Earnings Call Transcript - KNTK Q2 2023

Operator, Operator

Good morning, everyone, and welcome to the Kinetic Second Quarter 2023 Results. My name is Chach, and I'll be coordinating your call today. I'd like to hand you over to Maddie Wagner to begin. Maddie, please go ahead.

Operator, Operator

Thank you. Good morning, and welcome to Kinetic's Second Quarter 2023 Earnings Conference Call. Here with me is our President and Chief Executive Officer, Jamie Welch, as well as Matt Wall, our Chief Operating Officer; Steve Stellato, our Chief Accounting and Administrative Officer; Anne Psencik, our Chief Strategy Officer; Trevor Howard, our VP of Finance; and Chris Kendrick and Tyler Milam, our VP of Commercial. The press release we issued yesterday, the slide presentation, and access to the webcast for today's call are available at www.kinetics.com. Before we begin, I would like to remind all listeners that our remarks, including the question-and-answer section will provide forward-looking statements, and actual results could differ from what is described in these statements. These statements are not guarantees of future performance and involve a number of risks and assumptions. We may also provide certain performance measures that do not conform to U.S. GAAP. We've provided schedules that reconcile these non-GAAP measures as part of our earnings press release. After our prepared remarks, we will open the call to Q&A. With that, I will turn the call over to Jamie.

Jamie Welch, CEO

Thank you, Maddie. Good morning, everyone, and thank you for joining our call today. Yesterday, we reported our second quarter 2023 results, in line with our internal budget and slightly better than consensus estimates. The results further build off the momentum of our first quarter. Following record processed gas volumes in April, we continue to experience volume strength during the quarter, processing an average of 1.48 billion cubic feet per day and setting a new company record for quarterly processed gas volumes. This represents approximately 10% growth quarter-over-quarter and is attributed to the elevated development activity that typically occurs throughout the second and third quarters combined with encouraging producer well results. During May and June, our processed gas volumes were impacted by record high temperatures experienced in West Texas. The extreme heat affected producers, utilities, and service providers alike as they worked tirelessly to maintain their mechanical equipment run times and overall production. In fact, this past June in West Texas was the hottest in over 10 years, with temperatures consistently exceeding 100 degrees for half the month. Our operations team has gone above and beyond battling the summer heat while endeavoring to ensure smooth and reliable service for our customers. Therefore, despite the weather-related challenges, we still had a record quarter, thanks to our operations team. We remain on track to meet or exceed our 2023 exit rate guidance of 1.6 billion cubic feet per day. This is predicated on our constantly growing customer base, step-ups in contractual volume commitments occurring this summer, and the commencement of new contracts later this year. As we enter the second half of the year, 2023 adjusted EBITDA continues to trend towards the high end of our guidance range of $800 million to $860 million. We forecast sustained growth quarter-over-quarter, primarily driven by midstream logistics volume growth and the commercial in-service of Delaware Link and the PHP expansion in the fourth quarter. By year-end, our annualized adjusted EBITDA should be well over $900 million. Our operations team has continued to lead by example, and as a result, our unit operating expenses are expected to decline throughout the remainder of the year and come in below budget. Additionally, current commodity pricing forecasts indicate an improved outlook in the second half of the year as compared to the first. Our 2023 capital expenditures are expected to be at the top end of our guidance range, largely driven by incremental capital spending on PHP. It is worth noting our midstream logistics and Delaware Link capital spending is tracking at the low end of our guidance. Our 2024 free cash flow outlook remains robust as we anticipate significant adjusted EBITDA growth year-over-year, coupled with capital expenditures below $150 million. Moving to our growth projects, Delaware Link is ahead of schedule. Construction is progressing well, and we are now targeting mechanical completion in September and commercial in-service on October 1. Once in-service, Delaware Link will directly connect three of our processing facilities to Waha, providing enhanced system reliability and flow assurance to our customers. Progress continues on the PHP expansion, and the project remains on track for expected in-service by December 2023. Our New Mexico gathering system expansion into Lea County is on schedule and is expected to be mechanically complete in January, with the gathering and processing agreement now underpinning that project commencing at the beginning of April. During the second quarter, we executed a gas gathering and processing agreement with a new customer in Lea County supported by a multi-year minimum volume commitment. The contract is expected to commence following the in-service of the pipeline into early 2024. We continue to have constructive commercial discussions with several New Mexico producers, both existing relationships and several new to Kinetics. And we're excited about the opportunities to grow our business in the Northern Delaware. Following the in-service of Delaware Link, the PHP expansion, and the New Mexico gathering expansion, we will be able to provide a highly competitive integrated wellhead to Gulf Coast solution to New Mexico producers for residue gas and natural gas liquids. Moving to the Texas side of the Delaware Basin, we identified a handful of commercial opportunities, particularly with private producers. In the second quarter, we executed several gas gathering and processing agreements with new customers that have plans to bring on incremental production later this year, and additional development next year. Our commercial team has done a terrific job building partnerships with new customers and meanwhile growing our existing relationships. We have grown our customer base by over 25% following our merger last year, and today, our midstream logistics customer count stands at over 35. We also want to congratulate Chevron on the closing of its PDC acquisition and look forward to working more closely with them as a major customer within our midstream logistics segment. Finally, we released our 2022 sustainability report last week. Our company has made meaningful progress advancing our sustainability initiatives over the past year. I highly encourage you to take a look at the report if you have not yet done so. I am proud of the progress that we made in 2022 and look forward to our continued improvement and achievements. With that, I'd like to now hand the call over to Trevor Howard, our VP of Finance.

Trevor Howard, VP of Finance

Thanks, Jamie. We reported adjusted EBITDA of $208 million in the second quarter of 2023. Looking at our segment results, our Midstream Logistics segment generated an adjusted EBITDA of $138 million in the quarter, up 15% quarter-over-quarter. This was largely attributed to strong process gas volume growth in the quarter. Regarding the segment's fee-based revenue growth, the second quarter of 2023 was up 10% versus the second quarter of 2022. As Jamie mentioned earlier, operations and the rest of the Kinetic team have done a tremendous job managing costs despite difficult operating conditions and inflationary pressures. The second quarter midstream logistics OpEx came in 3% below budget, and we expect these lower realized costs to carry through in the third and fourth quarters. By the end of 2023, we anticipate unit cost per MCF to decrease by approximately $0.02 from the second quarter as OpEx is effectively flat and volumes continue to increase. Together, we estimate unit cost decreased 8% year-over-year. Shifting to our Pipeline Transportation segment, we generated an adjusted EBITDA of $75 million, up approximately 6% year-over-year. Growth within this segment was driven by volumes and margin expansion at the Shin Oak and Epic Crude pipelines. We remain highly focused on derisking our future earnings potential and our balance sheet. During the second quarter, we reduced our remaining 2023 commodity-linked gross profit to 5%, and we will continue to opportunistically hedge our remaining 2023 exposure. We have also shifted our focus to derisking 2024 and beyond. To date, we have hedged over 20% of our 2024 commodity-linked gross profit exposure, much of which took place in July as the market rallied and we were selling into strength. It is worth noting that in 2024, we expect Kinetic's commodity-linked gross profit as a percent of total gross profit to decrease by approximately 10% to 9% as our new growth projects, which primarily carry minimum volume commitments, are placed into service later this year and early next. On floating interest rates, we have approximately 90% of our total debt capital either fixed or swapped at fixed rates to at least June of 2025. While we continue to opportunistically derisk our balance sheet, we are currently comfortable with our fixed to floating rate mix. Next, from a capital investment standpoint, total capital expenditures for the quarter were $195 million; $65 million was within our midstream logistics segment and $130 million was at the pipeline transportation segment. We have seen tremendous capital cost control in the midstream logistics segment, which offsets some of the cost increases on our non-operated pipeline side. For the quarter, we generated an adjusted distributable cash flow of $144 million. And turning to the balance sheet, Kinetic exited the quarter with a 4.1x leverage ratio. On July 20, we declared a $0.75 per share quarterly dividend to be paid on August 16. During the quarter, we opportunistically repurchased approximately 112,000 shares or $3.3 million under the previously announced $100 million repurchase program. Year-to-date, we have repurchased approximately 194,000 shares for $5.8 million, leaving $94 million of remaining authorized capacity for share repurchase. The repurchase of KNTK Class A shares partially offset share issuances under the second quarter DRIP in August. And with that, I would like to open the lines for Q&A.

Operator, Operator

Our first question comes from Spiro Dounis from Citi.

Spiro Dounis, Analyst

First question, maybe just to start with growth and some of your available capacity going forward. It sounds like a lot of commercial momentum. So I know in the past, you've alluded to the potential to expand on the processing side. It sounds like that was further away. Just want to get an update on where that stands now? And when you think further downstream from there, do you have enough downstream capacity right now to facilitate all this commercial momentum?

Jamie Welch, CEO

Thank you for your question, Spiro. Regarding our processing capability, I believe that deciding on a new processing facility in the second half of 2024 is prudent. This facility would likely be operational by the end of 2025 at the earliest, or possibly the very beginning of 2026, depending on factors such as the supply chain and logistics. We currently have adequate capacity for NGLs, along with the flexibility we need, as well as sufficient capacity on PHP. We feel confident about our customer outlook moving forward, and this will not affect our capital expenditure plans for next year. The $150 million budget accounts for at least a deposit and likely one milestone payment for a box, keeping us around that budget. If growth continues to accelerate, we can reassess. We aim to maximize efficiency within our existing operations, as demonstrated by our successful expansion of Diamond Cryo by 120. Matt and his team will work to maximize output from Toya and Pecos Bend while maintaining high recovery rates and excellent customer service.

Spiro Dounis, Analyst

Got it. Helpful color. Second one, maybe just going to GCX. Looks like you are still exploring the sale there, and I think a lot of us sort of expected maybe a potential deal to close by now, but I know since that last discussion, I guess it sounds like KMI is now exploring an expansion of that pipeline, which was not originally in the plan, I suppose. Curious how much of that is sort of impacting the sales process now?

Jamie Welch, CEO

That's a very good question regarding GCX. Yes, we are currently in the second round of discussions and have several parties involved in the process. You're correct, as highlighted by Kinder Morgan's recent conference call, where they revisited the idea of expanding GCX. This is likely influenced by the successful Final Investment Decision for next decade LNG. It's clear that nearly 12.5 Bcf a day will be directed to Agua Dulce, while the current capacity is only between 6 and 6.5 Bcf a day. Therefore, there is a significant need for additional capacity. I believe the chances of this expansion happening are quite favorable. As the owner of GCX, it is our responsibility to ensure we secure the best price, including for the expansion, because we share the belief, similar to Kinder Morgan, that this expansion is likely to occur in the near future.

Operator, Operator

The next question on the line is from Neel Mitra from Bank of America.

Indraneel Mitra, Analyst

I wanted to touch on capital allocation going forward. I know the goal is to ultimately get to investment grade as well as turn off the DRIP. So just wanted to understand kind of the order of events here. So it sounds like GCX is still very much on the table. There's likely going to be some sort of expansion, and that's probably holding up some things. Then after that, do we look to turn off the DRIP first? Or do we look to keep the DRIP to get to investment grade then turn off the DRIP? I'm just trying to understand which one is the priority first: getting to investment grade or turning off the equity issuances?

Jamie Welch, CEO

Neel, it's a really good question, and it's something we discuss a lot internally. So obviously, the element at GCX maximizing the value, particularly with the likelihood of the expansion of that particular pipeline. We intend to reduce to at least the minimum level, if not terminate the DRIP for the remainder of its existing term, which would be 2 quarters: the third quarter and fourth quarter of this year. Our viewpoint is that the business remains even more robust than we expected. We do not see a need to continue to worry about the dividend reinvestment plan in order to achieve our 3.5x leverage target, which we think is a controllable outcome. Investment grade is somewhat out of our control because we are reliant on two or three other parties to make determinations on our overall credit standpoint. We know what we need to do within our control, and I think it will be as we think about the business right now, it is stronger than we anticipated, both for 2023, being at that high end of guidance and '24 being a significant step change as far as EBITDA is concerned. So I think we have a lot of conviction that the dividend reinvestment plan will no longer be required. I think, Trevor, if I'm not mistaken, we get through this third quarter; we're cash flow positive all the way through from there on out.

Trevor Howard, VP of Finance

Yes, that's exactly right. So as Jamie mentioned, turning off the DRIP or reducing the DRIP meaningfully or turning it off for the third and fourth quarter dividend payments is the plan. We intend to delever with excess free cash flow beginning in the fourth quarter of this year and 2024 until we hit that 3.5x leverage target. Then thereafter, it will be a mix of repurchase and dividend growth.

Indraneel Mitra, Analyst

Okay. Great. And then maybe a broader macro question. It sounds like on the crude side that there were some basin-wide processing constraints because of the heat. You've heard some commentary that some oil producers delayed completions or even shut in some wells during the second quarter due to the midstream constraints because of the heat we've had here in Texas. Did you see any of that with your producers or your underlying growth such that there's a spike in the second half of the year, assuming that we get some relief from heat here in the third quarter?

Jamie Welch, CEO

Trev, do you want to take that?

Trevor Howard, VP of Finance

Yes, we definitely experienced the impact of the higher temperatures in June and July. However, as we look ahead to the second half of the year, we do not anticipate any changes to our overall volumes for the full year. While it wasn't mentioned in our press release or slides, I want to emphasize that we still expect to be tracking towards 1.6 Bcf a day of excess processed gas volumes in 2023. So, there are no changes to our business at this time.

Operator, Operator

Our next question is from Robert Mosca from Mizuho.

Robert Mosca, Analyst

I wanted to ask around your CapEx expectation for next year. I understand that Shin Oak isn't included in that, or expansion of Shin Oak, but is that estimate more like a barebones estimate without any prospective growth projects? I guess I'm just trying to piece out how you can step down to that level and what's currently budgeted.

Jamie Welch, CEO

So Robert, it's Jamie. So good question. I think if you go break down, obviously, our overall guidance, right? So for this year, in midstream logistics, it was $235 million to $265 million. The lion's share of that $235 million to $265 million, on top of what we consider to be regular growth. To us, maintenance growth will be done with much of our integration CapEx; and maybe there's a very small amount for the balance of the PB treating that's going to happen in the very beginning of '24. But that $235 million to $265 million, which was our guidance, a lot of it related to New Mexico. That will be done as far as the capital is concerned, or I would say 90% of it would be done. We don't have another Delaware link on our game board right now. We don't have another PHP expansion that of itself was $255 million to $275 million. So Robert, when we look at it, we say, it's not barebones; we just had a lot of one-off very large items. PHP expansion was one-off, Delaware Link, a New Mexico expansion taking us all the way up into the interior of Lea County. They are not things that we anticipate every year. When we think about our overall step-up in forecasts, we don't have anything right now other than what we've got. We have the East Toya treating that's already online, and we've got PB coming on at the very beginning of next year; that's the remainder of the integration CapEx that we identified as part of the merger. So $150 million, as I mentioned, actually has a decent-sized growth. There is a component of it related to Apache, and from June onwards, we expect that the Alpine High will basically be turned in line. There is some incremental capital there. We also can afford a deposit or a milestone payment in the context of a new Cryo. So the $150 million, we think, has more than enough room in the context of our continued growth.

Robert Mosca, Analyst

That's really helpful, Jamie. And maybe also a follow-up on that capital return outlook. I think it's sounding like that 3.5x leverage is kind of a precondition before you can introduce more buybacks and dividend growth. Is that the right way to think about it? And how early should we expect that to happen? It sounds like the majority of the GCX proceeds will be used to address the DRIP.

Jamie Welch, CEO

Our viewpoint is that in 2024, we expect to meet the 3.5x leverage target at some point during the year, whether that’s at the end of the year or around 12 months from now. We will continue to assess the overall forecast as we progress through the year. The forecast is strengthening day by day, and Anne Psencik has effectively managed our hedging strategy. We’ve taken significant steps to get ahead, with over 20% of our total exposures hedged out through 2024. While I believe we will achieve this in 2024, I cannot specify the exact date we will reach that milestone.

Operator, Operator

Our next question is from Tristan Richardson from Scotiabank.

Tristan Richardson, Analyst

Just looking at your slides, can you talk a little bit about your EBITDA target of $1 billion, maybe some of the things that need to happen to achieve that target? And then is that on the asset base you have today with Delaware Link PHP in New Mexico? Or does it presume additional infrastructure like a processing plan you've been talking about?

Jamie Welch, CEO

Short answer is, Tristan, it assumes same-store sales. So it's taking what you have and, obviously, in the context of our existing asset footprint and actually seeing that maximize the overall cash flow profile that we can actually harvest from that footprint. So it doesn't involve an incremental processing train. That would obviously just be over and above that target. This is sort of the target that we've got out there that we want to think about in the context of 2024; I mean we see where consensus is sort of in the $950 million or sort of there at $940 million, $950 million, I think, is it for EBITDA. We realize there are some things, and I think Matt and the operations team have done a great job. As I said, the commercial teams are doing a great job. There are really good prospects with some solid fundamentals that we can achieve our targets. So that's our goal, and that's how we think about it. So it doesn't involve anything necessarily further.

Tristan Richardson, Analyst

Appreciate it. Can you talk a little bit about the contracting environment in New Mexico? You mentioned that there are some early discussions with potential new relationships. What is the current landscape regarding Eddy and Lea? Are there still large packages available, and what are you observing in New Mexico?

Jamie Welch, CEO

Sure. Chris, Tyler, do you guys want to jump in?

Chris Kendrick, VP of Commercial

Yes, Tristan, this is Chris Kendrick. Thanks for the question. So, and then I'll let Tyler chime in. We see New Mexico as a great growth opportunity. Rig count up there exceeds what we're seeing in Texas. We've been successful filling up the 20-inch line and see some growth out there, both with new and existing customers. It kind of reminds us of the Texas Delaware circa 5 or 6 years ago. There's still a lot of opportunity surprisingly. The reason we got it there in the first place, there are some constraints. We feel optimistic about the continued growth, and we'll continue to pursue those opportunities. Tyler, anything to add on your side?

Tyler Milam, VP of Commercial

Yes, Tristan, thank you for the question. This is Tyler. I want to emphasize what we announced this quarter regarding our recent success. The pipeline isn't operational yet, but we are already observing demand, and customers are demonstrating their commitment to moving forward. So, stay tuned. We are definitely excited about this area.

Operator, Operator

Our next question is from Keith Stanley from Wolfe Research.

Keith Stanley, Analyst

First, just a quick follow-up. When you say the GCX sale, you'd look to turn off the DRIP or go to the minimum level for Q3 and Q4. Can you just remind us what the minimum level of the DRIP is?

Jamie Welch, CEO

20%.

Keith Stanley, Analyst

20%. Okay. And then a second follow-up on New Mexico. Is there any way or any disclosure you can give on a sense of how much volume you've either contracted on that New Mexico pipeline at this point? Or any rough sense or a way to think about how much incremental volume you expect on the system from that line coming on next year and then through 2025?

Jamie Welch, CEO

That's a great question. We need to consider how to address that in our disclosures. As you may remember, we've previously mentioned figures around $80 million to $90 million, reflecting less than a 4x build, which indicated the initial underwrite. Fortunately, the situation has improved. The new MVC we have is about 20% of the size of the one that was originally tied to the anchor. That's still a substantial size, and we recognize the importance of the anchor to our expansion. We'll explore how to share that information so that you have a clearer understanding, as we're quite enthusiastic about it and want to ensure it's communicated effectively.

Operator, Operator

The next question is from Jeremy Tonet from JPMorgan.

Jeremy Tonet, Analyst

Just wanted to come back, I guess, to the EBITDA trajectory outlook here. Again, as you talked about December 2023, over $900 million there. I think you've referenced $950 million Street consensus for '24. Just wanted to see how should we be thinking about that? Is that kind of like it stairsteps into $900 million run rate, and there's slight growth over there in the $950 million, 2024 for Street consensus makes sense? Or I just want to make sure I understood correctly there.

Jamie Welch, CEO

Well, I think what we have said is, yes, it's well over $900 million. Let's just start with that. I referenced the $940 million to $950 million, which I believe is where consensus is, and I suppose the easiest way to say it is that consensus doesn't trouble us.

Trevor Howard, VP of Finance

Jeremy, regarding cadence, unlike 2023, where we experienced a trough in the first quarter followed by a gradual increase, I would say that as we look ahead to 2024, it appears to be relatively flat. There are some variables to consider with commodity price trends, but overall, it won't resemble the sequential increases we witnessed in 2023.

Jeremy Tonet, Analyst

Got it. That's helpful. I wanted to turn to the business for a moment and discuss some of your larger third-party NGL pipeline and frac commitments, including when some of those might start to expire. Once they expire, would you consider building your own frac or explore other ways to maximize the value of that long NGL position?

Jamie Welch, CEO

Yes, sure. So we have, let's say, shorter-term arrangements on the NGL side with Lone Star. They are plant dedications for East Toya and for Pecos Bend. They roll off in 2026. As it relates to Targa, it's a longer-dated contract out into the early 2030s. I think they're about a similar time frame for the enterprise relationship that we have on Shin Oak. It's clear to me that we'll think about what to do on how to maximize the value for our producers, because at the end of the day, our business is keyed off the attractiveness of the netback for our customers. But in the near term, the only thing to play for in the next several years will be that Lone Star roll-off, and then we'll work out what makes sense. As far as investment opportunities, we've got enough on our plate to get through now. We can worry about that at a later point. Obviously, we wait for further updates on exactly what is or what will not happen with Shin Oak. We've got enough capacity on Shin Oak that makes us comfortable as far as what we've got moving on from an NGL standpoint, both now and going forward. I think we are open to outcomes. We'll see what happens, see what comes our way. If it's particularly attractive and compelling, then we'll think about it. But for now, it's not built into our base plan at all.

Operator, Operator

We have no further questions on the question queue. So we will now conclude today's conference. Thank you all for joining. You may now disconnect your lines, and enjoy the rest of your day.