Q3 2019 Earnings Call

October 24, 2019

Well both of those segments were impacted by slowing us activity drilling technologies experienced a steeper than expected decline driven by the sharp decrease in the us rig count as well as that related de stocking of polycrystalline diamond cutter inventories by our drill bit customers.

With DMP operators annual production targets within reach and with the goal of preserving and living within cash flow. Our MP, an oilfield service customers pull back their spending year earlier than expected this year.

Apogee is meeting the challenges of the current macro environment had arm.

During the third quarter and into the fourth quarter, we took restructuring actions to adjust our cost structure.

The actions we have taken so far will result in annualized savings of about $20 million.

We are continuing to evaluate additional actions and we will start to executing on them in the fourth quarter.

We are stepping up our productivity efforts and continuing our cost discipline, while preserving our technology investments.

Our strong margin performance and robust free cash flow generation will continue to reinforce apogees position as set top box company.

We intend to carry this momentum through the remainder of the year and deliver another year of solid free cash flow performance.

We repaid $25 million of term loan debt in the quarter.

Since our spinoff, we have repaid 120 million of debt, we remain committed to deleveraging our balance sheet.

Turning to or segments.

Production on automation technologies segment revenue decreased 5% sequentially, which was driven by lower customer spending for artificial lift products and the other production equipment.

Although all of our artificial lift products were affected by the earliest startup BNP budget exhaustion, our rod lift product line held up well and were supported by our strong aftermarket service offering as well as customers converting older wells brought left.

Digital product revenue grew 10% year over year led by our downhole monitoring and production optimization products.

Turning to drilling technologies revenues decreased 22% sequentially in the third quarter.

The revenue decline was driven by the sharp, 7% sequential decline than the average Usthree account.

Yes people and longer than expected period of customer Destocking, there polycrystalline diamond kind of inventories.

And the push out of diamond bearing orders due to capital discipline by our oilfield service customers.

Given the significant impact we are experiencing some destocking I would like to provide some historical perspective to this phenomenon.

We see inventory destocking cycle during periods of rig count declines.

During inventory Destocking, we see impact from two levels of Destocking.

First is our oil field service customers rightsizing their drill bit fleet to lower activity level.

This includes lowering bluebird build rate readjusting, and redeploying global field inventories.

The second level of impact is rightsizing, our catalyst pattern inventories themselves.

This involves lowering safety stock levels, increasing use of reclaim the cutters from all the beds and optimizing global inventory by moving excess inventories to wherever needed around the globe.

Hence during destocking the drilling technologies revenue will fall faster than rig count and during restocking periods, our revenues will significantly outpaced rig count growth.

This is a temporary phenomenon.

We have included a graph showing this historical perspective on slide eight of our earnings slide deck.

Based on our experience from prior cycles, given the steepness of Destocking, we expect a sharper recovery at inventory level normalizes and activity improves.

We have been through these cycles and situations before.

We have already reduced headcount appropriately in the segment to match the lower activity levels.

We continue to preserve our technology investments in the segment to protect and expand our leadership position.

Our drilling technologies team is executing well during this challenging market.

Both segments recorded year over year growth outside of North America.

Additionally, we made a strategic investment in a startup manufacturer of sucker Rod in Argentina.

This investment will help us to advance our growth in South America.

Before I turn the call over to Jay to take you through the details of the consolidated and segment financial results. Let me take a few minutes to share our view of the current market for our products.

For the fourth quarter of 2019, we expect continued weakness in us onshore activity driven by traditionally lower seasonal activity as well as further impact from the customer trends, we saw in the third quarter.

This includes.

NPS restraining spending as they look to land their 2019 capital budgets within cash flow as well as additional use Rick Rick come declines.

We also expect our oilfield service customers to extend that these talking of their polycrystalline Diamond Carter inventories into the fourth quarter aspect just to lower drilling activity and adhere to capital discipline.

We expect our PMT segment performance to remain resilient.

And outside of North America, we expect to international markets will continue to see growth and we intend to capitalize on these opportunities.

For these reasons in the fourth quarter, we expect to Apogees to poor post a sequential decline in revenue and adjusted EBITDA.

Given the short cycle nature of our business and added uncertainty due to customer destocking.

Visibility continues to remain challenging.

Therefore, we will provide an update to our fourth quarter outlook in early December .

We do expect activity levels to sequentially improve from current levels as we enter 2020 driven by new budgets and restocking by our drill bit customers as they prepare for improved activity levels.

We continue to remain focused on the factors under our control, including advancing our growth initiatives, maintaining cost discipline implementing productivity improvements and generating free cash flow.

Although the current market dropped this challenging our product lines remain highly profitable with long term growth opportunities.

Yes, well position to continue to deliver top box performance, given our margin resiliency and free cash flow generation capabilities.

Now, let me turn the call over today.

Good morning, everyone as David mentioned I'll be referring to the slides posted on our website.

Beginning with slide four for the third quarter revenue is $278 million, a decrease of 38 million or 12% compared to third quarter of 2018, and a decrease of $28 million or 9% sequentially.

Excluding the effects of acquisitions and divestitures revenue was down 11% compared to the years off period.

Cash flow from operating activities were strong at $64 million in the third quarter up $30 million from a year ago period, and 25 million compared to second quarter. This year.

In the third quarter, the adjusted working capital contribution to cash flow improved compared to the second quarter due to continued efforts to reduce our accounts receivable balances and drawdown on inventory.

Capital spending in the quarter was 9 million. Additionally, in the quarter, we used 12 and a half million of available cash to close on the acquisition of digital technology, which is strategic to our artificial lift portfolio.

Turning to slide five.

We're currently navigating a challenging market environment in North America.

Looking at rig count the average us rig count declined 7% sequentially in the quarter with the ended period rig count being down 11% compared to the end of June .

Year over year changing rig count at the end of September was down 18%.

After adjusting for the impact of spinoff environmental remediation charges and restructuring related items in the quarter. Adjusted net income was $21 million, resulting in diluted earnings per share of 27 cents.

We generated adjusted EBITDA of $67 million during the third quarter, a decrease of $11 million compared to 78 million in the third quarter 2018.

Sequentially adjusted EBITDA decreased $8 million from 75 million in the second quarter.

Year over year and sequential decreases were primarily driven by the sharp decrease in us drilling activity in the third quarter.

Deeper and longer period of oilfield service customers Destocking, there polycrystalline diamond cutter inventories in the push out at Diamond bearings deliveries.

We also experienced slower MP customer spending on artificial lift products and other production equipment.

In the third quarter net interest expense was $10 million, which was 5% lower than the second quarter as we're seeing the benefits of our deleveraging efforts.

In the third quarter, we funded to strategic technology acquisition and retained another $25 million a term loan debt from available cash.

Since the completion of the spin off on May 9th of last year was repaid $120 million of term loan debt or 17% as the initial debt taken at the time in the spin.

Our effective tax rate in the third quarter was 23%, which was within our guidance range.

Free cash flow conversion from adjusted EBITDA for the first nine months at 2019 was 43% substantially ahead of the 23% through the first nine months of last year.

Turning to slide seven.

Production and automation technologies revenue finished at $223 million, a decrease of $18 million or 7% from the third quarter, 2018, and a decrease of $12 million or 5% sequentially.

Excluding the effects of previously announced acquisition and divestiture activity revenue declined 6% compared to the year ago period.

Year over year decline was due to lower in key customer spending North America, partially offset by international growth.

The sequential decline was due to reduced customer spending for both our artificial lift products and other production equipment.

Adjusted segment EBITDA of $53 million increased $2 million or 4% compared to the year ago period, driven by cost discipline, and a high level of productivity benefits, which offset some loss of operational efficiency as a result was lower volume.

Adjusted segment, EBITDA increased $2 million sequentially or 3% from 52 million in the second quarter of 2019 due to strong cost reduction actions and the productivity benefits in the quarter.

Adjusted segment EBITDA margin was 24% compared to 21% in the third quarter of 2018 and 22% in the second quarter. This year.

Regarding our SSP leased asset program.

And capital investments in the downhole cables and pumps net of customer reimbursements at the conclusion of the lease is reflected in our cash from operating activities.

For the full year 2019, we've lowered our estimates and now expect that we own thus between 40 million and 45 million net of customer reimbursements in the cash from operating activities section of our financial statements supporting leased asset portfolio.

Compared to the second quarter 2019.

Against our Q3.

Due to capital discipline, many of our customers have pushed out there diamond bearing orders as they look to reduce spending in the current market environment.

But given the compelling economic benefits of Diamond bearings, we're confident we will continue to see adoption in the coming years.

Additionally, in the third quarter, we displayed our diamond bearings technology at a water environment Federation annual technical exhibition in New Orleans, as part of our efforts to diversify outside of oil and gas for this important technology.

Before I open the call for questions I want to share another validation of our customer centric strategy.

We achieved the highest net promoter score among artificial lift providers for the fourth consecutive year in an independent survey of over 300 qualified customers respondents conducted by combat light for 2019 apogee earned a net promoter score of 43% compared to the industry.

Average of 24%.

Our next closest competitors achieved 15%.

Net promoter score is a measure of customer loyalty. We believe this result is a validation of our customer centric strategy and more importantly, the dedication and hard work off apogee employees in improving the lives of our customers.

Finally, I want to thank all of our employees for their continued efforts and passion improving the lives of our customers our employees, our shareholders and our communities.

Im proud of their accomplishments and it's a privilege to for me to lead such a great team with that I would like to open the call for questions.

We removed from the question do you May press, the pound side or the Heskey.

And if you're using a speaker phone you may need to pick up the answer first refer prosumer numbers.

Also because we have a fairly large Q of questions. We enjoy these person. The please limit yourself to one question only so once again if you have a question press star one.

Morning, guys.

Good morning, Brian Yes.

Just as they look at production in automation technologies I'm struck by the.

Cost reduction efforts that are already underway, but.

Could you speak to was there a mix issue at play there as well.

Yes, so bad and I would say that the combination of things one is definitely the cost reduction.

Had an impact the mix what favorable but the productivity improvement at Innovia continuously executing these productivity projects.

And that those productivity projects in the quarter yield at a much higher than anticipated.

Benefit.

So in our guidance going forward, we have normalized that back because we don't expect that mix, sometimes that productivity projects the timing of when we get the benefit.

Okay, and then just in the context of the Q4 guidance what were on on that topic could you just remind us realize that you guys are expecting earlier than normal maybe budget exhaustion from some of your customers, but could you just remind us of the seasonal elements.

Within the prediction and automation technologies portfolio to be mindful of.

Yeah, so that the seasonal elements because as you know.

When you think of our <unk> auction left they tend to be mostly book and ship type a product lines very short cycle book and ship pump shopper and things like that right. So the seasonal aspect is you know that that the holiday period, then about working days the holiday period.

That affect that.

And second as you know the budget a caution Bai Yun Pete.

That that affects us.

And then lastly, we typically see lower absorption due in our manufacturing plants during holiday period as well.

Okay. That's helpful and thanks for the utterance for drilling technologies, that's really helpful. Historical context, I appreciate that I'll turn it back.

Yeah.

Our next question from Steve Anderson of Barclays.

Am I reading that right in do you still expect that same pattern to go.

Yeah, I think you know.

Because this the first time publicly we are going through this so Rick restocking Destocking Restriking cycle. So if you look at the data. We provided you know, it's roughly about 60 quarters going back right and out of the 60 quarters. There were one of the like 14 quarters, where the variation sequence.

Finally, I'd been within a 5%.

Six of the 50 quarter 66 quarters had sequential declines which are more than 20%.

And Alternatively, you know, we have 12 quarters, where the sequence will increase I've been more than 15% and five quarters, where the sequential increase I've been more than 25%.

So that two locations where that have been sequential decline in two consecutive quarters and that is Q1, all nine Q2 nine.

And that next one is Q1 15 and Q2 15.

But if you look at the subsequent quarter following two sequential decline quarters.

He has been a sharp recovery. So in Q3 of Oh, all nine it went up 19% and in Q4 or four nine it went up 53%.

And then when you look at Q3 up 15.

Following Q1 on Q2 15 of sequential decline it went up 18%.

Now if you look at that happen. So we had a Q3.

And customer commentary to us.

Quicker because off the two quarters top these talking they've done.

So what we are seeing right now is a level off these talking we normally see doing that industry downturn.

And I personally think that partly a function off the top capital disciplined by oilfield service companies and also the focus on cash flow generation of isotope company. So Dave hope that the prospective helps and I think for US. We really think every time, we are seeing it.

That.

That recovery will be much sharper and we have ever really well honed playbook and we know how to respond to those comedy and capitalize and if you look at our historical performance you will see that.

Oh, So one thing I'm kind of wondering about as your international business on your we're obviously folks on the U.S. side, but you also have a pretty big international presence has that mix changed when I'm looking at your historical numbers here and that chart has that mix of international versus us changed much that could maybe they can exacerbate.

David This is down turn a little bit more we've seen the past.

Yeah, you know I mean, it does that's an interesting observation because you know if you. If you apply the same thing with worldwide rig count you know.

Yeah, the rig count time series will look less wallet tile.

When Dave and that is a U.S. decline.

Becomes one of Destocking right. So the U.S. rig count tend to have a bigger impact on the destocking process than that international rig count.

<unk>.

Yeah, so going back to the digital acquisition, it's absolutely a very strategic acquisition for us. The what we are quite as that downhole technology gauge technology, which is integral part of our artificial left. So this provides the important for me.

Four month number one I know, but to give another capital priorities you know and clearly we are focused on deleveraging our balance sheet. So we always.

Make that keep that as a priority.

Thanks, Good morning, guys I wanted to ask about the pricing dynamics across both sides your business I know that.

On on drilling technologies, you have a very strong and rational market structure, there and I would not expect that you.

Yes, there are the refrain has been yes, there is hurting your pricing pressure on our products that we transcend those with.

Our productivity gains and innovation and you see that in our margins I wanted to get a status check on on that narrative as well, but also.

Ask you a pricing pressure has accelerated given the collapse and activity since September .

Yeah. So on the on the drilling side are you know yeah. You know we pacing is said to you know it's not have major issue right now and ER and what we are seeing it'd be expressed in the Q2 call is our customers wanting to think about mid tier capital usage, you know and for us.

Yeah, that's not a lot of margin difference between them, but the two product lines.

On the K T I would say the pricing side, it's not a meaningful right now because I think a that has had a recognition that you know.

If theres any either directional or or specific.

Sure one way, we had a good quarter in Q3 in terms of managing down the receivables and drawing down inventory due to the lower activity levels and we expect to continue that momentum into Q4 may not be quite as strong as we achieved in Q3, but we do expect to continue our efforts around receivable collections, even in a tough.

Our collection environment. These days capital discipline, and then managing the inventory requirements for today's activity levels. So we we expect to manage to some working capital contribution and cash flow Q4.

Our next question from China Mobile Hill of Bank of America.

Good morning I.

I guess personal hey, good morning, So I guess first just kind of stick on drilling technologies.

And we think about you know margins here what happened in the third quarter. They came in below what we were expecting you know, but could you maybe just talk about the impact on margins in split up between you know absorption and pricing you talked about.

Respond to that as well.

Yeah.

The volume coming out of the quarter was a significant step down as de stocking continue.

Through September and so we believe that we'll see a further impacted that in Q4, but hopefully we're coming closer to the end of that.

Okay, all right I'll turn it back over they still.

So looking forward to the mid quarter up in December but wanted to ask you a real quick about 2020, let's let's say the Jay is right and increased spending in the U.S. is down let's say high single digits, but then when you layer in your international growth through digital expansion you know maybe some restocking.

In a P 80 segment right because of the growth initiatives and because of the.

Efforts, we are doing we should do better than the market you know and I think we feel good about bad because you need to demonstrate that you know even given throughout this year you have demonstrated that so you should expect that.

The.

So you should be should see that.

Try to lower cost for on the manufacturing side, just a little bit more color there will be helpful.

Cost reduction initiatives, the $20 million annualized benefit when will that be fully realizing can you give us a little more detail on what was in that.

So so that's how I would I would think about it and in terms off or just on that 10 million a a 20 million most of that actions have been completed as we speak.

No there was that a few in about that off the left but most of that actions have been completed as we speak.

Okay and then my second question [noise] in this relates to adding new customers on the U.S.P. side, but maybe could you give us an update in terms of the conversion of customers or the user U.S. piece.

So using your rod lift equipment, and maybe how that's trending as you had new customers.

Yeah. So as we've said before you know it does the the customers that don't buy artificial lift that's a full lifecycle, so which means just because you have the U.S. be a installation doesn't automatically guarantee yeah rod lift conversion to it but since every one of the U.S. piece we.

Install goes on about monitoring.

Platform.

We have a better insights around that constantly providing a consultation smaller customers.

On the right kind to convert it so like we've said in the past you know two out of three time.

We tend to be successful getting the rod lift conversion.

Associated with or SP.

Thank you.

Yeah.

Our next question from Marc Bianchi of Cowen.

Thank you.

I'd like to follow up on the on the cost cutting first that that would just discuss some of you mentioned that pretty much all of the fixed portion has been implemented did you actually realized as well in the third order no caught in the third quarter.

Okay. So we should expect towards the end of September September that's when we saw the significant weakness.

Dan and and so.

This is mostly you end up September .

Beginning October type actions yeah, okay. So the anticipation as you get a full quarter of it in the fourth quarter then.

Yeah, probably yeah two months okay yeah.

Okay, Yeah, I get the reason I'm asking the question is if I'm doing some of the mass on on the guidance you're kind of the the midpoint of the revenue collide and the and the midpoint of the EBITDA guide still imply pretty hefty decremental margins in the fourth quarter.

And I would think that you know the tailwind of cost cost saves airway would offset some of that.

Could you, perhaps provide some more commentary there.

Yeah, and also the that that the high Decrementals sequentially are related to fuel thing you know, but and let me talk about the ones that impact and then what could potentially off that up so that they so things that impact are typically as I mentioned to you know that's that's the thing.

Sequential decline in drilling technologies, which we have built into our guidance in a definitely impacts that right because up though what we are trying to preserve flawed being able to on the second aspect to that is the lower manufacturing absorption, which I mentioned during holiday period, you know that would definitely.

A you know and we see that every every year, we see that ER. So that that also impact that.

And then the higher productivity, we saw in third quarter in ER in in our production on automation technologies or we're not planning that the peak.

No. So when you think about a sequence show you know that has an impact as well.

Now we are evaluating additional action or as we yes, we continue to work through our restructuring so that could potentially offset you know the high up incremental.

We have planned into the guidance.

So that's a possibility you know I mean, we're focused on lowering that but that's not how we felt that guidance right. Now so that would be a potential you know ER to that and then the last piece I would say as I think Jay mentioned, if you recall. He mentioned the you know we have built we have also built in them.

Billion dollars.

Off a legal costs due to defend our.

Intellectual property and a this relates to our drilling technologies business.

And so so that also oh that I'll come back. So in this period I mean that drilling technologies is that it's the highest decremental issue not merely because I'll ask we're preserving those technical capabilities and resources.

Okay. That's very helpful. Perhaps on the revenue side, if you could talk a little bit about the.

What's expected for the segments in fourth quarter I would suspect that drilling tech has the larger decline and I think you've already called out kind of a 5 million dollar headwind from de stocking I mean, I would presume that maybe we're talking about low double digit declines in revenue for drilling tech, which would imply production is.

Maybe.

To low single digits on the revenue side in the fourth quarter is that how you guys see it.

Yeah, you want to answer that yeah, yeah. So as you pointed out Mark we've already called the 5 million additional Sacramento from restocking and then also there will be a continued impact of bearings push out as a auto service customers just can't take those parents deliveries because they're a capital constrained on top.

All tool development, so he will be up higher than in the low double digits that you just quoted for drilling technologies.

And then a little bit higher.

Further the recent someone mentioned wet weather in and the holidays.

That's all that.

Okay.

That's great and then my last question just relates to the that's sort of restocking that you would anticipate in the beginning of 20.

Does that.

Well what might be the magnitude if the rig count it's just that full out from here because I think there's some anticipation from investors that maybe there really isn't a recovery the and huh.

Prior periods, but just maybe.

Q3 2019 Earnings Call

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