Good morning. My name is Felicia, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cactus Q2 2019 Earnings Call. [Operator Instructions] Thank you. Mr. John Fitzgerald, you may begin your conference..

Thank you, and good morning, everyone. We appreciate your participation in today's call. The speakers on today's call will be Scott Bender, our Chief Executive Officer; and Steve Tadlock, our Chief Financial Officer.

Also joining us today are Joel Bender, Senior Vice President and Chief Operating Officer; Steven Bender, Vice President of Operations; and David Isaac, our General Counsel and Vice President of Administration. Yesterday afternoon, we issued our second quarter earnings release, which is available on our website.

Please note that any comments we make on today's call regarding projections or expectations for future events are forward-looking statements covered by the Private Securities Litigation Reform Act. Forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond our control.

These risks and uncertainties can cause actual results to differ materially from our current expectations. We advise listeners to review our earnings release and the risk factors discussed in our filings with the SEC.

Any forward-looking statements we make today are only as of today's date, and we undertake no obligation to publicly update or review any forward-looking statements. In addition, during today's call, we will reference certain non-GAAP financial measures.

Reconciliations to these non-GAAP measures to the most directly comparable GAAP measures are included in our earnings release. With that, I will turn the call over to Scott..

Thanks, John, and good morning to everyone. I'm pleased to report record second quarter results having delivered top line sequential growth of over 6% and an – all-time revenue highs in each of our 3 business lines. Our growth significantly exceeded the trajectory of the U.S. land rig count, which was down 6% sequentially in the second quarter.

During the period, average U.S. market share in our products business, which we define as a percentage of onshore rigs followed, increased from 29.1% to 29.4%. Furthermore, we maintained our overall margin profile despite the softening macro environment.

In summary, revenues increased 6.1% sequentially, adjusted EBITDA increased 6.2% sequentially, adjusted EBITDA margins were 37.2%, operating cash flow was $64 million and ROCE was in excess of 47%. I'll now turn the call over to Steve Tadlock, our CFO, who will review our second quarter financial results.

And following his remarks, I will provide some thoughts on our outlook for the near-term before opening the lines for Q&A.

Steve?.

Thanks, Scott. As mentioned, Q2 revenues of $168 million were 6% higher sequentially and up 22% year-over-year. Product revenues were a record $94 million, 29% higher than Q2 2018 and 9% higher sequentially despite the decline in the U.S. onshore rig count.

This revenue growth was achieved given greater equipment sales relative to rigs followed, a result of more wells being completed and put into production. Product gross margins increased modestly on a sequential basis to 39% of revenues due to leverage of our fixed cost base.

Rental revenues were a record $40 million, up slightly from the first quarter. Growth was partially attributable to continued investments in our asset base, as well as the initial impact from our new innovations.

Rental gross profit margins declined 290 basis points sequentially due to higher depreciation expense and higher repair expenses as a percent of rental revenue. We expect these repair costs to moderate in the coming quarters, commensurate with lower anticipated completion activity.

Field service and other revenues in Q2 were $34 million, up 2% from the first quarter.

This represented approximately 26% of combined product and rental-related revenues during the quarter, which is lower than our typical ratios given the impact of our rental innovations, which utilize existing field service personnel and the higher level of product revenues during the quarter.

As a reminder, product revenues tend to have lower associated field service revenues than that of our legacy rental business. In Q3, we would expect this ratio to be in the range of 25% to 26%. SG&A at $13.3 million for the quarter was $600,000 higher than during Q1 2019.

The sequential increase arose primarily from higher stock-based compensation expense from a full quarter impact of annual grants made in March and incentive compensation accruals associated with our strong performance during the first half of the year.

We would expect SG&A in 3Q '19 to be approximately $13 million, with stock-based compensation expense running at slightly under $2 million per quarter for the remainder of 2019. Depreciation and amortization expense during the quarter totaled $9.4 million, up $0.5 million sequentially.

We currently expect third quarter depreciation expense to be closer to $10 million. Second quarter adjusted EBITDA was nearly $63 million. This was 14% greater than the equivalent period last year and up 6% sequentially. Adjusted EBITDA for the quarter represented 37% of revenues, similar to the first quarter.

Our public ownership was relatively stable in 2Q and was 53% at the end of the quarter. This should result in an effective tax rate of approximately 15% in Q3 barring further changes in our public ownership percentage. GAAP net income was $41 million in Q2 2019, which was inclusive of an additional noncash tax expense during the quarter.

Internally, we prefer to look at adjusted net income and earnings per share as it assumes the public entity held all units with the resulting additional income tax expense related to the incremental income attributable to Cactus Inc.

With fully diluted shares outstanding of approximately 75 million and an effective tax rate of 24%, our adjusted earnings per share this quarter was $0.52 per share compared to $0.49 per share in Q1 2019, an increase of 6%. We estimate that adjusted EPS in Q3 will continue to have an effective tax rate of 24.0%.

Our cash position increased by over $43 million during the second quarter to $131 million at June 30, highlighting the strong free cash flow generation of the company. For the quarter, operating cash flow was $64 million and our net CapEx spend was $15 million.

Net working capital was a source of cash despite the increase in revenue during the quarter. While accounts receivable increased by $5 million sequentially, DSO declined to 61. Additionally, while inventories increased, they did not increase at the same rate as our product revenue with inventory days outstanding declining to approximately 175.

Net working capital at the end of the second quarter expressed as a percentage of Q2 annualized revenues was 24%, down slightly from the first quarter. We would expect working capital as a percentage of revenues to be relatively stable as the year progresses, consistent with our typical levels averaging 25%.

Given the uncertainty regarding drilling and completion activity in the second half of the year, we are reducing our 2019 capital expenditure budget by approximately $10 million to the range of $50 million to $60 million. The majority of our CapEx will still be directed toward growth capital in our rental business.

And for the second half of the year, we currently expect roughly half of our rental CapEx to be directed towards the build-out of our fleet of new rental innovations. The success of these innovations in the field has given us the confidence to move a portion of the associated CapEx to our longer lead time and lower cost supply chain.

During the third quarter, we expect to make total tax-related payments of approximately $10 million, inclusive of the TRA liability. This payment represents 85% of the cash tax savings that accrued to Cactus, Inc., resulting from our overseas structure. All in all, we expect the third quarter to be another strong quarter of cash generation.

That covers the financial review, and I'll now turn you back to Scott..

Thank you, Steve. So despite declining drilling activity, the second quarter highlighted the breadth of our customer base and our participation in the industry from drilling through completions to production. That said, the U.S.

land rig count has continued to move lower in the third quarter, and recent volatility in crude oil prices will no doubt serve to reinforce our customers' focus on capital discipline.

We currently expect Cactus' rigs followed to be down approximately 5% sequentially for the third quarter, although based on preliminary results through July, we would not anticipate the impact of product revenues to be as pronounced.

Due largely to the impact of additional Section 301 tariffs implemented in May, we expect product margins to be down low single digits sequentially, less severe than we had previously anticipated.

As noted during our last earnings call, while we have yet to make any significant breakthroughs with the major international oil companies, we've managed to grow our market share in an environment where the companies to which we are the most exposed, the large public E&Ps, have been disproportionately impacted by calls for capital discipline, a reflection of our ability to win new business.

On the rental side of the business, completion activity outperformed the rig count during the first half of the year, reflecting a drawdown of the DUCs that were added in the latter part of 2018. During the third quarter, we would expect rental revenue to trend in line with the trajectory of U.S.

onshore drilling activity though we're hopeful the continued adoption of our new innovations will lead to outperformance. Regarding our new completions innovations, I'm pleased to take this opportunity to provide a bit more color on a few of these offerings.

Let me start by saying we've been working with our customers to improve efficiencies at the well site in order to drive down overall well cost, complete more stages per day and improve safety.

This comes in the form of reducing the amount of time waiting between the various operations at the well site, reducing the amount of time needed to maintain equipment at the well site and reducing the amount of equipment needed to support frac operations.

I'll start with our SAFEINJECT system, which effectively reduces or eliminates the nonproductive time associated with the maintenance of the flow control equipment installed on a frac location. SAFEINJECT, like many of our new innovations, is controlled using an HMI control panel outside of the exclusion zone.

The system maintains our equipment, gathers useful data on valve performance and positions our business toward automated maintenance. Our SAFELINK system provides a singular and continuous large bore connection from a missile to the frac stack.

Traditionally, numerous small diameter lines are individually hammered into place, requiring excessive time to install and remove. Such connections are susceptible to leaks and sustain costly damage. Our large diameter connection allows for high flow rates, maintaining the integrity of the connection and limiting equipment wear.

In contrast to competing solutions, this system provides a singular connection to multiple wells, eliminating the time and safety hazard associated with transferring connections between multiple wells on a single pad.

Finally, we've been able to leverage our field proven wellhead technology to minimize the rig up and rig down time associated with installing the system, saving the operator hours on site. This system occupies minimal real estate, is adaptable to any pad size or layout and we believe it is far more cost-effective than competing solutions.

It's our belief the industry will move toward a model where hammered iron is obsolete. Our safe plan system was developed based on customer requests for a more reliable method to connect the wireline lubricator to the frac tree without the need for human intervention within the exclusion side.

On a typical frac site, employees in a man basket will make connections between the wireline equipment and the frac tree. Utilizing our safe plan system, operators can more quickly transfer between wellbores and reduce time spent waiting on transitions.

Our expertise in flow control connections has enabled us to develop a solution that our customers have indicated is not only more reliable than competitive offerings, but also safer. Thus, while this equipment makes up a very small portion of the well cost, it translates into significant time savings and the ability to complete more stages per day.

Importantly, by bundling these offerings with our legacy rental products, our customers avoid incurring additional personnel cost to operate and maintain competing solutions.

While we have other innovations currently in development, these are just 3, which we believe will ultimately lead to significant reductions in personnel and nonproductive time, including the time spent by pressure pumpers repositioning their spreads. Moving onto field service. This segment continues to be driven by both product and rental activity.

As mentioned previously, one of the many benefits for customers utilizing our new completions innovations is that they are able to limit the amount of additional personnel at the well site as Cactus associates servicing our legacy rental equipment are able to operate and maintain these new innovations.

In light of this, we'd expect revenue from field service to be in the range of 25% to 26% of our combined product and rental revenue during the third quarter. Clearly, our free cash flow generation was strong during the quarter as we added $43 million of cash from the end of Q1.

Working capital had been a drag on cash during the last several quarters, and we believe the second quarter demonstrated the cash flow potential of the company during times of more moderate growth. We continue to evaluate capital allocation in light of our enviable cash position and expectations for further free cash flow generation.

However, the potential impact on other equipment service providers from anticipated weakness in North American activity compels us to exercise patience as we evaluate where best to deploy cash.

I'd like to reiterate that we remain more closely aligned with our shareholders than the management teams of our public company peers, and continue to generate returns well in excess of our cost of capital, as evidenced by our best-in-class return on capital employed of over 45% during the quarter.

Despite mixed commentary from our peers regarding the North American land market, we've shown the ability to generate record results in the current environment, and we believe we will continue to outperform. With that, I'll turn it back over to the operator, and we can begin Q&A.

Operator?.

[Operator Instructions] Your first question comes from Marshall Adkins..

Good morning, guys. So pretty darn solid performance here. Help us – so the overall rig count in U.S. down 6%. You guys are down like 4.5% in the rigs you follow, but revenue is up 9%. So I know there's probably a product mix thing going on here where you're selling more stuff related to completions.

But help us understand what happened there, because that's substantial outperformance.

And looking forward, does that change back? Or are you going to be able to continue putting up that type of the mix change?.

So I'll ask Steve Tadlock to chime in when he feels it's appropriate. But let me answer your second question first, Marshall. Our indications through July are that we'll be able to maintain our revenue per rig, our product revenue per rig, despite the fact that it went up so much in the second quarter.

So I think we can assuage your concerns in that regard. In terms of why it went up so much, you're right, it has to do with product mix. We also feel like it has to do with rig efficiencies as the rigs we're following are drilling more wells..

Okay. And what type of – help us with the product mix. Was it more production trees or production valves? Or help us understand what the mix change was..

Yes, I think, it's 2 things, Marshall. It's higher pressure and more production trees..

Okay. And my second one, kind of unrelated. Obviously, we're all looking at the tariff thing, and it seems like your competitors are much worse positioned than you to deal with tariff increases. How do you see that playing out? It seems like you're going to be better positioned to handle that. They're going to be forced to increase prices.

So should we expect prices overall to go up and you to benefit versus your competitors? Or just tell us what your thoughts are on that..

Well, Marshall, do we have any competitors listening to this call? Little bit concerned about giving you this answer. I think we're – I mean, I'm very proud of our supply chain. I think Joel does the most remarkable job in the industry. So I do think that we're handling the tariffs, I think, much more effectively than our peers.

And I do expect that as the market begins to maybe be a little bit more conducive to an increase, there'll be no choice but to see an overall increase in the price of wellhead equipment and associated API 6A products going forward. So to the extent we continue to do the job we've done in the past, I would hope that we would outperform..

Your next question comes from the Chase Mulvehill..

Hey good morning.

So I may have missed this, but did you give rental margin guidance for 3Q?.

Chase, we didn't say anything too specific, but we would expect it to be broadly in line with Q2..

Okay. All right. And then appreciate all the color that we've all been waiting for on the new product rollouts on the rental side. I don't know, now that you've kind of disclosed this a little bit, I don't know if you want to share with us the potential addressable markets.

And maybe when we think about how you get market penetration into the back half of the year, and maybe quantify that for us on the revenue contribution in the back half from the new product rollouts..

Okay. So I'd say that we're seeing a steady increase in our innovation-related rental revenues and that we are comfortably on pace to meet the figures that we discussed during the last earnings call, the exit rate.

In terms of penetration of the market – or I'm sorry, in terms of the addressable market size, it's at least as large, I've said this before, it's at least as large as our legacy rental market.

So if we look at a pad that has a full suite of our innovations on it in addition to our legacy product, the innovations account for more than 50% of the total revenue per day. In terms of the speed at which, we're rolling it out comfortably. These are new products for us.

We're a little bit more careful maybe than some others, and I'm happy with the pace. As I said, we'll meet our objectives that we discussed earlier..

Okay. All right. That's helpful. Appreciate the color here. Last one is just on the tariffs. It looks like the tariff impact, like you said, is going to be a little bit less in the back half of the year.

Can you kind of help us connect the dots here? I don't know if there was any waivers or anything that maybe you were successful on or maybe it's the foreign exchange? And maybe if you've decided at this point to hedge out any FX risk?.

Yes, Chase, it's a little bit of all of those things. It's FX, it's better supply chain management. And yes, we did – we have locked in some more favorable FX rates. But it really is – and it's also talking to customers. It's a combination of all those things. Same things we did at the end of last year. The same sort of playbook..

Okay, alright. That’s all I had, I turn it back over..

Your next question comes from Scott Gruber..

Good morning. Just on the outlook for rental to trend in line with drilling activity, if I heard that right.

Is that inclusive of the benefit of the new innovations? Or is that legacy and exclusive of the benefit?.

Well, I think that our legacy equipment will probably trend with the rig count and the innovations will be accretive..

Got you. Got you. And I think I heard you right that the expectation by year-end, you originally gave us a guide that the new innovations would be 20-plus percent of the revenue profile.

Is that still valid?.

Yes. I wish I knew what the completion profile in the industry was going to be in Q4. I'm sure we're all expecting a little bit of a repeat of the budget exhaustion, although I feel pretty good about Q1 2020..

Got you. Got you.

And just stepping back, can you just discuss the pros and cons of utilizing a rental model with the new technology and not a sales model?.

The obvious, Scott, you sell it one time, you rent it over and over and over again. And in our particular case, of course, because we're not constrained by cash, we would prefer to invest in these rental assets and enjoy the proceeds over an extended number of years..

And you think there's additional IP protection around the rental model? Or does that matter at all?.

Well, I think it matters much more in terms of these innovations. And so I think we've mentioned before that we're heavily engaged in IP for the 3 offerings that we discussed today, at least..

And your next question comes from George O'Leary..

Y'all ran through the 3 new technologies, which was super helpful. I was just wondering if you could frame for us, that you've done it for some of the other products you offer, which of the 3 offer the greatest level of efficiencies or maybe reduce nonproductive time and maybe quantify that in an hour’s perspective.

Any of that would be super helpful..

Some pretty detailed questions, George. But I'd say that being able to maintain flow control equipment remotely, continuously and outside of the exclusion zone probably provides the greatest near-term reduction in NPT of all the innovations.

I'd say next would be our SAFECLAMP, which is the way that – you know that many people have a device similar to this. We happen to think ours is significantly more robust and reliable and safer. I would say that probably comes second. And then the ability to remove hard line is – clearly, the installation time is greatly reduced.

The maintenance is greatly reduced. The failure rate is greatly reduced. But unless you have a failure, you're probably not going to see the savings..

Okay, great. That's very helpful, Scott. And then just secondly, as you think through the plan going forward, and I realize now may not be the time to be coming up with brand-new widgets, but you guys are always innovating.

What are your customers coming to you and asking you guys for help on? You guys have a good relationship with your customers and are constantly in dialogue with them, and I think that's how a lot of these innovations come about via that dialogue.

So that's kind of leading-edge discussion with customers and where do they need help?.

Yes, George, I'm probably not going to respond to that question..

And your next question comes from Connor Lynagh..

So I think you said in the past that you guys tend to have a little bit sooner notice than rig operators. So you've made a comment around feeling good about first quarter 2020. Is that based on really orders that you're seeing from customers? I'm just wondering if you could quantify or just speak to what makes you say that..

Yes. I probably shouldn't have said that, Connor, but the truth of the matter is we spend an awful lot of time, we do, with our customers and the indications are, and it's early, that we're going to see some rig count additions for some of our large customers next year, end of this year beginning of next year..

Okay. Fair enough. And just sticking with product.

So the margin degradation that you're expecting in third quarter largely related to tariffs, is there a follow-through effect in the fourth quarter as well as you move through your inventory? Or is this sort of the extent of what we're going to see here?.

No, you'll see a follow-on through the fourth quarter..

Any rough magnitude?.

So it'll be less severe in the third quarter, more severe in the fourth quarter. I don't know that I can actually quantify that. But as we run through inventory, it's just logical. We'll probably see another 25% maybe..

Yes. Look, I mean, Steve, I think in the third quarter, we would expect it probably to start hitting us halfway through. And we've talked about down low single digits. And so a little bit more than that.

But maximum impacts in sort of a worst-case scenario was a little over 3% in terms of margins, and we don't expect that for the reasons Scott's talked about already. So that's what you're kind of looking at as you move forward..

And your next question comes from Tommy Moll..

So Scott, we appreciate all the detail you gave us on the new rentals innovations. I think you touched on this, but if you could just flesh out a little bit more how the new innovations should drive continued utilization on your current rental fleet.

Or in other words, how the new innovations have to work with what you already rent or how it's better for a customer if they take the full package from you?.

When we first began to look at these innovations, our thought was that they could be utilized independent of our legacy offerings. But now, we've taken a different approach. They're fully integrated. So these innovations will turn out to be very supportive of our legacy equipment. And it's not just because one – and this is important.

Not just because the same operator or field tech who operates our regular frac trees, operates all of these, which means the incremental cost to our customers is greatly reduced in comparison to some of the competing solutions.

But it just works together so that we're doing a whole lot of pre-installation in our shops to reduce the amount of time on location. But that means we integrate it with our legacy equipment before it ever arrives on location..

Okay. And that leads me to a related point on a topic you discussed on prior calls, specifically on service differentiation, which is something I think we all understand intuitively. But I'm trying to just get as granular an understanding as possible.

So could you maybe give us a hypothetical scenario where a customer wants to change something, maybe relating to wellhead design, for example, midyear? How does your organization quickly respond to that from the field to Bossier and back? And are there any brackets around a turnaround time from when customer comes to you with an issue to when you – how quickly you guys are able to execute using the Bossier facility?.

There are actually – there are 2 – I'm going to answer that in 2 parts, tommy. The first, when you talk about service, you're referring now to our ability to rapidly deliver. So I think you've heard Joel say, if he has the raw material in Bossier, and we keep a lot of raw material in Bossier, he can deliver in 24 hours.

We can deliver in 8 hours depending upon how large the piece is and how detailed the machining is. So that's just not an issue. We have an engineering team that works on these sort of ad hoc requests. It's what they do every single day. So we don't let engineering hold us up.

And because of the supply chain model that we've adopted in Bossier City, I'm very comfortable in saying 24 hours, even if we have to do the design work, and it's not a radically new design, but maybe a modification, 24 hours is probably the norm in this company.

The other part of service that really is important and no one ever speaks about is the responsiveness and the capability of our field service technicians. And so issues happen in the field.

And I think one of the great differentiators of this organization is that when there's a field issue and, look, there are field issues no matter how well we believe we execute. We've got 350 or 400 service techs that all get up on the right side of the bed every day.

The difference between Cactus and our peers is that when there's an issue, it pops up on a vendor's phone immediately. And so our field service managers, our branch managers, our service techs know they're going to get a call. And I think that's a strong incentive for them to perform..

Your next question comes from David Anderson. Your next question comes from Sean Meakim..

So guys, I was hoping we could just take a little bit of a step back. You guys grew market share substantially in the downturn in '15 and '16 when you were still private.

Could you maybe talk a little bit about how that environment helped accelerate adoption of the wellhead technology? And maybe just compare and contrast that situation versus today's a bit more muted of a drawdown of activity in terms of how that creates or how that informs the opportunity set for you?.

Yes. So we're – it's fair to say that during a downturn like this, we – more doors are opened. So we've probably got more proposals out now to new customers than – clearly than we had at the beginning of the year. So it's the same, same routine, customers eager to increase efficiency, save time and look at something new.

So as I said, we have quite a few new proposals out right now..

And then, so just taking that line of thinking and applying it to the rental business. So you're rolling out these new innovations and you're hoping to grow that wallet share at the well site.

The current environment's not necessarily great from a growth perspective, but does that similarly enhance your confidence in terms of your ability to drive adoption compared to maybe if things were a bit more blowing and going from a market share perspective?.

Yes. Even though when rates are going up, truly these innovations are more impactful. It seems to be our customers feel, I guess, much more compelled to talk to us when things are going badly. And so I think it'll be very constructive over the next quarter or so..

Your next question comes from Scott Gruber..

Wanted to dig a little bit more. For several quarters now, you guys have been trying to penetrate the majors with the wellhead product.

Can you provide some color on the roadblocks that you face in that effort and how you're trying to overcome those?.

Scott, they're the same roadblocks we've discussed before. Change in terms of wellhead providers occurs much more slowly at majors than it does anywhere else, much more slowly than frac provider changes at majors. And the difference is, when a frac valve fails, it costs them money right now and they want a solution.

In terms of wellhead equipment, if you think about who the IOCs use, the wellhead equipment works. And as long as it's not shutting a rig down, there's not the pressure on them to try something new.

So the fact that our wellhead system could save them hours of rig time per well, is not nearly as pressing an issue to them as if they were having wellhead failures, and they're not having wellhead failures. So it's a matter of really a down market like we're in right now providing the impetus for some of these majors to look elsewhere.

So I just want to tell you, Scott, we haven't relaxed our ambitions at all in that regard..

Got it. Got it. And just on the share of rigs followed, that's holding up better than the U.S. rig count despite some of these big E&Ps dropping more rigs than originally anticipated.

Could you just give us a little more color on how you're mitigating that challenge?.

Yes. We're adding new customers. I mean, that's – the short answer is we – I don't know how many new customers we've added. But if I look at the profile of our rig count, there are names on there that just simply were not on there at the beginning of the year. A lot of this, interestingly, has to do – I may have mentioned this before.

When some of the larger publicly traded E&Ps scale down, these engineers go somewhere. And when they go somewhere, they tend to take us with them..

There are no further questions..

Thank you, everyone, for joining us on the call, and we look forward to speaking with you in the next quarter..

Thanks, everybody. Have a good day..

This concludes today's conference call. You may now disconnect..