Good morning, ladies and gentlemen, and welcome to the Natural Gas Services Group Third Quarter Earnings Call. [Operator Instructions] Your call leaders for today’s call are Larry Lawrence, Chief Financial Officer and Vice President; Steve Taylor, Chairman, President and CEO. I’ll now turn the call over to Mr. Lawrence. You may began..

Thank you, Erica, and good morning, listeners. Please allow me a moment to read the following forward-looking statements prior to commencing our earnings call.

Except for the historical information contained herein, the statements in this morning’s conference call are forward-looking statements and are made pursuant to the safe harbor provisions as outlined in the Private Securities Litigation Reform Act of 1995.

Forward-looking statements, as you may know, involve known and unknown risks and uncertainties, which may cause Natural Gas Services Group’s actual results in future periods to differ materially from forecasted results.

Those risks include, among other things, the loss of market share through competition or otherwise, the introduction of competing technologies by other companies and new governmental safety, health and environmental regulations, which could require Natural Gas Services Group to make significant capital expenditures.

The forward-looking statements included in this conference call are made as of the date of this call, and Natural Gas Services undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.

Important factors that could cause actual results to differ materially from expectations reflected in the forward-looking statements include, but are not limited to, factors described in our recent press release and also under the caption Risk Factors in the company’s annual report, Form 10-K with the Securities and Exchange Commission.

Having all that stated, I will now turn the call over to Steve Taylor, who is President, Chairman and CEO of Natural Gas Services Group.

Steve?.

Thank you, Larry, and Erica, and good morning. And welcome to Natural Gas Services Group’s Third Quarter 2018 Earnings Review. This morning we reported third quarter 2018 results. The company posted solid growth in rental revenues in the third quarter reaching $12 million, the first $12 million plus quarter since the fourth quarter of 2016.

Comparatively, rental revenues increased 5% sequentially and 7% when compared to the same quarter of 2017. Rental trends remained positive, which should lead to additional revenue growth in the upcoming quarters. In the quarter, we placed more active horsepower in the field, led by our shift into the higher horsepower rental compression market.

And our backlog of contracted rental equipment continues to grow. Opportunities continue to present themselves in the high horsepower market, and we continue to allocate capital to meet this increase in demand.

As some of our peers have indicated in the past several days, both on earnings calls and other representations, the compression market, unlike some of the other oil field service specialties, continues to strengthen. Our backlog and indication from customers suggest that growth will likely continue as we finish 2018 and enter the new year.

The need for compression and unconventional production, especially gas lift operations, will continue to grow in West Texas and other resource place, which should contribute to our growth in the quarters to come.

In addition, compression is the key part of the solution to the transportation and infrastructure bottlenecks in West Texas, which can provide a catalyst for growth in the coming months. With rental revenues growing, our sales backlog increasing and our capture of large high horsepower rental contract, all of which we will discuss later.

We anticipate further growth as we finish 2018 and enter 2019. I’ll provide more detail as we review our financial results. NGS reported total revenue of $16.4 million for the third quarter of 2018, a 3% increase from the third quarter of 2017.

This growth was primarily driven from the increase in the number of units on rent as well as a move toward renting high horsepower units, which carry higher rates.

Total revenue decreased $1.8 million when compared to the second quarter of 2018 as our sales revenues fell due to the timing of unusually large compression and flare sales in the second quarter of 2018. This drop was partially offset by a 5% sequential increase in rental revenue through the third quarter of 2018.

Total adjusted gross margin for the three months ended September 30, 2018, decreased to $7.8 million from $8.3 million for the same period ended September 30, 2017. Adjusted gross margin as a percentage of revenue for the three months ended September 30, 2018, of 48% decreased from 52% for the comparable period in 2017.

Sequentially, adjusted gross margin decreased from $8 million in the previous quarter of 2018. Adjusted gross margin as a percentage of revenue increased to 48% for the three months ended September 30, 2018, compared to 44% in the previous quarter.

The increase in the adjusted gross margin as a percentage of revenue can be attributed to our ability to trim cost even in a quarter if our revenue is falling off. Selling, general and administrative expenses of $2.4 million remained relatively flat for the year-over-year and sequential quarters.

SG&A as a percentage of revenue is 14% in the third quarter. On operating basis, the company essentially broke even in the third quarter compared to operating income of approximately $225,000 in the second quarter and $600,000 in the third quarter of 2017.

The falloff in compressor sales, the higher depreciation load from larger horsepower equipment as well as our costs related to preparing rental units for service and increases in fuel services costs pressured operating income this quarter.

For the quarter ended September 30, 2018, the company reported fully diluted net income of approximately $200,000 or $0.02 per common share compared to net income of roughly $500,000 or $0.04 per common share fully diluted in the third quarter of 2017.

Sequentially, net income of approximately $200,000 remained relatively flat when compared to the second quarter of 2018.

Earnings before interest, taxes, depreciation and amortization or EBITDA for the three months ended September 30, 2018, was $5.7 million, a slight decrease from $5.9 million for the same period of 2017 and $5.8 million for the second quarter of 2018. EBITDA margins have roughly averaged about 35% of revenue in all comparative periods.

Total sales revenues, which include compressors, flares and aftermarket activities can be somewhat unpredictable and can cause considerable swings period to period. On a year-over-year, NGS sales revenue decreased 7% to $3.9 million for the third quarter of 2018.

The sales variation was much more pronounced sequentially, where sales revenues dropped from $6.4 million in the prior quarter. Three quarters of this revenue drop is attributable to compressor fabrication with remainder due to lower flare sales.

Compressor sales revenues of $2.9 million for the third quarter in 2018 were up slightly year-over-year from $2.7 million last year. However, we saw a transitory drop in sales from $4.7 million in the second quarter of this year to $2.9 million this quarter.

This quarter’s total sales gross margin as a percent of revenue is 22% compared to 23% in Q2 and 24% a year ago. There can be quite a bit of margin variation quarter-to-quarter in our sales business due to scheduling and the different projects that might be on the floor at any given time, some with lower margins than others.

However, significantly, gross margin as a percentage of revenue for the first nine months of this year is averaging 23% compared to 19% for the same period in 2017. I mentioned a transitory drop in quarterly sales and this exactly what it is.

Our sales backlog as of September 30, 2018, was approximately $13 million, a nearly threefold increase from the end of the second quarter of 2018, which was $4.1 million.

One of the other sales impact we now have to keep in mind, which contributes to the traditional variability in sales revenues is the allocation of fabrication space between rental and sales.

Both product lines are robust and at times are trade-off, so we have to consider between scheduling the each type of build; however, our priority is usually rental fabrication. We continue to be pleased with our rental segment results, with rental revenue of $12 million for the third quarter of 2018.

This is an increase sequentially year-over-year and for the first nine months of 2018 compared to 2017. Additionally, rental revenue in the third quarter 2018 was the highest since the fourth quarter of 2016.

Although the year-to-date rental revenue increase was nominal, we believe it’s important as it signifies that we have likely turned the corner to consistent future rental growth.

We saw an increase in rental units utilized at quarter end of 6% year-over-year and, sequentially, while our horsepower running in the field increased 20% year-over-year and 11% sequentially. Rental revenues increased 7% year-over-year and 5% sequentially.

This anomaly, the disconnect between higher rates of horsepower deployment and lower corresponding revenues is due to the timing between when horsepower is deployed and when full rental revenues are booked. The variation being a combination of commissioning time and interim standby rates.

The good news here is that full revenues will kick in within three to six months of deployment and, at that time, we will see future revenue gains on already set equipment.

We continue to expand our large horsepower presence and then coincident to that received a very significant combined order from a couple of large long-term customers during the third quarter. The order represents over $31 million in additional capital expense through the first quarter of 2020.

NGS secured the order at market leading rates in a long-term rental contracts. This represents a largest single combined order in the history of the company and will keep our fabrication shops significantly loaded through 2019.

If you recall, NGS entered the high horsepower market just over a year ago with the largest order we had received to that date. We have since added interim large horsepower equipment. This current order is even larger than the one last year and alone will more than double our large horsepower fleet concentration.

By the time this order is built and delivered, I estimate that the active large horsepower component of our business will exceed 30% on horsepower basis. This is up from essentially zero a year ago. In conjunction with this order, we’re also going to build additional large horsepower speculative rental units through 2019.

The capital associated with this will be approximately $15 million. Compared to the second quarter of 2018, our average rental rates on a per unit basis were flat and down 3% on an average per horsepower basis. This is an improvement from the prior two quarters and may point to firmer price in the future.

We are, in fact, selectively increasing pricing as activity trends up. Rental gross margins this quarter were 55%, similar to last quarter, but down from last year’s quarter of 62%.

Our rental gross margins have been subdued over the last couple of quarters due to large amount of overhaul work, we’ve been performing to prepare contracted equipment for rent. As I previously noted, we’re seeing the beginning of results for this expense as the equipment gets set and starts to generate revenue.

Also impacting our rental margins was a $220,000 increase in lubricating oil cost and surprisingly a $200,000 increase in gasoline costs in the comparative nine-month periods. Fleet size at the end of September was 2,567 compressors, in addition to the 11 units during the third quarter.

This represented 10,880 horsepower, all of which from our larger horsepower units. Our utilization was – when measured by horsepower climbed from 51% last quarter to 55% this quarter. Our unit base utilization grew from 49% to 52% this quarter.

For the past 12 months, we have added 34 new fleet units that totaled 28,800 horsepower with 90% of that being on a large horsepower category. This represents an increase of 8% in fleet horsepower.

To demonstrate the growth and penetration we’re seeing in our large horsepower line, as of September 30, 2018, a full 17% of our utilized horsepower is classified as large.

I’ve mentioned opportunities a few times in this call and, as an example, I read this morning that DUCs, drilled but not completed wells, have climbed in the Permian over 50% this year alone to 3,722 wells.

Once pipeline bottlenecks are relieved, which should be in 2019, this alone is a very large backlog of production that will require gas compression to move all associated gas out of the basin. Last quarter, I raised our rental compression CapEx target for 2018 from $25 million to between $25 million and $27.5 million.

Year-to-date, we have spent $22 million. With the added business, we now estimate that we will capitalize $30 million for rental compression equipment this year with approximately 95% of that outlay already contracted. There has been a fair amount of angst in the market about higher CapEx spending among E&P and OFS companies.

But I want to reassure every one about our capital spending. First, NGS has essentially no debt. We have self-funded over $220 million in capital additions since 2010. Over 95% of our historical capital has been new fleet rental equipment. So we have a successful history of managing capital and the balance sheet.

Secondly, approximately 95% of the capital we’re spending in 2018 is for committed contracts at higher-than-market rates in a long-term contracts. This is what can be referred to as money in the bank. I mentioned this to remind every one of our capital discipline, so we are not thrown into the deep dark capital spending abyss.

Moving to the balance sheet, our total bank debt is a little over $400,000 as of September 30, 2018, and our cash balance remained strong just over $63 million.

This amount is down about $10 million since our cash peaked last year, and we desired to invest back into the company with vast majority of our investment directed at new high horsepower rental compression equipment.

NGS occupies a differentiated position among small cap companies with respect to our liquidity and ability to routinely generate significant amounts of EBITDA, which with our negligible debt position results in healthy cash levels on our balance sheet.

Our ability to maintain exceptional levels of liquidity enables us to take advantage of opportunities otherwise we wouldn’t be able to participate in. We have demonstrated this multiple times in our company’s history.

In 2010, when our cash balance coming off the financial crisis allowed NGS to quickly enter the gas lift market and build a medium horsepower, high-pressure compressors demanded by our customers. The second time is our current use of cash penetrated the large horsepower market.

Our cash balance has routinely allowed us to capitalizing on opportunities when others did not have access to ready cash. One thing I learned about cash. You don’t need it until you need it, and then when you need, you better have it. Translation is opportunities can be fleeting and ready access to cash can often make a difference.

At the end of the final three months of 2018, the recent market volatility is likely to create a number of potential opportunities for NGS.

While we have been and we’ll continue to be very disciplined in evaluating growth opportunities, we believe that number of such opportunities is likely to grow, and we want to make certain we have the right tools and flexibility to take advantage of such opportunities.

A strong balance sheet and cash position provide a good foundation to consider a number of opportunities. In addition in the coming days, we will likely file a new universal shelf registration statement, which will allow the company to have access to a wide range of additional debt and equity capital options from the public markets.

This simply provides additional tools as we continue to look for ways to add value for our stakeholders. We continue to deliver solid financial and operating results and so the future looks bright as we conclude 2018 and enter the new year. Our rental business posted solid results in the third quarter and is poised to continue this growth in 2019.

While our sales results were transiently lower coming off a very strong second quarter, existing and new orders continue to fulfill our backlog. Although just a year into the higher horsepower market, our utilization of market traction and penetration continue to show positive results and significant opportunities.

Our CapEx targets continue to increase amid the growing demands of our customers. And finally, our cash and balance sheet – cash flow and balance sheet continue to provide a strong base to fund our growth in the future. All these combined factors fuel our optimism regarding the outlook for the compression market and our performance in the future.

Erica, that’s the end of my prepared remarks. So please open the phone lines for any questions..

[Operator Instructions] Our first question comes from Rob Brown from Lake Street Capital. Please tell your question..

Good morning, Steve. Starting with the sales backlog, that stepped up nicely.

Was that really the one contract you referred to? And maybe some color on that situation?.

No. The contract is strictly rental, so the – and the backlog is sales. So the two, distinctly different levels of activity that we are seeing. So the sales grew quite a bit. The backlog grew quite a bit this quarter and then again we’ll receive that contract, which is 30-plus million dollars just for rental equipment..

Okay, okay. So both sides are bringing up activity. Maybe could you give us some color on that $30 million contract on rental equipment? How long that takes to get deployed and sort of how that....

That, that will be built – we’ve ordered the equipment already. We’re seeing equipment deliveries of around six months on engines and compressions and coolers. And we will be deploying that equipment throughout 2019, essentially starting Q2 of 2019 through Q1 of 2020. So that’s about the deployment schedule on that equipment.

Now as we’ve seen in the past, that stuff can move around, fluctuate quarter-to-quarter and may even stretch out a little bit. But that’s the schedule as to right now..

Okay, good.

And then maybe some – what kind of margin kind of headwind did you see in the quarter as you prepped units for new placements? Do you have a sense of what that was in terms of rental gross margin?.

Our gross margins are holding up pretty well from the point if, X, the makeready expense, which is a big expense that’s come along this year. So if you take that out from an operating standpoint, the margins are fine.

It’s just the fluctuation that you see and like I said some pressure and subdued margins right now as we go through a lot of this makeready expense.

And then, so it means we have seen pressure from an operating standpoint on lubricants and gasoline and that sort of thing, but we – there shouldn’t be – it’s been fairly significant incremental this year. Yes, we’re not seeing an increase in those going forward.

So future comparison should be flat on that, but this year has seen fair amount of expense on that rental gross margin because of those expenses. And again, remind everybody, we’re capitalizing this stuff. It’s all expense, so we tend to show those quarter-to-quarter as we move over the year..

Okay. Last question is really on 2019.

How does the CapEx spending look there? And I guess, what sort of the opportunity set out there for new products? You said that your cash balance is giving you some opportunities, maybe some color on what those – what that could be?.

Yes. I haven’t announced the 2019 CapEx, we will in the next call. But, I mean, it’s pretty easy if you add the numbers up throughout, the big rental contract involved a little over $30 million in capital. We plan on spending another $15 million for spec units. And I’d say, spec units not to alarm anybody, but this high horsepower spec stuff.

You almost have to have that stuff in – within weeks of completion or in the yard to rent that stuff. And so we think we’ll be – obviously, be successful putting that stuff out too, but now you have $30 million extends like, say, from Q2 2019 to Q1 2020, so part of that’s in 2020.

But pretty easily, it’ll certainly exceed or we’re seeing this year, which is what is measuring around $30 million..

Okay. Great, thanks..

Our next question comes from Richard Dearnley from Longport Partners. Please tell your question..

Good morning. What is your capacity, your manufacturing capacity at the moment? I take it, you have some – what? Let’s just leave it at that..

It’s variable and it depends a lot, number one, on what our flare sales are? What our rental – what our compressor sales are? And what our compressor rental bill requirements are? And, of course, the size of the units too. So it’s hard to give a specific number either in throughput on dollars or throughput on units.

Now if you just take the numbers we just talked about, we think we can say roughly, $40 million to $50 million worth of big horsepower through the two shops in 2019, which would be 40 units to 50 units roughly, a little over $1 million a piece. Yes, that will give you a rough idea.

And of course, it – that can vary plus or minus 10% to 20% depending on what’s your build and what’s going on..

Right.

If you’re making smaller horsepower units, the capacity goes down?.

Well....

What if you’re just making big horsepower units?.

Well, the capacity goes up on a number of units. Yes, but the – yes, your corresponding CapEx is a lot lower, probably a fifth of it. For example, in 2014, I guess, we built over 300 small horsepower compressors, probably about 150 horsepower average. Yes, but that was about $50 million.

So this year, we’ll build about 40 to 50 units, it’ll be about $50 million. So it’s just hard to calculate unless you have. Hey, here’s the exact number and the calculated number, but your capacity is probably historically and today, probably $50 million, $60 million worth of equipment..

Right. Thanks. And in your comments, you said that the rental backlog for all horsepower was high. That strikes me as a change because all horsepower would include small horsepower.

Am I using that correctly?.

Yes. I mean, the backlog is relative number obviously. So the smaller horsepower is relatively small part of that, but it’s grown a little bit. And, obviously, the big deal is, in that medium horsepower, say, the 150- to 300-horsepower, which is a primarily the wellhead gas lift stuff. That’s what we’re seeing. That’s start to perk up there.

So – and then the – there’s not really a rental backlog. And while there is a rental backlog in the big horsepower, but that’s all new builds. So the makeready expense is across the board, but it’s just – it’s relative, so your small horsepower has grown a little, but it’s still a small piece..

Right.

What’s your mix at the moment of gas lift to total either units or horsepower?.

On a per unit basis, gas is – as far as the total fleet, it’s well fleet and utilized. It’s probably, I’d say, 60% utilized and/or the total fleet. With the big horsepower, you would probably move that up to maybe 65% on a horsepower basis. But 60%, 65%, well that units of horsepower is – yes, we will classify as gas lift sort of equipment..

I see. And if the midstream, the pipeline folks are adding capacity like mad in many basins. And in general, that’s supposed to start coming on through 2019, but a lot of it will be in place by say the end of 2019 give or take..

All right. Right..

If assuming all that continues to happen, would it be logical to expect a falloff in demand for new capacity – pipeline capacity in 2020, which would have the effect of loosening high horsepower demand in 2020? Or....

Well, I think – from our business, I don’t think so. Because the majority of our equipment is going out on gas lift whether it’s wellhead gas lift or centralized gas lift. So while this big horsepower is going out on the production site, not really on the midstream sort of perspective.

Now obviously, everything feeds into the midstream, but the – you could have a adequate infrastructure of midstream, but if we’re still drilling wells and still producing gas, we’re still going need more compression out there. So you might have a little flurry in 2019 of some of the stuff and like you say the DUCs. Yes, that’s a big backlog out there.

That will all come on – will not be completely same time, et cetera. So I think we got a pretty good runway on activity in the market..

Great. Thank you..

[Operator Instructions] At this time, we have no further questions..

Okay. Thanks, Erica, and thanks, everybody, for joining me on the call. I appreciate your time this morning and look forward to visiting with you again, next quarter..

This concludes today’s conference call. Thank you for attending..