Earnings Call Transcript - INVX Q1 2021

Luke Lemoine, Analyst (Capital One Securities)

Good morning everyone. Thanks for joining. My name is Luke Lemoine with Capital One Securities. And I am joined with Dril-Quip’s CEO Blake DeBerry, and CFO Raj Kumar. Blake and Raj thanks for taking the time to chat about Dril-Quip in the quarter today.

Blake DeBerry, CEO

Thank you, Luke, and thanks for hosting us.

Raj Kumar, CFO

Thanks, Luke.

Luke Lemoine, Analyst (Capital One Securities)

Yes, you got it. Blake, could you maybe start off with just some opening remarks about the quarter and some things you accomplished and some highlights there?

Blake DeBerry, CEO

Sure, Luke. First off, I'm just really proud of the men and women of Dril-Quip that executed the quarter. The quarter was a really good quarter from my view. We're seeing our strategic growth pillars are helping to drive our bookings. So bookings were up. We had really strong downhole tools growth, which we've been working on that business pretty strongly over the last year. And we're starting to see the impact of the cost reductions we did in 2020 show up in the results. So all in all, I'm very happy with the result.

Luke Lemoine, Analyst (Capital One Securities)

Good. Maybe just to start with the orders there that were very strong at 1Q $57 million—you’ve guided kind of $40 million to $60 million so at the top end of that range—what's the outlook for the remainder of the year as far as quarterly orders? And do you see a pathway of getting back to that $80 million to $100 million range per quarter at some point next year?

Blake DeBerry, CEO

So yes, with respect to Q1, we were pleased to have two horizontal trees booked for an operator in the Gulf of Mexico. And we did that in collaboration with Proserv on the controls and that's one of our strategies is peer-to-peer collaboration. And we call it consolidation by collaboration. So that was a big win. Going forward we still believe that orders will be in that $40 million to $60 million range for 2021. But we see some strength happening in the back half of the year. So we're hopeful that we'll be at the top end of that range. As the economy continues to recover from the pandemic, if that pace continues, then we would expect to see orders to continue to prove into 2022 and be at a potentially higher range of bookings.

Luke Lemoine, Analyst (Capital One Securities)

Maybe turning to your downhole tools that you mentioned in your opening remarks as well—had the highest quarterly revenue since the acquisition in 4Q '16 and revenues doubled quarter-on-quarter. Can you give us an outlook on how you expect this to trend the rest of the year?

Blake DeBerry, CEO

Yes, so I think we're likely to see some lumpiness during the year. Q1 was really strong in Saudi Arabia, because we had some carryover orders and Mexico was also very strong. But downhole tools is one of our key growth pillars. And with the recent stocking program we initiated last year, we expect to see a meaningful growth year-over-year in that business, in particular in Saudi Arabia, Latin America and deep-water, and that's where we see our strength for that particular product line.

Luke Lemoine, Analyst (Capital One Securities)

Okay. Subsea was a little lighter than we expected in the quarter—kind of got off to a rocky start with some delivery project delays. How should we think about the progression here for the remainder of the year?

Blake DeBerry, CEO

Yes, that's true. We're proceeding with some significant improvements in the U.S. in terms of COVID restrictions and demand coming back, but the demand is still slower to recover in parts of Europe and Asia. And that's somewhat muting our subsea business. We're starting to—really what we're seeing is the impact of the challenging bookings numbers that we had in 2020. So it's not really surprising that the revenue is going to be a bit challenging through the year, but Q1 was a good bookings quarter, and that's a good indicator of our future revenue. And as the vaccines become more widely distributed and economies open up, we expect to see that part of our business pick up accordingly.

Luke Lemoine, Analyst (Capital One Securities)

So even with the subsea revenues declining some in 1Q, gross margins were very strong and showed a nice increase quarter-on-quarter. Can you talk a little bit about the margin cadence for the balance of the year with your projected mix and the cost savings you've outlined?

Blake DeBerry, CEO

Yes, sure. Raj is probably best to talk about that. I'm going to hand that over to him.

Raj Kumar, CFO

Yes, thanks for allowing us to talk about our margins. We are extremely pleased with our margin performance in Q1. We made good progress; as you recall, last year we had some structural cost takeouts that were about $20 million. We're seeing the benefit of that play into this year. And we're also in a very good position in terms of this year's productivity gains. We started off this year with $2.5 million of productivity gains. And as you recall, we are targeting about $10 million of productivity savings this year. From this, we expect supply chain savings from our downhole tools business to hit in the later part of the year. So if you think about it on the cost side, I think we've got tailwinds in terms of helping us from a margin perspective. Now if I shift to the mix side of things, this quarter we saw help from the downhole tools revenue that we talked about, as well as aftermarket service revenue which was strong this quarter. Going forward, I expect to see some lumpiness in the near-term—we're seeing higher mix on project activity, which is essentially a good sign for us if we see our customers go back to work. So, I expect that as we progress through the year and go into the back half of the year margins will hold and mix will become more favorable and with the productivity gains margins will start to firm up as we exit the year.

Luke Lemoine, Analyst (Capital One Securities)

Okay, very good. I'm not sure what you can say at this point. But has there been any resolution with litigation involving FMC over trade secrets?

Blake DeBerry, CEO

It's a pretty timely question, Luke. Actually, we've just been through about a three-week jury trial, the jury did reach a verdict yesterday. And we received a verdict in our favor, which we are obviously very pleased with that outcome. And I have to say, we are grateful to the judge and the jury for their work on this case, because it really validates the tremendous work of our team to develop this technology. And it was done solely on our own with Dril-Quip resources. And so we are just glad to have that behind us now.

Luke Lemoine, Analyst (Capital One Securities)

Okay, congratulations on that. That's really good to hear. Maybe turning to some operational and strategic items, you've mentioned in recent quarters your efforts to broaden your customer base, including looking at some of your peers as customers—how have these conversations been progressing, how are our peers responding and kind of what's the value proposition for everybody involved?

Blake DeBerry, CEO

Yes, so we're pleased with the initial discussions that we've had with a couple of our peers, primarily focusing on our subsea wellhead products. And really, the value proposition is, in my view, relatively simple. We've done some independent work on wellheads and market providers and we are considered a Tier 1 provider and quite honestly want to be only Tier 1 providers of subsea wellheads in this space. And so that gives us the ability to provide a wellhead system to one of our peers that gives the latest technology to the end user. And that's why I always find this—it's one of those rare circumstances where you have a win-win-win scenario: it's a win for Dril-Quip if we follow this model, because we get more volume through our manufacturing facility and reduce our manufacturing overhead. It's a win for our peer—they get the latest technology to offer to the customer end user, but they can also choose to exit that market if they choose to and reduce their costs. And it's definitely a win for the end user, because they're not tied to one specific set of equipment through some EPC contract that's all bundled together. They get the best of breed in multiple classes of equipment. And so I think it's going to be a positive outcome and the conversations are continuing. And we're hopeful that we make some progress this year.

Luke Lemoine, Analyst (Capital One Securities)

Okay. We talked about the downhole tool business a little bit earlier. Your good quarters there are making a lot of progress. This is the legacy TRW Corporation that was acquired in late 2016—we talked about it could be lumpy this year just quarter-to-quarter. But when you look longer term, kind of multi-year, how do you modify your operations or business strategy? And what are your expectations kind of over a multi-year period for this?

Blake DeBerry, CEO

Hey, Raj, you want to take this question?

Raj Kumar, CFO

Yes, I'll take that, Blake, thanks. So first Luke, we brought in a new leader to that business and this individual has experience in the downhole tool business. He led the strategic review of what needs to be done in this business to grow it. And from that we've made some inroads into standardizing our product offering. So that allows us to stock more easily. If you look at this business, it's a quick-turn, quick-execution customer base; the customer places a high level of importance on service quality and execution. And, as Dril-Quip, customer satisfaction is our #1 priority. You saw the results of the EnergyPoint survey that point to that. So that's how we've approached it. We have closed down some locations that we deemed are not performing. And we have become more focused on the markets where we are a leader and the markets where we expect there's going to be growth. So if you think about the Middle East, Latin America and the deep-water space, that's where we're going to be focusing the downhole tools business. And as you can see from Q1 results, setting aside the lumpiness over the year, I think we're well on our way to make good year-over-year progress in this segment.

Luke Lemoine, Analyst (Capital One Securities)

Got you. In the past year, you've been highlighting the e-Series product line. How are you progressing gaining acceptance for these products with your customers? And what are the challenges you're seeing in terms of adoption? And what are your goals for these technologies in the future?

Blake DeBerry, CEO

So yes, it was actually a good quarter for our e-Series products. All of these products that we've developed over the last several years are bundled together with one primary goal, which is to structurally change how our customers drill wells to provide them permanent cost savings. And in Q1, we ran our first Big Bore IIe, which was a success. And it's always good to get that first one done; we talked about what are the impediments—the largest one is usually that somebody has to have done it first. So the first Big Bore IIe is in the ground. Also in Q1 we ran our first X Pack TE, so that has been done as well. So those are all positive signs. We've been speaking with our customers about how all these products work together to reduce time and mitigate risk and lower the carbon footprint for our customers. And I think this is a very attractive proposition for them. We're continuing to invest in technology. We've applied for another spotlight award, we'll see what OTC does for a new e-Series product coming out. And hopefully we'll see more of that in the coming months that's accepted. And we're going to market that whole series pretty heavily here coming up.

Luke Lemoine, Analyst (Capital One Securities)

The VXTe has been a product that you've shown enthusiasm for during the past year and even received some attention from your peers, so any update you can provide in terms of how the marketing of this product is going, and when you could see some of these trees booked and possibly the first VXTe installed?

Blake DeBerry, CEO

Yes, that's a fair statement—I am very bullish on VXTe, I think it is one of the most disruptive pieces of technology in the subsea development space. But in all honesty, the lawsuit did put a damper on some of our marketing efforts and put that on pause. We had customers that said, 'Hey, I like the product, but I don't want to get tangled up in the middle of the lawsuit.' So I'm going to put it on pause until the lawsuit resolved. So they were just waiting to see what happened before fully engaging. So now we believe these discussions are going to pick back up, doing all the trials behind us. And I think that will lead to more bookings and installations in the future. Our first VXTe has been sold; that tree is in final assembly, it should be done here in the next month or so. And so we look forward to getting that in the hands of our customers and this putting for the customer the full value of what VXTe allows you to do, which is you have the tree and stock and they drill the well. And if it is a keeper and commercial, they go ahead and just do the completion right there and land the tree. So it's really a matter of when they're going to have the next opportunity to run it. Once we get that one run—like everyone else, all these other new products—that'll be serial number one behind us. And I think that's when we'll see acceleration of that product into the market.

Luke Lemoine, Analyst (Capital One Securities)

Okay. Raj, we kind of touched on it earlier, but Dril-Quip’s set productivity targets for 2021—you made some progress toward these in the first quarter? How do you expect this progress for the remainder of the year and any challenges involved in reaching these targets? And maybe, if you can just kind of quantify how much of these costs do you think will be fixed versus variable with a market recovery?

Raj Kumar, CFO

So Luke, yes on the productivity gains, right? I'm very happy with the progress we've made in Q1 as I mentioned, we got $2.5 million of savings, most of that was fixed in nature. We would like to see the biggest productivity gains coming in late Q2 into Q3 as we transition the downhole tools business from an in-house manufacturing model to a third-party supply chain model. And that's probably going to be more variable in nature—direct costs related to selling a product. So if I would sum it up fixed versus variable, I would say early gains are more fixed and as we move and progress through the back half of the year, it's probably going to be more variable coming from the downhole tool segment outsourcing initiative.

Luke Lemoine, Analyst (Capital One Securities)

It may be just turning to the market outlook—market for subsea has been very subdued since 2014. As we begin to see some improvement in commodity price and activity post-COVID period, give us a view as to when you could see pricing improve and have you seen competitors react in terms of pricing on fewer available projects?

Blake DeBerry, CEO

So yes it's interesting to look at what's going on in the market. What we're really seeing is on large, what we call mega tenders—pretty high value, large quantity tenders—the pricing seems to be extremely aggressive; that's probably intuitive and what you would expect. And we are seeing a few competitors that are being aggressive in order just to keep their manufacturing facilities open. That's never been our strategy; I'm always happy to say I'm happy to win the second order at good margins rather than cut my margins just to secure the work. On a positive side, Luke, we are seeing some push-outs in delivery, particularly on subsea trees. And that, as you will know, is often the precursor to better pricing for us. So I think there is starting to come some scarcity, and that is always a positive for pricing.

Luke Lemoine, Analyst (Capital One Securities)

A lot of talk about investment from your customers on energy sources outside of traditional oil and gas. How is Dril-Quip preparing for the shift in spending? And how do you see it impacting the demand for your products? And maybe just a tack on to that: how are you looking at ways to potentially mitigate any negative impact on demand in the medium and long term?

Blake DeBerry, CEO

Right. So our view is it's really more of a three-pronged approach. Firstly, oil and gas is still the cheapest form of energy that's going to help improve the lives of a billion people around the world—that's just a reality. But there are things that we can do to help our customers reduce their carbon footprint. That's why we rolled out a marketing campaign for e-Series products called 'green by design.' The VXTe tree for example eliminates 40 tons worth of hardware; that's about 70 tons worth of CO2 that doesn't go in the atmosphere just to make steel. And then you have to look at the whole transportation and manufacturing cycle—you don't have any carbon induced from that. More importantly, when you go into the offshore spread, all of those e-Series products working together save about five days of installation time. So we think of all the vessels out there running diesel engines for propulsion and power and all that—we take five days of that carbon footprint out for our customers. I believe, and I think we strongly believe, going forward that carbon footprint is going to be another element on a bid review, just like price, delivery, quality, reliability—it's going to be carbon footprint. So that's probably number one for us. Right now, there are things that we can do with our existing products that allow us to participate in geothermal and carbon capture or carbon mitigation that are just within our existing product line. So we are doing that right now and participating in that. In the longer term, the strategic view is we're going to follow our customers and maybe look for new customers in that space. We've recently dedicated resources really to focus on energy transition and what other opportunities there are or technologies that may be available for us to use and that really fit with our R&D prowess and strengths.

Luke Lemoine, Analyst (Capital One Securities)

Maybe we could just circle back to the geothermal and carbon capture—some of your products you can point to that could be used there; could you just give us a few examples?

Blake DeBerry, CEO

Yes, so there's a lot of carbon capture and sequestration work that involves injecting carbon in a slurry and then injecting that into an existing reservoir. So that's effectively like a water injection tree, there are some different materials and things that we have to do in that environment, but it's wholly like drilling a well. It's much like drilling a water injection well for waterflood on a field development. And geothermal is really just more high temperature—it's a little bit lower pressure. But we've spent a lot of R&D energy and effort in our HPHT work in Singapore. So we have developed subsea equipment for high temperature environments. And that's something that we can do. So that's pretty easy for us to flip into.

Luke Lemoine, Analyst (Capital One Securities)

Maybe, on the M&A side you've been exploring ways to consolidate through collaboration on subsea equipment supply, but how does Dril-Quip view inorganic M&A or expansion and new products versus developing those capabilities in-house?

Blake DeBerry, CEO

Raj, you want to take that?

Raj Kumar, CFO

Yes, thanks, Blake. So Luke, we're always looking at technologies that accelerate our R&D roadmap—we lead with technology, I think you're well aware of that—but we've said before we know that consolidation needs to take place in the industry. But right now we're not just going to pursue consolidation for consolidation's sake. We have a set of guidelines and we look at this from market share scale, leverage levels and free cash flow generation. So all of these are areas that we focus on when we look at any potential opportunities. I must admit, the bid-ask spread is still wide. So we'll have to see how things develop over the course of this year going into next year. But in terms of technology tuck-ins, that's something that we constantly review. It's active and ongoing.

Luke Lemoine, Analyst (Capital One Securities)

Okay. Turning to your balance sheet—so it's been a strength for Dril-Quip—how are you guys looking at the allocation of excess free cash flow and what scenarios or circumstances would you need to see to consider resuming repurchase of shares?

Blake DeBerry, CEO

We need to be able to show our customers that we have the wherewithal and we are going to be around and we have the balance sheet to support that. If I go back to my earlier comment about a simple capital structure—when I say simple, it's not complicated; there isn't any refinancing risk, we don't have debt or convertibles or any hybrid type of security on our balance sheet. And given the environment we're in right now, where liquidity and credit is challenged in this sector, we believe that having a balance sheet like ours is kind of like a fortress—strong balance sheet to help us drive our business forward.

Luke Lemoine, Analyst (Capital One Securities)

So you've talked about your cash flow and working capital improvements in achieving that 5% free cash flow margin as a percentage of revenue—you exceeded that in 1Q with the working capital benefit. How are things progressing in these areas? And what's the outlook for these targets for 2021? Any challenges or risks in meeting this free cash flow margin?

Blake DeBerry, CEO

So Luke, we're progressing in play. I'm very encouraged by Q1 performance; we had close to $11 million of free cash flow. If I think about what we've done, we've been working on implementing our billing turnaround times, we are looking at milestone payments, we are pushing some of our inventory risks to our suppliers. And what we're basically doing is controlling what we can control on the inventory side. Of course, this won't be immediate—we will need to wait for the inventory to convert before we start seeing the working capital pick up. When I think about challenges in order to reduce inventory, we've made great efforts in looking at substitutions using current inventory to substitute for current sales. But at the end of the day, we need to add bookings to facilitate inventory reductions. We are off to a good start, but we have to see this trend continue. While I say we've stepped up our efforts with collections from customers, we have seen in prior quarters where our customers have held collections and that's caused us to have a detrimental free cash flow number. I am encouraged that our interaction with our customers has picked up. We are in constant communication with them. And I think, especially with our larger customers, there's an appreciation that meeting payment obligations is something that's critical for us at Dril-Quip. We saw good performance in Q1 and I'm hopeful and I expect this trend to continue in 2021.

Luke Lemoine, Analyst (Capital One Securities)

Good—maybe if we could just kind of step back from a high-level view and look at how things are playing out for the first four months of the year relative to your expectations for 2021: where are you seeing more opportunity? Which areas do you think might be further behind in resuming activity? What factors do you think most contribute to seeing improvement across all geographies and customers in the back half of the year?

Blake DeBerry, CEO

So with respect to regional level activities, Norway has been strong—there's been some governmental regulation there that's incentivizing exploration for oil and gas. So that's been strong. South America, Latin America is strong. Mexico's a bit uncertain, because there's some dynamics there. But certainly in the Caribbean, Guyana and Suriname and then Brazil, we think is going to be strong. I think with the improved commodity price, I think we're going to see West Africa pick up. I think Asia will be strong on the gas side down in Australia. So that's a positive. And then a lot of the seas that are in countries that are not net exporters of oil and gas are strong, because they're developing their oil and gas reserves for internal consumption and so that business continues. The Gulf of Mexico has been a little bit weak. I think that's something to do with uncertainty around the regulatory environment in the U.S. I hope that mitigates; certainly it's a world-class resource out there. But I like our position. We are not scrambling to figure out how we reduce the carbon footprint for our customers, which is becoming more and more important. This is something we've done as a business since its inception back in 1981—how do we help our customers do things faster and safer and smarter. And by doing things faster and safer and less costly, we also have the benefit of reducing the carbon footprint. So I think we have the right suite of products that can help our customers. I'm incredibly excited about VXTe—I think it's going to be game changing. It's just so much simpler than what's been done in the past. And I think the outlook for Dril-Quip is positive once demand for oil and gas starts recovering.

Luke Lemoine, Analyst (Capital One Securities)

Okay, good. Well, we kind of breezed through all the questions I had. And I think you hit a lot of the high points in that last question. But any closing remarks you wanted to make, Blake?

Blake DeBerry, CEO

Really just in closing, I just want to say to the employees of Dril-Quip: 2020 was tough. 2021 we're starting to see recovery. And I appreciate all the efforts of our employees globally. We're—in the U.S. we're back into the office in mid-May. And I'm looking forward to that. So we will end the work from home there. And I think, you know, 2022—if the vaccines continue to roll out and the economy starts to open up, people start to travel, I think the future's looking pretty good for Dril-Quip.

Luke Lemoine, Analyst (Capital One Securities)

Good. Blake and Raj, really appreciate you all taking the time to chat about Dril-Quip and hope you all have a great weekend.

Raj Kumar, CFO

Thanks, Luke.

Blake DeBerry, CEO

Thank you, Luke. I appreciate it.

Luke Lemoine, Analyst (Capital One Securities)

Okay. Take care.

System, Transcript Note

End of Q&A: