Good day. Thank you for standing by, and welcome to the Dril-Quip Q3 2021 Fireside Chat Conference Call. I would now like to hand the conference over to your speaker today, Mr. James West with Evercore ISI. The floor is yours.

Thanks, and good morning, everyone. Welcome to this morning’s fireside chat with Dril-Quip’s management team. As mentioned, I’m James West from Evercore ISI. I’m joined today with Blake DeBerry, the company’s President and CEO, and Blake’s soon-to-be successor Jeff Bird, who will take over as President and CEO at the turn of the year. Perhaps before we get started, I’d like to say a few words about Blake and Jeff. I began covering Dril-Quip in the early 2000s when the company’s three founders shared the titles of Co-Chairman and Co-CEOs, and while Larry, Gary and Mike did an excellent job building Dril-Quip into the highly successful company it is today, it was during Blake’s tenure as CEO when the successful transition from a founder-led start-up to a modernized global leader really unfolded. Blake’s tenure has been impressive. He was further augmented when Jeff joined the company in 2017. And together, these two gentlemen have further strengthened the company and successfully navigated one of the most challenging periods in the modern oilfield. So I’m very confident Blake is leaving the company in good hands with Jeff as its leader. Perhaps, to start off here though, I’d like Blake to say a few words, maybe give a brief recap of the third quarter and some opening comments.

Sure. Thank you, James, and thanks for covering Dril-Quip throughout my tenure, from the 2000s—so 20 years or so you’ve covered. I agree with you; I think the company has been in good hands and is going to be in good hands with Jeff as I depart, and I look forward to seeing how the company progresses going forward. With respect to the third quarter, the bookings came in at the lower end of our $40 million to $60 million range, which is still within the range that we expected but on the lower side, and revenue was pretty much in line, but our EBITDA was impacted by some one-time items and some margin pressure. On the positive side, our downhole tools group again had a really strong quarter, setting another high for that business since its acquisition in 2016. That business continues to grow and accelerate. We had another good quarter with respect to free cash flow, which has been a big focus for the management team of Dril-Quip this year. Looking forward, we saw improvement quarter-over-quarter in our aftermarket and our leasing revenues, and this is always a good indicator of a pickup in activity, as our customers are getting back to work and consuming their inventory. Additionally, we’ve had good conversations with customers that are trending more positively on activity levels. So we’re seeing that happen. And just looking at the market, particularly the offshore rig market, we’re hearing more and more positive signs about quotation activity for offshore rigs, the number of quotes for offshore rigs, as well as the duration of the requests for the contracts. Those are all positive indicators of an improving market.

So, maybe I’ll turn it over to Jeff for a second here. As I think all of us know with any transition, as soon as you announce it—even though Blake may not be in the room—everybody starts spending more time in Jeff’s office than Blake’s office. So you are the man leading the charge here. Commodity prices have strengthened this year and over the past several quarters, but not all regions are experiencing the same conditions and recovery. When do you think we’ll see growth improvements in the Gulf of Mexico?

Yes. Thanks, James. Walking around the world, if we think about the Gulf of Mexico, we are starting to see signs of recovery there. Specifically, the independents that are more susceptible or more responsive to higher commodity prices are starting to come back to the market, and we’re optimistic about that. If we go around the rest of the world and just talk subsea, Brazil is definitely back. We talked a little bit about the 11 wellhead exploration tender that we received last quarter and 26 liner hangers that we received last quarter as well, so that’s definitely coming back. There is also a tender out there right now on development wellheads. We’re optimistic about that and expect it to be awarded sometime in the fourth quarter as well. So Brazil is back. If we look at offshore U.K., it’s a return; it’s not at 2019 levels yet, but it’s definitely returned. Norway is very strong right now with a lot of government incentives there, so we’re optimistic. China is also hot, and we’re looking at a tender either late this year or early next year as well. Areas that are slower are Malaysia, Indonesia, India and Australia, and those are mainly COVID-related; we’ve just seen the activity really curtail there. Further out, we are starting to see some of the large greenfield developments in Africa starting to have conversations again.

Okay, makes sense. Do you think that your capital discipline and working capital management are playing a role in how customers think about ordering activity?

Yes. If we think about that, obviously in the Lower 48 onshore case, we’ve got almost no exposure in the Lower 48, so that’s not really impacting us. In our conversations with customers, though, we do see a lot of customers reloading their balance sheets in the fourth quarter and probably the first half of next year, where they’re going to take advantage of higher commodity prices to reload balance sheets before they start ordering again in the back half of next year. As a result, we believe that the IOCs are more back-end loaded and some of our customers are more back-end loaded next year, primarily because of capital discipline and reloading their balance sheets.

Okay. Are you seeing any change in behavior as it relates to the energy transition? Is there hesitancy to sanction larger projects at this point?

Yes. I think there is certainly a little more caution around the larger projects than there might have been in the past, so it’s going to be more brownfield tie-back type projects. We are starting to see some of the large greenfield projects that I mentioned, but it’s going to be more brownfield tie-back. As it relates to energy transition, we’re seeing more robust comments in tenders and more requests specifically around carbon footprint—specifically around what we can do to help customers reduce their carbon footprint. In fact, we received a tender last quarter that was probably the most robust on that topic that we’ve seen. We’ll be curious to see how that factors into the tendering process; it’s not exactly clear right now other than a very robust list of questions and requests.

Sure. I do want to come back to that tender and carbon, but maybe to touch on where we are now: orders seem to be running in that $40 million to $60 million range. What do you need to see for orders to break outside that range? Do you think that happens late Q4 or in 2022?

Yes. We’ve been quoting $40 million to $60 million. We believe we’ll be at the high end of that range in Q4. That Q4 range is largely dependent on how the independents come in, and right now we’ve got a lot of nice projects with those independents that would dictate whether we’re at the high end of the range or actually exceed the high end in the fourth quarter. If we look out to next year, 2022, it’s early days and we see a lot of our customers in the middle of their planning projects right now. When we met with one customer earlier this week, they were actually surprised at the amount of activity within their own company during their budgeting process. So those customers are still in a state of flux. Early days right now, but we see 2022 bookings up 20% to 25% on 2021 from a booking standpoint. This year we expect the bookings; next year we would expect double the number of trees that we’ve booked this year. So we’re definitely optimistic about next year. I do think it’s going to be choppy as we come out.

Sure. Are there any large projects you’re tracking or have updates on?

Yes. There are really two. One is the Petrobras development tender that we’re talking about, where we believe we’re well-positioned and are pretty optimistic it will be awarded in the fourth quarter. The other is with CNOOC, and that is actually a collaboration agreement. That would be our first large collaboration tender, and we expect that either in the fourth quarter of this year or the first quarter of next year.

When you say collaboration, what do you mean?

That’s the one-subsea collaboration. In that case, we’re actually going in with one subsea: we provide the wellhead, and they provide a lot of the other equipment.

Okay, great. Since you got involved in the business, Jeff, you’ve been taking costs out and running operations more efficiently. Are the actions you took last year playing out as you expected? What scenarios could cause you to consider further changes to the cost structure?

Yes. I think everything is playing out as we expected. We’ve gotten costs out of the business, and we’re actually a little ahead this year on our productivity projects. If you remember the transformation, when we positioned that, we set a $400 million revenue target with $40 million to $50 million of EBITDA. We thought that would be the trough revenue level. Obviously, we didn’t expect the pandemic so the trough revenue is a little lower than we thought. It’s unquestionable right now that we’re holding more costs than we need to hold in anticipation of a recovery. The spot we don’t want to be in is cutting a bunch of costs this quarter and finding out next quarter or two quarters from now that a recovery is underway and then having to add those costs back. We estimate that we’re probably holding $20 million to $30 million of excess cost right now as a result of where we are in the cycle. We’ll continue to monitor that. To answer your specific question on what triggers: we’re looking at that $40 million to $60 million orders range. If we start to see orders at the low end or even the mid part of that range persistently, we’ll have to react accordingly from a cost standpoint. We know what the triggers are that we need to pull; we’re just trying to be thoughtful about it.

Right. There’s been a lot of conversation about rising materials and rising freight prices. What are you seeing on that side in terms of impacts to your business, and how are you trying to mitigate those impacts?

Let me divide the business between downhole tools and subsea. On the downhole tools side, that is a short-cycle business—12-week lead times—so we see the impact much quicker and we have to pass on price much quicker. We’ve immediately gone out with price increases for the downhole tools business and have been largely successful. On the subsea side, lead times can be anywhere from 26 to 52 months or 18 months, so we’ve got a lot longer runway there. We will see increases and we are passing along about a 10% price increase on the subsea side, and largely we believe we’ll be successful there as well. Freight is a different story. We’re seeing two problems with freight: the escalation in freight prices and the availability of routes and modes. We find ourselves in situations where we might normally ship ocean freight but can’t get an ocean route, so we end up air-freighting because the customer needs it. That creates inflation in freight costs, and in some cases the inflation results from having to use a more expensive mode than normal.

I want to go back to the collaboration you mentioned with one subsea and CNOOC. Historically, collaboration was a big part of Dril-Quip’s business. You’re putting some collaboration efforts back in place. What impact has that had thus far, and what are your future expectations?

We’ve really got two major collaboration agreements announced. One is Proserv, where Proserv is providing the controls for us. We did that largely because, candidly, we were holding excess cost and would have had to invest a considerable amount to raise our controls capability. The benefit there is clear: if you look at the BHP Norskan award earlier in the year, that was a direct result of that Proserv collaboration agreement. Over the next 18 months we know there will be at least a few more trees that will come out of that BHP award, and that will be a direct result of the Proserv collaboration. We believe that’s working. The downside is there is some pass-through impact, so those controls pass-through at a lower margin than you might normally expect; that depends on how the customer wants to contract. BHP is a good example where they wanted one contract—one party accountable—so we pass through to BHP. Other customers contract separately and that makes the margin look a little better. The one-subsea collaboration we signed recently is around wellheads. We meet every month, go through joint opportunities, and bid jointly with one subsea in many cases. The CNOOC example is one where we bid with them. There are opportunities where we bid with them and opportunities where we bid separately, and that’s part of the collaboration. It’s taken a little while to take off because of the long bid cycles—26 to 52 weeks on wellheads—so it doesn’t happen immediately. This fourth quarter will likely be the first opportunity where we could see a win.

Okay.

Fourth quarter of this year, first quarter next year.

Are you thinking about exploring other product lines and collaboration partners?

Yes. There are a couple of opportunities. One is on the downhole tool side specifically around liner hangers; that’s part of the one-subsea collaboration agreement. That’s a little behind where wellheads are right now, but we’re starting to gain traction—it's an area where we already sell through Schlumberger but are gaining more traction. In terms of VXTe, we would expect to work with other tree manufacturers to provide VXTe through those other manufacturers. Another major opportunity is energy transition: we’ve got a nice offering on shallow water trees and there are larger enterprises pursuing carbon capture and storage projects that don’t have good shallow water tree solutions. We’re in conversations with partners on that as well. So the next opportunities are VXTe and something around CCUS—specifically shallow water trees.

That’s great. I did note your downhole tool business had another record quarter in Q3. What’s happening in that business? What’s driving the improvements, how are you making progress in key markets, and what are the longer-term targets for this business?

We brought Steven in over the last 18 to 24 months and he looked at where we were playing in downhole tools globally. We made a few strategic decisions: we exited regions where we couldn’t be profitable—specifically parts of the Middle East, parts of Latin America and certain deepwater segments. We brought in new general managers in each of the focused regions and put stocking programs in place. We now have specific SKUs stocked in those regions, allowing us to respond quickly to customers. We made inventory investments—about $6 million this year—which will allow us to be up roughly 30% year-on-year in revenue for downhole tools, and we expect another 30% year-on-year next year. We see a path to $100 million to $120 million in downhole tools revenue—not necessarily in 2022 but as a 2023 target and beyond—based on the geographies and SKUs we’re focusing on. The next piece beyond that would involve entering additional geographies and expanding SKUs.

Makes a lot of sense. Let’s talk about the e-Series family of technologies: they are beginning to see success in bookings and installations. Which products are seeing success, and do you have an update on VXTe post-trial and how the conversation has changed?

I’ll start with BigBore IIe. For our wellhead, we’ve seen wide success; by the end of next year we would expect 60% to 70% of incoming orders to be BigBore IIe. That wide acceptance helps inventory and manufacturing efficiency. On the DXC connector, we’ve seen two to three installs in Norway and we’re starting to gain good acceptance there. On XPak, we’ve done two deepwater installs and are seeing traction. So BigBore IIe is way ahead, followed by DXC and XPak. Regarding VXTe, we would expect an install in the fourth quarter of this year or maybe the first quarter of next year; it largely depends on the well being drilled now. I think we’ve talked already about Walter Oil & Gas doing that well, and it depends on how that well looks. If that works out well, I think we’ll see VXTe move forward quickly. We’re already in conversations with large IOCs and other customers about VXTe, but in our industry many customers want to be the first or second adopters. Everyone is anxiously watching that install. So the trifecta of success for VXTe is getting the install in the fourth quarter, pulling interest from large IOCs/majors, and the endorsement from one subsea on the technology.

How do you think about R&D spend going forward since launching the e-Series products? What projects are next in the queue?

As a new person in the seat, I’m focusing on the period between now and our February earnings call. By then, I hope we can be more explicit about our R&D allocation. We will continue to spend on innovation and R&D; we’re keenly focused on energy transition. We believe we have real opportunities in carbon capture and geothermal. It’s not that we won’t continue to invest in core products, but those two areas are growth opportunities where we think we can gain traction in the short term. I’d like to discuss in February what percentage of our R&D is being spent on energy transition specifically around those areas.

Perfect. That leads to my next question: how is Dril-Quip approaching energy transition? How has the 'Green by Design' campaign been resonating with customers, and what are the key benefits or advantages your technology offers compared to competitors?

Green by Design has been very well received by customers and plays nicely into the tender I mentioned earlier where customers are specifying carbon footprint reduction targets. The e-Series products fit well into that and resonate across NOCs, IOCs and some larger independents. We spent the summer going through every energy transition vertical and landed on the 'no regret' areas for us: carbon capture and geothermal. That’s not to say we won’t pay attention to other areas, but those are the easier, more immediate opportunities. We hired an energy transition lead who reports directly to me, and we continue to evaluate other verticals. We’re also seeing inbound interest from early-phase companies that lack manufacturing capability. Those companies often call seeking a manufacturing partner when they win tenders, and we’re meeting with them. We’re not looking to be a contract manufacturer exclusively; instead, when we invest time and resources to set up manufacturing for such companies, we look to take a small equity stake so we benefit if the company succeeds. It’s a low-risk approach for us.

Okay, makes sense. Turning to the balance sheet: Dril-Quip has historically had substantial cash and no debt. Going into an upturn, is there opportunity to return cash to shareholders or pursue M&A? How are you thinking about capital allocation over the next several quarters?

Yes. Similar to our R&D strategy, capital allocation is something we’re working on over the next few months. Without any debt, we estimate we need $100 million to $150 million of cash to maintain the business even in an upturn. That leaves a fair amount of excess cash. You saw we did some stock buybacks—some in the third quarter and more in the fourth quarter—and we’ll remain thoughtful around buybacks. Beyond that, we want to be thoughtful about M&A and where opportunities might be. The industry needs some level of consolidation; at our current revenue size it’s a scale issue for us and many peers are in the same spot. We’re constantly looking at opportunities. Early in my tenure I’ve been meeting with CEOs of other oilfield services companies to gauge their view of the industry and where thoughtful partnerships might be formed. Those opportunities might not always be M&A; they could be collaboration agreements. In February we’ll be clearer articulating our capital allocation strategy: how much cash we need in a recovery, how much we’ll invest in energy transition via small collaboration investments, and what an M&A strategy will look like—probably a bit more aggressive.

Good to hear. You set a lot of targets this year around cash flow, working capital improvements and free cash flow as a percentage of revenue; you exceeded the 5% target. Do you expect that to continue? Working capital trends have been positive—can you discuss that?

Yes. We’ve trended higher; a 10% free cash flow number is closer to what we think about versus the 5% this year. This year we saw a lot of improvement in accounts receivable: getting past-due receivables down and shrinking time to invoice. Those trends have legs into the fourth quarter, but it gets tougher to keep pushing those improvements through a recovery next year as receivables may grow with revenue. We did see a nice reduction in inventory this quarter and we’re continuing to focus there. Improving inventory is a tougher lift—you need incoming orders and a dedicated team to match existing material to incoming orders. That effort is starting to gain traction and should continue into the fourth quarter and next year. We’re probably tapped out on accounts payable; we have a decent DPO now and it will be challenging to expand further. Cash flow will remain a focus next year, but if we start to see multiple quarters of orders at $100 million, you can expect some burn on working capital as shipments and inventory ramp.

How do you expect CapEx to trend? Your current run rate looks like it’s below the $15 million to $17 million expectation. Do you think that moves up or are you in a good range?

We will probably come in below that $15 million to $17 million sustaining CapEx number; that figure has typically been our sustaining capital amount. We are looking at potential investments over the next 12 to 24 months to ensure our manufacturing footprint is positioned correctly, but we don’t see anything material right now. We’ll likely be more specific in February if anything changes.

You mentioned inventory improvements in Q3. Are there more improvements to come? How do you think about inventory as a competitive advantage—some competitors may be caught off guard when recovery happens if they don’t have inventory.

I’ll address that on two fronts. First, there is opportunity, but incoming orders can be choppy over the next several quarters. There will be quarters like this one with the right orders and quarters where the right orders don’t come in at the right time. On the competitive advantage front, we invested in downhole tool inventories in each key region and set specific inventory targets, which is starting to drive the revenue increases. The next item is improving turns: currently we’re at 1.5 to 2 turns on downhole tool inventory and I’d like to get that to four turns, but I won’t do that at the expense of revenue—we’re focused on the 30% revenue increase first. On the subsea side, we’ve gone from 15 wellheads to four wellheads. With BigBore IIe expected to be 60% to 70% of our orders by the end of next year, we’re focused on stocking those four wellheads. We tell customers that if you order one of those four wellheads, you’ll get it faster and at a better lead time; if you order something outside those four, it will take longer and likely be more expensive. Customers generally want to be in those four wellheads because they’re looking to push inventory holding back. We run monthly sales-inventory-operation-planning sessions to decide where to strategically stock items—downhole tools and wellheads are intentional areas we’ll keep focusing on.

How should we think about Q4 in terms of revenue and margins, and how about a more normalized margin profile further out?

Q4 will look very much like Q3—plus or minus a bit. At our current revenue scale, a $1 million change can look big as a percentage, but in the grand scheme it’s modest. As we get deeper into 2022, we’ll be more dependent on orders. We’re starting to see some of the low trends we saw in 2020 flow through in revenue and EBITDA. If we think about next year, orders up 20% to 25% in 2022 likely won’t fully manifest in revenue until the back half of next year or early 2023. We get some immediate percentage-of-completion revenue from some orders, but largely the uptick comes later. For normalized product margins, we expect to get back into the low-20% range.

Blake, this is your last fireside chat and your last call with Dril-Quip. Any parting thoughts for shareholders, investors, employees and directors?

Yes. I’ve spent 40 years in the oilfield services industry, 33 of those with Dril-Quip and the last 10 as CEO. It’s been an incredible ride. As I start to clean up my office, I’ve pulled out mementos and things that I’ve saved—many of which are reminders of the people I’ve worked with. I certainly appreciate the employees, shareholders, the Board and our customers; it’s been an incredible experience traveling and living all over the world. I pulled out my stack of passports and realized I’ve been on every continent including Antarctica. I’m really optimistic about the future. That’s one reason I feel comfortable stepping down now: I feel comfortable with Jeff taking this on and I believe Dril-Quip is positioned to outgrow the market. I’m optimistic about the go-forward prospects.

Good.

My wife and I have built a vineyard and winery in Central Texas. It’s been operational for a little over six years and she runs the business. When I raised the topic of stepping down, I had to negotiate a position at the winery—she’s a tough negotiator. She’s told me several times she doesn’t think I’ll like my new boss very much, but she did agree to let me retain the title of CEO, which I was pretty excited about. She also defined my job duties: I’m responsible for cleaning electrical items and other tasks—some of which are scary, especially if they involve something in the bathroom. I’m looking forward to spending more time with family; today I’m going up to watch my grandkids play soccer for the first time. I look forward to making more wine and having more family life.

That’s a good plan, Blake. You had a great run at Dril-Quip and did a great job stewarding the company. Jeff, best of luck as we move forward—it’s you and me now, Blake will stay connected as well, and we’ll give it a go.

I look forward to it.

Absolutely. Well, thanks everybody for listening in today, and with that we’ll go ahead and end the call.

All right. Thank you, James.

Thank you, James.

Thanks, guys.