Good day and thank you for standing by. Welcome to Drill-Quip Second Quarter 2021 Fireside Chat. At this time all participants' lines are open. Operator instructions. I would now like to hand the call over to your speaker today, Mr. Daniel Burke. Please go ahead.

Good morning. I want to welcome everyone joining our Drill-Quip discussion via the phone or webcast. And I'm happy to introduce Drill-Quip Management, CEO Blake DeBerry and CFO Raj Kumar. Welcome, guys. And thanks for the opportunity to host this conversation.

Good morning Daniel.

Yeah, good morning.

Hi, thanks for having me, Daniel.

Yeah, likewise. I want to plunge right in and start with some questions on the second quarter results you guys just released yesterday evening. But before I jump right in, let me hand the floor over to you, Blake and ask you to highlight any key themes you want to make sure we emphasize here before delving into the specifics.

Sure, Daniel. Look, I think the main thing is we've laid out several pillars of strategy that we believe will help the company be successful in the future. And we're getting success on all those strategic initiatives. We've outlined our peer-to-peer strategy, which is really consolidation by collaboration, and during the quarter we signed our first peer-to-peer agreement, or actually our second if you include the Proserv agreement. Our downhole tool business, which we've been focused on pretty intently to get improvement in that business, is gaining significantly more traction, and that business is doing very well, so we're very pleased with that. Further, we've spent a lot of time, energy and effort on new products. And we are starting to see new product adoptions. We've had several of those in the quarter and ran a lot of serial number one units, which is the most difficult thing to do—getting somebody to try it the first time—and that generally lends itself to adoption of that product. So we've had success there. And lastly, we identified a $10 million productivity gain for 2021, and we're well on our way to meeting that productivity gain. So on balance, strategically, the things that we're trying to do, we're having success within the quarter.

Okay, appreciate that, Blake. Thanks. Let me go ahead then and start with a couple of questions really catalyzed by the Q2 release. Let's start with one that's a bit high level: you included a handful of updates on your 2021 targets — a little bit of an update on year-over-year revenue, trend, order outlook and free cash flow target margin. Maybe it'd be worthwhile if you guys can take a second and highlight those updates.

Sure. On the revenue side, we originally forecast 2021 to be similar to 2020. I think we guided that down just slightly. So our revenue was down a little bit on the quarter, but that really is just a result of the lower bookings that we had in the back half of 2020 starting to manifest themselves in the top line. That's just really it. As our bookings level increase, which we're hopeful for in the back half of the year, we should see improvement in the revenue and things turning around. On the booking side, we had a pretty good bookings quarter—right down in the fairway of our range of $40 million to $60 million. But if you just compare Q1 to Q2 on baseline bookings: in Q1 we booked about $57 million to $58 million, but we had a $20 million booking in there for two subsea trees and control systems. So net of that, our baseline bookings were lower. In Q2 there was not a similar large one-time order. We did see solid baseline bookings in Q2, and so that's a positive sign. On free cash flow, we had a pretty good free cash flow quarter. We're trending significantly better than expected and I think we will exceed our target by year end for sure in that area.

Got it. Thanks. That's a helpful rundown Blake. So as you mentioned orders, you mentioned an expectation that Q4 2021 orders in particular will be strong. Can you talk about the visibility you have into what's giving you that conviction? And is there any timing element to watch out for where we could see a dip in orders in Q3 before a correspondingly strong rebound in Q4?

Yeah, sure. So first off, on the visibility, some of it is qualitative and some of it is quantitative. Some things we can put our hands on and say that's something new in the order book, and some of it is just more qualitative—what you're seeing in the environment. Specifically, when we look in our CRM, we see more opportunities coming up, particularly in Q4 and into 2022. We're starting to see what I call availability plays with some of our independent customers: 'I'm going to go drill a well, do you have something in inventory that we could take now?' So those opportunities are starting to appear. Be quite candid, if I look at our markets on a segmented regional basis, there's more areas where there's upside and increased activity than there are down or neutral. And that's different than what we've seen in the past. Looking forward, bookings in Q3 I think will be similar to Q2, kind of mid of that $40 million to $60 million range. And then Q4 is where we hope to see some momentum in our bookings, and then that continue on into 2022.

Okay, hopeful. And then, again just to lean on 2022 for a moment: any reason to think you'll break out of that $40 million to $60 million per quarter type range you've been at since the onset of COVID?

So we expect Q4 to kind of end the year on a stronger note; right now, we're just saying we think we're going to be toward the top end of that $40 million to $60 million range for bookings for the quarter. As for 2022, it's looking optimistic, but I'm not ready to call a specific number. I think our Q4 number will be a consistent jump-off point. We're just seeing a lot of improvement in the market. I think you're seeing some of the rig contractors make commentary that they're getting more activity on leasing rigs. I think Transocean recently came out and said that rigs in the Gulf are expected to be mostly subscribed and under contract by the end of the year, and that bodes well for us.

Got it. Also wanted to talk about margins. Q2 product margins did dip about 400 basis points sequentially. You mentioned mix as a reason, but harkening back to last quarter, you'd mentioned margins in the back half of the year likely to firm up on improving mix and your cost-out programs. I guess I want to affirm that's still the case and you expect to reclaim some ground on the margin line?

Yeah, Raj, you want to talk about that?

Yeah, I'll take that, Blake. So Daniel, margins in Q2: we talked about the AF Global impact to margin. About a year and a half ago, we leased our forge operation to AF Global. As part of that, we accounted for leasing revenue that we had to accrue for, and some of this leasing revenue was forward in nature that we had accrued for. The termination of that lease had an impact on our margins because it impacted our cost of goods sold. I'd consider that to be around 300 basis points of impact in Q2. We also had some mix issues in Q2. When I say mix issues, it's actually a good story here: we saw pipe and connector mix go up. That's always a leading indicator for us because it means our customers are going back to work, they're ordering pipe and connectors and they're going to run down the wellhead inventory. Soon we'll see those wellhead inventories have to be replenished, and that's going to help us with our mix going forward. So if you think about that, I would expect mix to improve in Q3 and firm up in Q4. We also had very good results in our downhole tools outsourcing; we're seeing very positive results there and expect that to continue. I do expect project mix could present headwinds in some areas—in particular, we are doing a lot of controls work with partners where we have margin-sharing arrangements, and that could be a headwind to our overall margin. But overall, as I look into Q3 and Q4, I see stabilization in Q3 and firming in Q4. If I were to guide you in terms of EBITDA, I would say that on a normalized basis our EBITDA should be in the mid- to high-teens going forward.

Okay, that's helpful. So a recurring theme this earnings season has been input cost pressures and how well companies can manage them. One of the more interesting elements of your release was the disclosure that you will impose a 10% surcharge on orders as an effort to be proactive with rising costs. Can you talk about how that has been received by customers and how easy you think it'll be to implement?

So Daniel, I think our customers are understanding of this cost increase. We're not pushing because it's demand-based; they're seeing the same cost pressures themselves. While nobody likes a price increase, it's the reality that transportation and materials are going up, and that's putting pressure on our margin and cost base. I recall back in 2003–2004 and again in 2006–2007 we saw the same kind of price increases on raw materials, and our customers—while they may not like it—accept that that's the reality of the market. So I don't expect too much pushback in that regard.

And then, more specifically, what do you see in terms of steel pricing, raw material pricing and freight? What exposure, if any, do you have now against your existing backlog?

So right now, as we look at our backlog and the transportation and material elements in there, there's really about a blended 10% increase. That's kind of why we're pushing that surcharge number out there. The fortunate thing for us is our business is longer-cycle in nature so we have the ability to plan ahead. Our supply chain organization that we stood up in 2019 has done a really great job of securing long-term contracts. So even though transportation rates and container freight rates are up—some headlines show container rates up to $9,000 to $10,000 per container—we still have contracts where we're paying $3,000 to $4,000 per container coming from Asia, for example. But those contracts have an end, and so that's why we're pushing this surcharge through: we have to cover those additional expenses as they come through.

Got it. Okay. Raj, you mentioned earlier the impact of the cancellation of the forge lease with AF Global on the Q2 results. Strategically, now that they've canceled the lease, what are your options for sourcing and what are your plans for the forge itself?

So right now, the immediate step is to warm-stack the forge. Our supply chain organization has been very successful in ensuring that we have access to forged supplies from multiple suppliers, so we've mitigated that risk. AF Global had been supporting us domestically, and we were very quickly able to pivot and get other sources of forge supplies, so we're not too concerned about that. From a warm-stacking perspective, the cost of doing that is negligible; it won't be anywhere close to the $11 million to $13 million we saw when we were operating the forge back in the day—this will be maybe around $100,000 a month. We're actually having conversations with a number of forge operators right now; some are looking to lease, some are looking to buy, and those conversations are proceeding. I'm confident we should get to some closure on this issue with the forge by the end of the year.

Okay, that's helpful. And Raj, just to stay with you for one moment: I wanted to revisit a comment you made earlier about normalized high-teens EBITDA margins going forward. Are you talking about adjusted company-wide EBITDA margins in the high teens once things normalize, meaning getting past the G&A burden you've had related to litigation and the AF Global situation?

So yeah, that's absolutely right, Daniel. When I talk about normalized, I mean once we get back to steady state—and we're nowhere near steady state right now. To Blake's earlier comments, the lower orders from earlier periods are coming to roost now. By normalized I mean activity levels that we saw maybe three to four years ago. Once we get to that level, I would expect us to be in the mid- to high-teens for EBITDA. On the litigation side, yes, that's been a headwind this year, but we're putting that behind us; we could have some additional costs, but nowhere near what we've experienced over the past year. So with that perspective, I would expect very easily once we get to normalized activity, we should be trending up into the mid- to high-teens for EBITDA margins.

Okay, that's helpful context. So to be clear, it's cleaning up some of the specials as well as getting back up to maybe a more robust top line than you're experiencing this year. Also, an element to that margin progression is the cost savings you guys have implemented—the $10 million this year. Frankly, looking at the Q2 update, you're well on your way to that $10 million. Are there any scenarios you could envision that would result in further changes to the cost structure for the company?

So Daniel, it's in our DNA to constantly evaluate our cost structure. Over the past three years, you've seen structural or transformational cost changes. We call them transformational because we're leveraging every dollar of cost that we have—being more efficient in how we spend. Where we are right now and the outlook we have for bookings, I think we're in a very strong position to get a lot of operating leverage in this recovery. We always had the view that when the recovery comes back, we need to be ready to flex our manufacturing, and we are in that position now. Obviously, we'll have to pull on overtime to get the first 20% to 30% of output. Once we get stability in activity levels, we'll probably have to add some variable costs to maintain the level of activity we anticipate going into next year. For now, we're focused on productivity improvements; we had a $10 million target, and we've exceeded the run rate—we're close to $8 million right now in productivity savings. Any additional structural or transformational changes will be evaluated against the market context. But as of now, we are poised and well-positioned to take advantage of the recovery.

Got it. Let me pivot and ask a couple questions on the commercial side. Starting with your consolidation-by-collaboration strategy: you mentioned the agreement you signed with an integrated services provider for wellheads and related equipment, and that sounds like it could be significant. Is there any way you can frame or provide some incremental color on the size of the opportunity and maybe timeline to first sales under the agreement?

Certainly. I'm really pleased with our team in reaching the agreement. The agreement we signed is with one subsea provider and it is for the provision of wellheads, liner hangers and tubular grids—so pipes and connectors. It's significant because these teams are just now starting to work together and compare opportunities. The way to frame it is: to the extent that our subsea partner is successful, Drill-Quip will be successful because they will give us access to markets we previously didn't play in—particularly integrated developments. I think we're likely to have some success by the end of this year or early next year. There's at least one opportunity that comes up at the end of this year and several out in the future. I think it's going to be meaningful to our wellhead business.

Okay, that's helpful. And then on the e-Series technologies, you've had some booking success: VXTe, BigBore IIe, and I think you mentioned the DXe connector in the press release. Generally, highlight some of the initial successes you've seen and maybe speak more specifically to VXTe: your thinking on the timeline for first project or product deployment and opportunities beyond that point?

Sure. It's been a good quarter for new products, and that's something I'm extremely pleased about. Xpak DE liner hanger: we've just signed a multi-year contract with a major Brazilian NOC for the Xpak DE liner hanger system. Turnkey suppliers like the big service companies will be coming to us to get the Xpak DE for use by this operator, so that's a big win. BigBore IIe: we announced last quarter; we ran our first BigBore IIe and ran a second one this quarter. We are now seeing a Brazilian NOC looking closely at BigBore IIe in a current tender and we're optimistic, though we don't have the contract yet. They’re starting to realize the time savings has real value and is meaningful to their cost structure. Two IOCs are looking to standardize on it and are consolidating their wellheads from 15 different skews to four; BigBore IIe is a big part of that. The DXe wellhead connector is a bit more subtle: the top of the wellhead has a profile that has been the de facto standard for decades. The DXe connector uses a different profile with very high fatigue resistance, which in markets with large rigs and shallow water—like Norway—extends the effective time the rig can stay on the well by an order of magnitude. That's significant because it's not just a product purchase; it's a change in a de facto interface standard. Specifically for VXTe, we do have another opportunity to run VXTe with a customer who is stocking trees in inventory; they buy these trees and put them in inventory, and when they drill a prospect suitable for subsea development they just go ahead and run the completion and run the tree. So every time they drill a well, we have an opportunity to run that VXTe. I'm hopeful they'll be successful on the current well and we'll get that tree run at the end of this year or early next year and have that serial number one behind us. That said, we had a lot of pressure during the lawsuit and several majors stepped back from VXTe until the lawsuit was resolved. We are reengaging with multiple potential customers who have come back, and I think we're getting back on track with our VXTe marketing strategy. It's a meaningful product from a time, cost and carbon footprint standpoint.

Got it. Staying on the commercial side, let me pivot to downhole tools. That business had a really strong Q1 and a pretty good Q2 as well—revenue up about 30% year-over-year. Help me better understand drivers: is any portion of this catch-up related to a disrupted 2020, and what portion is structural? I know you've made some changes to the business. Also, can you sustain this higher revenue run rate into the second half of the year?

There's a little bit of catch-up from 2020, but that's a small part. It's more about the changes we've made to the operating model of the business. We brought in new leadership for the Downhole Tools group, changed regional leadership, increased geographic focus, and deployed new technology. We also closed some underperforming businesses to reduce distractions and focused on key areas—specifically the Middle East, Latin America and our offshore business. We've improved our supply chain with better stocking programs and lower costs, making us much more competitive and improving margins. Downhole tools—specifically liner hangers—is a business you sell from inventory; if you don't have inventory you don't get the business. We've built that inventory up and are being much more competitive. We're maniacally focused on service quality, with initiatives to improve it. We're also seeing more peer-to-peer activity for liner hangers. Those are structural changes that should continue to support growth.

Got it. And on the commercial front, you've had questions on energy transition before, but one more: when you look at your 'Green by Design' campaign and the message you've been conveying to customers, what's the reception been like?

Green by Design is a campaign that ties together our R&D focus for all the new products we've developed. I challenged our engineers to develop equipment that structurally changes how our customers drill wells to provide permanent cost savings—eliminate steps, reduce time, reduce steel. As focus shifted to carbon footprint and environment, we realized saving time on an offshore spread has a significant impact on carbon footprint. That changed how we think about R&D: time is important for IRR and for carbon. To put a finer point on it, we started estimating carbon footprint savings for installing the VXTe tree. Preliminary numbers—probably conservative—show a VXTe saves about 1,000 metric tons of carbon per well, in addition to about five days and roughly $5 million of cost savings. That's pretty meaningful for our customers.

Got it. And you've mentioned Drill-Quip has some ability to step into markets like carbon capture and geothermal. Any actual commercial opportunities emerging on the horizon?

Our plan is to be an active player in the energy transition. Carbon capture and geothermal are adjacent to what we already do. We've bid a couple of carbon capture projects and have not been successful yet, though we have a big one coming up next year that we're really focused on. Each bid teaches us more about the requirements and I think we'll be successful. We're spending some R&D money to fine-tune our tree systems for carbon capture requirements. This is an area where we're moving from ad hoc opportunities to a more strategic focus—our sales team actively pursues customers planning geothermal or CCUS projects.

Okay. Pivoting back to free cash flow margins: Raj, you hinted normalized EBITDA mid- to high-teens; could you share thoughts on where free cash flow margin could trend over the intermediate term?

Absolutely. We guided at the beginning of the year to expect our free cash flow margin to be around 5% of revenue. Based on year-to-date progress, we will exceed that target in 2021. In fact, I'm confident we will get close to double that target—close to 10% by the end of 2021. My only caution is as we approach next year, and the back half of this year going into next year, we’re starting to see orders come in and backlog start to build. I expect working capital to grow as a result—good headwinds, because they reflect increasing activity. That may cause a slight dip next year, but I expect that to be transitory and we should get back to a roughly 10% free cash flow margin very quickly. If you look at my comment on EBITDA, with CapEx and some cash taxes included, you can very easily land at that 10%+ yield on a normalized basis.

Got it. Raj, on working capital, it looks like you made good progress this year on AR and AP, but inventory still seems a bit elevated. What can you do and is there ability to see improvement there as order trends rise?

Good question. On AR, we've made process improvements initially rolled out domestically in the U.S. and then into the regions—improvements in invoicing turnaround, collections, coordination with customers and meeting payment terms. That's coming to bear fruit. On AP, our supply chain group has done a lot of vendor management to secure better payment terms and deepen relationships with fewer vendors, which has helped. Inventory is an issue we've highlighted and we're maniacally focused on it. We've done substitution efforts and looked at consignment with some vendors to help reduce inventory levels. But there's only so much you can do: at the end of the day, bookings need to come in for us to turn inventory. So as bookings improve in the second half of this year and into next year, we should start turning inventory faster, which will help working capital.

Okay, got it. Another balance sheet question: you have about $370 million in cash after a couple quarters of free cash flow. What are your latest thoughts on capital allocation and M&A opportunities—are they receding or growing as the market transitions to recovery?

The way we look at cash and run our business is very much return-on-invested-capital focused. A couple of examples: the forge was a capital allocation discussion; leasing it to a third party was an ROI decision. Collaborating with Proserv on controls leveraged our ROIC and increased our leverage on the business. Regarding M&A, there are opportunities and consolidation opportunities for sure, but the bid-ask spread continues to be wide. Some targets have balance-sheet constraints that make deals difficult. We're not going to do a deal just for the sake of doing a deal; it has to make sense strategically, operationally and financially. I expect sentiment may change over the course of the year and valuations may become more reasonable; we continue to monitor the marketplace. We've also shifted some focus to energy transition opportunities—areas like carbon capture and geothermal—because we see ourselves well-positioned with our product suite to target those markets.

Okay, got it. As a high-level closing thought: markets are poised for growth but peak industry activity levels may be far off. You've done a lot to take costs out. Blake, could you sum up the initiatives most important to you as ways to grow the top line? We've touched on a number of these, but it'd be helpful to run through them.

Certainly. First, set the stage: I think our customers will be more conservative with large, lump-sum orders. I don't think we'll see the huge one-off bookings that happened pre-downturn as often. It's going to be more of a call-off environment where contracts are supported over time. Nonetheless, our strategic growth pillars should help us outpace the market. Peer-to-peer gives us access to markets and opportunities we previously couldn't win; the early work we've done almost doubles our addressable opportunities. Our downhole tools business is on track to get back toward previous peak levels—when we acquired TIW in 2017 their peak revenue was about $140 million, and we could see a path to grow that business meaningfully over the next few years. New products we've worked on are being installed and adopted; the more we run, the more customers see the savings and carbon-reduction benefits. We have the company positioned to lean on the backlog, and we have a track record of keeping costs low. Put it all together, even if the market remains flat, we believe we can gain share through peer-to-peer initiatives and our product set and grow the top line.

Got it. I think that was a good summation, Blake. That concludes my questions. Blake, any last messages or thoughts you'd like to share?

I just say that we're really optimistic about 2021, similar to how we were optimistic in 2019 going into 2020. There may be some bumps in the road, but on balance things are returning to normal and I think that's going to be good for our business. We've got everything lined up to be very successful going forward, and I'm encouraged about what 2022 has to bring for Drill-Quip, its employees and its shareholders.

That's great. Thank you, Blake. Thank you, Raj. I think that will conclude our discussion then and hope everybody does have a nice weekend. Thank you.

Thank you, Daniel.

Thank you, Daniel.

And this concludes today's conference call. Thank you for participating. You may now disconnect.