Kodiak Gas Services, Inc. (KGS) Earnings Call Transcript & Summary

Welcome. Good afternoon. My name is Theresa Chen. I'm the midstream and refining analyst here at Barclays. It is my pleasure to welcome our next company, Kodiak Gas Services. From Kodiak, we have Mickey McKee.

Thanks. All right. Thanks, Theresa. Pull my notes up here real quick. All right. Good afternoon. I appreciate you having me here. Again, my name is Mickey McKee, CEO of Kodiak Gas Services. Start with -- I'm going to start with a little bit of an overview of kind of who Kodiak is and what we do, for people that aren't familiar with us. As you might know, we completed our IPO in July of this year. So this is our first conference as a public company. So let me know if I do anything wrong. Theresa, thanks. So we operate across the U.S. in rich gas and oil-directed basins. Most notably, over 70% of our assets are located in the Permian Basin. Many presenters today have noted the Permian is a key driver for natural gas and model growth in the United States today and looking forward. So what is it that we do? We're a contract gas compression business focused on large infrastructure type horsepower that's critical to both oil and natural gas production. We have -- that's deployed with E&P customers. We use our compression for large-scale gas lift facilities to lift oil, but also centralized gathering facilities with midstream companies that collect gas and send it on processing facilities. Within those processing facilities, our compression is used to strip [ valuables ] out of rich gas and transport [ lines ]. So let's start here with our -- a little bit of our macro view on the environment and where Kodiak kind of fits into the value chain. I think we've heard from everybody that's presented in these rooms today that hydrocarbons and in particular, natural gas is going to be a key player going forward throughout this energy transition over the next multiple decades. The world needs reliable, secure and affordable energy and the EIA is projecting global energy consumption to increase by 47% from 2020 to 2050. Renewables will play a role in this increase, but they're not going to be able to displace the role of natural gas as we've [ learned from ] our last interesting presentation today, too. So the U.S. is pretty uniquely positioned to take advantage of this throughout -- through the growth in our LNG export capacity. We currently have 13.8 Bcf a day of LNG liquefaction capacity today with another 13.7 Bcf a day under [ construction ] and another 16.9 Bcf a day approved. With U.S. dry gas production of just over 100 Bcf a day today, this is a investment growth in demand for U.S. natural gas over the next multiple decades. With over 95% of new LNG capacity being built on the Gulf Coast of Texas and Louisiana, it's our belief that the gas that's going to have to be produced as feedstock for these LNG facilities will predominantly be supplied from the Permian Basin, the Eagle Ford and Haynesville Shales, which I believe the majority of that gas is going to come out of the Permian Basin as well with oil-directed associated gas drilling. So why the Permian? It's easily the lowest ongoing tax production cost of any basin in the United States, with currently owning the majority of the land rigs in the U.S. that are working in the Permian Basin. Permian oil and gas production has seen significant development and investment over the last decade. And again, the Permian is going to be the growth engine of the domestic U.S. oil and gas production. So why does this matter to Kodiak and our investors? Well, Kodiak's fleet was purpose-built for the Permian Basin. We're exclusively focused on large horsepower infrastructure deployments, which are very expensive to move, and they stay in place for very long periods of time. We have the youngest fleet among our public peers with an average age of our fleet of less than 4 years old, making it the most missions friendly of fleet in the industry with over 95% of our compressors able to meet the most stringent emissions regulations. We custom designed our fleet and our equipment to run on rich gas Permian applications in the heat of West Texas. We have -- this standardized fleet is suitable for upstream and midstream types of applications in the Permian. We've built an operating strategy [ built ] on years of experience, are intently focused on creating an environment that maximizes run time for our customers. We have a rigorous maintenance and overhaul schedule that effectively 0 hours are units over 8 to 12 years depending on the size and horsepower of the equipment. We offer thousands of hours of training opportunity for our technicians to make sure that we have the most capable workforce in the industry, and we take 24-hour first call on all of our equipment inventory on all of our field locations, allowing for better response time in the cases of unexpected shutdowns. These are just a few of the things we do to maximize our performance for our customers. We have a contract structure that enhances our cash flow visibility and stability with fixed monthly revenue contracts with multiyear terms with annual inflationary adjustments, guarantee a 98% mechanical availability on all of our equipment and our customers bear the cost of mobilization and demobilization of our equipment, with currently only 7% of our customers have rolled over to month-to-month contracts, and we're working to renew those, indicating the high level of renewal success that we experienced and the stickiness of our assets. We've assembled a roster of some of the best customers in the industry, all premier Permian operators, most of them -- a lot of them we've heard from today, both E&P and midstreamers. And it's the strength of our counterparties that has contributed to the continuous growth in horsepower and EBITDA throughout the years. Over 50% of our customer base is investment-grade rated with 58% in upstream and 42% being midstream currently. In order to provide a high level of service, you have to focus on your employees. We have over 800 dedicated members of the Kodiak team, and we've worked very hard to make Kodiak a great place for them to call home. As a result, we've won multiple top workplace awards, including national recognition. And I'm proud to say that as a result of our IPO, we made every employee at Kodiak a shareholder. We have an experienced and diverse leadership team that I'm proud to call every one of them, my colleagues. You'll get to know them better at subsequent conferences. We're also an industry leader in ESG and sustainability initiatives with the goal to be the most responsible operator of natural gas compression. We're environmentally focused within the initiatives to minimize emissions, including the deployment of our proprietary and patented ecoView system, which is our emissions monitoring and leak detection technology. We prioritize safety in our culture and diversity. And we have intentionally constructed a Board that prioritizes diversity and independence. So what does all that mean? The result is that we've maintained over a 98% utilization of our assets for a very, very long period of time. This contributes to the visibility and the stability of our cash flows. Even through 2020, when the COVID pandemic pushed our competitors' utilization rates down to the low 80s and the high 70s, Kodiak continued to grow profitably, increased revenue rates and increased margin. This next slide shows our compression operations adjusted gross margins by quarter overlaid with WTI crude oil prices and Henry Hub gas prices. So you can clearly see that commodity prices have little to no effect on our business as we've executed our strategy that's insulated us from that volatility. So now getting into some of the financial highlights that we reported on for the second quarter. We priced our IPO on June 28 of this year with the green shoots fully exercised in July. Also in July, as a result of the IPO, we reduced our debt, and our covenant pro forma leverage post-IPO was [ 4.75 ]. We have about 70% of our interest rate exposure currently hedged, with our closest debt maturity in March 2028. Second quarter total revenues were up 14.8% year-over-year. The second quarter total EBITDA was up 11.3% year-over-year, maintaining our industry-leading utilization rate of 99.9%. So quickly to touch on our capital allocation framework that we've developed to go forward with as a public company. We define our discretionary cash flow as our adjusted EBITDA less interest, cash taxes and maintenance capital. From that discretionary cash flow, we plan on paying a recurring dividend that we have guided at being between $0.35 and $0.40 per share per quarter, with the balance of that discretionary cash flow will be used for the combination -- for a combination of growth CapEx and debt paydown. Current midpoint of our guidance for growth CapEx to this year -- for this year is $170 million, all living within our -- all living within our cash flows. So flipping now to the guidance that we published with our Q2 earnings call because this is what we've guided to, and so this release with Q2 earnings. And that's it for my presentation, and I will open it up if you want, Theresa, to any questions or yourself.

For questions, you can take a seat, and I could kick things off.

All right.

Okay. So maybe help educate some of us who are not as elbow deep in the details on the spread of the value chain, but if you highlight several key factors that differentiate yourselves versus your competitors, what do you think is the true barriers to entry are within complete compression industry?

Well, I think that there's a lot of barriers to industry in the compression industry today. There's a pretty significant supply chain tightness in our market today. It's over a year delivery time to get equipment from Caterpillar for engines to build compressors with. Job space is very limited today as well as the interest rates are climbing. It's much harder today to finance a some sort of a private equity like start-up compression companies, but it's more difficult to do that. So lots of barriers to entry. It's an industry with a pretty significant labor shortage, I mean, basically -- based on specifically that would make it tough for somebody to compete on a large horsepower scale with our competitors as well.

Got it. And if anybody in the audience has a question, please feel free to raise your hand. We can make this interactive. But in the meantime, I'll continue. So you had a slide about -- talking about your uptime and what that means in terms of the deliverability of your services to the customers. Help us understand like from a customer's perspective, yes, good uptime sounds great, but what happens if it's not up to par? Like what does it mean for them economically?

Yes. I mean in our industry, the most expensive thing that our customers have is downtime. In fact, the lost production that they have in instances of those excessive downtime far and away outpace the cost of our services for a given month. And so it's a very, very significant impact for them. And then especially when you talk about a compressor that might be an oil lift service or something like that, it's very, very significant for them. So our customers, specifically our customers are more keen to worry about and focus on run times than they are the cost of the compression because, like I said, it's -- the downtime is more expensive than what they're paying for from a [indiscernible] standpoint. And when a compressor is down, our customers are not getting paid. We stand directly in between our customers and their revenue streams. And so they're -- they want to make sure that they have a good partner in their compression service provider and make sure that their o[indiscernible] (00:14:20) levels are the same.

Makes sense. And to that point of them being very focused on the production volumes and everything running smoothly, any midstream operator is only as good as the resource being brought by their customers, right? So can you talk about the growth outlook for your customers, the resource as a rock and the areas that they operate.

Yes. I mean that's why we're so specifically focused on the Permian Basin like -- going back to some of the things I talked about in the presentation. We wanted to take the commodity price volatility out of our -- out of the business that traditionally in small horsepower compression world has been more tied to the wellhead, more tied to the drill bit. And so by focusing on large horsepower compression that is specifically deployed in the Permian Basin, then you can focus on -- you look at Permian and its 20-, 25-, 30-year life production forecast there, and you have customers like the Pioneers or the [ Targas ] or the EOGs of the world that are making investment decisions based on the 10-, 15- and 20-year production forecasts. And so that's what we really strategically focused on and why we wanted to focus on being in the basins that have the best rocks and the highest quality reserves and reservoirs. And even the stuff that we have that's not in the Permian Basin is still deployed on associated gas oil-directed type drilling. It's -- we try to stay as much as possible away from dry gas type of basins. It just doesn't fit our strategy.

Got it. And as you think about the growth trajectory, your contract renewal timeframes and such, clearly, your publicly traded customers have their own views about compression, either outsourcing or in-house. And some of them have been semi-public about the opinions on that. How do you see this trending over time? Do you think some of them might opt to bring it in-house over time or continue to outsource? How do you think the industry evolves?

We actually are seeing an increased propensity to outsource compression in the customers that we deal with in -- typically in the basins that we're in, for one, all of those companies which have -- especially the public ones have their own pressures to live within their cash flows and commitments to shareholders to live up to and mid-streamers and E&P companies alike would spend their precious capital on what they're good and what makes them money versus spending it on compression, which is a pretty intense business.

Got it. And within this framework of capital intensity and they're chunky sizable assets, right, you mentioned the supply tightness, the 1-year lead timeframe of getting something online or delivered. How are you managing the pricing pressure?

We do have KPIs for the contracts. So we've all dealt with a pretty significant inflationary pressures over the last year or 2. We have had the ability to pass a good part of that on to our customers. But look, you'll see some price inflationary pressures on labor and some parts and pieces with Caterpillar in that company. But we have started to see some things, inflationary pressures start to moderate around the wells and that kind of thing. So you might see with the [indiscernible] in crude pricing that the oil pricing might follow that up a little bit in the future. We'll be keeping a close eye on that. But all in all, we're focused on every dollar of capital that we deploy, making sure we get a return on that capital deployed that is set by, not only us as management, but our Board, and approved by our Board. We make sure that with those [ inflationary ] pressures, we're going to have to make sure -- I want to make sure we get the same capital to [ investment ].

Got it. And during your presentation, you also touched on the LNG build-out, right? So it had an engine of demand-driven growth domestically. So as you think about what Kodiak looks like today versus in the future, there are pinch points in the natural gas value chain that necessitate more infrastructure investment, right? You are managing what you can on the compression front, but as far as long-haul infrastructure or anything further downstream, do you think Kodiak would have appetite for that? Or...

We'll see. That's to be determined. We're obviously keenly focused on the takeaway capacity out of the Permian Basin as we're so focused on the Permian. The interesting thing about the Permian is it's so much more compression intense than other basins that historically have been around. So when you have a barrel of oil being produced out of the Permian, it requires compression for gas lift, compression for gathering, compression for plants and NGL take out and all that kind of stuff. And so -- not to mention the fact that gas-to-oil ratios within the Permian Basin are [ repped ] all the time. So it's almost even if production is outlined in the Permian Basin, as reservoir pressures come down, it requires more compression horsepower. So even noted capacity increases, you're going to see compression environments increase because obviously, business long-term.

Definitely. Hopefully, there will be to takeaway capacity.

I think that we'll figure that out.

Well, it's [ metaphor ] that I wanted to ask you about since you were very deep within like the upstream as well as the midstream portion of value chains which you'd have to interact with both entities. Do you think that the Permian will get to a point there basis blows out and we are seeing visible pinch points and the operators, the constructors don't come together to find a solution in time? Do you think the industry will figure things out ahead of time such that we'll have some smooth pricing? What's your view on that?

I think when you talk about the bigger, more mature operators that have the balance sheets, they're going to together figuring out when you talk about the investment grade, they didn't have -- counterparties that we deal with a lot, they're going to make sure that they have takeaway capacity for what they need to do because it will really affect their -- obviously, their long-term plans. Now I do believe there would be pinch points and that kind of thing and some pressure there. But what I think will happen is it will push some of the smaller players out that don't have the ability to plan as far in advance. I mean so because we have year-long lead times with Caterpillar right now, we're talking to our customers about Q4 2024 CapEx requirements right now and into 2025 already. So with sophisticated customers that are able to plan and look out in advance and commit to takeaway capacity that part in advance, those are the customers that we've had success with in the past. And I think those are going to be the ones at the end of the day that win when there's going to be obvious takeaway capacity constraints in the short term. But I do think -- I keep -- like thinking in long term, we get that figured out as an industry.

Okay. And I guess, over the next, let's call it, like 5 years or so, just IPO-ed, you have a big runway ahead of you, how do you see your business mix changing, if at all? And also, I would ask about the cash flow mix as well, but I imagine it's once a day, fee-based and volume related as much as possible. I'd love to get your thoughts on those topics.

Yes, for sure. I think that we will look to just kind of scale the business up with what we're doing now. We want to grow the business by kind of 8% to 10% kind of EBITDA increases every year. We have to reach an amount of growth CapEx right now to be able to do that while also paying a very nice dividend that's going to be on the high -- kind of higher than the S&P 500 average that we think is a good return of capital to shareholders. And then by doing that, we can -- and with that EBITDA increase over time, we can begin to increase dividends and then participate in some share buyback. Hopefully, at some point when -- as you know, we have a large equity -- private equity holding down 75% of their stock. And my goal is to be able to participate in share buybacks as they begin to monetize and sell down on some of their stock to walk trades and...

That would be great.

I think so, too.

So as we think about your recent -- recently haven't been brought public, and being on the road and meeting with investors and educating people about the story, what has been one issue assets that you think have surprised you, that you get some misunderstanding out there or the most education necessary on these things?

Well, the compression industry specifically, it's been a traditionally under-researched covered business. And I think that with our IPO having yourself and multiple other research analysts covering our stock today, they just brought a lot of knowledge and light to the compression industry as a whole. And I think that the whole industry in our little niche of the world here has benefited from our IPO and the research that's come along with it and hopefully that we can benefit everybody. And we're in a market right now is really tight and so you talk to the competitors out there and they've done pretty well. And I think that our business, maintaining that -- our discipline that we've had kind of created this [ real ] situation for us right now is going to be key for all of us being successful going forward.

Excellent. Are there any questions in the audience? Sir? Mic's coming to You right now.

A bit of a technical question. I'm a bit intrigued. You mentioned something about your compression equipment being rated to operate in the heat of West Texas. How much of a cost does that increase on your capital compared to your competitors that you just mentioned?

I think it's not more than probably a 5% or 10% increase in -- probably closer to the 5% increase. But when you look at your coolers that are basically radiators for your engines, we've designed those with ambient [ heat ] so they're probably [indiscernible] and the advantage that we have of being able to do that is if you look at USA Compression that a lot of their fleet was designed initially for the Northeast where you can design that equipment for 90 degree ambient temperatures and you really never have any problems. And then over time, if you want to reallocate that equipment down to the Permian Basin, you really have hard times with the heat of West Texas that's 115 degrees in the heat of summertime. So it causes pretty significant challenges for the run time mobility of that piece of equipment without major overhaul costs and [ repair ] costs.

Okay. Well, thank you very much, Mickey.

Thank you. Thanks for having me.