NCS Multistage Holdings, Inc. Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing-by. And welcome to the NCS Multistage Second Quarter 2020 Earnings Conference Call. At this time, all participant lines are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. Please be aware that today’s conference is being recorded. I would now like to hand the conference to speaker today, Ryan Hummer, CFO. Please go ahead.

Thank you, Victor. And thank you for joining NCS Multistage's second quarter 2020 conference call. Our call today will be led by our CEO, Robert Nipper, and I will also provide comments. Before we begin today's call, we would like to caution listeners that some of the statements made on this call could be forward-looking. Our remarks may contain information other than historical information. Please note that we are relying on the Safe Harbor protections afforded by Federal Law. Such forward-looking statements may include comments regarding our future expectations for financial results and business operations and are subject to known and unknown risks and uncertainties, including with respect to the COVID-19 pandemic and its impact on the global economy, oil demand and our company. I'd like to refer you to our press release issued last night along with other public filings made from time-to-time with the SEC that outline those risks. I also want to point out that in today's conference call, we refer to adjusted EBITDA, free cash flow and net working capital, which are non-GAAP financial measures. We use these measures because they allow us to compare performance consistently over various periods without regard to the costs associated with our capital structure and in a manner that we believe better reflects our operating performance. Our press release and the updated investor presentation posted yesterday, which are both available on our website, ncsmultistage.com, provide reconciliations of these non-GAAP financial measures to the nearest GAAP financial measure. I'll now turn the call over to Robert.

Thank you, Ryan. And welcome to our investors, analysts and employees during our second quarter 2020 earnings conference call. I hope that everyone listening today is healthy and safe in these challenging times. The second quarter was by far the most challenging one that we faced. The pace of decline in industry activity in response to the reduction in oil demand and pricing related to the global COVID-19 pandemic was extraordinary. During the second quarter, rig counts in the U.S. and Canada reached multi-decade lows, and U.S. completions activity fell even more swiftly than the U.S. rig count. This contributed to a reduction in revenue for NCS of 84% as compared to the first quarter, which included declines of 78% and 95% for our U.S. and Canadian operations respectively. Our performance in the U.S. in the second quarter was impacted by the waiting that we had with activity in the Permian Basin through Repeat Precision, where many of our customers quickly laid down completion crews and suspended completion operations for much of the quarter. Our U.S. performance was also impacted by the reduction in our tracer diagnostic services business, especially during periods when oil prices were at their lowest given the more discretionary nature of the service. While starting from a low base, I'm encouraged by the rebound in completion activity from the trough experienced in the middle of the second quarter. So far in the third quarter, we've seen an increase in demand in the U.S. for our frac plug product line as well as our tracer diagnostic services. The increase in tracer diagnostics work is also partially attributable to a new service we're offering that provides a lower price point to our customers and reduces the cost of service on our end. NCS continues to be known for this type of adaptation and innovation to draw solutions that benefit us and our customers. In Canada, the weakness in the second quarter was far greater than the typical seasonality we experienced as a result of spring breakup. The rig count began to fall in mid-March and reached a multi-decade low of only 12 rigs in late June. Normally, we would have expected the rig count to start picking up in early June as weather conditions permitted. As with the U.S., Canadian activity has increased from the trough in the second quarter, but the rebound has been muted, with 47 active rigs as of last Friday compared to approximately 135 rigs this time last year. International activity was a relative bright spot for us in the second quarter, with international revenue representing 30% of our total revenue even with shutdowns in Argentina and travel restrictions in other markets negatively impacting our business. We remained active supporting our largest customer in the North Sea, and we were also able to participate in tracer diagnostics projects in Latin America in the Middle East. We made progress during the quarter in qualifying more of our products and services with customers in the Middle East, paving the way for future opportunities in those markets consistent with our objective to continue to increase the share of our revenue generated from outside of North America. In response to the prevailing environment in our industry, we have taken swift and decisive action to lower our cost structure to align with the current and expected level of industry activity. Our earnings release from last night details these actions, though I will touch on a few. Since late March, we made the difficult decision to reduce our workforce by over 45% in the U.S. and Canada, representing a reduction of over 190 employees. In doing so, we have better aligned our field service capability with current market activity levels and significantly reduced our SG&A expense including changes that we believe to be structural in nature that will enhance our efficiencies as industry activity recovers. We have reduced our assembly and fill facility footprint and we'll continue to look for additional opportunities to do so while continuing to reduce our third-party spending across departments, including performing additional work more cost-effectively in-house. With the actions outlined above, as well as other initiatives that we have executed on already, we expect to reduce our reported SG&A expense in 2020 by over $25 million as compared to 2019 and over $30 million if you exclude the approximately $6 million in severance expense that we expect to incur this year. This represents a $5 million increase to the cost reduction expectation that we provided on the last quarter's call. We've also taken actions to further enhance our liquidity. We've reduced our CapEx budget for the year to $2.5 million at the midpoint and expect to generate additional cash through vehicle sales to further reduce our net capital expenditures. We're filing for tax refunds that we expect to receive in the second half of the year. Most importantly, we were able to amend our revolving credit facility to a borrowing base structure that we believe will provide us with enhanced financial flexibility. We generated free cash flow of over $16 million in the quarter and over $19 million in the first six months of the year. This is largely due to the impressive collections performance, especially during the second quarter. While we expect that working capital will reverse from a benefit to a use of cash in the second half of the year, we continue to expect that we will be free cash flow positive for the full year 2020. The next several quarters will likely continue to be challenging for our industry and our company, though we believe that the second quarter represented the trough in the industry activity and that the benefits from the actions we've taken will be demonstrated as activity recovers from the trough levels. Now I ask Ryan to discuss our financial results in more detail.

Thank you, Robert. As reported in yesterday's earnings release, our second quarter revenues were $8.7 million, 78% lower than the prior year’s second quarter. On a sequential basis, revenue in the second quarter was 84% lower than revenue in the first quarter reflecting the steep decline in completions activity in the U.S. and historically low rig count and activity levels in Canada. Gross profit, defined as total revenue less total cost of sales, excluding depreciation and amortization expense, was $2.3 million in the second quarter or 27% of revenue. This compares to $16.7 million or 42% of revenue in the prior year’s second quarter. For sequential comparison, our gross profit was $23.9 million or 44% of revenue in the first quarter. Our gross margin percentage was lower during the second quarter of 2020, primarily due to the sharp decrease in revenue, which led to the under absorption of fixed costs, partially offset by our cost reduction actions that we've taken throughout the year. Selling, general and administrative costs were $15.5 million in the second quarter, which was $7.4 million or 32% lower compared to the $22.9 million of SG&A in the prior year’s second quarter and over $5 million lower than the first quarter’s level of $20.8 million. Our reported SG&A includes share-based compensation and certain non-recurring expenses, including litigation costs and severance expenses. During the second quarter, our non-recurring severance expenses totaled $3.5 million while litigation expenses were a benefit of $0.4 million due to $1.1 million in proceeds that we received from our D&O insurance, reimbursing us for certain legal defense costs. Our adjusted EBITDA for the second quarter was negative $7.9 million as compared to negative $1 million in the prior year’s second quarter. Our depreciation and amortization expense for the quarter totaled $1.1 million, and we had a net loss attributable to non-controlling interest of $0.1 million reflecting a modest loss at our joint venture Repeat Precision. Our average basic and diluted share counts for the quarter were approximately 47.3 million shares. Turning now to cash flow items in the balance sheet. Cash flow from operations for the second quarter was $16.5 million and our net CapEx for the second quarter was $0.2 million, resulting in free cash flow for the quarter of $16.4 million and $19.5 million through the first six months of the year. At June 30, 2020, we had $31.3 million in cash and total debt of $21.4 million, which included $15 million that was drawn under our revolving credit facility, of which $10 million was in the U.S. and $5 million was drawn in Canada. On August 6, we entered into an agreement to amend our existing cash flow-based revolving credit facility into one that is governed by a borrowing base formula tied to our accounts receivable. In doing so, we eliminated certain financial covenants, including our maximum leverage and minimum interest coverage tests. The amendment also reduced the total facility size from $75 million to $25 million and added a new minimum liquidity covenant. In connection with the amendment, we repaid the full $15 million that we had outstanding under the facility at June 30. Following the repayment, we had approximately $12 million in consolidated cash and a borrowing base of approximately $3 million under the amended credit facility. In addition, NCS had net working capital of $48.6 million at June 30, and Repeat Precision also has access to over $9 million in borrowing capacity that is separate from our revolver. Further details regarding the amendment are available in the 8-K that we filed yesterday. As Robert mentioned, we expect the second quarter represented a trough for us for revenue, and we expect third quarter total revenue to increase by at least 75% compared to the second quarter. With increases in completions activity, especially in the Permian Basin, we expect our U.S. revenue to increase by at least 35% sequentially in the third quarter. We expect our international revenue in the third quarter to be roughly in line with the second quarter, with the remainder of the revenue increase related to our Canadian operations as activity increases from the second quarter's historically low levels. The increase in activity and the impact of additional cost reduction initiatives completed in July is expected to improve our gross margin in the third quarter relative to the second quarter with incremental margins expected to be in excess of 40% during the third quarter. We expect our reported SG&A inclusive of share-based compensation, non-recurring items and severance to be between $12.5 million and $13.5 million for the third quarter. This includes approximately $1.6 million in share-based compensation, $1 million in severance expense and approximately $0.5 million in litigation expenses. We expect our third quarter depreciation and amortization expense to be approximately $1.3 million and our net interest expense to be approximately $0.3 million. Our expected growth capital expenditures for the full year 2020 had been revised to $2 million to $3 million, a further reduction from our guidance in May and at the midpoint over 60% below our gross capital expenditures of $6.4 million in 2019. I'll hand it over to Robert for closing remarks.

Thank you, Ryan. Before we open up the call for Q&A, I'll close with a couple of brief comments. We continue to face an uncertain environment and we are focused on the aspects of our business that we control. We've taken actions to structurally reduce our cost structure while preserving our ability to provide exceptional customer service and drive further innovation and value for our customers. We are being very judicious with our capital, but continue to make targeted investments to advance and enhance near and long-term opportunities for our business. We've taken steps to enhance our liquidity and preserve our strong balance sheet. Our revolver is undrawn and we have demonstrated our ability to generate free cash flow. We are positioned to weather the current industry downturn and to benefit from a rebound in industry activity. With that, we'd be happy to take your questions.

Please stand-by, while we compile the Q&A roster. And our first question will come from line now George O'Leary from TPH & Company. You may begin.

Good morning, guys.

Good morning, George.

Good morning.

The gross margin, the decremental margins in the second quarter were pretty impressive given the magnitude of the revenue decline quarter-on-quarter. You guys put out that list of cost reductions that you made in the press release, which is very helpful. I wondered if you could walk through some of the primary structural cost reductions on the costs side of the business. Excluding the SG&A adjustments, things like relocating U.S. assembly operations, I assume would be part of that. But any color on structural costs reductions would be super helpful. And then it seems some of those costs may come back a little bit in the third quarter. Is that part of the driver of the more muted than usual incremental margins or is that more pricing headwinds and things like that?

Yes, so we've made a number of moves that we talked about in the press release. You asked specifically about manufacturing. What we've done with manufacturing is we've lowered our costs because we were under-absorbed in the manufacturing facility that we had. We have a vendor that's been manufacturing components for assemblies for us for a number of years, and they were under-absorbed as well. So we've constructed a deal with that particular vendor. They have now taken on the assembly with some of our employees in-house there to oversee that. So we still have full control over the assembly. However, what's been done is that now, between both of the companies, we are fully absorbed in the manufacturing facility. That move has also reduced our internal costs because of the under-absorption. So we don't expect that to change for the next 12 to 18 months. As we look out into the future, we believe that we may start seeing some recovery later next year. But full recovery may be with 150 frack spreads and for mid-400s in rig count. So we've made these cost reductions, assuming that this is where we're going to be. As far as the costs coming back, we don't really expect that a lot of these costs will return. We were in the quarter because a lot of our fixed costs are in the cost of sales. We did have these decremental margins, but because of some of the moves that we made, we were able to control that decrement.

Yes, and maybe I'll just follow up a bit there, George. Our cost structure for the Canadian business has always been highly variable. We do have in-house field hands, but we also use a contractor model in Canada due to the big swings on a seasonal basis. It's always been a market where we've utilized contractors, which has helped to soften the blow in the second quarter from a decremental margin perspective. But we did take additional actions in the U.S. certainly, in addition to what Robert mentioned. We have closed a couple of our field districts, one in Oklahoma City and one in Corpus Christi. So we're really consolidating our U.S. footprint as much as possible. We've also been working with both our vendors on the field side, as well as the contractors to ensure that our rates match market conditions, which has also helped to preserve margins. As far as turning forward into the commentary around incremental, there are a couple of things there. Certainly, there has been some pricing pressure throughout the year, however, I think that's largely behind us. What I will say is that we're very focused on using our inventory as a source of cash. So we're moving some of the goods that we have and you may see some sales through inventory, which are slightly lower margins compared to what we had seen historically as we work to harvest that source of capital and cash on our balance sheet.

Okay, great. That's very helpful. Thank you both for that. And then the revenue increase on a sequential basis. I fully appreciate that we're coming off a low base. But given the activity rebound, seasonal activity rebound in Canada was late to kick-in, it’s still an eye-popping percentage. I wonder if focusing on the U.S. in particular, is the completions rebound you guys are seeing on the plug in the tracer side fairly balanced or is this more of a Permian specific phenomenon at this point?

It's fairly balanced, but the Permian is weighted more in terms of activity. Looking back for Repeat Precision, specifically, the customer mix that had declines in activity hit us especially hard in the quarter. Some of those customers are bringing back activity, adding additional frac spreads. So we're already seeing the benefit from that. For the tracer business, we saw a hard decline in the first quarter towards the end, but in the second quarter, we began seeing activity increases as well. Another factor driving those two products, especially between tracers and composite plugs, is the duck activity. We are seeing more duck completions now, and that's helping to drive activity increases as well.

Got it. And just one more if I could. On the free cash flow side, you've done an impressive job thus far generating free cash flow. Your guidance for full year 2020 to be free cash flow positive is helpful. Whereas working capital is probably a headwind in the second half, but there will be some tax benefits hopefully that you guys will get in the second half, as you alluded to on the call. How do you think that we are targeting like our free cash flow-neutral program. So that $19 million is kind of what you get for the year? Is there a chance that you’ll be free cash flow positive in the back half as well?

Yes, so George, I think working capital is likely to be a little bit of a headwind, certainly in the third quarter. We're still working our way back from the profitability level in the second quarter towards something approaching EBITDA breakeven as we get towards the latter part of the year. So I'd expect a little bit of a negative free cash flow quarter in Q3, getting back to breakeven on a quarterly basis as we approach the fourth quarter. So the full year will be a little lower than the $19 million that we're at right now.

Got it. Thank you both very much.

Thanks.

And the next question will come from the line of Kurt Hallead from RBC. You may begin.

Hey, good morning, everybody.

Hey, Kurt.

Good morning, Kurt.

You mentioned your $21 million in debt exiting the second quarter at $230. Given the changes in the revolver, and your cash balance, can we assume that the reduction in your cash balance is predominantly related to debt reduction?

Yes, you can assume that with the $15 million reduction to the revolver associated with the amendment that the cash balance went down one-for-one associated with that. If that's the question?

I appreciate your insights. Robert, you provided a solid overview of the factors influencing revenue dynamics in the U.S. However, I'm still puzzled, not just about NCS but also about other companies. We're seeing average rig counts and frac activity declining sequentially in the third quarter compared to the second quarter. Typically, we'd expect revenues to improve quarter-on-quarter even with decreased activity. Additionally, the exit rates were lower than entry rates. I'm seeking more clarity on the reasons behind this sequential revenue increase, especially considering that average activity and exit rates are set to decline as we move into the third quarter. Any further details on this would be very beneficial.

Yes, just to address Canada, we haven't talked about that yet. In Canada, we had bad weather coming out of the spring breakup which delayed increases in activity by about three to four weeks. The rig count went down to single digits, it was really tough. Now it has rebounded to low numbers, but it's four to five times higher than it was at the low. The rigs that are coming back on are ones that we have higher market share with. The dynamics in the U.S. are similar, if you look at where we’ve gone from frac spreads in the mid-40s up to around the 70s, the frac spreads that came off are those where we had higher market shares with customers. An example would be our market share for composite plugs went from the low teens down to about 5% as activity went down. But now, as those frac spreads are coming back on, the market share is actually increasing above where it was before. It's about the customer mix and the activity increases, so our revenue is going up disproportionately because of that.

Okay.

On the completion side, we really saw the activity start to move significantly lower in early April. So we didn't have that slope down that you might have seen; you’re talking about completion spreads were very heavily weighted to people that went on frac holiday early and were quite vocal about it.

Got it. That's great information, I appreciate it. I have one follow-up question. Can you tell me what the liquidity covenant is on the new revolver?

We need to maintain $7.5 million of liquidity. Liquidity is defined as cash on hand and the controlled accounts related to the facility, as well as the unused portion of the borrowing base, the combination of the two.

Okay, great.

Kurt, one more thing I'd like to add. Another dynamic we have for this year is the litigation expense. We've had a lot of litigation expense on a number of different fronts. We’ve got intellectual property cases, most of our technologies are developed in-house, and we've had high market shares with them. There are a number of companies that we believe may be infringing on our IP, thus we've made the decision to allocate funds to defend our intellectual property. We have several lawsuits ongoing around IP, and we've just entered into a licensing agreement with a company allowing us to settle a lawsuit there. We are in discussions with a number of other companies, so we believe that ultimately we will end up with a revenue stream from royalties that will offset some market share gains and losses we’ve experienced over the last couple of years from these companies. We intend to continue to defend our intellectual property vigorously.

Got it. Thanks, Robert.

Thank you.

Thank you. And our next question will come from line of Chris Voie from Wells Fargo. You may begin.

Thanks. Good morning.

Good morning.

First, I was wondering if you can update the product mix in North America. We think about frac spread their spectrum tracer, can you give maybe some kind of percentages or a ranking of the size of those and what you expect going forward?

Chris, that's information that we really just give out on an annual basis. That's given the seasonality and candidate tends to move a lot quarter-to-quarter.

Sure that's fair. And then maybe think about the CapEx budget down to $2 million to $3 million. Could you help us think about how sustainable that is, specifically, if you think about frac which is a decent share of a mix now? There’s a sense of a lot of innovation and new products in the market all the time. Is that enough to keep your product lines competitive and enough innovation in the product lines going toward or will that CapEx exposure have to come up a little bit next year?

Well, that number is sustainable, Chris. When we think about CapEx and when we really don't have a lot of CapEx, the majority of that CapEx is machines that we're buying for a new product line that we're starting. That's... we might spend $0.5 million kind of thing. We're buying vehicles, that's been a big part of our CapEx budget in the past, but we're not buying vehicles now. In fact, we've got about 30 or 40 that we're selling right now. So it is somewhat sustainable.

Yes, Chris, I mean, we've maintained a capital-lite business model intentionally since the inception of NCS. Think of maintenance CapEx being a $1 million or less frankly. But there's a distinction as far as product development between what's required for CapEx and the spending that we’re doing on R&D. We're continuing to put forward significant effort in research and development both with our in-house engineering team as well as the relationships we have with respect to third-parties for testing, that all goes into the continuous development of new products. So the spending for both sustaining engineering and new product development is reflected in our operating expense line, not in the capital expenditures line.

Okay, that's helpful. Maybe squeeze one more in. You mentioned maybe the 200 frac crew or less environment going forward potentially in the lower 48. This is causing cost reduction issues for a lot of companies. Just curious if you can give an update on what you're seeing lower 48 in terms of consolidation conversations and whether you guys would potentially be open to a merger of equals type situation, anything like that just an update?

Well, my belief is that there are too many service companies out there today. I think a lot of people believe that as well. There doesn't seem to be much of an appetite to action things unless a company has a gun to their head. But it's going to have to happen. There's too many management teams and too many service companies. There are a lot of service companies that are sitting on a lot of inventory. As they burn through that inventory, profitability is going to matter. It will be necessary to get that excess inventory into the market. Once that happens and once people have to return to profitability, I think there are many companies that are going to have that proverbial gun to their head. So I think we'll see it, but I don’t believe we’ll see it soon. As far as our view on consolidation, we’re open to anything that makes sense. We have liquidity to get us through the environment I anticipated for the next 12 to 18 months. We've got technology, a growing business internationally, and we have the ability to say we have a new product pipeline that is still working, albeit at a more muted pace than in the past. We do have new products that will come out over the next few months. So we intend to weather the storm; if an opportunity presents itself that makes sense, we'll consider it but we're not going to do something reckless.

Yes. Great, thanks. Thanks for taking my questions.

Thank you. I’m not showing any questions at this time. I’d like to turn the call back over to Robert Nipper for any closing remarks.

Thank you, Victor. On behalf of our Management Team and the Board, we'd like to thank everyone on the call today, including our shareholders and the research analysts who cover NCS, but especially our employees and our former employees. I'm very proud of our team at NCS which has reacted swiftly to changes in the industry environment. We've made significant adjustments to our headcount and cost structure to match the current market activity level. We continue to operate safely with zero reportable incidents so far this year. We're providing excellent service and continue to innovate to add value to our customers. A large part of our organization is working remotely and is taking on additional responsibilities as a result of the workforce reductions. The team has done a tremendous job managing the myriad of challenges that arise from the double whammy of COVID-19 and its impact on our industry and NCS. We're only as good as our people and I believe we have the best team in the industry. We appreciate everyone's interest in NCS Multistage and we look forward to talking again on our next quarterly earnings call in November. Thank you.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.