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Archrock, Inc. (AROC) Q2 2020 Earnings Call Transcript

By Motley Fool Transcribers – Jul 31, 2020 at 4:30PM

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AROC earnings call for the period ending June 30, 2020.

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Archrock, Inc. (AROC 3.45%)
Q2 2020 Earnings Call
Jul 31, 2020, 11:00 a.m. ET


  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Good morning and welcome to Archrock Second Quarter 2020 Conference Call. Your host for today's call is Megan Repine, Vice President of Investor Relations at Archrock. I would now like to turn the call over to Ms. Repine. You may begin.

Megan Repine -- Vice President of Investor Relations

Thank you, Devin. 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 second quarter of 2020. If you have not received a copy, you can find the information on the company's website at

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 assurance that such expectations will prove to be correct. Please refer to our latest filings with the SEC for a list of factors that may cause actual results to differ materially from those in the forward-looking statements made during this call.

In addition, our discussion today will reference certain non-GAAP financial measures, including adjusted EBITDA, gross margin, gross margin percentage 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 second quarter results and provide an update of our business.

D. Bradley Childers -- President and Chief Executive Officer

Thank you, Megan, and good morning. I appreciate everyone joining our conference call today. Last night, we posted solid second quarter results in the context of one of the most difficult environments the industry and Archrock have ever faced.

As we've highlighted for some time, Archrock provides critical U.S. natural gas infrastructure and the company is built by design to endure market cycles, I guess the backdrop of a global pandemic, economic slowdown and precipitous decline in commodity prices. The resilience of our business was tested and demonstrated during the second quarter.

Our impressive performance was driven by outstanding execution in the field and significant progress on our cost and capital savings efforts. Among the accomplishments in the quarter, we generated EBITDA of $101 million, flat compared to the prior year period. We improved our contract operations gross margin percentage by 400 basis points sequentially and annually to 66%.

We reduced SG&A expense by more than 6% from $31 million in Q1 to $29 million in the second quarter. Our second quarter capex was down meaningfully year-over-year, but remain somewhat elevated as we took delivery of the units to meet orders that were placed by customers in 2019. Aside from these units. which are already out earning revenue, we put the brakes on additional 2020 new equipment capex. This will drive substantially less spend in the second half of the year and we've reflected this lower investment in the updated guidance that Doug will cover later in the call.

We generated free cash flow in the quarter and thereby demonstrated our differentiated financial flexibility. Our adjusted EBITDA is holding up well, and we paid down a small amount of debt in the quarter, which kept our leverage ratio largely unchanged from the first quarter at 4.1 times.

As a result of our lower capex spending, we expect our second half free cash flow generation and debt repayment to accelerate significantly and we continue to pay an attractive dividend complemented by peer-leading dividend coverage.

As discussed last quarter, in light of market conditions, and in order to maximize profitability, cash flow and our financial position, we proactively initiated an aggressive cost and capital reduction effort. Our push to rightsize the organization for activity levels cut across both business segments and our corporate overhead.

Today, I'm pleased to share that we are well on our way to deliver the annualized cash savings of between $75 million and $85 million promised in May. We expect these savings will accelerate in the second half of the year as planned.

We anticipate no new equipment capex for the remainder of the year and have slashed our full-year 2020 capex budget as compared to 2019 by more than $240 million at the midpoint of our revised guidance. We're already seeing substantial declines in maintenance capital with maintenance capex down 40% compared to the first quarter. We expect continued benefits from a lower make-ready capital and our optimized maintenance practices while maintaining our excellent customer service and safety standards.

On our SG&A spend, we implemented several actions to reduce discretionary spending and compensation expense. We continue to manage over time hours tightly and the previously announced salary reductions for certain employees, the executive leadership team, as well as reductions to Board retainer fees went into effect in June.

While the entire management team is focused on retaining our great talent through this downturn, as business softened further during the quarter, we made a difficult decision to take deeper action. This included furloughs and layoffs in several business units and segments.

We remain steadfast in our drive to maximize our free cash flow and maintain our differentiated financial position. We continuously evaluate additional savings initiatives and are committed to a rigorous and ongoing analysis of our costs as the market evolves.

The other cost reduction efforts. We continue to transform our fleet, streamline our business and invest in technology to extend our runway for efficiency gains.

Building on our success in 2019, we continue to manage and prune our compression fleet, accelerating EBITDA recognition from less strategic and uneconomic horsepower and bringing in additional cash to redeploy toward debt reduction.

During the quarter we sold 24,000 horsepower that had an average age of nearly 30 years. And just after quarter-end, we sold a portion of our AMS business, which will result in gain on sale income during the third quarter of about $9 million.

As we do every quarter, we also conducted an extensive review of our fleets and identified compression units that were either not likely to go back to work or did not warrant additional investment to put back in the field. From this review, we retired 184,000 operating horsepower that resulted in a non-cash impairment of $55 million.

This number was larger than in past quarters due primarily to the sharpness of the downturn and customers determining that portion of their production operations were no longer economic. Unsurprisingly, some of our equipment that does service those locations is also no longer economic for redeployment based on its age or configuration.

On our technology upgrading work, we're making good progress on expanding our communications and remote monitoring capabilities throughout our field operations. That investment is proceeding nicely and we expect to start seeing benefits from this investment in the 2021 timeframe.

Now, I'd like to turn to the market and outlook for our businesses. At the time of our first quarter earnings call, it was clear the COVID-19 pandemic would cause severe commodity demand and price impacts as well as widespread capital reductions by our customers. We took quick action to prepare for the inevitable downturn without knowing the exact timing and magnitude of the pending change in demand for our compression services.

The market deteriorated quickly and sharply during the second quarter as a result of the COVID-19 pandemic. The rig count fell over 60% during the second quarter and U.S. dry gas production fell from over 94 Bcf a day to as low as 86 Bcf a day.

While we will not try to predict the timing of a recovery, we began to see signs of stabilization in the overall market and in our compression operations entering the third quarter.

Oil prices have improved off of April as the pace of rig count declines is slowing and we're seeing modest growth in natural gas production in recent weeks, as shut in wells have resumed production.

Should current oil prices hold up, we could also see some producers look to allocate capital to the large backlog of drilled but uncompleted wells in the second half of this year.

While all of these improvements are encouraging and we're hopeful we've seen the worst of the downturn, visibility remains limited. As we closely monitor market developments, we will continue to control what we can to position Archrock for success.

Turning to our operations in contract compression, our strong execution and cost savings initiatives drove an increase in our gross margin percentage versus the first quarter despite lower horsepower.

I'll first touch on the challenges during the second quarter. With the sharp drop in commodity prices, producers and midstreamers quickly rationalized costs. And in some cases, this resulted in the return of our compression equipment in the field.

Our long-term contracts, standby strategy and focus on large horsepower of midstream applications certainly helped mitigate the impact. However, our second quarter operating horsepower and exit utilization is still declined. We continue to work closely with our customers to support their businesses, maximize our operating horsepower and maintain revenue and pricing as best we can.

On a strongly positive note, we drove an increase in contract operations gross margin to 66% in the second quarter, up 400 basis points on both a sequential and annual basis. As a reminder, a significant portion of our operating costs are variable, a key advantage as we made adjustments to align our business with market conditions.

I also want to highlight that in the midst of a global pandemic and severe energy downturn, we had record safety performance and continuum to provide excellent customer service and equipment uptime. This speaks to our strong safety culture and to the result in great talent of our employees.

Moving on to our aftermarket services business. With the effects of COVID-19 and decreased commodity prices, customers are preserving capital and still delaying maintenance activity on their equipment. This resulted in a revenue and gross margin decline off an already low base, as we've yet to see any changes in AMS customer behavior, we remain focused on optimizing our cost structure.

Turning to our capital allocation strategy. Our message is consistent with last quarter and our focus remains on balancing appropriate levels of investment, debt reduction and shareholder return.

With the infrastructure already in place to support U.S. natural gas production and meet the needs of our customers for the next few years, our priorities are -- first -- shareholder returns even during this downturn. We believe having a reliable and attractive dividends is important to our investors and to the value of our company and we will continue to work with our Board each quarter to assess our forward views of future cash flows and the dividends.

Our second but equally important priority at this point of the cycle is to execute all available measures to reduce our debt and protect our financial position. Ultimately, we believe somewhere between 3.5 times and 4 times is the optimal leverage level for our stable compression business.

Before turning the call over to Doug, I'll leave you with a few thoughts on what I believe is Archrock's compelling value proposition, one that stands out when you look not only at the realm of energy investments, but across other income-oriented sectors as well.

We continue to demonstrate predictable cash flows and attractive free cash flow yield, as well as a durable, well-funded distribution. While the coming quarters won't be free of challenges, I'm excited to prove out what our differentiated business model and financial framework can deliver today and well into the future.

With that, I'd like to turn the call over to Doug for a review of our second quarter performance and 2020 outlook.

Doug S. Aron -- Senior Vice President and Chief Financial Officer

Great. Thank you, Brad. Let's look at a summary of our second quarter results and then cover our financial outlook. We maintained flat adjusted EBITDA of $101 million compared to the second quarter of 2019. Lower revenues were more than offset by intense cost management.

Our second quarter adjusted EBITDA included $2 million in net losses related to the sale of assets. We recorded a net loss for the second quarter of 2020 of $30 million, which included several one-time charges. The majority of which were non-cash. As Brad mentioned, we retired 184,000 operating horsepower and recorded a $55 million long-lived asset impairment during the quarter. We also took a $2 million restructuring charge related to severance benefits and had a $4 million non-cash loss associated with the early retirement of debt.

Finally, we had an $8 million non-cash income tax benefit during the second quarter. Excluding these items, we reported net income of approximately $25 million.

Turning to our business segments. Contract operations revenue came in at $188 million in the second quarter, down from $207 million in the first quarter due to lower operating horsepower, pricing pressure and horsepower on standby. However, gross margin improved to 66% due to solid cost management.

In our aftermarket services segment, we reported second quarter 2020 revenue of $32 million, down from $43 million in the first quarter. Customer activity remained low given cost constraints and market uncertainty. We had a few cost items come in above our forecast for the quarter, including higher warranty expenses. We also experienced lower labor utilization during the quarter, given the often lumpy nature of our AMS work and as we continue to balance, retaining our high quality technicians with rightsizing the business for activity levels. Both resulted in second quarter AMS gross margin that was below our mid-teens target.

SG&A was down nearly $2 million compared to the prior quarter's $31 million as we saw the initial benefits of discretionary spending reductions and other cost savings.

For the second quarter, growth capital expenditures totaled $23 million, down more than 50% from $49 million during the first quarter. We also reduced maintenance and other capex during the second quarter of 2020 to $18 million from $23 million in the prior quarter.

Our total debt of $1.8 billion reflected $8 million in net debt repayments during the second quarter. Our credit facility doesn't mature until 2024 and we currently have over $400 million in available liquidity.

Our leverage ratio of 4.1 times was essentially flat compared to the prior quarter, but down from 4.4 times from the second quarter of 2019. We expect debt repayment to accelerate in the second half of the year, which will mitigate the expansion of our go-forward leverage ratio until the market recovers, and we can deliver on our goal of 3.5 times to 4 times.

We recently declared a second quarter dividend of $0.145 per share or $0.58 on an annualized basis, unchanged on a quarterly and annual basis. Our dividend payout is supported by our internal cash generation, strong balance sheet and robust dividend coverage.

Cash available for dividend for the second quarter totaled $58 million, representing peer-leading dividend coverage of 2.6 times. Our existing dividend represents a compelling yield of 8% based on yesterday's closing price.

We remain committed to returning cash to shareholders and to reducing our debt from available free cash flow.

I'll end with some commentary on our 2020 outlook. As you know, the relative resilience of our business, allowed us to provide an updated 2020 outlook in May, as many companies were pulling guidance due to the COVID-19 pandemic and commodity price declines. Based on solid second quarter execution and our current view of the market, we still expect to deliver between $380 million and $420 million and full year 2020 adjusted EBITDA. And with our cost and capital reductions, we've enhanced our outlook for free cash flow and cash available for distribution for the year.

We've provided some adjustments to segment forecast in the press release issued last night.

We are maintaining a wider adjusted EBITDA guidance range given continued market volatility. And contract operations were largely on-track for the year as lower horsepower and revenue is being mitigated by aggressive cost management. In AMS we're trending below expectations provided in May, as our customers have further delayed releasing their budgets for maintenance work.

Turning to capital on a full year basis, we've lowered our total capital expenditure range to $130 million to $155 million or down about 8% at the midpoint, compared to previous guidance. This is largely being driven by maintenance capex savings as we continue to optimize our maintenance practices.

Our updated growth capex range of $70 million to $85 million adjust the high end of our prior range down by $5 million.

To sum it up, our expected operating performance combined with the reduced capex profile in the second half of the year will drive an acceleration of free cash flow generation. We expect full year free cash flow generation after dividends to be substantial, approaching $100 million, which we expect to use to repay debt.

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

Questions and Answers:


[Operator Instructions] Our first question comes from the line of Kyle May with Capital One Securities. Please proceed with your question.

Kyle May -- Capital One Securities -- Analyst

Good morning.

D. Bradley Childers -- President and Chief Executive Officer

Good morning.

Kyle May -- Capital One Securities -- Analyst

Brad, you mentioned that compression operation started to stabilize entering the third quarter. Can you talk more about what you're hearing from your customers and also what you're seeing in the field?

D. Bradley Childers -- President and Chief Executive Officer

Sure. So, when we look at the timing of this, we had an amazing May. I mean, it really hit so quickly. And what we saw for the quarter was sharp increase in stock activity as customers rightsized for production levels and for economic. Bookings and starts, basically came to a strong stop, and standby activity hit a record pace, that is the number of units we've put on standby, which -- we still collect revenue but at a lower rate.

What we saw already coming into Q3 is that stop activity is already moving to a more normalized level. I'll remind you that that's a normal part of our business. And standby horsepower, about half of what went on standby initially has already come back off standby. And so, those are the positive that we've seen.

Bookings, however, continue to lag as would be expected given production expectations. But it's that normalization of stock activity and the return of the horsepower of those previous on standby to full operations that are some of the indications we've seen.

Look, on the bright side, I would point out that despite the market and the timing we had, we did see incremental growth in a couple of markets, including the Northeast and the Haynesville as some dry gas production was brought back on. I think that offset some of the decreases that we saw at least partially in the shale plays.

So, it wasn't all bad. And those are the highlights from the way I think about what we are seeing currently in the market.

Kyle May -- Capital One Securities -- Analyst

Got it. Okay, that's helpful. And as my follow-up, you highlighted that the gross margin percentage really strengthened in the second quarter and it sounds like maybe that's partially due to some of the equipment being on standby. But I guess, as that equipment returns and you look at the back half of the year, can you go into more detail about how you're thinking about cost management, and then maybe if that better margin is sustainable beyond 2020?

D. Bradley Childers -- President and Chief Executive Officer

Sure. So first off, the field team did an outstanding job managing -- what we have is a highly variable cost structure and they just did a great job managing it to both rightsize the business, and obviously, based on our results to get ahead of the market declines. And we saw savings in all of the components of our cost structure, labor, parts as well as lube oil.

There was, as you pointed out, Kyle, a contribution from the standby revenue, which has zero, almost zero operating cost associated with it. But our guidance range moved up for contract operations gross margin to 63% to 65%, which is indicating the amount of that improved profitability we expect to hang on to certainly in 2020. We're not going to really comment beyond that, but we're going to be very ambitious about how well we can continue to drive profitability into this business.

And in 2021, we're looking forward to getting more of the results from our technology investments into our profitability as well. So, we're pretty ambitious about how well we can drive this.

Kyle May -- Capital One Securities -- Analyst

It sounds great. Well, I'll jump back in the queue. Thanks.

D. Bradley Childers -- President and Chief Executive Officer

Yes, thank you.


[Operator Instructions] Our next question comes from the line of Daniel Burke with Johnson Rice. Please proceed with your question.

Daniel Burke -- Johnson Rice -- Analyst

Yes. Hi, good morning, guys.

D. Bradley Childers -- President and Chief Executive Officer

Good morning.

Daniel Burke -- Johnson Rice -- Analyst

Brad, just trying to think about the trajectory of the business in the second half of the year in terms of contracted horsepower. Maybe one way to ask this, I don't know if it'd work, but would be to ask you, what sort of a normal run rate of stop activity if that's what's going to prevail in the second half of the year. Any way to think about that? I mean, there won't be a lot of net adds, but I was wondering how to think about stops?

D. Bradley Childers -- President and Chief Executive Officer

Yes. So, number-one, I'm going to just express that visibility into the market is not great. And the communications with our customers right now still look at, I think, of flat to slightly declining level of gas production throughout the course of the year. And so, we don't see that there is going to be a lot of bookings or growth available in the market. And at the same time though, we also see a stabilization around the horsepower levels required to support current gas production.

So, and finally, our guidance includes our expectations for what's going to happen to revenue and contract operations. And I think that's the -- my commentary in that is the best indication that we have and forecasting horsepower changes for the rest of the year.

Daniel Burke -- Johnson Rice -- Analyst

Okay. Yes, fair enough. With just two quarters, it gets a little easier to box that in. All right. Maybe a smaller one then on the AMS side. I think you ir Doug highlighted, there was a sale. Didn't sound like it was particularly sizable, but I was wondering if it did have any impact on gross margin for the full year as we kind of look at the scale and try to balance where in that guidance range you fall out for the year?

D. Bradley Childers -- President and Chief Executive Officer

Yes. Not really. The business we sold was a small portion of that business. By the way, it's a great team and that was a good business. It just so happened however that given some changes in that subsection subset of the market -- we had a buyer that was able to value it well and accelerate for us a lot of the value that we saw in that business too, but at a time when our capital allocation priorities and debt reduction would be well served by monetizing some of that future value, which is what we did in that transaction.

So, we're really pleased with that transaction as one of the incremental steps in the context that we're doing all we can do to figure out where we can monetize and reduce debt.

Doug S. Aron -- Senior Vice President and Chief Financial Officer

And I just would add Daniel that from a modeling perspective, because it was as Brad pointed out, relatively small in the grand scheme that it shouldn't have an impact in our guidance, again our range there, really more reflects -- even less visibility in the AMS business for the back half of the year, but we're hopeful we've captured the right range for that and what we put out in the updated guidance.

Daniel Burke -- Johnson Rice -- Analyst

Okay, guys. Well, look, I'll tell you what, that's helpful. I'll go ahead and leave it there.

D. Bradley Childers -- President and Chief Executive Officer

Thanks, Daniel.


Our next question comes from the line of Ryan Pfingst with B. Riley FBR. Please proceed with your question.

Ryan Pfingst -- B. Riley FBR -- Analyst

Good morning, guys.

D. Bradley Childers -- President and Chief Executive Officer

Good morning.

Ryan Pfingst -- B. Riley FBR -- Analyst

Doug, you mentioned you are maintaining the wider EBITDA guidance down. Understandable with the uncertainty there. But what do you think are some of the factors that would get you to the higher end of that range? Is it just activity levels or is there more room to actually save on the cost side?

Doug S. Aron -- Senior Vice President and Chief Financial Officer

Look, I think activity levels obviously have a big impact and we are continuing to be hopeful that our sales organization will fill needs where there are. I mean, it all really comes down I think to commodity price. And as Brad highlighted, do we start to see drilled but uncompleted wells pickup in activity in the back half? Your modeling is going to be way better than ours probably in terms of what you expect there.

We did, as we just talked about with Daniel, have the $9 million gain on sale of a portion of the AMS business. So, I know it varies for each of you on the line as to whether you include that or you don't in our adjusted EBITDA. We do include it. Including that, we think that will be above that midpoint that we described previously. If you don't, it certainly will be a little more challenging to get there, at least based on what we know today.

So, that -- all of that goes into our thinking in the wide -- a little bit wider than usual guidance range at this point of the year, but again appreciate what the rest of the energy industry is going through, more broadly just about every industry outside of Apple and Amazon, and we feel pretty good about the 2020 outlook for Archrock.

Ryan Pfingst -- B. Riley FBR -- Analyst

That's helpful. Thank you. And then on M&A, certainly a distant third in terms of capital allocation priority right now. Just wondering what you're seeing out in the market with perhaps some of your competitors struggling right now, and if you would potentially have any appetite at the right price?

D. Bradley Childers -- President and Chief Executive Officer

You know, our perspective on M&A industry consolidation hasn't really changed. On the one hand, we favor and we'd like to see consolidation wherever it occurs. We think it brings discipline into the capital side especially of the industry. And I think that as with other sub sectors, there are certainly some -- there's costs that could come out through consolidation.

We are absolutely a willing participant where we can find value and quality combined in the same operation for us. We think that that's always a good path to get some incremental growth. Looking back, we're still completely pleased with the acquisition we had last year of Elite Compression, which was both excellent equipment, excellent team, well-run company. And we were able to bring that on to our platform really effectively.

But I'll point out that, very often, distress doesn't come with quality in the operations. And so, we just want to make sure that we stick to our disciplined fleet strategy of growing and upgrading continuously the locations in which our businesses operate, that is the basins, the quality and age and standardization of the fleet that we've continued to invest in and grow.

And on that point, one of the things that we noted in the quarter is that that fleet upgrading work which any acquisition has to be consistent with has resulted in the average age of our fleet now in the range of between 10 and 11 years. We've gotten to the point where we are operating today the most competitive and youngest fleet we've ever had. And any consolidation and acquisition in which we participate, needs to be consistent with that strategy.

Ryan Pfingst -- B. Riley FBR -- Analyst

Great. I appreciate the detail. I'll turn it back. Thanks, guys.

D. Bradley Childers -- President and Chief Executive Officer

Thank you.


[Operator Instructions] As there are no further questions, I would like to turn the call back over to Mr. Childers for any final remarks.

D. Bradley Childers -- President and Chief Executive Officer

Thank you, everyone, for participating in our Q2 call. We believe we have taken and continue to take the right steps to position Archrock to navigate this current cycle and plan to continue to focus on cost and capital management for the remainder of 2020.

I look forward to updating you in our third quarter call later in the year. Thanks very much.


[Operator Closing Remarks]

Duration: 34 minutes

Call participants:

Megan Repine -- Vice President of Investor Relations

D. Bradley Childers -- President and Chief Executive Officer

Doug S. Aron -- Senior Vice President and Chief Financial Officer

Kyle May -- Capital One Securities -- Analyst

Daniel Burke -- Johnson Rice -- Analyst

Ryan Pfingst -- B. Riley FBR -- Analyst

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