Good morning. Welcome to the Archrock Third Quarter 2019 Conference Call. Your host for this morning's call is Paul Burkhart, Treasurer and Vice President of Investor Relations at Archrock. I will now turn the call over to Mr. Burkhart. You may begin, Mr. Burkhart. .

Thank you, Jerry. Hello everyone and thanks for joining us on today's call. With me today are Brad Childers, President and Chief Executive Officer of Archrock; and Doug Aron, Chief Financial Officer of Archrock. Yesterday, Archrock released its financial and operating results for the third quarter of 2019.

If you have not received a copy, you can find the information on the company's website at www.archrock.com.

During this call, we will make forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934 based on our current beliefs and expectations as well as assumptions made by and information currently available to Archrock's management team.

Although management believes that the expectations reflected in such forward-looking statements are reasonable, they can give no assurance that such expectations will prove to be correct.

Please refer to our latest filings with the SEC for a list of factors that may cause actual results to differ materially from those in the forward-looking statements made during this call.

In addition our discussion today will reference certain non-GAAP financial measures including adjusted EBITDA, gross margin, gross margin percentage, and cash available for dividend. For reconciliations of these non-GAAP financial measures to our GAAP financial results, please see yesterday's press release and our Form 8-K furnished to the SEC.

I'll now turn the call over to Brad to discuss Archrock's third quarter results and to provide an update of our business..

First, to meet the needs of our customer base by investing in high return large horsepower compression equipment. The growth we delivered in our operating horsepower and financial performance demonstrated how well we’ve been able to meet this objective. Second, leverage reduction. We're on track to reduce our leverage to below 4 times in 2020.

Our current leverage ratio stands at 4.3 times, a reduction of about 1 turn from year-end 2017. As we now expect our 2020 growth CapEx to be less than $125 million combined with our continuing profitability improvement, we believe we are well positioned to achieve our 2020 leverage reduction target. Third, capital return.

We're delivering on our promise to provide an ongoing and growing return to our shareholders through the payment of the quarterly dividend. We increased the dividend by 10% in each of the second quarters of 2018 and 2019 and we’re committed to growing the dividend by another 10% to 15% by the end of 2020.

And significantly, the successful execution of our strategy has put us in a position to generate positive free cash flow in 2020. Over the long-term were committed to positioning and managing this business to generate positive free cash flow.

Finally, as we began working with our customers to understand their plans and needs for next year, let me share with you what are we focused on for 2020 and beyond. First and foremost we will continue to work diligently to meet the needs of our customers safely every day. As we do so we're committed to delivering the highest levels of service quality.

To accomplish this, our employees have worked and will work tirelessly to hydrate every part of our business. This is meant investing in a competitive compression fleet which has continued to grow the categories of large horsepower equipment that is most in demand and the high growth place today.

Since 2010 our large horsepower equipment as a percentage of our operating fleet has increased from approximately 55% to 74% today.

We remain just as committed to investing in the technology, systems and operating platform equipments that will continue to drive superior service for our customers as well as continuing profitability and returns for our investors.

Together with the improvements we've made to our fleet, the improvements we have made to our operating platform were substantial contributor to profit improvement that we driven into this business, elevating our contract operations gross margins from 51% in 2010 to 62% in the most recent quarter.

Looking into 2020, these efforts to high-grade our fleet, invest in technology and high-grade our operations and our profitability will continue and support our commitment to deliver on our capital allocation objectives, including delivering free cash flow in 2020.

Now, I would like to turn the call over to Doug for a more detailed review of our third quarter performance. .

Great. Thanks Brad and thanks to all of you for joining us this morning. Archrock reported another period of solid operational and financial results. Revenue for the third quarter totaled $245 million, an increase of 5% compared to the prior year period.

Our adjusted EBITDA of $112 million this quarter is $22.5 million or 25% higher than the third quarter of 2018 and was driven primarily by higher operating horsepower and improved pricing. As Brad noted the third quarter results include $7 million in gains related to the sale of compression assets to Harvest Midstream and others.

Net income for the third quarter of 2019 was $20 million, double the $10 million reported in the third quarter of 2018. Turning to our business segments, in contract operations, revenue improved for the 10th consecutive quarter to $198 million, up 17% from the third quarter of 2018.

This increase as compared to the prior year resulted from higher operating horsepower and rate increases implemented across our fleet at the start of the year.

We delivered gross margin in contract operations of $122 million, up from $100 million in the prior year quarter as again we benefited from price increases, a larger operating fleet and focused cost management. Third quarter gross margin percentage of 62% is equivalent to the last quarter and up over 200 basis points from the prior year quarter.

In our aftermarket services segment we reported third quarter revenue of $47 million compared to $63 million in the prior year third quarter, driven by several customers deferring maintenance activities. We continue to prioritize high margin business within our AMS operations.

And as a result, have maintained gross margins of 19% which was at the high-end of our full year expectation of between 17% and 19%. SG&A totaled $30 million for the third quarter compared to $26 million from the prior year and 20 million -- $29 million last quarter.

The increase in SG&A over the prior year was partially driven by our investment in significant technology initiatives. For the third quarter growth capital expenditures totaled $49 million, bringing year-to-date growth CapEx to $241 million as we continue to expect full year growth CapEx to be between $285 million and $300 million.

Maintenance CapEx for the third quarter of ‘19 was $14 million, bringing year-to-date total to $46 million and keeps us on pace for our full year guidance of between $60 million and $65 million.

We generated $34 million from asset sales in the third quarter, including $30 million associated with our previously announced sale of non-core compression equipment to Harvest Midstream. For the first three quarters of 2019, we have completed $56 million of asset sales as we continue to manage and putting our fleet where it makes strategic sense.

For the full year, we expect approximately $70 million of asset sales, including the aforementioned sale to Harvest. We exited the third quarter with total debt of $1.83 billion up from $1.63 billion at the end of the second quarter as we funded with debt a portion of the Elite acquisition.

For the third quarter leverage reduced to 4.3 times from 4.7 times in the third quarter of 2018 and from 4.4 times last quarter. This was achieved despite our strategic acquisition of Elite which was leverage neutral and continued investment in high return compression assets to support our 2019 growth program.

We remain steadfast in our focus to reduce leverage and we remain on target to achieve our leverage goals of below 4 times in 2020. We exited the third quarter with available liquidity of $246 million.

We recently declared our third quarter dividend of $0.145 per share or $0.58 on an annualized basis, unchanged from prior quarter and reflecting a 10% increase over the prior year. Our latest dividend represents a yield of 5.9% based on yesterday's closing price and a total estimated dividend payment of $22 million.

Our third quarter dividend will be paid on November 14th to all shareholders of record on November 7. Cash available for dividend for the third quarter of 2019 totaled $68 million, leading to third quarter dividend coverage of 3.1 times.

We are proud of our ability to deliver value to shareholders through an attractive dividend yield combined with peer leading dividend coverage. Our strong third quarter results keep us on pace to deliver on our guidance we provided on our second quarter earnings call, including adjusted EBITDA of between $400 million and $410 million.

We don't plan to give full year 2020 guidance until we report our fourth quarter 2019 results. However, as previously had mentioned, we do expect capital expenditures to be less than $125 million next year. And as a result, we should be well positioned to deliver free cash flow in 2020. With that, we would now like to open up the line for questions.

Jerry, can you begin that process?.

[Operator instructions]. The first question is from TJ Schultz, RBC Capital Markets. Please go ahead, sir. .

I guess just first thinking about supply and demand for compression and ultimately your ability to kind of maintain pricing into 2020 as you guys discussed producers are downing back some activity.

How does that evolve and at the same time you and others have pointed to lower horsepower additions next year, just kind of your thoughts there over the next 12 months or so?.

Sure, look we're still seeing good activity in the market, let's say the market remains constructive in its demand for compression equipment and for our services. Clearly, however, we’re off the frenetic pace that occurred in ‘18 and ’19. And so, coming off of our pace, I wouldn’t consider it to be a decline.

It’s just a reduced level of growth and it still remains constrictive and quoting activity with customers remains good. As that translates into pricing I would point out that I think pricing remains firm in the marketplace and that’s what we're seeing currently as we are being quoting and starting horsepower.

And this finally I’m going to point out relative high level of utilization both in our business at 88% in industry overall and in the past utilization rates in the high 80s have been accretive, really constructive pricing for the market.

And I think that's going to be the case -- it looks like it’s going to continue to be the case in the current market. .

Okay and as we think about things like utilization and supply and demand, do you have view on how much of the industry fleet could be retired next year or over the next 12 months just based on age and things like that or is that not really material to the equitation?.

It’s not immaterial to the equation. So I will give you a way to think about it, it’s the way we think about it and that is that the equipment is 25 to 30 year equipment, sometimes longer, and that should mean that equipment that was added into the space 25 to 35 years ago is that it has a good chance of being retired.

That would equate to decline rate or amount of horsepower moving out of the space of 2% to 3% overall. Unfortunately it’s not that simple but not all the equipment was added ratably, the business has grown over time. And so the horsepower additions currently are larger than the horsepower additions 25 and 35 years ago.

That gives you a way to think about it for the industry overall. .

Just last one from me, kind of consolidation in the space I think that continues I guess Kodiak and Pegasus, most obvious recent deals, do you see those private deals specifically changing kind of the competitive landscape for you all, do you anticipate further consolidation in the space and how do you see Archrock kind of fitting into that theme moving forward? Thanks..

So a couple of things. In our business we are really pleased with the consolidation activity we had in the quarter. The acquisition that we made of Elite was really a good acquisition and a good combination for our business, high-quality assets.

It was a part of additional 300,000 horsepower in the quarter, all located with newer equipment and a great place for us with a couple of marquee customers. So we thought that, that consolidation was great to see in the space.

As for what others do, less interested in talking about their business but any consolidation in this space is good and we're happy to see it.

And then finally just to close the loop on your question, this space has always had some private players entering into it and the management teams are a part of some of the private players that have entered into the business, recently we are part of private players that entered into the business 20 years ago.

And so that part of this business remains more consistent than it is novel. So that’s just not new to what the competitive landscape looks like. .

Next question is from Jeremy Tonet, J.P. Morgan. Please go ahead. .

Just quickly back to pricing and looking more specifically at this quarter, quarter-over-quarter, was that increase more reflective of Elite or legacy assets or maybe just a mix?.

It’s just a mix, it is very hard to distinguish the two. We did not have Elite for a long and it’s not such a large addition to our already 3.5 million horsepower fleet that it can show up clearly is driving it. We think however, it's just been a healthy environment from overall revenue for horsepower and pricing.

We’ve captured that in our base business and Elite had that too. .

And I know it’s smaller, but aftermarket services, it sounds like more kind deferrals into year-end.

Do you see kind of that trend continuing in then 2020? And then more specifically do you think the guidance range, is there a possibility that maybe following a bit below the lower end?.

Well, clearly the business has continued to decline throughout 2019. Look, we think the reasons for that are a few that have to change. There is a combination of budget exhaustion going on with some of our customers.

Dry gas plays in particular are especially financially tight given the current dry gas price, that’s where a lot of legacies equipment that attracts aftermarket services activity.

And finally, capital discipline, look, it’s definitely set into the marketplace, it’s been very good for our contract operations business and that our customers have looked to us to help them with their compression needs, but it has incentivized I think more deferrals in the AMS space.

All of those factors will change over time and as they do we expect that business and the revenue in that business to rebuild. Calling the timeframe for that, pretty challenging, however, but we’re looking for that to occur not in the fourth quarter but more into the middle of 2020. That business typically picks up more in Q2 and Q3. .

And Jeremy I think maybe I’d just add to the back half of your question on the guidance side. Historically AMS has always been a little bit more difficult for us to forecast, a little more variability than contract compression.

So it's certainly not to the point where we want to update guidance for Q4, we're going to stick with our annual guidance model. But as Brad mentioned, two things.

One, we don't believe that this maintenance deferral can happen forever and despite budget exhaustion at some point people will need that work to be done and we're just not quite sure when that is but overall very comfortable reiterating our EBITDA of between 400 million and 410 million for next year. .

Okay great. That's helpful. Last one from me, I’m just thinking about the current environment obviously with activity normalizing as we move the next couple of years, even some talks of certain types -- takeaway types been even pushed out couple of years from now.

What's -- when you think about the dividend growth rate, what is sustainable growth rate longer term for your business and how you really think about that?.

So when we set the current capital allocation policy including the dividend growth rate guidance through 2020, I will remind you that was in 2018 and it was a part of our corporate simplification.

As we look at this business -- and by the way we’re really pleased that we achieved not just that growth rate but an increasing coverage on top of that greater than 3 times for the current quarter. So it’s pretty robust on demonstration of healthy growth in our business and disciplined capital management in achieving the targets that we set.

As we achieve that goal we will look ahead candidly starting in 2020 to think about what our capital allocation should and could look like.

I will point out that once we achieve these objectives and are generating free cash flow, the whole opportunity set of capital allocation options will then be available to us and whether the best return for our investment is then by increasing the dividend at whatever rate whether it’s repurchasing shares, given market conditions, investing in the business, or repaying debt, we will have all those options available.

And we will look into the 2020 period to come up with how we recommend to the Board and if Board approve that next level of what capital allocation should look like. .

We have a question from John Watson, Simmons and Company. Please go ahead, sir. .

In past years, you have discussed how Archrock could order more horsepower than you did end up ordering.

Should we think about that being the case for your 2020 budget? Said differently, is there more demand for your units next year than your initial CapEx budget suggests in your exercising capital discipline?.

Thanks John, I’m going to trust that our sales team did put you up to this question. But the truth is yes, look for every year including ‘18, ‘19 and as to look out to ‘20, candidly we think that there is incremental demand potentially with new customers for equipment that we are not positioning our business to satisfy this time.

We’re fully meeting the needs and we're investing at a level that meets the needs of our core customers. We're in tight communication with them to ensure we can supply their needs. But yes, we believe there's an increment of investment available that we are not chasing.

But look, we believe at some point, capital discipline means something and generating good returns for our investors and getting this business to show the strength of the stable production leverage business model is worth making sure we can do. So answer to your question in short is yes. .

Given the Elite acquisition and the CapEx spent year-to-date I had expected operating horsepower deployed to increase more significantly by the end of the quarter.

I'm sure asset sales were an offsetting factor, but can you walk me through the other puts and takes, influencing operating horsepower that I might be missing?.

Look horsepower for the quarter was essentially flat but it was in fact down about 7,000 horsepower.

I wouldn’t read a lot into it and some quarters we grow and some quarters it doesn’t grow as much, so we're down 7,000 from an organic horsepower in the fleet perspective before taking into account the Elite acquisition and the divestitures that we described.

So overall still a very good quarter from utilization and bookings and starts for the customers but starts were slightly down and stops were slightly up and that level of movement on a 3.9 million horsepower horsepower fleet, and produced pretty much in just a flat quarter and that's what I think you're seeing. .

Okay.

And then lastly, you mentioned some softness in dry gas basins more generally I guess for the oil basins are you expecting a deceleration in gas lift demand given what we've seen with completions activity over the past few months?.

Yes I think so. I mean we haven't been able to translate that directly into change in demand for gas lift. Demand still remains for that portion of the market as well.

But I think that with overall production levels not growing on the oil side, just like on the gas side at the rates that we had in ‘18 and ‘19 that, that will slow the growth also for demand for gas lift. .

We have a comeback question from Mr. Daniel Burke, Johnson Rice. Please go ahead..

Let's see, I think I’ve two query on, looks like the -- on the CapEx side for this year, it looks like the pace of spending Brad for other CapEx where you guys are spending some on your tech initiatives is a little behind schedule. But I don't know if that's the right way to put it.

What do we see in there, what's the update on those initiatives? And you guys had a lot going on internally, certainly, over the last few months..

We did, on the technology improvements that we’re looking at, that spending is actually moving up in the fourth quarter and it was up a little bit in the third quarter, moving up in the fourth quarter. Through 2020 is going to be I think the heavy spend area.

Some of that movement quarter-to-quarter is just the inability to forecast exactly when the dollars are going to leave. So I wouldn’t draw any conclusions out of the spend rate on that. The project itself though is one that we're pretty excited about.

So getting our platform migrated to the cloud and into full cloud environment with our ERP, putting in [depth bar coding] mechanisms with supply chain to get some efficiencies there, as well as improving the communications infrastructure we have in the field is the project that we’re investing in.

Again that investment phase goes through 2020 and into 2021 and we’re excited about what that’s going to bring to business, overall the project is progressing. But we're still on the front end real heavy lifting part of that. .

And then to shift gears maybe. Talk a little bit about maybe gross margin on the contract op side.

Just wondering as the business flows from as you put as the frenetic pace you’ve seen at the last couple of years, what's your ability to manage your input costs and prevent that creep from chewing into to margin a little bit looking forward?.

I will share with you first that the business and the operations team have done a great job managing our overall OpEx and spend rate to date to deliver the gross margin performance that we’re achieving.

It’s no small feet to safely operate in the field to deliver excellent customer service and meet the cost target that we’ve laid out to support our profitability targets. So they’ve done a great job to-date.

I think that what you are going to see is some equilibrium on both revenue and costs as the market does not grow at the same accelerated rate it was previously and we see the opportunity set contract a little bit. We see lead times for equipment coming in a little bit.

I believe that the pricing environment will remain more stable and I believe the cost environment will remain more stable.

And I think that’s going to support us being able to maintain the level of profitability we’ve achieved with the long-term ambition as evidenced by the technology project that we’re never going to be satisfied, we're still going to look for more. .

We have a question from Kyle May, Capital One Securities. Please go ahead..

Apologies if I’ve missed this earlier, but as we are thinking about the fourth quarter in the context of your full year guidance for 2019, can you walk us through the different variables that could swing results to one end or the other of your guidance range?.

I think as you -- first you've got the two main operating segments both contract operations, which we’ve seen is very predictable and performing at levels that we are at or maybe even exceeded our expectations.

Obviously, the addition of the Elite horsepower I think from a modeling perspective what we’ve talked about with folks is that we initially said when we bought that business it would be about $55 million of annual EBITDA that included $5 million of annual synergies, that it would take us up to 12 months to achieve those synergies.

So for modeling purposes I think we updated folks after we made that acquisition, it was sort of 5/12ths of that 50 million. And so all of that sort of variable coming into the quarter. We touched a little on AMS having been below our expectations certainly on the revenues side so far year-to-date. Candidly we probably model that for Q4.

At the beginning of the year, we would have expected that to be a little on a lower end.

So those are two key items that you might think about as what could reflect the difference between the lower and higher end of our range and then we’ve seen -- pointed out in a few morning notes this morning that perhaps folks aren’t as willing to give us credit for the gain on asset sales that we achieved in the third quarter and I think it's easy to think about those as one-time events because it's not necessarily “our core business” but what I would tell you as you think about our trust strategy of pruning the fleet historically, getting rid of either less standardized packages or particularly once use Harvest as an example because that’s the one we have made public, those were 23 or 24 year old average aged equipment with a single customer in very much a mature base and that being the San Juan basin.

It made very good sense for the operator there or the owner to own those assets. We got a reasonable price and we did book a gain.

We traded existing EBITDA for that gain and so that would be I guess the last piece I would point to in terms of if you're trying to think about whether we come in at that middle of the range, high end of the range, low end of the range or even above that higher end of the range would be in my mind whether or not to include that gain on sale of assets that we include in our adjusted EBITDA perhaps some of you guys don’t.

To me those would be the areas that could mean the difference for the quarter. .

And one other question that we get oftentimes in well just say more distressed environments like we're in now.

People often ask about the strength of your contracts and I guess really what it boils down to is when you're thinking about your long-term contracts that are three plus years, what’s the potential that these get either canceled or restructured or I guess big picture how do we think about that?.

Sure, [I’m going to say], our business on the contract side as well as on the longer term stable performance is that first on the contracts this business has a history of our customers honoring our contracts and contracts having integrity of holding up through the cycle. We have not had a history of canceled contracts at all.

In the space I’m not aware of that being a part of anybody else’s history but it’s certainly not part of what we experience at Archrock. So integrity of contracts in this space is really good.

The second thing I’d point out and probably more fundamentally and maybe why that’s the case is that this business is levered to natural gas and oil production that generates great stability of our operations and increased stability for the customers as well because we'll lever for their production, into their cash flow and into their revenue.

And that means that through the last period of time, I will point out in contrast to what others in the industry experienced, our utilization went from about peak of 87% to 88% to a trough of 79%, not exactly a crisis in what was considered to be one of the deepest sharpest drops in the space in energy for long time and this business held up well and the industry held up well.

We expect this is not change in the future if anything, we're going to continue to bring that bottom up through the improvements we’ve made to our fleet and to our operations. We expect to maintain strong utilization through industry conditions in multiple industry environments..

We have a question from Tom Curran, FBR. Please go ahead. .

Brad, returning to the technology modernization program, when it comes to that program’s major initiatives, my understanding is the first one expected to be completed is the Oracle ERP system migration to the cloud.

Could you please just confirm or correct that and then give us an idea of when you would expect that that initiative finished?.

Sure, so it’s not really the case. Fortunate, we've already migrated components to the cloud and so this has been an ongoing project.

The details of like every step in the project is for migration like this is too detail to get into on a conference call such as this but fortunately we’ve already had success moving some of our modules and work modules in the company to the cloud. The migration of Oracle to the cloud is going to be in 2020.

Beyond that right now we're not going to go to public with the exact timing of when that’s going to occur and how it’s going to occur. We believe the team is well positioned to mitigate managing the risks around ERP projects and the scope and scale.

I will point out that we’re fortunately with one vendor today and we’re sustaining with that vendor and using that vendors cloud base products. So it’s a not change of a vendor or system, it’s moving from an on-premises system provided by that vendor to their cloud solution. .

Good to hear, Doug sticking with the technology program, any visibility at this point on how next year's 20 million roughly investment is likely to be split between SG&A and CapEx?.

I would say yes, we do have an internal view of that and Tom again I think we're going to stick with our kind of plan of laying out our 2020 guidance in more detail when we provide that on our fourth quarter earnings call.

Not trying to be cagy at all but again having gone from quarterly guidance to annual guidance this year and feeling very good about delivering on that, I do think that again points to sort of the stability and predictability of this business and we want to make sure our pencil is sharp before we deliver that information. .

Fair enough. Last one from me and understandable, the answer is somewhat the same.

So you did touch on the fact that ongoing asset sales are in some ways an actual returning reality for you, coming out of the merger and integration could you update sort of what that quarterly run rate range should be for asset sales?.

Yes. I would look at our historical numbers and I don’t think that the Elite -- the Elite units that we acquired, the business that we acquired is a very young fleet and so we wouldn’t expect that to have an impact other than specifically the transaction with affiliate of Elite that had us sell the horsepower that we did there.

So again that is a little bit of an unpredictable part of our business, but we will give guidance on what we expect that to be when we report our fourth quarter results. .

Great. So stay tuned for all the above with the upcoming annual guidance. I appreciate taking my questions. .

Yes, maybe not quite the hook we’d hope for to keep you interested in the next call but we will do our best..

There are no more questions. Now I'd like to turn the call back over to Mr. Childers for final remarks. Please go ahead, sir. .

Thank you, everyone for joining our call this morning. Look I’m proud of our entire team who continue to dedicate themselves to delivering reliable, safe and quality service on behalf of our customers and I believe this dedication is evident in our performance for the quarter and our outlook for the future.

Thank you everyone for participating on our call this morning and for your interest in Archrock..

Ladies and gentlemen, this concludes today's conference call. You may now disconnect your telephone calls. Thank you and have a good day..