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Archrock, Inc.  (NYSE:AROC)
Q3 2018 Earnings Conference Call
Nov. 01, 2018, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning. Welcome to the Archrock Inc. Third Quarter 2018 Conference Call. Your host for this morning's call is Paul Burkhart, Vice President of Finance at Archrock. I will now turn the call over to Mr. Burkhart. You may begin.

Paul Burkhart -- Vice President of Finance

Thank you, Jenny. Good morning, everyone. 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 third 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 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's management team. Although management believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurances that such expectations we'll 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 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 third quarter results and to provide an update of our business.

Bradley Childers -- President and Chief Executive Officer

Thank you, Paul, and good morning, everyone. Before we get into the quarter and our performance, I want to start by welcoming Doug Aron as Archrock's Chief Financial Officer. Doug joined our team in August. Doug is a highly experienced energy CFO with a strong track record of driving results and we're excited to have him on board. I'm confident, that together with the rest of our leadership team, Doug will make a meaningful contribution in our efforts to drive Archrock to new heights as the leading US compression provider.

Turning to our latest results. I'm extremely pleased with how our business performed in the third quarter. Achieving results ahead of our expectations driven by strong customer demand and outstanding execution. The growth and performance we delivered in the quarter reflects multiyear highs in our bookings, horsepower is -- horsepower started and fleet utilization, all supported by strong market fundamentals and execution by our team. Simply said, demand for our services is as good as we've ever seen, and we're positioned to further benefit from these dynamics for the remainder of this year and well into 2019.

With that in mind, let me hit a few of the highlights from the quarter. Adjusted EBITDA of $89.5 million is nearly 3% (ph) higher than for the same period a year ago. Contract operations revenue was higher by 10% compared to the year ago period, and revenue in our aftermarket services business was 42% higher than the same period last year. We increased operating horsepower by 110,000 marking our strongest quarterly growth in nearly four years, and bringing our net growth over the last 12 months to about 260,000 horsepower, and the utilization was up to 88%.

We continued to improve on our financial position further reducing our leverage by growing the base of stable cash flows generated by our business. And in our contract operations business, firm customer commitments for horsepower to be placed into service remain at levels that are higher and out further than we've ever seen providing strong visibility for 2019, and building a base of commitments even beyond 2019.

Let's review our contract operations segment performance. Our team did a tremendous job growing our operating horsepower, exiting the quarter with a total operating fleets of approximately 3.5 million horsepower. The growth of 110,000 operating horsepower this quarter marked the largest quarterly horsepower increase, since 2014. Higher fleet utilization of 88% was up from 86% in the prior quarter and 83% a year ago. Large horsepower utilization continues to be excellent and our utilization is now up to 91%.

Pricing within our contract operations business remained strong, with spot pricing on units replacing into the field up over 25% from a year ago for high-demand units across all horsepower ranges.

The vast majority of equipment that is in high demand and in which we are investing continues to be large horsepower deployed to service stable midstream activity. Of our 2018 newbuild capital over 95% is invested in large horsepower units. We're meeting customer demand for bigger compressors, that can efficiently move large volumes and operate on multi-well pad locations. The horsepower growth in the quarter was spread across several growth plays within Archrock's diversified footprint. Year-to-date, roughly half of our horsepower growth has been in the Permian basin, with the balance driven by the SCOOP/STACK, Niobrara and Eagle Ford.

Moving to our aftermarket services segment, we reported third quarter results above our guidance for both revenue and gross margin. Revenues were at the highest levels since 2014 as our AMS business continues to benefit from improving market dynamics, increasing pricing, and our focus on operational efficiency.

In addition to solid execution during the quarter we realized benefits from installation projects and a large parts sell. These were outsized contributors this quarter and are hard to forecast. This pushed us above the high end of our guidance range. Strength in our AMS business is consistent with the drivers we cited last quarter, including maintenance activity on an increasing base of customer-owned compressors and helping our customers catch up on their deferred maintenance.

From a capital policy standpoint, we remain committed to our capital allocation strategy, which focuses on balancing three key objectives: first, is to invest in capital-efficient, high-return assets that grow the business and meet our customers increasing needs, our growth is focused on large horsepower units that support stable, midstream applications, tied to natural gas and oil production; our second objective is to further reduce our leverage. We reduced leverage to 4.7 times in the third quarter, and reiterate our goal of achieving below 4 times leverage in 2020; and our third objective is to continue our track record of returning capital to shareholders in the form of quarterly dividends. For the third quarter, we will pay a dividend that is 10% higher than the prior year quarter and we remain committed to increasing our dividend by 10% to 15% annually through 2020.

Finally, our merger transaction with Archrock Partners completed earlier this year was consistent with this capital strategy. It simplified our corporate structure lowered our cost of capital and further delevered our company while maintaining ample dividend coverage.

Next, I'd like to share with you our perspective on the market. This is a tremendous market for compression, and we see no slowdown in compression activity in the near future. The key drivers of our business are US oil and natural gas production, each of which the EIA is forecasting will have double-digit percentage increases in 2018 and strong increases in 2019.

As an energy infrastructure company dedicated to facilitating natural gas and oil production we've never been busier. Compression like a pipeline is a critical piece of infrastructure needed to gather and move gas to market. And about 75% of our operating fleet is deployed on midstream gathering applications to do just that. And critically, since our activity level is most closely aligned with production which is growing we are not exposed to the shorter cycle volatility facing drilling, pressure pumping, and completions-focused businesses.

In oil and liquids-focused plays, such as the Permian, Eagle Ford, Niobrara and the SCOOP/STACK much of the growth of our business is driven by associated gas and that is the natural gas that's produced in association with crude oil. These plays produced substantial volumes of natural gas. In fact, gas associated with oil is expected to account for over 50% of the growth in natural gas produced over the next five years. While 75% of our fleet is deployed for transportation and gas gathering applications. The other 25% is deployed for Gas Lift to enhance oil production.

Gas Lift is an artificial lift method that moves liquids to the surface of a well. As more oil is produced, the demand for compressors directed at Gas Lift also increases. Gas Lift has been a growing piece of our business and the increase to 25% of our operating fleet currently is up from 19% at the end of 2016. With this incredibly strong market for compression to support the transportation of natural gas and the production of oil, customer bookings and commitments for contract compression horsepower to be placed into service in 2019 and even into 2020 are at record levels.

Our firm customer commitments for contract compression are up 25% as compared to the same period last year. While 2018 has already been a strong year for growth. This increase level of customer commitments provides us with even greater visibility on our horsepower and EBITDA growth into 2019 and beyond.

Now I'd like to turn the call over to Doug for a review of our third quarter financial performance and to provide our latest outlook.

Douglas Aron -- Senior Vice President and Chief Financial Officer

Thanks, Brad. I'm really pleased to be part of the Archrock team, and I'm excited to have started at such a dynamic time for our company. Archrock continued on the momentum achieved so far this year delivering another quarter of strong financial and operating results. Revenues for the third quarter totaled $232 million reflecting an increase of 17% compared to the prior period -- prior year period. The growth in revenue was driven by increased operating horsepower better pricing in our contract operations business and better-than-expected results in AMS.

For the third quarter, we generated adjusted EBITDA of $89.5 million an increase of 39% over the prior year. In contract operations, revenue improved to $170 million for the third quarter up 10% from the third quarter of 2017. This increase was driven by an increase in operating horsepower and improved pricing.

Gross margin percentage remains strong at 59% at the midpoint of the range we provided last quarter and up 600 basis points from a year ago. Our strong growth and execution came despite ongoing cost inflation especially labor, parts, and lube oil as our team remains intensely focused on managing our expenses. Aftermarket services revenue increased to $63 million for the third quarter up 42% from the third quarter of 2017. This marks the largest quarterly revenue for this segment since 2014. From a margin perspective our AMS business delivered gross margins of 20% up significantly from the 13% we recorded last year and 17% in the prior quarter.

SG&A expenses were $26 million for the quarter, nearly $3 million lower than the prior year period and largely unchanged versus last quarter. Our SG&A for the third quarter came in below our guidance range of $28 million to $29 million driven by timing of headcount additions and compensation expense. In the third quarter, growth capital expenditures totaled $92 million. This is consistent with our previous guidance that capital investment for the year would be more second half weighted.

Through the end of the third quarter, we've deployed $191 million of growth CapEx in high-return projects to meet the strong customer demand we're seeing across several basins. Maintenance CapEx for the third quarter totaled $13 million similar to the second quarter of this year. Debt at the end of the third quarter was approximately $1.5 billion, up approximately $57 million compared to the second quarter.

Strong cash flow generation resulted in further reduction to our leverage position which was 4.7 times at the end of the third quarter down from 4.9 times in the prior quarter. Further reducing our leverage ratio remains a key focus for us and we reiterate our expectation to achieve sub-4 times leverage in 2020. We exited the third quarter with available liquidity of $324 million up from $288 million in the prior quarter. This $36 million improvement in our liquidity position was driven by improving leverage and improving trailing 12-month EBITDA. We recently declared a third quarter dividend of $0.132 per share or $0.528 on an annualized basis representing just over a 5% yield on yesterday's closing price, and a total dividend payment of $17 million. Our third quarter dividend will be paid on November 14 to all shareholders of record on November 7.

We increased our second quarter dividend by 10%, and we remain committed to increasing our dividend by 10% to 15% on an annual basis through 2020. We've maintained an extremely strong dividend coverage position with third quarter coverage of 2.95 times up from 2.76 times reported during the prior quarter reflecting the continued growth we're experiencing in our business performance.

Let's look ahead at our outlook for the fourth quarter of 2018. In contract operations, we expect revenue in the range of $173 million to $177 million. As we continue to realize growth in our operating horsepower combined with the benefit of price increases as we set into operation horsepower booked at higher rates. We expect fourth quarter gross margin to be between 58% and 60% consistent with our performance in the third quarter.

In our AMS business, we expect revenue of $50 million to $60 million with a gross margin of 16% to 18%. As a reminder, the first and fourth quarters generally see some seasonal slowdown in our AMS business compared to our second and third quarters. We expect SG&A for the fourth quarter of $28 million to $29 million.

Depreciation and amortization expense is expected to be in the mid-$40 million range and interest expense for the fourth quarter is expected to be in the mid-$20 million range. On a full year basis for 2018 we expect total capital expenditures to be approximately $320 million, of that we expect newbuild CapEx to be approximately $250 million and maintenance CapEx to be approximately $50 million. Our newbuild CapEx program reflects the ongoing opportunities to deploy additional horsepower in high-demand large horsepower units. We continue to expect a sale of equipment to raise approximately $30 million in proceeds during the year supporting our newbuild investment program. To date, we've raised approximately $24 million through equipment sales.

Before we open the line for Q&A, I'd like to update you on a change in our guidance practice that we expect to implement early next year. Historically, Archrock and its predecessors have provided guidance on a quarterly basis. We expect to transition to annual guidance on our fourth quarter earnings call to be held in February of 2019. This practice is consistent with our energy infrastructure peers and is better aligned with the way in which we monitor our performance and invest in our business.

With that, we'd now like to open the line for questions. Jenny, will you please see if there are questions?

Questions and Answers:

Operator

(Operator Instructions) And we have a question from Kyle May from Capital One Securities.

Kyle May -- Capital One Securities -- Analyst

Hi, good morning, guys. And, Doug, welcome to the team.

Douglas Aron -- Senior Vice President and Chief Financial Officer

Thank you. Glad to be here.

Kyle May -- Capital One Securities -- Analyst

Wondering if we can start off with, maybe a longer or preliminary longer-term look, because it sounds like you have a pretty good view of your backlog into '19 and '20. So, if we take the midpoint of your 4Q revenue guidance, it looks like you're going to generate about 15% top line growth year-over-year. Wondering if you can give us any preliminary thoughts about directionally how you see revenue changing next year?

Bradley Childers -- President and Chief Executive Officer

Yes. We're -- this is Brad. So, Kyle, we're not giving guidance yet for 2019, we definitely will do that in our February call. But as I look forward into '19 I'll share with you a perspective that I've shared in the past on this call, and that is that, we don't see a change in the market or a let up. And what we've said in the call today is that, as we look into 2019 our commitments are 25% higher at this time, this year compared to this time last year, meaning that 2019 is going to look like 2018 plus. And so that's pretty apparent from our numbers. But we're not reducing that to guidance at this time.

Kyle May -- Capital One Securities -- Analyst

Okay. Got it. That's helpful. And one of the other things that you mentioned in the press release, you talked about placing horsepower into service in several growth plays next year. Can you talk anymore about what those plays could look like? Or any other growth opportunities that you're seeing?

Bradley Childers -- President and Chief Executive Officer

Well, the placement generate and have generated the activity for us, we think are going to be largely consistent with probably some expansion and addition on a couple of plays I can touch on. So the vast bulk of the activity and investment from our customer base, we still see as a dominance in the Permian. So that's going to continue for sure.

We will also see a lot of activity in both bookings and customer activity and discussions in the Eagle Ford, in the mid-continent plays of the SCOOP/STACK and in the Northern Rockies in the Niobrara. And we see increasing activity in the Powder River as customers are starting to really focus on monetizing in that play as well. And so I expect those are the hot plays people are going to be talking about, certainly that's where we're seeing a lot of the activity. There is still however a base of activity in other plays that includes the Northeast -- and the Utica will also command some growth, I believe, as some of the transportation debottlenecking gets completed for that market.

Kyle May -- Capital One Securities -- Analyst

Got it. And maybe if I could just sneak one more in. You had some nice margin improvement in AMS segment growing to 20%. Can you talk anymore about the change that you saw in the third quarter? And any trends that you are seeing as part of this business going forward?

Bradley Childers -- President and Chief Executive Officer

Yes. The AMS business is executing well. We see a lot of -- we see a nice uptick in activity across all of the services we provide so that includes overhauls, revamps of existing customer equipment maintenance as well as parts. And because the market has improved we see top line improvement we also see and have made some pricing moves to improve margin. So the combination of revenue growth, improved pricing, improved execution, all of that has led to a really nice quarter in AMS.

And then I did note in my comments that some of the outperformance was driven by activity that is lumpier, that is we don't see it every quarter but we see it every year which is an outsized margins on part sales as well as execution on the installation business that we have where we'll go in and put together facility for our customer. Both of those showed up nicely in this quarter. Doesn't show up every quarter, but it's also activity that generates higher margin work that we're pretty excited about seeing in our revenue mix.

Kyle May -- Capital One Securities -- Analyst

Got it. It's very helpful. All right. That's all for me. Thanks guys.

Operator

(Operator Instructions) And we have a question from John Watson from Simmons Energy.

John Watson -- Simmons Energy -- Analyst

Good morning.

Bradley Childers -- President and Chief Executive Officer

Hi, John.

John Watson -- Simmons Energy -- Analyst

Hi, Brad, I completely agree on your comments on the strength of the compression market. And I won't try and pin you down to a specific number for CapEx next year. But conceptually, should we be thinking about similar growth in terms of the fleet in 2019, that we've seen year-to-date thus far in 2018?

Bradley Childers -- President and Chief Executive Officer

Yes. John, I think that's fair. I keep saying if -- based on what we see in the marketplace, we should expect 2019 to look a lot like 2018 did. The add that we tried to share quantitatively this quarter is that, but our outlook looks like it's up even higher at the end of '18 compared to the end of '17. And again, the exciting thing for this -- about this for us is we're talking about firm customer commitments to put in this infrastructure. What's going on in the market that we're seeing is we're putting out compression, which is a critical piece of infrastructure to support a higher level of gas production as well as Gas Lift activity as production levels for both gas and oil are increasing and projected to continue to increase. So we see the bullishness that we're expressing in our backlog, customer activities, customer commitments and the fact that all four casts seem to indicate continued growth in both oil and gas.

John Watson -- Simmons Energy -- Analyst

Perfect. That's great. And speaking of this firm commitments, is there any change with regard to the type of commitment you're getting from customers either related to duration or just how the relationship has evolved? And I'd also be curious to hear how you think your percentage of Gas Lift units might change a year from now?

Bradley Childers -- President and Chief Executive Officer

The tender of the contracts has pushed out a bit. So, for larger horsepower units we're seeing longer terms in our contracts. So we're more in the 3- to 4-year category for the large horsepower installations, small horsepowers remains about the same tenure. So we are seeing some of the term expand out. And I think some of our customers are looking to lock in some longer-term contracts at pricing because with all of the inflationary pressures that everyone's experiencing people get concerned about future cost management.

So the point there being that, it's a trade-off between getting more tenure in a contract versus having more pricing flexibility to pass-through costs for the future that we're trading-off. So I wouldn't describe the positioning as a material change in how we're doing business with our customers or how our customers are seeking to do business with us. We're trying to balance the right, overall management of revenue and costs in our commitments going forward. And I can't predict a shift in the mix Gas Lift. I would just point out that it's changed pretty materially over the last two years and we see a lot of activity there. So it's a growing part of the market. I can't conclude it's going to outpace the growth we'll see in gathering and transportation.

John Watson -- Simmons Energy -- Analyst

Okay. Understood. On the pricing front, clearly pricing has moved materially higher from where we were a year ago. Are you continuing to see leading-edge pricing inch higher? I would think the answer is yes, but I just wanted to confirm.

Bradley Childers -- President and Chief Executive Officer

You're thinking right. Leading-edge pricing and spot pricing keeps moving up incrementally. The thing I'd share however, is that so do costs. So we've got to manage costs and we're seeing a lot of cost pressure in labor in parts and materials and incrementally in lube oil that also are a part of our equation. So, we are balancing aggressively the idea that we can generate great returns on this business. We're very happy with the returns we're generating right now in our investments. But also providing great service to our customers at a competitive rate.

John Watson -- Simmons Energy -- Analyst

Yeah. Thanks for that, Brad. Very helpful. And congrats on joining the team. Doug, looking forward to working with you.

Douglas Aron -- Senior Vice President and Chief Financial Officer

Yeah. Likewise. Thanks very much.

Operator

And our next question comes from Thomas Curran from B. Riley.

Thomas Curran -- B. Riley FBR -- Analyst

Good morning, guys.

Douglas Aron -- Senior Vice President and Chief Financial Officer

Good morning.

Thomas Curran -- B. Riley FBR -- Analyst

Doug, let me echo the sentiments. Welcome aboard and best of luck. I also look forward to working with you.

Douglas Aron -- Senior Vice President and Chief Financial Officer

Yes. Thanks, Tom. Me as well.

Thomas Curran -- B. Riley FBR -- Analyst

I'm curious as you've secured these firm long-term customer commitments on the latest newbuild larger horsepower units, so the 1000 horsepower newbuilds. What type of returns are you locking in at this point? And as part of that, what sort of time frame are you at now for cash on cash pay back?

Douglas Aron -- Senior Vice President and Chief Financial Officer

So, our returns that we're targeting are in the mid-teens, solidly in the mid-teens. And if you just do the math on that IR that converts into a 6-year plus in increment payback period. That second part is just math.

Thomas Curran -- B. Riley FBR -- Analyst

Right. And Brad, how does that compare to sort of a full cycle average or what the norm has been historically? Are you above it or just curious as to where that's at relative to history?

Bradley Childers -- President and Chief Executive Officer

The answer is yes. We're above where we've been historically, and it expresses a few things that are going on in the business today. The first is that the market has candidly made room and demanded investments in growing infrastructure. And I'm reminded that these are 30-year assets that we're investing in that generate those returns. And so we're on the higher end of that now. As you know from just the way we think about returns, the ability to lock in good returns early in the life of an investment really boosts those investment returns. And so that's what we're seeing in this marketplace. So yes, we're on the high end of where this business operates historically. But one of the caveat, it's also largely cost of capital driven. And so in times when capital costs have been higher I think the returns have been higher to reflect that. But that's not a real, that the net returns we're getting in the business right now are really solid, they're very good and yes they're at the higher end of what we've seen historically.

Thomas Curran -- B. Riley FBR -- Analyst

Great. Turning to M&A. I would love to hear an update on how the pipeline of prospects has evolved in terms of attractiveness, number of opportunities. And then, where Archrock's appetite is at this point?

Bradley Childers -- President and Chief Executive Officer

The good news about the market today and our position in the market is we see tremendous organic growth available to us. Those are our best investments. And we're thrilled and we're busy with the amount of work we get to do with our customer base to grow and support their businesses and to invest in growing our fleet and our business organically. There are a number of competitors out there, as you know, and the market could definitely see some consolidation in the future. I remain convinced that any consolidation is good for the marketplace whether it's by us or by others. And if we encounter the right opportunity of high-value assets in the market at the right price, we will continue to be acquisitive as we have been in the past.

Thomas Curran -- B. Riley FBR -- Analyst

And then, last one for me. And I'm sorry, if you already touched on this in your opening remarks, I might have missed it, Brad. But have you had any customers relocate assets out of the Permian to other basins? And if so, where have they gone?

Bradley Childers -- President and Chief Executive Officer

Interesting question. More than relocating assets out of a basin which we haven't seen a lot of movement in, what we do see is a changed investment profile building a backlog in other plays outside of the Permian. So it's not so much -- we are really funding growth and our customers are not shifting the assets that they've contracted for the Permian, out of the Permian, but they have shifted to put more investments in some of the other plays that I already referenced is the way it works in our business more than the move of current assets. And keep in mind that to see assets move you'd really have to see a reduction in the production level or a reduction in the expectation of the production level. We're not seeing that in the Permian. In fact, our customers appear to have capacity to get their oil and gas out. And so some of the challenges that we hear from others on the Permian slowdown really is not impacting our business and we don't expect it to. So we haven't experienced that to the same degree as others.

Thomas Curran -- B. Riley FBR -- Analyst

Very helpful answers. I appreciate the time.

Bradley Childers -- President and Chief Executive Officer

Sure.

Operator

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

Bradley Childers -- President and Chief Executive Officer

Great. Thank you, everyone, for joining our call this morning. I'm excited about the performance this quarter. The outlook for the future is equally bright for Archrock. Our entire team at the company's working hard to continue our excellent execution and capture the market opportunities that are ahead of us. I especially want to thank all of our employees for their hard work to deliver safe and excellent service to our customers, while improving performance for our shareholders. I look forward to updating you on our fourth quarter results early next year. Thank you, everyone.

Duration: 34 minutes

Call participants:

Paul Burkhart -- Vice President of Finance

Bradley Childers -- President and Chief Executive Officer

Douglas Aron -- Senior Vice President and Chief Financial Officer

Kyle May -- Capital One Securities -- Analyst

John Watson -- Simmons Energy -- Analyst

Thomas Curran -- B. Riley FBR -- Analyst

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