Archrock - Q2 2023

Transcript

Operator (participant)

Good morning. Welcome to the Archrock Q2 2023 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.

Megan Repine (VP of Investor Relations)

Thank you, Julianne. Hello, everyone, thanks for joining us on today's call. With me today are Brad Childers, President and Chief Executive Officer of Archrock, and Doug Aron, Chief Financial Officer of Archrock. Yesterday, Archrock released its financial and operating results for the Q2 of 2023, as well as updated guidance for the full year of 2023. If you've not received a copy, you can find the information on the company's website at www.archrock.com. During this call, we will make forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, based on our current beliefs and expectations, as well as assumptions made by and information currently available to Archrock's management team. Although management believes that the expectations 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 discussion today will reference certain non-GAAP financial measures, including adjusted EBITDA, gross margin, gross margin percentage, free cash flow, free cash flow after 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's Q2 results and to provide an update of our business.

Brad Childers (President and CEO)

Thank you, Megan. Good morning, everyone, thank you for joining our call. Exceptional execution drove Archrock's outstanding Q2 performance. In our results, we see the long-term and hard, hard-fought-for benefits of our transformed platform, combined with and operating in a compression market that remains undersupplied. In the Q2, our net income of $25 million was up nearly 50% compared to the Q2 of 2022. We generated adjusted EBITDA of $113 million, up 16% compared to the Q1 of 2023, and up 13% compared to the Q2 of last year. These increases were driven by positive momentum in unit start activity, pricing, and profitability in both our contract operations and our aftermarket services business segments.

In contract operations, revenue increased 7% sequentially and was complemented by a strong contract operations gross margin as we saw record utilization and record pricing. In aftermarket services, performance meaningfully exceeded expectations for the Q2 in a row. We delivered a 42% increase in gross margin dollars compared to the same period last year. We concurrently continued to increase returns to investors, raising our dividend for the second time this year, while also maintaining robust dividend coverage of 2.1 times. In addition, we began repurchasing shares under our buyback authorization. Last, as we continue to embed sustainability in our strategy, I'm proud to share that we recently received recognition for our progress from Hart Energy by being named one of 12 energy companies to receive the Hart 2023 Energy ESG Awards in the public midstream category.

These are just a few of our Q2 achievements. These achievements are the direct result of our employees' outstanding efforts over the past several years to execute on our strategic transformation and to deliver a first-rate customer experience each and every day, 365 days a year. As we continue to raise the bar for our company, our employees continue to step up to deliver excellent safety performance, outstanding operations, and strong financial results. For this, I'd like to pause and thank the incredibly hardworking women and men of Archrock. The step change in Q2 results is just the beginning for Archrock, and we believe we are set for an extended period of strong and sustained performance. I want to take a moment to reiterate what I said on our call last quarter.

We believe Archrock has never been in a better position than it is today. I'd like to expand on that statement and offer the reasons why we are in this position, which we believe is driven by three factors. First, natural gas production fundamentals remain durable and promising. Second, the compression industry is as tight as we've ever seen. Third, our competitive position is as strong as it's ever been, and our balance sheet offers distinctive flexibility within the compression sector. First, on the durability and promise of natural gas fundamentals. Let me reiterate and highlight a key differentiating aspect of our natural gas compression business. which is that our business is tied to natural gas production volumes and not commodity prices.

U.S. natural gas production forecasts continue to show growth in 2023 and 2024 volumes, with most forecasts showing projected growth rates in the low single digits on an annual basis. Associated gas volumes in the Permian and other liquids-rich shale plays, where the majority of our operating fleet is located, are expected to grow at an even faster pace. This is consistent with the elevated customer demand that we continue to experience for our large horsepower units, as compression infrastructure is required to transport these associated gas volumes to market. Second, the compression industry is as tight as we've ever seen, and we currently don't see a disruptor to tight market conditions. There is simply not enough equipment to satisfy current natural gas compression demand, much less to support the growth in gas volumes I just described.

The industry is still catching up following a period of significant underinvestment during and coming out of the COVID-driven downturn. In addition, Archrock and other outsourced compression providers, like many companies in the energy industry, are responding to broader market demands for capital discipline and restraining the amount of growth CapEx being invested. Last, lead times for new equipment remained around 1 year. This brings me to my third and final point. Our competitive and financial position offer significant flexibility within the compression sector. As we've sold small, non-strategic horsepower, we've quickly replaced this with higher quality EBITDA by investing in large and standardized horsepower in the more stable infrastructure segment of the market, high-grading our customer relationships, and enhancing our leverage to growth plays. As I step back and think about our position today, we have the most experience with over 68 years of operating expertise.

We are the leader in large midstream horsepower. Our fleet has the most horsepower, the largest horsepower per unit, and the highest percentage of large horsepower. We have the best balance sheet and financial position. This includes the lowest leverage ratio in the space, and as I will get to in a moment, we're moving our target even lower. With Archrock's superior platform, we have strong visibility and confidence in our ability to generate free cash flow and allocate capital with discipline, and we are well positioned to create and return value to our shareholders. A testament to our conviction, we increased our financial guidance for 2023, which Doug will walk through shortly. In addition, today, we're in a position to share some initial expectations for 2024, a lot sooner than we have been able to in the past.

Based on our current outlook for 2024, we are set up to grow our dividend with a 2024 target of 5% and maintain a dividend coverage ratio of approximately two times. Concurrently drive our leverage ratio even lower to a range of three to three point five times. Fund our growth capital expenditures, which we currently anticipate to be in the $160 million range in 2024, down 20% compared to 2023. This capital plan preserves significant optionality to buy back additional shares. Moving to our contract operations segment, we're seeing unprecedented levels of tightness in the market. This is evident in key demand indicators, including utilization, booking activity, and pricing. Fleet utilization exited the Q1 at 95%, another record for Archrock.

We also delivered approximately 75,000 in horsepower growth, excluding non-core active asset sales of 7,000 horsepower. Our team continues to do a great job putting our remaining idle fleet back to work. We continue to see historically low customer stop activity, and when we do have equipment returns from the field, this horsepower continues to be promptly rebooked at higher rates. On booking activity, customer demand is unwavering and in fact, extending in duration. With the compression market undersupplied and customers cognizant of long lead times, not only do we have an early and elevated order book for 2024, but booking demand for 2025 is already heating up. On pricing, with utilization at historic highs and continued strong booking activity, we've continued to move pricing higher. We achieved a record monthly revenue per horsepower during the quarter, reflecting a sequential increase of 5%.

This is the largest sequential increase since the current cycle-- upcycle began. Record spot pricing is holding, and we expect to continue to make progress moving rates up on our installed base. Gross margin percentage increased 450 basis points sequentially, based primarily on a couple of factors. First, make-ready expenses have started to decline to more normal levels with our more fully utilized fleet. Second, the price increases we're implementing this year are catching up with the cost increases we experienced over the last few years. Turning to aftermarket services, we're seeing noteworthy performance. Trends on the service side of the business really stand out as customers continue to catch up on deferred maintenance.

In addition to elevated activity, results also reflect the outstanding effort by our team to high-grade our AMS operations, both in terms of the quality of activity and the profit margins we are targeting. This has been really great work. In summary, our fleet transformation efforts over the past several years paid off in a big way during the Q2, and we believe the best is yet to come. Trends continue to point to a multi-year run for natural gas, and in particular, compression, one with a longer duration than previous cycles. As the leading outsourced compression provider in the U.S., we are well-positioned to capture significant value for our shareholders. With that, I'd like to turn the call over to Doug for a review of our Q2 and to provide additional color on our updated outlook for 2023.

Doug Aron (CFO)

Thank you, Brad. Good morning. We appreciate all of you joining us. Let's look at a summary of our Q2 and then cover our financial outlook. Net income for the Q2 of 2023 was $25 million. This included a long-lived and other asset impairment of $2.9 million, and an unrealized change in the fair value of our investment in an unconsolidated affiliate of $1.7 million. We reported adjusted EBITDA of $113 million for the Q2 2023. Underlying business performance was strong in the Q2 as we delivered meaningfully higher total gross margin dollars on both a sequential and annual basis. Results further benefited from approximately $1.2 million in Q2 asset sale gains.

Turning to our business segments, contract operations revenue came in at $201 million in the Q2, up 7% compared to the Q1 of 2023. Operating horsepower and pricing both increased sequentially. Compared to the Q1 of 2023, we grew our gross margin by nearly $17 million or 16%, resulting in gross margin percentage of over 62%. This was up 450 basis points compared to Q1 levels. In our aftermarket services segment, we reported Q2 2023 revenue of $46 million, up 10% compared to the Q1 of 2023. Q2 AMS gross margin of 24% was up from 19% in the Q1 of 2023, and 16% in the year ago period.

Growth capital expenditures in the Q2 totaled $71 million, as we continue to invest in new equipment to meet strong customer demand. Maintenance CapEx for the Q2 was $27 million, compared to $23 million during the Q1. Make-ready CapEx was down sequentially, which was offset by higher overhaul spending. In May, we completed the extension of our $750 million revolving credit facility through 2028. I'm very pleased with the continued support from our lenders in the debt markets, an indication of the health and steadiness of our business. We exited the quarter with total debt of $1.6 billion. Variable rate debt continued to represent 21% of our total long-term debt. In addition, we maintained strong available liquidity of $404 million.

We reduced our leverage ratio to 4.2x, down from 4.4x in the Q2 of 2022. As we execute our plan and our earnings power continues to build, we expect to achieve a leverage ratio well below 4x by year-end 2023, and currently anticipate taking that even lower in 2024 to a range of 3-3.5x. We recently declared an increased Q2 dividend of $0.155 per share or $0.62 on an annualized basis. Our latest dividend represents a solid yield of around 6% based on yesterday's closing price. Cash available for dividend for the Q2 of 2023 totaled $52 million, leading to impressive quarterly dividend coverage of 2.1x, even on the higher dividend level.

In addition to increasing the dividend this quarter, we repurchased approximately 220,000 shares for $2 million at an average price of $9.33 per share. This leaves $48 million in remaining capacity for additional share repurchases. Turning to our 2023 guidance, we have tremendous confidence in compression market fundamentals, in the execution we're seeing and in our financial outlook, both near and longer term. Taking into account solid first half performance and our enhanced outlook, we are raising our 2023 annual adjusted EBITDA guidance range to $430 million-$450 million, from $400 million-$430 million. This compares to $363 million in 2022.

After normalizing for 2022 net gains on asset sales totaling $40 million, 2023 adjusted EBITDA is projected to increase 35% year-over-year. Turning to capital, on a full year basis, we expect total 2023 capital expenditures to be around $295 million. Of that, we are holding the line on growth CapEx of $200 million to support investment in new build horsepower and repackage CapEx to meet continued customer demand. As Brad mentioned, we believe 2023 is just the beginning. Our exceptional execution, the undersupplied compression market, and strong backlog give us confidence to expect this robust market to continue well into the future. In the coming quarters, we look forward to build upon what we believe is a compelling value proposition for Archrock through durable and enhanced earning powers and growing return of capital to shareholders.

With that, Julianne, I think we'd now like to open the line for questions.

Operator (participant)

Thank you. If you would like to ask a question, please press star followed by one on your telephone keypad. To withdraw your question, please press star one again. Our first question comes from James Rollyson from Raymond James. Please go ahead. Your line is open.

Jim Rollyson (Director and Equity Research Analyst)

Good morning, gentlemen. How are you today?

Doug Aron (CFO)

Good morning.

Brad Childers (President and CEO)

Good morning, Jim. We're great, thanks.

Jim Rollyson (Director and Equity Research Analyst)

Brad, just to follow back up on the, on the contract compression margins, obviously, you kinda got it coming from, from both sides of the equation, with higher pricing, and then you saw costs come down. On the cost part of that equation, I think you've talked for a few quarters now about elevated make-ready costs, and, and as you kind of run out of... if you're close to full utilization, obviously, that, that fades. As we think about that part of the equation, the cost side, how sustainable is that kind of over the next handful of quarters? I mean, obviously, we know what the guidance is, but I'm just thinking even beyond this year, is, is low 60s to, you know, 60%-62% type of number, a, a sustainable number?

Do you see any inflationary things that are still lingering, or just kinda how are you thinking about that side of, of the equation?

Brad Childers (President and CEO)

Thanks, Jim. On the good news side, you know, we are very confident in the forecast, the guidance that we've laid out for 2023. That's definitely the best reference point for you to think about, the profitability. Supporting that, we still see opportunities, for pricing to continue to move based upon how tight the market is, how high utilization is. The long lead times for equipment remain very supportive on the revenue side of the equation. Then on the cost side, we've benefited from a more normalized make-ready expense, for sure, but we've also seen some inflationary pressures that previously pushed us, abating a bit, and that includes not just the make-ready expense, but also our overall management of the labor in the field.

As activity levels come down, we can manage our labor better, and we've also gained some incremental downward momentum in a few categories, including notably lube oil. All of that suggests we're highly confident in our gross margin guidance, and you're right, it's definitely coming productively from both the revenue and the cost management side.

Jim Rollyson (Director and Equity Research Analyst)

Curiously, I don't know if you'll answer this, but I'm gonna ask it anyway. If you were to mark to market your kind of entire fleet today that's out there working to where leading-edge pricing is, like, what kind of delta would that imply for your kind of average monthly revenue per horsepower, just from what you just posted in this quarter? If you don't know that number by perchance?

Brad Childers (President and CEO)

You're right on multiple fronts. We believe that one of the key drivers and benefits of the market that we are in is the value of our compression fleet has increased significantly based upon the demand for compression in the space. Your hypothesis is a strong one, and as is your assertion that we don't have a number for that.

Jim Rollyson (Director and Equity Research Analyst)

No worries.

Doug Aron (CFO)

We do have a number. We do have a number, James. Unfortunately, that's not one we're gonna share.

Jim Rollyson (Director and Equity Research Analyst)

Yeah, it's fine. understood. Then just one last follow-up. I was gonna ask you about growth CapEx. You obviously gave some color next year at $160 million, down from $200 million. Curious, the philosophy there, how much of that reduction is tied to kind of capital discipline versus your desire to return capital or reduce debt or, or what have you, versus just customer demand delta?

Brad Childers (President and CEO)

Yes. The answer to those three points is yes. First, on just the demand in the marketplace today, which we see, you know, both at high levels and extending in duration, because we've also suggested we, we have bookings, pressure already for 2025. I'll note that demand is, is strong, but we're now in August, and with one year lead times, that leaves us only a portion of the year left to book more equipment and spend more CapEx. That reinforces the strength of that guidance. The second I'd point out is that that number is already substantially booked, with, with customer commitments, which is really strong, setting up a really strong 2024.

Finally, I want to emphasize, we're very committed to generating free cash flow through the cycles, and that includes that we expect and target to have a very firm commitment to generate free cash flow and return of capital to our investors in 2024.

Jim Rollyson (Director and Equity Research Analyst)

Great. Thanks for your answers. Appreciate it. Good quarter.

Brad Childers (President and CEO)

Thanks, Jim. Thank you.

Operator (participant)

Our next question comes from Selman Akyol from Stifel. Please go ahead. Your line is open.

Selman Akyol (Managing Director)

Thank you. I want to go back to you talked about prices moving higher. You said up 5% sequentially. As we think about that, and I guess a little bit kind of going back to the last question, that would just be, I guess, for stuff you're placing newly into service and stuff that just recently came up for recontracting. I guess how much further to go, number one, on the 5%? Then can you say, like, in the next year, you're going to be repricing 10% of your fleet, 15, 20% of your fleet, 25? Because it goes out there at a three -fiveyear tenor.

Brad Childers (President and CEO)

Thanks for the question, Selman. First, the pricing that we see in the market today does not just apply to spot, spot pricing. While spot, spot pricing is up significantly, like, you know, definitely double digits on a year-over-year basis, we also are working hard to raise the pricing on our installed base, and that's justified for a few reasons. One, the super tightness in the market, but also, we've been catching up and kind of to some of the price cost inflation that we experienced over the last couple of years. That's providing a justification and a need for us to see pricing come up on the fleet in its entirety.

To your question, on the good news front, about 70% of our fleet is either, you know, out of term or under contracts that have pricing mechanisms built into them and will be available for repricing within the next year. We see a lot of opportunity and a lot of need and momentum, given the market tightness that we're experiencing, for us to continue to put the pressure on pricing.

Doug Aron (CFO)

Selman, this is Doug. I, I'll just add a couple more data points here. You know, for us, revenue per horsepower per month is now up seven quarters in a row. You know, obviously coming out of, of, of COVID and, and at a time when utilization was at a much lower number than it is today, you would expect that to continue.

As you look at not just Archrock at, you know, 95% utilization, but the industry, as Brad talked about, so tight right now and no available equipment, I think while we'd love to pin us down, and this will be the second or third question on pricing on, on where it can go, so long as lead times remain in this, you know, north of a year period, and utilization remains in the 90s for everyone, we, we think that, we're going to continue to see that trend, and, and the, the pace and the size will, will be for further reporting on further quarters.

Selman Akyol (Managing Director)

Got it. That is certainly helpful. We should be thinking about it as really the, the leading indicator is just the long lead times. If, if that starts to shrink, that's says something. Is that the way you view it?

Brad Childers (President and CEO)

Selman, the one thing I'd add is it's a combination. We have so many strong indicators of, of market demand and tightness in the market right now. Historically, utilization has been a key reference point, and when we've been in the mid to high eighties and positively inclined, that is a market that typically denotes tightness and pricing prerogatives to the compression service companies, including Archrock. I would just add to that, it's the tight utilization in addition to the long lead times that are key indicators of that pricing prerogative.

Selman Akyol (Managing Director)

Got it. Very helpful. I mean, you guys are, you know, the leader, and, you look out there, and, you know, you clearly you see the improvements in the balance sheet, and you talk about, you know, commitment to free cash flow, and returning capital to shareholders. Kind of given this multiyear period that you see, do you see any other opportunities for capital other than just either reinvesting in the business or, you know, lowering debt or, increasing the distribution, i.e., are you going to maintain a very narrow focus, or is there anything else you might look to do with capital in terms of expansion of the business?

Brad Childers (President and CEO)

Well, thanks for the question. number one, we're actually pretty excited about the opportunity to deploy capital in the business, and in augmenting our returns to our investors through an increased dividend, as well as through the possibility of continued share buybacks. These are exciting opportunities for us, and we think that's gonna those mechanisms will create a lot of value to our investors, especially as we attract new investors with a debt target and a leverage ratio down into the 3 to 3.5 times for 2024. We're excited about those possibilities.

On the market itself, one of the things that is supportive of our overall strategy is we see natural gas production growth continuing in a very solid way, but at about a 2%-3% rate per year, which is very supportive of the levels of CapEx that we're targeting and leaving a lot of room for free cash flow generation. Those are real indicators in the market that we're pretty happy to take advantage of and return value to our investors in the near term. As far as investing outside of the space or in adjacencies to us, we have new venture investments that we believe could really help the energy space manage their emissions better, reduce emissions. We're very focused on that. This is still in the early innings of those ventures.

While we're excited about the promise and the possibility they bring, especially to being effective in helping to improve the sustainability of our business and our customers' businesses, those are the investments that we're excited about right now. We're gonna probably stay pretty tightly in our lane, and exploit our existing core competencies and those adjacencies in the sustainability space going forward.

Selman Akyol (Managing Director)

Got it. Thank thank you very much.

Brad Childers (President and CEO)

Thanks, Selman.

Operator (participant)

Our next question comes from Steve Ference from Sidoti. Please go ahead, your line is open.

Steve Ference (Director of Communication)

Good afternoon, Brad, Doug, thanks for all the color on the call. Wanna ask about the 95% utilization. It seems like you're at peak every quarter, but the, the new peak is, is a little bit higher. Sustainability of 95%, and then are you seeing any pickup in-- and I know, clearly, if, if you are, you're turning it around fast, but on relocations and rebooking, I know you have minimal assets in some of the gassier plays, but has there been any pickup there?

Doug Aron (CFO)

Yeah, thanks for the question. The, the 95%, we believe, is holding and holding well. I can share with you that we have probably less than 100,000 horsepower that we could book today, which, you know, is a little around 2% of the fleet. Which means that if we were to have a pro forma number off of our 95% for what we could actually, you know, report today, that pro forma number of what we expect to be working is higher than 95% meaningfully, and that's supportive of maintaining this high level of utilization going forward. We like the position we're in, and we think that that level of utilization in this tight market is likely to be stable for a period of time.

Stated differently, we don't see what is going to disrupt that right now. As far as the returns, on the good news front, as soon as we get any unit stop activity, it gets rebooked very promptly, usually before it stops, and our overall level of stop activity remains at historically low levels. And that's, we don't see that changing, and we don't see when and how that's gonna change with the tight market that we have today. Last comment is, equipment is so tight, our customers appear very reluctant to give up equipment because they know it's gonna be a challenge for them to get it back and relocated.

Steve Ference (Director of Communication)

Yeah.

Doug Aron (CFO)

... It's, just an exceptionally tight market.

Steve Ference (Director of Communication)

Perfect. In terms of the guidance, it's sort of implied that maintenance CapEx will be meaningfully lower in the second half. Can you just sort of cover the dynamics on that?

Brad Childers (President and CEO)

I, I think that's mostly around the, the make-ready.

Steve Ference (Director of Communication)

Yeah

Brad Childers (President and CEO)

... we've, you know, we, we put a lot of idle units back to work already this year. So the expectation going forward is that, that you won't see that same level.

Steve Ference (Director of Communication)

When I think about how that plays into 2024, then we could stay at a lower level compared to where we were for the six quarters when there was a lot of make-ready. That start would imply that given the other sort of guidance you've, you've given, that 2024 could be a very strong cash flow year, unless I'm missing some other costs.

Brad Childers (President and CEO)

You're not missing it. We believe 2024 will be a strong cash flow year, and we will not have equipment that we can make ready. We'll be looking for growth at that incremental level I described a minute ago, based on natural gas production, primarily from our new build horsepower and from restarting existing horsepower, that does not require the same level of investment as it did in 2023.

Steve Ference (Director of Communication)

Great. Thanks, Brad. Thanks, Doug.

Brad Childers (President and CEO)

Yeah, thank you.

Operator (participant)

There are no more questions. Now, I'd like to turn the call back over to Mr. Childers for final remarks.

Brad Childers (President and CEO)

Great. Thank you, everyone, for participating in our Q2 review call. As the results show, we're seeing the intersection of unprecedented market fundamentals and the fruits of our labor. Archrock is no doubt firing on all cylinders. We look forward to updating you on our progress next quarter. Thank you, everyone.

Operator (participant)

This concludes today's conference call. Thank you for your participation. You may now disconnect.