Archrock Q3 2023 Earnings Call Transcript

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November 2, 2023

There are 7 speakers on the call.

Operator

Good morning, and welcome to the Archrock Third Quarter 2023 Conference Call. Your host for today's call is Megan Repine, Vice President of Investor Relations at Archrock. I will now turn the call over to Ms. Repine. You may begin.

Speaker 1

Thank you, Nadia. Hello, everyone, and thanks for With me today are Brad Childers, President and Chief Executive Officer of Archrock and Doug Aron, Chief Financial Officer of Archrock. Yesterday, Archrock released its financial and operating results for the Q3 2023. If you 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 Although management believes that the expectations reflected in such forward looking statements are reasonable, it can give no assurance that such expectations will Proved to be correct.

Speaker 1

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, free cash flow, free cash flow after dividend 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 ks furnished to the SEC. I'll now turn the call over to Brad to discuss Archrock's 3rd quarter results and to provide an update on our business.

Speaker 2

Thank you, Megan. Good morning, everyone, and thank you for joining our call. We delivered excellent Financial and operational results during the Q3, which included setting several performance records. This continues to be a tremendous market for compression. But more importantly, the results Archrock delivered in the Q3 and the consistency and execution we've delivered all year Reflect the changes we've driven across the business to enhance our fleet, customer service and profitability To drive improved returns for our investors.

Speaker 2

Let me hit a few of the highlights from the quarter. In the Q3, we doubled our net income to $31,000,000 compared to the Q3 of 2022. We generated adjusted EBITDA of $120,000,000 which was a quarterly record for Archrock And was up 7% sequentially. The increase was driven primarily by positive pricing and profitability momentum And our contract operations segment. I'm also proud to share that we achieved an important balance sheet milestone during the quarter As we drove our leverage ratio to 3.8 times and we intend to drive leverage even lower next year.

Speaker 2

We continue to increase shareholder returns. We paid a quarterly dividend per share of $0.155 Which was up 7% compared to a year ago, all while maintaining robust dividend coverage of 2.6 times. In addition, we continued repurchasing shares under our share buyback authorization. I'd now like to share my perspective on the market. Archrock is positioned in a unique segment of the natural gas value chain And we believe compression market fundamentals have never been better.

Speaker 2

Similar to pipelines, We're an energy infrastructure company supplying a critical piece of infrastructure needed to move gas to market with the majority of our large horsepower equipment Deployed in natural gas gathering applications. We run a fee based business, which is closely aligned natural gas production volumes and not natural gas prices. So we're not exposed to the shorter cycle volatility facing drilling, Pressure Pumping and Completions Focused Services. Looking at the outlook for natural gas production, Again, the biggest driver of our business. We expect to see consistent and modest growth rates in the low single digits on an annual basis.

Speaker 2

This is being driven by 2 dynamics. First, we continue to see strong investment in associated gas plays in the U. S. Like the Permian and the Eagle Ford where the majority of our operating fleet is located. We also believe The recent U.

Speaker 2

S. Shell mega deals announced by major integrated producers reinforce the competitiveness and longevity of U. S. Shell. 2nd, our customers are planning critical infrastructure to support growing LNG exports from the U.

Speaker 2

S, Further extending the attractive fundamentals for our industry well into the future. As natural gas demand and production grows, we're experiencing unprecedented tightness in the compression market, which we believe is driven by structural And industry wide changes to capital allocation practices. Priorities have changed. With capital discipline permeating the energy sectors, companies look to drive moderated and profitable growth as well as consistent free cash flow to return to shareholders. We're seeing this capital discipline by our producer and midstream customers, Other compression companies and even our equipment providers.

Speaker 2

We believe this powerful combination The expected continued growth in natural gas production plus the commendable discipline we're seeing across the industry Supporting comparably steadier and more durable upcycle for compression and for Archrock. Moving on to our contract operations segment. We've positioned our compression platform selling non strategic assets Investing in highly standardized large midstream compression units. The benefits are clearly beginning to pay off in our results. Fleet utilization exited the 3rd quarter at 96%, another record for Archrock.

Speaker 2

We also delivered nearly 650,000 in active horsepower growth excluding non core The growth was primarily driven by newbuild equipment deliveries As we have few idle units remaining to redeploy and as we continue to experience historically low levels of equipment returns from the field. When we do receive a notice of a customer's determination to return a unit, most of that equipment is booked for its next job Before it ever stops in its current location. On booking activity, robust customer demand is showing no signs of slowing down And our 2024 newbuild capital is fully committed. With lead times for new equipment still around a year, The window to order compressors for delivery in 2024 is closing and our customers are beginning to plan for their 2025 horsepower needs. On pricing, we've now achieved sequential increases in our monthly revenue per horsepower for 8 consecutive quarters.

Speaker 2

Over this time period, our monthly revenue per horsepower is up over 17%. The pricing trajectory remains positive And we expect to continue to make progress gradually moving rates up on our installed base next year. We delivered an impressive 3rd quarter gross margin percentage of 64%, which was above our annual guidance range And is now approaching peak performance during prior cycles. This is due to a few factors. 1st, as I just highlighted, we've repositioned our compression platform for a more stable and profitable future.

Speaker 2

2nd, the price increases we're implementing this year are catching up with the cost increases we experienced over the last few years. And third, we've maintained a consistent and unwavering focus on cost management as we grow modestly And profitably with our customers. Turning to aftermarket services, we saw steady and strong performance. We saw solid demand and activity on the service side of the business during the quarter and profitability remains substantially higher than 2022 levels As our team focuses on targeting higher quality and higher margin activity. From a capital allocation standpoint, we remain on track to deliver the enhanced framework that we laid out on last quarter's call, which is underpinned by our commitment to generate free cash flow.

Speaker 2

Based on our current outlook for 2024, we remain set up To grow our dividend with a 2024 target of 5% and maintain a dividend coverage ratio of approximately 2 times. We currently drive our leverage ratio even lower to a range of 3 to 3.5 times. Fund our growth capital expenditures which we currently anticipate to be approximately $160,000,000 in 2024. And this capital plan preserves the ability to continue to buy back additional shares. In summary, 2023 is shaping up to be a banner year for our company and we believe we are set up for an extended period Strong and sustained performance.

Speaker 2

Natural gas production fundamentals remain durable. The compression industry is as Height as we've ever seen due to capital rationalization by both the energy industry and our suppliers. And Archrock's competitive and financial flexibility It's as strong as it's ever been. With that, I'd like to turn the call over to Doug for a review of our Q3 and to provide additional Color on our outlook for the rest of the year.

Speaker 3

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

Speaker 3

Turning to our business segments, contract operations revenue came in at $208,000,000 in the 3rd quarter, up 3% compared to the Q2 of 2023 And 22% versus the year ago period. Operating horsepower and pricing both increased sequentially. Compared to the Q2 of 2023, we grew our gross profit by nearly $7,000,000 or 6%, Resulting in a gross margin percentage of 64%. This was up 150 basis points compared to the 2nd quarter And nearly 600 basis points year over year. In our Aftermarket Services segment, we reported Q3 2023 revenue of $46,000,000 consistent with 2nd quarter levels and up 6% compared to the Q3 of 2022.

Speaker 3

2nd quarter AMS gross margin of 20% was down sequentially, but was consistent with annual guidance and up From 300 basis points versus the Q3 of 2022. Growth capital Expenditures in the Q3 totaled $45,000,000 This was consistent with our previous guidance that capital investment for the year Would be more first half weighted. Through the end of the Q3, we've deployed $175,000,000 of growth CapEx And high return projects to meet the strong customer demand we're seeing, primarily in associated gas basins such as the Permian. Of note, we've raised approximately $55,000,000 so far this year through non strategic equipment sales To support this new build investment program. Maintenance CapEx for the Q3 was $24,000,000 Compared to $27,000,000 during the Q2.

Speaker 3

Make ready and overhaul CapEx was down sequentially. We exited the quarter with total debt of $1,600,000,000 and variable rate debt continues to represent approximately 20% of our total long term debt. In addition, we maintained strong available liquidity of $439,000,000 We reduced our leverage ratio to 3.8 times, down from 4.3 times in the Q3 of 2022. Achieving a leverage ratio of less than 4 times has been a goal since before I joined Archrock, And we are excited to deliver this important company milestone during the quarter. We have more progress to make and believe it's prudent to move the goalposts Even further, particularly in a high interest rate environment.

Speaker 3

As Brad mentioned, we currently anticipate taking our leverage ratio lower In 2024 to a range of 3 to 3.5 times. We recently declared a 3rd quarter dividend of $0.155 per share or $0.62 on an annualized basis. This is consistent with 2nd quarter levels and up 7% year over year. Our latest dividend represents a solid yield of nearly 5% based on yesterday's closing price. Cash available for dividend for the Q3 of 2023 totaled $63,000,000 leading to impressive quarterly dividend coverage of 2.6 times.

Speaker 3

In addition to increasing the dividend this quarter, we repurchased approximately 354,000 shares for $4,400,000 At an average price of $12.49 per share. This leaves approximately $43,500,000 in remaining capacity for additional share Turning to our outlook, we continue to see great execution year to date compared to our plan And we have great confidence in the compression market fundamentals, our ability to execute and our financial flexibility. Looking at adjusted EBITDA guidance, we expect to come in close to the high end of our most recent guidance range Of $430,000,000 to $450,000,000 This implies relatively flat adjusted EBITDA in the 4th quarter, Which reflects continued strength in our contract operations segment offset by seasonal weakness in our AMS business And approximately $3,000,000 in 3rd quarter asset sale gains that are not expected to recur. Turning to capital, on a full year basis, we continue to expect total 2023 capital expenditures to be around $295,000,000 Of that, we are holding the line on growth CapEx of $200,000,000 primarily for new build horsepower to meet key customer demand. In summary, we are focused on finishing the year on a high note and are planning for an even better 2024.

Speaker 3

This includes our expectation for enhanced profitability, improved financial returns and positive free cash flow, While remaining committed to our differentiated capital allocation framework with shareholder return at the top of the list. We hope you will join us for what we believe will be an exciting and rewarding ride. I will now turn the call back over to Nadia for question

Operator

And our first question goes to Jim Rollison of Raymond James. Jim, please go ahead. Your line is open.

Speaker 4

Good morning, guys. Congrats on another great impressive quarter moving forward. Brad, just maybe As we think about growth going forward, obviously, you're probably getting closer to maxing out on utilization. And as you mentioned, so incremental horsepower adds, which you're going to spend $160,000,000 next year, will be part of that equation. And the rest of the It seems like from a top line perspective will be how your pricing moves from here and it's been a pretty steady trend upward.

Speaker 4

I'm trying to understand maybe as you sit today and look across the portfolio of the fleet at your most recent contracts and the implied pricing And some of your maybe older contracts that haven't repriced or moved up with an inflator basis. Trying to understand the spread there to Kind of figure out how much upside room there is just from today's market if you mark your fleet to the market today.

Speaker 2

Thanks, Jim. We believe there is substantial upside And the profitability to the business. When you think about profits, you cited 2 of the 3 items that will continue to move the needle for our performance. The first is incremental horsepower growth as we grow our fleet responsibly with great investments at very solid returns for our investors. One that you missed and I'll come to pricing third.

Speaker 2

One that you missed is we remain ambitious about managing our costs with the investments we've made In technology to improve the performance of our fleet, we believe it's also going to enhance the profitability of our fleet. We believe that that is an investment that's going to yield incremental improvements and returns for years to come. And we intend To exploit that aggressively in 2024 just as we have in 2023, but also in 2024 and beyond. And then finally on pricing, We certainly have room to bring the installed base up to more current spot pricing over time. And we're ambitious about what we can do with those pricing moves.

Speaker 2

So we believe these are 3 solid levers that are going to be available for us to drive returns For investors in this market.

Speaker 4

Understood. I didn't miss cost. That was going to be my next question. Is there anything it sounds like there's still levers to pull to improve that side. Historically speaking, and this seems like a different time than most of history, at least as far as I've been following this space.

Speaker 4

With pricing trajectory you have today and obviously the momentum behind it and where your costs are today with more things you just Kind of alluded to improving that potentially going forward. Where do you think margins can go? We're kind of back in the historical peaks Pretty close to that. And I'm just curious, is this 64 ish percent margin, can that continue to kind of inch higher over the next Few quarters or how do you think about that?

Speaker 2

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

Speaker 2

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

Speaker 4

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

Speaker 2

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

Speaker 4

Great. Thanks again, guys.

Speaker 5

Thanks, John.

Operator

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

Speaker 5

Afternoon, Brad, Doug. Appreciate all the color on the call. I feel like I probably asked this last Quarter, but worth asking again. Utilization rates now a new record didn't seem like it could go higher. Just a question as we get into a seasonally higher Demand area, and I'm sure your asset turnover has to be at near record lows.

Speaker 5

Is it safe to say that utilization is sustainable because You're not going to be returning compression into the winter months. Is that a fair way to look at it?

Speaker 2

Yes, it is. What we said in the past, I can say again And that is that there is not enough compression equipment in the market today to meet current production needs. Not to mention the growing production that we see coming from the expansion of LNG exports. So we see High utilization rates continuing. We see incremental growth ahead to support that level of production.

Speaker 2

And so we think utilization can maintain and candidly can even continue to tighten from here based on The demand we see in the market today.

Speaker 5

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

Speaker 2

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

Speaker 3

Steve, if I could just Emphasize a portion of Brad's answer there, right. If we go back to end of 2019, end of 2020, I think we said this on our last call. We've seen nearly a 40% increase in the cost of new build Large horsepower equipment from something in the $900 a horsepower to approaching $1200 a horsepower. That increment means that be it customers that are ordering their own equipment with the foresight of doing so again with long lead times for that equipment, A potential new entrant, which we haven't yet seen or anyone else in order to get any kind of a recovery is going to have To be pricing it at what we see as current rates. And so again, I think one of the really attractive parts The Archrock story is a 3,600,000, 3,700,000 horsepower installed base That in a large in a lot of cases was acquired at a much different timeframe.

Speaker 3

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

Speaker 5

That's helpful. Thank you. If I could just get one last one in. Just on maintenance CapEx came down this quarter. Is there much idle capacity left to make ready?

Speaker 5

Or what would you expect trends being that you're going to have to maintain a larger fleet going forward Theoretically into next year?

Speaker 2

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

Speaker 5

Great. Thanks, Brad. Thanks, Doug.

Speaker 2

Thank you.

Operator

Thank you. Archrock. And our next question goes to Selman Akyol of Stifel. Selman, please go ahead. Your line is open.

Speaker 6

Thank you. Good afternoon. Good morning. So let me just start with in terms of spot pricing, If you were to characterize it versus 6, 9 months ago, how is that trending?

Speaker 2

No, let me expand on that a bit. We find that we are in a very aggressive pricing posture now for reasons we've already discussed on the call. So I won't go into all of them Selman, But just catching up with original equipment costs for new builds, catching up with parts, labor, lube And the fact that cost of capital has increased, has justified significant amount of price reclamation In the energy space and in compression that we and you can see it in our competitors also are benefiting from. We do not see the ability to raise prices changing or abating. The slope of the curve may start to flatten a bit, But we still are very positive that we can see more pricing gains from our installed base in 2024 And that's still ahead of us.

Speaker 2

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

Speaker 6

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

Speaker 2

We estimate that still 2 thirds of our fleet can be repriced over the next 12 months. Part of that comes in the form of units that roll off term. Part of it comes in the form of units that are under a major Strategic alliance with our customer base and has pricing mechanisms in there, some of which are indexed and some of which are just negotiated. So but that allows us to keep the pricing fresh on our fleets. And it's about 2 thirds that will be repricing over the next 12 months.

Speaker 6

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

Speaker 2

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

Speaker 6

Yes. I mean, I

Speaker 3

think, well, we're not we're definitely not going to give you a 2024 guidance today Because we're still in the process of putting that plan together. But look, I think we've said 8 consecutive quarters of sequential revenue growth From where we sit today, from the conversations we're having with our customers, we certainly expect that Street to continue and you got to leave us something excited to talk to you about when we report Q4 early next year.

Speaker 6

Okay. I want to just pivot over to the balance sheet and some comments you made there. You talked about your goal of getting down to 3, 3.5 And you talked also about wise thing to do in higher interest rate environment. Complete agreement there. I guess my question is and I'm thinking about interest expense.

Speaker 6

Even with lower leverage, unless you actually take your debt levels down, your interest expense So it would be would it be so in order to lower that, are you guys planning on paying down additional debt? Or do you are you seeing your leverage Just being achieved through higher EBITDA.

Speaker 3

So a couple of comments there. And I think You coined a phrase that I've now used since then when we were last out on the road with you, Selman. We are not just planning to take leverage down as you call it the Texas way by growing EBITDA, right? But We have actually repaid $230,000,000 or so worth of debt since 2019. And that has been a meaningful part of the leverage reduction.

Speaker 3

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

Speaker 6

Understood. And I guess you mentioned conversations on 2025 are starting. Just how are those going? And I'm just kind of curious. I mean, they're very open to seeing continued price increases out that far, Still hearing things are going to be tight.

Speaker 6

Is there just any insight you can kind of give on what's going on there?

Speaker 2

Demand is high for 2024. Demand signals overall pricing and Horsepower amounts and unit amounts, those discussions with customers are as strong at the beginning of 2024 as they were in 20 And in fact, I think in some cases they are earlier because with the tightness of the market, our customers Have become accustomed to planning further in advance than they ever have. So it's a robust market And it looks to be very demand and growth oriented continuing through 2024.

Speaker 6

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

Operator

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

Speaker 2

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

Operator

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

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