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

Thomas Curran - B. Riley FBR John Watson - Simmons & Company Daniel Burke - Johnson Rice & Company.

Good morning. Welcome to the Archrock, Incorporated Second 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 Chief Executive Officer of Archrock; and Randy Guba, Interim Chief Financial Officer of Archrock. This morning, Archrock released its financial and operating results for the second 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 release 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 release 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's filings with the Securities and Exchange Commission, which are currently available at www.archrock.com.

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

For 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 Securities and Exchange Commission. I will now turn the call over to Brad to discuss Archrock's second quarter results and to provide an update of our business..

first, the transaction is simplified with corporate structure and structurally lowered our cost of capital resulting in improved returns for our capital investments; second, the transaction was deleveraging for our company and it accelerated the progress to our goal of achieving leverage below 4 times in 2020. Turning to the market, the U.S.

outlook for natural gas production remains robust. The EIA is forecasting an annual increase of 10% in 2018. Producer are focused on developing the United States vast natural resources, increasing amount of natural gas produced in the U.S. is associated with crude oil production.

Archrock has an extensive presence in place driven by associated gas, including the Permian, the SCOOP/STACK, the Eagle Ford, the Bakken, and the Niobrara. Natural gas demand is growing in both domestic and for markets. On the domestic front, demand we primarily supported by significant growth in power generation. As the U.S.

retires coal plants and switches to natural gas fired plants. While, we expect the U.S., to continue to face attractive demand in the domestic market. Demand outside the U.S. is supporting much of the production growth and it's expected to consumer even more of the United States' abundant supply of gas. By 2022, the U.S.

is forecasted to become the world's second largest exporter of natural gas, underpinning this level of exports in the growing base of LNG export facilities. To put it in perspective, the EIA forecasts that 2018 natural gas production will average about 81 billion cubic feet a day, compared to 74 billion cubic feet a day in 2017.

LNG terminals are currently providing export capacity for over 3 billion cubic feet a day and are forecasted to provide an additional 7 billion cubic feet a day in export capacity by 2020. In addition, natural gas exports to Mexico are also expected to grow. Now before I close, and with our simplification now completed.

I'd like to take a few minutes to discuss Archrock's market position, specifically who we are and where we fit in the broader energy value chain. Simply stated, we're in energy infrastructure company focused on compression services, primarily supporting midstream applications.

Four key characteristics that capture Archrock and our value proposition to our investors. First, we generate relatively stable cash flows, driven by compression business to provide mission critical equipment services for the production and transportation of natural gas.

And demand for our services is increasing driven by significant growth in natural gas production. Further the stability in our business is supported by the geographic diversity of our operating footprint as we service customer demand in all major U.S. shale plays.

The second defining characteristic of our Archrock is our focus on servicing the midstream segment. As I mentioned earlier about two-thirds of our fleet is large horsepower, which is mostly use just for midstream applications, primarily for natural gas gathering.

This strategy aligns our business and its results most closely with the production of natural gas, establishing and supporting a relatively stable - comparatively stable business model. Third is our focused on multiyear key based contracts with the diverse portfolio of high quality long-term customers.

Our unit average time on site is more than three years, demonstrating the stability in duration of our assets, once they're operating for a customer. Further, we service many blue-chip customers and have a broad base of over 600 contract compression customers across the major U.S. plays. And our relationships are deep rooted.

Our top 10 customers have worked with us for an average of approximately 15 years. Finally, as I discussed earlier, we are focused on returning capital to our investors, increasing long-term value through disciplined investments and growing dividend.

I believe this combination of attributes is high attractive and unique positioned us to profitably participate in the growing market and delivered value to our shareholders. We've accomplished a lot over the past several years and particularly over the last several quarters, and we are excited with how we're positioned and our path ahead.

Now I'd like to turn the call over to Randy for a review of our financial results..

Thanks, Brad. I'll start with the summary of results for the second quarter of 2018, and then I'll cover guidance for the third quarter. Archrock delivered solid second quarter results. We generated adjusted EBITDA of $85 million for the second quarter, an increase of 14% year-over-year and 5% sequentially.

Revenues were $227 million for the second quarter, up 15% compared to the second quarter of 2017 and 7% compared to the first quarter of 2018 driven by increased operating horsepower price increases and robust aftermarket services top line growth. Turning to our segments.

In contract operations revenue came in strong at $165 million in the second quarter, up 9% from the second quarter of 2017 and 3% from the first quarter of 2018.

On a sequential basis, little more than half of the top line growth in the quarter was driven by an increase in operating horsepower with the balance of the growth due to a mix of rate increases and freight revenue.

Gross margin percentage remained solid with second quarter margins of 59%, flat from a year ago and down slightly from the first quarter of 2018 and within our guidance range.

The slight decline sequentially is due to more maintenance activity on our units, so we are pleased overall with the field's performance of managing cost pressure and labor in parts. In aftermarket services, revenues of $61 million for the second quarter are up 31% from the second quarter of 2017 and 21% compared to the first quarter of 2018.

This is the strongest quarter of aftermarket services revenue, since the fourth quarter of 2014. Gross margin percentage of 17% remained solid in the quarter, up 200 basis points from the second quarter of 2017 and flat compared to the first quarter of 2018.

SG&A expenses were $27 million in the second quarter, down 3% compared to the first quarter levels. Second quarter SG&A benefited from lower compensation and bad debt expense.

In the second quarter, Archrock's growth capital expenditures totaled $45 million, which combined with the first quarter growth CapEx of $54 million, resulted in the first half growth CapEx of $99 million.

We remain on track with our full-year growth CapEx budget of $230 million to $250 million, as we continue to invest in new equipment to meet strong customer demand. Maintenance CapEx for the quarter was $13 million, about 18% higher than the first quarter levels.

Debt on a consolidated basis at the end of the second quarter was $1.5 billion, up $32 million from the first quarter levels. The increase in consolidated debt in the second quarter is primarily due to the continued investment in the fleet.

As Brad noted, we made strides in further reducing leverage with second quarter leverage of 4.9 times as compared to 5.2 times at the end of 2017, figured on a pro forma basis to the merger.

Our available but undrawn capacity on Archrock's revolving credit facility at the end of the second quarter totaled $288 million, while consolidated cash stood at $4 million. Archrock's second quarter dividend was $0.132 per share, a 10% increase from the first quarter.

The second quarter dividend amount of $17 million will be paid on August 14 to all shareholders of record on August 7. Archrock's cash available for dividend coverage was strong at 2.76 times for the second quarter.

Turning now to an outlook for the third quarter of 2018, in contract operations, we expect revenue of $166 million to $170 million, as we continue to benefit from increasing operating horsepower, combined with the price increases we implemented at the start of the year. We expect third quarter gross margin to be in the range of 58% to 60%.

For AMS, we expect revenue to total $50 million to $60 million with gross margin between 16% and 18%. On SG&A expenses, we expect $28 million to $29 million for the third quarter. Depreciation and amortization expense is expected to be in the mid-$40 million range with interest expense in the mid-$20 million range.

For full year 2018, we are reiterating our total CapEx guidance of $300 million to $320 million. Maintenance capital spending for 2018 is expected to be $45 million to $50 million, up $5 million from our prior guidance, but does not affect our full year total CapEx guidance.

Newbuild capital expenditures are expected to be $230 million to $250 million for the full year of 2018, unchanged from prior guidance as we continue to invest in high demand large horsepower units. We also expect the sale of equipment to raise roughly $30 million of proceeds for 2018, which supports our investment in new equipment.

Before I conclude, I want to remind everybody that beginning in the second quarter of 2018, we revised our adjusted EBITDA calculation to exclude non-cash stock based compensation. This change will put us more in line with how our peers report. And with that, we'd like to now open up the lines for questions.

Operator?.

Thank you. We'll now begin the question-and-answer session. [Operator Instructions] And our first question comes from Tom Curran from B. Riley. Please go ahead..

Good morning.

Can you hear me?.

Yeah, we can now. Good morning..

Oh, great.

I guess, I want to start, Brad, for contract operations, could you tell us for the larger horsepower class, where is pricing at this point relative to where a peak in the last up-cycle? And then, do you see the potential for to go on to actually set a new record high over the balance of this up-cycle?.

Sure. So the answer is, relative to the peak of the prior cycle on the largest horsepower pricing on a spot basis is back to those prior peak levels. And maybe increment more.

And we do see that pricing is likely to have more legs in future periods for us as we absorb cost, because what we are experiencing in the marketplace today with increasing labor, cost pressures, increasing parts price pressures as our vendors are also getting into the mode of increasing their pricing.

We do see that there is going to be a - but we need an opportunity for us to think about how we start with our customers through pricing in the future. But from a spot price basis, we're back to historic levels on large horsepower..

And that, you touched on inflationary pressures and the cost you're grabbling with, which I think provides a nice segue to margin.

Could you just provide some color around the key swing variables in your gross margin expectation and moving from 2Q to 3Q?.

Yeah, so we gave guidance on what we thought revenue and margins would look like. So behind that, guidance that Randy already gave, what we've seen in the field right now is inflationary pressure driven primarily by labor, some by parts and some by lube oil. Those are the categories where we see the pressure currently.

And we expect it to continue with labor, historically low unemployment rates, certainly across the country, but especially in the oilfield and parts of the areas where we all operate. But in the face of this cost pressure, I think it's important to just note, we have strong routines and initiatives in place to help mitigate.

And that includes solid preventative maintenance practices in the field, a very disciplined system to manage service quality balanced with the activity and maintain high uptime for our customers, but with efficient maintenance by us.

So the thing I'd point out is that, I'm actually really pleased with the current level of profitability at which we get to grow the business. And longer term, we're targeting maintaining this business in the 60% plus or minus level of gross margin.

We're on the lower side of that right as we're absorbing a lot of inflationary cost pressures, experiencing rapid growth and putting a lot of horsepower to work, but trying to keep this business in that range seems like a really key objective for us..

So, no change in expectation about your ability over time to hit that trend gross margin level of 60% then?.

Yeah, working in that 60% plus or minus on a quarter-over-quarter basis and year-over-year basis is where we're going to push this business..

Okay, great.

And then, last one for me, if we were to see AMS nicely surprised relative to your guidance ranges for both revenue and gross margin in 2Q, if we were to see it deliver upside again in 3Q, of the three main drivers you highlighted which you would expect to be the most likely source of that upside?.

Well, we've seen growth that's been fairly ratable or fairly even across the main buckets of AMS activity, the main categories of AMS activity. So they include and increase year-over-year and parts to support our customers' units, as well as field maintenance activities and overhauls.

So what we've seen is the spikiest growth in parts, but the other two categories have also been at a comparable level of growth even if parts is leading it..

Okay, great. I appreciate the answers. I'll turn it back..

Thanks..

And our next question comes from John Watson from Simmons & Company..

Good morning, guys..

Good morning..

A quick follow-up on AMS. I think we talked about last quarter, a change in how revenue would be recognized for that segment.

Did that contribute to the really strong quarter in 2Q?.

Incrementally, it did. But it was not the only driver, the real driver of this is increased activity in AMS as our customers are just requiring more support and more work on customer owned units. So it was an incremental contributor, but the biggest driver was activity based..

Sure. Okay, thanks for that, Brad. And then secondly, we've talked about gas lifts and that being an incremental source of demand for you guys, especially with all the associated gas coming out of places like the Permian.

When you are deploying new gas lift units, do you have any feel that it's because of a switch from other forms of artificial lift or if it's just new wells coming online, where customers have used gas lifts in the past and are continuing to use it?.

Thanks, John. I don't have a great breakout on that. I would tell you that based on what we see in the locations that include a lot of new installations that, it's a lot of new gas lifting added.

But I do know that several customers have switched away from alternative gas lift methods, ESPs, pump lifts in favor of compression, but I don't have a good catch from the volume of that..

Right, okay.

And then, lastly, the guidance for 3Q, is there any expectation that activity in the Permian potentially stalling that that might affect your business, is that baked into the guidance for the third quarter?.

Sure. So the direct answer is yeah, anything that we would have seen is baked into the guidance. But let me address the underlying point, and that is that we don't see the same risk of capacity constraints in our high quality customer base.

And we believe that in our discussions with our customers, that our customer base largely has access to committed capacity going forward. So we just don't see the risk materializing for us the way maybe some have asked or thought about it for other energy sector participants.

The other thing I'd point out is that even if that's the case, we really think that any flattening out or limitation on capacity is likely to be transitory. In longer term, the outlook for the play remains robust as capacity comes in. So we just don't see it the same way.

And part of this is just reinforcement of our market position, because we're leveraged to production, and with a very diverse high quality customer base..

Great answer. Thanks for that, Brad, and congrats on another strong quarter..

Right. Thanks, John..

[Operator Instructions] And our question comes from Daniel Burke from Johnson Rice..

Hey, guys, good morning..

Good morning..

Good morning..

So it looks like the growth CapEx spend this year is just a touch back-weighted.

And can we assume the same is the case for the new-builds you're delivering to the field this year?.

Yeah, we do expect, based upon the scheduling that we have that the CapEx spend is heavier in the back-half and the start activity also is expected to be heavier in the back-half and moving into 2019. That's a fair point Daniel.

The main thing I think that that expresses is just the market remains really strong and so we do expect to see good deployments against the record backlog going through the next two and certainly three quarters..

Okay. And then, Brad, I don't know to what extent lead times for your primary components remain extended at this point. But I would imagine you already internally thinking about a growth CapEx plan for 2019.

Is there anything you can share at this point about may be the scale of that program relative to the scale of the program you're sponsoring this year?.

Sure, the market remains strong. And, the pressure for our customers to grow and to deploy equipment remains at high levels. So although it's too early to really have capital talks with our customers that process will begin now as the budget season is beginning. And we're not giving any guidance on 2019.

I will say that if 2019 remains as opportunity rich as we've experienced - if 2019 is opportunity rich as we experienced in 2018, then the level of magnitude and opportunity for capital deployment will remain at a comparable level..

Okay. Great. And then, maybe just one last one, since we talked about kind of longer dated targeting or management of margins on the NACO side, when we look at the aftermarket business, I guess, historically in the last up-cycle challenges, we were staring at margins that embedded in international business as well.

And mix matters as well, parts versus services.

But is there ability to get that business closer to a 20% margin overtime with further topline growth?.

Long term, 20% is a target for us to push that business back toward. It is what we've achieved historically. And we'd like to see it move back. The offsetting pressure on that is that the parts business is an incrementally lower margin business in the overall mix and we're seeing that grow as well.

So as long as we can generate good profit on that very low overhead, parts business will accept those gross margin dollars even if it appears dilutive to the overall AMS business margin..

Okay.

And so, getting to that type of 20% target is contingent upon seeing a level of service activity that mirrors what you saw in the past cycle, is that then the conclusion?.

Yeah, yeah….

Okay.

How far away are we from that when we see a $60 million type top-line figure?.

Yeah, we will aim deliver a higher top-line figure..

Okay. All right, guys. I'll leave it there. Thank you..

Thanks, Daniel..

We have no further questions at this time. Now, I'll turn the call back over to Brad..

Thank you, everyone, for participating in our second quarter earnings call. Our focus at Archrock remains on strong execution, as we move forward within this fast growing market. We are strategically deploying capital in the high quality assets with attractive returns.

And our operations teams are working to efficiently and safely put our large horsepower to work. Our team is world-class and to our employees at Archrock, I'm grateful for your contributions and your ongoing success. Before I conclude, I would like to take a minute and thank Randy Guba for serving as our Interim CFO.

Randy has done a fantastic job shepherding the organization through this transition and we're grateful for his services. In a couple of weeks, Doug Aron will join Archrock as our new Chief Financial Officer. And we look forward to welcoming Doug onto the team at that time. I also look forward to updating you during our third quarter call.

Thanks, everyone..

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