After years of struggling with the precipitous decline in oil prices and an onerous debt load, management at Archrock (NYSE:AROC) decided to bite the bullet and buy out its subsidiary master limited partnership Archrock Partners. According to management, the deal would free up some cash and lower its cost of capital. The combination of these two things would make it easier to grow the business and take advantage of the monumental growth of natural gas production in the U.S.
This past quarter, we got a first look at what this transformative acquisition would do for the company's income statement and balance sheet. While the initial results were encouraging, they still present some challenges for management to face down in the coming quarters. Here's a look at Archrock's most recent earnings results and what investors should make of the changes management made to the business.
By the numbers
|Metric||Q1 2018||Q4 2017||Q1 2017|
|Revenue||$212.0 million||$208.9 million||$189.9 million|
|Adjusted EBITDA||$78.7 million||$71.9 million||$65.3 million|
|Net income||($3.8 million)||$47.5 million||($11.6 million)|
This was the first quarter where we get to see Archrock's financials after absorbing its subsidiary partnership. There were some encouraging signs. Even though the company's net income result swung to a loss compared to the prior quarter, that's because Archrock benefited from a one-time $55 million gain as a result of the changes to the U.S. tax code.
What was even more encouraging than the narrowing net income loss was that the company's operating metrics improved pretty much across the board. Utilization of its compression horsepower was up to 86%, which was the highest rate in over two years. Also, with higher utilization rates comes a tighter market, which lifted prices and resulted in a 50% gross margin, which was another multi-year high.
The one thing that is a little hard to swallow is the company's debt metrics. After assuming all of Archrock Partners' debt, Archrock's debt to EBITDA for the quarter was 5.7 times. To be fair, it is quite the improvement from a couple of years ago, but debt levels that high will likely restrict the company's ability to grow in the short term.
What management had to say
In Archrock's press release statement, CEO Brad Childers outlined some of the benefits the merger will have for the business and the direction he wants to take the business in the rest of 2018:
With the merger behind us, we are focused on leveraging our strong operating platform and financial position to profitably expand the business. Demand for compression services remains robust, creating opportunities for us to put existing fleet units back into operation, as well as to invest in new larger horsepower units that provide attractive returns to our company and investors. As a result, we plan to invest $230 million-$250 million of growth capital this year.
One of the reasons that Childers has increased Archrock's capital spending for the rest of the year is because he sees a massive opportunity to supply compression horsepower to America's booming natural gas industry. Here's Childer's statement on the long-term outlook for gas in the U.S. and how it is influencing his decisions:
We are excited about the expected increase of U.S. natural gas production and its implications for Archrock. Natural gas production is the primary growth driver of our contract compression business. The Energy Information Administration forecasts 7.5 bcf/d of growth in U.S. natural gas production in 2018, with additional growth into the next decade. We are well positioned to capitalize on this growth, win profitable business, grow our operating fleet, and increase our cash flow and our earnings.
Better results mean better investment opportunity?
Archrock is in a challenging situation right now. Natural gas production in the U.S. is growing by leaps and bounds, which provides the company with significant room to grow its business. Unfortunately, it is saddled with a high debt load after assuming all of the debt from its subsidiary partnership. This means that the company needs to thread the needle of growing (which requires capital) while deleveraging the balance sheet at the same time. That's no easy task for any management team.
Fortunately, the combination of Archrock and Archrock Partners into a single entity will make it easier, even though it was a tough pill for investors to swallow when the deal was announced. There are some encouraging signs that the market for compression horsepower will get better, such as higher utilization rates and higher gross margins. Until investors get to see management prove it can handle this delicate balancing act of growth and balance sheet discipline, however, it is probably best to sit on the sidelines for a while.