Independence Contract Drilling, Inc. (NYSE:ICD) Q4 2022 Earnings Call Transcript

Independence Contract Drilling, Inc. (NYSE:ICD) Q4 2022 Earnings Call Transcript March 2, 2023

Operator: Hello and welcome to the Independence Contract Drilling Inc. Fourth Quarter and Year End 2022 Financial Results Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Philip Choyce, Executive Vice President and Chief Financial Officer. Please go ahead.

Philip Choyce: Good morning, everyone and thank you for joining us today to discuss ICD’s fourth quarter 2022 results. With me today is Anthony Gallegos, our President and Chief Executive Officer. Before we begin, I would like to remind all participants that our comments today will include forward-looking statements, which are subject to certain risks and uncertainties. A number of factors and uncertainties could cause actual results in future periods to differ materially from what we talk about today. For a complete discussion of these risks, we encourage you to read the company’s earnings release and our documents on file with the SEC. In addition, we refer to non-GAAP measures during the call. Please refer to the earnings release and our public filings for a full reconciliation of net income and loss to adjusted net income and loss, EBITDA and adjusted EBITDA and for definitions of our non-GAAP measures.

And with that, I will turn it over to Anthony for opening remarks.

Anthony Gallegos: Hello, everyone. Thank you for joining us for our fourth quarter earnings conference call. And during my prepared remarks today, I want to talk about three things. First, I want to highlight our 2022 accomplishments. Second, I want to describe the current market for super-spec, pad-optimal rigs and how that will impact ICD. And third, I want to close out with what we are focused on as we navigate 2023 and beyond. But first just a few comments on the quarter. Overall, ICD’s fourth quarter results came in well ahead of expectations in terms of revenues, margins and adjusted EBITDA. Phillip will go through the detail, but I want to point out that our reported revenue per day, margin per day and quarterly adjusted EBITDA were all again records for ICD.

This is the second quarter in a row we have produced record results. In addition, as the full year 2022 played out, we saw adjusted EBITDA increase by more than 5x measuring fourth quarter to the fourth quarter of last year. And we are well positioned so that 2023 will be the best year by wide margin in ICD’s history, whether it’s revenue per day, margin per day or overall free cash flow. As we closed out last year, we achieved additional strategic goals. In addition to generating rig margin per day exceeding most of our industry peers, we ended the year with 20 rigs operating, activated 2 additional rigs during the fourth quarter. Both of those rigs went to work in the Haynesville on very good contracts. In addition, we successfully completed our first 200 to 300 series conversion, involving a rig working for a customer in West Texas, proving that our 200 to 300 series conversions are technically and commercially viable, it was very important for us as we can now market 100% of our marketed fleet with 300 series specification if the market pulls us that way.

On the operational safety front, our safety performance based upon reported TRIR was over 20% better than the U.S. land average as reported by the International Association of Drilling Contractors. We accomplished so much in 2022 and I am very proud of how our operations and support teams continue to deliver high levels of customer service, performance and professionalism, which our customers expect from ICD. This is especially noteworthy given the unprecedented challenges involving the labor market and supply chain challenges, which continue to plague the global business community and more recently, the softness in natural gas prices. Looking ahead, we are finalizing the reactivation of our 21st rig in our Odessa, Texas yard, which is another 300 series rig.

This reactivation project was started back in October of last year and will be our last reactivation for a while. Like our other 300 series rigs, this rig possesses the technical capabilities that our target customers prefer today. We are in final contract negotiations for this rig and expect the rig will be mobilized into its maiden contract involving work in West Texas during the second quarter. All-in-all, ICD entered 2023 in a very strong position, whether from a margin per day and cash flow generation perspective or a fleet composition perspective where we have materially increased the percentage of rigs marketed with our 300 series specification. ICD has never been stronger. All of the hard work we have put into positioning ICD while bouncing off the pandemic bottom will be on full display as we navigate the New Year.

And with that, I want to shift to our current market perspective. And in particular, what’s on everyone’s mind, what the softness in natural gas prices means for ICD strategically in 2023. First, let me address the overall market and outlook for rig activity for pad-optimal super-spec rigs in our target markets of Texas in the contiguous states. Overall, demand for pad-optimal super-spec rigs remains strong. Today, overall utilization remains above 90% in the industry and we expect continued improvement in our rig margin per day in the first quarter driven by contract rollovers as we reprice rigs contracted early last year. Phillip will provide more detailed guidance, but I wanted to highlight that we currently expect our margin per day to increase to between $15,000 and $15,500 per day in the first quarter ahead of our prior guidance for that quarter.

However, the sharp decline in natural gas prices during the past 4 months has created a disparity between our two primary operating basins. In the Permian, which is all directed activity, demand remains robust and we are expecting an overall uptick in the super-spec rig count in that basin in 2023. In terms of our Haynesville market, which is tied to natural gas commodity prices, we are seeing softness in the Haynesville rig market driven by the E&P’s response to Henry Hub natural gas prices, which have declined from $9.68 on August 22 to $2.12 per million Btu last week. As we are nearing the end of winter and gas inventory levels remain high on a historical basis, combined with takeaway constraints in the Haynesville, the outlook for natural gas prices to remain softer, longer.

With that market backdrop, we see two primary impacts on ICD. First, the overall Haynesville directed rig counts going to decline. We have one customer in particular who has informed us that they will be moving to zero operating rigs. Several current prior and prospective customers in the Haynesville are also terming their active rig plates. The impact to ICD’s Haynesville fleet will include some rig relocations to West Texas, which have already commenced. Right now, we are confident that we will need to relocate 5 to 6 rigs, which will take place primarily during the second and third quarters of this year. The process has already started with 1 rig relocating without any operational whitespace. And I would be remiss if I didn’t point out that we received a day rate increase in the process.

We are in the final contract negotiations for our second relocation, which will also occur with minimal whitespace and a day rate increase. We believe market demand and strength in the Permian for pad-optimal super-spec rigs as well as our customer base is strong enough to absorb rig additions to the basin. We are already seeing some lower spec rigs gets displaced as a result of the churn underway. Also rigs brought from the Haynesville into the Permian will actually absorb rig count growth opportunities previously reserved for rig reactivations. In this environment, we expect overall rig reactivations to slow considerably or even stop until this overall rebalancing process is complete and the market is settled. Thus, we have elected to defer the reactivation of what would be our 22nd rig.

Overall, during this process, we expect the overall super-spec rig market to remain robust and maintain current utilization levels, which are above 90% utilization. As we have mentioned on prior calls, 80% utilization or above is typically where drilling contractors were able to maintain and increase pricing. But over the next two quarters or so, there is going to be some choppiness as we reshuffle the deck as a result of what’s happening in the Haynesville, I expect there will be more rig on rig competition where rig additions are occurring or a rig replacement opportunity exists. This will have some impact on pricing. Principally, we would expect the pace of day rate margin acceleration to moderate. So as we move past the first quarter and all of the rigs have repriced to current market day rates, I expect day rate and margin improvement to flatten out for ICD after the first quarter.

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Phillip will provide more financial details on our outlook, but overall, it means we will likely move sideways after the first quarter for a quarter or two until the market is rebalanced following rigs transitioning between basins. We remain optimistic about market momentum beginning to accelerate again towards the back part of this year, primarily in the Permian based upon our expectation that WTI will be higher in the back half of 2023. From a rig utilization perspective, while we relocate rigs to the Permian, we are not expecting a major reduction in our overall utilization rate. We will have some rigs in transit, but we do expect to reach full effective utilization of our 21 rigs operating in the fourth quarter or by year end. Overall, we would expect to operate in the neighborhood of 19 to 20 average rigs during this year, taking into account the transition time that might occur on rig relocations during the second and third quarter.

Phillip will go through more of the details, but financially our backlog of contracts in the Haynesville will mute much of the potential financial impacts, while rigs are transitioning. So how will all this impact ICD this year and strategically? Overall, we do not expect it will have a material overall impact other than to postpone rig reactivations. All of ICD’s strategic and financial goals regarding generating significant free cash flow and reducing overall leverage remain intact. As Phillip will discuss, we still expect 2023 to be a record year for ICD from a revenue per day, margin per day, EBITDA and free cash flow perspective. In fact, in the near-term as we slow our capital investments and additional rig reactivations, our free cash flow and net debt reduction plans will accelerate as we improve our working capital position by putting some cash on the balance sheet.

Strategically, we remain very focused on creating a pathway towards steadily decreasing our net debt position as we move towards the refinancing window for our convertible notes. One of our long-term goals is to reduce our net debt to adjusted EBITDA ratio meaningfully towards the range of less than 1x to 1.5x during the refinancing window involving our convertible notes. For reference, we are currently at 2.5x levered on an annualized basis using our fourth quarter results. And based upon the market expectation I just described, we expect to exit 2023 around 2x or below utilizing the same metric. So, while we have some work to do in this regard, everything is in place for ICD to achieve its short and long-term financial and strategic goals.

I will make some additional concluding remarks. But right now, I want to turn the call over to Phillip to discuss our financial results and outlook in a little more detail.

Philip Choyce: Thanks, Anthony. We were essentially breakeven from a profitability standpoint in the fourth quarter. During the quarter, we reported an adjusted net loss of $87,000 or $0.01 per share and adjusted EBITDA of $18.5 million. Reported adjusted EBITDA increased sequentially 48% compared to the third quarter of €˜23. Adjusted net loss and income excludes the impact of a tax benefit recognized during the fourth quarter following completion of our analysis regarding the deductibility of interest expense under our convertible notes. We operated 18.5 average rigs during the quarter, representing a 6% increase compared to the third quarter. Anthony previously mentioned our fourth quarter revenue and margin per day were quarterly records for ICD.

Revenue per day of $32,778 represented a 14% increase compared to the third quarter and margin per day of $14,517 represented a 28% sequential increase compared to the third quarter metrics. SG&A costs were $7.7 million, which included approximately $1.9 million of stock-based and deferred compensation expense. Sequential increases in cash SG&A over the third quarter were driven by higher incentive compensation accruals based upon improvements in the company’s safety, operational and financial performance compared to performance goals. Interest expense during the quarter aggregated $8.6 million. This included $2.4 million associated with non-cash amortization of deferred issuance costs and debt discounts, which were excluded when presenting adjusted net income and loss.

During the quarter, cash payments for capital expenditures, net of disposals were approximately $18.8 million in this CapEx out approximately 79% related to rig reactivations and upgrades and 21% related to maintenance CapEx. Moving on to our balance sheet, adjusted net debt was $182.5 million at quarter end. This amount represents the face amount of our convertible notes and borrowings under our ABL and ignores the impacts from debt discounts, deferred financing costs and finance leases. I do want to point out that the adjusted net debt we reported this quarter also includes accrued interest at year end that we intend to pay in time when due in March of 2023. Our backlog at year end was $79.1 million, with an average day rate over $35,000 per day.

Our financial liquidity at quarter end was $26.6 million comprised of $5.3 million of cash on hand and $21.3 million available under our revolving credit facility. Now moving on to guidance for the first quarter and some items related to fiscal 2023. Let me start with the first quarter. We expect operating days to approximate 1,715 days, representing approximately 19 average rigs working during the quarter, reflecting some rigs beginning to transition from the Haynesville to the Permian. Our 21st rig is not expected to reactivate until the second quarter. We expect margin per day to come in between $15,500 per day as Anthony mentioned. We expect revenue per day to come in between $33,200 and $33,600 per day. Cost per day is expected to range between $18,100 and $18,400 per day.

Unabsorbed overhead expenses will be about $600,000 and are not included in our cost per day guidance. We also estimate approximately $800,000 of transition expenses associated with rig relocations to the Permian, principally related to crew carrying costs during the transition period and unreimbursed transportation costs. We expect first quarter cash SG&A expense to be approximately $5.9 million and stock-based compensation expense is expected to be approximately $2 million on top of that. We expect interest expense to be approximately $8.8 million. Of this amount, approximately $2.4 million were related to non-cash amortization of deferred financing costs and debt discounts. Depreciation expense for the first quarter is expected to be $11 million.

As Anthony mentioned, we will be transitioning rigs from the Haynesville to the Permian. That process has already begun and we currently expect it to occur over the second and third quarters of 2023 with most movement during Q2. Although as Anthony mentioned, our first relocation occurred with minimal non-operating days. There could be some transitional time between contracts. Although we will look to minimize these periods, it is dependent on the timing of our Permian customers drilling programs. So, our internal planning processes are budgeting that we generate revenue on approximately 17, 18 average rigs during the second quarter, approximately 19 to 20 rigs in the third quarter, and then we resumed full effective utilization of our 21 reactivated rigs in the fourth quarter by year end.

We will incur transitional costs associated with relocating the rigs, expect to maintain crews due to the brevity of this transition period. We currently estimate total transition cost associated with this exercise to be approximately $3 million to $4 million, with the majority of it occurring during the second quarter of 2023. And moving on to guidance relating to fiscal 2023 as a whole, overall, our SG&A budget for 2023 is $27 million comprised of $18.5 million of cash SG&A and $8.5 million of stock-based and deferred compensation expense. There is a component of stock-based compensation that is variable and tied to the value of our common stock for accounting purposes. So, it will be some variability in that metric based on changes in our stock price at the end of each reporting period during the year.

Capital budget for 2023 is $30,400,000 net of disposals. It does not assume that we reactivate our 22nd rig, which Anthony mentioned we have postponed. Breaking out our capital budget $4.5 million relates to the reactivation and upgrade costs principally associated with reactivation of our 21st rig, $21.5 million relates to maintenance CapEx and other matters, and $4.4 million relates to planned tubular purchases. For 2023, we expect our overall effective tax rate to be 20% although we do not expect to be cash federal tax income there. For weighted average shares outstanding in periods of net income, our fully diluted shares outstanding will include the shares associated with assumed full conversion of the convertible notes. And with that, I will turn the call back over to Anthony.

Anthony Gallegos: Thanks, Phillip. Before opening the call up for questions, I want to briefly summarize ICD’s strategic positioning and what I think it all means for ICD’s stockholders. Last year, we significantly transformed our company and positioning. In terms of our positioning, I think about three important facts. First, our utilization and margin growth coming out of the pandemic has been best in class. This speaks to the quality of our people, our assets and our performance. Also, today, our daily rig margins are the best in ICD’s history and are on par with and exceeding some of our larger company peers as we continue to earn recognition from our customers for industry leading customer service and professionalism. The company has never performed better.

Second, we have the youngest and we believe the best-in-class rig fleet. The market for pad-optimal super-spec rigs remains strong outside of the gas driven basis. We continue to demonstrate our fiscal discipline by securing contracts that earn full simple payback on the reactivation CapEx we are investing and by deferring further investments in additional reactivations beyond the 21st rig, which will come out early this year until this market settles out. And finally, we have substantially improved our liquidity and balance sheet and expect meaningful improvements and leverage ratios and other debt metrics as we move through 2023 and beyond. Although softness in gas markets will impact the pace of rig reactivations and will require us to reposition some rigs, ICD has never been in a better position to navigate these types of short-term challenges.

Our operational strength and reputation with our customers has never been stronger. Our fleet which has been transformed by the market penetration of our 300 series rigs and our ability to market and complete 200 to 300 series conversions has never been more valuable. From a revenue per day, margin per day, EBITDA and free cash flow perspective, the outlook for ICD to improve those metrics in 2023 is intact and in many ways will accelerate. To summing all this up, ICD checks all the boxes, whether you are looking for best-in-class assets, leading rig margins or an outstanding customer base in rigs focused on the most important oil and gas shale plays in U.S. and conventional, ICD delivers on those metrics. With all this in place, we are poised to generate meaningful free cash flow during 2023, which we believe will work toward closing the stock valuation gap between ICD and our peers as we continue to execute upon ICD’s strategic initiatives.

With that, operator, let’s go ahead and open up the line for questions.

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Q&A Session

Operator: Thank you. Today’s first question comes from Don Crist with Johnson Rice. Please go ahead.

Don Crist: Good morning, gentlemen. How are you all this morning?

Philip Choyce: Good, Don.

Anthony Gallegos: Good morning, Don.

Don Crist: Anthony, I wanted to start with obviously the macro is very topical these days. And it’s the contention amongst analysts and the investor community that the rig count is going to get a little bit weak towards the summer possibly, but then increase as we go into the fall. And the genesis of my question is what do we look like in 2024? We all think that it’s going to be weak in €˜23. But if gas directed drilling comes back to a similar level to where it is today. Could we find ourselves in a rig shortage opportunity there and potential for higher day rates as we go into €˜24 as that Haynesville or gas directed drilling increases?

Anthony Gallegos: Yes, Don. That’s exactly what we see over the next 12 to 24 months, where €“ on a geographic basis, where you will likely see a rig count decline is in the Haynesville. And listen, I am talking about our target markets of Texas and the contiguous states. Based on our conversation, certainly, the negotiations that we have been in the last couple of months, we see the Permian relatively flat here in the first half of the year. What’s interesting is when we talk to customers about the back half of the year and rolling into 2024 most of them are talking to us about incremental adds. In the short-term, there is some high-grade opportunities where some lower spec rigs are getting changed out. And then there is a tranche of E&Ps that maybe haven’t been busy that are picking up rigs and that’s where we are finding opportunities today.

I am encouraged by the fact that we are not having to take a deep discount in day rate to be able to place those rigs. One other anecdote I’d share with you is even in the Haynesville, this is true when we talk to our customers who maybe reducing activity levels, they are working very, very hard to make sure that they keep their people. And that’s a pretty strong signal to me that they expect activity to pickup maybe a little sooner than the overall market maybe expecting. So no, I think it’s a relatively flattish type rig count in the first half of the year beginning Q3, Q4, I begin €“ I think it begins to tick up. We all know how tight it was in the fourth quarter of last year. And I think that’s the environment that we are back in probably sooner than people realize.

Don Crist: And you touched on it in the comments a second ago can you just talk about pricing? We have heard a couple of anecdotes of E&Ps €“ larger E&Ps that are operating multiple rigs kind of going back to operators and securing 5% or 10% discounts, but that still equates to 50% margins. Are you seeing any kind of haggling there on price?

Anthony Gallegos: Haven’t had any customers come to us and ask for a day rate reduction. We had positioned quite a few of our rigs and especially the rigs in the Haynesville to rollover here in the second quarter anyway, which was going to give us an opportunity to increase rates a little more. Just to give you some a feel for what we are seeing day rates are maybe there are 1,000, 2,000 a day less than we would have thought they would be at this time of the year compared to if I €“ when I answered that question, the last time we had a call, not a disaster by any means. As you said, margins are still very, very strong. Phillip just provided some guidance on what we see here in the first quarter and even in the quarters beyond in terms of it being relatively flattish.