Archrock - Q3 2023

Transcript

Operator (participant)

Good morning, and welcome to the Archrock Q3 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, Nadia. Hello, everyone, and 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 Q3 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 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 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, adjusted gross margin, adjusted gross margin percentage, free cash flow, free cash flow after dividends, and cash available for dividends. 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 Q3 results and to provide an update on our business.

Bradley Childers (President and CEO)

Thank you, Megan. Good morning, everyone, and thank you for joining our call. We delivered excellent financial and operational results during the Q3, which included setting several performance records. This continues to be a tremendous market for compression, but more importantly, the results Archrock delivered in the Q3 and the consistency and execution we've delivered all year reflect the changes we've driven across the business to enhance our fleet, customer service, and profitability to drive improved returns for our investors. Let me hit a few of the highlights from the quarter. In the Q3, we doubled our net income to $31 million compared to the Q3 of 2022. We generated Adjusted EBITDA of $120 million, which was a quarterly record for Archrock and was up 7% sequentially.

The increase was driven primarily by positive pricing and profitability momentum in our contract operations segment. I'm also proud to share that we achieved an important balance sheet milestone during the quarter as we drove our leverage ratio to 3.8 times, and we intend to drive leverage even lower next year. We continued to increase shareholder returns. We paid a quarterly dividend per share of $0.155, which was up 7% compared to a year ago, all while maintaining robust dividend coverage of 2.6 times. In addition, we continued repurchasing shares under our share buyback authorization. I'd now like to share my perspective on the market. Archrock is positioned in a unique segment of the natural gas value chain, and we believe compression market fundamentals have never been better.

Similar to pipelines, we're an energy infrastructure company supplying a critical piece of infrastructure needed to move gas to market, with the majority of our large horsepower equipment deployed in natural gas gathering applications. We run a fee-based business, which is closely aligned to natural gas production volumes and not natural gas prices. So we're not exposed to the shorter cycle volatility facing drilling, pressure pumping, and completions-focused services. Looking at the outlook for natural gas production, again, the biggest driver of our business, we expect to see consistent and modest growth rates in the low single digits on an annual basis. This is being driven by two dynamics. First, we continue to see strong investment in associated gas plays in the U.S., like the Permian and the Eagle Ford, where the majority of our operating fleet is located.

We also believe the recent U.S. shale megadeals announced by major integrated producers reinforce the competitiveness and longevity of U.S. shale. Second, our customers are planning critical infrastructure to support growing LNG exports from the U.S., further extending the attractive fundamentals for our industry well into the future. As natural gas demand and production grows, we're experiencing unprecedented tightness in the compression market, which we believe is driven by structural and industry-wide changes to capital allocation practices. Priorities have changed. With capital discipline permeating the energy sector as companies look to drive moderated and profitable growth, as well as consistent free cash flow to return to shareholders. We're seeing this capital discipline by our producer and midstream customers, other compression companies, and even our equipment providers.

We believe this powerful combination of expected continued growth in natural gas production, plus the commendable discipline we're seeing across the industry, support a comparably steadier and more durable upcycle for compression and for Archrock. Moving on to our contract operations segment. We've positioned our compression platform, selling non-strategic assets and investing in highly standardized, large midstream compression units. The benefits are clearly beginning to pay off in our results. Fleet utilization exited the Q3 at 96%, another record for Archrock. We also delivered nearly 650,000 in active horsepower growth, excluding non-core active asset sales of 35,000 horsepower. The growth was primarily driven by new build equipment deliveries, as we have few idle units remaining to redeploy, and as we continue to experience historically low levels of equipment returns from the field.

When we do receive a notice of a customer's determination to return a unit, most of that equipment is booked for its next job before it ever stops in its current location. On booking activity, robust customer demand is showing no signs of slowing down, and our 2024 new build capital is fully committed. With lead times for new equipment still around a year, the window to order compressors for delivery in 2024 is closing, and our customers are beginning to plan for their 2025 horsepower needs. On pricing, we've now achieved sequential increases in our monthly revenue per horsepower for 8 consecutive quarters. Over this time period, our monthly revenue per horsepower is up over 17%. The pricing trajectory remains positive, and we expect to continue to make progress, gradually moving rates up on our installed base next year.

We delivered an impressive Q3 gross margin percentage of 64%, which was above our annual guidance range and is now approaching peak performance during prior cycles. This is due to a few factors. First, as I just highlighted, we've repositioned our compression platform for a more stable and profitable future. Second, the price increases we're implementing this year are catching up with the cost increases we experienced over the last few years. And third, we've maintained a consistent and unwavering focus on cost management as we grow modestly and profitably with our customers. Turning to aftermarket services, we saw steady and strong performance. We saw solid demand and activity on the service side of the business during the quarter, and profitability remains substantially higher than 2022 levels as our team focuses on targeting higher quality and higher margin activity.

From a capital allocation standpoint, we remain on track to deliver the enhanced framework that we laid out on last quarter's call, which is underpinned by our commitment to generate free cash flow. Based on our current outlook for 2024, we remain set up to grow our dividend with a 2024 target of 5% and maintain a dividend coverage ratio of approximately 2 times. We currently drive our leverage ratio even lower to a range of 3-3.5 times. Fund our growth capital expenditures, which we currently anticipate to be approximately $160 million in 2024. And this capital plan preserves the ability to continue to buy back additional shares.

In summary, 2023 is shaping up to be a banner year for our company, and we believe we are set up for an extended period of strong and sustained performance. Natural gas production fundamentals remain durable. The compression industry is as tight as we've ever seen due to capital rationalization by both the energy industry and our suppliers. Archrock's competitive and financial flexibility is as strong as it's ever been. With that, I'd like to turn the call over to Doug for a review of our Q3 and to provide additional color on our outlook for the rest of the year.

Doug Aron (Senior VP and CFO)

Thank you, Brad, and thanks to all of you for joining us this morning. Let's take a look at our summary of our Q3 and then cover our financial outlook. Net income for the Q3 of 2023 was $31 million. This included a long-lived and other asset impairment of $3 million and restructuring charges of $600,000. We reported adjusted EBITDA of $120 million for the Q3 of 2023, a quarterly record for Archrock. Underlying business performance was strong in the Q3 as we delivered higher total gross margin dollars on both a sequential and annual basis. Results further benefited from approximately $3 million in Q3 asset sale gains.

Turning to our business segments, contract operations revenue came in at $208 million in the Q3, up 3% compared to the second quarter of 2023, and 22% versus the year ago period. Operating horsepower and pricing both increased sequentially. Compared to the second quarter of 2023, we grew our gross profit by nearly $7 million or 6%, resulting in a gross margin percentage of 64%. This was up 150 basis points compared to the second quarter, and nearly 600 basis points year-over-year. In our aftermarket services segment, we reported Q3 2023 revenue of $46 million, consistent with second quarter levels and up 6% compared to the Q3 of 2022.

Q2 AMS gross margin of 20% was down sequentially but was consistent with annual guidance and up from 300 basis points versus the Q3 of 2022. Growth capital expenditures in the Q3 totaled $45 million. This was consistent with our previous guidance that capital investment for the year would be more first half weighted. Through the end of the Q3, we've deployed $175 million of growth CapEx in high return projects to meet the strong customer demand we're seeing, primarily in associated gas basins such as the Permian. Of note, we've raised approximately $55 million so far this year through non-strategic equipment sales to support this new build investment program. Maintenance CapEx for the Q3 was $24 million, compared to $27 million during the second quarter.

Make-ready and overhaul CapEx was down sequentially. We exited the quarter with total debt of $1.6 billion, and variable rate debt continues to represent approximately 20% of our total long-term debt. In addition, we maintained strong available liquidity of $439 million. We reduced our leverage ratio to 3.8 times, down from 4.3 times in the Q3 of 2022. Achieving a leverage ratio of less than 4 times has been a goal since before I joined Archrock, and we are excited to deliver this important company milestone during the quarter. We have more progress to make and believe it's prudent to move the goalposts even further, particularly in a high interest rate environment.

As Brad mentioned, we currently anticipate taking our leverage ratio lower in 2024 to a range of 3-3.5 times. We recently declared a Q3 dividend of $0.155 per share, or $0.62 on an annualized basis. This is consistent with second quarter levels and up 7% year-over-year. Our latest dividend represents a solid yield of nearly 5% based on yesterday's closing price. Cash available for dividend for the Q3 of 2023 totaled $63 million, leading to impressive quarterly dividend coverage of 2.6 times. In addition to increasing the dividend this quarter, we repurchased approximately 354,000 shares for $4.4 million at an average price of $12.49 per share.

This leaves approximately $43.5 million in remaining capacity for additional share repurchases. Turning to our outlook, we continue to see great execution year to date compared to our plan, and we have great confidence in the compression market fundamentals, our ability to execute, and our financial flexibility. Looking at Adjusted EBITDA guidance, we expect to come in close to the high end of our most recent guidance range of $430 million-$450 million. This implies relatively flat Adjusted EBITDA in the Q4, which reflects continued strength in our contract operations segment, offset by seasonal weakness in our AMS business and approximately $3 million in Q3 asset sale gains that are not expected to recur.

Turning to capital, on a full year basis, we continue to expect total 2023 capital expenditures to be around $295 million. Of that, we are holding the line on growth CapEx of $200 million, primarily for new build horsepower to meet key customer demand. In summary, we are focused on finishing the year on a high note and are planning for an even better 2024. This includes our expectation for enhanced profitability, improved financial returns, and positive free cash flow, while remaining committed to our differentiated capital allocation framework with shareholder return at the top of the list. We hope you will join us for what we believe will be an exciting and rewarding ride. I will now turn the call back over to Nadia for question and answers.

Operator (participant)

Great. Thank you. If you would like to ask a question, please press star followed by 1 on your telephone keypad. If you choose to retract your question, please press star followed by 2. When preparing to ask your question, please ensure your phone is unmuted locally. And our first question goes to Jim Rollyson of Raymond James. Jim, please go ahead. Your line is open.

Jim Rollyson (Director and Equity Research Analyst)

Good morning, guys. Congrats on another great impressive quarter moving forward. Brad, just maybe as we think about growth going forward, obviously, you're probably getting closer to maxing out on utilization. And as you mentioned, so incremental horsepower adds, which you're going to spend $160 million next year, will be part of that equation. And the rest of the equation seems like from a top-line perspective, will be how your pricing moves from here, and it's been a pretty steady trend upward. I'm trying to understand, maybe as you sit today and look across the portfolio of the fleet at your most recent contracts and the implied pricing and some of your maybe older contracts that haven't repriced or moved up with an inflation base.

Just trying to understand the spread there to kind of figure out how much upside room there is just from today's market, if you mark your fleet to the market today.

Bradley Childers (President and CEO)

Thanks, Jim. We believe there is substantial upside in the profitability to the business. When you think about profits, you cited, you know, two of the three items that will continue to move the needle for our performance. The first is incremental horsepower growth as we grow our fleet responsibly with great investments at very solid returns for our investors. One that you missed, and I'll come to pricing third. One that you missed is we remain ambitious about managing our costs with the investments we've made in technology to improve the performance of our fleet. We believe it's also gonna enhance the profitability of our fleet.

We believe that that is an investment that's going to yield incremental improvements in returns for years to come, and we intend to exploit that aggressively in 2024, just as we have in 2023, but also in 2024 and beyond. And then finally, on pricing, we certainly have room to bring the installed base up to more current spot pricing over time, and we're ambitious about what we can do with those pricing moves. So we believe these are three solid levers that are going to be available for us to drive returns for our investors in this market.

Jim Rollyson (Director and Equity Research Analyst)

Understood. I didn't miss cost. That was gonna be my next question. Is there anything... It sounds like there's still levers to pull to improve that side. So, you know, historically speaking, and this seems like a different time than most of history, at least as far as I've been following this space. With pricing trajectory you have today, and obviously, the momentum behind it, and where your costs are today, with more things you just kind of alluded to you know, improving that potentially going forward, where do you think margins can go? You know, we're kind of back in the historical peaks or pretty close to that, and I'm just curious, you know, is this 64%-ish margin, can that continue to kind of inch higher over the next few quarters, or how do you think about that?

Bradley Childers (President and CEO)

We believe the investments we've made and the market we have ahead of us support a very sustained margin level like we're experiencing currently. And I'm ambitious that we can move margins higher. Stepping back and looking at the historic returns in the compression space, and candidly, in the energy space overall, returns have to go up. When you step back and look at the cost factors to our business, acquisition of equipment, those costs are up, labor costs are up, lube oil is up, parts pricing is up, and we have to improve the profitability of the business to catch up with those returns and then exceed them. Because very critically, cost of capital is up. And in a space with extreme capital discipline right now, to attract capital and to deliver returns that attract capital, our returns have to go up, too.

So we believe there is room in the energy industry, and certainly in compression, to continue to improve profitability, to accomplish those improved returns.

Jim Rollyson (Director and Equity Research Analyst)

Makes perfect sense. And then just one last question. With leverage kind of already getting to your original, in the range of your original year-end goal, and obviously, next year, you're, you're moving the envelope down to 3-3.5 times. Once you get to that leverage level that you, you're looking for, what then? Because that's obviously consuming some of your, your, your cash flow to get your leverage where you want it to be, and your dividend coverage is 2.6 times and, and seemingly growing. Just kind of curious how you think about allocating capital beyond 2024 when you get your leverage where you want it to be.

Bradley Childers (President and CEO)

We are a returns-focused investor. We're gonna look to return and invest our cash where we're gonna yield the best return. That includes, you know, increasing the dividend for the benefit of our investors. That includes looking at share repurchases for the benefit of our investors. With the managed liquidity and the objective of maintaining a free cash flow objective through the cycle and year-over-year, as we grow that cash flow, we'll have more to invest in the market if the returns on the equipment are there also.

Jim Rollyson (Director and Equity Research Analyst)

Great. Thanks again, guys.

Bradley Childers (President and CEO)

Yep. Thanks, Jim.

Operator (participant)

Thank you. Our next question goes to Steve Ferrazzani of Sidoti. Steve, please go ahead. Your line is open.

Steve Ferazani (Senior Equity Analyst)

Afternoon, Brad. Appreciate all the color on the call. I feel like I probably asked this last quarter, but worth asking again: Utilization rates now a new record, didn't seem like it could go higher. Just a question, as we get into a seasonally higher demand area, and I'm sure your asset turnover has to be at near record lows, is it safe to say that utilization is sustainable? Because you're not gonna be returning compression into the winter months. Is that a fair way to look at it?

Bradley Childers (President and CEO)

Yes, it is. What we've said in the past, I can say again, and that is that there's not enough compression market, compression equipment in the market today to meet current production needs, not to mention the growing production that we see coming from the expansion of LNG exports. So we see high utilization rates continuing, we see incremental growth ahead to support that level of production. And so we think utilization can maintain, and candidly, can even continue to tighten from here, based on the demand we see in the market today.

Steve Ferazani (Senior Equity Analyst)

You know, and I think I know the answer to this, but I'll ask it anyway. Obviously, in more drilling-related sectors, we've seen smaller operators getting more aggressive pricing and pushing down margins. Clearly, the numbers show it's not happening here. Any pressure from smaller operators, or is everybody, to your previous answer, operating at such full capacity that there's, that's just not any kind of a near-term risk?

Bradley Childers (President and CEO)

There's definitely pricing competitiveness in the marketplace that we experience. But with the high-quality group of customers we have that are looking at growth and the need to expand their compression operations, they understand. And with the inflation that we've experienced in the past, the market has been digesting and understanding of the rate increases that we've put in place to date. We've had a good level of accomplishment in our overall rate book. So it's not that there's not competition, there is, but it's that with the growth in the market and recovery from inflation and the need to improve returns, the pricing that we've accomplished and the pricing that we expect to continue to drive in 2024, we believe will be accepted by the market to boost those returns.

Doug Aron (Senior VP and CFO)

Steve, if I could just emphasize a portion of Brad's answer there, right? If we go back to end of 2019, end of 2020, I think we said this on our last call, we've seen nearly a 40% increase in the cost of new build, large horsepower equipment from, you know, something in the $900 a horsepower to approaching, you know, $1,200 a horsepower.

That increment means that, be it, you know, customers that are ordering their own equipment with the foresight of doing so, again, with long lead times for that equipment, a potential new entrant, which we haven't yet seen, or anyone else, in order to get any kind of a recovery, is going to have to be, you know, pricing it at what we see as current rates. And so, you know, again, I think one of the really attractive parts of the Archrock story is a 3.6-3.7 million horsepower installed base, that in a lot of cases, was acquired at a much different time frame.

We think that continues to attract a higher price, and as Brad talked about, that upside for 2024 and beyond, I think the likelihood of somebody coming in, you know, and cutting price just would be destroying value or destroying capital.

Steve Ferazani (Senior Equity Analyst)

That's helpful. Thank you. If I could just get one last one in. Just on, maintenance CapEx came down this quarter, is there much idle capacity left to make ready, or what would you expect trends being that you're gonna have to maintain a larger fleet going forward, theoretically, into next year?

Bradley Childers (President and CEO)

We still have about 100,000 horsepower that could be made ready and go to work over the right time frame. But we will not, and we do not expect to have the same level of make-ready expense flowing through maintenance CapEx that we experienced in the first half of 2023.

Steve Ferazani (Senior Equity Analyst)

Enough. Great. Thanks, Brad. Thanks, Doug.

Bradley Childers (President and CEO)

Thank you.

Operator (participant)

Thank you. As a reminder, if you would like to ask a question, please press Star followed by 1 on your telephone keypad. Our next question goes to Selman Akyol of Stifel. Selman, please go ahead. Your line is open.

Selman Akyol (Managing Director of Energy and Power Sector)

Thank you. Good afternoon, good morning. Let me just start with, in terms of spot pricing, if you were to characterize it versus, you know, 6, 9 months ago, how's that trending?

Bradley Childers (President and CEO)

Now, let me expand on that a bit. We find that we are in a very aggressive pricing posture now, for reasons we've already discussed on the call, so I won't go into all of them, Selman. But just catching up with original equipment cost for new builds, catching up with parts, labor, lube, and the fact that cost of capital has increased, has justified a significant amount of price reclamation in the energy space and in compression that we and you can see it in our competitors also are benefiting from. We do not see the ability to raise prices changing or abating.

The slope of the curve may start to flatten a bit, but we still are very positive that we can see more pricing gains from our installed base in 2024, and that's still ahead of us. By the way, let me expand on one point that-

Selman Akyol (Managing Director of Energy and Power Sector)

Please-

Bradley Childers (President and CEO)

...that I kind of expanded on it earlier. I wanted to expand on one point, which is that one of the really interesting aspects of this high inflation phase that we just went through, that is yet not fully appreciated, and you can see it in the pricing and returns that we're going to achieve in the future, is the value of our investments that we made ahead of this inflationary period.... The value of our fleet has gone up substantially, and we expect to claim improved returns off of those great investments that we made before this high inflation environment kicked in.

Selman Akyol (Managing Director of Energy and Power Sector)

Understood. And then if I think about how much of your fleet is left to reprice, how would you say that?

Bradley Childers (President and CEO)

We estimate that still two-thirds of our fleet can be repriced over the next 12 months. Part of that comes in the form of units that roll off term. Part of it comes in the form of units that are under a major strategic alliance with our customer base and has pricing mechanisms in there, some of which are indexed and some of which are just negotiated. But that allows us to keep the pricing fresh on our fleets, and it's about two-thirds that will be repriced over the next 12 months.

Selman Akyol (Managing Director of Energy and Power Sector)

Understood. And so this is ultimately where I wanted to get to: How, I guess, with your focus on costs, how does your gross margin not keep from expanding from here?

Bradley Childers (President and CEO)

We are very ambitious about our ability to continue to improve our gross margin and the profitability of our business based upon both factors, price increases that we expect are ahead, as well as cost opportunities that we are attacking, vigorously inside the company.

Doug Aron (Senior VP and CFO)

Yeah, I mean, somehow-

Bradley Childers (President and CEO)

I think...

Doug Aron (Senior VP and CFO)

Well, well, we're not-- we're definitely not gonna give you a 2024 guidance today, because we're still in the process of putting that plan together. But, you know, look, I think we've said eight consecutive quarters of sequential revenue growth. From where we sit today, from, you know, the conversations we're having with our customers, we certainly expect that streak to continue. And, you got to leave us something exciting to talk to you about when we report Q4 early next year.

Selman Akyol (Managing Director of Energy and Power Sector)

Okay. I want to just pivot over to the balance sheet and some comments you made there. You know, you talked about your goal of getting down to 3-3.5, and you talked also about wise thing to do in a higher interest rate environment. Complete agreement there. My – I guess my question is, and I'm thinking about interest expense, even with lower leverage, unless you actually take your debt levels down, you know, your interest expense would be what it would be. So in order to lower that, are you guys planning on paying down additional debt, or do you typically – are you seeing your leverage just being achieved through higher EBITDA?

Doug Aron (Senior VP and CFO)

So, a couple comments there. And I think you coined a phrase that I've now used since then, when we were last out on the road with you, Selman. That we are not just planning to take leverage down, as you called it, the Texas way by growing EBITDA, right? But we have actually repaid $230 million or so worth of debt since 2019. And that has been a meaningful part of the leverage reduction.

Yes, as we look forward and think about EBITDA growth into next year and the use of free cash flow thereafter, we've said that, you know, the three things that we'll look at there are new growth CapEx expenditures, increasing our dividend, and then leverage reduction and/or share buybacks, right? So, we'll continue to evaluate all of those. And again, I think when comparing us, certainly to other midstream companies and definitely to the rest of the compression peers, we're a best-in-class provider there. We have flexibility that some of our peers don't have, and we will look to find the right balance of all of those different possibilities of what to do with free cash flow.

Selman Akyol (Managing Director of Energy and Power Sector)

Understood. And I guess you mentioned conversations on 2025 are starting. Just how are those going? And I'm just kind of curious, meaning they're very open to seeing continued price increases out that far, still hearing things are going to be tight. Is there just any insight you can kind of give on what's going on there?

Bradley Childers (President and CEO)

Demand is high for 2024. Demand signals, overall pricing and horsepower amounts and unit amounts, those discussions with customers are as strong at the beginning of 2024 as they were in 2023. And in fact, I think in some cases they are earlier because with the tightness of the market, our customers have become accustomed to planning further in advance than they ever have. So it's a robust market, and it looks to be very demand and growth-oriented continuing through 2024.

Selman Akyol (Managing Director of Energy and Power Sector)

All right. Thank you very much. Keep up the good work.

Bradley Childers (President and CEO)

Thanks.

Operator (participant)

Thank you. We have no further questions. I'll now hand back to Mr. Childers for any final remarks.

Bradley Childers (President and CEO)

Thank you, everyone, for joining our Q4 call this morning. Our performance was exceptional this quarter, and with Archrock's enhanced platform and financial flexibility, we are well positioned to capture opportunities presented by the current market. I look forward to updating you on our progress next quarter. Thank you, everyone.

Operator (participant)

Thank you. This now concludes today's call. Thank you all for joining. You may now disconnect your lines.