Brad Childers - President & CEO David Miller - SVP & CFO.

Blake Hutchinson - Howard Weil Mike Urban - Deutsche Bank Andrew Burd - J.P. Morgan John Watson - Simmons & Company.

Good morning and welcome to the Archrock Incorporated and Archrock Partners LP Third Quarter 2016 Conference Call. Yesterday, Archrock and Archrock Partners released their results for the third quarter of 2016. If you have not received a copy, you can find the information on the Company's website at www.archrock.com.

During today's call, Archrock Incorporated may be referred to as Archrock or AROC and Archrock Partners as either Archrock Partners or APLP. Because APLP's financial results and position are consolidated into Archrock, any discussion of Archrock's financial results will include Archrock Partners unless otherwise noted.

I want to remind listeners that the news releases issued yesterday by Archrock and Archrock Partners, the Company's prepared remarks on the conference call and the related question-and-answer session include forward-looking statements.

These forward-looking statements include projections and expectations of the Company's performance and represent the Company's current beliefs. Various factors could cause results to differ materially from those projected in the forward-looking statements.

Information concerning the Risk Factors, challenges, and uncertainties that could cause actual results to differ materially from those in the forward-looking statements can be found in the Company's press releases as well as in the Archrock Annual Report on Form 10-K for the year-ended December 31, 2015 and Archrock Partners Annual Report on Form 10-K for the year-ended December 31, 2015 and those set forth from time to time in Archrock and Archrock Partners filings with the Securities and Exchange Commission which are currently available at www.archrock.com.

Except as required by law, the Companies expressly disclaims any intention or obligation to revise or update any forward-looking statements. In addition, our discussion today will include non-GAAP financial measures including EBITDA as adjusted gross margin, gross margin percentage, cash available for dividend, and distributable cash flow.

Reconciliations of our non-GAAP financial measures to our GAAP financial results please see today's press releases and our Form 8-K furnished to the SEC. Your host for this morning's call is Brad Childers, President and CEO of Archrock. I would now like to turn the call over to Mr. Childers. Please go ahead sir..

first, a debt-to-EBITDA ratio at Archrock Partners trending toward four times or lower; second, sustainable distributable cash flow coverage at Archrock Partners; and finally, adequate liquidity at Archrock Partners to support the growth opportunities ahead of us in the market.

We believe the drop-down transaction announced yesterday is an important step towards achieving these targets. Additionally, in the third quarter, we maintained our focus on reducing costs and capital expenditures across the board, including operating expenses, SG&A, and maintenance and growth capital expenditures.

And we will continue to evaluate alternatives to strengthen the financial position of Archrock Partners. We remain committed to maximizing our cash flow, protecting our liquidity, and solidifying our financial position.

These actions have helped us to navigate the current cycle and position Archrock and Archrock Partners to capitalize on growth opportunities that we expect will result from increasing demand for natural gas in the U.S. Now I would like to turn the call over to David for a review of both companies' financial results..

Thanks Brad. Let's look at a summary of third quarter results and then cover guidance for the fourth quarter. Starting with our operating segments, in contract operations, revenue came in at $157 million in the third quarter, down from $163 million in the second quarter.

In the third quarter, much like the second quarter roughly two-thirds of decline in revenue is related to the decline in operating horsepower and about one-third related to declines in pricing. Gross margin decreased modestly to 62% but continue to be solid as we maintain disciplined cost management.

Gross margin percentage was down sequentially about 200 basis points mostly due to competitive pricing and increased spending on equipment make-ready expense, parts, and labor in growth plays including the Permian.

In after-market services, revenues of $39 million for the third quarter decreased 5% compared to second quarter revenues of $41 million as customers continue to defer maintenance activities or perform typically outsourced work with internal resources. Gross margins remained unchanged at 17%.

SG&A expenses were $26 million in the third quarter, down 8% from the second quarter including about $1.3 million of benefits related to insurance and compensation accrual reversals. We are continuing to see the benefits of right-sizing activities and savings initiatives implemented during 2016.

During the third quarter, on a consolidated basis, we determine that approximately 60 idle compressor units totaling around 25,000 horsepower would be retired from the active fleet. As a result of the retirement of these units, we recorded $9.1 million long-lived asset impairment charge.

45 of these units were owned by the partnership and an impairment charge of $4.7 million was recorded at Archrock Partners. Additionally during the quarter, we reviewed the carrying value of units which have been called from our fleet in previous years and are available for sale.

Based on that review we took an additional impairment of $7.6 million at Archrock on a consolidated basis. Approximately $3.2 million of this amount was recorded at Archrock Partners. In the third quarter, we incurred $4.7 million in restructuring charges.

This cost primarily related to severance benefits and consulting fees incurred to reduce our cost structure. Of this amount, approximately $1.9 million was allocated to Archrock Partners.

In the third quarter, Archrock's growth capital expenditures were $19.5 million, up from second quarter levels of $9.3 million as we purchased new equipment in highly utilized categories to meet customer demand.

Maintenance CapEx for the quarter was $5 million, down from second quarter levels, as we continue to focus on tight capital management in all areas of the business.

As noted on our second quarter earnings release pursuant to the separation agreement entered into in connection with the spinoff, Exterran Corporation intends to contribute to us an amount equal to the remaining proceeds it receives from PDVSA relating to its previously nationalized Venezuelan assets.

In July 2016, Exterran Corporation received payments of $19.5 million from PDVSA and transferred cash to us equal to that amount. The same payment we disclosed in our second -- this is the same payment we disclosed in our second quarter earnings release.

As of September 30, 2016, PDVSA owes the remaining principal amount of approximately $37.5 million. We cannot predict when PDVSA will pay the remaining amount. Third quarter ending debt on a consolidated basis was $1.47 billion, down $91 million from second quarter 2016 levels.

On a de-consolidated basis, Archrock's third quarter 2016 debt balance was $101 million, down $51.5 million versus second quarter levels. Available but undrawn capacity on Archrock's revolving credit facility was around $240 million at September 30, 2016.

Cash distributions to be received by Archrock based on its limited partner and general partner interest in Archrock Partners are approximately $7.1 million for the third quarter of 2016 compared to the same level for second quarter 2016.

In the event that the drop-down closes, prior to Archrock Partners third quarter distribution record date, Archrock has agreed to waive third quarter distributions on the incremental LP and GP units received as consideration for the drop-down since Partners will not have owned the assets in Q3.

In connection with the drop-down, Archrock announced that it will increase its quarterly dividend by $0.025 per share to $0.12 beginning with the third quarter dividend. Archrock's $8.5 million quarterly dividend will be paid on November 17. Archrock's second quarter 2016 dividend was $6.7 million.

With this increase, Archrock's cash available for dividend coverage was approximately two times for the third quarter.

Turning to the financial results for the partnership, Archrock Partners third quarter EBITDA as adjusted was $68 million, down 5% as compared to $71 million in the second quarter of 2016 primarily driven by lower revenue partially offset by lower SG&A expense.

Net loss was $600,000 in the third quarter compared to net income of $3.3 million in the second quarter. Revenue for the third quarter was $135 million as compared to $140 million in the second quarter. The decline in revenue was primarily attributable to the full impact of Q2 operating horsepower decline and competitive pricing as already noted.

Revenue per average operating horsepower was $49.25 for the third quarter, down 1% compared to $49.75 in the second quarter. Cost of sales per average operating horsepower was $18.49 in the third quarter, up 6% compared to $17.52 in the second quarter 2016 as we deployed additional resources in the growth plays including the Permian.

Gross margins were solid at 62% in the third quarter but down from 65% in the second quarter 2016 for reasons noted previously. SG&A expenses for the third quarter were $18 million, a reduction of approximately 9% or $2 million compared to the second quarter 2016.

Distributable cash flow was $44 million in the third quarter of 2016, down from $47 million in the second quarter. Our distributable cash flow coverage remained very strong at 2.5 times in the third quarter compared to 2.7 times in the second quarter 2016.

Archrock Partners capital expenditures for the third quarter were approximately $18 million, consisting of $13 million for fleet growth capital, and $5 million for maintenance activities. On the balance sheet, Archrock Partners total debt decreased $40 million sequentially and stood at $1.37 billion as of September 30, 2016.

Available but undrawn debt capacity under Archrock Partners debt facilities at September 30 was approximately $274 million. As of September 30, 2016, Archrock Partners had a total leverage ratio which is covenant debt-to-EBITDA as adjusted as defined in the credit agreement of five times, up slightly from 4.9 times at the end of the second quarter.

As a reminder, our covenant maximum debt-to-EBITDA is 5.95 times through the end of 2017. Archrock Partners senior secured leverage ratio which is senior secured debt-to-EBITDA as adjusted as defined in the credit agreement was 2.5 times at September 30, 2016, as compared to 2.5 times at the end of the second quarter.

Leverage of the partnership continues to be a primary focus for Archrock and Archrock Partners as evidenced by our equity finance drop-down transactions. Now let's discuss Archrock guidance for the fourth quarter of 2016, which includes the consolidation of Archrock Partners results.

In contract operations, we expect revenue of $150 million to $155 million with gross margins in the 61% to 63% range. As Brad mentioned, we do not expect customer activities to change meaningfully in the fourth quarter. For AMS, we expect revenue of $37 million to $42 million with gross margins between 16% and 18%.

We believe our aftermarket services business will generally be in line with third quarter performance. On SG&A expenses, we're targeting $26 million to $27 million for the fourth quarter as we continue to focus on cost management.

Depreciation and amortization expense is expected to be in the low to mid $50 million range with interest expense of approximately $20 million. For 2016, total CapEx is expected to be in the range of $110 million to $120 million which lowers the top end of guidance provided on the second quarter call by $10 million.

Within our total CapEx outlook, we have increased our growth CapEx guidance for the year but that increase is offset by a decrease in expected total maintenance CapEx.

Maintenance capital spending for the year is expected to be $30 million to $35 million roughly 55% lower than 2015 levels and $10 million lower than our guidance on the second quarter call.

New build capital expenditures are expected to be in the $75 million to $85 million range for the full year 2016, which represents a 40% to 50% reduction from 2015 levels.

This is moderately higher than guidance in the prior quarter driven primarily by the award of projects from customers requiring equipment; that is in tight supply both in the market and in our fleet.

At Archrock Partners, we expect new build capital expenditures to be in the $45 million to $55 million range and maintenance capital expenditures in the $20 million to $25 million range.

As a final note before I open the call for questions, I want to mention that we're continuing with our audit committee, the process of determining the impact on our pre-spend historical financial statement of the previously disclosed investigation at Exterran Corporation and to certain accounting items related to its Belleli subsidiary.

As discussed last quarter, Exterran's Corporation results have been reported as income from discontinued operations net of tax, in Archrock's consolidated statement of operations was historical periods presented in Archrock's 2015 Annual Report on Form 10-K.

As a result of the ongoing process, we are again providing an operational update only in lieu of our typical earnings release for Archrock because we are not able at this time to provide financial information that would require a reconciliation to historical information that could be impacted by this process.

Our discussion of Archrock's financial results on this call took this limitation into account and we will not be filing Archrock's 10-Q today as we have traditionally done pending the outcome of this process.

As previously stated, Archrock Partners is not expected to be impacted by this process and we expect to file Archrock Partners 10-Q later today consistent with past practices. Since this process is ongoing we cannot comment further at this time.

I would like to assure you however that we and our counterparts of Exterran are working as diligently as possible to resolve this matter for both Archrock and Exterran. I will now turn the call back to the operator and open it up for questions..

Thank you. We will now begin the question-and-answer session. [Operator Instructions]. And our first question comes from Blake Hutchinson from Howard Weil. Blake your line is now open..

I guess first of all Brad, I wanted to make sure we're not mischaracterizing your outlook in the business although it was kind of sideways for 4Q, it sounded like as you look into the first half of the year unlike recent years where we had some customers go out and reconfigure fleet to the negative, you might actually see the reconfiguration trend to be a net positive to you, is that characterizing kind of your first half outlook correctly?.

Blake the reconfiguration thought is not the way, I would characterize it. So I want to say I'm not sure what to do with the reconfiguration characterization. But I can't -- I can't expand on what I'm trying to put into our outlook.

And that is that while for the near-term and that means Q4 it could be beyond Q4 because the market is just stabilizing and showing us signs of secular growth in the future, picking the point at which we see that actual turn is too hard to do.

So where we were at in providing the guidance for the market outlook that we provided is that while it does look like we had good activity in Q3, we expect that to continue into Q4 and beyond. What we're not seeing is yet that turn in the market or the timing of the turn with the great clarity that we would all like to see.

Another way of saying is that while we believe the market is stabilizing and nicely, we see an uptick in order discussions with our customers, which is good.

And looking out, we certainly see increases in production of natural gas ahead, we're not out of the woods yet I don't think the sector is out of the woods, so we saw some of the choppiness in the market even this week. So that's the way I would characterize what we are -- what we are looking at in the future..

Okay, that's fair and exactly what I was looking for. And then I guess as we -- as we look at the opportunity set on the new build side, clearly has gone up and you talked a little bit about the incremental adds mix shift towards gathering applications.

As we think about potential turn and all these adds, you have mentioned several times that obviously pricing is quite competitive.

At some point I guess stepping back given the mix predilection I guess for lack of better term, would you expect that the impact on margin from the incremental capacity you're putting back would be relatively seamless or at some point do we need to consider that as dilutive just because the new kind of pricing regime?.

When we move to a stronger growth mode, it will and we will incur mobilization expense both in the form of make-ready as well as mobilization into the field. We will incur those expenses ahead of revenue starting. And we believe that you will see that investments show up in incremental gross margin deterioration..

But yes, sorry --.

When we get to that point however we will be pretty happy to see that investment level of equipment going to work and going back into the field..

Okay.

And then just finally you noted a lower number of maintenance CapEx, I mean is that just a function of kind of lower average working horsepower throughout the year or have you post-separation kind of identified higher level of efficiency and distributable maintenance CapEx spending just like to hear about that?.

There are three contributors to that, lower level of maintenance CapEx. The first really is the one you cited and that is lower average working horsepower in the field.

We don't spend as much money in maintain -- we don't spend money maintaining that equipment although we do button it up and get it ready for to wait until it's -- it can go to work in the next job.

The second is that we actually have made structural improvements to the way that we manage our maintenance CapEx through a combination of both the centralization process for decision-making as well as better decision-making in how we approach the units in essence, we look at on a condition based hours run time approach with more discipline than we've been able to in the past whether and when that equipment is required to incur major maintenance fees.

And then third, it's the case that when you're reducing cost, we absolutely have tried to ensure that every dollar we spent, the dollar needed to be spent at that point and so there's a small amount, there is an amount of deferred maintenance that we believe is acceptable and wanted that in no way has impaired our performance in the field or the operation of the equipment.

So it's those three categories..

And our next question comes from Mike Urban from Deutsche Bank. Mike, your line is now open..

Wanted to follow-up on the cost question as well, you've done a great job of reducing cost overall, you just addressed the maintenance costs and I know there is always more you can do but have we seen the big decrements to your cost structure at this point kind of the structural changes you've obviously made some cyclical changes and may be some of that would I guess hopefully be temporary in terms of salary reductions and things like that hopefully a better time with that.

But are we most of the way through that process and it will be more incremental going forward or are there still some big kind of structural chunks that you can take out?.

I think that we're running in the 60%, low and mid 60% gross margin for this business and like businesses is a very good run rate. There are natural limitations on what you can achieve from a gross margin percent in the marketplace; among them is the competition, that's the competition both within our customer base as well as externally.

And so this is a very good run rate, while I am definitely in agreement that we never feel done with improving the operation. I do believe that the amount of profitability that we've achieved is testament to both maintaining revenue with customer pressure as well as reducing cost through grade operations.

So we're at a level where I do believe it's going to be incremental gains that will allow us to maintain margin and will improve margin going forward knowing that there will be headwinds in the form of both pricing, potential increases in commodity pricing because we've seen an uplift in commodity pricing that will obviously impact parts of our business going forward as well as in the labor category.

So I do believe that we're not turn up the flag, not calling quits, we believe there is more head but they are going to be incremental..

Got it.

And historically I think there has been a little bit of seasonality in your cost structure, I think kind of peaking in the warmer months longer daylight hour that kind of stuff, is that going to be the case this year or you're starting to see some of those headwinds creep in Q4, Q1?.

We have a couple of times of the year where operating activities are driven by environmental and ambient conditions more than at other times of the year.

We experienced that primarily in some of the peaky hot summer months in the South in particular and we experienced it in some of the very cold months primarily in the North and that does generate incremental operating activity around how we maintain the equipment.

And so we will experience some of that but for the fourth quarter we did take that into account in our guidance..

Okay, got it. And then last one from me looks like you did experience a little bit of additional pricing pressure in the quarter.

And what are you seeing I guess at the leading edge on average presumably it continued to come down, are you seeing any stabilization on the pricing front or is that still continuing to come down at the leading edge?.

So Mike we always look forward to the pricing discussion especially any forward pricing talk with a bit of caution. So it's not an area that we go to specifically.

But generally what I would share with you is that when we look at the industry across the board there is definitely excess capacity in the market, our utilization which is at 79% right now on the total fleet reflects incremental capacity that needs to go back to work.

And as long as we see utilization below the low-to-mid-80s I believe we and the industry will continue to experience price pressure in those categories that are underutilized and we will continue to see some pricing aggressiveness to put that equipment back to work until utilization kicks back up..

And our next question comes from Andrew Burd from J.P. Morgan. Andrew, your line is now open..

Hi good morning.

Perhaps if you could just walk us through a little bit more the drop-down decision, was it purely because you view APLP units are so cheap or is there something else either offensive or defensive that might have driven the timing decision on that?.

No, it's Brad. Let me take a cut at this question. The real issue that we wanted to focus on and we have been focused on is primarily bolstering APLP's combination of leverage and liquidity, at this time as well as the execution of our longer term strategy of transferring horsepower from Archrock to Archrock Partners over time.

And the timing of this is really driven by those two factors and that's what we start to do.

I do think that we were encouraged by some of the increasing in the price that we've seen and the valuation and yield on APLP over the last several months and that was a factor that allowed us to want to proceed at this time and at the same time, it was a supportive transaction from AROC to APLP from a value perspective and for the benefit of Archrock, we also don't get the benefit of what we think are well priced APLP units especially given the robust distribution coverage that we have at Archrock Partners..

No, no that's helpful.

And just a follow-up on kind of the characterization of the assets being dropped down, I appreciate the color that was provided in the press release but anything you can offer in terms of utilization of those assets contractual coverage any region or anything would be helpful there?.

So the assets are basically like a cross section of our overall asset base. As far as utilization we only dropped down 100% utilized assets. So the assets 150,000 horsepower is all utilized and it's slightly larger than the average size -- than the overall average of our fleet but only slightly larger.

And so I think when if you -- when you're really trying to model it out I think these issues Archrock Partners financial metrics and apply them to horsepower and you get pretty close to where we are at..

Okay.

And kind of taking that or also using the words from the press release of the kind of immediate accretion that's expected, is it fair to say that the drop-down multiple is probably below where APLP is trading right now?.

Yes..

And our next question comes from John Watson from Simmons & Company. John, your line is now open..

As a follow-up onto Mike questions, Brad once utilization does reach may be high 80s percentage, what units and in which basins you expect pricing improve in those quickly or may be said another way on what types of units and in which basins is there the most excess capacity at the moment?.

Sure. So let me address the basins first.

We've seen and we believe will continue to see customer capital funding growth and expanding production capacity more aggressively in the Permian, in the SCOOP and STACK in the Mid-Continent, in the Niobrara, in the Marcellus Utica ahead of other plays although other plays will also have some potential for growth.

So that's why I think that capital goes back to work first and puts the most up the largest opportunities for growth ahead in our business.

From an equipment type perspective, we still see even though utilization is in the 79% for us and I think that's somewhat reflective of the overall market in that range from an equipment perspective there is still fair amount of tightness in certain categories especially larger horsepower units, so that would be the 1,400 horsepower size and above and there are also some mid-range in the six and 800 horsepower range units we also see a little bit of tightness.

But we see still excess capacity at smaller horsepower ranges and in some categories of equipment that's slightly larger but coming out of the dry gas plays, so that it's been, it's older model for example of the 1,200 horsepower type units.

So that's what we expect to see the tightness first in the market, that's where we're seeing some of the tightness now from a play perspective and it's in the larger horsepower where we expect to see the tightness in the equipment type..

Okay, great.

And then an unrelated one also follow-up to one of Mike's questions, are their cost cuts that have been made over the past few quarters that you think might not be sticky when that -- when the market does turn and we don't know when that inflexion point is, but any thoughts there?.

Overall the thought is we've made reductions that have permanently improved our structure operationally and financially that we absolutely intend to leverage going forward. So a lot of what we've done, we intend to make sure and govern tightly to make it permanent.

And that said when you're in a declining market of course you take out costs ahead of the decline and you reduce costs that you would otherwise need to invest and incur whether they're at the CapEx level or at the SG&A level or OpEx, when the market returns to growth going forward.

So the main point is good structural improvement that we're going to leverage going forward but of course there are some costs and investments that we will need to incur in the growth market, you don't have to incur in declining market..

Right.

And then last one from me on the aftermarket side, what are some catalysts that you think might cause customers to stop deferring maintenance?.

The primary drivers around, I think their decision-making on AMS and it's a complicated market related to maintaining their own workforces and the demands on their equipment.

So any downturn everybody wants to maintain their workforce as best they can and that means they'll turn their attention on more maintenance activities at the expense of outsource providers. When they get busy thinking of that growth those same resources focus elsewhere and they need the outsource provider more.

And second like all businesses they rationalize hard their decision making around maintenance expense. And once the upturn comes, they're going to have to get back to maintaining the equipment at a different spin level than they have.

So I believe that as we see the industry picking up that that naturally will occur, that's what we have experienced in the past..

We have no further questions at this time. I would like to turn the call over back to Mr. Childers..

Great. Thank you everyone for joining our third quarter conference call and we look forward to talking to you again with our fourth quarter results next year. Thank you..

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