Cactus, Inc. Q2 FY2023 Earnings Call

Good day, and thank you for standing by. Welcome to the Cactus Second Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Alan Boyd, Director of Corporate Development and Investor Relations.

Thank you, and good morning. We appreciate you joining us on today's call. Our speakers will be Scott Bender, our Chairman and Chief Executive Officer, and Steve Tadlock, our Chief Financial Officer. Also joining us today are Joel Bender, President; Steven Bender, Chief Operating Officer; TS, CEO of FlexSteel; and Will Marsh, our General Counsel and Executive Vice President. Please note that any comments we make on today's call regarding projections or expectations for future events are forward-looking statements covered by the Private Securities Litigation Reform Act. Forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond our control. These risks and uncertainties can cause actual results to differ materially from our current expectations. We advise listeners to review our earnings release and the risk factors discussed in our filings with the SEC. Any forward-looking statements we make today are only as of today's date, and we undertake no obligation to publicly update or review any forward-looking statements. In addition, during today's call, we will reference certain non-GAAP financial measures. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are included in our earnings release. With that, I'll turn the call over to Scott.

Thanks, Alan, and good morning to everyone. We are understandably pleased with the company's performance in the second quarter despite a weakening US land market. We're particularly proud to be in a net cash position today, well ahead of our internal plan. As you know, free cash flow generation has always been a strength of our company and has been enhanced further by the FlexSteel acquisition. On a stand-alone basis, each of Cactus and FlexSteel set records for both quarterly revenue and adjusted EBITDA. This strength reflects the highly differentiated offerings in each of our segments. Today, we'll walk through results in our recently introduced segment reporting format consisting of Pressure Control, which is legacy Cactus, and Spoolable Technologies, which represents the FlexSteel business. Some second quarter total company highlights include revenue of $306 million, adjusted EBITDA of $115 million, adjusted EBITDA margins of 37.7%. We paid a quarterly dividend of $0.11 per share, record cash flow from operations of $108 million. Yesterday, we announced that our Board approved a 9% increase in the quarterly dividend to $0.12 a share. On July 31, we repaid the full $155 million of debt raised to finance the FlexSteel acquisition, leaving us once again free of bank debt. I'll now turn the call over to Steve Tadlock, our CFO, who will review our financial results. Following his remarks, I'll provide some thoughts on our outlook for the near term before opening the lines up for Q&A. Steve?

Thanks, Scott. As Scott mentioned, total Q2 revenues were $306 million. Pressure Control revenues of $199 million were up 2.3% sequentially, driven primarily by increased customer activity despite the decline in US land activity as the quarter progressed. Operating income increased $5.1 million or 10.3% sequentially, with operating margins increasing 200 basis points primarily due to lower transaction expenses, partially offset by an increase in the allowance for doubtful accounts, which was primarily attributable to a single customer. Adjusted segment EBITDA was $69.9 million, an increase of $0.8 million or 1.2% sequentially, with margins decreasing slightly by 40 basis points, driven substantially by the aforementioned allowance. As a reminder, we closed the FlexSteel acquisition on February 28. So the second quarter results represent our first full quarter of ownership of the business, while the first quarter included only March results. Spoolable Technologies revenues were $106.7 million and operating loss was $6 million. Operating loss was inclusive of $19.3 million of inventory costs associated with the step up in value of inventory on hand at acquisition, $8.7 million of intangible amortization expense, and $18.1 million of expense associated with the remeasurement of the earn-out with the FlexSteel acquisition. The remeasurement expense this quarter reflects the revenue outperformance versus our prior forecast. This liability will be remeasured and adjusted, if necessary, on a quarterly basis through the final earn-out valuation date of June 30, 2024. Adjusted segment EBITDA, which excludes all the above non-cash charges, was $45.5 million with margins of 42.6%, an approximately 1,200 basis point increase from March levels due to the depletion of higher cost material in the prior quarter and improved operating leverage. Note that no corporate costs have been allocated to FlexSteel in the period. On a total company basis, second quarter adjusted EBITDA was $115 million, up 45% from $79 million during the first quarter. Adjusted EBITDA margin for the quarter was 37.7% of revenues, an increase from the first quarter due to operating leverage and higher contribution from the Spoolable Technologies segment. Adjustments to total company EBITDA during the second quarter of 2023 included approximately $2.2 million in transaction-related fees and expenses, and non-cash charges of $5.3 million in stock-based compensation, $18.1 million related to the FlexSteel earnout liability, and $19.3 million of purchase accounting-related step-up in inventory, which impacted Spoolable Technologies cost of sales. Depreciation and amortization expense for the second quarter was $22 million, which again includes $9 million of amortization expense related to intangible assets booked as part of purchase accounting. Total D&A expense during the third quarter is expected to be approximately $15 million, $7 million of which is associated with our Pressure Control segment and $8 million of which is associated with Spoolable Technologies. This figure is inclusive of an expected $4 million of intangible amortization expense within Spoolable Technologies during the third quarter. Intangible amortization expense is expected to remain relatively stable at $4 million per quarter for the next several quarters as the longer-lived acquisition intangibles amortized at a steady rate. Net interest expense during the second quarter was approximately $5.9 million. Interest expense increased sequentially due to the debt level and accelerated amortization of deferred financing fees, which contributed approximately $3.3 million to interest expense as we paid down debt faster than our forecast and recognized these expenses in the second quarter. We expect interest expense of approximately $1 million during the third quarter. Income tax expense during the second quarter was $10 million. Tax expense increased due to higher expected earnings and the elimination of the benefit related to a release of our valuation allowance utilized in the first quarter. During the second quarter, the public or Class A ownership of the company averaged 81% and ended the quarter at 81%. Barring further changes in our public ownership percentage, we expect an effective tax rate of approximately 21% for Q3 2023. GAAP net income was $32 million in the second quarter versus $52 million during the first quarter. The decrease was driven by higher income tax expense, higher interest expense, increased inventory step-up expense, increased purchase price intangible amortization, and the expense related to the remeasurement of the earn-out liability associated with the outstanding performance of FlexSteel. We prefer to look at adjusted net income and earnings per share, which were $67 million and $0.84 per share, respectively, during the second quarter versus $51 million and $0.64 per share in the first quarter. Adjusted net income for the second quarter applied a 26% tax rate to our adjusted pretax income generated during the quarter. We estimate that the tax rate for adjusted EPS will be 26% during the third quarter of 2023. During the second quarter, we paid a quarterly dividend of $0.11 per share, resulting in a cash outflow of approximately $9 million, including related distributions to members. The Board has also approved a 9% increase to the quarterly dividend of $0.12 per share, which will be paid in September. Additionally, we repurchased approximately 4,000 shares of Class A common stock in the final days of the second quarter under our new authorization for approximately $159,000. We ended the quarter with a cash balance of $64 million and gross bank debt of $55 million. Since the end of the quarter, we repaid the entirety of our bank debt outstanding and are once again in a net cash position. Looking ahead to the third quarter, we expect to make our 2022-related TRA payment and distribution, which will be approximately $34 million, along with an estimated 2023 cash tax payment of $9 million and a quarterly dividend of $10 million. Net CapEx was approximately $6 million during the second quarter of 2023, and we're reducing our full year 2023 CapEx outlook to $35 million to $45 million on lower expectations for near-term growth spending at Pressure Control given moderating activity levels. This range is inclusive of planned investments in low-cost supply chain diversification but excludes investments in the Middle East, which we now believe will occur in early 2024. That covers the financial review, and I'll now turn the call over to Scott.

Thanks, Steve. I'll now touch on our expectations for the third quarter based on our reporting segments. During the third quarter, we expect Pressure Control revenue to be down approximately 10% versus the $199 million reported in the second quarter as the decline in drilling activity impacts our business, which remained resilient to the declining rig count in the first half of the year. As of last Friday, Baker Hughes US land rig count is down 17% from year-end 2022 levels and down 14% from Q1 2023 average levels. Our differentiated Pressure Control business continues to outperform this activity decline. We expect that rig count might continue to be pressured in the third quarter, although customer indications suggest activity will be flat to up in the fourth quarter if commodity prices remain constructive. Our larger well-capitalized customers remain committed to investing in their business through commodity cycles, and our revenue outperformance of the declining rig count year-to-date is reflective of this commitment. Adjusted EBITDA margins in our Pressure Control segment are expected to be 32.5% to 34% for the third quarter, inclusive of pressure control, SG&A and general corporate expenses. This adjusted EBITDA guidance excludes approximately $4 million of stock-based compensation expense within the segment as well as transaction-related expenses. Margins are expected to be down sequentially on lower operating leverage, although we've begun to see deflation in our supply chain costs after many months of inflationary pressures. We expect the benefits of this to begin to materialize in the third quarter and more significantly in the fourth quarter. In the Mid-East, we continue to work through testing and trials, which are progressing on schedule. We're also continuing our work on evaluating ownership structures in the region. Upon the completion of our evaluation, we expect customer acceptance and first orders in late 2024. As mentioned earlier, we now expect to finalize our investment structure in the region in early 2024. Switching over to Spoolable Technologies segment, we expect revenue to be relatively flat versus the second quarter, driven by continued penetration and share of wallet and share of market. This outperformance of the market highlights the benefits of the product diversification achieved with the acquisition. As discussed last quarter, our Spoolable Technologies segment was also working through some higher cost inventory during the first quarter, and that headwind is now behind us. We expect adjusted EBITDA margins in this segment to be in the approximately 40% range for Q3, moderating slightly from record Q2 levels with volatility in our supply chain. Note that this margin guidance excludes approximately $1 million of stock-based compensation in the segment. Also, given the high inventory turnover, we have now completed the amortization of the non-cash step-up in value of inventory associated with purchase price accounting ahead of plan, and we will not have that cost or add back going forward. As mentioned in the Form 8-K that was filed last night with our earnings release, we announced a few changes. Our Chairman, Bruce Rothstein, who has served in that role since the company's founding in August of 2011, has stepped down from the Chairman role after his many years of valuable service. He will remain a Director and continue to contribute to the Board for which I'm very thankful. I've assumed the role of Chairman in addition to continuing my current responsibilities as CEO. Given my additional responsibilities as Chairman and my role supporting the integration of FlexSteel, Joel has assumed the role of President. As President, Joel will continue to oversee our supply chain, including our manufacturing and production facilities. Steven Bender has assumed Joel's role of Chief Operating Officer, where he will continue to oversee our branch and field operations, managing the majority of our associates and introducing significant technology enhancements to our service delivery and invoicing processes. Gary Rosenthal, an independent Board member since 2018, has assumed the Lead Director role. You should not infer any retirement plans from these changes. We are still in the early innings of introducing the FlexSteel product line to Cactus's much larger customer base through joint meetings and are highly encouraged by early efforts to integrate our sales organizations both in the US and internationally. Just like Cactus, the FlexSteel team is highly technical, delivers a superior product and service, and strives to exceed customer expectations. I'm confident that, as with the Cactus legacy business, more customers will learn to appreciate the many benefits associated with the FlexSteel Spoolable product, including speed of installation, total cost of ownership reduction, increased safety, and reduced emissions for more efficient field operations. We anticipate introducing new products and services in 2024, the details of which will be discussed when appropriate. As stated previously, our substantial free cash flow in the five months since the acquisition closed enabled us to repay all of our $155 million of bank debt well ahead of plan. The debt-free balance sheet and increased confidence in the strong through-cycle cash flow profile of the combined business has led us to re-evaluate our cash return priorities, as evidenced by our June announcement of the inaugural share repurchase program and the increase to the base dividend announced yesterday. Going forward, we expect to remain discerning buyers of our own stock, as we believe we will continue to be rewarded for having the flexibility to invest in attractive organic and inorganic growth opportunities with our excess cash while maintaining a strong balance sheet. While third quarter activities for Pressure Control are expected to be down given the year-to-date decline in US land activity, Spoolable Technologies is expected to remain stable. We're confident that our consolidated business will continue to outperform the market and we remain encouraged by the investment discipline we see from both our customers and service industry peers. Moreover, we expect that our in-process supply chain diversification will further strengthen our low-cost, high-quality competitive advantage in future periods. And with that, I'll turn it back over to the operator so that we may begin Q&A.

Our first question comes from Stephen Gengaro of Stifel.

Thanks, good morning, everybody.

Good morning. How are you?

I am good, thanks. I am good. So my first question, when I think about the legacy business, we had modeled and expected market share to grow a little bit. And I know you're not going to speak directly to market share, but can you talk about what you're seeing in that business, both from a pricing perspective and just sort of if the competitive landscape there has changed at all? And if you want to tell me if you think we're right, you gained about 200 basis points of market share, we'd love to hear that, too.

Well, as you know, we're not going to talk about market share directly, but I will share with you that we set a record for market share during the quarter. I am absolutely not going to talk about pricing. I never have, and I certainly never will. So sorry about that, Stephen. At least you got part of your question answered.

What can you tell us about the competitive landscape? Has there been any change, and do you believe the competition has made progress, or is your position as strong as it has been for the past several years?

Well, I guess the best evidence of that is the statement I made about record market share for the quarter.

Thank you. I wanted to follow up on your earlier comments regarding rig counts in the third quarter and the possibility of stabilization. Can you elaborate on what gives you the confidence in this stabilization and the potential recovery in 2024? Are you basing this on conversations or early orders?

Yeah. So let me be clear, even though you haven't asked this question explicitly. But I believe in transparency, as you know. From conversations with our customers, my feeling now you may recall, I called a trough of 650 earlier. I'm revising that 650 down to closer to 600 for the US land count. I think that that's going to probably occur in the mid to latter part of the third quarter, after which time we'll see some stabilization. I feel like we'll begin to see some increases, particularly coming from the privates who have suffered the most in terms of activity decline, and they always respond first.

Great. And since you mentioned that, I'll slip one in. On the private side, you've made progress with privates, and it seems like the last couple of quarters. That’s fair, right?

We have historically made progress with privates. The fact of the matter is privates used to account for about 35-or-so percent of our business. They're down to about 30%. But that's not terribly surprising when you consider how much the privates have dropped.

Yes, great. Great color. Thank you.

Thank you. One moment for our next question. Our next question comes from David Anderson of Barclays.

Hey, David.

Hey, good morning, Scott.

How are you doing?

Great. I’d like to follow up on Stephen's question. Regarding your larger customers, would it be accurate to say they have been maintaining their current approach? I'm curious about their comments, if any, regarding 2024. Do you expect them to remain steady going forward, with any additional progress likely coming from private customers or possibly natural gas? Overall, how are you viewing the next two or three quarters?

To clarify, without naming specific customers, the significant player you might be considering has shown strong activity in the Permian and Delaware regions, though they have reduced their presence in gas-focused areas. While that reduction wasn't substantial, it was significant enough. Keep in mind that those gas rigs that were operational have either ceased or are close to ceasing operations. Therefore, it's misleading to claim that the major companies have kept their rig counts stable. Looking ahead, we have a fairly clear view through the end of the year, but I don't see any of our customers discussing their plans for 2024 just yet. I believe that, assuming oil prices stay around the $78 to $82 mark, we'll likely see some budget adjustments. This could lead to increased activity from both private companies and larger firms. I mentioned before that despite expectations that we could offset the decrease in gas rigs by increasing oil operations, cash flow remains paramount. As cash flow decreases while shareholder returns stay consistent, adjustments are necessary, and changes have already occurred. I know I’m getting ahead of the questions you may not have asked, but…

Please do, please do.

If I think about the decline that we've seen in our rig count, believe it or not, it's about 50% gas, 50% oil-related, which kind of supports my position that cash is cash.

So some are talking about natural gas rigs coming back later in the year. I know you didn't get too specific there, but I know there is this kind of LNG build-out happening at some point in '24. Are you in that camp there? Or do you think this is going to be more kind of privates on the oil side will be more sort of that uptick 4Q into 1Q?

Yeah, the latter.

You mentioned that nobody is discussing 2024, and I'm curious if you find it surprising that there isn't more conversation about it. Are your customers perhaps waiting to grasp the cost structure? Typically, would you expect discussions about 2024 to be happening around this time of year?

I would say that when you're in the January time frame, you normally get visibility over six months, but as you approach a budget reset period, I think that period of visibility contracts a bit. So ask me again in September, and I think I'll have a much better idea of what we can expect.

It makes a lot of sense. If I could just shift over to the Spoolable side, the margins and the EBITDA margins were impressive this quarter. It sounds like you're projecting margins in the 40s for the next quarter. However, it seems that the normalized numbers are significantly different from your initial expectations. I'm curious about what has changed. Since you have had the business for four months now, are you noticing something different? Is it related to cost opportunities, or are you just managing it better? I'm interested in understanding the changes in your long-term margin outlook.

Well, I'm not managing it. TS is managing it, and TS is with us this morning. So I want to be clear about that. This is not a reflection of Scott Bender. TS, would you like to maybe offer a comment there?

Yeah, David, this is TS. The FlexSteel business is a very robust business. I think you should not read too much into the first quarter to second quarter change in margins because the first quarter, Cactus had owned FlexSteel just for a month, David. It also had a lot of accounting-related adjustments to inventory, et cetera. So on a go-forward basis, the 40-plus-percent margin that Scott guided towards is near term, the expectations. Business has got a phenomenal competitive advantage. The business has got a really meaningful customer value proposition. It's very differentiated, and we are firing on all cylinders. So I hope that provides you a little bit of an overview. Scott, anything else?

That TS's polite way of saying he's confident that he can maintain those margins.

40-plus, all right. So look, I'm going to address this question a little bit here. I know you don't want to discuss pricing and I know you don't want to go into details on contracts.

Don't ask me about it, David.

I'm not going to ask you about it. I'm posing a very general question here. I'm interested in how your customers order your Spoolable products. Does this usually fall under frame agreements? Is it job to job? I'm not sure if you want to respond to this, but is there a general guideline regarding how much volume gets repriced each quarter? I'm asking because steel prices have decreased significantly since March. You mentioned that part of it involves clearing out that expensive inventory. I'm generally curious about how this business operates from that standpoint.

So, David, let me just help TS a little bit. You have two questions here, right? The first is how the customers place orders. Is that right?

That's correct.

Are you asking how far in advance they place orders?

It's more as it kind of relates to the timing of pricing, like, is there like a loose frame agreement, which you just kind of plucking it down and it gets like every once a year, you kind of look at it. I'm just sort of trying to understand like with steel prices correcting as much as they have, like how much does that roll through, I guess, kind of loosely trying to understand.

Okay. TS, please.

Yeah. David, just a big picture, just stepping back, one of the things E&P operators focus on is clearly managing costs. They manage it pretty tight through their supply chain departments. The benefit we have in the FlexSteel side is that business has got a really differentiated value proposition. The value proposition is based on safety and quality. And the safety and quality, FlexSteel has got a tremendous track record. We've not had one operating field failure in the history of the business. As a result, we were able to differentiate ourselves versus competition. The other part, just before I answer your question that you should just keep in mind is Spoolable products and services make up less than 2% or right about 2% of share of wallet of an operator's spend. So that’s background. All to say, operators really place callouts, it's sort of like a milk run, David. And it's just a milk run order purchased, and now we do both products as well as services. We deliver it all through delivery to length products and services that we offer our customers. So all to say that sometimes we get products and services that are required to be in customer site within three days, most of the time within five to seven days. And that's how we manage the business.

Thank you very much. Appreciate it.

Thank you. One moment for our next call. Our next question comes from Kurt Hallead of Benchmark.

Hey, good morning.

Good morning, Kurt. How are you?

Good, Scott. Thanks. How are you doing?

I’m great. Thanks.

Awesome. So, hey, Scott, in the press release, you kind of referenced that Spoolable Technologies would lag the Pressure Control business in terms of the revenue impact or slowdown in activity. So I was just kind of curious in that dynamic. Is it kind of like a quarter lag? Question number one. And question number two, do you expect that the Spoolable business would kind of see the same sort of magnitude of decline that you indicated that Pressure Control is going to see in the third quarter?

Okay. I may not have explained that accurately. TS, feel free to chime in if I’m wrong, and don’t worry, it won’t affect your job. Regarding Spoolables, TS' team is expanding their market presence and share of wallet. We aren't currently in a position to specify what percentage of their revenue fluctuations are due to market penetration or wallet penetration as opposed to timing delays. However, they rely on the drilling, completion, and online activation of wells to drive their business. Therefore, their operations will be affected. The key question, which I believe TS has addressed, is whether this increase in share of wallet and market will offset those impacts. Is that accurate, TS?

I won't disagree with you, Scott. But I would like to add to the comment. Kurt, the share of wallet is a unique market lever that we have to continue increasing penetration into our customers. To provide some background on that, unlike products that are offered only in one part of the customer's value chain, Spoolable products are available at multiple points in the value chain. For example, it's used during the construction of the pad. In this case, the business's revenue and bookings will mirror the rig count movements. Additionally, it is installed further down the value chain. For instance, when connecting the well pad to the central tank battery, that's one segment. Then, connecting the central tank battery to the water disposal line is another segment. Similarly, connecting the central tank battery to the midstream takeaway lines creates multiple segments. When we refer to share of wallet penetration, we mean that when we first engage a customer, it is usually on one of these segments. Once they see how well FlexSteel performs and how effectively the team delivers service, they start using us in other segments of their operations. This trend is expected to continue growing, as it has over the last 10 years that I've been here, and I hope it will keep growing in the future.

That's great. Fantastic. Appreciate that. Scott, follow-up in the comment you made about the Middle East, kind of, rollout and what you see for Pressure Control. I think you kind of referenced sometime late 2024. Again, I don't want to mince any words that you mentioned, but is it late '24 when you think you'll start to generate incremental revenue? Or is the real incremental revenue opportunity, 2025 and beyond?

Our expectation is you'll see that at the end of 2024, and then it will accelerate into '25 and thereafter.

Okay, got you. All right, appreciate that. That’s all for me.

Thank you. One moment for our next question. Our next question comes from Saurabh Pant of Bank of America.

Hi, good morning. Good morning, Scott.

Good morning. How are you?

Thank you for your question, Scott. I wanted to follow up on your response to Kurt's inquiry regarding the Spoolable aspect. I believe I understood you to say that while there is a lag when Spoolables are affected, you feel confident that share of wallet penetration could help mitigate that impact. Can we consider the possibility that Spoolable's revenues might not decline at all over the next few quarters?

Well, we never provide guidance beyond a quarter, as you know or you don't know. So I really would only like to offer you, I think, guidance on the next quarter. I think that our guidance stands, that is that despite this falling rig count and activity level that they're going to maintain their Q2 levels. I'm sorry, I can't be more precise, but...

Yeah. No, Scott, I totally understand that. But just the way we should think about the lag, obviously, completions lag, the rig count and production and how you carry that production to the central tank batteries and onwards, that lags completions, right? So just what kind of a lag should we think about? Is it six months? Is it nine months? Is it different than that? Or just conceptually, how could we think about that lag?

Yeah. Saurabh, this is TS. Scott, if I may?

Sure.

I think it's very challenging to accurately predict the future, particularly when it comes to estimating customer budget allocations across different segments. However, I will attempt to address your question. Historically, we have observed a lag of about three to four months. With our enhanced cross-penetration capabilities with Cactus, where we are selling more products, we are also having numerous meetings with Cactus customers. We're starting to see growth in the Pipe-Under-Pad segment and increased line pipe sales to various types of customers. While historically the lag has been three to four months, this time it might be slightly shorter or longer, but that has been our usual timeframe.

Okay. No, that's very helpful. And then a quick follow-up on the cost side of things in Spoolables, I know steel is a big cost, but you don't price your product like it's steel, right? It's a value-based pricing. But can you help at all in terms of how should we think about operating leverage, fixed cost, working, variable costs? Anything you can give along those lines.

Yes, Saurabh, this is Steve. We are not providing any guidance on material costs as a percentage or similar details. We prefer to keep that information confidential for competitive reasons.

Okay, guys, thanks for the answers. I’ll turn it back.

Thank you. I am showing no further questions at this time. I would now like to turn the conference back to Alan Boyd for closing remarks.

We appreciate everyone joining today and look forward to speaking with you next quarter.

Have a good day, everybody. Thanks.

This concludes today's conference. Thank you for participating. You may now disconnect.