Earnings Call Transcript - TH Q2 2020

Operator, Operator

Greetings and welcome to the Target Hospitality Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Mark Schuck, Senior Vice President of Investor Relations. Thank you. You may begin.

Mark Schuck, Senior Vice President of Investor Relations

Thank you. Good morning, everyone, and welcome to Target Hospitality's second quarter 2020 earnings call. The press release we issued this morning outlining our second quarter results can be found in the Investors section of our website. In addition, a replay of this call will be archived on our website for a limited time. Please note the cautionary language regarding forward-looking statements contained in the press release. This same language applies to statements made on today's conference call. This call will contain time-sensitive information as well as forward-looking statements, which are only accurate as of today, August 10, 2020. Target Hospitality expressly disclaims any obligation to update or amend the information contained in this conference call to reflect events or circumstances that may arise after today's date, except as required by applicable law. For a complete list of risks and uncertainties that may affect future performance, please refer to Target Hospitality's periodic filings with the SEC. We will discuss non-GAAP financial measures on today's call. Please refer to the table in our earnings release posted in the Investor section of our website to find a reconciliation of non-GAAP financial measures referenced in today's call and the corresponding GAAP measures. Leading the call today will be Brad Archer, President and Chief Executive Officer, followed by Eric T. Kalamaras, Executive Vice President and Chief Financial Officer. After their prepared remarks, we will be joined by Troy Schrenk, Chief Commercial Officer and open the call for questions. I will now turn the call over to our Chief Executive Officer, Brad Archer.

Brad Archer, President and Chief Executive Officer

Thanks, Mark. Good morning, everyone, and thank you for joining us on the call today. In addition to discussing our second quarter performance, I will touch on our continued focus around capital discipline and cost reductions, as well as the recent trends we have seen from our energy end market customers. In this challenging environment created by the COVID-19 pandemic and simultaneous shocks to global commodity markets, Target delivered solid second quarter results. We took decisive steps in reaction to what was a pronounced reduction in customer activity and utilization levels. These steps align Target with customer demand and supported continued strong cash generation with discretionary cash flow for the second quarter of approximately $15 million. As the COVID-19 pandemic accelerated entering the second quarter, Target quickly implemented an operational response plan to ensure the health and well-being of our employees and customers. We have maintained this focus and as a result, we have not had any cases of COVID-19 impact our business. We also took immediate action to appropriately position the business for what we anticipated to be a challenging 2020. Amidst sharply declining utilization, we began dynamically managing capacity across our network to align with demand and our customers' needs while quickly reducing costs across the organization. Our cost reduction initiatives remain on track and our second quarter results reflect meaningful reductions in capital spending, cost of services, and recurring corporate expenses. These cumulative steps have allowed Target to maintain operating leverage and preserve robust cash generation in this challenging environment. We have positioned Target for long-term success, and as market dynamics evolve, there is potential to organically gain additional market share as we return to a more normalized pace of activity. Now, turning to the recent trends we have seen across the business. As we exited the second quarter, we began to see signs of activity stabilizing from our energy end-market customers and incremental gains in Target's occupancy and utilization trends. We have seen improvement in these metrics from lows that occurred in late May. Albeit modest, we have seen these positive trends continue through June and July. As a result, we have reopened several lodges that were temporarily closed early in the second quarter to meet increasing customer demand in both the Bakken and Permian. However, like many other industries, as we continue to move through 2020, there is downside risk from potential slower economic recovery or further COVID-19 related shutdowns. We remain cautious on a meaningful increase in activity levels through the remainder of 2020 but do anticipate marginal improvements as we move into the third and fourth quarters followed by seasonal deceleration late in the year. Even with incremental improvement in the second half of 2020, progress is likely to be uneven in the near term. As activity progresses towards normalizing, we will provide the market with a revised 2020 outlook when enough clarity is available. We have positioned Target to be successful through a variety of business cycles. While this one is certainly different, we will benefit from incremental improvements in activity levels as a result of our high-quality top-tier customer base and expansive networks in the most economical basins. These are key factors that differentiate Target, allowing us to appropriately manage the business in challenging environments. The second quarter results are indicative of our ability to navigate an unprecedented situation and remain focused on ensuring the long-term success of Target Hospitality. I will now turn the call over to Eric to discuss our second quarter results in more detail.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Thank you, Brad, and good morning, everyone. I will begin with the discussion of our results, review our capital program, and conclude with details on our progress mitigating financial impacts from the economic uncertainty we are experiencing. As we anticipated, we experienced a sharp decline in utilization in the second quarter due to the COVID-19 pandemic and declining global commodity markets. However, in this challenging environment, we were able to produce strong quarterly results. Second quarter 2020 total revenue was approximately $54 million, adjusted EBITDA was approximately $14 million, and discretionary cash flow was approximately $15 million. Turning to our segment performance. The Permian Basin delivered second quarter revenue of $21 million compared to $52 million in the same period last year. This decrease was driven by lower utilization as customer demand was sharply reduced in response to the accelerating global pandemic and crude oil price volatility. In the Bakken, as a result of the temporary closure of our communities in May, the second quarter revenue was negligible. We have seen incremental improvements in customer activity and demand in the region and have recently reopened lodges in response to this increase in demand. Our government segment remained consistent with quarterly revenue of approximately $17 million. Our All Other segment, which consists primarily of construction fee revenue from the TC Energy pipeline project, had revenue of approximately $16 million for the second quarter compared to $3 million in the same period last year. The revenue increased as a result of TC Energy's announcement to proceed with the project in March. However, as a result of the Supreme Court ruling in July, we anticipate limited activity associated with this project for the remainder of 2020. Recurring corporate expenses for the quarter were approximately $7 million. We took decisive steps to reduce cash expenses across the company and restructure the organization to match activity where appropriate. These measures contribute to an over 7% reduction in recurring corporate expenses from the first quarter, and we are on track to contribute annualized savings of approximately 20%. With our expense reductions, we anticipate recurring corporate expenses to remain around $6 million to $7 million per quarter for the remainder of 2020. We generated cash flow from operations of approximately $15 million in the second quarter, and a 27% discretionary cash flow yield of revenue, which illustrates the significant resiliency in our business model. Even in this challenging environment, we expect to continue generating robust operating and discretionary cash flow, providing sufficient capacity to fund all normal course business activities, as well as to strengthen our balance sheet. Capital expenditures for the second quarter were approximately $1 million, including minimal maintenance capital. As a result of lower aggregate demand in reduced customer activity levels, Target anticipates capital expenditures to be less than $3 million for the remainder of 2020, or $7 million to $10 million for the full-year. We ended the quarter with $425 million of total long-term debt, including $85 million drawn on our revolving credit facility, and consolidated net leverage of 3.4 times. As a reminder, our long-term debt consists of $340 million in Senior Secured Notes due 2024, and $125 million ABL facility which have no near-term maturities or immediate financial covenants, providing us with significant flexibility and liquidity within our capital structure. In addition, we anticipated our outstanding debt balance to be reduced in the second half of 2020 from continued cash generation, which will only further strengthen our available liquidity. Now, turning to the progress we’ve made in mitigating the effects of the ongoing economic uncertainties. The second quarter results illustrate the pronounced reduction in activity and utilization levels we anticipated. However, we took decisive action to reduce costs during the quarter and were able to reduce our Permian and Bakken cost of service by over 30% compared to the first quarter. As we previously outlined, we took proactive steps to modify select commercial contracts for the long-term benefit of Target. These discussions resulted in a mutually beneficial outcome, providing lower committed beds to our customers in 2020, while maintaining contract integrity by preserving ADR and margins for Target in future years. In addition, we gained greater visibility and long-term revenue and cash flow by extending contract commitments including exclusivity from 2021 into 2025. As part of our negotiations, we obtained approximately $60 million of additional minimum revenue commitments at attractive margins. This also significantly reduces near-term contract renewal risk that was coming up in 2021. These modifications appropriately positioned Target to participate in increased demand, given our enhanced market share capture as we progress to a more normal operating environment next year. Our cumulative response to these economic uncertainties has been taken with the focus of preserving liquidity, protecting our balance sheet, and retaining financial flexibility. Our cost reduction initiatives, along with our focus on capital discipline, allowed us to exit a challenging quarter with approximately $60 million in liquidity, an increase of $14 million in the first quarter of this year. We believe the strength of our balance sheet and cash position, along with a continued focus on capital stewardship, will provide the opportunity for Target to emerge as a stronger, more resilient company as we return to a more balanced market.

Brad Archer, President and Chief Executive Officer

Thanks, Eric. We anticipated the second quarter to be challenging, and it was. We witnessed a significant reduction in our energy end-market customer activity, which resulted in a pronounced reduction in utilization across our network. In a challenging environment, our strong second quarter results are a testament to Target's ability to quickly react to an unprecedented situation. We protected our balance sheet and exited the quarter with an enhanced liquidity position. We have intentionally established Target’s expansive network within the most economical basins in North America while aligning with first-class customers and the best operators in the region. These factors underscore our ability to continue to succeed in a challenging environment. While the scale and pace of an improving economic outlook is difficult to predict, Target is well-positioned to adapt to changing market conditions and take advantage of the eventual recovery. I appreciate everyone joining us on the call today, and thank you again for your interest in Target Hospitality. Operator, you may now open the line for questions.

Operator, Operator

Our first question is coming from Jeff Grampp of Northland Capital Markets. Please go ahead.

Jeff Grampp, Analyst

I was curious - first off, appreciate the commentary on kind of inter-quarter and 2Q and what you guys have seen thus far in 3Q. Just hoping to dive in on that a little bit more. Do you guys have any sense, I guess, or any level of confidence at this point to be able to say that 2Q was kind of the trough if we look at just kind of the energy business ex-Keystone? Because I know that kind of a separate kind of dynamic there, but if we just kind of look at the core Permian Bakken exposure? Do you guys feel that 2Q was the trough given what you've seen thus far in 3Q or can you just kind of talk about how you're seeing directionally the remainder of your plan now?

Brad Archer, President and Chief Executive Officer

Yes, Jeff, this is Brad. Let me take that first; then Eric can jump in as well. But we do believe it's the trough. I think the question is, how fast and how steadily does it continue to rise, right. If you look at the trough in May, we’ve seen 10 consecutive weeks now of increase in our occupancy. We think that definitely sheds some light on us calling it a trough. I think there are definitely things out there that could change it depending on what happens with COVID and how it goes. But it's at a steady state and we believe it's still a slow crawl up, but we see better occupancy as we continue to move into the third and fourth quarters.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Jeff, it’s Eric; good morning. I think as we indicated last quarter, I wouldn't say a lot has changed in our outlook as we think about the back half of the year. Certainly, the one positive thing that has been helpful is that the movement off the trough is a little faster than what we had initially modeled, which is helpful. I think as Brad indicated, as you look out going into Q3 and into Q4 to some extent, we do expect this movement up. But I think from a planning perspective, we're cautiously optimistic, but we are being sober about there are certainly a number of unknowns, and we'll just have to play those out as we move through the year. But we're certainly looking forward to some positive momentum as we continue some trajectory here.

Jeff Grampp, Analyst

And my follow-up on the ADR side, Permian outperformed quite a bit than what we were expecting and was up a decent amount sequentially. Is there anything going on there that you could kind of point to, and is that a good baseline to think about going forward or just how we should think about maybe ADR kind of going for the rest of the year? Thanks.

Brad Archer, President and Chief Executive Officer

Sure, that's a great question, and you're right. Yes, there is something going on there. And so, if you recall, we had worked through some contract modifications with a handful of large key customers. Some of those discussions involved amounts owed to us that we imputed as part of the change in contract. What you're seeing, and particularly this quarter, was some of that revenue coming through and hitting ADR positively, but certainly, doing it with no increase in utilization and certainly no cost of service attached to it. So, that had the net benefit of increasing the ADR above and beyond what you otherwise would have expected. I think you look to normalize those out. If I'm you, I would take a few dollars off of that as we look out in the future. I wouldn't think your ADR will be much different than it was, let's say, in the first quarter. So, if you think about first quarter relative to third and fourth quarter, that probably puts you in a better spot moving forward.

Operator, Operator

Our next question is coming from Stephen Gengaro of Stifel. Please go ahead.

Stephen Gengaro, Analyst

I guess while you're on the topic you were just on, I'll ask you this. Your Permian gross profit margin was down. I know occupancy was down and the market was awful. But given that ADR move, if you get back to a similar ADR going forward, I guess what I'm getting at is how much of the change is ADR-related and how much is kind of under absorption as we try to think about back half margins in the Permian?

Brad Archer, President and Chief Executive Officer

Sure, so, let's take a step back. You're asking a great question, but let's take a step back. When we look at the contracts and had the discussions with some of the counterparties, we made the election this year to be constructive and work with our customers and a handful of customers at that, which did impact how we think about the business and the performance of the business as we move through 2020. But that has a positive impact on us in 2021 through nearly 2025 at this point, okay. So there were absolutely some positive things for us. So, when you think about your question, it's really a function of occupancy at that point. And we came out of this with a better contract structure. But the reality is, the occupancy was down substantially. And we did give on some of the committed revenue that we otherwise would have expected, which had a net impact of hurting the margin. Now, we expect to get a substantial portion of that back in 2021, and particularly in 2022. I think when you look at it, you have to look at it in totality and not just look at it in 2020.

Stephen Gengaro, Analyst

And then the - can you talk about - so we look at the Permian numbers, and they were better than expected in aggregate. But when we look at the monthly progression through the quarter and when we look at July, and we're on August 10. So, I think you have pretty good visibility into August by now. How does - how did the first - what's that trajectory look like? And how is the third quarter occupancy shaping up relative to the second quarter and sort of the monthly progression? Because, you're halfway through the quarter almost, I figure you have a pretty good sense for the first couple of months?

Brad Archer, President and Chief Executive Officer

Look, I'll take that, and again, Eric can jump in if he wants. But the trajectory is a little slow. It started off fairly quick; it hit the bottom. As I said, 10 straight weeks of increase in our occupancy, but we've seen that it's still on a trajectory going upward, but it’s slowed some in the past few weeks. So look, we look for that to continue upwards as we continue into the third and fourth quarters. The question is how fast, right? Right now, we believe that's going to be a slow crawl up and definitely throughout 2020 and part of 2021.

Eric Kalamaras, Executive Vice President and Chief Financial Officer

Yes, I think Stephen, you're asking great questions. And I think the reality is this, there are so many unknowns that we are not expecting what I'll call something that's a meaningful improvement until kind of mid-next year, based on what we know today. Now, we're not getting that feedback necessarily from customers. We're giving that feedback from our experience in these businesses and how long it takes to typically come off cycles. And kind of peak and trough and all that. I'm not saying there's a peak in the year certainly either. I'm saying that we don't expect that we’ll see meaningful improvement. And so, I think we're planning on 12 to 18 months before we are at approaching levels of utilization and ADR peaks that are consistent with what we would have expected for this business on a mid-cycle basis. And so, we think we're a little bit away from that, but we're continuing to make some improvement.

Stephen Gengaro, Analyst

And just one more, if you don't mind, and then I'll get back in line. But the - when I think about the occupancy and I look at a market right now that will seemingly have a meaningfully lower average rig count in the third quarter, but a rising completion count and more frac crews. Is there a way to think about those competing factors on your utilization as we - even maybe not just third quarter but just going forward? Like are there more people on the completion side, more people on the drilling side fairly close if we get completion rising 20% and drilling falling 10%? Is that good or bad? Is there a way to think about those two dynamics?

Brad Archer, President and Chief Executive Officer

That's getting pretty binary. I mean, at some point…

Stephen Gengaro, Analyst

It's clearly the completion activity is rising and drilling is falling, right?

Brad Archer, President and Chief Executive Officer

Yes, I mean, to be fair, I mean, there are more people that are doing the servicing when you're doing perforations and fracking and then re-fracks and all that than there is actually drilling, right? There’s no question about that. What we are seeing are customers taking advantage of lower rig rates. So, producers are drilling more wells, right? But they are not completing them, okay? So, I think what you would expect to see over time as pricing allows is for an influx of completions which then provides more opportunity for human capital to come in. But look, there’s a lot that can happen between here and there.

Stephen Gengaro, Analyst

You know, because the data we see suggests that completion crews are rising pretty nicely and drilling activity is down quarter-over-quarter just on average?

Brad Archer, President and Chief Executive Officer

I mean, if you look at who is on our lodges, it's definitely the completion crews that came back, right.

Stephen Gengaro, Analyst

Got you, yes.

Brad Archer, President and Chief Executive Officer

So, we're definitely seeing that. I think, again, our question goes back to how this continues going forward, how fast? What's the pace of that? But we've had some of these come back really nicely, especially our larger customers, right? So, we like where that’s headed; it’s just not as fast as we’d like to see it at this point.

Operator, Operator

This brings us to the end of the question-and-answer session. I would like to turn the floor back over to Mr. Brad Archer for closing comments.

Brad Archer, President and Chief Executive Officer

Sure, thank you. Thanks everyone for your time today. We appreciate your continued interest in Target Hospitality, and we look forward to speaking again next quarter. Thanks.

Operator, Operator

Ladies and gentlemen, thank you for your participation. This concludes today's event. You may disconnect or log off at this time, and have a wonderful day.