Kodiak Gas Services, Inc. Q3 FY2023 Earnings Call

Greetings, and welcome to the Kodiak Gas Services Third Quarter 2023 Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Graham Sones, Vice President of Investor Relations. Thank you. You may begin.

Good morning. We appreciate you joining us for the Kodiak Gas Services conference call and webcast to review third quarter 2023 results. Participating from the company today are Mickey McKee, President and Chief Executive Officer; and John Griggs, Chief Financial Officer. Following my remarks, Mickey and John will provide a high-level commentary on the company, our market, third quarter financial results and our updated 2023 outlook before opening the call for Q&A. Before I turn the call over to Mickey, I have a few housekeeping items to cover. There will be a replay of today's call available via webcast and also by phone until November 16, 2023. Information on how to access the replay is to be found on the Investors tab of our website at kodiakgas.com. Please note that information reported on this call speaks only as of today, November 9, 2023, and therefore, you're advised that such information may no longer be accurate as of the time of any replay or transcript reading. In addition, the comments made by management during this conference call may contain forward-looking statements within the meaning of the United States Federal Securities laws. These forward-looking statements reflect the current views, beliefs and assumptions of Kodiak's management based on information currently available. Although we believe the expectations referenced in these forward-looking statements are reasonable, various risks, uncertainties and contingencies could cause the company's actual results, performance or achievements to differ materially from those expressed in the statements made by management. And management can give no assurance that such statements or expectations will prove to be correct. Listeners are encouraged to read Kodiak's prospectus and quarterly report on Form 10-Q available on our website or sec.gov to understand those risks, uncertainties and contingencies. The comments today will also include certain non-GAAP financial measures. Additional details and reconciliations to the most comparable GAAP measures are included in the quarterly press release, which can be found on our website. And now, I'd like to turn the call over to Kodiak's CEO, Mr. Mickey McKee. Mickey?

Thanks, Graham, and thank you all for joining us today. I'll start by discussing our recently announced inaugural dividend payment to our shareholders. Then I will share some highlights from the third quarter and ultimately provide some commentary on the industry and our company. When I'm finished, John will provide additional financial details from the third quarter and discuss some updates to our 2023 outlook. We are excited to have announced our first quarterly dividend on October 24. Our Board declared a dividend of $0.38 per share for the third quarter of 2023 or $1.52 per share on an annualized basis. The stable positive cash flow provided by our resilient business model supports returning capital to shareholders through a well-covered dividend. We believe that with the initiation of our dividend, Kodiak represents one of the most compelling yields in midstream energy today. It is an important part of our capital allocation strategy that also involves reinvesting a portion of our cash flows to grow our fleet, given the attractive returns we see in the current market environment. To be clear, we intend to generate positive free cash flow after growth capital and dividends are funded, while driving towards our long-term leverage target of 3x to 3.5x. Now turning to yesterday's earnings release. We are very pleased with our third quarter results, which reflect the continued execution of our strategy, focused on deploying large horsepower compression infrastructure assets in high-quality basins with the best customers. The compression market remains tight as many of our competitors are near full utilization of their deployable assets, and we are well positioned as the compression provider of choice for our customers. To touch on a few highlights from the third quarter, we maintained our industry-leading utilization rate, ending the third quarter at 99.9% utilization. We have maintained this high utilization rate for years, and now this has allowed us to deliver record revenues of $186.7 million from compression operations and consolidated adjusted EBITDA of $110 million for the third quarter. Both are the highest figures on record in Kodiak's history. As we have discussed many times, our methodical and intentional deployment strategy of our equipment and contracts generates highly visible, steady cash flows that create very compelling infrastructure investment opportunities. As we look forward to the fourth quarter and next year, our new unit deliveries are completely contracted and are exclusively large horsepower units. As I mentioned on our last call, we know the cost of the equipment, the customer it will be deployed with and the contract rate predetermined. And because equipment lead times remain extended at about a year, we're already in discussions with our customers related to new equipment orders and customer contracts into 2025. We're also pleased to be in a position to update some of our previously disclosed guidance ranges for the full year 2023. We are raising the low end of our guidance and now anticipate record adjusted EBITDA of $430 million to $440 million. John will cover a few other guidance updates. I provided a detailed background on Kodiak on our second quarter call for those of you not familiar with our story. I won't rehash that in full, but I do want to cover a few things that differentiate Kodiak. Our purpose-built fleet of over 3.2 million horsepower of predominantly large horsepower compression equipment is the youngest, most emissions-friendly fleet in the sector, specifically engineered and built to operate in rich gas environments like the Permian Basin, where over 70% of our horsepower is deployed. We have seen additional consolidation in the Permian Basin from our customer base this quarter. This dynamic is ultimately creating more contiguous acreage positions and allowing for longer drilled well laterals; and ultimately, larger infrastructure build-out, creating more demand for services of a company like Kodiak specializing in large horsepower. We view this consolidation in the industry as a positive as our customer base continues to trim costly overhead and drive down ongoing cash production costs. At Kodiak, we strive to deliver the highest level of service and mechanical availability in the industry, also contributing to the superior utilization of our fleet. We charge a fixed monthly revenue rate for our services and ended the third quarter with less than 7% of our horsepower on month-to-month contracts. These factors combined to help insulate our business from short-term commodity price cycles. Natural gas prices have ticked above $3 recently, but remain low by historical standards. However, our customers, which operate primarily in liquids-rich oil-directed basins, continue to exhibit strong demand for compression services. We continue to be excited about the tremendous amount of LNG export capacity being constructed on the U.S. Gulf Coast and the resulting growth in natural gas production that's needed to provide feed gas to these plants. FERC data indicates that there's almost 14 Bcf per day of LNG liquefaction capacity under construction on the Gulf Coast today, with about 15 Bcf per day of approved projects behind that. Our view remains that the incremental gas will largely come from the Permian and Eagle Ford basins, and we are well positioned as the leader in those basins to capitalize on this growth. As every incremental cubic foot of gas produced out of these basins will need to be compressed multiple times. Additionally, our industry as a whole has shown tremendous capital discipline, while new unit deliveries have extended out over a year with the lack of idle horsepower available to be deployed. This means that the supply side of our industry will remain very tight with little relief on the horizon. So to quickly recap, we are pleased with our third quarter results and continue to believe in a supportive energy market with a multi-decade runway for conventional energy and particularly large horsepower compression to feed the growing LNG export base on the Gulf Coast, providing clean, secure supplies of natural gas to the world. Our strategy is to continue to provide compression services safely and sustainably in the best basins with the best customers, while providing investors with an attractive return on their investment through steady growth in cash flows and a compelling dividend. Now, I'll hand the call over to John to discuss our financial results for the quarter and 2023 outlook, and I'll come back with some closing comments before we move into Q&A. John?

Thanks, Mickey. As Mickey emphasized, it's a wonderful time to be in the contract compression business and an even better time to be at Kodiak. Here are some of the results from the quarter. Total revenues for the third quarter were approximately $231 million, up about 14% sequentially and 27% compared to the third quarter of last year. Adjusted EBITDA for the quarter was $110 million, up over $2 million or 2% from Q2, and up over 8% versus the same quarter of last year. Both metrics exceeded our expectations. And since you'll see it in our 10-Q later today, I'll mention it now. Adjusted EBITDA for the quarter included an approximate $2 million allowance for doubtful accounts related to a particular compression customer in the midst of a restructuring. Excluding the impact of that reserve, adjusted EBITDA for the quarter would have been about $112 million. Looking at our segments, Compression Operations revenues were nearly $187 million, up about 14% year-over-year. Revenue-generating horsepower grew by about $112,000 on a year-over-year basis. Consistent with last quarter, revenue growth in this segment was a function of growth in revenue-generating horsepower combined with higher overall fleet pricing. In our Other Services segment, 2023 third quarter revenues were up substantially compared to both last year's third quarter as well as the prior quarter. This was driven mostly by quality execution and faster-than-expected progress on some project completion schedules in particular on one relatively large job. From an adjusted gross margin perspective, our Compression Operations segment generated just shy of a 65% margin, up 70 basis points compared to the second quarter. Our operations team continues to focus on containing costs that are within our control. We continue to chip away at some of the margin compression we experienced in the last couple of years from acute inflationary pressures. On a dollar basis, adjusted gross margin in our Other Services segment was about $5.5 million, up nicely from the prior quarter. From an adjusted gross margin percentage basis, the margin came in at 12.4%. As we've discussed, each project is different, and our third quarter margin percentage reflects a couple of larger projects that carried lower-than-normal margins. As a reminder, while the segment has a lower margin profile in our core Compression Operations segment, station construction projects are synergistic with our compression business and they require no capital. Every dollar of incremental cash flow adds to both our overall return on capital employed and discretionary cash flow, which in turn allows us to pay more dividends and invest in high-return growth projects. So as long as we manage our contractual and operating risks and project-related working capital carefully, this work is beneficial to Kodiak and our investors. In terms of CapEx, for the quarter, our maintenance CapEx was about $12.3 million, a bit higher than the prior quarter. Growth CapEx was $56 million for the quarter and $3.5 million of that amount was non-new unit CapEx. We've mentioned in the past that growth CapEx in 2023 would be back-end loaded. So you saw that in Q3, and you'll see it again in Q4. Moving to the balance sheet. So as a quick reminder, we received the proceeds from our IPO on July 3, and simultaneously completed the paydown and novation of the term loan we described in our S-1. That reduced our debt by $1 billion. At the end of Q3, we had debt of $1.78 billion, consisting entirely of borrowings on our $2.2 billion asset-based loan. Our credit agreement leverage was 4.07x, and we had about $396 million in borrowing capacity at quarter end. With our IPO and associated deleveraging complete, we think we're well on our way to achieving our long-term leverage target of 3x to 3.5x during 2025. We continue to benefit from our interest rate swaps on a little less than 70% of our debt that fixed our interest rate well below prevailing floating rates. Now let's move to our updated 2023 outlook. Given the clarity that we've received from our third quarter results and our expectations for Q4, we included updated full year '23 guidance in our earnings release yesterday. For the year, we estimate adjusted EBITDA will range between $430 million to $440 million. In our core Compression Operations segment, we're sticking with our prior revenue and margin guidance. Bottom line, given the constructive market dynamics alongside our crisp execution, we're highly confident in our segment outlook, and we're laser focused on growing long-term high-quality cash flows. In our Other Services segment, we now forecast full year revenue of $95 million to $115 million, and segment margins of 15% to 17%. We're providing a pretty wide range to account for some of the things that we can't control, but can have an impact on outcomes, particularly in the fourth quarter, things like weather events, customer budget exhaustion and customer or subcontractor holiday season work schedules. If we have smooth sailing on those items, then we'll likely be at the high end of our range on both revenues and margins. And though we're not giving official guidance for 2024 until we deliver our full year 2023 results, we do think this year is an outlier to the high side in terms of station construction projects and revenues. For adjusted SG&A, believing the guidance remains as is, but we noted in our release that we're not including the $2 million allowance for uncollectible accounts that we took this quarter since that was an isolated noncash event; we wanted to keep the guidance focused on normalized expenses. Turning to CapEx, for the year, we now see maintenance CapEx coming in between $34 million and $38 million. Our maintenance CapEx spend is largely predicated on the agent hours of our units. So the slight move up in guidance is related to the timing of when our team tackles the scheduled overhauls. We're working to get a few more things done this year in that area than we previously anticipated. On the growth side of CapEx, we're leaving our prior guidance alone. Included in the forecast is about $15 million in non-new unit-related CapEx, which at the midpoint of our updated guidance, would suggest that we'll be adding just shy of 140,000 of new horsepower during the year. Last thing on CapEx. Recently, our landlord on a few of our more significant operations facilities approached us with a compelling package deal to buy them out of the properties. It's got a few moving parts, but assuming everything comes together as planned, we would incur an incremental $10 million in real estate-related CapEx during the fourth quarter. We've not included that in our updated guidance, which should it occur, we'll still be free cash flow positive for the year. We believe the deal is compelling, and we were faced with imminent and disruptive moves in the near future to accommodate our substantial planned growth. So this opportunistic purchase allows us to control our own destiny in terms of facility and expansion in our most important growth regions and enables our operations leaders to stay focused on taking care of business. To wrap things up, as Mickey noted, our Board declared an inaugural dividend payment of $0.38 per share, and we'll pay that tomorrow. This equates to an annualized dividend of $1.52 per share, yielding nearly 9% of our recent price range. Our capital allocation framework is a crucial aspect of the Kodiak Gas Services investment thesis, measured growth alongside attractive return of and return on capital, while living within cash flow and deleverage. That's it for my prepared comments. Thanks again for your participation and support. I'll turn it back over to Mickey.

Thanks, John. In summary, we've built a market leader in contract compression infrastructure with a focus on large horsepower compression and its critical role in the energy value chain. We've concentrated our purpose-built fleet in the most economically advantageous basins with the best customers under long-term fixed revenue contracts that are resilient to short-term commodity price cycles. We've built Kodiak with a commitment to sustainability. We are very pleased with our third quarter results, our initiation of a meaningful dividend, and we look forward to continued profitable growth in 2023 and beyond. I'd like to close the call by thanking the extraordinary women and men of Kodiak Gas Services. Their hard work and dedication to safety and our customers are what makes Kodiak special, and we wouldn't be an industry leader without their commitment to excellence. At this point, we'll open up the line for questions. Operator?

And our first question comes from Jeremy Tonet with JPMorgan.

I would like to begin by discussing capital allocation in more detail. I understand there will be more to discuss regarding this topic. Given the growing market for compression and the demand in that area, do you currently have a strong dividend yield? It appears that the market is not fully recognizing the value of this yield. As you consider future growth capital expenditures, the possibility of increasing the dividend, or even buying back shares, I’m interested in any high-level insights you might have on these options.

Yes, Jeremy, this is Mickey. I think all of those things are possibilities going forward and things that we will be discussing with our Board more over the next couple of quarters. But I think right now, we're focused on executing the business and making sure that we have a good yield and a return on capital to shareholders and increasing discretionary cash flow, so that we can continue to grow CapEx and dividend over a long period of time.

Got it. That makes sense there. And then kind of pivoting towards the compression market as a whole, very tight market. We've heard about it across the industry how tight it is and the need there. Just wondering, if you could expand a bit more on how you're dealing with supply chain challenges out there servicing your customers, securing large equipment, fulfilling these orders here; given some of the disruptions and tightness that we see out there. Just wondering, if you could talk a bit more about that.

Yes. I mean it's an ongoing management that we have to do with not only our customers but with our suppliers as well to make sure that, a) Our customers are planning out well in advance to secure equipment at this point with Caterpillar engine deliveries out longer than a year. It's a challenge, but it's something that we work on pretty much daily with our customers and making sure that they're in the right position, as well as with our suppliers in making sure that deliveries and the ability for them to produce equipment for us and make sure that it's ready when they say it's going to be ready is something that's an ongoing supply chain management process that we do every day, too. So we are out into discussing Q1 2025 potential equipment needs with our customers right now and looking at a very productive and fully subscribed kind of 2024 year already. So, it's a challenge that we deal with on a daily basis, but it's something that we're used to managing and have been doing this a long time. So, we know how to handle it.

And our next question comes from Theresa Chen with Barclays.

First, I'd like to touch on the comments about 2024, understanding that you're not giving guidance today, but on that fully subscribed asset-level trajectory, can we get some color on the puts and takes on risk to the upside and downside from here, as to how you see both pricing and margins evolving relative to 2023 and even some of the base IPO materials for the 2024 year?

Yes, Theresa, we've worked with these suppliers for a long time. We understand what price increases are coming from them, and we're able to plan ahead. This allows us to price our equipment for 2024 and early 2025 to ensure that we achieve an adequate return on capital investment while aiming to maintain and hopefully expand our margins over time.

Got it. Regarding capital allocation and the small real estate transaction, are there similar opportunities that you foresee in the near term? Or should we focus on using the free cash flow mainly for returning cash to shareholders?

I think that we're going to stick to our kind of stated capital allocation policies that we've had where 35% to 40% of our discretionary cash flow is planned to pay a dividend. And the majority of the balance of that discretionary cash flow will go to growth CapEx. I think this specific real estate transaction was one that was just pretty opportunistic that came along and we said, we looked around and said, 'Man, this is a really good opportunity for us to control our own density' and make sure that we don't have any kind of unforeseen interruptions in our operations group up in the Permian Basin. So, it was something that we wanted to take advantage of, but we were in a position to execute on the transaction and still remain cash flow positive, which is one of our stated goals and still take advantage of that opportunity and save some money in rents along the way. So we decided to take advantage of that. I don't foresee too many significant opportunities like that popping up over time. But if they do, we'll evaluate it and make sure that we're making the right decisions for the business.

And our next question comes from Neal Dingmann with Truist.

Great quarter. Mickey, I have a demand-related question framed differently. You have one of the strongest demand scenarios right now, especially when speaking with customers about 2025. Given that, are you considering structuring longer contracts? What advantages do you see, considering your strong demand picture?

Thank you for the question, Neal. You've touched on an important point. We have been working on several initiatives and have successfully secured longer contract durations over the last year. Our average contract length has increased slightly, which is a positive trend. As mentioned in my prepared remarks, currently, less than 7% of our contracts are month-to-month, and we are focused on converting as many contracts as possible to longer terms. This strategy is aimed at ensuring better visibility of our future cash flows. Additionally, we have been implementing increases in renewal rates to counteract the inflationary challenges we faced last year, while maintaining our margin within the expected range of 64% to 65%. We are optimistic about the potential for continued margin expansion, building on the positive results from this quarter.

No, that's great. Great to hear. And then maybe taking that demand over to John's question. John, because this sort of long-term demand picture you have, does that give you all more confidence? You obviously, really materially raised your distribution, 9% again obviously starts too cheap and that should readjust. But I'm just wondering, does that give you confidence to continue to raise that? Or when you think about the shareholder return, your coverage seems more than ample. So John, just wondering, does it factor in when you're seeing this demand and sort of the certainty around there? Or what drivers sort of help shape that?

Yes. So thanks. As it relates to the dividend, it's all part of that big capital allocation framework that Mickey described a couple of times. We obviously regularly discuss the strategy on capital allocation framework with our Board. For the foreseeable future, we like that 35% to 40% of our discretionary cash flow being paid out in the form of the dividend. If you just roll our business model forward based on '24, '25 and kind of the demand picture that we see, we see the ability to grow EBITDA in that upper single-digit range for the foreseeable future, that would translate into increases in discretionary cash flow. So, we will evaluate growth in the dividends over time, but we do think we'll see growth in the discretionary cash flow to afford it.

Our next question comes from Jim Rollyson with Raymond James.

Congratulations on a successful quarter. Mickey, I wanted to revisit the roughly 140,000 horsepower you expect to deliver this year. You mentioned that you're mostly committed to the orders for next year. As we look ahead, how much additional horsepower do you anticipate being delivered next year? Also, considering the current discussions for 2025, what do you think the growth rate will be for horsepower additions beyond 2023? Any insights on that would be helpful.

Thank you for your question, Jim. It's great to speak with you. We are still finalizing the budgeting process for 2024, so we aren't ready to offer guidance yet. However, I can tell you that the horsepower deployment for 2024 will be similar to 2023, potentially with a slight increase. I expect to see that same trend continue into 2025. As John mentioned regarding our capital allocation strategy, if we can achieve upper single-digit percentage growth in EBITDA, which would also increase discretionary cash flow by the same margin, we could then allocate that growth towards both dividends and expansion over time.

That's helpful. Since no one else asked, I wanted to know about one of your largest customers being taken out early next year. I'm curious about how you view that as a potential opportunity going forward, considering their growth plans.

Yes, Exxon is acquiring Pioneer, which is one of our biggest customers and has been a long-standing partner. We are looking forward to the chance to collaborate with Exxon moving forward. They have ambitious plans for the Permian Basin, and their investment there suggests they have a long-term view on its potential, which is encouraging for our business. Additionally, Exxon is already a smaller customer of ours, so we have an established relationship. We are eager to continue our partnership and become one of their larger suppliers.

Our next question comes from Jackie Koletas with Goldman Sachs.

Just wanted to start more on the cost side. So as we're seeing pricing continue to rise, could you comment on what you're seeing more so on the cost side and how inflation pressures have been abating? And how you see that going into 2024?

Yes, Jackie, thanks for the question. I think we've dealt over the last couple of years with pretty significant inflationary pressures hitting us kind of left and right. And we've combated that as much as we could, and I think we've done a pretty good job of keeping margins pretty flat. So looking towards 2024, I think that we expect those inflationary pressures to kind of abate a little bit and remain pretty flat going into 2024. I think obviously, you'll have some increases from a labor perspective as you do every year. But I think that we're kind of expecting our cost of operations metrics to stay relatively flat next year from the standpoint of costs from our suppliers and lube oil providers.

Okay. Great. And then lastly, just as a follow-up. I know that the cat engine availability overall is now over a year plus. Is it specifically worse than what you saw during the second quarter? And has there been any update from cat on that easing at all either in the near or long term?

Haven't had any updates on that easing anytime soon, so we expect to keep having to deal with that. And it's kind of typical for these kinds of up cycles that those deliveries get out to be that long. Although, we expect for this up-cycle to last longer than traditionally you've seen them in the past, just because we think that the supply side is so depressed, and as well as such incremental high demand for compression services with the dynamic of the fact that the Permian Basin is providing a lot of the gas production growth in the United States, and it requires so much more compression to just produce the Permian Basin gas to get out of their feed LNG plant. So like I said, high, high demand that we foresee for a long time and really tight supply for a long time, so we expect this to continue on. And I don't foresee much relief in delivery times from caterpillar anytime soon either.

And there are no further questions at this time. I'll hand the floor back to Mickey McKee for closing remarks. Thank you.

Okay. Thanks, operator, and thanks to everyone for participating in today's call. We look forward to speaking to you again in the new year and with our fourth quarter and full year 2023 results. Thanks.

Thank you. And we conclude today's conference. All parties may disconnect. Have a good day.