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

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 third quarter highlights and market outlook.

Jay will then discuss our third quarter results and be referring to the slides posted on our website, 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 third quarter press release and slide presentation for this call, which are on our website. I will now turn the call over to Soma to discuss Apergy's third quarter results..

Thank you, David. Good morning everyone. I would like to welcome our shareholders, our analysts, and our employees to our third quarter 2019 earnings call. Thanks for joining the call. Our team has executed well through a challenging and tough North American market environment.

Strict adherence to capital discipline and spending austerity by both our E&P and oilfield service customers impacted activity in the quarter. As the third quarter progressed, U.S. onshore activity levels deteriorated more rapidly than anticipated, resulting in lower than expected operational results.

However, our focused execution, strong cost discipline and continuous productivity initiatives enabled us to drive strong adjusted EBITDA margin performance and strong free cash flow performance in the quarter.

In the third quarter, we posted $67 million of adjusted EBITDA on $278 million of revenues as we continue to see the effects of capital discipline in the oilfield. While both of our segments were impacted by slowing U.S. activity, drilling technologies experienced a steeper than expected decline driven by the sharp decrease in the U.S.

rig count as well as the related destocking of polycrystalline diamond cutter inventories by our drill bit customers. The destocking continues to go deeper as our drill bit customers focus on cash generation and spending cuts.

With E&P operators and your production targets within reach and with the goal of preserving and living within cash flow, our E&P and oilfield service customers pull back their spending earlier than expected this year.

This resulted in a particularly weak month of September for customer spending and we expect this trend to continue into the fourth quarter. Apergy is meeting the challenges of the current macro environment head-on. During the third quarter and into the fourth quarter, we took restructuring actions to adjust our cost structure.

The actions we have taken so far will result in annualized savings of about $20 million. We have continued to evaluate additional actions and we will start executing on them in the fourth quarter. We are stepping up our productivity efforts and continuing our cost discipline while preserving our technology investments.

Our strong margin performance and robust free cash flow generation will continue to reinforce Apergy’s position as a top box company. With respect to free cash flow generation, we have posted outstanding performance on this metrics. Year-to-date we have generated 83% more free cash flow than in the first nine months of 2018.

We intend to carry this momentum through the remainder of the year and deliver another year of solid free cash flow performance. In line with our capital allocation priorities, we continued to make good progress on deleveraging our balance sheet. We repaid $25 million of term loan debt in the quarter.

Since our spinoff, we have repaid $120 million of debt. We remain committed to deleveraging our balance sheet. Turning towards segments, production on Automation Technologies segment revenue decreased 5% sequentially, which was driven by lower customer spending for artificial lift products and the other production equipment.

Although all of our artificial lift products were affected by the earlier start of E&P budget exhaustion, our Rod Lift product line held up well and were supported by our strong aftermarket service offering as well as customers converting older wells to Rod Lift.

Digital product revenue grew 10% year-over-year led by our downhole monitoring and production optimization products. From a profitability perspective in the quarter, PAT delivered strong performance driven by the cost actions and productivity efforts. We feel our PAT segment performance is resilient and strong relative to the market.

Turning to drilling technologies, revenues decreased 22% sequentially in the third quarter. The revenue decline was driven by the sharp 7% sequential decline in the average U.S.

rig count, a steeper and longer than expected period of customers destocking their polycrystalline diamond cutter inventories and the push out of diamond bearing orders due to capital discipline by our oilfield service customers.

Given the significant impact we are experiencing from destocking, I would like to provide some historical perspective to this phenomenon. We see inventory destocking cycles during periods of rig count declines. During inventory destocking, we see impact from two levels of destocking.

First is our oilfield service customers rightsizing their drill bit fleet to lower activity level. This includes lowering drill bit build rate readjusting and redeploying global field inventories. The second level of impact is rightsizing up of cutter inventories themselves.

This involves lowering safety stock levels, increasing use of reclaimed cutters from old beds and optimizing global inventory by moving excess inventories to wherever needed around the globe.

Hence during destocking, the drilling technologies revenue will fall faster than rig count and during restocking periods our revenues will significantly outpace rig count growth. This is a temporary phenomenon. We have included a graph showing the historical perspective on Slide 8 of our earnings slide deck.

Currently, we are seeing a more pronounced level of destocking in the second half relative to rig count declines due to the focus on cash generation and spending austerity by our oilfield service customers.

Based on our experience from prior cycles given the steepness of destocking, we expect a sharper recovery as inventory level normalizes and activity improves. We have been through these cycles and situations before. We have a well honed playbook to manage this.

We have already reduced headcount appropriately in the segment to match the lower activity level. We continue to preserve our technology investments in the segment to protect and expand our leadership position.

Our drilling technologies team is executing well during this challenging market, preserving our share position with key customers and we are positioned well to capitalize as activity improves and our customers start the restocking cycle.

Looking at our business geographically, while American activity was soft, international markets continue to remain a bright spot in 2019. Apergy’s revenues outside of North America grew 13% year-over-year, led by Middle East region. Both segments recorded year-over-year growth outside of North America.

Additionally, we made a strategic investment in a startup manufacturer of sucker rod in Argentina. This investment will help us to advance our growth in South America.

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. For the fourth quarter of 2019, we expect continued weakness in U.S.

onshore activity driven by traditionally lower seasonal activity as well as further impact from the customer trends we saw in the third quarter. This includes E&P’s restraining spending as they look to land their 2019 capital budgets within cash flow as well as additional U.S. rig count declines.

We also expect our oilfield service customers to extend the destocking of their polycrystalline diamond cutter inventories into the fourth quarter as they had just to lower drilling activity and adhere to capital discipline. We expect our PAT segment performance to remain resilient.

And outside of North America, we expect the international markets will continue to see growth and we intend to capitalize on these opportunities. For these reasons in the fourth quarter, we expect the Apergy to post a sequential decline in revenue and adjusted EBITDA.

Additionally, within our drilling technologies business, due to the steepness of the decline, we are likely to experience higher than normal detrimental as we continue to preserve our technology investments. Given the short cycle nature of our business and added uncertainty due to customer destocking, visibility continues to remain challenging.

Therefore, we will provide an update to our fourth quarter outlook in early December. We do expect activity levels to sequentially improve from current levels as we enter 2020 driven by new budgets and restocking by our drill bit customers as they prepare for improved activity levels.

We continue to remain focused on the factors under our control, including advancing our growth initiatives, maintaining cost discipline, implementing productivity improvements, and generating free cash flow. Although the current market drop is challenging, our product lines remain highly profitable with the long-term growth opportunities.

We are well positioned to continue to deliver top box performance given our margin resiliency and free cash flow generation capabilities. 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 website. Beginning with Slide 4, for the third quarter revenue was $278 million, a decrease of $38 million or 12% compared to the third quarter of 2018, and a decrease of $28 million or 9% sequentially.

Excluding the effects of acquisitions and divestitures, revenue was down 11% compared to the year ago period. Year-over-year revenue decline in North America was $44 million, or 16%, partially offset by international revenue growth of $6 million, or 13%.

Adjusted diluted EPS was $0.27, down $0.10 when compared with the third quarter of 2018, and $0.08 sequentially. Cash flow from operating activities was strong at $64 million in the third quarter, up $30 million from the year ago period and $25 million compared to the second quarter of this year.

In the third quarter, the adjusted working capital contribution to cash flow improved compared to the second quarter due to continued efforts to reduce our accounts receivable balances and draw down on inventory. Capital spending in the quarter was $9 million.

Additionally, in the quarter, we use $12.5 million of available cash to close on the acquisition of a digital technology, which is strategic to our artificial lift portfolio. Turning to Slide 5, we're currently navigating a challenging market environment in North America. Looking at rig count, the average U.S.

rig count declined 7% sequentially in the quarter with end of period rig count being down 11% compared to the end of June. The year-over-year change in rig count at the end of September was down 18%.

For 2019, North America E&P capital spending is forecasted to be down in the high single digits as E&P operators continue to remain disciplined about their spending and living within cash flow.

Moving on to Slide 6 and looking at consolidated third quarter performance, net income in the quarter was $14 million and diluted earnings per share were $0.18.

After adjusting for the impact of spinoff, environmental remediation charges and restructuring and related items in the quarter, adjusted net income was $21 million resulting in diluted earnings per share of $0.27.

We generated adjusted EBITDA of $67 million during the third quarter, a decrease of $11 million compared to $78 million in the third quarter of 2018. Sequentially adjusted EBITDA decreased $8 million from $75 million in the second quarter. The year-over-year and sequential decreases were primarily driven by the sharp decrease in U.S.

drilling activity in the third quarter, a steeper and longer period of oilfield service customers destocking their polycrystalline diamond cutter inventories and to push out of diamond bearings deliveries. We also experienced lower E&P customers spending on artificial lift products and other production equipment.

In the third quarter, net interest expense was $10 million, which was 5% lower than the second quarter as we're seeing the benefits of our deleveraging efforts. In the third quarter, we funded a strategic technology acquisition and repaid another $25 million of term loan debt from available cash.

Since the completion of the spinoff on May 9th of last year, we have paid $120 million of term loan debt, or 17% of the initial debt taken on at the time of the spin. Our effective tax rate in the third quarter was 23%, which was within our guidance range.

In the third quarter, we invested $9 million in capital expenditures, including growth capital associated with the surface equipment for our ESP leased asset portfolio. Current quarter capital spending was lower compared to the $14 million of investments made in the third quarter of 2018 was also down sequentially.

As we continue to be focused on capital discipline and aligning capacity to market activity to ensure a continued strong return on investment. Our free cash flow conversion from adjusted EBITDA was very strong at 83% in third quarter of 2019 and free cash flow as a percent of revenue was 20%.

Both ratios improved sequentially and were positively impacted by the reductions in adjusted working capital and capital discipline around capital investments during the quarter. Free cash flow conversion from adjusted EBITDA for the first nine months of 2019 was 43% substantially ahead of the 23% through the first nine months of last year.

Turning to Slide 7, production and automation technologies revenue finished at $223 million, a decrease of $18 million, or 7%, from the third quarter of 2018, and a decrease of $12 million, or 5% sequentially. Excluding the effects of previously announced acquisition and divestiture activity, revenue declined 6% compared to the year ago period.

Year-over-year decline was due to lower E&P customer spending in North America, partially offset by international growth. The sequential decline was due to reduced customer spending for both our artificial lift products and other production equipment.

Adjusted segment EBITDA of $53 million increased $2 million or 4% compared to the year ago period, driven by cost discipline and a high level of productivity benefits, which offset some loss of operational efficiency as a result of the lower volume.

Adjusted segment EBITDA increased $2 million sequentially or 3% from $52 million in the second quarter of 2019, due to strong cost reduction actions and the productivity benefits in the quarter. Adjusted segment EBITDA margin was 24% compared to 21% in the third quarter of 2018 and 22% in the second quarter of this year.

Regarding our ESP leased asset program, up-front capital investment in the downhole cables and pumps, net of customer reimbursements at the conclusion of the lease, is reflected in our cash from operating activities.

This investment was $6 million in the third quarter, which is down compared to the second quarter levels as we scaled back investments as a result of slower E&P customers spending. Through the first nine months of 2019, we've invested $37 million in cables and pumps net of customer requiring reimbursements.

For the full year 2019, we've lowered our estimates and now expect that we will invest between $40 million and $45 million net of customer reimbursements in the cash from operating activities section of our financial statements supporting the leased asset portfolio.

Moving to Slide 8, drilling technologies posted revenue of $55 million representing a decrease of 27% from the third quarter of last year compared to a 7% decrease in the worldwide average rig count and a 12% decrease in the U.S. average rig count. The $20 million year-over-year decrease in revenue was due to the sharp decrease in U.S.

rig count, which caused customers to aggressively destock their polycrystalline diamond cutter inventories. Additionally, in the third quarter, revenue for diamond bearings was $7 million down from $9 million in the year ago period as oilfield service customers push out orders due to the effects of capital discipline.

Compared to the second quarter of 2019, drilling technologies revenue decreased 22% due to the sharp drop in the U.S. rig count as well as customers continuing to destock their diamond cutter inventories throughout the quarter. We estimate that destocking had a negative impact of $12 million against our Q3 results.

In addition to the impact of destocking, the reduction in deliveries of bearings due to capital discipline also had a negative impact on the sequential revenue. Adjusted segment EBITDA decreased 43% to $17 million in the quarter from $29 million in the third quarter of 2018 due to the lower volumes in the quarter.

As we've previously shared, we experienced higher decrementals to adjusted segment EBITDA and drilling technologies business, during periods of sharp declines in revenue. Sequentially, adjusted segment EBITDA decreased 38% from $27 million in the second quarter due to the steep revenue decline.

Adjusted segment EBITDA margin was 30% in the quarter compared to 38% in the second quarter of 2019 and 38% in the third quarter of 2018 as cost actions taken in the current quarter, we're only able to partially offset the impact of the revenue decline.

As you can see in the chart at the bottom of this slide, we provided a historical perspective of how drilling technologies business is affected by significant changes in rig count over short periods of time.

As Soma shared earlier, what's clear from the charts is that when there is a significant change in rig count, we will tend to under perform on revenue when rigs are coming out of service as our oilfield service customers will execute their destocking plans.

As you can see the destocking impact can have an immediate exaggerated impact on quarterly revenues and earnings, and this is the primary driver of our current quarterly segment results.

Similarly, drilling technologies business will tend to outperform on revenue when rig count is increasing as customers restock cutters for higher levels of drilling activity. We've experienced these cycles several times over the past decade.

And as we've demonstrated exiting the quarter, we'll continue to align our capacity to match market activity levels. Moving ahead to Slide 9 on the balance sheet, third quarter ending debt, net of debt discounts and deferred financing cost was $589 million, cash at the end of the quarter was $41 million.

We have repaid another $25 million of debt on our term loan during the quarter consistent with our commitment to our capital allocation priorities, which includes funding our organic CapEx needs tied to our growth accelerators as well as reducing our leverage through debt reduction.

At September 30, Apergy's total leverage ratio was 2.0 times and our available liquidity was $285 million. Turning to Slide 10, due to the current market backdrop, we're providing a wider range for fourth quarter guidance and we'll also publish a mid-quarter update to our guidance in December.

For the fourth quarter of 2019, we expect consolidated revenue in the range of $255 million to $270 million and adjusted EBITDA in a range of $53 million to $63 million. The sequential declines in revenue and earnings are due to a further reduction in U.S.

drilling activity and associated customer destocking of polycrystalline diamond cutters for which we estimate an incremental $5 million impact in the fourth quarter. In addition, we anticipate continued delays in bearings deliveries due to spending discipline by our oilfield service customers.

On the production and automation technologies segment, while the portfolio is more resilient to fluctuations in E&P spending, we do expect an earlier start to E&P budget exhaustion relative to the prior year.

Finally, we also anticipate a charge of approximately $1 million, which is built into our guidance pertaining to legal expenses that we expect to incur in defense of our intellectual property portfolio.

We estimate that interest expense will be $9 million in the quarter and that our depreciation and amortization expense will be approximately $30 million. Our effective tax rate is expected to be in the range of 22% to 24% in the fourth quarter.

Our full year capital spending forecast continues to be approximately 2.5% of revenue for infrastructure related growth and maintenance plus an additional $10 million to $15 million for capital investment in surface equipment for our portfolio of ESP leased asset portfolio, which has revised down from our previous guidance of $15 million to $20 million as we scale back capital spending to match business activity and maintain our strong cash flow and return on investment.

For the full year of 2019, we estimate adjusted EBITDA to free cash flow conversion of approximately 45% to 50% and free cash flow as a percent of sales of approximately 10% to 11% with free cash flow being defined as cash from operating activities as capital expenditures.

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

Thank you, Jay. I would like to update you on our progress on the key growth initiatives for 2019 and beyond. On the ESP growth initiatives, in the third quarter, we generated our first revenue from ESP installations in the U.S. with one of the major international oil companies.

We have been awarded additional wealth with the customers and we are well on our way towards growing our share of wallet with this customer. We are also making progress on qualifying with other measures in the Permian basin.

With respect to the operational issue we experienced in Bakken in Q2, I'm pleased to report that we have completed the needed improvement and we are starting to see recovery in revenues as we exit the quarter. Our second growth initiative is focused on existing well conversions to Rod Lift as production declines. In spite of a difficult U.S.

onshore environment, for the 12 months ended September 30, 2019, we achieved a mid single-digit revenue increase in our Rod Lift product line in the U.S. We believe that our strong brand and the position we have in the market will enable us to continue 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 continuing to develop and deploy fit-for-purpose solutions designed to improve customer productivity and operational economics as well as growing our software related recurring revenue stream.

Our digital revenues grew 10% year-over-year in the quarter. During the quarter, we closed on the acquisition of a digital technology, which is strategic to our artificial lift portfolio.

We have continued to invest in developing smart edge hardware and artificial intelligence models that enhances our ability to predict failures, increase insights and prescribe corrective actions to our customers to improve their efficiency. Our fourth growth initiative is the continued innovation and advancement of our diamonds science of technology.

In the third quarter of 2019, our drilling technologies segments had 22 new patents issued, bringing the total issued patents since the beginning of 2008 to 785. We continued to preserve our investments in this area even during weaker market activity to expand our competitive and shared position.

Our final growth initiative is focused on driving continued adoption of our diamond bearings in downfall applications. Year-to-date revenue in this product line is up 34% compared to the first nine months of last year.

In the near term, due to capital discipline, many of our customers have pushed out their diamond bearing orders as they look to reduce spending in the current market environment.

Strong capital discipline by customers may slow the adoption from time to time, but given the compelling economic benefits of diamond bearings, we are confident we will continue to see adoption in the coming years.

Additionally, in the third quarter, we displayed our diamond bearings technology at the Water Environment Federation Annual Technical Exhibition in New Orleans as part of our efforts to diversify outside of oil and gas for the important technology.

Before I open the call for questions, I want to share another validation of our customer centric strategy. We achieved the highest net promoter score among artificial lift providers for the fourth consecutive year in an independent survey of over 300 qualified customer respondents conducted by Kimberlite.

For 2019, Apergy earned a net promoter score of 43% compared to the industry average of 24%. Our next closest competitors achieved 15%. Net promoter score is a measure of customer loyalty.

We believe this result is a validation of our customer centric strategy, and more importantly, the dedication and hard work of Apergy employees in improving the lives of our customers.

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

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

Good morning guys..

Good morning, Byron..

Good morning..

Yeah. Just as I look at production and automation technologies, I'm struck by the EBITDA margin improvement sequentially. And it sounds like some of that was a function of the cost reduction efforts that are already underway.

But Soma, could you speak to – was there a mix issue at play there as well?.

Yeah, so Byron, I would say that it's a combination of things. One is definitely the cost reduction had an impact, the mix was favorable, but the productivity improvements – as you know, we are continuously executing these productivity projects. And those productivity projects in the quarter yielded much higher than anticipated benefits.

So in our guidance going forward, we have normalized that back because we don't expect the mix, sometimes those productivity projects, the timing of when we get the benefit. So there was an impact of the productive – higher than normal productivity improvement as well..

Okay.

And then just in the context of the Q4 guidance while we're on that topic, could you just remind us, I realize that you guys are expecting earlier than normal maybe budget exhaustion from some of your customers, but could you just remind us of the seasonal elements within the production and automation technologies portfolio to be mindful of?.

Yeah, so the seasonal elements, because – when you think of our artificial lift, they tend to be mostly book and ship type product lines, very short cycle book and ship, pump shops and things like that, right. So, the seasonal aspect is the holiday period, the number of working days, the holiday period that affects us.

And second is the budget exhaustion by E&P that that affects us. And then lastly, we typically see lower absorption during – in our manufacturing plants during holiday period as well. And from time to time, we will also see weather impact whether it is in Bakken or sometimes even in Permian where the access to the well site can be restricted.

So from time to time we see that as well..

Okay, that's helpful. And thanks for that turret for drilling technologies. That's really helpful, historical context. I appreciate that. I'll turn it back..

Yes..

Our next question is from Dave Anderson of Barclays..

I also like that chart quite a bit of what Byron was just pointing out there. One thing as I was kind of noticing there is that if you look historically, it seems like the restocking tends to be kind of 2x the size of the destocking side.

Am I reading that right? And do you expect that same pattern to go – going forward here?.

Yeah, I think, Dave like you ask, and let me give you some more color on that, right, so – because this is really important, because this is the first time publicly we are going through this restocking – destocking, restocking cycles. So if you look at the data we provided, it's roughly about 60 quarters going back, right.

And out of the 60 quarters, there were only like 14 quarters where the variation sequentially had been within a 5%. Six of the 60 quarters had sequential declines, which are more than 20%. And alternatively, we have 12 quarters where the sequential increase had been more than 15% and five quarters where the sequential increase has been more than 25%.

So there are two occasions where there have been sequential decline in two consecutive quarters and that is Q1 2009, Q2 2009 and next one is Q1 2015 and Q2 2015. But if you look at the subsequent quarter following two sequential decline quarters has been a short recovery. So in Q3 of 2009, it went up 19% and in Q4 of 2009 it went up 53%.

And then when you look at Q3 of 2015 following Q1 and Q2 2015 of sequential decline, it went up 18%. Now if you look at that pattern, so we had a Q3 2019 decline. We are expecting a Q4 2019 decline. So two quarters of sequential decline. So if the historical pattern repeats, we anticipate Q1 or the first half to have a very sharp recovery.

And customer commentary to us particularly from their procurement departments, the customer commentaries has been that they are somewhat concerned that our ability to respond quicker because of the two quarters of destocking they've done. So what we are seeing right now is a level of destocking, we normally see during an industry downturn.

And I personally think that partly the function of the capital discipline by oilfield service companies and also the focus on cash flow generation of oilfield service companies. So they hope that the perspective helps.

And I think for us, we really think every time we have seen it that that recovery will be much sharper and we have a really well honed playbook. And we know how to respond to those recoveries and capitalize. And if you look at our historical performance, you will see that..

So one thing I'm kind of wondering about is your international business on here. We're obviously focused on the U.S. side, but you also have a pretty big international presence. Has that mix changed if -- what I'm looking at your historical numbers here and that chart has that mix of international versus U.S.

changed much? That could maybe – exacerbated this downturn a little bit more than we've seen in the past?.

Yes, I mean, that's an interesting observation, because if you plot the same thing with worldwide rig count, the rig count time series will look less volatile, right. But that doesn't change the volatility in the order rates. And that's partly because the major drill bit manufacturers, when there is a U.S.

decline, right, their focus becomes one of destocking, right. So the U.S. rig count tends to have a bigger impact on the destocking process than the international rig count..

Kind of a different question on your digital side on your lift business, obviously, it's a growth market for you. You're very optimistic on the prospects there. You made an acquisition during the quarter.

I know it's a small one, but could you just maybe just tell us what that brings to the table? And would you expect to be active in the M&A market as obviously -- there's a lot of kind of smaller start-ups out there that are going after some of this market.

I'm just curious kind of how you're approaching that market as you're thinking about that the next couple of years..

Yes. So going back to the digital acquisition, it's absolutely a very strategic acquisition for us. What we acquired is that downhole technology, gauge technology, which is integral part of our artificial lift.

So this provides the important information on the downhole pressure, temperature that helps us continue to provide monitoring and optimization capabilities to our customers. So this is a – if you kind of think of it’s a vertical integration of our optimization solutions.

With respect to M&A activity, we always look at through the lens of our top box performance, number one. And number two, given our capital priorities and clearly we are focused on deleveraging our balance sheet, so we always make that as a – keep that as a priority.

And then we are balancing that with smaller acquisitions as we have communicated before, which are mostly tend to be technological and geographical in nature for us. And you should expect us to continue to do that, balancing that with deleveraging the balance sheet..

Great, thank you, sir..

Our next question is from Ian MacPherson of Simmons..

Thanks. Good morning, guys. I wanted to ask about the pricing dynamics across those sides of your business. I know that on drilling technologies, you have a very strong and rational market structure there and I would not expect that you used to come to pricing, significant pricing pressure there, just maybe a comment on that side.

But then on PAT, I think when we've talked about this before, it's generally been yes, there – the refrain has been, yes, there is perennial pricing pressure on our products that we transcend those with our productivity gains and innovation and you see that in our margins.

I wanted to get a status check on that narrative as well, but also ask you if pricing pressure has accelerated, given the collapse in activity since September..

Yes, so on the drilling side pricing is not a major issue right now. And what we are seeing, we expressed in the Q2 call, is customers wanting to think about mid-tier cutter usage, and for us there is not a lot of margin difference between them, the two product lines.

On the PAT, I would say the pricing side, it's not a meaningful right now, because I think there is a recognition that that there has been quite a bit of pricing concessions that has played out in the market. And I think the capital discipline, generally the oilfield service companies are talking about are also being very constructive in that regard.

So I wouldn't say pricing pressure is accelerated or anything, it's been sequentially pretty much flat, I would say. There is no increased pricing pressure..

That's helpful, Soma. Thanks. And then, Jay, I was wondering if I could get a comment on your expectations for working capital in the fourth quarter, given the drawdown in your business. And if there is any either directional or specific comments you might have on that side..

Sure, Ian. We had a good quarter in Q3 in terms of managing down the receivables and drawing down inventory due to the lower activity levels and we expect to continue that momentum into Q4.

It may not be quite as strong as we achieved in Q3, but we do expect to continue our efforts around receivable collections, even in a tougher collection environment these days, because of capital discipline and then managing the inventory requirements for today's activity levels.

So we expect to manage, do some working capital contribution in cash flow in Q4..

Okay. Hey, thanks as always for a thoroughly detailed and illustrative presentation..

Thank you..

Thanks..

Our next question from Chase Mulvehill of Bank of America..

Hey. Good morning..

Good morning, Chase..

Hey, good morning, Soma. I guess first, just kind of stick on drilling technologies, and we think about margins here, what happened in the third quarter. They came in below what we were expecting, but could you maybe just talk about the impact on margins and split that between absorption and pricing.

You talked about taking some cost out towards the end of the quarter. So I am just trying to understand the impact of both of those on margins in the third quarter..

Yes, I think when you think about the third quarter, the steep decline contributed to that bigger decrementals, and we tend to preserve the capabilities around the technology investments, we pretend to preserve capabilities around – and capacity management, so that we can respond quicker.

Because as I've described we expect a sharper recovery and so we want to be in a position to be able to respond to that as well. So for us, I think the – that the bigger decrements are mostly driven by the lower volume. Jay, do you have any other color to that..

Yes. Chase, the pace of deterioration that Soma talked about coming out of Q2 into Q3, where we expected continued destocking and expected that to end near the end of Q3.

We saw actually quite the opposite, where the volume coming out of the quarter was a significant step down as destocking continued through September, and so we believe that will see a further impact of that in Q4, but hopefully we're coming closer to the end of that now..

And that's the reason. Okay. So I – we decided to do a update in December is because – it's not because that we are worried about something, it's more because of the uncertainty around the destocking, when it's going to end.

And we have seen some slight improvement in order rates in our Drilling Technologies business compared to how we exited September to the first couple of weeks into October. Now, we are not trying to say that that's a trend, which we, it's only two weeks. But, that's how it starts sometimes, right.

So that's the reason we wanted to make sure that in periods of uncertainty, we always believe internally we increase our communications and so we want to do the same externally as well so we'll see how that trend continues..

Okay, all right. I appreciate the color. Just one quick follow-up. If we think about E&P capital discipline and kind of the impact that it's having on production and automation.

Are you seeing any changes on how E&P has optimized lift and digital solutions, given that there is such an intense focus on capital discipline in – and returns these days?.

Yes. That the conversations are starting to increase around our digital solutions and we are encouraged by that. We are doing lot more proof of concepts with our customers. So we are definitely seeing that and the other aspect we are seeing, we are also seeing that even on our midstream customers, that the proof of concept continuously going up.

So, but what is interesting is also that the proof of concepts also take – they take a longer time than we originally thought. Customers want to try it for five months, six months before they make a solution on it. The good news is all of these, proof of concepts we are doing, they are all paid.

So which means that indicates the customers are serious about it, they are willing to invest in these test and trials. So, yes, absolutely, we are seeing a increased conversations on it..

Okay. All right. I'll turn it back over. Thanks, Soma..

And our next question from J. B. Lowe of Citi..

Hey. Good morning, Jay. Good morning, Soma..

Hey, good morning..

So looking forward to the mid-quarter update in December, but I wanted to ask you, real quick about 2020. Let's say that Jay is right and E&P spending in the U.S. is down, let's say high single-digits.

But then when you layer in your international growth through digital expansion maybe some bit restocking in Q1, maybe it's taking some shares with the IOCs.

What do you think 2020 top-line growth could look like – look like in that environment? And then when you add in your $20 million in annualized cost savings, what do you think incrementals could be in that scenario?.

So we are not going to give guidance on 2020 at this point, right. But directionally, let me tell you. So in our PAT segment, right, because of the growth initiatives and because of the efforts we are doing we should do better than the market, and I think we feel good about that.

We continue to demonstrate that even throughout this year, we have demonstrated that. So you should expect that. And on the drilling technology side, I think from – sequentially from current levels of activity, you should definitely see a meaningful improvement and as we have shown the historical patterns, we should see that.

Outside of that, I think in our bearings product line. I think we will definitely see improvements from current levels as we go into the next year, we should see that. So that's probably as much color I would like to give right now regarding 2020..

Okay, that's fine. Just a quick follow-up on the investment you guys made in Argentina. Was this more of a capacity investment or more of like a cost-out program, trying to lower costs on the manufacturing side.

Just a little bit more color there would be helpful?.

Yes. It's more investment to produce things locally for the South American market. So it's more a growth-oriented investment..

Okay. Thanks very much..

And our next question from Martin Malloy of Johnson Rice..

Good morning..

Good morning..

I just wanted to ask about the cost reduction initiatives, the $20 million annualized benefit.

When would that be fully realizing and can you give us a little more detail on what was in that?.

Yes. So I mean the way to think about it, Marty is obviously in any of these type of annualized savings, there is an element of structural savings and some variable saving, right, related to volume. So roughly, I would dimension that as about 50% of that $20 million is related to structural type savings.

And then the remaining 50% is more related to – the variable or volume type savings, which you would expect made a turn – at – thus the volume returns so that's how I would think about it. And in terms of just on that $10 million – of the $20 million, most of that actions have been completed as we speak.

There is few in and out that are still left but most of that actions have been completed as we speak..

Okay, and then my second question. And this relates to adding new customers on the ESP side.

But maybe could you give us an update in terms of the conversion of customers or that – the user ESPs to using your rod lift equipment and maybe how that's trending as you add new customers?.

Yes. So as we have said before, the customers don't buy artificial lift as a full lifecycle.

So which means just because you have the ESP installation doesn't automatically guarantee your rod lift conversion to it? But since every one of the ESPs we install goes down of our monitoring platforms, we have a better insights around that constantly providing consultations to our customers on the right time to convert it.

So like we have said in the past, two out of three times we tend to be successful getting the Rod Lift conversion associated with our ESPs..

Thank you..

And our next question is from Marc Bianchi of Cowen..

Thank you. I'd like to follow-up on the cost cutting first that we just discussed. Soma, you mentioned that pretty much all of the fixed portion has been implemented.

Did you actually realize that as well in the third quarter?.

No..

Okay..

Not in the third quarter, yes..

Okay. So we should expect it to....

Mostly toward the end of September, because September is when we saw the significant weakness set in. And so, this is mostly end of September, beginning October type actions. Yes..

Okay.

So the anticipation is you get a full quarter of it in the fourth quarter then?.

Yes. Probably two months of it. Yes..

Okay. Yes, I guess the reason I'm asking the question is, if I'm doing some of the math on the guidance here, kind of the midpoint of the revenue guide and the midpoint of the EBITDA guide still imply pretty hefty decremental margins in the fourth quarter. And I would think that the tailwind of costs – cost save there would offset some of that.

Could you perhaps provide some more commentary there?.

Yes. So the high decremental sequentially are related to few things, and let me talk about the ones that impact, and then what could potentially offset.

So the things that impact are typically, as I mentioned to you that's – the sequential decline in Drilling Technologies, which we have built into our guidance, definitely impacts that, right, because of the – what we are trying to preserve for being able to respond.

The second aspect of that is the lower manufacturing absorption, which I mentioned during holiday period. That would definitely – and we see that every year, we see that. So that also impacts that. And then the higher productivity, we saw in third quarter in our production and automation technologies. We are not planning that to repeat.

So when you think about a sequential, that has an impact as well. Now we are evaluating additional actions, as we, yes, we continue to work through our restructuring. So that could potentially offset the higher decrementals we have planned into the guidance. So that's a possibility.

I mean, we are focused on lowering that, but that's not how we've built our guidance right now. So there could be a potential to that.

And then the last piece, I would say is, I think Jay mentioned, if you recall – he mentioned the – we have built – we have also built in $1 million of legal costs to defend our intellectual property and this relates to our Drilling Technologies business. And so that also impact.

So in this period, I mean the Drilling Technologies is the highest decremental issue normally because of – as we are preserving those technical capabilities and resources..

Okay, that's very helpful. Perhaps on the revenue side, if you could talk a little bit about the – what's expected for the segments in fourth quarter. I would suspect that Drilling Tech has the larger decline. And I think you've already called out kind of a $5 million headwind from destocking.

I mean – I would presume that maybe we're talking about low double-digit declines in revenue for Drilling Tech, which would imply production, is maybe mid-to-low single-digits on the revenue side in the fourth quarter.

Is that how you guys see it?.

Jay, you want to answer that?.

Yes. So as you pointed out, Marc, we've already called the $5 million additional decremental from destocking, and then also there will be a continued impact of bearings push out as some of the oilfield service customers just can't take those bearings deliveries, because they're capital constrained on downhole tool development.

So it will be higher than the low double-digits that you just quoted for Drilling Technologies. And then for the....

A little bit higher than that..

A little big higher, yes. For the reasons Soma mentioned with weather, and the holiday schedule, and the number of shipping days in Q4, there will also be a sequential decline in artificial lift..

Okay, that's great. And then my last question just relates to the sort of restocking that you would anticipate in the beginning of 2020.

Does that occur or what might be the magnitude, if the rig count, it's just dead flat from here, because I think there is some anticipation from investors that maybe there really isn't a recovery and maybe it's not like prior periods.

But just maybe, more normalization of sort of the required levels of demand for inserts?.

Yes, I would say based on what we are seeing and what we are hearing from our customers. The current level is not sustainable, the level of destocking how deep – they have gone, right. So that's not sustainable. So coming out of it, I would expect that even if the rig count is flat.

In the past, the first quarter right out of – a deeper destocking, have been in the 18% to 20% sequential increase and if – and if you look at the quarter following that, it's been higher than the 18% to 20%, but that is because of the – as the rig count starts climbing up – the – so if you think of the rig count being flat, you can kind of think about how that can work.

I'm not going to put a number right now, but it's definitely going to be in double-digits..

Right, that's very helpful color. Thank you very much. I'll turn it back..

Thank you. And this concludes our question-and-answer session. We now turn the call back to Soma for closing remarks..

Thank you. Again, I want to thank all of our employees for their continued hard work during this challenging time. And thanks again for everyone for your continued interest in Apergy and we look forward to talking to you on the fourth quarter earnings call. Thank you..

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