National Energy Services Reunited Corp. Q2 FY2021 Earnings Call

Greetings, and welcome to the National Energy Services United Earnings Second Quarter Earnings Call. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Blake Gendron, Vice President of Investor Relations. Please proceed.

Thanks, Maria. Good day, and welcome to NESR's Second Quarter 2021 Earnings Call. With me today are Sherif Foda, Chairman and Chief Executive Officer of NESR; and Chris Boone, Chief Financial Officer. On today's call, we will comment on our second quarter results and overall performance. After our prepared remarks, we will open up the call to questions. Before we begin, I'd like to remind our participants that some of the statements we'll be making today are forward-looking. These matters involve risks and uncertainties that could cause our results to differ materially from those projected in these statements. I, therefore, refer you to our latest earnings release filed earlier today and other SEC filings. Our comments today may also include non-GAAP financial measures. Additional details on reconciliations to the most directly comparable GAAP financial measures can be found in our press release, which is on our website. Finally, feel free to contact us after the call with any additional questions you may have. Our Investor Relations contact information is available on our website. Now I'll hand the call over to Sherif.

Thanks, Blake. Ladies and gentlemen, good morning, and thank you for participating in this conference call. I'm very pleased with our continued growth momentum in the second quarter, with revenues growing 16% year-over-year and 11% sequentially, outpacing the market and all our peers. If you compare it from the start of the pandemic, we have grown roughly 20% while the broader sector has dropped more than 20%. Over the last 12 months, our free cash flow conversion has been in excess of 40% of EBITDA, near to top among our larger, more mature peers, which considering the continued growth CapEx needed to sustain our trailing three-year CAGR of 22%, is indicative of the strength in our strategy and execution. We continue to be very watchful and vigilant about the evolving COVID situation with the Delta variant causing disruptions in most of the countries where we work. More importantly, we are very focused on the well-being of our employees and their family members back in their hometown, as you have seen some countries suffer a higher degree of disruptions and travel restrictions like India. We will continue to strive for utmost support of personnel throughout the organization during these challenging times. As most of you would appreciate, it has been a fluid situation, which has led to several changes in plans by the countries where we operate. In several cases, some have gone into curfews, locked down with strict measures to control the spread of these variants during the month of Ramadan and the Eid holidays. Mandatory quarantining in safe countries is now the rigor for most of our main operations, and severe restrictions have been put in place for citizens leaving or coming from certain countries from which a large portion of the workforce comes. While this has affected the service sector globally, we have been advantaged due to our large in-country workforce and have navigated these logistical hurdles with the target of 100% operational capacity under the leadership of our Crisis Management Team. Several of our customers have mandated vaccine requirements to access their facilities, and we are working very closely to enable access to our personnel. Vaccine availability is a bit varied across the different countries, and we are working with these limitations and have achieved more than 50% vaccination across our population. Our goal remains a zero-turndown of any job, and we are meeting that necessary goal. The other angle to all of this is the significant cost and the discontinued state of the new normal under COVID is causing. Just to give you a scale, to date, and since we started keeping records, we are approaching 13,000 PCR tests. I have personally passed over 100 PCR tests since the beginning. When you start to add additional quarantine, hotel costs for 14 days, and air travel to and from green countries, you start to capture a non-negligible cost to the countries, and we continue to record it as a normal cost of operation. I know some of the small service companies, especially those relying heavily on crew rotation, are suffering a great deal from restrictions on their employees, sharp increases in their internal costs, and in some instances, they would not be able to deliver on their rig capacity or services in the short term. Now moving to the macro and activity outlook. Global oil demand is now expected to eclipse pandemic levels by the end of 2022, which is exactly what we predicted a year ago. We see all of the OPEC countries preparing for the increase in production and readiness to deliver the supply to the world. The main NOCs have the capacity and capability to ramp up and manage the speed in an efficient manner to respond to this growth. Nearly all of the low-cost swing producers are in the MENA region and are our key customers. The rest of the region either needs to invest in long-cycle projects or in exploration where they have access to reserves. As you have seen by the commentary from some of the majors, they first have to clear the hurdles they are facing in the market and with their shareholders in terms of what the company can invest in, or they need to spend significant amounts to upgrade the aging infrastructure, which cannot be cranked up even though the resources might be in the ground. On top of it, there now needs to be a certain level of capital discipline. The retained metrics have evolved such that the past regime of production sharing contracts or higher IRR in the case of U.S. independents have all moved to higher thresholds. All of this leads to one thing. In my opinion, the price of oil will be solid, and we are now going to see a longer cycle similar to the early 2000s, which lasts several years. The only players who will be able to deliver are the NOCs in the region, as they have concrete plans, are very well organized with long-term goals, and importantly, have the ability to adjust since their marginal costs are the lowest in the world. Additionally, they are focused on energy transition, and they need to continue to develop their massive gas fields for their internal consumption. The other topic which is very relevant for the service industry and consequently to our customers is the overall health of the industry, which I believe needs some thought. We have all seen several commentaries on inflation, but if you look at the numbers and the actions of the industry, it gives you a separate picture on the state of affairs. Since the beginning of the year, if you look at the main constituents of the PPI composite index, like steel and chemicals, for example, these have gone up by almost 100%. If you look at shipping container costs, we have seen costs increase by over 50%. And obviously, there is significant labor cost inflation, which are a consequence of demand across many industries. If we look back to the start of the last major cycle in 2000 and index the cost to that, you will see key representative oilfield service input costs increased by 100% until 2008. Since 2008, the input costs have grown steadily in line with overall inflation until basically the beginning of 2021, where they have skyrocketed. Oil prices have had several runs in this period, and the service industry has adjusted and largely absorbed any changes to these costs in that period, allowing the operator to continue to produce effectively at a much lower oil price environment. Obviously, the supply organizations are managing their best to curb those increases. However, at a certain point, one cannot escape the baseline structural increase. Most of the time, the industry finds innovative technologies over the years to enable such sharp reductions of prices against inflationary pressure. In most countries where we work, service industry upstream costs are essentially a very small fraction of the oil price, especially when the total lifting cost is in single digits. Unlike 2008, where the baseline profitability of the service industry was good and enabled solid investment in new innovation and technology, after more than 10 years of absorbing additional costs, the industry has slowed down their R&D spending compared to earlier cycles. As a matter of fact, we need more investment in disruptive technology, especially with the need to find sustainable tools and methods to produce oil and gas in a friendly manner. Also, opposite to some of our peers, we continue to invest in CapEx and tools to ensure we have the capacity and buffer of resources in order not to affect our service quality and operational delivery. We need to ensure, despite all odds, that we can be the reliable provider to our customers in the coming cycle where talent and equipment will start to tighten, and differentiation in service delivery will be the key factor determining work scope and tender awards. Our customers in the region are extremely intelligent; they know and understand who is spending and investing for long-term healthy growth, and they see how the different companies perform. We are very proud of being recognized as the best quality provider to one of our major customers for the fifth consecutive quarter. Now switching gears to another topic, which is very close to my heart—our progress on our ESG and energy transition efforts under the auspices of our ESG Impact segment. We are pleased to have published our inaugural ESG report in the second quarter, which we view as a pact with customers, shareholders, and the community alike in driving impactful change that transcends subjective rating metrics. This report will perpetually serve as a yard marker for continued ESG improvement for us. I encourage everybody to read it. As the national champion of MENA, we are proud to lead the way for other companies from the region. In our view, the environmental category shows where oilfield services broadly have the most potential to pave new commercial avenues as our large NOC and IOC customers push ahead into the energy transition. We are excited about a broad opportunity set across water, emissions, flaring, and most notably, the announced flagship water management project that will showcase the combined power of net service delivery and technology partnerships. As we recently announced, we were awarded a significant contract to make brine for one of the majors in Iraq. We have worked with our customer to now shift the existing conventional approach at the facility and deploy technology developed with our partner, Clean TeQ, to use produced water as the feedstock for the operation and allow the salt generated from this process to be turned into brine. Given we are moving away from this additional process and deploying new technology, there is a higher CapEx upfront, but we believe it's our duty and responsibility to shift from a risk-return mentality to a risk-return impact. Our customer is very excited to partner with us; it supports their efforts to take what has historically been a carbon-intensive project and transform it 180 degrees into something that benefits the environment due to its circular economy. In addition to this, we are discussing how to utilize their flares or excess gas to meet the electricity needs of the plant in Stage 2, completely turning a heavily carbon footprint into something with a very small increment. Again, we are working to transform that project into a flagship for the industry to follow. I believe this will be the world's first such facility. On another note, we are moving ahead with a project in Saudi where we are looking at converting produced water to portable water with another strategic partner, Salttech from Holland. We are in the middle of shipping pilot project equipment. Upon trial completion, it will lead to a significantly larger water facility. Again, our client is leading the industry and is focused on creating significant environmental impact. They have the lowest CO2 intensity per barrel and are dedicated to creating value while looking for a state-of-the-art project that serves the community and the environment. It has been a pleasure working with them, as we are totally aligned in our approach. As we have worked together on the frac business that has essentially transformed the region, today, we have proven that working closely together, we can achieve top quartile delivery of the number of stages per month than any U.S. operator has achieved. This was deemed an impossible task just a year ago. Together, our customers have proven that it is a reality, and they remain by far the best-in-class in everything they do. Lastly, we announced last quarter that early in Q2, we closed on our M&A in Kuwait and are fully responsible for running the contract despite the elevated restrictions on travel and entry to the country. We have planned properly to send equipment from within the company to manage the increased amount of work, which we are targeting. We are extremely excited to establish our stronger presence and consider Kuwait one of our anchor countries in the region. They have solid plans for growth and activity expected to increase in the years to come. We are investing for a long-term partnership with our esteemed customers in Kuwait. As a reminder, we funded the first tranche of payment, which covers the main portion of the acquisition, through our operating cash flow. All the M&A we have done up to now has been funded internally. This might change going forward depending on the size of the opportunity, but our excellent cash generation capabilities allow us this freedom to be very nimble when opportunities arise. On that note, I will pass the call back to Chris to discuss the financial details.

Thank you, Sherif. Turning to our results, we reported quarterly revenue of $235 million. This represents an increase of 16% over the prior year quarter and an 11% increase over the first quarter. The year-over-year and sequential quarterly increases were driven by higher production activity, primarily coiled tubing stimulation and frac in Saudi Arabia and Kuwait. Adjusted EBITDA in the second quarter was $54 million, or 23% of revenue. This represents a decrease from 26% in the prior year quarter and 24% in the prior quarter. The sequential decline was driven primarily by the impact of inflation and D&E product line mix. EBITDA adjustments of $5 million for the quarter were mainly for headcount restructuring costs in certain markets, transaction and integration costs associated with our recent Kuwait acquisition, and certain noncash FX charges due to currency weakness in Iraq and across North Africa. As Sherif highlighted in his commentary, we continue to incur significant COVID-related costs such as labor, testing, travel restrictions, and administrative costs. For example, employees must be tested several times a week before entering the operating sites on some rigs. As is our practice, we do not reflect any of these COVID-related or other items in EBITDA or EPS add-backs. Moving to our segments. Our Production segment revenue for the second quarter was $153 million, growing 10% compared to the same period last year and 12% over the prior quarter. Sequential growth was primarily driven by higher frac activity in Saudi Arabia and work in Kuwait. Adjusted EBITDA margins for the production group were 27% in the second quarter, flat sequentially, as inflation and COVID costs offset the benefit of higher utilization of manpower. Separately, our Drilling and Evaluation segment revenue of $82 million in the second quarter was up 28% compared to the same quarter last year and 9% sequentially. The sequential increase was driven by higher drilling-related activities across multiple markets in the region. Adjusted EBITDA margins of 21% in the second quarter were down from 25% in the prior year quarter and 24% compared to last quarter due to the impact of inflation and less favorable product line mix. Depreciation and amortization increased to $35.1 million in the second quarter compared to $31.8 million in the first quarter of this year. The sequential increase was primarily related to the additional depreciation and amortization from the recent Kuwait acquisition, as well as the impact of an additional employee equity grant. We expect depreciation and amortization to be in the $36 million range next quarter. Interest expense in the second quarter was $3.2 million, flat from $3.2 million in the prior quarter. The reported tax rate for the first six months of 2021 was 17.2%. Excluding the net benefit of adjustments of reserves on prior year taxes, our reported tax rate would have been 20.2%, which we expect to continue to improve upon going forward. Adjusted net income and EPS, which includes the impact of the noted EBITDA adjustments, were $12.8 million and $0.14 per diluted share. Switching to free cash flow, we are pleased with another quarter of positive free cash flow generation of $12 million. This brings the year-to-date cash generation to $47 million compared to $2 million in the first six months of last year. The sequential free cash flow decline was primarily related to higher VAT and income tax payments as well as higher capital expenditures. We continue to improve our invoicing and collections. Overall, DSO improved by another nine days over the prior quarter level, bringing the year-to-date DSO down by 25 days, a strong accomplishment by the whole NESR organization. Additional actions are in process to lower DSO even further during the second half of the year. Capital expenditures in the second quarter were $21 million, up from $11 million in the first quarter. In 2021, we continue to expect capital expenditures to be flat to slightly up from 2020 levels to support planned growth. CapEx spending should increase to $30 million to $35 million per quarter during the second half. We continue to expect free cash flow in 2021 to significantly increase over 2020 levels due to flat planned CapEx, continuous improvement in fleet utilization, and improved DSO. Net debt increased to $335 million at the end of the second quarter compared to $302 million at the end of the first quarter. The sequential increase is primarily from the use of our existing cash balances to fund the Kuwait transaction. As of June 30, 2021, our net debt to adjusted EBITDA ratio was 1.6, flat from 1.6 last quarter and should reduce to our target level of approximately 1.5 or lower in future quarters. Also, we remained in full compliance with our primary credit facility of financial covenants in the second quarter. We are very pleased with the strong financial health of our balance sheet and our ability to fund acquisitions internally. We are currently working on several other technology investments, and we are ready to fund those as they come along. With this, I'd like to pass to the operator for your questions.

Our first question is from James West with Evercore ISI.

Sherif, with the recent OPEC deal to add barrels to the market, I'm curious to hear your thoughts on this. Your main countries of operations are in the region, and you're having to ramp up to put these barrels back on the market. Is that, one, happening? And two, was that actually already underway, probably pre-deal announcement, in anticipation of the need for barrels to come back to the market?

So all the clients and the main NOCs, as you rightly said, are preparing for the growth, for the increase in activity. I would say the main delay on the increase is the COVID situation. If you look at the obvious preparation from each country without going into more details in that, you can see that the main constituents of the production definitely have very, very strong plans to add rigs, to add rigless site production facilities. Some of the projects were publicly announced that they are back on track. I would say if there were no closures, you would have seen those rigs from this month straight after the Eid holidays. I would say that mainly you've got a quarter delay because of the COVID situation. Some of the countries that were announced to open up their borders on the 1st of August are now saying it's September; some of the restrictions on travel and airlines have been pushed another month or so. But definitely, everybody has a plan, this is a long cycle, and they will be adding rigs and facilities to produce more. Obviously, they have, as you know, the buffer to be able to put that production without adding activity. They have that capability to add production and activity with a quarter delay.

And then, Sherif, you outgrew the market very substantially, both sequentially and year-over-year. Do you think this level of outperformance versus the market is sustainable over the next several quarters, especially as things get going, as you mentioned, as the COVID restrictions ease? Or will there be some slowdown in that outperformance? I expect it to outperform, but I've just been impressed by the continued significant outperformance.

I would say, obviously, our ambition is to continue at this pace. Our ambition is to have that outperformance definitely on a sequential basis and year-on-year. The only drawback or restriction would be COVID. It's not only us; some of the capacity constraints are really affecting other companies in the region, especially local firms that are suffering with their rig capacity. Even when we have projects lined up and we have won the tenders, we are waiting to execute some of the work; sometimes the rig is not ready because they do not have a crew. They rely on totally rotational personnel. So I would say that if the total market gets delayed, we would just have some delay ourselves. But definitely, our focus is to outpace the market as we've been doing. If you start gaining more contracts, you should be able to do the same.

Our next question is from David Anderson with Barclays.

Sherif, you talked about the margins. The margins were impacted this quarter by inflation and COVID issues. I would think that those should start to turn the corner, presumably over the next quarter. You didn't mention pricing; could you comment about industry pricing as you see it? When things begin to pick up, where do you think pricing ends up? We've been hearing talk that the big players have been very competitive on large tenders. I know you don't participate in those, but is that spilling into your pricing mix? How do you think about that as we go into next year?

Yes, definitely. I spoke about our cost, and the industry as well. The COVID situation has started to ease. You start to feel it, right? For example, some of the rigs now, if you have one case—a crane operator, for instance—has COVID, then every single person on that facility will have to test twice, and they'll quarantine the other crew for a week. So you have to pay for hotels amidst these situations. Definitely, costs are really climbing. I would say the other part is that inflation; we don't feel it yet, but we can feel it when talking to some of the CEOs of chemical companies and transportation firms, etc. They clearly say they cannot maintain pricing as is for the long term. So they're trying to delay increases as much as possible until it hits them. Back to your point, pricing has been, I would say, a lack of leadership. Pricing has not moved; nothing has been passed on. Businesses are still dropping pricing, unfortunately, across all tenders—big and small—despite tightening up the situation. You can see this reflected in the service quality of certain service companies in the region, as they continue to drop prices and end up providing poorer service quality in some of the projects. And as I noted, the health of the industry shows this, as even if you look at R&D spending, it has dramatically slowed down compared to earlier cycles. Some of the firms around haven't seen an up cycle. They have been in down cycles for the past 15 years or so. Outside North America, there is a dynamic approach in the market, but overall, international markets haven’t adjusted to pricing movement just yet. Unfortunately, pricing is not moving at all in regular projects. However, if you talk about LSTK, it’s a complete disaster; people are still bidding on a loss-making basis. As those scaled projects, especially in drilling, get larger, you'll see the margins of those companies squeeze further.

I've seen an up cycle, sure thing. We know it's coming, and I'm looking forward to seeing that again. One big aspect of the up cycle is capacity, right? One good thing about these LSTK projects is they'll soak up a lot of capacity. Haven't we seen a significant cut in CapEx by your competitors? Do you think that certainly, for pricing to pick up, you need to have a blend of activity and where capacity levels are? Does that give you confidence that pricing can get passed through early next year as a natural market development?

Yes, spot on. You've analyzed it extremely well, David. It's absolutely right. There is capacity in the international market still. That capacity is going to tighten, which is what I was saying. Actually, I think the talent pool is going to be even more concerning. People are not investing at all in CapEx, while I am investing much more as a percentage—obviously about 15% on capacity as a buffer to ensure we can execute projects smoothly. What will eventually happen is exactly what you said: once the capacity gets absorbed by the increase of activity, clients will start seeing service quality deteriorate, and pricing will naturally begin to follow suit. You are correct; this will happen over a longer time frame, similar to North America, but there's always been a lag. It's important to understand that these contracts in the international market are longer term, and people should be careful about their pricing now, especially if they have contracts lasting four to five years. The health of the industry is critical.

Our next question is from George O'Leary with TPH & Company.

Apologies if I missed it; I got dropped from the call about 15 minutes in and had to redial. I wondered if you could frame the revenue trajectory for the second half of 2021. Assuming the COVID issues don't get worse from here, should we expect Q4 '21 revenue to climb significantly, especially more so than in Q3? Any initial expectations for revenue growth in 2022 based on discussions or announcements from your customers?

I think it's very positive. I'm extremely excited about the second half and next year. I tried to convey that this is a long cycle. I think we're going to see a nice uptick in activity. All the increase, in my view, will come from the OPEC countries. They are extremely smart and organized; they have very solid growth plans and know where the rigs will go. They do their reservoir management better than anyone else. We believe that increases will be evident in the second half, and as most people have noted, you'll see double-digit growth, definitely in the second half, compared to the first half or second half of last year. So I anticipate considerable growth going forward. I believe that 2022 will even surpass expectations. The only caveat is: what will happen regarding COVID? What will be the restrictions? Not in terms of Europe possibly having closures again—it's more about the restrictions you're seeing in the Middle East, which take very strict measures. It’s crucial that we keep in mind that people cannot travel, and some countries have restrictions preventing certain individuals from entering. I believe this may just shift the increase in activity by about a quarter. Nevertheless, Q4 is going to be solid because rigs will start arriving and crews will be ready. I’m extremely excited about what's ahead, and again, I believe we are looking at a multi-year up cycle.

M&A is especially important in this story. You touched on it a bit in your prepared remarks. How is the M&A landscape? What are your thoughts regarding M&A? And how do you balance that with forming partnerships, especially in technology and investment? Are there any areas of interest for you as we move forward?

We've always been very focused since the company started. We know exactly what we're looking for and who we want to buy. Our primary objective remains ensuring that geographical M&A is accretive; we must acquire companies that are less expensive than we are trading at, especially considering how we are growing. However, if we maintain that multiple, we need to ensure we acquire companies that add significant value. We look at governance with great detail; understanding how they run their business, their governance, and their shareholder base is crucial. Our ideal scenario is one where one plus one equals three. Regarding partnerships, we continue on the same path we have been on. We now have nearly a dozen partnerships, and I am very excited about the ESG Impact partnerships. We have two water companies, and we are looking into emissions, and now we're almost on our third or fourth company in that regard. We don’t announce these things yet because much of it is R&D sensitive. Once we reach a more mature stage, we will announce those partnerships when we can clarify how they create value and why we are pursuing them. Simultaneously, we are looking at early ventures with disruptive technology. We have already invested in a couple this quarter but will not disclose any names to maintain confidentiality. Much of our focus is on ensuring that we invest in nimble, smart companies that prioritize R&D because the larger companies don't seem to be investing heavily in oilfield services. We are also actively seeking partnerships with larger companies in the context of technology and how that can fit in the Middle East. When we do enter those partnerships, we must ensure they add real value for our customers, providing them with access to diverse technology and ensuring they're not bound by outdated options. They need to be willing to invest. They have to have skin in the game to operate in the best interests of our dear customers in the NOC in the region. Overall, I am very excited about our plans. We hope to close a deal before the end of the year.

Our next question comes from Igor Levi with BTIG.

You talked about two water projects, one in Iraq and one in Saudi. Could you provide a bit more color on the size and objectives of both, considering that Saudi is more of a pilot? On a previous call, I think you said there were three pilots on the way, so can you update us on the project pipeline for water management?

The Iraq project is obviously one we are extremely excited about, as I've mentioned. We received a contract to produce conventional brine, the way it's been done in the industry up until now. Our clients are emphasizing ESG principles. We presented an alternative approach to changing the way this is handled for the last two years. Our client loved the idea; we confirmed we would honor the same price, despite the higher cost, by using the technology developed by our partner, Clean TeQ. By employing our process, we can save significant CO2 emissions as we utilize existing salt from produced water, which we clean and then repurpose into brine. What's unique about this approach is, we believe it could serve as a flagship project for the industry. The Saudi pilot is a different situation; it’s a different company and approach looking to create portable water rather than just water for the oilfield today. It remains in the pilot stage because the technology hasn't been used thus far in this capacity. We see great promise in it, and if it's successful, it can significantly help - not only for oilfield projects but also for community water needs. The beauty of it is that it contributes to the environment while meeting various community needs, especially in desert regions. So collaboration with our customers in Saudi, who are top-tier operators, has led to this innovative pilot project. Once it proves effective, we'll expand that success across our other operational territories.

In terms of oilfield services, are there any major contracts set for renewal this year or any incremental work that you're anticipating could be awarded in the second half?

We tender all the time, Igor. It's a $20 billion market. If you look at just 10% of that, it’s $2 billion. It's an ongoing process. That's what I tried to express in my earlier replies: we expect to see improvements in the tender approach largely because of inflation and how the entire market is evolving. While we have several projects in play right now, as soon as we secure major awards, you will be the first to hear about it. We consistently aim to update our clients on contract outcomes and upcoming awards.

Ladies and gentlemen, we have reached the end of our question-and-answer session. I would now like to turn the call back over to management for closing remarks.

Thank you, Maria. Thanks, everybody, for attending our call. Again, I am very excited about the upcoming upcycle. We've been missing that for a while, and I look forward to speaking with you soon. All the best. Thank you.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.