Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Dril-Quip Second Quarter 2022 Fireside Chat. At this time, I would like to turn the call over to Ms. Erin Fazio, Director, Corporate Development, Investor Relations & FP&A. Ma'am, please begin.

Thank you, Howard. Good morning. Welcome to Dril-Quip's second quarter 2022 fireside chat. Our news release and financial statements issued yesterday can be found on our website. As a reminder, during the course of this conference call, we will provide forward-looking statements. These statements are not guarantees of future performance and involve a number of risks and assumptions. Please review our SEC filings and website for a discussion of the factors that could cause actual results to differ materially. As you know, reconciliations of operating income and other GAAP to non-GAAP measures can be found in our earnings release. With that, I'll turn the call over to Dave Anderson.

Great. Thanks, Erin. Good morning. My name is Dave Anderson, I head up the Energy Services Research at Barclays. I'd like to thank Jeff for the opportunity to host this quarter's earnings fireside chat. We should call it something a little bit different because we're in the middle of a hot summer, maybe we should call it a fireside pit, I'm not sure. Jeff's going to provide a brief recap of the second quarter after which I'm going to have a series of topics and questions to discuss for the remainder of the hour. We're not going to be taking any questions at the end.

Hi, thanks, Dave. Thanks for hosting the fireside chat. I appreciate it. And you're absolutely right, probably something more appropriate than fireside chat as we sit here in Houston, Texas, in the middle of an awfully hot summer. First, I'd like to thank the employees for a strong quarter and the hard work that went into delivering the results. I really appreciate it myself, the management team, and our customers appreciate the quality and safe manner in which we conduct our business in the second quarter. This is probably one of our best quarters since the beginning of the pandemic, so we're pleased with that. From a revenue and adjusted EBITDA standpoint, we beat both our expectations and consensus; it was really broad-based growth across a number of our products. I'll go through each of those. If I think about Subsea Services, we're most encouraged by Subsea Services; it was a little over 20% sequentially. We really liked the growth in services specifically as a result of the fact that that's often a leading indicator of our customers' activity levels coming back to work. When customers bring properties back online, you start to see recertification and rework happening. That's often an early indicator and probably our shortest-turnaround and shortest-cycle business of our three. The next is Downhole tools, also a short-cycle business. We've talked a lot about Downhole tools over the last few quarters and the growth we expect to see there. We had a nice sequential increase quarter-on-quarter there as well; that's really broad-based. Latin America was strong, both in Mexico and Ecuador; the Middle East was strong, specifically Saudi, and we're starting to see our deepwater business emerge — there's a real growth opportunity there. Last but certainly not least, on the Subsea product side, a solid 7% quarter-on-quarter increase. We like the increase there; that's largely because we started to see orders pick up. In the back half of last year, orders were up about 10% to 15% over the first half; that trend really maintained in the first half of this year and we're seeing that start to translate now into revenue. So overall, a solid quarter. We're pleased with it. And once again, like to thank our employees. With that, I'll turn it back over to you, Dave, for a robust conversation.

Great, thanks, Jeff. So one of the things we've been seeing this quarter has been a growing expectation of an offshore inflection, but it doesn't hit everybody at the same time. We're seeing a lot of tenders out there for both deepwater and jackup rigs. Maybe let's start with what you're hearing from your customers — what you're hearing about the current economic environment. When people are talking about a recession, are your customers talking about that at all, or are they instead looking the other way and really thinking about this global energy crisis and how they see that playing into their plans?

Yes. First and foremost, we're seeing our customers maintain capital discipline and that's really across the board, regardless of the size of the customer and whether it's an IOC or an NOC. There's a lot of capital discipline in the market right now. Some of our customers have gone back and are reevaluating and sharpening their pencils on projects, looking at what they believe demand will actually be. We're in a high-inflation environment, so they're reassessing project economics. We see a lot of projects pushing to the back half of the year as they reassess the economics. What we're hearing from customers is that while it's easy to look at today's environment — $90 to $100 oil and everybody getting back to work — they're modeling much lower breakevens to be resilient if things turn the other direction. We're hearing numbers anywhere from $35 to $40 as what they're thinking about, so they can be resilient. So, cautious optimism is how I'd describe the environment.

If I look at your orders this quarter, you did around $50 million. I was running some quick math and over the last 10 quarters you've averaged around $50 million a quarter. How do we think about that and how that could potentially change based on what you're seeing out there? Specifically, thinking about 2023, how could these numbers trend? What's your 12- to 18-month view on how orders could trend?

Yes. We'll talk about this year and then a more general environment for next year. This year we still expect orders to be up year-over-year around 20%. You can do the math and see that's a bit back-loaded right now. It doesn't surprise us that it's back-loaded. We might have gotten a little optimistic earlier in the year when oil prices were higher and inflationary pressures weren't as visible. As inflation crept in, some products were slower to come online. We expect, as we discussed earlier, that of the 16 to 19 tree bookings this year, about 11 will be in the back half. That is reflected in our roughly 20% year-on-year increase. Another trend across the board is that we're seeing far more Master Service Agreements (MSAs) now and fewer immediate purchase orders that automatically convert to bookings. For example, Petrobras placed an MSA for 87 wellheads; those do not automatically go into bookings until they're called off. If you go back five to seven years, customers typically placed purchase orders outright. So we're seeing a lot of good activity, it's just translating into MSAs instead of immediate bookings. For 2023, we view the environment as constructive. We expect oil prices to remain relatively high, and we believe the Subsea Services growth we saw in Q2 is indicative of customers coming back to work. We would expect strong bookings again next year and likely growth from 2022 to 2023.

I was curious — you mentioned earlier about some of the short-cycle business flowing through. Subsea Services doesn't typically run through backlog; I assume that goes straight to revenue. Could you talk about your overall mix in terms of short-cycle versus longer-cycle opportunities and how that compares to a few years ago? I would have thought much of your business would have been longer cycle previously.

Yes. To clarify, most services do not go through backlog. There are situations where services are contracted in a way that they might go through backlog — Petrobras would be an example — but outside of Petrobras, most services go straight to revenue. That's obviously short cycle. A customer could buy a wellhead or a tree or a connector and it may be months or even years before we actually service that and see the service revenue; those are longer cycles. Think about a wellhead at anywhere from 26 to 52 weeks depending on specs and location; a tree might be 12 to 18 months, probably toward the higher side now given supply chain constraints. Downhole tools are very short cycle — we have stocking programs for downhole tools. The customer shows up, asks for the equipment, and it can go to work almost immediately; at the longest maybe 12 weeks depending on the application. So when we say we're seeing short-cycle businesses pick up, that's primarily downhole tools — a business we didn't own back in 2016 — and services as customers come back to work and start working through inventory.

If I think about your wellheads and trees, are your orders coming more from short-cycle work, meaning step-outs and field extensions, versus new fields? Is that how your bookings look?

Yes, it's more brownfield and greenfield, with a tilt toward brownfield extensions and step-outs.

So if trees are about 12 to 18 months out and wellheads are shorter cycle, then most of your wellhead and other business should be more of a '23 event — shorter cycle versus longer cycle. Is that fair to say?

Yes, that's exactly right. If you compare wellheads, which are our core product line, to trees, trees tend to come later in the cycle. Another point: customers sometimes hold more wellhead inventory, whereas they don't typically hold many trees in inventory. Often when a cycle rebounds, they'll work through wellhead inventory first before reordering.

Speaking of inventory and inflationary pressures, do you have concerns about realized margins? Is it almost just-in-time so you can capture inflationary pressures, or do you expect margin compression?

Yes, you have to split it into two pieces. For the downhole tools business — as Jeff mentioned — it's a shorter-cycle business. They're out on the forefront getting pricing. Where they're seeing cost inflation, their margins have been relatively stable during the last several quarters. They were out late last year raising prices across the board for both service and product. On the subsea product side, the cycle is a little longer, so when you're purchasing inventory, that goes into cost and it flows through later. The folks in that business are identifying where they're seeing inflation part by part and are trying to pass pricing along to customers even though it may not clear inventory for a while. So we're being very aggressive on pricing. On the margin side, specifically on downhole tools, you're seeing them stabilize and in fact grow product margin.

Okay, that's good to hear. Maybe we can take a bigger picture look globally. Where are you seeing activity increase more than others? What's happening on the leading edge that has you most excited for the next 6 to 12 months?

If you step back, Brazil is very, very strong right now. I mentioned the 87 wellhead MSA; calls are coming off much faster than we anticipated. We actually expect them to probably go out for tender again a bit earlier than we would have thought. In the Middle East, Saudi remains strong — I was there four or five weeks ago — and our downhole tool business is humming along and expected to grow in the back half of the year in Saudi, both for downhole tools and for some connector and service equipment business. Norway remains strong; there's an economic scheme there that's encouraging drilling. Asia-Pacific is probably the slowest to come back, although even there we started to see Subsea Services increases in recertification and rework as rigs come back online. Guyana is interesting; they're looking for regulatory certainty. Our customers there want to know the operating environment for the next five to ten years, and the timing will depend on how the legislation plays out.

Could you circle back to Brazil and talk about the MSA in more detail? This is a big business for you. How different is it from the last cycle in terms of contract structure? You touched on it before but can you break down how those 87 wellheads flow through backlog and how that differs from the past?

Yes, it's a lot different than before. In the last big upswing, customers placed large purchase orders and those orders went straight into backlog and we delivered against them. Today they typically use MSAs with a min/max structure that covers both equipment and service, and customers call off against that contract. From a recognition standpoint, we recognize the minimum (if there is a minimum) when we sign the contract, but anything above that minimum is not recognized until a call-off actually happens. So when we announce something like an agreement for 87 wellheads with Petrobras, that doesn't immediately go into backlog — the minimum goes into backlog, but the balance goes into backlog only as it's called off.

It clarifies things. So would you say all 87 of those wellheads will have gone through backlog by early next year based on your commentary about another MSA on the horizon?

About 30% are already through backlog. The remaining 70% will probably happen over the next 12 to 18 months. They may not be fully through it before they do their next tender; I would expect that when they're 70% to 80% of the way through the contract, they'll probably go back out to tender again. It won't be a single digital event — there will be some overlap and cutover.

Middle East and Saudi — that's not typically the first market that comes to mind for Dril-Quip historically. Could you talk about the opportunity in that market? I'm assuming this is related to offshore and jackup activity. How has that market evolved and where do you fit in?

You're right that it wouldn't have been top-of-mind historically; we really built our presence there through the acquisition of TIW. That's primarily the downhole tools market, and TIW has had a very strong presence in Saudi. We're one of the key liner hanger players in that market serving RAMCO. We also sell sub-mudline, surface connectors, and diverters from time to time. The largest business for us in Saudi is the liner hanger business. We're looking at opportunities as activity ramps up, and RAMCO is looking to add more vendors given supply chain concerns.

On wellhead qualification in Saudi, are you qualified with RAMCO? Is that something you're pursuing? Historically it has not been easy to get qualified but things are different in Saudi these days. Any update there?

Qualification is not easy. We're qualified on diverters. I believe we're through some qualification on sub-mudline. On the surface wellhead side, we're not qualified yet. Primarily, our focus in Saudi has been the liner hanger market, where we are qualified. We are working on qualification for surface wellheads, but we're not qualified yet.

You mentioned West Africa. It's always been fits and starts there. Are you seeing any early signs of activity in Nigeria, Angola, or other countries that could be meaningful over the next 6 to 12 months?

Yes, very early days, but we are seeing activity where we hadn't seen it in a while. It's not anything material in the next 6 to 12 months though.

Could you discuss the competitive dynamics? For a while this was a sort of two-horse race. Has competitor behavior changed in this early part of the recovery? Anything to glean compared to the prior recovery?

If you think about the competitive landscape, we do have collaboration agreements. We have a collaboration agreement with OneSubsea where we'll work with them on wellheads; we actively tender there and rely on OneSubsea to win the EPCI work at times so we can tag along. We also have quieter collaboration agreements where we will bid with Aker from time to time. For EPCI bids, we typically partner with either OneSubsea or Aker when it makes sense. There are still customers like Petrobras that tender their wellheads separately from trees and other bundles, and we remain competitive in those tenders.

Shifting to finance and capital allocation — Kyle, could you talk about how you see the second half playing out? You discussed top-line growth and incremental margin targets. Where are you hoping to land by year-end and what is the setup for next year?

As I think about the back half, Q3 and Q4 will probably be somewhat similar to Q2. Jeff mentioned tree orders are lumpy and critical to bookings and margin; but I would expect Q3 and Q4 to be more or less in line with Q2. In terms of '23, it's a bit early; we're starting to roll up budgets in the next couple months and get CapEx plans from customers, so I'd be hesitant to jump into '23 guidance right now.

On free cash flow expectations, you mentioned building up cash in the second half. Working capital builds have been a recurring theme for many companies. Could you discuss the expected free cash flow dynamics in the second half?

I would expect a pretty strong second half for free cash flow. Year-to-date we had negative about $25 million; we expect to come back and have a positive second half. Accounts receivable was a bit of a drag in Q2 even as we grew sequentially, and we saw a sequential decline in AR. We expect working capital to pick up as revenues flatten in Q3 and Q4 and that will improve cash flow. There are a couple of one-off items in Q4 that will impact it, but overall we expect to drive free cash in the back half. We're sticking to the five pieces of guidance we put out in February: bookings up 20%, revenue up, incremental margins, $40 million to $60 million free cash, 3% to 5% yield, and CapEx of $15 million to $17 million. We're on track for those as we hit the back half. As for 2023, it's a little too early to talk about it.

On M&A, you've done a few things over the last couple of years. What makes the most sense strategically? You have a differentiated asset base — wellheads, trees, and consumables. Is the inorganic path the same direction as your organic business, or are you looking at adjacent or energy-adjacent sectors?

I think it's about Dril-Quip DNA and the expertise we have: high pressure, high temperature, highly engineered manufacturing capability, and a footprint we can build on. It doesn't necessarily need to be right next to wellheads or trees; it could be energy or energy-adjacent markets. We've engaged a third party and narrowed down to a final two or three areas to explore, and we'll be working on that over the next nine to twelve months. For the remainder of this year, we'll focus heavily on getting our roof line right, making manufacturing investments, and standing up the new organization. But as we exit the year, you should expect to hear more on M&A.

We'll put a pin in M&A strategy in the next couple months. We'll meet with the board and discuss how we want to communicate it. As Jeff said, it will be about stepping out Dril-Quip's DNA — it could be energy or energy-adjacent. We have guiding principles to take us through the process. Inorganic growth will likely be a key pillar of our growth beyond the organic markets. Internally we have a lot of work streams — reorganization, property sales, footprint rationalization, and manufacturing investment — which will keep us busy for the next six months. We'll be standing up an inorganic capability inside the organization. How we point that ship is still TBD, but any targets will have a clear connection to Dril-Quip's DNA: highly engineered, specified solutions that can be extended into adjacent markets.

Dril-Quip historically has had no debt. Does your approach to M&A change that balance-sheet philosophy? Would you consider taking on debt to finance growth?

We view the balance sheet as a critical asset. We would not anticipate taking on debt in these scenarios. We want to maintain a very healthy cash balance. From an M&A standpoint, we'll likely be programmatic — a string of pearls over time rather than a big bang deal. Our organic business needs to generate a little more free cash than it currently is, and we won't entertain taking on meaningful debt at this juncture. We want to continue holding healthy cash on the balance sheet to give us options, including share buybacks — we've done $21 million this year. But we want to preserve financial flexibility.

On subsea trees — one of your competitors has said they can't make that business work. Is there an opportunity on the tree side given changing competitive dynamics? Historically it's been opportunistic for you; could it become a steadier line of business?

We look at trees in two aspects: shallow-water and deepwater. In shallow water we have a decent share and we're bringing a new tree online called SBTE that leverages some of our technology. We think we could get a first win on SBTE sometime early next year. That same tree will be used in carbon capture and storage (CCUS) applications, so it could ultimately become our CCUS tree. On deepwater, we do sell deepwater trees, and those tend to be more opportunistic and typically involve partnering with EPCI providers like Aker or OneSubsea for large projects. But on the shallow-water side, we have a competitive offering with the SBTE and expect to pursue that opportunity, including CCUS.

On the CCUS side, when would you expect first trees and wellheads to be installed? When should we expect the first seabed or surface installations?

It depends on the project, but conservatively we would expect first orders late 2023 and probably first revenue in 2024. First installations would likely occur in 2024 as well.

What other markets are you targeting beyond CCUS? For example, hydrogen or geothermal — are there translatable opportunities?

CCUS is the most immediate opportunity because it's an extension of things we already do. Hydrogen could be interesting from a high-pressure, high-temperature standpoint, but it's much more nascent and would require more R&D. Geothermal is a commoditized market; we accidentally sell some products to geothermal via connectors and pipe, but it's challenging and largely opportunistic. We would participate opportunistically in geothermal, but we wouldn't aggressively build a dedicated product line there; any investment would likely be small.

Let's talk about the downhole tools business. You had good growth this quarter. How is that business developing, and is there anything different about this cycle that suggests more sustainable growth for downhole tools than in the past?

If you go back before the TIW acquisition, the downhole tools business was material but relatively small to Dril-Quip overall. Acquiring TIW in 2017 made this a much more substantial business for us. A key difference now is our stocking programs around the world. We have stocked inventory in Saudi, Ecuador, Mexico, and other key markets. In the past we tried quick-turn manufacturing, which is less effective in today's logistics environment. With inventory on the ground, customers can pull kit immediately and that provides a competitive advantage. We've also worked hard to get many sizes and kit qualified in Saudi. We expect a fair amount of restocking in Saudi in the back half and into next year. When we bought the business we perhaps didn't fully appreciate just how quick turnaround needs to be for liner hangers; now we understand and are organized accordingly.

When you say stocking programs, do you mean you have capacity and inventory staged in-market to meet demand quickly?

Yes. You need inventory on the ground — think of it as a compound where certain sizes and kits are on site. When a customer pulls inventory, that signals our manufacturing and supply chain to restock. If you don't have that kit in-market, customers will find a different solution.

Do competitors generally not have that in-market stocking approach? Are you seeing that as a differentiator?

There is some of that. Also, note that we supply many competitors with liner hangers — Schlumberger and Halliburton will buy liner hangers from us at times. Two things matter in this business: service quality and having inventory on the ground. We've dramatically improved service quality and have the inventory, which gives us more at-bats with customers.

Schlumberger had a big pickup in Gulf of Mexico activity — does downhole tools correlate with offshore activity like that?

Keep in mind our downhole tool business is not predominantly deepwater like wellheads and trees. There's a healthy amount of international land activity in that business — Mexico, Ecuador, Saudi, Brazil — those are core markets for us. We certainly supply other markets, and sometimes we sell equipment to larger competitors who then install it for us.

Which markets are you ideally positioned for with downhole tools and stocking programs?

Core markets are Ecuador, Mexico, Saudi, and Brazil — particularly with Petrobras we're starting to see an MSA for XPak DE and a potential 27-system MSA. Those are the main markets where we see opportunity and where we've positioned inventory and service capabilities.

In 2021 you had 35% growth in this business. Do you have a stated expectation for this year? Should we expect double-digit growth in downhole tools next year?

Yes, we would expect double-digit growth in the downhole tools business this year. They had a strong 2021 and the markets they're operating in, particularly Saudi, have been key contributors. It's a good service-and-product business with healthy margins. They've done a good job managing inflation over the last six to nine months.

To add color, pre-acquisition that was about a $130 million business. Over the next couple of years it's possible to get back toward that level; perhaps not fully to the 'peak' but you could easily see it getting back toward $100 million as an exit run rate.

Next year $100 million?

Over the next couple of years, possibly toward the exit of that period.

Let's shift to the E-Series technology expansion and the product line. Can you explain what the E-Series is, where it fits in the market, and the longer-term prospects?

The E-Series is a set of products we've brought to market over the last four to five years focused on reducing costs and reducing carbon footprint for our customers. Customers can use the entire suite or individual products. We're often seeing them used individually. From a wellhead standpoint, we have E-Series wellheads and increasingly customers are gravitating toward E-Series. We expect to exit the year with perhaps 70% of wellhead orders being E-Series, which helps us in several ways including inventory. The DXC connector is a high-fatigue connector; we've seen traction in Norway and the Gulf of Mexico. The XPak DE and the Petrobras MSA I mentioned earlier are positive developments for the XPak DE. We have one XPak DE actually headed to Brazil right now, as a matter of fact. SBTE is the shallow-water tree I mentioned earlier, which is another extension of the E-Series product family.

What's the pitch to the customer on E-Series? Why choose a DXC connector or E-Series wellhead?

There are three main selling points. One is time — you can reduce time and reduce trips. Fewer trips means less cost, and fewer trips also reduces carbon footprint. Depending on the product, fewer trips and less equipment can materially reduce the total cost of operations. We're seeing customers start to build carbon footprint considerations into their tenders, and E-Series helps reduce carbon footprint as well. It's difficult to see exactly how that will be weighted in tender economics, but I'd expect that consideration to grow over the next couple of years.

Last section: operations and footprint changes. You've made a number of operational changes over the past few years. Where are you on the path to operational efficiency? What changes are complete and what remains?

When I became CEO we began shifting to a product-focused organization. Historically we were very functionally organized and handoffs across sales, engineering, and manufacturing added time and inefficiency. We're reorganizing into product groups, appointing leaders, and co-locating people to improve communication and efficiency. We have a large campus — 218 acres — and we've identified at least 100 acres that we can divest. In our release we said property sales could be in the $40 million to $60 million range; given market conditions today it's tightened a bit and we're guiding more toward $40 million to $50 million. We're confident in $40 million to $50 million in proceeds. We'll take some of that, about $20 million, and reinvest it in manufacturing. We expect proceeds from property sales and we'll use some of that to make manufacturing investments in the business.

Another element is getting income statements by product line to understand true profitability across the portfolio. That effort is underway and is helping inform footprint rationalization and where to focus resources. It's allowing us to understand who is doing well and where we need to invest.

You mentioned the forge facility is under contract. How does that change your sourcing for forgings going forward? Where will you source forgings from and how are you thinking about securing continuity of supply?

We moved the forging supply chain off-site about 18 months ago. We have forging sources in North America and Italy, which are two of the largest. We're always looking at cost and lead times for forging suppliers around the world. The on-campus forge we're selling will not operate as a forge under the new owner. Professional forging suppliers have told us that to operate economically they need roughly $50 million a year in throughput; in our peak we had about $35 million and in the low point about $7 million. Operating economics and continuity of supply have to be balanced, and when you get down toward $7 million it's hard to justify running a forge. When we shut down the forge it saved roughly $8 million to $10 million annualized, if I remember correctly.

Taking all of this into account — the operational efficiencies, portfolio rationalization, and manufacturing investments — how are you thinking about normalized gross margins? Fast-forward 12 to 18 months, what is the target for gross margins?

Today we're in the mid-20s (percent gross margin). Over the next 18 to 24 months, after the investments, roof-line reductions, and manufacturing investments, we would expect gross margins to be in the mid-30s. That's the math we're working off to get us toward that long-term target.

Final question: what are your ambitions on decarbonization and ESG? What are you doing on Scope 1, Scope 2, and Scope 3 emissions and other ESG efforts?

We've identified our Scope 1 and Scope 2 greenhouse gas emissions and have a good handle on Scope 3 as well. We have specific targets around Scope 1 and Scope 2 reductions and have implemented some renewable strategies in Houston for electricity and gas. We also have solar installations in our Singapore facility. Footprint optimization is a large opportunity — cutting our roof line and consolidating operations will materially reduce emissions. So we've done a lot of work to understand and set clear targets around Scope 1 and Scope 2.

That's all the questions I had, gentlemen. Jeff, Kyle, thank you very much for the opportunity to host this. A lot is percolating across markets at different times, and it's helpful to get your perspective.

Yes. Thanks a lot, Dave. We'll see you in a little over a month in New York.

That's right. Looking forward to that.

Okay. Thanks, Dave.

Thanks, Dave.

Okay, guys. Thank you.

Well, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone, have a wonderful day.