Archrock, Inc. (AROC) Earnings Call Transcript & Summary

Good afternoon, everyone, and apologies for the delay. Today, we have Archrock. I'd like to introduce Mr. Brad Childers, President and CEO of Archrock, a position he's held since December 2011, for nearly 10 years. Prior to joining Archrock, Brad serviced President, North America of Exterran Energy Solutions from 2008 to 2011. Brad, thank you so much for joining us today. The floor is now yours to give a short update on your company, and we'll field some Q&A by myself if there's time afterwards. So Brad, the floor is yours.

Great. Thanks very much, and thank you, everybody, for joining us today. I'm excited to be with you and to show what I believe is Archrock's compelling value proposition, a value proposition that stands out when you look not just at the realm of energy investments, but across other income-oriented sectors as well. We continue to demonstrate predictable cash flows, have an attractive free cash flow yield as well as a durable and well-funded and covered dividend. As I'll talk to you today, we've been able to maximize performance and advance our long-term strategies even during this challenging time brought on by COVID-19 and by this pandemic. We've delivered solid performance during the first 2 quarters of 2021, and I'm excited about what lies ahead for Archrock as we move closer to the up cycle and as the longer-term secular and steady growth in demand for natural gas materializes. Before I get started today, I'll just note the forward-looking statements for you to take a look at. So starting out, who is Archrock? Archrock is a pure play natural gas compression company. Now compression represents a must-run service for the natural gas industry. It's what allows gas to flow through a pipeline so that it can be brought and transported from production to consumption. We're diversified geographically with significant scale in all major U.S. basins. We have a fleet of 3.3 million operating horsepower, with that fleet we're the largest outsourced compression provider in the United States. Our strategy is to focus on large horsepower, primarily servicing midstream assets. This allows us to engage with our base of high-quality customers under fixed-fee multiyear agreements. From a profile perspective, today, we have a total market cap of just under $1.2 billion, an enterprise value of about $2.8 billion. We pay a fixed quarterly dividend currently $0.145 per quarter per share or about a 7.5% yield on the equity prices. Now as I move through this presentation, I'm going to hit on these key investment highlights, but I want to give you a road map on -- of these themes that I'm going to emphasize before I dig in. First, demand for Archrock's midstream infrastructure is driven by production. It's not driven by commodity prices. And this means that our business is stable and predictable as compared to those businesses that are more tied to drilling and completions activity. We are the market leader in large horsepower, both in terms of aggregate horsepower and number of units. Our large horsepower fleet is deployed in midstream applications, like gas gathering systems, primarily. These large horsepower units tend to stay out in the field longer and for longer periods of time, even during downturns, which underpins the stability in demand for our service and for our cash flows. On top of the stable platform, we benefit from structural long-term demand drivers. Our business is tied to long-term U.S. natural gas demand. Natural gas is reliable, cleaner burning and affordable fuel. And the growth outlook for U.S. natural gas demand production is very favorable with steady growth expected over the next several decades. We have a unique financial position. Our free cash flow generation and our dividend are standouts in our story and are a key part of the value we generate for our shareholders. And lastly, we have a leadership team with a strong track record of prudent capital allocation, successful operational improvements and prioritizing ESG. So with that overview, let's move to the basics of our business. We do have this compression 101 perspective, and what does compression do? Well, compression moves gas. The primary function is to increase the pressure of natural gas that can move through the transportation system. Producers and midstreamers require compression to move gas through pipelines from producing fields to and through gathering systems, processing facilities, storage facilities and align intrastate and interstate pipelines to end markets. The natural gas we help transport satisfies demand from electricity generation, heating and cooking and the industrial and manufacturing sectors. Compression is a must-run service. It's required 24/7, 365 days a year. And producers and midstream companies, they have a choice to own themselves or to operate compression equipment on their own or to outsource it to service providers and third parties such as Archrock. There are many applications in which compression is -- it's best outsourced. And that is why you see even the largest and the most experienced and successful oil and gas companies outsource all or a portion of their compression services. As I mentioned, compression is a direct function of production. And as production increases, additional compression is needed through the value chain. Archrock's primary focus is servicing midstream applications. Approximately 75% of our horsepower is deployed in those midstream applications. This midstream production focus has many benefits compared to other energy companies more directly tied to the drill bit. Look, these include higher equipment utilization rates. Through the last cycle, our band of utilization ranged from 79% to 89% of our fleet. We also benefit from longer-term assignments. Our equipment through the last cycle -- our equipment -- I'm sorry, our equipment on average stays on location for about 3 years and can often remain much longer. And we offer great earnings stability and financial flexibility. We [ self ] a self-funded business that allows for ongoing returns to shareholders in the form of a stable and well-covered dividend. Over the past several years, we worked hard to build a platform and to improve a platform that will profitably support the consistent growth forecasted ahead. We've modernized our fleet, invested in technology and standardized practices in the field and across the organization. In my time with Archrock, our fleet has never been younger, or more competitive than it is today. Today, our large horsepower equipment as a percentage of our fleet is 80%, and this is up from 74% just a few years ago. As you can see on the right, this has extended our runway for efficiency gains. We've driven significant improvement in gross margin percentage for our contract operations business even as our revenues declined through the COVID-driven downturn. Our gross margin percentage has retracted a bit from 20 -- in 2021 due to the transitory -- some transitory inflationary pressures that we're experiencing, but still remains above historical norms. As with past cycles, our focus is now moving to the growth we expect to see ahead as we convert our growing backlog compression demand to revenue and get set up to raise pricing to align with our cost structure. Even as we manage costs tightly through this downturn, we continued a major technology project to lay the foundation for continued improvement in both our customer service delivery and our operating cost structure. This will result in improved equipment uptime and exceptional customer service experience and operating cost reductions. These investments will also help us to reduce our emissions and carbon footprint in the future, a point I'm going to come back to a little bit later in this discussion. We have strong relationships with top-tier energy companies. You can see some of our major high-quality customers on this slide, household names that we're very proud to serve on a daily basis, both producers and midstreamers. Our customer book is deep, with strong revenue diversification, which is reflected in our top 10 customers, which represent about 40% of our revenues, and no single customer represents greater than 10% of our revenue. And a large portion of our top customers maintain an investment-grade credit rating. Now in addition to providing contract operations, we also provide services to companies that have chosen to own all or a portion of their compression. We provide a range of services from field maintenance, to parts, to shop services. The current market is challenging for our AMS business, as budget constraints drive customers to defer maintenance activities. Our AMS business heavily leverages our contract operations footprint and adds additional gross margin dollars to Archrock with minimal incremental capital expenditures. And today, our business -- AMS business contributes just about 5% of our gross margin dollars. Okay. Stepping back and looking at the outlook for U.S. natural gas production, which is the primary driver of our business. I want to show that the shale revolution really did completely transformed the U.S. energy industry and led the significant growth in U.S. natural gas supply shown on this slide. Following 4 years of record supply growth, production is forecasted to decline slightly on a full year basis this year in 2021 as a result of the pandemic. But this is a temporary blip in supply. Most U.S. forecasts show natural gas production steadily increasing throughout the remainder of 2021, with year-over-year production growth anticipated to resume in 2022 and continue beyond. In fact, the EIA's 2021 Annual Energy Outlook predicts that U.S. natural gas production will return to pre-pandemic levels in 2023. We expect to leverage the market opportunities presented by the steady multi-decade growth cycle for natural gas that we believe is now underway. But beyond the cyclical recovery of [indiscernible] unfolding, the positive long-term fundamentals for natural gas, and as a result, our compression business remain in place. Even at a time when much of the focus in energy is on renewables, we believe that U.S. natural gas will continue to play a critical role in helping to power America well into the future and so Archrock. Natural gas remains a cornerstone fuel through a worldwide energy transition in the multi-decade forecast published by most major energy agencies. And as the solid oil and gas industry increases its commitment to reducing its own greenhouse gas emissions, this could further strengthen natural gas' value proposition and provide upside to current long-term demand. The graph on the top of this slide highlights the significant CO2 emissions reductions driven by coal to gas switching in the U.S. There is no doubt that the use of renewables is growing. But we're confident natural gas will continue to be a part of the solution as we meet growing global energy consumption in a more environmentally responsible way. As the graph on the bottom shows global natural gas consumption is anticipated to grow 43% from 2018 to 2050 and maintain a stable market share of 22%. Archrock has been a leader in the industry to develop a robust ESG program to secure a prosperous future for Archrock. I'm very proud of our growing commitment to our ESG performance and disclosure. In the last year alone, we established a methodology to calculate the emissions associated with our operations, and this will serve as a baseline for achieving long-term improvements. We adopted the SASB reporting standards for the midstream industry. We've formalized the governance structure Archrock will use to manage our ESG efforts. We enhanced the diversity on our Board of Directors. And on safety, TARGET ZERO says it all. We believe all incidents are preventable, and we have a strong track record of delivering peer-leading safety performance. Let me spend a little more time on the environmental side of these efforts, which has been a big focus for Archrock. Through capital investments and acquisitions of new units, coupled with the divestiture of other older units, our fleet is more efficient and produces fewer emissions on a per horsepower basis today. The chart on this slide shows improvements in our emissions efficiency from 2017 through 2020. Alongside our shift to larger, more efficient units, we've launched a multiyear initiative targeted to equip all of our units in our fleet with remote monitoring functionality. Remote monitoring is expected to improve service efficiencies and enable us to proactively diagnose and mitigate potential issues before they arise. The project will drive efficiency on scheduling prevented maintenance. It's going to reduce ad hoc callouts and improve supply chain performance, which will result in reduced vehicle mileage and emissions from Archrock fleet. Finally, our compressors are generally powered by natural gas produced at the site, but we do provide electric powered compression units for some customers. And while electric powered compression represents a small portion of our fleet today, we believe that it offers a growth opportunity, as our customers become more focused on reducing their carbon footprint. Throughout this discussion, I've talked a lot about the stability of our business, demand for our services and cash flows. Now let's look at the financial results of the stability. Like with any company providing products or services to the energy sector, it's easy to too quickly associate the business drivers to commodity prices. But unlike other participants in the energy value chain and even the oil and gas services market, our business is not directly commodity price driven. It is largely production-driven. Gas and oil prices are going to ebb and flow. They're going to have their highs and lows and some periods of relative stability. The driver of our business, on the other hand, is primarily gas production, which typically does not decline and is expected to grow significantly. We have a track record of earning attractive margins over time in a variety of commodity price environments. Much of this is driven by the production-oriented nature of our business. In 2020, we delivered adjusted EBITDA of $415 million, which was flat compared to 2019 despite a 9% decline in revenue. It's also in line with the low end of our pre-COVID guidance range. And with our cost and capital reductions, we actually increased our full year free cash flow to cash available for dividend compared to 2019 as well as compared to our initial forecast for 2020. I think very few companies get to say the same thing about their businesses over that time period. Now I'll walk through all aspects of the financial performance that you see on this slide, but I do want to highlight a few key recent takeaways. We've done a good job keeping our assets deployed and running. Our revenue has been relatively flat over the past 3 quarters, and recent utilization is holding steady at 82%, higher than our prior cycle low and much better than utilization rates for early cycle services like drilling and completion. Despite top line pressures, we've delivered solid gross margin and EBITDA performance with tight cost controls. Looking ahead, there is a lot to be excited about for 2022. In the second quarter of 2021, we captured our highest level of horsepower bookings since our second quarter of 2019, reinforcing our confidence in this unfolding recovery. We expect increasing booking activity to continue through the balance of the year, which for Archrock should translate into a robust outlook for 2022 and beyond. Our solid financial performance is not only supported by the stable demand for our services, but is also underpinned by our disciplined capital allocation framework. We're continuously balancing appropriate levels of investment, leverage and return of capital to shareholders through commodity cycles. We invested significantly in our fleet through 2019 to support 25% plus growth in the natural gas demand and production. Given lower customer demand in 2020, we proactively slammed the brakes on CapEx, and our discipline has continued into 2021. I'm proud to share that strong year-to-date operational execution as well as proceeds from asset sales have accelerated our targeted debt reduction from an expected $100 million to $150 million or more during 2021 and from $250 million to $300 million or more since the end of 2019. Our priorities for this robust free cash flow remains shareholder dividend, shareholder returns and debt repayment. As I mentioned, we continue to prioritize shareholder returns even during this downturn, and this slide highlights our compelling and well-funded dividend. Particularly in the slow interest rate environment, our dividend provides a healthy coupon to clip as we look forward to the market recovery ahead. Our dividend yield compares favorably to the broader market and other income-oriented sectors, including utilities. And compared to other midstream yields, we offer the right combination of a compelling yield and attractive dividend coverage. We have a dividend coverage target of around 2x or more, and this is certainly differentiated compared to traditional MLPs and the MLP model. Moving on to our second and equally important capital allocation priority, debt reduction. We're proud of the progress we've made in respect of our balance sheet position. We summarize our balance sheet position into 3 separate components: First, strong liquidity, which allows us to be both offensive and defensive in how we run our business. We exited the second quarter of 2021 with more than $400 million of total liquidity. Second is our debt schedule. It has no near-term maturities. Last year, we extended our revolver through 2024 and completed 2 successful senior notes offerings to extend our maturity profile, and our senior notes now mature in 2027 and 2028. And third is leverage. We executed -- we exited the second quarter with a leverage of just over 4.1x pro forma for the July asset sales. And we target getting into the 3.5 to 4x range as our long-term goal. We're in a position today to pay down debt this year. And though -- even though that's the case, we do highlight that our leverage ratio will likely tick up a bit in the year as our EBITDA declines in the back half. Now comparing Archrock to our compression peers, Archrock has an attractive mix of attributes and evaluation. The dividend I covered on the prior slide is one component and shown here again. We also have manageable leverage, particularly in light of our free cash flow profile. I'll note that while our closest public peer pays a dividend close to 14%, they carry significantly higher debt load. With our current equity value to EBITDA multiple at 8x, we believe this provides an attractive entry point and gives a solid investment proposition and outlook with these midstream characteristics for new investors. So with that, let me close by summarizing some of the keys to our success. Our stable fee-based production-oriented business provides a solid foundation of relative stability in down cycles and growth in up cycles. We're the market leader and have the largest fleet in the compression industry deployed across every major producing basin in the United States. We have a significant long-term growth profile and opportunities from structural long-term natural gas demand growth. We're a full-cycle outsourced provider with the management team that has a strong track record of driving operational improvement. And we have a strong capital structure and ample free cash flow to pay dividends and repay debt. So I thank everybody for your interest in Archrock today. And I'd like to turn it back over to the moderator and open up for questions if there's time.

Great. Thank you so much, Brad, for that comprehensive overview. We probably have time for just maybe one question here. But I mean it seems like there are definitely a lot of tailwinds in your business right now. You mentioned the high level of horsepower bookings. You booked this most recent quarter as well as kind of the long-term demand outlook for natural gas. Just on your slide there, where -- when you highlighted the EIA's forecast out to 2025, what's really driving that growth in natural gas production? Is it mostly kind of higher internal consumption? Is it LNG? We know LNG prices are at elevated levels currently? If you could just talk about the drivers of that natural gas demand forecast?

Yes. Absolutely. Thanks for the question. Look, I think that you just summarized a couple of them. Top line, I do think that exports in the form of LNG are a top line driver of more natural gas production for the U.S. We also still have solid export profile to Mexico by pipeline. And then following that is a restoration of demand from industrial, probably in that order is what we think is driving the natural gas production decline -- production growth through that forecast period.

Got it. Got it. And maybe if I could just squeeze one more. You mentioned that electric fleets are currently a small portion of your overall fleet. Where -- I mean it seems like the whole world is trending in that direction, I mean, where -- what proportion do you think electric fleets could make up in 2025 or even 2030?

Like any forecast, the only thing I know is that if I ventured a guess on a percentage basis is that I'd be wrong, but let me talk about -- qualitatively about magnitude. We expect that for the growth ahead where existing infrastructure and the grid permits that we see customers moving to a mix of electric powered electric motor drive compression, but still retaining investments in natural gas fire compression as well. So we think this is going to be an evolution as the grid expands and electric motor drives are available for growth. We see a portion of the growth moving in that direction, I would just be really magnitude wrong to venture on a percentage basis. But I believe that it's going to start out -- we're going to start to see 10% to 20% of some investment for growth and compression in electric motor drive. And fortunately, for Archrock, it's a business we've already been in. And we have customers that have proven out the business model and the capability with us. And so we're excited to see that level of growth and that level of performance in ESG. And we're excited about being able to help out our customers with that.

Great. Thank you so much. And that's about all the time we have here today. So Brad, thank you so much for, again, that overview and for presenting at the conference today.

My pleasure. Thank you very much.