Paul Burkhart – Vice President-Finance Brad Childers – President and Chief Executive Officer Randy Guba – Interim Chief Financial Officer.

Blake Hutchinson – Scotia Howard Weil Andrew Burd – JP Morgan John Watson – Simmons & Company.

Good morning. Welcome to the Archrock, Incorporated First Quarter 2018 Conference Call. Your host for this morning's call is Paul Burkhart, Vice President of Finance at Archrock. I will now turn the call over to Mr. Burkhart. You may begin..

Thank you, Adrian. Good morning, everyone. With me today are Brad Childers, President and CEO of Archrock; and Randy Guba, Interim CFO of Archrock. Today, Archrock released its results for the first quarter of 2018. 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. I want to remind listeners that the news releases issued today by Archrock, 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 statement 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, 2017 and those set forth from time to time in Archrock and Archrock filings with the Securities and Exchange Commission, which are currently available at www.archrock.com.

Except as required by law, the company expressly disclaim 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 net loss attributable to Archrock's stockholders, excluding certain item.

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

Thank you, Paul. I'm excited to share that 2018 is off to a great start. Archrock achieved strong operating performance in the first quarter on both revenue and profitability, and we increased the operating horsepower and achieved a record backlog of contracting fresh new orders.

The strong market outlook continues to support high levels of new bookings and forecasted increases in U.S. natural gas production will serve as a foundation for continued expansion beyond 2018. Let me share some highlights.

In the first quarter, our contract operations revenue increased by 3% sequentially to $161 million, with strong contract operations gross margin. For the fourth consecutive quarter, we increased operating horsepower, adding 60,000 in the quarter. We continue to book new orders at record levels and at improved pricing, positioning us well into 2019.

We closed the merger of Archrock and Archrock Partners, further strengthening our financial platform to propel our next leg of growth. And we started the deleveraging process, ending the quarter with a debt-to-EBITDA ratio of 5.0 times pro forma for the merger. Now turning to our operations.

Our sales team continues to convert customer demand into profitable contract operations bookings, with the strongest demand from the Permian and the SCOOP/STACK, Niobrara and the Eagle Ford.

As a result of this strong demand and excellent customer service, our sales team again secured contract operations bookings at historically high levels and at pricing levels that were higher than in the previous quarter.

Of the strong 3% sequential increase in contract operations revenue, roughly half is attributable to higher operating horsepower and the other half is attributable to rate increases on the operating fleet.

We implemented a price increase on the eligible portion of the operating fleet in the first quarter, and we expect to realize additional price increases on our operating fleet throughout 2018. In the field, our operations teams continue to cost effectively deliver industry-leading safety performance and equipment runtimes to our customers.

And we posted strong gross margin performance, despite weather related operational challenges early in the quarter. Our team remains laser focused on quickly and economically starting new units for customers, so we can convert our sizable backlog into revenues.

The aftermarket service segment had a solid quarter during what is typically a seasonally slower quarter. This segment is expanding its customers catch up on deferred maintenance. With strong demand for our aftermarket products and services, we started implementing price increases during the first quarter.

Now I'd like to turn to the market and outlook for our businesses. A robust natural gas production forecast serves as the foundation of Archrock's growth. The compression business is highly correlated to natural gas production. And the EIA is forecasting that U.S.

natural gas production will be 7.5 bcf a day higher in 2018 than it was in 2017, with additional growth throughout at least 2022.

The United States have significant amounts of affordable and accessible natural gas due to the technologies that have unlocked the abundant reserves in our shale plays in both dry gas as well as associated gas in more oil and liquids prone plays, such as in the Permian and the SCOOP/STACK.

This abundance of natural gas is expected to give natural gas prices range bound and stable for the next decade. And we believe it will continue to support increasing use of natural gas for power and as a feedstock for petrochemical use. In power, we see increasing demand in LNG, U.S.

power plants and exports to Mexico, with LNG being the largest driver of this demand. By the end of 2022, analysts anticipate that the U.S. will have five operational terminals, averaging 8 bcf a day of LNG exports. In sum, the strong supply demand fundamentals for natural gas production make this an exciting time to be in the compression business.

The increasing demand for our services is demonstrated via contract operations utilization, which ended the first quarter at 86%, an increase of 1% from the fourth quarter of 2017. On units greater than 1,000 horsepower per unit, our utilization was 89% at the end of the first quarter as compared to 87% at the end of the fourth quarter.

And on all three stage units, which are typically the best technical solution for most current growth plays, our utilization was at 91% at the end of the first quarter.

While the market for large horsepower tightens, we're also experiencing a recovery in the small horsepower market due to increased completion rates driving single well gas lift opportunities. As a result, our utilization for units under of 1,000 horsepower ended the first quarter at 80%, a 2% improvement over a year ago. Based on the U.S.

natural gas production forecast and our customers expanding production plans, we are revising our full year growth CapEx guidance upward by $30 million to a range of $230 million to $250 million for 2018.

The $30 million incremental increase in growth CapEx from our prior guidance will be used to meet customer demand in growth plays with large horsepower units. We expect to fund the additional CapEx with internal funding sources.

And we expect our net cash consumed by the increase in growth CapEx to be negligible as we are targeting proceeds of $30 million from the disposal of assets in 2018, $15 million of which occurred in the first quarter. Now let me turn to our financial strategy. Our current financial strategy has three priorities.

The first one I want to highlight is our priority to capture the organic growth opportunities generated by the market and to do so with internal funding sources. During this period of rapid market expansion, we're working to balance an abundant and attractive opportunity set with investors demands for capital discipline and return of capital.

We're selecting investments that provide attractive returns and that will fulfill market demand in the long term with enhanced shareholder value. The second priority, I want to discuss is our objective to reduce leverage. Our goal is to reduce leverage to below four times debt to EBITDA, and we're targeting reaching this goal in 2020.

In the first quarter, our trailing four-quarter EBITDA increased for the first time since the market began its recovery. The inflection point reached in the first quarter is an important step to allow for organic deleveraging. And we ended the quarter with a debt to EBITDA ratio 5.0 times pro forma for the merger.

As we roll in future quarters of improving EBITDA, we expect to continue to deliver. Finally, we're committed to returning capital to our investors. Having closed the merger early in the second quarter, we intend to recommend to the Archrock Board of Directors, a 10% increase in the annual dividend rate beginning with the second quarter dividend.

This is an acceleration of our initial plan, which was to recommend an increase in the first full quarter following the merger closing. That would have been the third quarter. Thereafter, we're targeting a 10% to 15% annual increase in the dividend through 2020. This leads me to the merger of Archrock and Archrock Partners, which closed in April.

The merger clearly supports our long term strategy and financial objectives, and Archrock's shareholders and Archrock Partners unitholders strongly supported the transaction. Our simplified structure strengthens our financial profile and enhances our ability to execute on our strategic growth plans.

It accelerates our deleveraging and allows us to invest additional retained cash flow into the business to take advantage of the robust market we're currently seeing. In addition, the transaction broadens our access to capital and reduces our cost of capital. The long-term outlook for Archrock is robust.

Our strategy is to provide exceptional service to our customers, with high quality compression assets in growing natural gas producing basins across the United States. Our focus in 2018 will be in putting our sizable backlog to work, operating efficiently and capturing profitable new opportunities with customers.

We will also continue to invest in our fleets, our processes, technology and our great employees. I'm confident we can meet increased demand from our customers and drive returns for our stockholders. Now I'd like to turn the call over to Randy for a review of our financial results..

Thanks, Brad. Let's look at a summary of first quarter 2018 results and then cover guidance for the second quarter of 2018. Archrock delivered solid first quarter results. We generated EBITDA as adjusted of $79 million for the first quarter compared to $72 million in the fourth quarter.

Revenues were $212 million for the first quarter, up about 1% compared to fourth quarter levels, as we increased revenue in our contract operations business. Turning to our segments.

In contract operations, revenue came in strong at $161 million in the first quarter, up 3% from $156 million in the fourth quarter, due to higher operating horsepower and rate increases. Gross margin percentage in the first quarter increased to 60% from 59% in the fourth quarter. Our expense per horsepower ticked down 1.8% in the quarter.

Improvement in our contract operations margin in the quarter is attributable to U.S. GAAP revenue recognition changes that we implemented on January 1, 2018, as required. Prior to its adoption, revenue and expenses related to mobilization and freight on our units was recognized as incurred.

Starting January 1, 2018, this segment is recognizing these items over the average contract term. In aftermarket services, revenues of $51 million for the first quarter are down 3% sequentially from $53 million in the fourth quarter. This is primarily due to the first quarter being a typically seasonally slower quarter.

Gross margin percentage was up 50 basis points sequentially. As the energy market expansion unfolds, we will be working to drive gross margin percentage higher in this business. Similar to contract operations, our aftermarket services segment was also affected by the U.S. GAAP revenue recognition changes implemented in the beginning of the year.

Prior to its adoption, revenue and expenses for our aftermarket services segment was recognized when completed, starting January 1, this segment is recognizing revenue and expense over time. SG&A expenses were $28 million in the first quarter, down 7% compared to fourth quarter 2017 levels.

First quarter SG&A benefited from lower compensation and benefit costs as well as lower bad debt expenses. During the first quarter, we determined that approximately 45 idle compressor units, totaling approximately 22,000 horsepower, would be retired from active fleet.

As a result of the retirement of these units, we recorded a $5 million asset impairment charge. In the first quarter, Archrock's growth capital expenditures were $54 million in line with the fourth quarter, as we continued to invest in new equipment to meet strong customer demand.

Maintenance CapEx for the quarter was $11 million, similar to fourth quarter levels. First quarter ending debt on a consolidated basis was a $1.4 billion, up approximately $10 million from the fourth quarter levels. First quarter consolidated cash was $4 million.

The increase in consolidated debt in Q1 is primarily due to continued investment in our fleet. We started the deleveraging process in the first quarter, reducing our leverage to 5.0 times on a pro forma basis for the merger. Our available but undrawn capacity on our revolving credit facility was $282 million on a pro forma basis for the merger.

Archrock's first quarter dividend was $0.12 per share, unchanged from the fourth quarter. The first quarter dividend amount of $16 million will be paid on May 15, to all shareholders of record on May 8, which will include all of the Archrock shares issued as part of the Archrock merger with Archrock Partners that closed in April.

Archrock cash available for dividend coverage was a strong 2.9 times for the first quarter. Now before we move to guidance, I'd like to take a moment to discuss the change we will be making to our EBITDA as adjusted calculation.

Beginning for our results of the second quarter of 2018, we will exclude non-cash equity compensation from our EBITDA as adjusted calculation. Excluding this expense from the first quarter 2018 results would have resulted in an approximately $2 million additional EBITDA as adjusted.

Excluding this expense from 2017 results would have resulted in an approximately $8 million additional EBITDA as adjusted. This change would put us more in line with our peers from a comparable reporting perspective.

However, it should be noted that the change will not affect our credit facility leverage as this expense is already excluded from the calculation. Now let's discuss Archrock's guidance for the second quarter of 2018.

In contract operations, we expect revenue of $162 million to $166 million as we continue to benefit from increasing operating horsepower as well as a price increase we implemented at the beginning of 2018. We expect gross margins in the 59% to 61% range. For AMS, we expect revenue of $48 million to $52 million, with gross margin between 15% and 17%.

On SG&A expenses, we expect $28 million to $29 million in the second quarter. Depreciation and amortization expense is expected to be in the mid $40 million range with interest expense in the low $20 million range. For our full year 2018, we expect total CapEx of $300 million to $320 million.

As Brad mentioned, this is an increase in $30 million for additional newbuild capital to support the strong market we're experiencing. Maintenance capital spending for 2018 is expected to be $40 million to $45 million, consistent with our prior guidance.

Newbuild capital expenditures are expected to be $230 million to $250 million for the full year of 2018, as we continue to invest in our high demand, large horsepower units. As Brad mentioned, this is an increase of $30 million and is expected to have a negligible effect on our net cash position due to targeted asset sales of $30 million.

I will now turn the call back to the operator and open it up for questions..

[Operator Instructions] And our first question comes from Blake Hutchinson from Scotia Howard Weil. Please go ahead..

Good morning. Brad, I guess, kind of following on the discussion of the opportunities sets that's out there, requiring a bit of a aggressive capital spend and balancing that with your goals of leverage reduction.

Can you just talk, in terms of giving us comfort on this capital outlays, the typical initial terms you're seeing in terms of length of contract for the equipment you're currently adding.

And has that increased with the bookings increasing? And also maybe speak to the typical life span of initial contract in the field? Just to give us an idea of what the cash flow stream or the more secure portion of the cash flow stream, I guess, would look like for some of these units going out there?.

Sure. So just a couple of thoughts on it and let me answer the question. The utilization that we're seeing the fleet right now and in the marketplace, the point I wanted to make sure that was clear, is that three stage units, which are the units that are in demand right now, are at 91% utilization in our fleet.

Like we discussed in the past, 90% to 91% utilization in a category like that is the highest we've experienced as a company, full stock, which means that the market, and everybody's experiencing this, needs equipment. So that's a starting position.

Second issue for us is that we did make the decision in the quarter and executed in the quarter to exit one market that was nonstrategic to us, that's California, which generated some CapEx and generated some cash inflows.

We also had some purchases by customers sometimes through repurchase option and otherwise just through discussions with customers, that we think are aggregating some CapEx. And so we saw this in the quarter and we saw this happening in the business, our plan is to redeploy that cash per units.

So the comment I made that we expect this to have a negligible impact on our net cash position for the year is one we meant for those reasons. Now to go the question you asked also, in terms of definitely expanded on large horsepower, we're typically seeing terms that are in the three- to four-year category for large horsepower.

And the rates are excellent. And what I'll point out also though is that, beyond the primary term, these units, typically, specially large horsepower, tend to stay out substantially longer beyond the initial term and get renewed at very high rates.

So we're very comfortable, we like the investment opportunities that we're seeing right now, which I know the market is trying to understand. But with an amount of gas that is being produced and expected to be produced, we see this as great long-term growth opportunities, generating great returns for our investors..

And then I guess on the flip side, the cost structure or at least the implied cost per horsepower that we're looking at for the quarter, quite a step down from kind of averages that last year, for a quarter that we usually think about being kind of rich with mobilizations.

I mean, is there something new in terms of less friction in the business, more seamless process in terms of putting equipment to work? Or are you just kind of getting some advantages of scale as you add to the fleet here?.

Well, it's two things. One thing I'd out is that our level of start mobilization and make-ready activity remain at elevated levels and at levels comparable Q4 to Q1.

The biggest impact to the quarterly performance is what Randy described and that is that we will required to adopt an accounting policy change that is going to differ and amortize into future periods more of that installation, mobilization and transportation cost.

And so the quarter had a pickup due in large part to that accounting convention that we're required to adopt. I think that's the biggest impact you're seeing for the quarter.

But one thing that I want to emphasize is that, on top of that, we had a very good operational quarter, especially in the face of extreme – with some extreme weather challenges earlier in the quarter. We continued to have make-ready expenses at elevated rates, which impacted both the CapEx and the OpEx. And it's a tough labor market out there.

So we still are contending with wage and compensation expense challenges as is everybody wants to do the right job in bringing in the talent and retaining the talent required to grow the aggressive growth rates to market so wanting us to support right now..

Great. Thanks for the time. I’ll turn it back..

And our next question comes from Andrew Burd from JP Morgan. Please go ahead..

Hi, thank you, nice quarter. So my first question is in the context of the recently completed merger with AROC, and now you're probably better classified as an operating company versus a holding company, previously.

So the question is, in your opinion, is AROC a midstream company or an oil field services company? And based on that answer, how are you viewing financial priorities based on your perceived investor base? For example, if you're catering for midstream investors or are you focused on distributable cash flow and dividends? Versus maybe oilfield services investors, who are less familiar with seeing free cash flow yield and leverage where they are.

So any color on how your thoughts may have changed given the new structure?.

Yes. Totally fair question. As we're looking to the future of Archrock as an operating company, we note that the operations and assets that we continue to operate have not changed substantially, rather than the envelope we are going to be focusing with our investors and targeting the right investment market in the operations that we have.

We note that 60% to 80% of our business is gas gathering, either at the wellhead or in some sort of gathering stations, which is very much a midstream operation. The other 20-plus percent, approximately 23% to 24% currently, is Gas Lift, which is directly tied to production and critically not to drilling and completion activities.

Our contract terms are longer than typical oil and gas service businesses. And the capital investment that we've – and the capital we deploy is typically longer lived. So what we see is that we primarily are right now a C corp that has very good cash flow generate – stable through the cycle, cash flow generating assets.

It's probably more comparable to the midstream space than it is in the oil and gas servicing space. So that's the way we're going to be talking to our investors and thinking about how our investors want to see return of capital and growth balanced from us going forward..

That's a great answer. And housekeeping question. On the revenue guidance for next quarter, quite a modest uplift seem to have given the capital deployed in the first quarter and rising utilization and pricing trends.

Is there any asset sale factored into that revenue guidance or not?.

It's not material..

Okay..

No material asset sales factored into that..

Okay. On the asset sales, if you could just expand on because, obviously, it's been a larger number over the last two quarters and it sounds like you have a bit of visibility on some continued asset sales over the course of the year.

Can you – if there are kind of chunky portions of that asset sale bucket, can you just kind of talk to what those assets look like? Are they utilized, are they unutilized, are they in a particular region? Maybe an anecdote or two would be helpful as we kind of frame what's leaving the fleet?.

Yes. So let me talk first about first – fourth quarter 2017, and then I'll talk about first quarter 2018. And then an idea of what our expectations are for this activity going forward. In the fourth quarter of 2017, we had a pretty substantial transaction, where we sold equipment that we had previously already culled out of our feet.

So not only was it not operating horsepower, it was no longer a part of the fleet that we were seeking to redeploy. And so we had one large – relatively large transaction for horsepower that we no longer want to invest in try to operate or try to put back to work, we sold back to the used equipment market in one sizable transaction.

This is an important priority for us. We're focused on continuing to standardize and improve the competitiveness of our fleet longer term. And we've seen the process of addressing some of these more experienced veteran – these veteran units of our fleet as an important part of our process, as important as in – what we invest in.

So that was all idle, not operated and actually not even in the fleet. In Q1, we have one substantial transaction, the biggest part of the cell, was we exited our California contract operations business. It's a non-growth market, it's not a strategic market. We had a small amount of horsepower in that market. Its' equipment that we do not move well.

We don't want to pull it out and move it to another market. And the customer was very minimal to taking over the operation of that equipment. So those are two examples, the two anecdotes as requested.

And again, I think it's important to note that this reflects our continuing focus on improving the quality and competitiveness of our fleet as well as it generates some cash that we can redeploy. On a go-forward basis, right now, I candidly don't see sizable transactions available to us in 2018.

And what we will continue to do, however, is need to meet purchase option exercises where customers have those. That's a very small portion of the fleet, typically. And we will also continue to try and sell and monetize assets that we no longer want to use or compete with. But it should be smaller numbers compared to the last – compared to Q4 and Q1..

Great. Thanks very much..

[Operator Instructions] And our next question comes from John Watson from Simmons & Company. Please go ahead..

Brad, I apologize if I missed this. But with the increased CapEx – the increased growth CapEx budget for 2018, is there an update on how much horsepower you expect to build for the year? I think previously, the number was 250,000 horsepower. But correct me if I'm mistaken..

Yes. That number's a little low. I think that, that would relate to a spend rate of a couple of hundred million, would be $250 million. What I'll tell you – what I'd share with you is that based on both what we spent in 2017 and what we're spending in 2018, we expect delivery of about 330,000 horsepower in 2018.

And another thing that's really important is that about 85% of that is committed to customers. So this – the horsepower that we're bringing in has just a huge backlog of commits to support a level of spend we're engaging in..

Very helpful. Thank you for that. The release talks about your record contract ops backlog, which is exciting to hear.

Can you break down for us the portion of that you expect to be filled by some of this new horsepower you're ordering versus units that are currently in the fleet?.

Yes. The way we look at that, about – and I think I've said that in the past, is that we expect about 60% of our starts in 2018 to come out of existing fleet assets and 40% to be – to apply new our horsepower..

And do you expect that to be consistent in 2019, since you're expecting part of that backlog to go well into next year?.

No. I expect that the portion – if the market continues at its current pace, this very rapid and aggressive growth we're experiencing, we are not going to have the same level of idle fleet capacity to meet that same ratio.

So we believe that as we get – as utilization continues to tick up, that this level of growth will require more newbuild horsepower in the future. But I also note that what we – we haven't really seen what customers are going to demand fully for 2019. And so it's a little too early to fully date what 2019 is going to look like yet..

Sure. Sure. I appreciate the color nonetheless. On pricing, you talked about pricing being higher than in previous quarters on the Q4 call, we talked about spot pricing improving by roughly 20% year-over-year.

Is it safe to assume that pricings move higher than that range of quoted on last quarter's call? Or am I thinking about that the wrong way?.

Easy answer is yes. Spot pricing is yet higher, it was higher in the first quarter and currently, than it was when I made that comment in respect to the fourth quarter.

The correction on kind of – clarification I want to offer you is, that really relates to the large horsepower that we're putting out, the greater than 1,000 horsepower units that are going out. It's not an across-the-board 20%. In smaller and midrange horsepower, the pricing differential compared to the larger, smaller..

Great. One last one for me.

Could you quantify what percentage of your idle fleets are three stage units?.

I don't have that on the top of my head. I'll share with you, it's – the vast bulk of the fleet is three-stage. But with apologies, John, I just don't have that. I don't have that handy..

No worries at all. Thanks for the color. I appreciate it..

Yes. Thank you..

And this concludes our question-and-answer session. I'll turn the call back over to Brad for final remarks..

Thank you, operator. And thank you, everyone for participating in our first quarter call this morning. I'd reiterate, the market outlook for our business continues to remain very robust, and we look forward to describing our performance for the second quarter in our next quarterly call. Thank you very much..

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