Archrock, Inc. (NYSE:AROC) Q3 2023 Earnings Call Transcript

Archrock, Inc. (NYSE:AROC) Q3 2023 Earnings Call Transcript November 2, 2023

Operator: Good morning, and welcome to the Archrock’s 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.

Megan Repine: Thank you, Nadia. 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 third quarter 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 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, 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-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 on our business.

Bradley Childers: Thank you, Megan. Good morning, everyone, and thank you for joining our call. We delivered excellent financial and operational results during the third quarter, which included setting several performance records. This continues to be a tremendous market for compression. But more importantly, the results Archrock delivered in the third quarter 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. Let me hit a few of the highlights from the quarter. In the third quarter, we doubled our net income to $31 million compared to the third quarter of 2022. We generated adjusted EBITDA of $120 million, which was a quarterly record for Archrock and was up 7% sequentially.

The increase was driven primarily by positive pricing and profitability momentum in 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 3.8x, and we intend to drive leverage even lower next year. 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 2.6x. 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.

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 to 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. 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.S. Shell mega deals announced by major integrated producers reinforce the competitiveness and longevity of U.S. Shell. Second, our customers are critical infrastructure to support growing LNG exports from the U.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 permitting — 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. We believe this powerful combination of expected continued growth in natural gas production plus the commendable discipline we’re seeing across the industry, supporting comparably steadier and more durable up cycle for compression and for Archrock. Moving on to our contract operations segment. we’ve positioned our compression platform, selling non-strategic assets and investing in highly standardized, large midstream compression units. The benefits are clearly beginning to pay off in our results. Fleet utilization exited the third quarter at 96%, another record for Archrock. We also delivered nearly 650,000 in active horsepower growth excluding non-core active asset sales of 35,000 horsepower.

The growth was primarily driven by new build equipment deliveries as we have a 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 customers’ determination to return in units, 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 new-build 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.

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 third 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. First, as I just highlighted, we’ve repositioned our compression platform for a more stable and profitable future. Second, 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.

A close-up of a wellhead, showing off the company’s production of oil and natural gas.

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. 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 2x. We currently drive our leverage ratio even lower to a range of 3 to 3.5x. Fund our growth capital expenditures, which we currently anticipate to be approximately $160 million 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 of strong and sustained performance. Natural gas production fundamentals remain durable. The compression industry is as tight as we’ve ever seen due to capital rationalization by both the energy industry and our supplier and Archrock’s competitive and financial flexibility is as strong as it’s ever been. With that, I’d like to turn the call over to Doug for a review of our third quarter and to provide additional color on our outlook for the rest of the year.

Douglas Aron: Thank you, Brad, and thanks to all of you for joining us this morning. Let’s take a look at our summary of our third quarter and then cover our financial outlook. Net income for the third quarter of 2023 was $31 million. This included a long-lived and other asset impairment of $3 million and restructuring charges of $600,000. We reported adjusted EBITDA of $120 million for the third quarter of 2023, a quarterly record for Archrock. Underlying business performance was strong in the third quarter as we delivered higher total gross margin dollars on both a sequential and annual basis. Results further benefited from approximately $3 million in third quarter asset sale gains. Turning to our business segments. Contract operations revenue came in at $208 million in the third quarter, up 3% compared to the second quarter of 2023 and 22% versus the year ago period.

Operating horsepower and pricing both increased sequentially. Compared to the second quarter of 2023, we grew our gross profit by nearly $7 million or 6%, resulting in a gross margin percentage of 64%. This was up 150 basis points compared to the second quarter and nearly 600 basis points year-over-year. In our aftermarket services segment, we reported third quarter 2023 revenue of $46 million, consistent with second quarter levels and up 6% compared to the third quarter of 2022. Second quarter AMS gross margin of 20% was down sequentially but was consistent with annual guidance and up from 300 basis points versus the third quarter of 2022. Growth capital expenditures in the third quarter totaled $45 million. This was consistent with our previous guidance that capital investment for the year would be more first half weighted.

Through the end of the third quarter, we’ve deployed $175 million 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 million so far this year through nonstrategic equipment sales to support this new build investment program. Maintenance CapEx for the third quarter was $24 million compared to $27 million during the second quarter. Make Ready and overhaul CapEx was down sequentially. We exited the quarter with total debt of $1.6 billion and variable rate debt continues to represent approximately 20% of our total long-term debt. In addition, we maintained strong available liquidity of $439 million. We reduced our leverage ratio to 3.8x, down from 4.3x in the third quarter of 2022.

Achieving a leverage ratio of less than 4x 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. As Brad mentioned, we currently anticipate taking our leverage ratio lower in 2024 to a range of 3 to 3.5x. We recently declared a third quarter dividend of $0.155 per share or $0.62 on an annualized basis. This is consistent with second 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 third quarter of 2023 totaled $63 million leading to impressive quarterly dividend coverage of 2.6x.

In addition to increasing the dividend this quarter, we repurchased approximately 354,000 shares for $4.4 million at an average price of $12.49 per share. This leaves approximately $43.5 million in remaining capacity for additional share repurchases. 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 million to $450 million. This implies relatively flat adjusted EBITDA in the fourth quarter, which reflects continued strength in our contract operations segment offset by seasonal weakness in our AMS business and approximately $3 million in third 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 million. Of that, we are holding the line on growth CapEx of $200 million 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. 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 back — the call back over to Nadia for question and answers.

Operator: [Operator Instructions]. And our first question goes to Jim Rollyson of Raymond James.

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Q&A Session

James Rollyson: 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 million next year will be part of that equation. And the rest of the equation seems like from a top line perspective will be how your pricing moves from here, and it’s been a pretty steady trend upward. 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.

Bradley Childers: Thanks, John. We believe there is a substantial upside in the profitability to the business. And 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, 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 a more current spot pricing over time. And we’re ambitious about what we can do with those pricing moves. So we believe these are 3 solid levers that are going to be available for us to drive returns for our investors in this market.

James Rollyson: 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. So historically speaking, and this seems like a different time than most of history, at least as far as I’ve been following this space. 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 or 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?

Bradley Childers: We believe the investments we’ve made and the market we have 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 exceed them 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 to.

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