PRECISION DRILLING Corp Q3 FY2022 Earnings Call

Thank you, operator. Welcome everyone to Precision Drilling's third quarter earnings conference call and webcast. Participating on today's call with me is Kevin Neveu, our President and CEO; and Carey Ford, our CFO. Earlier this morning, Precision reported impressive third quarter results which Carey will review with you followed by an operational update and outlook commentary from Kevin. Once we have finished our prepared comments, we will open the call to questions. Some of our comments today will refer to non-IFRS financial measures and will include forward-looking statements which are subject to a number of risks and uncertainties. Please see our news release and other regulatory filings for more information on financial measures, forward-looking statements and risk factors. As a reminder, we express our financial results in Canadian dollars unless otherwise indicated. Carey, over to you.

Thanks, Lavonne. Precision's revenue in the third quarter was $429 million, 69% higher than the same period last year, while adjusted EBITDA was $120 million, an increase of 163% from Q3 2021. On a normalized basis, adjusted EBITDA, excluding stock-based compensation, was $130 million, representing a corporate margin of approximately 30%. These results reflect steadily increasing North American drilling activity, improved pricing, expansion of our alpha and Evergreen offerings, and a continued focus on costs throughout the business. We've been highlighting the operating leverage inherent in our business for several quarters. We believe our key results reflect the beginning of a multi-quarter demonstration of how rising activity and rates translate into expanding EBITDA and margins for Precision. During the quarter, we completed the acquisition of High Arctic's well service and related rental assets and successfully integrated the business. Having already realized $3 million of the $5 million in expected synergies, we expect to realize substantially by the end of Q1 2023. Moving on to the drilling business, Q3 activity increased 40% in the U.S. and 17% in Canada compared to the same period last year, while day rates increased 37% in the U.S. and 39% in Canada. In the U.S., our normalized average daily operating margin for the quarter, absent a Turnkey IBC impact, was USD 9,662, USD 2,488 higher than Q2 and in line with our guidance. With repricing of spot market rigs and the impact of Alpha Technologies and Evergreen solutions, we project normalized average margins to increase to approximately USD 11,500 per day in Q4 and we expect a similar sequential increase of average margins of USD 1,000 to USD 2,000 per day in Q1 of 2023. In Canada, our average Q3 daily operating margin was $10,034 and significantly exceeded our guidance of $8,000 to $8,500 per day. Our strong margin performance was supported by higher day rates, Alpha Technologies and Evergreen Solutions revenue, and increased labor and cost recoveries. For Q4, we project average daily operating margins to increase sequentially to approximately $12,000 per day and expect a similar sequential increase of $1,000 to $2,000 per day in Q1 of 2023. In our C&P segment, our revenue increased 101% to $57 million, while adjusted EBITDA was strong. These results were positively impacted by a 62% increase in well service hours, in part due to the completed acquisition of the High Arctic assets, and improved pricing as an industry-wide shortage of high-quality assets and skilled labor continues to support increases in hourly rates. Moving to the balance sheet, we remain firmly committed to reducing debt by over $400 million between 2022 and 2025 with a target of $75 million this year, and we are on track to achieve both the short-term and long-term targets. We ended this quarter with $40 million of cash on the balance sheet and $540 million of available liquidity, excluding letters of credit, and our average cost of debt is 6.9%. We expect our net debt to adjusted EBITDA before share-based compensation expense to be below 3x by the end of the year and to decline further into 2023, pacing us to achieve a leverage level below 1.5x much earlier than expected. To deliver on our customer-backed rig upgrades, of which we now expect to have over 30 during 2022 and certain drill pipe commitments, we are increasing our capital budget to $165 million this year from $149 million. As a reminder, for our upgrades, we will require full cash-on-cash payback within the term of the contract and rates of return well above our cost of capital. Moving on to guidance for 2022, depreciation is expected to be approximately $280 million. SG&A is expected to be approximately $80 million before share-based compensation expense. Cash interest expense is expected to be $85 million for the year. Cash taxes are expected to remain low and our effective tax rate is expected to be slightly negative for the year. That concludes my comments. I'll now turn the call over to Kevin.

Thank you, Carey, and good afternoon. Well, as Carey explained, our business performance in every service line in every region is strong and continues to improve. I'm especially thrilled to have returned to profitability. And the next key benchmark we are focusing on is a return on capital target but more on that later. I'll start by recapping our recent Kuwaiti contract award. We are very pleased to have been awarded the four contracts, which include reactivation of two of our idle rigs, bringing our active rig count up to five rigs in Kuwait by mid-2023. I want to thank our international team for their hard work and perseverance on the successful bid process, as we've stressed over several quarters. I remind you that these are very large 3,000-horsepower super triple rigs with the revenue and margin profile that looks a lot more like two North American rigs. Coupled with our recent contract renewals in Saudi Arabia, all eight international rigs will be operating under five-year terms. We continue to look for other good opportunities to activate more of our remaining five idle rigs in the region. Our international business is a meaningful and stable contributor to Precision's cash flow profile and now with firm visibility through the latter part of this decade. Following up on our recent well service acquisition, as Carey mentioned, the financial performance of Precision's well service business is strong. Tom and his team have done an excellent job integrating the acquisition while also keeping their focus on the business at hand. They're ahead of plan, achieving the expected synergies, and I believe will just continue to perform well for the foreseeable future. Now, as customer budgets wind down later this year and we hit the holiday season in mid-December, we expect a short-term moderation in activity. However, customer bookings and indicated demand for the winter season through 2023 will likely exceed our ability to staff those rigs. Now I think this is an area where Precision's reputation, coupled with our recruiting and training capabilities, creates a meaningful competitive advantage. We recently hosted a group of analysts for two of our new drilling operations where we highlighted our new employee recruiting and training capabilities including showcasing our Alpha-equipped super training rig. We also introduced the group to our acquisition teams based on the SQ Center. By the way, for any of you who attended the tour, you may be able to career change, we're accepting applications assuming you pass our controlled substance screening. I'm sure that those of you that were able to attend came away with a view that Precision is well on top of the recruiting challenges and is very well positioned to deploy high quality and very well trained personnel in the field for our drilling rigs. I'm expecting a significant challenge recruiting across the industry this winter for all OFS services, but I believe our recruiting and training teams have the confidence that we're up to the task. Now, as we've been saying for several quarters, the Canadian drilling market is very strong for Precision. Today, we have 73 rigs running, which, as expected, exceeds our winter peak from earlier this year. Our super triple fleet is fully booked for the coming winter and should have 100% utilization during Q1. During the third quarter, we redeployed another ST-1200 from the U.S. to Canada. And those of you that attended our open house will have seen that rig in Big 5 in our yard undergoing recertifications. That rig is now on location and drilling under a long-term contract for an oil and gas operator focused on LNG. So clearly, LNG drilling activity is underway and will increase for the next several years in demand for Precision's already fully utilized super triple fleet. While term contracts in Canada are less common, customers are increasingly looking to secure access to our super triple rigs by locking in those rigs with long-term take-or-pay contracts rather than running the risk of the availability with traditional pricing agreements with no firm use commitment. Besides guaranteed access to a rig, the primary customer benefit of a take-or-pay rig contract is recruitment and retention. That steady income opportunity, firm work schedule, and close operating relationship with their oil company stabilizes the rig crew and the reposition. This factor alone has substantial value for all customers. With strong commodity prices and a weaker Canadian dollar, conventional heavy oil and Clearwater activity is accelerating, driving high customer demand for our super single rigs, which are achieving the highest utilization levels since 2014, and we expect continued growth into next year. Our Evergreen products, including battery systems, fuel monitoring apps, and lighting systems, are gaining wide market appeal. Billing activity for the new Evergreen products approached 2,000 days during the third quarter and are meaningfully contributing to Canadian revenues and margins. The outlook for Canadian drilling activity is strong. Based on our customer expectations, we expect to see peak winter activity levels approach and likely exceed 80 rigs. With these high demand levels, our confidence in our margin guidance is firm. Now, turning to the U.S. While industry rig additions have moderated, our rig count continues to grow higher as customers look to displace lower-performing rigs with Precision's super triples, particularly by activating our AlphaAutomation services. We expect this trend to continue through 2023, with our current super triple fleet fully utilized during the first half of next year. There's a lot of talk about rates in the upper 30s and approaching $40,000 per day. While we agree with that, I would point out that with our add-ons such as AlphaAutomation, Alpha apps, Evergreen products, and managed pressure drilling systems, we have several rigs at rates well above that range. During the third quarter, over 20 rigs repriced to the current market rates. In the fourth quarter, we expect 10 to 15 rigs to repriced at a similar pace in the first quarter of next year. Based on our current contract book, our super triple utilization, and the customer interest we see, we have a degree of confidence in our forward margins and guidance for the U.S. Our press release mentioned that we're ahead of schedule on AlphaAutomation installations and we expect our full super-spec fleet to be ready by early 2024, almost a year ahead of our plan. The value proposition for Alpha is compelling and customer interest is outpacing our expectations. Our technology deployment team has been very busy installing Alpha kits, but more importantly, also training our drillers to become alpha drillers. I want to give a shout-out to our technology and remote ops team for the great job they're doing training and supporting our new Alpha drillers. Our Alpha drillers love how Alpha automation frees them from all the mundane and highly repetitive tasks they typically perform in manual drilling. With Alpha, they're better able to lead their crew and oversee the drilling operation. Alpha substantially improves drilling performance, crew safety, and the overall execution of the customer's well plan. Everybody wins. I want to circle back on pricing and value for a moment. Our customers in both Canada and the U.S. are struggling with cost inflation across all OFS services and I know that drilling rig rate inflation is concerning for them. Our sales team's job is to help our customers understand our cost drivers, our capital investments, and the efficiency gains that are driving the incredible value we are delivering today. When considering today's day rates, three factors must come into play which are different from prior cycles. First of all, Precision's cost to operate a rig with labor and supply inflation has risen more than $4,000 per day. Additionally, we have cost inflation driven by increased maintenance due to the accelerated wear on equipment and the higher pace of drilling today. The second factor is a substantial increase in capital equipment scope such as additional mud pumps, generators, advanced mud cleaning equipment, rig walking systems, and other upgrades on the rigs. These upgrades have involved significant investments by Precision but also raise the operating costs due to their complexity requiring more maintenance. These requirements still impact the potential new build or replacement cost for a rig. A $25 million rig from 2014 with today's super-spec equipment scope and steel inflation would likely cost over $35 million to build, and that's only if the components are available in the supply chain, which is highly unlikely. The third factor to consider is the efficiency gains these upgraded rigs deliver and the value we create through that efficiency. If you look back at the prior peak for day rates in 2014, when compared to today, the results are startling. In the U.S., across Precision's fleet, we're drilling wells 55% faster today compared to 2014, and in Canada, drilling productivity has more than doubled compared to 2014. These efficiency gains have been driven by the capital upgrades we've discussed, as well as pad walking systems, mud pump capacity, generating capacity, and improved capabilities. The equipment, crew, and digital capabilities have driven a massive step change in drilling performance. It’s fair to conclude that while day rates are well up from the lows of 2020, the value and cost of our rigs, crews, and technology have substantially increased and the value we provide to our customers has never been better. On that pricing note, I want to acknowledge that our sales team has been tasked with pressing rates upwards to aid in Precision's return to profitability. I need to give a shout-out to our Canadian and U.S. sales teams who have taken on that challenge. Thanks, team. Yet we still have work to do. We must continue to improve our results as we aim to achieve a reasonable rate of return on our investment, and we're on that path, making good progress but there is still work to be done. In short, great work, team, but please keep it up. Regarding our strategic priorities, all three are on track. I mentioned our digital Evergreen market growth earlier. We've reaffirmed our debt reduction plan, and we will achieve our goal. Precision's improving operating margins also reflect our strict cost controls and serve to demonstrate our operational leverage. To wrap up, I'd like to thank our shareholders and customers for their continued support. I want to sincerely thank all of our PD teams for their hard work and the great results they're producing this year. Thank you. I'll now turn the call back to your operator for questions.

Our first question comes from Aaron MacNeil with TD Securities.

Based on your Q2 and Q3 disclosures, it looks like there’re decremental rig upgrades. So in other words, going from 20 to 30 rig upgrades in 2022. So I’m just thinking about this in the context of incremental activity and your outlook there. How many of those rigs are already working post upgrade? How many were already working and you’re just doing an add-on upgrade to an already active rig? And I guess what I’m really driving at is of those 30 rig upgrades, like how many of those would be incremental to your current rig count today?

Well, it's actually a very complex question, Aaron. I don't have the details rig by rig. I can tell you that a number of these upgrades were third pump, fourth generator additions on rigs that were working and now they're stepping into much higher day rates with that addition. So of the additional upgrades we've added, I think probably something like two-thirds of those would be just stepping up the capability of the rig and reaching onto a much higher day rate class with that upgrade. I think that about one-third of those, probably three or four will be rig additions between now and into Q1.

Okay. That’s perfect. And then maybe Carey could follow up. Maintenance capital is obviously dependent on activity assumptions, but can you give us a glimpse of what a preliminary growth or upgrade capital spend might look like in 2023? And how many rig upgrades that might contemplate? And I know what you’re going to say that it depends on getting the right contract and everything but just trying to get your pulse there.

Yes. So upgrade capital is completely separate from maintenance. So I can tell you a few things about maintenance. It has gotten a bit more expensive per day. We're trending closer to $2,000 a day versus kind of the $1,500, $1,600 a day that we historically have trended at. So that's a function of inflation largely. The other thing I'll tell you is that long lead items, we're having to plan a lot earlier to purchase those. For the past year, we've been doing advanced drill pipe purchases and the lead time items on those might be 6 to 9 months. So we are doing more of those bulk purchases. The other item I'll point out is just the weaker Canadian dollar, and the majority of our capital expenditures, whether it's maintenance or upgrade, are purchased in U.S. dollars. When you convert to Canadian, that makes that number go a bit higher. With that all said, maintenance will still trend along with activity. So I think if your expectations for activity increases next year are, say, 20% higher than this year, then the baseline would be maintenance capital that's 20% higher than what we had in 2022.

And on the upgrade side?

On the upgrade side, we anticipate continuing to see similar types of upgrades as we experienced this year. This includes increasing the rig's capacity, implementing automation, and introducing Evergreen solutions to the rig, although this trend will eventually plateau. The additional upgrades we aim for, typically ranging from $1 million to $3 million, will depend on the demand for SCR to AC conversions, which we estimate will cost around $12 million to complete. To ensure a cash-on-cash payback within the contract period, we will likely need to see a two-year contract and a day rate nearing $40,000 before we proceed with that upgrade. Once the market for super-spec rigs becomes saturated and customers begin expressing interest in these upgrades, we will be prepared to act, but we are not quite at that point yet.

Okay, perfect. And maybe I'll just sneak one more in, if I could. The C&P business had a very strong quarter which sort of quickly proves out the rationale for the High Arctic acquisition. And I guess, Kevin, does this sort of embolden you to pursue more tuck-in acquisitions like this for C&P? And even if you wanted to, do you think you could transact at similar metrics?

So Aaron, I think this is an important deal for us and the team has been proven. They can integrate a fleet quickly and efficiently and achieve the synergies we thought we could achieve. There's a lot of proof of concept going on right now. The market still looks quite strong. We're seeing work that was kind of delayed for several years and the backlog of work now looking forward seems to be several years long. The well service business has legs to it right now. I think the market is still too fractured, so if there's an opportunity for us to do further consolidation, we'd be interested, but we're not going to overpay. If the seller expectations are too high, we won't do a deal.

Our next question comes from Waqar Syed with ATB Capital Markets.

Kevin, in the press release, you mentioned that at least eight rigs could be active in the Middle East by the middle of next year. Could you maybe provide some more color? Where would additional rigs be and what are the tenders you’re looking at?

Sure. The eight rigs we referenced are the ones that are contracted right now, and we have five more idle rigs in the region. I'd say the most relevant idle rig would be the rig that we have in Kuwait, which is a 1,500-horsepower AC super-spec rig but it's configured for well servicing. That rig could be easily converted to a drilling rig. I think that's our most likely candidate for early activation, probably somewhere in that same side of the Arabian Gulf, Saudi Arabia, Kuwait, somewhere like that. We have one rig in Saudi, two more rigs in Kurdistan, and one rig in Georgia that we continue to bid into opportunities in the region. I don't think we'll have all those rigs activated by the end of the year, but there's a good chance that we'll see opportunities that allow us to bid competitively on two or three of those. We do have active bids right now in multiple locations for those rigs. The first tender we've been involved in that has gone to award was the Kuwaiti tender, while all tenders are still hanging open.

Okay. And between now and the middle of next year when these rigs would be up and running in Kuwait, is that what the tender stipulates? Or is that because of the time that you require to activate the rig? What’s the reason for that delay of six to nine months?

Well, it's exactly according to their schedule for activation. They had this multi-rig project that they put out for tender, and they had a schedule of operations that we bid into. So we're following their schedule. There will be some recertification requirements we'll need to do in those rigs early next year. There'll be some capital tied to that, which we'll circle up on later once we have that all determined. But we bid into their schedule, and we'll have the rigs ready according to their schedule. There’s no early start bonus, and they seem to be quite tight on their scheduling.

Okay. In the U.S., you mentioned additional 12-horsepower rigs. Is there demand to move more horsepower rigs from the U.S. into Canada?

Great question. The market is short rigs in Canada for Q1. We don't know how that's going to play out for the year because not all of our 1,200 horsepower rigs are under firm take-or-pay contracts. We still have a few of these rigs that are on the typical Canadian pricing agreement. We're encouraging our customers that if they want to retain those rigs, they need to lock them up with term contracts, which is good for everyone. It's good for the rig crew and the customer. If we're successful in contracting up the majority of those rigs, we could get a contract to move another rig up, pending the right economics.

Yes. And Waqar, I'll just add that the utilization of our remaining 1,200 AC rigs is approaching 80% right now, so there is a very strong market in the U.S. for those rigs as well.

Okay. And Carey, what was the cost of mobilization embedded in that $4 million number? And would you be amortizing the reimbursement over the term of the contract?

Right. So it was roughly $1 million to move the rig, and we took the hit in the third quarter. So those are in our Canadian operating costs. We're going to recoup the cost of that rig through the day rate increase that we're charging the customer over the life of the contract.

Our next question comes from Cole Pereira with Stifel.

To start, can you just remind us where leading-edge rates would have maxed out in the 2014 period?

Cole, in Canada, we saw rates go close to $30,000 a day, but most rates were in the high 20s in Canada and kind of the same numbers in U.S. dollars.

Got it. And as well, can you just refresh us on how many super-spec rigs you have in your U.S. fleet? How many more are readily available and how many rigs would be the SCR to AC upgrade candidates?

Sure. Our U.S. fleet is comprised of 67 super-spec rigs right now, and 56 of those are running. We see a pretty good line of sight to get most of those working, as I said earlier, by mid-next year or sooner. We have another 15 rigs in the U.S. that are DC SCR rigs. They are good upgrade candidates for that sort of USD 12 million price range. In Canada, we currently have 29 super-spec rigs, and they're fully booked for the winter with some contracted up for multiple periods.

Okay, great. That's helpful. And some of your peers are talking about their leading-edge rigs generating 50% gross margins. Are you seeing any of that in your U.S. fleet yet? And I mean, is there conceptually a line of sight that this could occur on a blended reported basis for your U.S. business over the next few quarters?

Cole, I think Kevin did a good job covering the equipment difference between 2022 and 2014 and how there's a lot more value being provided with the rigs. There is an operating cost difference. Our operating costs back in 2014 were probably $13,500, and today it's about $17,500 in both markets. It’s about a $4,000 a day difference. The old $30,000 needs to be $40,000 just to get the same cash margin. On a percentage basis, we now need day rates into the upper 30s. We see that at the leading edge; I think Kevin covered that as well. We're seeing a handful of rigs that are in that 50% field margin range. In terms of getting the entire fleet to that range, we'll see how long the fundamentals of this industry stay strong. We've given guidance for Q4 and Q1 that shows significant margin increases for both Canada and the U.S. Should commodity prices hold together, we expect continued increases in margins in both markets.

Cole, I think we've guided in the past; it usually takes about three quarters for fleet rate changes to flow through into the fleet averages. That would push us into late Q2, mid-Q3 next year. The fundamentals certainly look firm through that period.

Okay, got it. And just one more quick one for me. How should we be thinking about working capital in Q4?

We should have kind of flat working capital, maybe a little bit of working capital relief depending on when the winter slowdown happens at the very end of the year. We did have quite a big increase so far this year, about $80 million, which is reflective of higher revenue and higher activity.

Our next question comes from Keith MacKey with RBC.

Just wanted to start out with what you’re seeing on the customer inquiry front, maybe in Canada and the U.S. Can you just talk about the level of inquiries you’re seeing versus the amount of super-spec rigs you have available? And I think importantly, are these inquiries from customers looking to pick up rigs or potentially high-grade from existing rigs they may be running that are either current mechanical or SCR rigs that are running now that they look to replace with a super-spec rig?

Yes. So first of all, in Canada, I would give guidance. I thought our rig count would get into the high 70s, maybe 80, possibly a bit above 80 in Q1, which would be about 15% higher than last year for activity based on customer conversations and indications for bookings that we have. On the super-spec front in Canada, I think the market is probably short four or five rigs in Q1, which means that customers may then look to push some more work into Q2, giving us a stronger push into Q2 and even into Q3. If we see a strong contracting pickup by our customers to lock in rigs, that might mean that we have room to bring one more rig up. We will see. In the U.S., the rig count is flattening out a bit, moving up slightly, but remains stable. There is still this trend to increase the capability of rigs in the field. A super-spec rig operating today may only have two mud pumps; it will automatically be replaced by a rig that has three mud pumps or an upgrade will happen, and the rate moves up with it. This is a good trade, and the capital gets recovered. We've replaced a few decent rigs, not super-spec, with some rigs now that have three pumps going out. There's still a strong narrative of capital discipline which is really healthy by the operators. It seems like when we get into a new budget cycle in 2022, along with fresh capital in the new year and likely strong commodity prices, I think we can see a move up in rig count. You could see rigs being added in January, probably not much before then.

Yes, and Keith, I'll just add one other point to answer your question. When we talk about customers looking to increase the capabilities and performance of the rigs, we are not seeing customers switch from mechanical and SCR rigs to Precision AC rigs. We're seeing competitors' AC rigs running for customers, and the customer is deciding to make a switch to improve performance by taking on a Precision rig.

I’d say that there's always been a desire in healthier times by E&P companies to try and level load. That was present in the mid-2000s when gas activity was going strong. Level loading was around in 2010 and 2012 with strong commodity prices. What’s changed and made it more likely now is this broad abundance of super-spec pad-walking rigs.

And I'm not showing further questions at this time. I would like to turn the call back over to Lavonne for any closing remarks.

Thank you. I’d like to thank everyone for your interest in Precision and joining us today. That wraps up our third quarter conference call. Have a great day. Bye.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect and have a wonderful day.