Good morning, and welcome to the Archrock and Archrock Partners Third Quarter 2017 Conference Call. Your host for this morning's call is David Skipper, Director, Investor Relations and Treasurer of Archrock. I will now turn the call over to Mr. Skipper. You may begin. .

Thank you, operator. Good morning, everyone. With me today are Brad Childers, President and CEO of Archrock; and David Miller, CFO of Archrock. Today, Archrock and Archrock Partners released their results for the third quarter of 2017. 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, Inc. may be referred to as Archrock or AROC, and Archrock Partners L.P. 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 today by Archrock and Archrock Partners, the company's prepared remarks on this 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 Archrock's annual report on Form 10-K for the year ended December 31, 2016, and Archrock Partners' annual report on Form 10-K for the year ended December 31, 2016, and those set forth from time to time in Archrock's 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 disclaimed 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, distributable cash flow and net loss from continuing operations attributable to Archrock's stockholders, excluding certain items.

For reconciliations of our non-GAAP financial measures to our GAAP financial results, please see today's press releases and our Form 8-K's furnished to the SEC. I will now turn the call over to Brad to discuss Archrock's third quarter results. .

Thank you, David. Archrock's horsepower growth accelerated in the third quarter and the company is positioned to capture improving earnings from the long-term secular growth of U.S. natural gas production as well as the current cyclical recovery in our business.

We drove record new orders in contract operations and are excited about our growth opportunities as the cycle unfolds. In the third quarter, our contract operations revenue increased by 2% sequentially to $154 million.

We increased our operating horsepower by 86,000 horsepower, and notably, 36,000 of this growth was with -- was at Archrock and represents about a 14% sequential increase in operating horsepower at Archrock. .

We drove new orders at the highest quarterly rate on record, setting the foundation for a strong 2018. For the second consecutive quarter, we were able to move prices higher on horsepower booked in the quarter compared to the previous quarter.

And we completed a $60 million equity offering at Archrock Partners, which both strengthened our capital position and partially funded our growth CapEx. .

Turning to our operations. New orders during the quarter continued to be impressive. Our sales team once again capitalized on surging customer activity levels and delivered a record quarter for new orders. We believe that our strong book of new orders this year will enable us to drive top line growth in the fourth quarter and into 2018.

Now from a play perspective, new orders were strong in growth plays where Archrock has a large operating presence, including the Permian, the Niobrara, the Eagle Ford and in the SCOOP STACK.

Demand for large horsepower units continues to be robust, and we believe the utilization for large horsepower units across the industry is significantly higher than for midsized and small horsepower units.

With the largest fleet of high-demand, large horsepower units and the greatest liquidity among the outsourced compression providers, Archrock is well positioned to benefit from the continued demand for large horsepower units through both our existing fleet and continued investment in new units. .

In contract operations, cost of sales was up about $10 million sequentially. $2 million of the increase was due to the incremental costs associated with increased revenue and operating horsepower growth that we delivered in the quarter and higher lube oil prices. The other $8 million was split about evenly between 2 categories.

The first half was due to higher medical and workers' compensation claim expenses as well as the receipt of late lube oil invoices due to a vendor billing issue. The lube oil vendor billing issues are behind us, and by their nature, medical and workers' compensation claims can be volatile.

The other half was driven by costs required to support our robust horsepower growth in the quarter. Our teams worked more hours to make units ready and start up horsepower, and we incurred the initial field costs of lube oil tanks on new starts.

Although costs were elevated in the third quarter, I'm confident in our ability to improve gross margin percentage performance sharply over the next 2 to 3 quarters.

In addition, I believe that the investments that we're making in both equipment and personnel are necessary to propel our business forward during the upturn as well as provide our customers with exceptional service. .

Stepping back and putting our quarterly results in a broader context, Archrock is now at an inflection point in the current cycle.

The horsepower declines and pricing pressure we experienced in 2016 and through early 2017 are now producing bottom of the cycle results in our financial performance, while at the same time, the steepness of the current recovery is requiring significant investment in both operating expense and capital expenditures to fund our growth.

And candidly, some of the costs we're incurring are the result of operating as lean as possible through the downturn and now shifting to a steeper-than-expected incline in the growth cycle. During the next few quarters, we will work to improve management of the cost of growth.

We're confident that Archrock will navigate this period, capture the growth ahead and restore profitability. .

On the SG&A line, we incurred $1 million in corporate office relocation costs for a recent move of our company headquarters. This move was part of our overall profitability improvement efforts and will result in ongoing cost savings for Archrock, as the lease expense in our new facilities is less than that of our former headquarters facility. .

In aftermarket services, revenues were down about $3 million or 5% from second quarter levels, primarily due to lower field service revenue. The AMS business again experienced more volatility in revenue due to the timing of large jobs.

During the quarter, gross margins in this business decreased sequentially to 13% from 15%, primarily due to lower revenues on our fixed cost base. As we move into 2018, we will regain operating leverage in the AMS business as the cycle expands. .

Turning to the partnership. In the third quarter, operating horsepower growth was robust at 50,000 horsepower. Increased costs due to the higher start activity carried through to the partnership. Distributable cash coverage was about 1.5x. During the quarter, we issued 4.6 million common units for net proceeds of $60 million.

The equity offering strengthened APLP's balance sheet as well as partially funded our growth CapEx. Leverage of the partnership remained flat sequentially at 5.1x debt to EBITDA. APLP's leverage continues to be a primary focus for Archrock, and we're committed to bringing it down over time. .

Now I'd like to turn to the market and outlook for our businesses. As highlighted already, demand for compression again accelerated in the third quarter. The effect of the continuing elevated levels of market demand are increased utilization, increased pricing and the expectation of continued horsepower growth.

Each of these will translate into improved revenue, earnings and cash flow. The 86,000-horsepower increase in operating horsepower in the third quarter drove improvement utilization to 83% from 81% sequentially and from 79% at the end of the year-ago quarter.

We see our OR and overall market utilization in the high 80s to 90% for large horsepower, in the low to mid-80% range for our midsize horsepower, and in the high 70s to low 80% range for small horsepower. .

Turning to pricing. As already noted, with a record quarter for new orders, we were able to continue to move prices up on new bookings for the second consecutive quarter.

With utilization expected to continue to improve based on our robust backlog of pending starts, continuing current strong customer demand and an outlet for growth, I believe we will be able to move prices higher in 2018 and begin to reclaim some of the price deterioration we experienced in the downturn as well as to offset the increasing costs that we're incurring at this stage of the growth cycle, as I highlighted earlier.

Combined with our efforts to improve costs as we normalize operating in this growth phase of the cycle, I believe we will be able to improve gross margin as the benefit of higher prices also begins to roll into our financial performance in coming quarters..

Looking out further, we continue to be excited about the outlook for longer-term growth in our compression business. And our enthusiasm for our business is supported by the market expectation of growing U.S. natural gas production. The EIA forecasts U.S. 2018 natural gas production growth of 3 Bcf a day compared to the 1 Bcf a day forecasted for 2017.

Additionally, over the summer, Cheniere commenced LNG shipments on Train 3 at it's Sabine Pass facility. And recently, Cheniere substantially completed Train 4 at Sabine Pass, with shipments starting early next year. .

As we have stated consistently, we believe our business is in an excellent position to participate in and capitalize on the secular growth drivers that are expected to increase natural gas production by between 15% and 20% through 2021, and likely more beyond that.

In the coming years, we believe the significantly improved quantities, accessibility and price stability of natural gas in the U.S. will continue to drive higher levels of demand for LNG export, pipeline exports to Mexico, power generation and use as a petrochem feedstock.

We believe that growth in natural gas production to meet this demand will lead to significant increases in demand for compression services. Our strategy is, and will continue to be, to provide excellent service to our customers with high-quality compression assets in growing natural gas-producing basins across the U.S.

We've modernized our fleets, built the largest fleet of in-demand large horsepower equipment in the market, invested in technology to improve our service delivery model, implemented systematic improvements to our field maintenance practices and standardized processes across our organization.

We're navigating the inflection point in the current growth cycle and intend to leverage our access to capital, our solid customer relationships, our unmatched service presence in every growing U.S. natural gas producing basin and our excellent service teams to drive shareholder returns. .

Finally, let me turn to our financial strategy. As we've stated, in order to begin growing our dividend and distribution, we need to see a path to achieving debt to EBITDA at Archrock Partners trending toward a ratio of 4x or lower.

Although I'm not providing guidance on the timing of a dividend or distribution increase, we still expect that in the first quarter 2018, our trailing 12 month EBITDA will begin to increase and contribute to deleveraging at Archrock Partners. Now I'd 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 2017 results and then cover guidance for the fourth quarter. Archrock grew operating horsepower by 86,000 in Q3 of 2017, driven by both higher start and lower stop activity in the quarter.

This is the second quarter of horsepower growth in our contract compression business as we enter into a cyclical recovery. In the third quarter, Archrock generated EBITDA as adjusted of $62 million, including other income of $3 million, compared to $72 million in the second quarter, which included $1 million of other income.

Revenue was $198 million for the third quarter, flat with second quarter levels, as higher contract operations revenue was offset by lower AMS revenue. .

Turning to our segments. In contract operations, revenue came in strong at $154 million in the third quarter, up from $151 million in the second quarter, primarily driven by higher operating horsepower. Gross margin percentage in the third quarter decreased to 53% from 59% in the second quarter as our cost of sales was up $10 million sequentially.

As Brad discussed, the increase in costs was due to higher medical and workers' compensation expenses and the receipt of late lube oil invoices due to a vendor billing issue as well as higher expenses due to elevated start activities and higher operating horsepower levels.

In aftermarket services, revenues of $44 million for the third quarter decreased $3 million sequentially from $47 million in the second quarter. This was primarily due to lower field service revenues in the quarter.

Gross margin percentage was down 200 basis points from 13% to 15% from -- to 13% from 15%, primarily due to lower revenue on our fixed cost base in the quarter. .

SG&A expenses were $29 million in the third quarter, up about $4 million compared to the second quarter 2017 levels.

This delta was driven primarily by $1.3 million of costs incurred for our corporate office relocation and higher bad debt expense in Q3, while Q2 included a benefit from lower compensation expenses that was not repeated in the third quarter.

During the third quarter, on a consolidated basis, we determined that approximately 50 idle compressor units, totaling approximately 20,000 horsepower, would be retired from the active fleet. As a result of the retirement of these units, we recorded a $6 million long-lived asset impairment charge.

45 units, or approximately 18,000 horsepower, were owned by the partnership, and an impairment charge of $5 million was recorded at Archrock Partners. .

In the third quarter, Archrock's growth capital expenditures were $40 million, down from $56 million in the second quarter as we continued to invest in new equipment to meet strong customer demand. Maintenance CapEx for the quarter was $9 million, flat with second quarter levels.

Third quarter ending debt on a consolidated basis was $1.39 billion, down approximately $50 million from second quarter levels. The reduction in consolidated debt is primarily due to Archrock Partners' $60 million equity offering in the third quarter. On a deconsolidated basis, Archrock's third quarter 2017 debt balance was $76 million.

Archrock's parent-level leverage ratio, which is debt to adjusted EBITDA as defined in our credit agreement, was 1.4x at September 30, 2017, and available but undrawn capacity on Archrock's revolving credit facility was approximately $156 million.

Cash distributions to be received by Archrock based on its limited partner and general partner interests in Archrock Partners were approximately $8.7 million in the third quarter, flat with Q2 levels. Archrock's third quarter dividend was $0.12 per share, unchanged from the second quarter.

The third quarter dividend amount of $8.5 million will be paid on November 15. Archrock's cash available for dividend coverage was 0.9x for the third quarter. Lower EBITDA in the quarter reduced cash available for dividend from second quarter levels. We're comfortable carrying slightly lower coverage at Archrock while our business ramps up. .

Turning to financial results for the partnership, Archrock Partners' third quarter EBITDA as adjusted was $60 million, down from $67 million in the second quarter, primarily due to higher costs incurred in the quarter.

Revenue for the third quarter was $140 million, up approximately $2 million from the second quarter, primarily driven by higher operating horsepower levels. Gross margin percentage was 55% in the third quarter, down from 61% in the second quarter. Again, this was due to higher costs incurred in the quarter, as we've discussed.

SG&A expenses for the third quarter were $21 million, up approximately $2 million from the second quarter, primarily due to a benefit from lower compensation expenses in the second quarter that was not repeated in the third quarter and higher bad debt expense in Q3.

Distributable cash flow was $30 million in the third quarter, down from $39 million in the second quarter, primarily due to lower EBITDA in the quarter. APLP's distributable cash flow coverage was 1.5x in the third quarter, down from about 2x in the second quarter.

APLP's capital expenditures for the third quarter were approximately $44 million, consisting of $37 million for fleet growth capital and $7 million for maintenance activities. .

On the balance sheet, Archrock Partners' total debt decreased $60 million sequentially and stood at $1.3 billion as of September 30, 2017. Available, but undrawn, debt capacity under Archrock Partners' debt facilities was $214 million.

And Archrock Partners had a total leverage ratio, which is covenant debt to EBITDA as adjusted, of 5.1x, flat with second quarter levels. Archrock Partners' senior secured leverage ratio, which is senior secured debt to EBITDA as adjusted, was 2.4x at September 30, 2017, as compared to 2.6x at the end of the second quarter.

Leverage at the partnership continues to be a primary focus for Archrock Partners. .

Now let's discuss Archrock guidance for the fourth quarter of 2017, which includes the consolidation of Archrock Partners results. In contract operations, we expect revenue of $154 million to $158 million as we continue to benefit from increasing operating horsepower. We expect gross margins in the 56% to 58% range.

This is above our Q3 performance level, as we believe some of the costs in Q3 will not carry into Q4, and we will increase our focus on managing our costs during this growth phase. This level is slightly below prior guidance as we believe accelerated growth will continue to put some pressure on margins.

For AMS, we expect revenue of $40 million to $45 million, with gross margins between 14% and 16%, as Q4 is typically a little slower quarter for our AMS business. On SG&A expenses, we expect $27 million to $28 million for the fourth quarter.

Depreciation and amortization expense is expected to be in the high $40-million range, with interest expense in the low $20 million range. For full year 2017, we're lowering our total CapEx guidance slightly to approximately $225 million as we expect to finish the year below our previous guidance.

Maintenance capital spending for the year is now expected to be approximately $35 million, at the low end of our previous guidance range. New build capital expenditures are expected to be approximately $175 million for '17, again, at the low end of our guidance range.

Finally, at Archrock Partners, we expect new build capital to be approximately $150 million and maintenance CapEx to be approximately $30 million. With that, I'll turn the call back over to the operator and open it up for questions. .

[Operator Instructions] Our first question comes from Andrew Burd from JPMorgan. .

Two questions. The first one, great to hear about the record new orders.

At this point, how many idle units does Archrock have to deploy towards most of those new orders versus buying new units? And then, I guess, the follow-on to that is, do you see CapEx higher or lower in 2018 versus '17?.

Sure. Thanks, Andy. The first point, from a starts perspective, in Q3, we saw our start activity at about 70% from the fleets and a little less than 30% from new build. It's a ratio we actually like to see. We have plenty of idle units in the fleet at lower horsepower, and increasingly, it tightens at mid-horsepower.

And in the large horsepower portion of our fleet, candidly, we are at the position of needing to build new. And that's where the bulk of our CapEx is going. In fact, 90% of our CapEx being spent right now is going toward large units.

So I hope that gives you a feel without going into the exact number of units but what we think we have to do from a how to deploy and where our CapEx is going perspective. .

And our next question comes from Blake Hutchinson from Howard Weil. .

Just to give us a feel, as a follow-on to that question, how much of the growth CapEx that you've outlined for 2017 has actually showed up in the field already?.

Interesting question. We probably can't give an exact number. But it's going to be, through Q3, clearly greater than -- about 50% of it is going to be the right ratio. We still had a lot of it that was targeted for later in the year, which is why it's not greater than 50%. It's not exactly proportionate spend throughout the year; it ramped up.

So I'm going to give you the opinion that it will validate and follow-up. But it's going to be around 50% of it is deployed currently.

The other thing I'll throw out is that we're real happy about is the cycle time on when we have a unit that hits kind of ready to go and to the time that we get to get it in the field and started in billing is less than 40 days right now. So we're seeing a real good cycle time on getting that CapEx to work for us. .

And what would a normal cycle time be?.

It's a fair question. Longer. .

Excellent. I guess I'll switch over because you're very forthcoming with regard to your kind of thoughts on pricing here.

But even as leading edge improves, we've got a full fleet that is still probably in the midst of winding down a little, has some downward to sideways inertia that you have to arrest before we can actually see it hit the income statement.

Just so we're exercising an abundance of caution, I mean, do we need to think about maybe midyear '18 for the fleet as a whole starting to gain pricing traction that we'll see?.

Fair characterization, and I understand the question. The short answer is going to be, with power, yes. That's not to dictate exactly the timing of how we plan to move pricing, but rather as to when it can start showing up more visibly in the financial statements. It does take time to work through.

And we have a large portion of the fleet that's been contracted recently, and so that's not available for pricing to move. We have a portion of the fleet that's with alliance agreements, where those are longer-term pricing mechanisms. And so I think your overall hypothesis is very responsible.

And what I would add to that is that if we think about the downturn in thinking about our business, what I want people to see, and it's very visible in the way our financial performance rolls out right now, is that at the peak of the prior cycle, if you have high pricing, high utilization and responsible cost-management in margins, when the downturn hits, utilization comes down, followed by spending comes down, followed by pricing comes down.

And as we're getting started, we're at that the real bottom and nadir from an overall financial performance. And what happens first is spending has to move, utilization has to move and then pricing.

So not only are we delayed from the industry, as we've always discussed, by 6 to 9 months, but we also have somewhat of a whiplash effect in that we have to move spending and utilization before pricing moves based upon the industry dynamic that we see and experience in compression. .

Great. And then, I guess, within your kind of cost-side discussion or cost of goods sold discussion for compression operations, I didn't hear a lot with regard to just kind of pure inflationary pressure.

Are there some onetime items, some frictional costs? I mean, is that stable to manageable and so we don't have to necessarily consider that coming out of left field on us? Or where do we stand just in terms of inflationary pressures?.

Yes, it's not going to come out of left field. There are inflationary pressures. We did see inflation impact on lube oil pricing in the quarter.

We are experiencing some inflationary pressures that are more annualized but -- in our cost of equipment and cost of parts, and we're definitely going to see some cost pressure in compensation and labor as the market tightens, and the labor market especially is getting tightened at a few of the growth plays.

So those are the pressures we definitely are experiencing in the market right now. But they're not going to be kind of violent appearances. They will be gradual cost pressures and headwinds that we're going to have to both manage and offset with some effort. .

And our next question comes from Jerry [ Zhu ] from Citi. .

Just a quick, kind of, couple of few questions. Just staying within the same train of thought in terms of the first few, I guess -- considered through the first few [ pennies ] of spending. Based off of what you said before, there's a contract, and I think based on what you guys said in the previous calls.

Would you say that the contract length, on average, has gone down a bit or is staying around same? Just Because I know you guys mentioned something around the lines of stronger pricing power moving forward. .

Yes. Thanks. You're right. We did see during the downturn the average contract length reduce-- contract length reduce, and we're at definitely a shorter contract length right now, and part of that does help us with pricing going forward, especially where it's contract pricing that's not also subject to kind of alliance pricing management.

So that's true. And the other thing I want to point out, too, is that even though we've reduced our contract length, we have not seen a reduction into the average time that our services stay on location, which remains in that between 3- and 4-year period of time.

So we really are talking about the contracting length that impacts pricing more than we're talking about the contracting length that impacts the time of service at a location. .

Our last question comes from John Watson from Simmons. .

A quick one on your active horsepower.

Is any of it working on huff-and-puff jobs? Are you planning to build any fleets designed for huff-and-puff work? Or is that not something Archrock is interested in?.

John, you're catching us a touch flat-footed.

What's a huff and puff job?.

Well, I think it's a colloquial term for enhanced oil recovery using a larger compressor for enhanced oil recovery. .

So we have -- okay, thank you. Interesting expression. We'll talk to the operating team as to why we're not hearing that. So we have about 21% to 22% of our fleet currently on Gas Lift, which is more about the hydrostatic pressure in the well bore than it is about enhanced oil recovery on the reservoir itself.

We do have and are hearing about some applications right now that a lot of the producers are exploring to use more gas, actual EOR, that is injection of gas into the reservoir for enhanced oil recovery. We haven't seen a lot of activity for the -- for our fleet in that application yet.

But we do know that producers are looking at that hard, and that could be a an expected future application. Then finally, we do have some of our services, probably as much AMS, but also we have seen the application of some our -- some compression in the form of CO2, where CO2 floods occur. Also not a big part of what -- of our business historically.

So that's the thought I have for you on where we apply compression for EOR. Primarily, it's Gas Lift in the well bore more than to date it has been for pressure in the reservoir. .

There are no further questions at this time. .

Okay. Operator, thanks very much. And thank you, everyone, for joining us for this Q3 call. We look forward to talking to you again when we have our results for Q4. Thanks very much. .

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