I'm understanding that we've looked at 2020 CapEx a little bit already. But, excluding growth projects, where do you see sustaining CapEx coming in for 2021, excluding growth?

David Barta, CFO

Yes, I believe that on a sustaining basis, nothing will significantly change our position. We have typically been in the $20 million to $30 million range. This includes Corporate IT and anything related to maintenance or renewal. I don’t anticipate that changing. I am confident that we can firmly state maintenance will remain between $20 million and $30 million. That seems like a reasonable figure.

Tim Monachello, Analyst

Okay. So, a fair assumption that you'd be free cash positive before growth and working capital investment in 2021?

David Barta, CFO

Yes, I think that's a fair way of thinking about it. We're not a business that when volume declines, there's a tremendous amount of working capital unwinds. So, it really is going to come down to the project investments we make. We will have a working capital use in this project, but we'll be as balanced and prudent as we can with those opportunities while protecting the balance sheet.

Tim Monachello, Analyst

Got it. In terms of the Q4 guidance, the presentation says high $30 million EBITDA, which is sort of in the middle of the preliminary range you had provided previously. Just curious what the gives and takes are there?

David Barta, CFO

I think we're anticipating a more normal business environment while considering the impacts of the second wave of COVID. We're feeling pretty good about that and have some opportunities, but we still end up in that similar space.

Tim Monachello, Analyst

Okay. Got it. So, some of that Middle Eastern project then shifted into 2021?

David Barta, CFO

Yes. That project is very large, and the initial schedule was two years long. We’ve definitely seen the project slide to the right. We are recognizing revenue for that project this year; it’s less than what we initially would have anticipated. We’ll see if that slips forward into 2021, and it will likely also go into 2022.

Tim Monachello, Analyst

Okay. Got it. And then, lastly, earlier in October, the Argentina government came out with a gas stimulus program. Are you seeing any positive impact from that program even on the horizon?

David Barta, CFO

Yes. There has been excitement in Argentina regarding the new discovery. However, it's been slow to develop. We're seeing renewed interest, but it really depends on how the capital will be available for investments. We are building relationships with new and existing customers, and we're confident in working through future opportunities.

Tim Monachello, Analyst

Has the view on returns from those projects changed?

David Barta, CFO

Nothing has really changed with the investment base we have there; we enjoy great relationships with our customers. But it does require you to be thoughtful about risk management in these projects.

Operator, Operator

There are no further questions at this time. I'll turn it back to management for closing remarks.

Andrew Way, President and CEO

Thank you everyone for dialing in today and allowing us to give you an update of where we are. I'd also like to finish by thanking all of our employees that have really gone above and beyond the last few months working through some difficult situations globally. Thanks for everything that you're doing. We look forward to updating you all at the end of the fourth quarter. Thanks. And be safe. Bye-bye.

Operator, Operator

Thank you. This concludes today's conference. All parties may disconnect. Have a good day.