Q3 2022 Archrock Inc Earnings Call

Good morning, and welcome to the Archrock third quarter 2022 conference call. Your host for today's call is Megan Repine, Vice President of Investor Relations at Archrock I will now turn the call over to MS. Repine you may begin.

Thank you Regina Hello, everyone and thanks for joining us on today's call with me today are Brad Childers, President and Chief Executive Officer, Archrock, and Doug Aron Chief Financial Officer of Archrock Yesterday, Archrock released its financial and operating results for the third quarter 2022, if you have not.

A copy you can find the information on the company's website at Www Dot Archrock Dot com.

During this call we will make forward looking statements within the meaning of section 21 E of the Securities and Exchange Act of 1934 based on our current beliefs and expectations as well as assumptions made by and information currently available to Archrock management team, Although management believes that the.

<unk> reflected in such forward looking statements are reasonable it can give no assurance that such expectations will prove to be correct. Please refer to our latest filings with the SEC for a list of factors that may cause actual results to differ materially from those in the forward looking statements made during this call. In addition, our disc.

And today, we will reference certain non-GAAP financial measures, including adjusted EBITDA gross margin.

Gross margin percentage free cash flow free cash locked or dividend and cash available for dividend for reconciliations of these non-GAAP financial measures to our GAAP financial results. Please see yesterday's press release, and our form 8-K furnished to the SEC I'll now turn the call over to Brad to discuss Archrock third quarter.

And to provide an update of our business.

Okay.

Thank you Megan and good morning, everyone.

Results for the third quarter reinforced my excitement about what lies ahead for archrock.

Demand for natural gas remains resilient and the market conditions for large midstream compression are excellent as evidenced by several leading indicators across our business.

Third quarter highlights include we generated adjusted EBITDA of $92 million, reflecting solid underlying business performance and sequential growth in total gross margin dollars.

In addition quarterly results benefited from a net gain on the sale of assets as we continued to advance our fleet high grading strategy.

The market for contract compression continues to be strong backed by a sharp customer demand high utilization of existing compression equipment and log long lead times for Newbuild units.

For the second quarter in a row, we grew our operating horsepower by 100000 horsepower excluding asset sales.

We increased our exit utilization by 200 basis points to a record 89%.

90% utilization as of the end of October and expect utilization will continue to increase through the end of the year and into 2023.

Spot rates for our compression services are tracking utilization higher as we made additional progress on repricing our installed base of horsepower during the quarter.

Year to date bookings have doubled compared to this time last year and our backlog remains robust.

This is providing us great visibility into horsepower growth utilization and as a result pricing power for the remainder of the year and into the next.

During the quarter, we also sold small noncore units totaling 124000 horsepower.

Included in this number is a sizable asset sale transaction divesting approximately 100000 horsepower, including all of our remaining active small horsepower units in South, Texas East, Texas, The Barnett and Louisiana.

Fleet high grading efforts have been central to our strategy for several years.

Through these efforts our goal has been to improve utilization and profitability through market cycles by focusing on standardization.

Large horsepower segment of the midstream market.

High grading customers and enhancing leverage to growth plays.

Since the end of 2019, we've closed major transactions and other assets other asset sells a small horsepower totaling 3500 units and over 700000 horsepower with an average size of 200 horsepower per unit.

Today, you can see the benefits of our fleet transformation and our fleet quality and standardization in terms of size.

Age and the configuration of our equipment.

Reduce volatility in our utilization and improved profitability.

Looking ahead, our focus shifts to adding more large horsepower that will continue to improve our earnings quality and emissions and efficiency.

This includes pursuing more electrification of our fleet both by converting some of our existing units to electric motor drive as well as building new electric units.

Since the end of 2019 sale proceeds of nearly $250 million has been used to reduce debt and manage our leverage during and as a result of a market downturn.

And are now also available to pre fund investment into new standardized and large horsepower for growth enhanced earnings and corporate returns.

Energy fundamentals and macro drivers confirm what we're experiencing with our customers and our powerful indicators. Both the multiyear opportunity that lies ahead for our compression business. One that we expect will provide a solid foundation for strong performance in the near term and improved stability and performance.

<unk> and utilization and profitability through future cycles.

So supply demand balances for oil and gas are tight as demand for hydrocarbons continues to prove resilient and at the same time as supply risks and constraints persist.

As a result, the range of commodity prices has shifted higher and these elevated levels are supportive of strong well economics and investment returns for our customers development programs.

Increases the capital budgets continue to be measured balanced by now well established cash flow objectives and in the near term supply chain and logistics challenges.

Together, we expect prudent and steady investment by our upstream and midstream customers, yielding low to mid single digit production growth rates.

This is consistent with the EIA as latest.

Latest projection for production growth in 2022, and 2023 of 2% to 3% for natural gas and 4% to 5% for oil.

A diverse energy mix is needed to satisfy global energy demand and preserve energy security for decades to come.

In particular, we remain encouraged by the growing potential for another wave of LNG projects that would result in a meaningful call on U S natural gas production and therefore, our natural gas compression services.

Okay.

Okay.

Turning to our contract operations <unk>.

Demand for our large midstream compression is robust.

Momentum continues to build across leading indicators for our business, including horsepower growth utilization and bookings.

The 100000 horsepower of organic horsepower growth that we delivered for the second quarter in a row reflects outstanding efforts by our team to put our idle fleet back to work.

We started a 155000 horsepower in the quarter, a near record and approximately 75% of this demand was met by our idle fleet.

Similarly stop activity continues to run at historically low levels as customers take advantage of higher commodity prices and as the market supply of available horsepower remains extremely limited.

Moving to horsepower utilization, we exited the quarter at 89% up from 87% in the second.

Quarter, and our fleet was 90% utilized as of the end of October .

In addition, a robust backlog provides outstanding visibility into future start activity and two off the chart utilization levels for our fleet as we enter 2023.

Utilization increases are driving spot prices sharply higher with our spot pricing for new deployments currently up a minimum of 20% year over year across the major the majority of asset classes.

We also implemented additional price increases on our installed base during the quarter and expect to maintain pricing leverage throughout 2023.

Similar to last quarter and as expected the acceleration of customer demand is requiring significant make ready and labor expense.

This short term dynamic of incurring higher costs to reactivate the idle fleet should abate in 2023 with a highly utilized fleet just as we've experienced with our late cycle business in prior cycles.

In addition, and as detailed on last quarter's call our third quarter results reflect the impact of higher prices or higher prices across major cost categories labor.

Arts and lube oil.

We remain confident in our ability to fully reclaim these impacts over the course of 2023 and are focused on navigating this reactivation phase of the up cycle with disciplined cost management and by continuing to use price increases to gain ground against the inflation driven cost increases we've experienced.

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Moving to our aftermarket services segment year to date activity and performance has improved meaningfully compared to 2021.

Both parts and service revenue are running at levels not experienced since 2019 due to customers catching up on deferred maintenance work.

Better pricing helped us achieve good gross margin performance consistent with our annual guidance range.

We're focused on continuing to optimize the performance and profitability of the segment as our revenue improves.

On new ventures, I am very excited about the progress, we're making to develop a suite of solutions to help our customers decarbonize.

Over the last two years, our internal team has been tasked with exploring opportunities with the following guiding principles.

Evaluate existing and emerging emissions reductions technologies for our existing business and installed asset base.

Identify ways to monetize our differentiated technological capabilities.

<unk> analyzed complementary new venture services aligned with our skill sets and competencies.

Through their work the team has identified methane emissions management as a segment of the clean tech market that is tightly proximate and value enhancing to our existing customer offerings.

In addition, we expect mitigating missing methane from leaks and ordinary operations will be critical and solidifying the important role natural gas will continue to play in delivering clean energy into the future.

Archrock is committed to being part of that solution and this week, we announced our second cutting edge solution that we're excited to begin commercializing.

The timing is ideal as the recent passage of the inflation reduction Act as further incentivized emissions management for many of our customers. While we are coming to market with these solutions for methane emissions.

Building on the Ecotec investment that we first announced in April we have developed a patent pending methane capture technology that reduces fugitive emissions from certain parts of the compressor package, including unit slowdowns and compressor packings.

The device is a skid mounted solution for natural gas powered and electric motor driven compressor packages for both existing compression facilities as well as greenfield locations.

This technology is complementary and value enhancing to our core contract compression services as many of our customers seek responsibly sourced gas certifications.

We believe it is cost competitive with our customers internal cost of carbon and will allow us to maintain our commitment to maximize uptime.

Over the last several months, we successfully piloted the technology in the field at a United production Partners' gathering facility operated by interest in the Barnett shale.

The field pilot comes following extensive testing of the technology in a lab setting.

We've already engaged with multiple customers across all basins on the technology have received positive reception and look forward to commencing full marketing marketing efforts during the fourth quarter.

This is an important milestone for our company, reflecting our commitment to power a cleaner America and I'm extremely proud of our new ventures team for their dedication to designing developing and successfully testing of technology, which has the potential to be a game changer for methane capture in the industry.

In addition, as you know we acquired a 25% stake in Ecotec earlier this year a company with impressive untested technology for continuous methane emissions monitoring and management.

During the quarter, we assisted Ecotec and successfully demonstrating the proven suite of solutions in oil and gas applications at a couple of customer locations.

This further validated the value of Ecotec comprehensive approach to methane litigation through the notification identification and quantification of emissions.

Yes.

I look forward to sharing updates on these new ventures as we work to drive our next leg of improvement further differentiation in our industry and ensure our sustainable future.

Now turning to capital allocation.

We're making high return investments in our fleet to grow prudently and profitably with our customers continuing our dividend commitments, while maintaining a healthy balance sheet and financial flexibility.

First on Capex.

We continue to hold the line on 2022 growth Capex at $150 million.

2023 demand is shaping up to be robust across our customer base and we are beginning at the annual work with our board of directors to solidify our capital budget for next year.

We have the opportunity to redeploy asset sell proceeds into an under supplied market at attractive long term returns and based on our customer engagements today, we expect the level of 2023 capex required to meet demands with core strategic accounts will be higher than in 2020.

Two.

In fact customers have already begun planning for compression needs to support 2024 programs given the limited supply of and long lead times for equipment.

Okay.

This is an ideal time as it comes just as we're also beginning to reap the benefits of a multi year strategic transformation to standardize and digitize our platform.

We intend to balance this investment in profitable profitable growth with our other capital allocation objectives of leverage reduction and shareholder returns and new interest development.

Maintaining a strong balance sheet and liquidity underpins our ability to execute on our plans over the last three years strategic divestments of older noncore assets have allowed us to effectively manage our leverage through the downturn.

And now with a much improved investment environment, we have essentially pre funded a portion of our growth investments and a higher profit large midstream compression units.

We remain.

<unk> committed to returning capital to our investors this quarter will mark the company's 36th consecutive dividend payment.

Today, our yield is a compelling 8%.

As well covered at one eight times.

The profitable growth. We see ahead gives us line of sight to leverage of below four times, which we will provide which will provide us enhanced financial flexibility and the opportunity to increase shareholder returns in 2023.

We believe our record utilization and robust backlog levels set us up to perform exceptionally well in 2023.

We expect to generate higher financial returns as we continue to reprice, our installed base of horsepower and.

As we at the same time work aggressively to drive cost optimization in our operations.

Market fundamentals for the compression industry are as exciting as I have ever seen.

And we intend to continue leveraging our best in class customer service and operational execution.

<unk> the benefits of digitalization and advancing our emissions management and reduction strategy.

With that I'd like to turn the call over to Doug for a review of our third quarter performance and to provide color on our updated 2022 guidance.

Thank you Brad let's take a look at the summary of our third quarter results and then cover our financial outlook.

Net income for the third quarter of 2022 was $15 million and included a noncash $4 million long lived asset impairment.

We reported adjusted EBITDA of $92 million for the third quarter 2022, compared to $99 million last quarter.

Excluding net gains on the sale of assets, our EBITDA declined by approximately $1 million.

Underlying business performance was solid relative to internal expectations.

We increased our total gross margin slightly on a sequential basis and by $3 million compared to the third quarter of 2021 in the face of meaningful cost inflation and despite non strategic asset sales totaling 134000 horsepower.

Turning to our business segments contract operations revenue came in at $170 million in the third quarter up $4 million or 3% compared to the second quarter.

Operating horsepower and pricing both increased sequentially.

Compared to the second quarter, we grew our gross margin dollars slightly as higher revenue was partially offset by increases in make ready parts and lube oil expenses.

Our third quarter contract operations gross margin percentage was 58% and was largely.

Consistent with our expectation for gross margin percentage due to decline in the second half of the year before resuming growth in 2023.

We are experiencing a lag affect typical of our business at this point in the cycle and believe we are seeing the bottom of our financial performance.

In our aftermarket services segment, we reported third quarter 2022 revenue of $43 million up $7 million compared to the year ago period or 19%.

Third quarter Ams gross margin of 17% was up 200 basis points year over year as higher revenue drove better cost absorption.

Growth capital expenditures in the third quarter totaled $39 million similar to second quarter levels as we continue to invest in new equipment to meet customer demand.

Maintenance and other capex of $24 million, reflecting a busy quarter of unit reactivation and the associated make ready capital.

This brought total capital spend for the quarter to $65 million.

Our financial position is solid we exited the quarter with total debt of $1 5 billion.

Reflecting $34 million of net debt repayment during the quarter.

And with the successful bond offerings in the last few years, our interest rate risk is very manageable.

Today variable rate debt represents less than 15% of our total long term debt.

Lastly, we maintain a healthy level of liquidity of $492 million as of September 30.

Our leverage ratio at quarter end was four three times.

Managing our debt during this period of investment in our fleet continues to be a primary focus for Archrock and we are committed to bringing our leverage down to our longer term target of three five to four times.

We recently declared a third quarter dividend of <unk> 14, five cents per share or <unk> 58 on an annualized basis. Today. This dividend level. This dividend level represents an attractive yield of 8%.

Cash available for dividends for the third quarter of 2022 totaled $41 million leading.

Leading to healthy third quarter dividend coverage of one eight times.

As we reinvest in our business our quarterly dividend will remain a fundamental pillar of our 2022 capital allocation, reflecting our confidence in archrock strong cash generation capacity.

And as Brad discussed earlier as the path to leverage below four times becomes clearer next year. This will provide opportunity to revisit our capital allocation, including the potential for additional returns to shareholders.

Turning to our 2022 outlook execution in the third quarter was solid in the second half of the year is playing out as expected with.

We forecast an increase in our total gross margin dollars in the fourth quarter with modest profitability growth in our contract operations segment, partially offset by seasonal weakness in the Ams business.

Looking at adjusted EBITDA guidance, we expect to exceed the high end of our prior guidance range of $330 million to $350 million.

This is due to our consistent performance during the third quarter.

The profitability growth, we anticipate in the fourth quarter as well as the added benefit of the third quarter net gain on sale of assets.

We remain focused on optimizing our performance until the positive trends in our bookings and price increases give way to a multiyear improvement in our financial results.

With that operator, I think we're now ready to take questions.

At this time I'd like to ask a question simply press star followed by the number one on your telephone keypad again that is star one for any questions. We'll pause for just a moment to compile the Q&A roster.

Our first question will come from the line of TJ Schultz with RBC capital. Please go ahead.

Yes.

Yes.

Great. Thank you and good morning.

Good morning first on.

Good morning.

Methane capture technology I do understand it will be complementary to your core business.

How should we measure the commercial commercialization of that technology.

As you start to market. It does it helps when your new business you monetize leak mitigation. If you can just provide any framework for.

How you measure that as a competitive advantage for you all how the hub value enhancing contract compression.

And then also how the IRA maybe expedite that thanks.

Thanks for the question.

First on the prospect of what it's going to mean to Archrock commercially it's going to take time for us to build.

Build out what that's going to look like for a few reasons number one we really are just at the front end of actually engaging customers in that commercialization discussion.

To the lead time for us to fabricate and receive units is going to put it out into mid.

Second or third quarter of 2023.

And over this timeframe, we expect to do the work to gain clarity on how impactful this could be.

On the positive side, however, I want to conclude by pointing out that we think that this technology could have wide applicability with 50 million horsepower in the market today, a number of locations that could benefit from this from our technology in this device and customers increasingly focused on <unk>.

Managing their emissions, we're looking to market. This to the intersection of those customers that are looking at their internal cost of carbon.

Focused on mitigating the methane that they could contain with with our technology and we think that looking forward it could it could be very impactful.

For the business, but candidly, we need time to build out that commercial model.

TJ. This is Doug I'll, just add for the avoidance of doubt we are not entering the fabrication business.

That will be an outsource.

Gilbert Archrock is not reoccurring.

And.

Our excited very much about this opportunity.

Okay. It makes sense, we'll stay tuned.

Okay switching gears.

Maybe Doug on capital allocation, you mentioned line of sight to leverage below four times you also indicate the opportunity to increase shareholder returns.

Next year.

So I guess the question is pricing power you expect meaningful.

Enough to do both in 2023, even with Capex next year above 22 levels.

Or as you invest in this.

Under supplied market and.

Preliminarily realize better returns in the message that you expect to be able to increase shareholder returns before maybe you explicitly hit that four times leverage threshold.

Yes.

Great and fair question and I'll start with the caveat of course that as we think about shareholder returns that's something we talk with our board with quarterly.

But TJ I think what we're seeing now is again that line of sight to sub four times.

In terms of the capital investment that you've talked about we will give guidance for capex for next year, and our fourth quarter call, but as Brad mentioned in his script.

The benefit of a couple of hundred million dollars of asset sales, a portion of which will be redeploying into that growth for next year.

I'd say, yes, it very much will be on the table, perhaps before we achieve four times, but it is that once we have a confident line of sight to that and as you described with the pricing environment. We think we are seeing with demand being really good and equipment availability being very tight.

Back to again grow Brad this is perhaps the most exciting time.

We've ever seen in this industry.

Okay makes sense. Thank you.

Yes.

T J, let me let me just add let me just add to that.

<unk> answer on that when we're looking at 2023 right now I would.

I would definitely suggest that the catalyst for a short term performance in our business, our excellence and our business is positioned well to take advantage of them. The combination of market demand, where we're seeing bookings already out into 2024 record utilization.

<unk> pricing prerogative and line of sight to leverage of below four times, we'll give more clarity when we give 2023 guidance of course, but I am ambitious we are ambitious that we can look at at achieving growth as well as an increase in shareholder returns.

In the near term.

Look forward to talking more about that when we get to offer 2023 guidance.

Again to ask a question simply press star one on your telephone keypad. Your next question will come from the line of Selman <unk> with Stifel. Please go ahead.

Okay.

Thank you good morning.

I guess first of all I'll, just kind of going back to deal electric side of it can you talk about that a little bit more on <unk>.

The demand that Youre seeing.

Just what the supply chain look like for putting more of this compression into electric.

Yes.

We see good bookings right now for electric Motor drive in fact, looking at our growth Capex budget for 2022, I think that about 15% of our Capex will go toward electric motor drive units both in the form of converting our existing horsepower electric motor drive as well as and in building new.

New units for delivery in 2023.

As.

That demand look.

Right now for 2023, we see it incrementally picking up but we also think this technology change is not going to be.

Super rapid in the near term it looks like it's going to be a measured ramp with that percentage increasing every year.

Some number percentage points, but probably more in the 5% to 10% range then.

And then higher than that and the reason for that is just that the electrification of the field that is getting power to so many locations is going to prove to be I think.

More time consuming and it's going to take longer than than rapid conversion to electric motor drive.

Would prevent.

Got it.

Can you just say if youre seeing a premium pricing for that relative to it.

You had two new units one.

<unk>.

Driven off of.

Diesel versus one driven off of electric or you're getting the pricing for that.

Couple of thoughts on that the first is that.

Our units that we have in the in this fleet today are natural gas driven meaning we take a portion of the natural gas that were that we would compress and use that to we burn that in our unit to provide the power to drive the compressor. So we don't use diesel use natural gas.

And there is a great efficiency in that in that we are using some of the customers production.

Now in contrast, when we provide electric motor drive then we have to bring a the customer has to bring electricity to that location and pay out of pocket cash for that electricity and that's a big distinction.

Incentivizing customers that want to electrify it really has to be that incremental cost for power has to be incentivized by their emissions ambitions. So that's that's a comparison of the two so it's not diesel versus electricity natural gas, which doesn't have a current cash cost versus electricity, which does and finally to address your questions.

Secondly, while we're seeing premium pricing in the market for our entire fleet today.

<unk> returns.

The returns we expect on.

Motor Drive electric Motor drive and gas fired are basically part of the same very comparable the rates are different but the returns will be the same to us overall Fortunately those returns are excellent in this current market environment.

I appreciate all that.

And then E.

Is carbon capture and opportunity for you guys.

Compression standpoint.

There will be multiple opportunities for us to evaluate participating in the carbon capture economy as it grows.

First carbon capture is going to require some compression and so we are definitely in the market to evaluate.

Where we can provide compression for our carbon capture projects for our customers.

The compression operations generate quite a bit of carbon and there are technologies that are.

Pretty nascent but developing to look at how to capture a small scale carbon emissions.

And sequester them also so those are two opportunities within the carbon capture economy, that's to develop that we'll be evaluating but it's very early it's very early going on that level of smaller scale carbon capture.

Got it.

Okay.

That'll do it for me I'm good thanks.

Thank you.

There are no further questions at this time I will turn the call back over to Mr. Childers for final remarks.

Great.

Thank you everyone for participating in our third quarter earnings call.

When I think of where Archrock stands today I am excited about what lies ahead for our business.

We are well positioned operationally and financially to capitalize on opportunities in the compression market as the demand for our services increases.

Thank you all very much.

Ladies and gentlemen that concludes today's call. Thank you all for joining you may now disconnect.

Okay.