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Archrock, Inc. (NYSE:AROC)
Q2 2018 Earnings Conference Call
Aug. 2, 2018, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning. Welcome to the Archrock, Incorporated, Second Quarter 2018 Conference Call. Your host for this morning's call is Paul Burkhart, Vice President of Finance at Archrock.

I'll now turn the call over to Mr. Burkhart. You may begin.

Paul Burkhart -- Vice President, Finance

Thank you, Adriane. Good morning, everyone. With me today are Brad Childers, President and Chief Executive Officer of Archrock; and Randy Guba, Interim Chief Financial Officer of Archrock. This morning, Archrock released its financial and operating results for the second quarter of 2018. If you have not received a copy, you can find the information on the company's website at www.archrock.com.

During today's call, Archrock, Incorporated may be referred to as Archrock or AROC. I want to remind listeners that the news release issued today by Archrock, the company's prepared remarks on this conference call and the related question-and-answer session include forward-looking statements. These forward-looking statements include projections and expectations of the company's performance and represent the company's current beliefs.

Various factors could cause results to differ materially from those projected in the forward-looking statements. Information concerning the risk factors, challenges and uncertainties that could cause actual results to differ materially from those in the forward-looking statements can be found in the company's press release as well as in Archrock's annual report on Form 10-K for the year ended December 31, 2017, and those set forth from time to time in Archrock's filings with the Securities and Exchange Commission, which are currently available at www.archrock.com.

Except as required by law, the company expressly disclaim any intention or obligation to revise or update any forward-looking statements.

In addition, our discussion today will include reference to non-GAAP financial measures, including adjusted EBITDA, gross margin, gross margin percentage, and cash available for dividend. For reconciliations of our non-GAAP financial measures to our GAAP financial results, please see today's press release and our Form 8-K furnished to the Securities and Exchange Commission.

I'll now turn the call over to Brad to discuss Archrock's second quarter results, and to provide an update of our business.

Brad Childers -- President and Chief Executive Officer

Thank you, Paul. Good morning, everyone. I'm excited to share with you the progress we made in the second quarter, building on the strong results and momentum we delivered to start the year. Our focus for the second quarter remained on solid execution. This includes; increasing our operating horsepower base, tightly managing our operations and costs, providing excellent customer service and maintaining our backlog for contract compression orders at strong levels and optimal pricing.

This focus resulted in strong revenue and gross margin performance in our contract operations and aftermarket services businesses in the quarter. The outlook for the compression market and our business remains positive, both of which continue to benefit from realized and forecasted growth in US natural gas production.

This backdrop underpins Archrock's growth and profitability to date and will serve as a catalyst for continued strong results in the quarters to come. Let's hit on a few of the highlights from the quarter. Second quarter adjusted EBITDA of $85 million exceeded expectations and was up $11 million or 14%, compared to the same quarter, last year.

Contract operations revenue was up 9% year-over-year while aftermarket services revenue was up 31% for the same period. Both business segments delivered strong gross margins. Contract operations margin at 59% was within our guidance range and on par with the second quarter of 2017, while aftermarket services margin of 17% was up about 200 basis points from the second quarter of 2017.

We increased our operating horsepower for the fifth consecutive quarter. Over the past 12 months, we've grown our operating base by 236,000 horsepower, and we will continue growing as we deploy our sizable backlog. In April, we closed the merger of Archrock and Archrock Partners which initiated several positive changes.

It simplified our structure, strengthened our financial platform and positioned Archrock well for our next leg of growth. The merger also accelerated our leverage improvement efforts and we exited the quarter with a debt-to-EBITDA ratio of 4.9 times.

And finally, consistent with our commitment to return capital to investors, we increased our dividend by 10% over the prior quarter. Moving to our contract operations performance, our second quarter 9% year-over-year revenue increase was driven by an increase in our operating horsepower and improved pricing dynamics. We grew our operating fleet by 40,000 horsepower during the quarter, predominately in the Permian, the SCOOP/STACK, Marcellus, Bakken, and Niobrara; all of these basins reflecting our diverse footprint.

Our backlog of new business remained robust and at historic levels providing us with good visibility well into 2019. Improving utilization of our fleet and our customer's future growth expectations are being reflected in pricing.

During the quarter, we booked new contract compression orders at strong rates and also pricing improvements across all horsepower ranges, including our small horsepower units. Our strong position in the market enables us to selectively place assets in the field with strategic customers, at prices that generate solid returns.

Looking at our expenses in the quarter, our cost per horsepower was relatively flat year-over-year. As I mentioned earlier, we remain laser focused on the prudent management of our expenses. Our operations teams worked hard to effectively execute on the start of the new units and maintain excellent customer service, all while delivering superior safety performance.

Moving to the aftermarket services segment. We delivered an exceptional second quarter. We're seeing strong activity in that business, which we attribute to a few factors. First, the total compression market is expanding in line with natural gas production growth. Our aftermarket services customers are tapping into our parts and service offerings to maintain their expanding compressor fleets.

In addition, aftermarket services customers are facing long lead times for new compressors, incentivizing them to search for alternative solutions which includes refurbishing and reconfiguring their own-owned compressors.

And finally, many of our customers are addressing past deferred maintenance on their units and the outsourcing of this work also benefited our business in the quarter. Turning to a review of our capital policy, we remained steadfast in the continued execution of our capital allocation plan, which seeks to balance three objectives. The first is to invest in capital efficient, high return assets that grow the business and meet our customers' increasing needs. The second is to reduce our leverage with the goal to be below four times in 2020, and third is to return capital to our shareholders in the form of quarterly dividends.

On our goal of strategically investing in the business, we're in a great position to capitalize on the growing demand for compression services.

We're investing in large horsepower units that support stable, midstream applications tied to natural gas production. The large horsepower segment remains a key focus for our business representing about two-thirds of our operating horsepower today, and we expect this percentage to continue to grow over time. On our goal of further reducing leverage, our solid financial performance further improved our leverage position to 4.9 times at the end of the second quarter.

Lastly, on our goal of returning capital, we increased our dividend by 10% up to a new rate of $0.132 per quarter or $0.528 on an annual basis. Including this increase in our dividend, our coverage remains strong at 2.76 times for the second quarter allowing us to continue to self-fund our growth, while also offering an attractive level of cushion to our quarterly dividend.

Looking forward, we reiterate our expectation to increase our dividend by 10% to 15% annually through the year 2020. Earlier, I highlighted the recent completion of our merger transaction with Archrock Partners. The completion of this transaction reflects our company's ability to remain nimble and proactive as we strive to maximize long-term value for our stockholders.

This transaction is aligned with our capital policy in two ways. First, the transaction simplified our corporate structure and structurally lowered our cost of capital, resulting in improved returns for our capital investments. Second, the transaction was deleveraging for our company and it accelerated the progress toward our goal of achieving leverage below 4 times in 2020.

Turning to the market, the US outlook for natural gas production remains robust. The EIA is forecasting an annual increase of 10% in 2018. Producers are focused on developing the United States' vast natural resources. The increasing amount of the natural gas produced in the US is associated with crude oil production. Archrock has an extensive presence in place driven by associated gas, including the Permian, SCOOP/STACK, the Eagle Ford, the Bakken, and the Niobrara.

Natural gas demand is growing in both domestic and foreign markets. On the domestic front, demand will be primarily supported by significant growth in power generation, as the US retires coal plants and switches to natural gas power plants. While we expect the US to continue to face attractive demand in the domestic market, demand outside the US is supporting much of the production growth, and is expected to consume even more of the United States' abundant supply of gas.

By 2022, US is forecasted to become the world's second largest exporter of natural gas. Underpinning this level of exports is the growing base of LNG export facilities. To put it in perspective, the EIA forecasts that 2018 natural gas production will average about 81 billion cubic feet a day compared to 74 billion cubic feet a day in 2017.

LNG terminals are currently providing export capacity for over 3 billion cubic feet a day and are forecasted to provide an additional 7 billion cubic feet a day of export capacity by 2020. In addition, natural gas exports to Mexico are also expected to grow.

Now before I close, and with our simplification now completed, I'd like to take a few minutes to discuss Archrock's market position, specifically who we are, and where we fit in the broader energy value chain. Simply stated, we are an energy infrastructure company focused on compression services, primarily supporting midstream applications.

Four key characteristics does capture Archrock and our value proposition to our investors. First, we generate relatively stable cash flows driven by a compression business that provides mission critical equipment and services for the production and transportation of natural gas.

And the demand for our services is increasing, driven my significant growth in natural gas production. Further, the stability in our business is supported by the geographic diversity of our operating footprints, as we service customer demand in all major US shale plays.

The second defining characteristic of Archrock is our focus on servicing the midstream segment. As I mentioned earlier, about two-thirds of our fleet is large horsepower, which is mostly used to support midstream applications primarily for natural gas gathering. This strategy aligns our business and its results most closely with the production of natural gas, establishing and supporting a relatively stable -- comparatively stable business model.

Third, is our focus on multi-year fee-based contracts with a diverse portfolio of high quality long-term customers. Our units average time on-site is more than three years demonstrating the stability and duration of our assets, once they are operating for a customer.

Further, we service many blue-chip customers and have a broad base of over 600 contract compression customers across the major US plays, and our relationships are deep-rooted. Our top 10 customers have worked with us for an average of approximately 15 years.

Finally, as I discussed earlier, we are focused on returning capital to our investors, including the long-term value through disciplined investments and a growing dividend. I believe this combination of attributes is highly attractive and uniquely positions us to profitably participate in the growing market and deliver value to our shareholders.

We've accomplished a lot over the past several years and particularly over the last several quarters and we're excited with how we're positioned and our path ahead. Now, I would like to turn the call over to Randy for a review of our financial results.

Randy Guba -- Interim Chief Financial Officer

Thanks, Brad. I'll start with a summary of results for the second quarter of 2018 and then will cover guidance for the third quarter.

Archrock delivered solid second quarter results. We generated adjusted EBITDA of $85 million for the second quarter, an increase of 14% year-over-year and 5% sequentially. Revenues were $227 million for the second quarter, up 15% compared to the second quarter of 2017 and 7% compared to the first quarter of 2018, driven by increased operating horsepower, price increases, and robust aftermarket services topline growth.

Turning to our segments, in contract operations, revenue came in strong at $165 million in the second quarter, up 9% from the second quarter of 2017 and 3% from the first quarter of 2018. On a sequential basis, little more than half of the topline growth in the quarter was driven by an increase in operating horsepower with the balance of the growth due to a mix of rate increases and freight revenue.

Gross margin percentage remained solid with second quarter margins of 59%, flat from a year ago and down slightly from the first quarter of 2018 and within our guidance range. The slight decline sequentially is due to more maintenance activity on our units though we are pleased overall with the field's performance of managing cost pressure and labor in parts.

In aftermarket services, revenues of $61 million for the second quarter are up 31% from the second quarter of 2017 and 21% compared to the first quarter of 2018. This is the strongest quarter of aftermarket services revenue since the fourth quarter of 2014. Gross margin percentage of 17% remained solid in the quarter, up 200 basis points from the second quarter of 2017 and flat compared to the first quarter of 2018.

SG&A expenses were $27 million in the second quarter, down 3% compared to the first quarter levels. Second quarter SG&A benefited from lower compensation and bad debt expense.

In the second quarter, Archrock's growth capital expenditures totaled $45 million which combined with the first quarter growth CapEx of $54 million, resulted in the first half growth CapEx of $99 million. We remain on track with our full year growth CapEx budget of $230 million to $250 million, as we continue to invest in new equipment to meet strong customer demand.

Maintenance CapEx for the quarter was $13 million, about 18% higher than the first quarter levels. Debt on a consolidated basis at the end of the second quarter was $1.5 billion, up $32 million from the first quarter levels. The increase in consolidated debt in the second quarter is primarily due to the continued investment in the fleet.

As Brad noted, we made strides in further reducing leverage with second quarter leverage of 4.9 times as compared to 5.2 times at the end of 2017, figured on a pro forma basis to the merger. Our available but undrawn capacity on Archrock's revolving credit facility at the end of the second quarter totaled $288 million while consolidated cash stood at $4 million.

Archrock's second quarter dividend was $0.132 per share, a 10% increase from the first quarter. The second quarter dividend amount of $17 million will be paid on August 14th to all shareholders of record on August 7th. Archrock's cash available for dividend coverage was strong at 2.76 times for the second quarter.

Turning now to an outlook for the third quarter of 2018, in contract operations, we expect revenue of $166 million to $170 million, as we continue to benefit from increasing operating horsepower, combined with the price increases we implemented at the start of the year. We expect third quarter gross margin to be in the range of 58% to 60%.

For AMS, we expect revenue to total $50 million to $60 million with gross margin between 16% and 18%. On SG&A expenses, we expect $28 million to $29 million for the third quarter.

Depreciation and amortization expense is expected to be in the mid-$40 million range with interest expense in the mid-$20 million range.

For full year 2018, we are reiterating our total CapEx guidance of $300 million to $320 million. Maintenance capital spending for 2018 is expected to be $45 million to $50 million, up $5 million from our prior guidance, but does not affect our full-year total CapEx guidance. Newbuild capital expenditures are expected to be $230 million to $250 million for the full year of 2018, unchanged from prior guidance as we continue to invest in high demand, large horsepower units. We also expect the sale of equipment to raise roughly $30 million of proceeds for 2018, which supports our investment in new equipment.

Before I conclude, I want to remind everybody that beginning of the second quarter of 2018, we revised our adjusted EBITDA calculation to exclude non-cash stock-based compensation. This change will put us more in line with how our peers report.

With that, we'd like to now open up the lines for questions. Operator?

Questions and Answers:

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions) And our first question comes from Tom Curran from B.Riley. Please go ahead.

Thomas Curran -- B. Riley FBR, Inc. -- Analyst

Good morning. Can you hear me?

Brad Childers -- President and Chief Executive Officer

Yes, we can now, good morning.

Thomas Curran -- B. Riley FBR, Inc. -- Analyst

Oh great. I guess I want to start, Brad, for contract operations, could you tell us for the larger horsepower class, where is pricing at this point relative to where it peaked in the last up cycle? And then, do you see the potential for it to go on to actually set a new record high over the balance of this up cycle?

Brad Childers -- President and Chief Executive Officer

Sure. So the answer is, relative to the peak of the prior cycle on our largest horsepower pricing on a spot basis is back to those prior peak levels and maybe an increment more. And we do see the pricing is likely to have more legs in future periods for us as we absorb costs. Because what we're experiencing in the marketplace today with increasing labor, cost pressures, increasing parts -- price pressures as our vendors are also getting into the mode of increasing their pricing. We do see that there is going to be both the need and opportunity for us to think about how we share that with our customers through pricing in the future. But from a spot price basis, we're back to historic levels on large horsepower.

Thomas Curran -- B. Riley FBR, Inc. -- Analyst

And that you touched on inflationary pressures in the costs, you're grappling with which I think provide them a segue to margin, could you just provide some color around the key swing variables in your gross margin expectation in moving from 2Q to 3Q?

Brad Childers -- President and Chief Executive Officer

Yes. So we gave guidance on what we thought revenue and margins would look like. So behind that, guidance that Randy already gave, what we've seen in the field right now is inflationary pressure driven primarily by labor, some by parts and some by lube oil.

Those are the categories where we see the pressure currently. And we expect it to continue with labor at historically low unemployment rates, certainly across the country but especially in the oil field and parts of the areas where we all operate. But in the face of this cost pressure, I think it's important to just note, we have strong routines and initiatives in place to help mitigate and that includes solid preventative maintenance practices in the field, a very disciplined system to manage service quality balance with the activity and maintain high uptime for our customers, but with efficient maintenance by us.

So the thing I'd point out is that I'm actually really pleased with the current level of profitability at which we get to grow the business. In longer-term, we're targeting maintaining this business in the 60% plus or minus level of gross margin and we're on the lower side of that right now as we're absorbing a lot of inflationary cost pressures experiencing rapid growth and putting a lot of horsepower to work but trying to keep this business in that range seems like a really key objective for us.

Thomas Curran -- B. Riley FBR, Inc. -- Analyst

So no change in expectation about your ability over time to hit that trend gross margin level of 60% then.

Brad Childers -- President and Chief Executive Officer

Yes. Working on that 60% plus or minus on a quarter-over-quarter basis and year-over-year basis is where we are going to push this business.

Thomas Curran -- B. Riley FBR, Inc. -- Analyst

Okay, great. And then last one from me, if we were to see AMS nicely surprised relative to your guidance ranges for both revenue and gross margin in 2Q, if we were to see it deliver upside again in 3Q, of the three main drivers you highlighted, which would you would expect to be the most likely source of that upside?

Brad Childers -- President and Chief Executive Officer

Well, we've seen growth that's been fairly ratable or fairly even across the main buckets of AMS activities, main categories of AMS activities. So they include an increase year-over-year in parts to support customers' units as well as fuel maintenance activities and overhauls. So what we -- what we've seen is the spikiest growth in parts but the other two categories have also been at a comparable level of growth even if parts is leading it.

Thomas Curran -- B. Riley FBR, Inc. -- Analyst

Okay, great. I appreciate the answers. I'll turn it back.

Operator

And our next question comes from John Watson from Simmons & Company.

John Watson -- Simmons & Company -- Analyst

Good morning, guys.

Brad Childers -- President and Chief Executive Officer

Good morning.

John Watson -- Simmons & Company -- Analyst

A quick follow-up on AMS. I think we talked about last quarter a change in how revenue would be recognized for that segment. Did that contribute to the really strong quarter in 2Q?

Brad Childers -- President and Chief Executive Officer

Incrementally, it did. But it was not the only driver, the real driver of this is increased activity in AMS as our customers are just requiring more support and more work on customer-owned units. So it was an incremental contributor, but the biggest driver was activity based.

John Watson -- Simmons & Company -- Analyst

Sure. Okay, thanks for that, Brad. And then secondly, we've talked about gas lifts and that being an incremental source of demand for you guys, especially with all the associated gas coming out of places like the Permian. When you are deploying new gas lift units, do you have any feel that it's because of a switch from other forms of artificial lift or if it's just new wells coming online where customers have used gas lifts in the past and are continuing to use it?

Brad Childers -- President and Chief Executive Officer

Thanks, John. You know, I don't have a great breakout on that, I would tell you that based on what we see in the locations that include a lot of new installations that it's a lot of new gas lift being added, but I do know that several customers have switched away from alternative gas lift methods, ESPs, pump lifts in favor of compression, but I don't have a good catch from the volume of that.

John Watson -- Simmons & Company -- Analyst

Right. Okay, and then lastly, the guidance for 3Q, is there any expectation that activity in the Permian potentially stalling, could that might affect your business, is that baked in -- into the guidance for the third quarter?

Brad Childers -- President and Chief Executive Officer

Sure. So the direct answer is yes, anything that we would have seen is baked into the guidance. But let me address the underlying point, and that is that we don't see the same risk of capacity constraints in our high-quality customer base and we believe that in our discussions with our customers that our customer base largely has access to committed capacity going forward.

So we just don't see the risk materializing for us the way maybe some have asked or thought about it for other energy -- for sector participants. The other thing I'd point out is that even if that's the case, we really think that any flattening out or a limitation on capacity is likely to be transitory. In longer-term, the outlook for the play remains robust as capacity comes in.

So I -- we just don't see it the same way and part of this is just reinforcement of our market position because we're leveraged to production, and with a very diverse high quality customer base.

John Watson -- Simmons & Company -- Analyst

Great answer. Thanks for that Brad and congrats on another strong quarter.

Brad Childers -- President and Chief Executive Officer

Right. Thanks John.

Operator

(Operator Instructions) And our next question comes from Daniel Burke from Johnson Rice.

Daniel Burke -- Johnson Rice & Company -- Analyst

Hey guys, good morning.

Brad Childers -- President and Chief Executive Officer

Good morning.

Randy Guba -- Interim Chief Financial Officer

Good morning.

Daniel Burke -- Johnson Rice & Company -- Analyst

So it looks like the growth CapEx spend this year is just a touch back-weighted, and can we assume that the same is the case for the new builds you're delivering to the field this year?

Brad Childers -- President and Chief Executive Officer

Yes. We do expect based upon the scheduling that we have that the CapEx spend is heavier in the back half and the start activity also is expected to be heavier in the back half and moving into 2019. That's a fair point, Daniel.

The main thing I think I -- that, that expresses is just the market remains really strong and so we do expect to see good deployments against the record backlog going through the next two and certainly three quarters.

Daniel Burke -- Johnson Rice & Company -- Analyst

Okay. And then Brad, I don't know to what extent lead times for your primary components remain extended at this point, but I would imagine you're already internally thinking about growth CapEx plan for 2019. Is there anything you can share at this point about maybe the scale of that program relative to the scale of the program you are sponsoring this year?

Brad Childers -- President and Chief Executive Officer

Sure. The market remains strong and the pressure for our customers to grow and to deploy equipment remains at high levels. So although it's too early to really have capital talks with our customers, that process will begin now as the budget season is beginning, and we're not giving any guidance on 2019. I'll say that if 2019 remains as opportunity rich as we've experienced, if 2019 is opportunity rich as we've experienced in 2018, then the level of magnitude and opportunity for capital deployment will remain at a comparable level.

Daniel Burke -- Johnson Rice & Company -- Analyst

Okay, great. And then maybe just one last one since we talked about kind of longer-dated targeting or management of margins on the NACO side. When we look at the aftermarket business, I guess historically in the last up cycle challenges, we were staring at margins that embedded in international business as well, but does that -- and mix matters as well, parts versus services. But is there ability to get that business closer to a 20% margin over time with further topline growth?

Brad Childers -- President and Chief Executive Officer

In the long term, 20% is a great target for us to push that business back toward. It is what we've achieved historically, and we'd like to see it move back. The offsetting pressure on that is that the parts business is an incrementally lower margin business in the overall mix and we're seeing that grow as well.

So as long as we can generate good profit on that at very low overhead, parts business, we'll accept those gross margin dollars even if it appears dilutive to the overall AMS business margin.

Daniel Burke -- Johnson Rice & Company -- Analyst

And so, getting to that type of 20% target is contingent upon seeing a level of service activity that mirrors what you saw in the past cycle, is that then the conclusion?

Brad Childers -- President and Chief Executive Officer

Yes.

Daniel Burke -- Johnson Rice & Company -- Analyst

Okay. How far are we already from that, will we see a $60 million type topline figure?

Brad Childers -- President and Chief Executive Officer

Yes, we will aim to deliver a higher top line figure.

Daniel Burke -- Johnson Rice & Company -- Analyst

Okay, all right, guys, I'll leave it there. Thank you.

Brad Childers -- President and Chief Executive Officer

Thanks Daniel.

Operator

We have no further questions at this time. Now I will turn the call back over to Brad.

Brad Childers -- President and Chief Executive Officer

Thank you everyone for participating in our second quarter earnings call. Our focus at Archrock remains on strong execution as we move forward within this fast growing market. We are strategically deploying capital in the high-quality assets with attractive returns and our operations teams are working to efficiently and safely put our large horsepower to work.

Our team is world-class and to our employees at Archrock I'm grateful for your contributions and your ongoing success.

Before I conclude, I would like to take a minute and thank Randy Guba for serving as our Interim CFO. Randy has done a fantastic job shepherding the organization through this transition and we're grateful for his services.

In a couple of weeks, Doug Aron will join Archrock as our new Chief Financial Officer and we look forward to welcoming Doug onto the team at that time. I also look forward to updating you during our third quarter call. Thanks everyone.

Operator

Thank you, ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.

Duration: 36 minutes

Call participants:

Paul Burkhart -- Vice President, Finance

Brad Childers -- President and Chief Executive Officer

Randy Guba -- Interim Chief Financial Officer

Thomas Curran -- B. Riley FBR, Inc. -- Analyst

John Watson -- Simmons & Company -- Analyst

Daniel Burke -- Johnson Rice & Company -- Analyst

More AROC analysis

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