Good morning and welcome to Apergy Corporation Second Quarter 2019 Conference Call. Your host for this morning's call is David Skipper, Vice President and Treasurer at Apergy. I'd now turn the call over to Mr. Skipper. You may begin..

Thank you. Good morning, everyone. With me today are Soma Somasundaram, President and CEO of Apergy; and Jay Nutt, Senior Vice President and CFO of Apergy.

During today's call Soma will discuss Apergy's second quarter highlights and market outlook, Jay will then discuss our second quarter results and will be referring to the slides posted on our Web site, before turning the call back to Soma to discuss the progress on our growth initiatives, and then we will open the call for Q&A.

I would like to remind our participants that some of the statements we will be making today are forward-looking. These matters involve risks and uncertainties that could cause material differences in our results from those projected in these statements.

Information concerning risk factors that could affect the company's performance and uncertainties that could cause material differences to actual results from those in the forward-looking statements can be found in the company's press release, as well as in Apergy's Annual Report on Form 10-K and those set forth from time to time in Apergy's filings with the Securities and Exchange Commission, which are currently available at apergy.com.

Except as required by law, the company expressly disclaims any intention or obligation to revise or update any forward-looking statements. Our comments today may also include non-GAAP financial measures.

Additional details on reconciliations to the most directly comparable GAAP financial measure can be found in our second quarter press release and slide presentation for this call, which are on our Web site. I will now turn the call over to Soma to discuss Apergy's second quarter results..

Thank you, David. Good morning, everyone. I would like to welcome our shareholders, our analysts and our employees to our second quarter 2019 earnings call. Thanks for joining the call.

We continued our strong execution in the second quarter and as expected we delivered sequential growth in revenue and adjusted EBITDA driven by growth in our artificial lift and digital product partially offset by a lower revenue and adjusted EBITDA in drilling technology.

In the second quarter and against a back drop of volatile oil prices, we continued to see the effect of capital discipline in the oil field.

As we expected, we saw sequential improvement in the market activity for our artificial lift and digital product, in drilling technologies in addition to the expected seasonal decline in Canadian activity, we also saw U.S. drilling activity decline through the second quarter. International activity continues to improve in the second quarter.

Turning to our financial performance, in the second quarter of 2019, our consolidated revenue was $306 million with adjusted EBITDA of $75 million. Our continued productivity focus and cost discipline helped us to achieve sequential margin expansion of 40 basis points. And we delivered an adjusted EBITDA margin of 24.4% in the quarter.

We generated $26 million of free cash flow in the quarter, year-to-date we have generated 23% more free cash flow in 2019 than in the first half of 2018. We intend to carry this momentum into the back half of 2019 and deliver another year of solid free cash flow performance.

In line with our capital allocation priorities, we continue to make good progress on deleveraging our balance sheet and repaid $25 million of term loan debt in the quarter. Since our spin-off, we have repaid $95 million of debt and we remain on the path toward achieving a leverage ratio of 1.5x debt to EBITDA in the first half of 2020.

Additionally, we closed on previously announced sale of our pressure vessel manufacturing business as it was non-core to our portfolio. We are committed to continuously evaluating and taking action when necessary to ensure that our portfolio is positioned to continue to deliver that top box performance, we discussed during our Investor Day in March.

This divestiture is an example of our work to ensure Apergy remains a top box performer. Turning to our segment, Production & Automation Technologies segment revenue increased 5% sequentially with artificial lift revenue growing 6%. Growth was driven by both U.S. and international markets.

Within this segment, we achieved 2% sequential growth in North America driven by 3% growth in the U.S. market offset by a seasonal decline in Canadian market. We achieved 24% sequential revenue growth in international markets outside of North America. In the U.S., we posted strong sequential growth in rod lift, while results for ESP were flat.

Strong growth in the Permian Basin for ESP was offset by lower revenue in the Bakken due to an operational issue. We expect this to be corrected in Q3 and we expect ESP revenue growth to resume in the second half. Our artificial lift second quarter results demonstrate the strength and benefits of having a broad portfolio of artificial lift products.

This broad portfolio helps us to continue to grow in spite of challenges in a particular basin or product. Digital products recorded revenue growth at 12% year-over-year and 10% sequentially. Growth in our digital portfolio in the quarter was led by our downhole monitoring, production optimization and artificial lift related digital products.

In the second quarter, Drilling Technologies revenues decreased 9% sequentially. As expected, we experienced lower seasonal drilling activity in Canada. Additionally, the decline in U.S. drilling activity through the second quarter prompted our customers to right-size their diamond pattern inventories this resulted in reduced volumes in the quarter.

From a geographic perspective, we continue to execute well internationally with revenues outside of North America up 6% sequentially. Our strong growth was led by artificial lift sales in Latin America and Asia Pacific particularly our rod lift and PCP product lines. Within North America, our U.S. revenue grew 2% sequentially.

Before I turn the call over to Jay to take you through the details of the consolidated and segment financial results, let me take a few minutes to share our view of the current market for our products.

As we look into the second half of 2019, North American activity is expected to be lower, while international markets will continue to show incremental growth. For the remainder of the year, we expect that our U.S. customers will maintain spending discipline and focus on free cash flow generation.

Against this backdrop, we expect Apergy to post resilient performance relative to the market with modest sequential revenue growth in the third quarter driven by our artificial lift and Digital products.

Within our Drilling Technologies segment in the third quarter, we expect our customers to continue to right-size their polycrystalline diamond cutter inventories to match activity level and push out some diamond bearing orders due to spending discipline.

This will result in a slight sequential decrease in our Drilling Technologies revenue in the third quarter. We expect our customers to complete the right-sizing up their cutter inventories in the third quarter.

At Apergy, we continue to remain focused on the factors under our control including advancing our growth and technology initiatives, maintaining cost discipline, driving productivity improvements and generating free cash flow.

To that end, for full year 2019, we are targeting a free cash flow conversion ratio of 40% to 45% of our adjusted EBITDA and believe that we are well-positioned to deliver another year of differentiated financial results. Now, let me turn the call over to Jay..

Good morning everyone. As David mentioned, I'll be referring to the slides posted on our Web site. Beginning with Slide 4, Apergy delivered revenue and adjusted EBITDA within our guidance range. Revenue is $306 million for the second quarter, which was $4 million higher or a 1% increase sequentially and flat compared to second quarter 2018 performance.

The sequential increase was due to growth both domestically and in our international business. In the quarter, there was a year-over-year revenue decline in the U.S. of $2 million or 1% offset by revenue growth outside of North America of $3 million or 4%. Adjusted diluted EPS was $0.35 down $0.03 when compared to the second quarter of 2018.

As we pointed out in our release, the second quarter 2018 results did not include the full quarter impact of standalone public company cost including a build out corporate staff and interest expense associated with our debt. The absence of such expenses in the prior year results limits comparability on an adjusted diluted earnings per share basis.

Cash flow from operating activities was $39 million in the second quarter down $12 million from the year ago period. Compared to the year ago period, Apergy interest payments increased approximately $12 million due to the debt that was placed on our balance sheet at the time of the spin.

We also made tax payments during the current period that were not incurred in the prior period due to the timing of the spin. During the second quarter, in spite of some slowing of customer collections, we still managed to draw down adjusted working capital $6 million sequentially on lower receivables and increased vendor payables.

Through the first six months of the year, cash from operating activities is ahead of 2018 performance in spite of the interest expense and higher cash tax payments made in the current year when combined with lower CapEx investments year-to-date compared to 2018. Free cash flow was 23% ahead of last year.

Turning to Slide 5, from a macro viewpoint, oil prices continue to demonstrate some volatility driven by global oil demand concerns from trade discussions, but more recently have rebounded as a result of the extension of OPEC, non-OPEC production cuts and lower supplies stemming from geopolitical developments.

As anticipated, the North American rig count declined sequentially due to the combination of the Canadian seasonality and a 5% decline in U.S. rig count as E&P operators have remained disciplined in their spending.

As we move forward into the second half of the year, we believe that operators will continue to remain disciplined about their spending and operating within their cash flow. We believe that industry fundamentals continue to be positive for our businesses and that our growth accelerators are aligned with the progression of the industry.

Moving to Slide 6, and looking at consolidated second quarter performance, net income in the quarter was $24 million and diluted earnings per share were $0.31. After adjusting for the impact of spin-off and restructuring related items, adjusted net income was $27 million resulting in diluted earnings per share of $0.35 in the quarter.

We generated adjusted EBITDA of $75 million during the second quarter compared to $77 million in the second quarter of 2018.

Once again, as a result of the timing of our spin in the middle of Q2 last year, results from the second quarter of 2018, do not include all of the expenses that would have been incurred had Apergy been a standalone public company for the full period.

In the second quarter of 2019, we incurred approximately $2 million of additional corporate costs associated with Apergy becoming a standalone public company compared to the prior year period. Sequentially, adjusted EBITDA increased $2 million on the $4 million revenue increase.

The sequential revenue increase within Production & Automation Technologies more than offset the larger than expected sequential revenue decline in Drilling Technologies.

In the second quarter, net interest expense was $10 million which was 4% lower than the first quarter as we're beginning to see some of the benefits of the effects of our deleveraging. In the second quarter, we repaid another $25 million of term loan debt.

Since the completion of the spin-off on May 9 of last year, we've repaid $95 million of term loan debt. Our effective tax rate in the second quarter was 22%. Our effective tax rate was slightly below our guidance range due to a non-recurring spin-related benefit in our international operations.

In the second quarter, we invested $13 million in capital expenditures including growth capital associated with surface equipment for ESP leased asset portfolio. Current quarter spending was lower compared to the total capital spending of $16 million in the second quarter of 2018.

Our free cash flow conversion from adjusted EBITDA was 35% in the second quarter of 2019 and free cash flow as a percentage of revenue was 9%.

Both ratios improved sequentially and we're positively impacted by the recovery of some of the working capital build from the first quarter that negatively impacted by the timing of income tax, interest, and insurance premium payments. Free cash flow conversion from adjusted EBITDA for the first six months of 2019 was 25%, compared to 21% last year.

Free cash flow as a percentage of revenue was 6% year-to-date through June compared to 5% in 2018. Similar to last year, we expect cash flow improvement to continue through the remaining quarters of the year.

Turning to Slide 7, Production & Automation Technologies revenue finished at $236 million in the second quarter, a decrease of $5 million or 2% from the second quarter of 2018 put up $12 million or 5% sequentially.

Year-over-year revenue decline was due to lower international volume specifically related to timing of deliveries in the Middle East and negative foreign exchange impacts. Digital products had revenue growth of 12% year-over-year.

The sequential growth came from stronger international activity mainly in Asia and Latin America along with improved volumes in rod lift and digital products. Digital products had sequential growth of 10%.

Adjusted segment EBITDA decreased $2 million or 5% from $54 million in the year ago period driven by the revenue decline adjusted segment EBITDA increased $6 million sequentially or 12% due to the revenue growth, the building momentum in productivity initiatives and continued strong cost discipline.

Adjusted segment EBITDA margin was 22% in the current quarter compared to 23% in the second quarter of 2018 and 21% in the first quarter of 2019. The sequential adjusted EBITDA increase of 140 basis points again reflects the benefits of continued cost discipline and operational leverage on the increased volume.

Regarding our EPB lease program, our upfront investment and downhole cables and pumps are reflected in our cash from operating activities. This investment was $9 million in the second quarter and is $31 million for the first six months of 2019.

As we noted, during our fourth quarter of last year, we released more capital and put additional inventory on order in anticipation of another robust growth year for ESPs in 2019. As a result of those actions, we built some inventory which we expect to draw down on in the remainder of the year through deployment to the leased asset portfolio.

We expect the investment in the second half of the year to be lower than the $31 million year-to-date due to the draw down. For the full year, we estimate, we will invest between $45 million and $50 million, which will be reflected in the cash from operating activities section of our financial statements.

As we shared in previously demonstrated, we will maintain capital and spending discipline on our ESP leased asset portfolio to ensure acceptable returns and cash generation.

Finally, in the second quarter, we completed the previously announced divestiture of our pressure vessel manufacturing business as it was not core to our portfolio and dilutive to our returns. Due to this divestiture, we recorded a $3 million loss on disposal in the quarter.

The business represented approximately 2% of Production & Automation Technologies revenue in 2018 and less than 2% in the first half of 2019. Moving to Slide 8, Drilling Technologies posted revenue of $70 million in the second quarter representing an increase of 8% from the second quarter of last year compared to flat worldwide average rig count.

The $5 million year-over-year revenue growth was driven by higher shipments in both our polycrystalline diamond cutters and diamond bearings. Revenue from Diamond bearings was up 54% compared to the year ago period.

Compared to the first quarter of 2019, Drilling Technologies revenues decreased 9% due to the seasonally lower rig count in Canada and a decline in U.S. drilling activity through the second quarter as a result of the U.S. average rig count declining 5%.

The lower rig count led to some rightsizing of diamond cutter inventory levels by several customers in the second quarter. Lower international bearing shipments contributed to the sequential revenue decline.

Adjusted segment EBITDA increased 10% to $27 million in the current quarter from the second quarter of 2018 primarily driven by higher volume and the benefits of our cost discipline and productivity initiatives. Sequentially adjusted segment EBITDA decreased 9% from $29 million in the first quarter due to their revenue decline.

Adjusted segment EBITDA margin was 38% in the second quarter of 2019 compared to 38% in the first quarter 2019 and 37% in the second quarter of 2018. Looking at Slide 9¸ on the balance sheet, second quarter ending debt -- net of debt discounts and deferred financing cost was $613 million. Cash at the end of the quarter was $24 million.

As previously noted, we repaid another $25 million of debt on our term loan consistent with our commitment to our capital allocation priorities which include continuing to fund our organic CapEx needs tied to our growth accelerators as well as reducing our leverage through earnings growth and debt reduction.

At June 30, Apergy's total leverage ratio was 2x and our available liquidity was $269 million. Turning to Slide 10, for the third quarter of 2019, we expect consolidated revenue of $305 million to $315 million and adjusted EBITDA of $72 million to $77 million.

We expect sequential growth in our artificial lift and digital businesses to be partially offset by a sequential decline in our Drilling Technologies business due to the lower North American drilling activity and the push out of deliveries of diamond bearing orders as customers constrain their investments.

We anticipate the interest expense will be approximately $10 million and that our depreciation and amortization expense will be approximately $30 million. Our effective tax rate is expected to be in the range of 23% to 24% in the third quarter.

Within the investing section of our cash flow statement, our full year of 2019 capital spending forecast continues to be approximately 2.5% of revenue for infrastructure related growth and maintenance plus an additional $15 million to $20 million per capital investment in surface equipment for our portfolio of ESP leased assets.

As a result for the full year of 2019, we estimate adjusted EBITDA free cash flow conversion of 40% to 45% and free cash flow as a percentage of sales of approximately 10%, with free cash flow being defined as cash from operating activities, less capital expenditures.

With that, I'll turn the call back over to Soma for some closing comments before we open up the lines for Q&A..

Thank you, Jay. Before we open the call to questions, I would like to update you on our progress on the key growth initiative for 2019 and beyond. Our first growth initiative is in our ESP product line where we continue to drive above market growth.

As you know, we have been working on qualifying our ESP product line with major integrated oil companies. I am pleased to report that in the second quarter, we completed the qualification process with one major IOC and received an order for our first set of wells for ESP installations.

We expect these installations to happen in the third quarter and begin generating revenues. We believe achieving this milestone is an important step in the continued growth of our ESP business, as our continued penetration into the major IOCs will further drive our ESP share in the market.

Additionally, we continue to advance technologies within the ESP product line to improve run life through increased reliability and remote monitoring capabilities. Compared to the year ago period, we have grown significantly our digital revenues associated with ESP monitoring.

Our second growth initiative is focused on the existing well conversions to rod lift as production declines. In the U.S. for the 12 months ended June 30, 2019, our rod lift revenues increased in the high single digits. In the second quarter of 2019, we saw strong sequential growth across our U.S.

footprint and we expect this to continue in the third quarter. We believe that we continue to see evidence of a multi-year growth story for our rod lift product line. Our strong brand and our position in the market will enable us to capitalize on the growing pool of available rod lift conversion candidates.

Our third growth initiative involves driving significant growth of our digital product revenues. We are focused on developing fit for purpose solutions designed to improve customer productivity and operational economics as well as growing our software-related recurring revenue stream.

We are constantly looking for opportunities that will continue to advance of our digital portfolio and deepen our customer engagement. To that end we are in the process of acquiring a bolt-on digital technology, which is strategic to our artificial lift portfolio.

We expect the acquisition to close in the third quarter although our digital portfolio revenue may be lumpy from quarter-to-quarter due to the current capital discipline environment. We continue to believe that we can pull significant year-over-year revenue growth in the years to come.

Our fourth growth initiative is in the continued innovation and advancement of our Diamond Sciences Technology including our polycrystalline diamond cutters. In the second quarter of 2019, our drilling technology segment had 22 new patents issued bringing the total issued patents since the beginning of 2008 to 763.

Although revenue growth in the third quarter will be impacted by reduced drilling activity in North America adoption continues to remain strong for new technology. And this resulted in 44% of our revenues in the segment in the second quarter coming from products introduced within the last three years.

In the second quarter, the continued advancement of our Diamond Sciences Technology helped us to achieve 8% year-over-year revenue growth in Drilling Technologies compared to a 7% year-over-year decline in the North American rig count. This is a differentiated performance.

Our final growth initiative is focused on driving continued adoption of our diamond bearings in downhole applications including rotary steerable mud motors and power generators. Year-to-date, we have seen strong performance in this product line with the revenue up 69% compared to the first half of last year.

Even with the temporary push out of some diamond bearing orders in the second half due to capital discipline, we will post strong revenue growth in our diamond bearings product line in 2019.

Additionally, we expect strong growth in the coming years driven by continued adoption of our downhole application and also from other applications where this technology can be applied. We delivered a solid financial performance in the second quarter and continued to execute well on our growth initiatives.

We are committed to maintaining a focused portfolio that is resilient and continues to deliver the top box performance through the cycle. Finally I want to thank all of our employees for their continued efforts and passion in improving the lives of our customers, our employees, our shareholders, and our communities.

I am proud of their accomplishments and it is privilege for me to lead such a great team. With that, I would like to open the call for questions..

Thank you. [Operator Instructions] Thank you. Our first question is from Byron Pope of Tudor Pickering..

Good morning, guys..

Good morning.

Good morning, Byron..

I just want to make sure, I'm thinking about the way you frame the outlook for production and automation technology.

I think I heard that you expect the strong growth that you saw and rod lift continuing in Q3, but could you frame how you think about that ESP installations that you're seeing as we stepped into Q3, and realized that product line is skewed toward the Permian.

Just looking for how you think about activity there, are the mix within production and automation technologies here in Q3 in the context of the guidance?.

Yes. Our conversations with our customers and also pump jack manufacturers continue to point that the rod lift conversions should continue to improve in the third quarter. So we do think across the U.S. footprint and we saw that in Q2, our rod lift sequentially grew in all basins and we expect that to continue into the Q3.

With respect to ESP installations, we definitely see on the Permian incremental improvement from Q2 -- Q1 to Q2, our ESP installations grew in Permian and we expect that to continue into Q3 as well and into the second half.

But, as I mentioned in the prepared remarks, we did have an operational issue in the Bakken, which we are correcting in Q3 and at that, [indiscernible] you will see the second half ESP will grow. So we expect our second half sequentially for ESP to be better than the first half..

Okay. That's helpful, Soma. And then just a quick second question on Diamond Technologies.

The orders for diamond bearings, they got pushed into the back half of the year, or is the expectation that they happen at some point before year-end or is just not that much visibility as we stand here today because I know you've had great traction with customers on the diamond bearings front as it relates to downhole tools and rotary steerables?.

Yes. Absolutely, Byron. I think we continue to believe the conversations with the customers are very strong to point out the continued adoption. In the first half as you have seen, we grew 69% in the first half in the diamond bearings business. It's a pretty strong growth.

And as you know the main customers for these are the large oilfield service company. So, as we move into the second half as the large oilfield service company continued to exercise spending discipline, capital discipline, some of these orders are going to be pushed out.

It's hard to say at this point whether it will resume before some of this orders will come back before the end of the year, but our plan today is, our visibility is, the assumption we are making is, it will be more into the first quarter of next year..

Got it. Thanks Soma. Appreciate it..

Sure..

Our next question from David Anderson of Barclays..

Hey, good morning Soma. So, there's a line of thinking out there that the so-called frac holiday from last year is going to cause an air pocket in the ESP demand and from the Permian kind of the second half of the year. Doesn't sound that's happening. It sounds like you sound pretty confident, that's going to continue to increase.

Can you just kind of give us a sense of some of kind of the dynamics that you're seeing out there? I mean I know this is more OpEx and CapEx, so is that sort of -- your view that should be fairly steady throughout the next couple of quarters?.

Yes. Good morning, David. It's exactly how you described that. Especially in the Permian it's being a more leased asset business. We're seeing as we came out of that Q2, we are seeing the installations continue to be stable and in some cases improving.

So, we feel that ESP installations to be continued to be improving and at least stable are improving in the second half. The other aspect that happens and we have talked about this before is that run backs. We have talked about it before that.

In the same valve where ESP has been installed that can be additional run backs of ESP which is -- as the production declines taking out one ESP and putting in lower volume ESP. And we have seen that to be -- two has become almost standard nowadays particularly in Permian. And we have seen in some cases as much as three.

And that's why we always say there is not a one-to-one relationship. And we have done multiple analytics to understand this and I can tell you that it's hard to find a one-to-one clear relationship between a fracking slowdown and ESP growth, so because of these factors..

Soma third ESP, you're talking about, they're going in the well.

Is that a new design, does that require a different rental piece from you? Do you have to build that out? Or is that similar to what you normally do, sort of just different sizing in your kit there?.

Yes. It's just different sizes in our kit..

Okay. It's a separate question here on the digital side.

You had a nice quarter up 10%, I was just wondering, if maybe you could just kind of step back and kind of help us understand kind of the overall market penetration with digital? I guess I don't know if it's the right way to think about it, but I think about all of your ESPs and the rod lift that you have out there in the field.

I mean what percentage of that, tell me this is the right way to look at it, but what percentage of your installed base has digital or some form of digital applied to it.

And secondarily, is it only your equipment goes through or can you -- do you also put the digital on other people's equipment?.

Yes. So, let me start with the last question first because the last piece where you asked we also put digital on other people's equipment, it is true. We also as you know we have hardware component and the software component.

And we work in a very collaborative manner with the customers, so we offer them a suite of products, so they can pick and choose what works best for them as well.

So, in some cases, our software will work and run on customers' -- competitors Web controllers meaning the exact -- taking data from a competitor's controllers and then doing the optimization work, right? So, the software, hardware components can work on, our own hardware as well as competitor's hardware.

The question of how should we think about digital penetration. If you look at our portfolio, we have those -- we have downhole monitoring aspect of the business where we provide downhole monitoring of pressure, temperature those elements.

And then, we have the production optimization element which involves artificial lift, a full set of artificial lift. Then we have our asset integrity management which includes monitoring of reciprocating compressors an engine in pipelines and gathering lines.

If you think about the downhole monitoring, a big driver of those type of things, when you think of it as intelligent completions, so continued permanent monitoring of valves improve, intelligent completions continued to improve. So, we're seeing the front up that come through in downhole monitoring.

When you think about the production optimization where we have the artificial lift products the ESP monitoring, we saw significant growth, continued growth in our ESP monitoring. And again, as we said all of our ESPs installations goes with the monitoring portfolio.

And so that's a continued aspect of our -- the third element, the asset integrity management and the reciprocating compressors and engine.

This is where our spotlight product line which we talk about and what we launch and we are seeing increased number of what I would call a proof of concepts, the way customers adopt this product is, if you have a pipeline with multiple compressors, they want to test it on few compressors first, they call it the proof of concept, it could be one, it could be a fleet of five.

And then, as they see the value of it, they adopt across their product portfolio. So what we are seeing is, that increased proof of concept, the number of proof of concept continues to improve, which will eventually turn into orders. We have always said, it's always hard to predict adoption and in the sense our portfolio as the hardware and software.

It is not completely immune to capital discipline, right? So, that's why we say it can be lumpy, but where we have conviction and the evidence, what we are seeing is that continued, you need to think about it from a year-over-year basis, you should continue to see healthy growth rates in this business and we are seeing evidence..

Great. Thank you, Soma..

Thanks David..

Our next question Marc Bianchi of Cowen & Company..

Thanks. Thanks very much. I would like to start with some of the puts and takes in third quarter. The inventory destocking in drilling and maybe the destruction that occurred in the Bakken.

Is your best guess that fourth quarter could be up from third quarter given these -- given these or perhaps transitory events or is the decline in customer activity can overwhelm that, it's most likely down from third quarter, I'm asking on a top-line perspective..

Yes. Excellent question, Marc, because we talk about this quite heavily internally. Look Q4 is always difficult to predict. And let me talk about it from a production and automation technologies perspective.

In our production and automation technologies perspective, in the fourth quarter, we typically see the holidays and the spending customer budget exhaustion come into play. So, from that perspective, we will see normally a sequential decline from Q3 to Q4.

But, when it comes to on the drilling technologies this year in particular, the Q2 to Q3, typically tends to be up as Canadian and the activity rebounds. This year, what we are seeing from Q2 to Q3 is, if you look at the Canadian rig count, in 2018, Q2 to Q3 when they exited, it was up 22% by this time last year.

But, this year, it's down 5% in Q3, right? And then, U.S. rig count is also modestly declining Q2 to Q3 sequentially and as customers continue to maintain their spending discipline. So, that's the reason why we feel Q2 to Q3 will be sequentially down in drilling technologies, one of the reasons.

But, our conversations with customers indicate that they will complete these talking adjustments in Q3. So, there is a potential possibility, Q3 to Q4, our drilling technologies will be up.

So net-net, either sequentially we feel it should be down, but it can be somewhat muted how much down it is based on the drilling technologies sequentially coming up from Q3 to Q4. So, that's as much visibility as we have right now Marc..

How much of a headwind in revenue is the destocking and maybe we can make up our own mind on what the market will do in the fourth quarter?.

You're talking about in Q2? I would say in Q2..

Yes, in Q2..

Yes, 3Q is hard to predict for us because again we are estimating the destocking impact. I can tell you in Q2 because if I isolate the U.S. impact, it's between $1 million and $2 million in revenue in Q2 in U.S. because of the destocking..

Okay, okay. That's great. And then, just on the idea of the downhole ESP investment that you're talking about the $45 million to $50 million, maybe Jay or Soma, could you help us understand just the dynamics of how that works. It seems to me like it's a little bit of -- almost like a working capital item rather than a CapEx item.

Maybe explain how that that business would behave or that piece of that business would behave if revenue for ESP were perhaps flat, if you weren't growing perhaps in 2020, and then, also could you discuss what that spending was in 2018?.

Sure, Marc. So, good question. And just to address the question that was in the pre-release, so of the 31 -- we spent $31 million year-to-date in 2019, that's reflected in the leased assets another line in our statement of cash flow. There's two components of this.

First, there's an element of timing of, when we receive inventory that's used in the leased asset portfolio, and then also, when we actually paid for that inventory as you may recall much of the inventory for the leased asset portfolio in ESPs is coming from the supply chain in China.

And this can add a timing element due to the extended transportation time. The second item that influences our spending and support of ESP growth is the mix between sold ESPs and leased ESPs in any quarter or year-over-year.

And we are as someone just mentioned with the growth in the fundamentals, we are experiencing a higher ratio of leased ESPs versus sold ESPs in 2019 versus last year.

I want to be clear that we have a very clear and disciplined capital allocation process with respect to the ESP spending, and we will review the spending forecast with the operations regularly as part of the approval and allocation of spending in support of our growth initiative.

We recognize that this is difficult to model from an outsider's perspective and therefore that's why we decided to provide more specific guidance regarding the spending for 2019 in the range of $45 million to $50 million. And again, the year-to-date $31 million is already included in that.

And we're going to continue to provide guidance on a go forward basis to assure you that we're exercising strong capital discipline associated with this growth initiative..

Okay.

If it is, if ESP is flat in 2020, what would you anticipate that line to look like?.

So, Marc, it depends upon again the mix, so if we are selling ESPs and just pulling ESP components out of inventory to sell that unit versus pulling components out of inventory to configure any ESP for less lease, it will have a bit of an impact.

But for 2020, right now, I would tell you that we would be in the same neighborhood as the 2019 expectation..

If it is flat..

If it is flat..

Yes..

Okay. Thanks very much for taking my question..

Sure..

Thanks Marc..

Next question from Chase Mulvehill of Bank of America Merrill Lynch..

Hey, good morning. I guess, I wanted to come back to the acquisition that you noted during the prepared remarks.

How material is that digital acquisition, and then, maybe talk about the opportunity to leverage that technology across your entire lift portfolio is that is -- is it just kind of rod lift, or is it across the entire portfolio that you'll be able to leverage that?.

Yes Thanks Chase. Just for competitive reason at this point, I'm not going to be specific about which lift type this refers to, but it relates to -- it's a critical component in the area of real-time monitoring and optimization of artificial lift products. So, today it relates to a particular type of lift.

And it's a very important investment, but the investment is between $10 million to $15 million. So, the second half impact of this will be somewhat small, but positive.

To your question of whether -- how will be able to leverage this across the portfolio, definitely we can leverage this across at least two of the artificial lift product groups for sure now because we -- the one we -- it is very strong in and they are in the process of developing a new product for another form of lift.

So, we are pretty excited about this product line although it is small, but it just adds an important critical capability to our digital technology..

Okay. Right. That's very helpful. A quick follow-up. I may have missed it, but did you talk about pricing across artificial lift, and then, maybe also kind of commentary on pricing across the drilling inserts business. And I'll turn it over..

Yes. So, with respect to pricing, we haven't seen sequentially any meaningful changes in the PAT segment. So, it's a fairly -- I would characterize this to be a fairly stable. With respect to drilling technologies, it is -- where we are finding some challenge is more as we introduce new technologies while the adoption is strong for new technologies.

Usually trying to get meaningful pricing improvement on that is always a challenge. So, technology adoption is strong, but meaningful price improvement to the technology is right now a little more challenging.

So, what we -- the way we are focused on is make sure that they continue to advance the technology, but then drive significant productivity internally to make sure that we continue to maintain those margins..

Okay. All right. That's very helpful. I'll turn it back over. Thanks Soma..

Yes..

Our next question from Blake Gendron of Wolfe Research..

Hey, thanks. Good morning. Just following on the inventory drawdown question on the drilling fixed side. Just trying to get a sense of what -- maybe you can quantify what inventory levels normally are in a -- call it a slow growth, rig count environment.

How long is the inflection after the recount bottoms potentially in 3Q, but say base case the recount stabilizes. And then, if we see in 2020, the rig count begins to recover should we expect that volumes outperform the rig count outside of any major market share gains just because you will see your customers restocking. Thanks..

Yes. Good question, Blake. If we don't have quantitative visibility of how much inventory our customers hold across their field locations. So we rely on the conversations we have with our customers on where they are in rightsizing their inventory to the activity level.

So, to your question on -- so right, now let me go back to the previous comment I made. Current conversations with our customers indicate that they will be completing their adjustment to rightsizing the inventory in Q3.

So, in 2020, if that means that -- if that account is continuing to be flat or if it starts going up, then, yes you would see restocking opportunity, if the rig count starts going up. And that's why we always say that you should expect in the upturn in a rig count growing environment that's [Technical Difficult] growth.

And then, on a declining environment, in the initial period of the decline, you will see a little bit more growth decline in our PDC cutter in the initial period until that inventory level adjust. And then it will stay flat..

Okay. That's very helpful. And then one more on the ESP side, if I may. Pretty encouraging data point with the IOC qualification. It seems that ESP growth in the Permian continues to grind higher, but at some point when that slows down, it's going to be a zero sum game. Some of your larger competitors have talked about ESPs being a source of strength.

So, you talked about potentially getting more runs on ESP per well and that's maybe creating a pent up demand for rod lift conversions in 2020 or 2021. But, if we do get into a more competitive ESP environment, slower growth in 2020, is there a whole a lot of share velocity.

I guess where if you get the initial ESPs installation a competitor can come and displace you or vice versa for the second and third runs on that ESP..

Yes.

So Blake typically, on the leased when they do that -- if you have the first installation in typically, you don't lose the second and third unless your equipment completely didn't perform, right? So, normally that's a very high stickiness in the run backs because again as we explained before the customers don't change the whole system when they do that in the run back, right? They only change certain elements of it.

The rod lift side, as I mentioned in the prepared remarks, we are very encouraged by what we are seeing in the rod lift activity. In the second quarter, we saw across all basins sequential improvement in rod lift activity and periodically we meet with pump jack manufacturers to understand how they are seeing the market.

And so far all the conversations continue to point to -- that should be a good continued sequential growth in this in Q3. Now Q4, as the budget exhaustion can come into play, but I just think that it is encouraging to see the continued evidence of that multi-year growth conversion coming through..

Okay. Perfect. Thanks..

Next question from Scott Gruber of Citigroup..

Yes. Good morning..

Good morning, Scott..

Thanks for all the color this morning.

The 40% to 45% free cash conversion targets for this year, is that a good range to think about free cash conversion potential in '20 and '21, let's say with a flattish macro backdrop and your growth initiatives progressing as expected?.

Good morning, Scott. This is Jay. I would say, yes, in a flattish environment next year that would be a good range for us to estimate free cash flow conversion for next year..

Great. And then, we received a few questions this morning, just on squaring your production growth outlook in 3Q with the order rate trend in 2Q, orders were up in 2Q, but the top-line growth in production was faster and book to bill was a little bit below, one. And I realize that the conversion cycle is quick.

So, are you seeing the pace of order intake accelerate here already in July? Is that what underpins the confidence for growth in 3Q in production?.

Yes. I think Scott, you rightly pointed out, ours is a very short cycle type business. So, there is -- big part of our business is book and shared particularly our rod lift portfolio and our ESP portfolio, right? And the longer term bookings backlog in PAT typically tends to be associated with our international type orders.

So, to answer your question, what we are seeing right now in July continues to support our view in terms of what Q3 progression will be sequentially..

Great.

And then, just a quick one on the international conversion cycle Jay with international taking share, how should we think about that conversion cadence? How different that was versus a lot of the book and ship revenues in the space?.

Yes. Our international revenues tend to be lumpy because of that reasoning, the reason what we said.

But, what we are seeing Scott is improved level of tender activity, number one; as the market itself is improving, but we also are seeing the benefit of some of the capabilities we built particularly in Argentina, if you recall we made that acquisition in October of 2017 and putting local capabilities in place, the capability we built in Colombia.

We are seeing not just activity being up, but our participation in the activity has also increased in those specific areas where we participate. So, we feel, I think in the Investor Day, if you recall we mentioned that we feel what the next three to five years, we should be able to continue to grow our international in the low double digits.

And I think we are on our way to do that in 2019 and beyond..

Great. Appreciate the color. Thank you..

And our last question comes from Saurabh Pant of Jefferies..

Hi, good morning, Soma and Jay..

Good morning, Saurabh..

Hi.

I'd like to go back to Marc's question, he was asking on the ESP leasing model rate, so I would like to make it slightly bigger picture, right? So, if you can explain to us, if I'm a customer, I want to leave your ESP, how does it work for me as a customer? And then, internally how do you account for all of that in your financial statement across all P&L cash loan balance sheet?.

Sure, Saurabh. So, I think as we have explained before, if it's a lease opportunity with a customer we have three revenue streams with the customer. We get paid upon the installation.

We get paid over the run life of the lease on the rental basis, and then, upon pulling the leased asset at the completion of the lease term, the downhole components that are not reusable get billed to the customer and the customer reimburses us for those at retail value, so that we have -- so that we can procure the inventory or draw down on the inventory so that we have a fully redeployable asset for their next run or for another customer.

So, what you see in the cash flow from leased assets and other in the cash flow statement is, the outflow for components predominately cable and pumps that are going downhole, and then, the net -- the remaining net book value that is unappreciated when that asset is pulled is recovered against that line item from the cash flow perspective.

But, within the net income because we are charging the customer for those components, the revenue less the cost of that is showing up in net income. So, there's two components in the cash flow statement where we are recovering from the customer on that original asset..

Okay. That's helpful. And if I think through that, right, you made it very clear the impact on the cash flow statement, right.

But, if I think about the P&L, right, again, sticking on the leasing side of things, you said that third stream -- rate revenue stream is when you pull that downhole pump and the customer would pay for that, right? So, if I were to think about that, what that tends to do in my mind is that further delays the revenue realization right? If a downhole pump [indiscernible] nine month, right? And in the first place that ESP system was installed six months from IP, right, your revenue realization on that pump, right, is nine months plus six months, 15 months, right.

So, when we talk about the impact of rack holiday anywhere, right, the lead time to revenue realization, right, just based on that accounting methodology, you can't put it when it gets pulled. The lead time is even more than just the installation of the initial pump..

You are correct. So, getting paid for those downhole components at the completion of the leased term that they [Technical Difficulty] upfront when you would get paid right upfront. So you're not getting paid for those pumps in [indiscernible] until the completion of the lease term..

One of the things Saurabh we monitor is our installed versus pull. As you pointed out in a high pull environment your revenues will go up because you get those. But all ESPs have to be eventually pulled, right. You can live up the downhole.

So, I think that's why as installation pays continues to improve, you should expect eventually that pull and customers are very focused on improving the run life because that is an aspect of ESP, we all know, customers are most concerned about. And that is a competitive advantage, customers grade you on how your run life is..

Right now, as Soma pointed out, we continue to see installations outpace pulls because of the growth again predominantly in the Permian where we had good sequential growth in the ESP in Q2..

Right, right. All of that makes sense. And that's really helpful. My quick follow up is, we have heard some of the pump jack manufacturers get retroactive exemption from the section 301, [indiscernible] tariff. I understand its restricted pump jacks only, but if you can talk about any potential impact view on ESPs in general that would be helpful..

Yes. Saurabh, we are currently evaluating that. And right now, we don't see that to be a meaningful thing for us at this point. But if we have any further progress on that, we will talk about that again in the third quarter call..

Okay. Okay. Okay. Last one, a very quick one Jay, for you.

When you said 40% to 45% EBITDA to free cash flow conversion, I'm assuming that before the $10 million to $15 million acquisition, right?.

That is correct..

That is correct..

Okay, guys. Thank you. I will turn it back..

Yes. Thanks again for joining our second quarter call and your continued interest in Apergy. We will look forward to talking to you in our third quarter conference call..

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for your participation. You may now disconnect..