Exterran Corporation

Good morning and welcome to Exterran Corporation's first quarter 2017 conference call. With me today are Exterran's President and CEO, Andrew Way; and CFO, David Barta.

During this conference call, management may make statements regarding future expectations about the company's business, management's plans for future operations, or similar matters. These statements are considered forward-looking statements within the meeting of US securities law, and speak only as of the date of this call.

The company's actual results could differ materially due to several important factors, including the risk factors and other trends and uncertainties described in the company's filings with the Securities and Exchange Commission. Management may refer to non-GAAP financial measures during this call.

In accordance with Regulation G, the company provides a reconciliation of these measures in its earnings press release issued yesterday, available on the company's website. With that, I will now turn the call over to Andrew Way.

Thank you, Greg, and good morning, everyone. Q1 was an excellent quarter for Exterran as we benefited from higher volumes in our oil and gas product sales business, coupled with ongoing productivity and margin expansion in contract operations.

Our focus on working capital continued to drive improvements across all elements of our cash management cycle, allowing us to pay down $33 million of debt in the quarter. Dave will cover the progress we made on our long-term capital plans, and the success we achieved in accessing the high-yield market, later in the call.

Starting first with ICO, during the quarter, we continued to see excellent execution and project management, enabling the large ICO projects we previously announced to be on time, on budget, with no cost overruns. Two of the projects we announced in January are on track and slightly ahead of plan to start up in the second half of the year.

And the large award we announced in February is already through HAZOP planning, full design approval, and is now in the capable hands of our supply chain. The project team is staffed and focused on the successful startup for 2018.

ICO margins were strong during the quarter. Productivity, lower planned maintenance, and margin expansion focus continued to be the key factors in improving returns.

These factors allowed us to offset the slightly lower top line resulting from lower recognized deferred revenue. We often mention the resiliency and the stability of this business model, but I'd also like to add that scalability, rescoping projects, and cost productivity are important components of our model.

From a new business perspective, our extensions are on track and in line with expectations. We also continue to see a strong project pipeline in both the Middle East and Latin America.

We think Argentina will present significant opportunities for us beyond the large presence we're already enjoying there. The most prominent opportunity is the Vaca Muerta formation.

The investment in this region is exciting and is just the beginning. Mexico and Brazil will also require additional midstream investment as both countries pivot to production growth.

In the Middle East, we see favorable trends in places like Oman, Kuwait, and Bahrain, as the region focuses on early monetization of natural gas development. Today, we see opportunities to bid on new projects in all of those markets.

In our aftermarket service business, our results were in line with our internal plan. The business continues to gain traction as our visibility into new opportunities increases.

By way of example, we recently won a new contract in Asia-Pacific leveraging our existing expertise, expanding to similar processes in adjacent markets. Because of our experience managing rotating equipment, we were able to expand our engine management services offering to this particular customer.

The project is one of several we are working on to demonstrate our AMS capabilities and growth potential in new markets. In product sales, demand for additional processing in treating plants are driving higher activity, pulling through the opportunity for a higher margins.

As we've discussed in prior quarters, the midstream infrastructure demands, especially in the Permian, are extensive. And the build-out is accelerating due to the lack of infrastructure in the region to support the processing of gas, and limited takeaway capacity.

This is also reflected in our bookings. In the first quarter, about half of our $249 million in orders came from the Permian.

And with sales inquiries continuing to increase, we believe we are still in the early stages of the gas infrastructure build-out. Our path to double-digit margins in product sales is executing ahead of plan.

The factories are making significant progress absorbing the additional labor costs we carried during the fourth quarter last year; and, in fact, from the beginning of the fourth quarter of 2016 through the end of the first quarter of 2017, we've increased our manufacturing headcount by more than 20%. Oil and gas product sales revenue in the first quarter was up more than 60%.

And our estimate for Q2 will be the highest sales output since the fourth quarter of 2015, and almost double the same period last year. We continue to focus on focus on several key factors that will help margin recovery.

First, we are selectively bidding on projects that allow us to leverage our differentiation, which we believe will translate into value over quantity. Much of this bidding is in processing and treating, where price and ultimately margins typically trend higher than some of the other product lines where capacity is still available.

Second, collaboration with our key customers. By staying in front of their needs, we can design to configured product and efficient build times, which will also enable us to stay ahead of lead times with what we can control.

And finally, we continue to invest in improved systems, implement best practices in inventory and supply chain management, improve our communications and coordination between our engineering and manufacturing teams, and diligently manage our cost, which all drive better outcomes. Turning to Belleli, the team just closed a very strong operational quarter.

We're on track to exit the business, in line with previous updates. We are working our way through the remaining EPC projects with $46 million of backlog to go.

Project execution continues to be favorable, which led to the recoveries mentioned in our earnings release. And Belleli in the first quarter generated positive cash flow in the quarter, and we have revised our internal plan to maintain a cash positive position for the balance of the year.

I'll now turn the call over to Dave for our first quarter financial review and second quarter outlook.

All right. Thanks, Andrew.

Before discussing the results, I'd like to give you an update on our internal controls and remediation efforts. We continue to make good progress on implementing enhanced controls and remediating the issues identified through our restatement process.

As you recall, the issues identified centered on the Belleli EPC business in a non-income tax receivable in Brazil. However, in addition, we reviewed accounting controls across other areas and regions.

We are aggressively addressing the specific issues of bolstering our global control framework. In the quarter, we also added a world-class leader in our audit controls function.

And at this point, there are no further updates with respect to the SEC discussions. As I discussed our segment results and drivers, I'll make comparisons to sequential quarterly performance.

Starting with the contract operations segment, revenue decreased 2% to $92 million, while gross margins remained flat at $61 million. This translated into a higher gross margin percentage of 67%, compared with 65% in Q4.

Andrew touched on the main factors, which were lower recognized deferred revenue from the impact of extensions of upfront payments, productivity, and lower maintenance expense. Aftermarket service segment revenue was $23 million or 22% lower than the fourth quarter, while gross margin was $6 million, an 18% decrease.

This resulted in a gross margin percent of 26%, compared to 25% in the fourth quarter. Lower parts sales in the Eastern Hemisphere were the primary reason for the revenue decline.

However, because parts sales is a lower-margin business, the offset was an increase in gross margin percent despite the decline in gross margin dollars. Revenue in the oil and gas product sales segment increased 68% to $131 million, with gross margin up more than 3 times to $11 million, resulting in a gross margin percentage of 9%.

Oil and gas product sales revenue in the first quarter breaks down as follows: 63% was compression, and 36% for production and processing. Geographically, the revenue split was approximately 80% from North America and 20% from international markets.

Oil and gas products sales bookings was $249 million, an increase of 8% from the fourth quarter, the highest since the fourth quarter of 2014. From a geographic standpoint, more than 90% of our oil and gas product bookings were from North America.

Our oil and gas product sales backlog was $425 million at the end of Q1, compared to $306 million at year-end 2016. And that backlog is the highest since the first quarter of 2015.

Quarter-end backlog was approximately 85% for North America and 15% for international markets. Belleli EPC product sales segment revenue was $35 million, and recorded gross margin of $17 million.

We had guided to our revenue range of $20 million to $30 million at 0% margin. During the quarter, recoveries, net of contingencies, were $13.1 million, which drove the increase in revenue and margin.

SG&A expenses were $45.4 million in the first quarter or 9% higher than the fourth quarter. This was primarily related to $2 million of costs related to management changes.

Included in the $45.4 million of G&A is also $1.5 million for Belleli, which will continue to migrate lower as the year progresses. Turning to capital expenditures, in the first quarter total CapEx was $21 million.

For 2017, we still anticipate total capital expenditures to be in the range of $150 million and $180 million. Of that amount, $15 million to $20 million is maintenance CapEx, and the remainder is primarily for contract operations project awards or extension.

I think it's worth noting, as well, we're putting more emphasis on increasing our return on capital to enhance product design and cost productivity efforts in sourcing programs. The goal is to reduce the capital required for the same level of revenue and gross margin.

And these initiatives did not exist before the spin. As result, while we're maintaining our 2017 CapEx guidance, it would not surprise us to see CapEx finish the year towards the lower end of that range.

Looking at the balance sheet, total debt at the end of the quarter was $317 million, with undrawn and available credit of $315 million. Our leverage ratio, which is debt to adjusted EBITDA as defined in our credit agreement, was 1.9 times at the end of Q1, and our net debt stood at $299 million, down from $313 million at year-end.

I think this definitely reinforces Andrew's comments about our continued focus on cash. Further, to Andrew's point, management's annual incentive compensation plan is once again, in part, tied to improved working capital and cash.

On March 30, we successfully priced at $375 million of new 8.125% senior notes due in 2025. As you are aware, the term loan put in place at the spin was maturing in November of this year.

While we had the ability to pay the term loan off with a revolver, we wanted to put in place a tranche of debt that would improve the terms of the revolver; and, more importantly, put in place a capital structure that would assist us in the growth we expect in the contract operations business. Now I'll turn to our outlook for the second quarter of 2017.

In contract operations, we should see revenue in a range of $90 million to $95 million, and margins in the low- to mid 60% range as we will incur some higher scheduled maintenance expense. For our aftermarket services business, revenue should be in the low- to mid-20s with gross margin percent remaining flat to Q1 levels.

In our oil and gas product sales segment, we should continue to benefit from the higher order flow, and we anticipate revenues between $185 million and $195 million with gross margin percent in line with Q1 with a potential to perform slightly better. For the Belleli EPC segment, with much of the project work behind, we would expect revenue in a range of $20 million to $23 million at a 0 gross margin.

And SG&A should be between $42 million and $45 million. Depreciation in the second quarter should be in the range of $26 million to $28 million, and interest expense should be approximately $8.5 million.

Cash taxes are estimated to be $23 million in the second quarter, as Q2 is the most significant quarter for tax payments. So now I'll turn the call back over to Andrew.

Thanks, Dave. So to summarize our outlook, we continue to feel good about the current trends, but certainly remain very focused on controlling what we can control.

We continue to win work in both contract operations and product sales at a pace that we can deliver timely to our customers. The market has shown signs of recovery, especially in certain US basins where the demand for processing and treating infrastructure feels like it has a long runway.

Internationally, we are maintaining margins in our contract operations business, while extending projects and seeking new opportunities for growth. The business model has proven its resiliency, and we should transition to growth as we execute on recent project awards, as well as win new projects in the near future.

Cost absorption in our factories has improved and will continue to improve the momentum we discussed last quarter, and it should lead to more positive margin outcomes in product sales as the year progresses. In addition to short-term momentum, we are gaining traction on our long-term strategic planning.

Our goal is simple: deliver solutions that solve our customers' problems. To execute this goal, we've developed strategies and operating rhythms around product management, portfolio optimization, value-based engineering, and business transformation.

At the same time, as Dave mentioned, we continue to be laser-focused on strengthening our internal controls and business processes. We are creating an internal culture that promotes and builds the main expertise, encourages curiosity to foster our competitive edge, and optimizes resources to leverage our core Exterran competency, while outsourcing non-core activities.

We believe the outcome will lead to products and services that promote efficiencies, lowering customer costs, and increase early optimization of production, while delivering better returns to our shareholders. So while we are benefiting from the early stages of this most recent market upcycle, we continue to focus on long-term value creation for all stakeholders.

With that, we'd now like to turn the call back to the operator for questions.

Thanks good morning guys.

Good morning.

Good morning.

Andrew, let's start with contract ops. Thanks for the color on 2Q.

Help us think about the rest of the year. I know there's some more maintenance coming through here in the quarter.

Do we really need to see some of the early awards from the awards earlier this year flow through before we get the margins back up closer to the, I'll call them mid-60s%? Or help us understand how that progression needs to happen based on what you have in hand today.

Well, first of all, the projects that I did mention are on track and will come on at the end of the second half, coming into the third and fourth quarters. So we feel very good that the projects that we announced at the beginning are on track.

In terms of the margin, I think overall for the year, we feel comfortable in that mid-60%. You're going to have, by nature of the equipment and the demographics of the operations; you're going to have lumpiness throughout the year in terms of maintenance activity.

And we saw that in the fourth quarter to the first quarter. We were able to increase margin in the first quarter; a little lower, we anticipate, in the second quarter.

But there's nothing that’s substantial that should take this business down to low, low 60s and hold there. So it's more of timing than anything.

The margins that we have in the contract that will come online are in line with the returns that we've spoken about before. So, I feel very good about the second-half margin, both dollars and percent.

And we should be coming into a period here shortly where the top line is growing, as well as seeing continued strength in the margins. And so we're closer to that than we were certainly this time last year.

That's perfect. That's really helpful.

And then on the product sales business, maybe a couple parts here. As we think about bookings, do you guys have a - can you help us think about what you think maybe the book-to-bill could look like for 2017, and as a whole, given we've seen some impressive quarters here in 4Q and in 1Q?

And then I think I heard you say there's a good - it looks like double digits is - margin could happen sooner than later; the flat to maybe up a little bit here in 2Q. Do you think we can get - does double digits seem doable the second half of the year now?

Yes. So let me take the first part of the question.

We continue to see strong demand for the product that we've worked hard to differentiate during the last 12, 18 months. As I said in my commentary, particularly around processing and treating, when you think of the capacity that's required to already deliver what many of our customers have committed to, one of the trends that I would say that’s evident today coming out of this cycle versus going into the cycle - when you really understand your customers' needs, when you think about some of the more consumable production equipment that your customers are holding in inventory, it's very hard to have visibility coming through 2014 and 2015, where those stocking levels were at.

The difference today for Exterran is that we’re selling for known basins, known projects. Many of our customers have committed production targets to their end and investors.

And so, for us, it's now less about if; it's more about when. And so there are some projects that are still a little lumpy.

We have a terrific backlog of inquiries and bids that we're working through right now. Our aim for the quarter is to certainly have above a one times book-to-bill ratio for Q2, and certainly that is our intention for the year as well.

So as we go through the quarter we're closely monitoring activity levels. There's lots of bumps in the road, and we're all experiencing, even today, a little bit of an industry view on our price that were different from what it was a few weeks ago.

So many of our projects, as we've told you in the past, is gas-related, but there's certainly a sentiment with our customers when some of their revenue is impacted by lower oil prices. So certainly see a path to double-digit margins.

I think we made terrific progress from the fourth quarter through the first quarter. And we certainly see that momentum continuing here in the second quarter and in the second half of the year.

So hopefully that covers both questions for you.

That's helpful. I appreciate it, guys.

Thank you.

Thanks.

Okay. So a quick call today.

So, thanks again. I'd like to thank all of you for your interest in Exterran, and have a good day.

Thank you.