Good morning. Welcome to the Archrock Third Quarter 2020 Conference Call. Your host for today's call is Megan Repine, Vice President of Investor Relations at Archrock. I will now turn the call over to Mrs. Repine. You may begin.

Thank you, Doug. 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 2020. 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 the assumptions made by and the information currently available to Archrock's management team. Although management believes that these expectations reflected in such forward-looking statements are reasonable, it 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 statements, 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.

Thank you, Megan, and good morning. I appreciate everyone joining our conference call today. Last night, we posted solid third quarter results despite significant demand headwinds brought on by COVID-19. I could not be prouder of how well the Archrock team has responded to the challenges we faced this year. Our standout third quarter results were driven by excellent execution in the field and an unrelenting effort to attack our cost structure wherever possible. Among the accomplishments in the quarter, we generated adjusted EBITDA of $113 million, up slightly compared to the prior year period. We defended our strong contract operations gross margin percentage driving more than a 100 basis point increase versus the prior year period after adjusting for a non-recurring tax benefit in this current quarter. We further reduced SG&A expenses by 12% in Q3 on a sequential basis and also adjusting for that non-recurring tax benefit. We continue to pay an attractive dividend complemented by peer-leading dividend coverage. And finally, we continued to generate robust free cash flow, both before and after dividends in the quarter. Year-to-date, our free cash flow after dividends totals $117 million. This is the combined results of operating cash flow resilience, lower CapEx spending, and approximately $50 million in non-core asset sale proceeds. In total, this has enabled us to repay borrowings on our credit facility and reduce our leverage to 4.0 times. These positive quarterly outcomes demonstrate the impact of the aggressive cost reduction and operational improvement measures we've implemented over the last several months. The disruptions to our industry required sacrifices from everyone at Archrock. And I'm very grateful for the continued efforts of our employees everywhere. We've taken significant action to squeeze costs out of our business, and our efforts are cut across all segments and all geographies. We…

Thank you, Brad, and good morning. Let's look at a summary of our third quarter results and then cover our financial outlook. Our third quarter performance strongly supports our financial goals of protecting liquidity, generating free cash flow and reducing debt. We reported adjusted EBITDA of $113 million, slightly higher than the third quarter of 2019. Our third quarter adjusted EBITDA included $9 million in net gains related to the sale of assets and an $11 million net cash benefit from tax audit settlements covering a 3-year period. 60% of this tax benefit was recorded in SG&A, with the remaining 40% reflected in our contract operations' gross margin. We recorded net income for the third quarter of 2020 of $18 million, which included a few one-time items, the majority of which were non-cash. We recorded an $11 million long-lived asset impairment during the quarter and took a $3 million restructuring charge related to severance benefits and property closures. Turning to the business segments. Contract operations revenue came in at $175 million in the third quarter compared to $188 million in the second quarter due primarily to lower operating horsepower. Looking at our gross margin percentage, we continue to benefit from a highly variable cost structure, a key advantage as we continue to make adjustments to align our business with market conditions. We remain on track to deliver a meaningful increase in our gross margin percentage compared to 2019 despite revenue headwinds. In our AMS segment, we reported third quarter 2020 revenue of $30 million, down from $32 million in the second quarter. Our AMS revenue reflected lower customer activity, given cost constraints and market uncertainty as well as lost sales from the divestment of our turbocharger business. We drove our AMS gross margin percentage back up to our 2020 target,…

[Operator Instructions]. Our first question comes from the line of Kyle May with Capital One Securities.

Appreciate the preliminary look at 2021, and I realize that you don't have formalized guidance yet. But Brad, I wanted to follow-up on one of your comments. And when you think about the next couple of quarters, how do you think about the trajectory or the rate of change in compression utilization compared to the 3Q rate?

Yes. So look, utilization is the output from the factors that are the dried up, which are bookings and stop activity and let me talk about those without giving you a quantification just because it is too early to preliminary. And candidly, the view right now into 2021, even through our customers' eyes remains opaque. So what we do expect, however, is to see bookings continue to steadily pick up as we have seen in Q2 -- I mean, in Q3 compared to Q2. And we expect stop activity to continue to moderate as we saw also from Q2 to Q3. But for the lines to cross and have us see net horsepower growth, we're expecting still softness into the first part of 2021, with the opportunity to maybe see some regrowth, both in natural gas production and of course then the horsepower in the back half of 2021. So that's my best shape of the curve that I can give you without trying to quantify it, which would just be guess work, Kyle.

Totally understand, and that's helpful. Also, maybe switching over to cost control. It's nice to see the ongoing attention to detail there. Can you give us any color if there's more cost that you can take out? And also how sustainable are these cost reductions?

Sure. So on the good news front, one of the things we really like about the compression business is that a majority, a lot of our costs of our OpEx are highly variable. By the way, our CapEx also can be highly variable. And it gives us a chance to really respond quickly to right size the business to both maintain profitability. And as you've seen in 2020, not just maintain positive free cash flow, but improve it. So it's just a real strength to the business model that we can pull cost out. The improvements you've seen in our profitability we believe will be sustainable, and we're going to continue to focus on expanding our gross margin over time. The teams in the field, both in contract operations and AMS, have been just tremendously well focused on improving profitability in a way that is sustainable. Now of course, if we hit too much pricing headwinds based on utilization, we may see some giveback and some erosion. But overall, the profitability improvements we've put into the business we think are sustainable. And candidly, we expect to see them expand over time as we leverage our investment in our technology.

Our next question comes from the line of Daniel Burke with Johnson Rice & Company.

Brad, I guess you alluded to this earlier, but when we compare this downturn to, I guess, it was '15 and '16, can you talk about the horsepower you've had sidelined. Is it -- can you compare and contrast maybe the horsepower you had sidelined in '15 and 16 to what's occurred this year? I would imagine the horsepower that's been pushed to the sideline or at least a portion of it this year is pretty high-quality, maybe more modern equipment than was the case 5 years ago?

Yes, I can. And I think your inclination is completely correct. The improvements into the fleet that we've put in over the last, certainly, 3 or 5, but even 10 years is really paying off in that the idle fleet today is younger, larger and higher quality than we experienced in past downturns. That's going to put -- give us the opportunity to put more of it back to work more quickly and at less cost and a reduced cost. So we like that aspect of what we have in the fleet today compared to what we experienced in prior downturns. So your inclination is right. The other thing I want to point out is that even as we hit this downturn, the equipment that we've been investing in, which is equipment that is large horsepower and newer and younger in our fleet overall, remains well utilized and pricing remains very solid. So we just see that, that aspect of our fleet performing really well. And it's just one of the strong points and the results of the investments we've made over the last several years.

Got it. Okay. And then maybe one of the smaller points in the guidance update this morning. There's a reduction in maintenance CapEx expectations for this year. And was just wondering, is that sort of sustainable on a per active horsepower basis? Or what's going on to drive that reduced expectation as this year has advanced? Is it -- does it reflect more of the fact that utilization has fallen off more than you expected? Or is it that you're managing that program more assertively?

Well, it's a combination. Number one, the team is absolutely doing a great job managing our maintenance CapEx. One thing I'd point out is that we do not manage the maintenance CapEx to the detriment of either customer service or to the equipment and standards that we have in place to maintain our equipment really well. So that's one. Second, however, you're seeing the benefit of both. We have more new horsepower in the fleet. The average age of our fleet has decreased as well as the fact that we had some stop activity. And all of that is decreasing our maintenance CapEx, but a combination of those factors. It's not really any single factor.

Got it. And certainly, given -- last one for me maybe, but given what's going on with sort of natural gas pricing, I wouldn't imagine there's still a meaningful component of standby horsepower, but I figured out, I look to mop that up as we look at where your utilization is now compared -- or I guess that would be included in utilization to be fair. But maybe an update on where you stand with standby horsepower?

Sure. The vast bulk of the standby horsepower has gone back to work and been turned back on. We always maintain a small amount of -- our customers maintain a small amount of standby horsepower just for operational reasons. And the delta between what we see as a traditional annual run rate of normal standby horsepower compared to that peak that we had back in the middle of the second quarter is down like 75%. So it's the significant improvement in the amount of standby horsepower that was used during that time.

Our next question comes from the line of Selman Akyol with Stifel.

Appreciate the difficulty looking out into 2021, but I was just going to ask you, can you talk about maybe what you see out there by basin? And I guess I'm a little surprised, at least when speaking with other companies, some sense of optimism with the strip over $3 and things potentially turning the corner, but I'm not sure I really heard that from you guys. So I was just kind of curious if you could just talk about it by basin, maybe what you're hearing from your customers?

Sure. So in our dry gas plays that are -- where we have customers, they're more driven by that commodity price. That would include the Marcellus, the Utica. We certainly share that optimism. But for the balance of customers, including an associated gas plays, or oil plays with associated gas production, we take a -- we have a much more moderate view. And the expectation is that we've seen both from analysts looking at natural gas production levels, as well as in dialogue with our customers is that we still expect to see aggregate softness moving into 2021 with optimism, and we're optimistic we're going to be able to pick up in the back half of 2021. But I think that maybe some of the discord you're hearing in the commentary is looking at businesses that are driven by dry gas as opposed to businesses that include oil and associated gas production.

Appreciate that. Just one other one for me. We've seen a lot of E&P consolidation, really starting to see it. Is there any thoughts on that in terms of relating to just sort of customer and customer concentrations, those kind of issues?

It doesn't throw up any concerns for us. We have a stable base of just top grade customers that we get to do business with. And as they're looking at consolidating and bringing in more capital discipline and financial discipline into their operations and take costs out, candidly, longer term, we expect to be a beneficiary of that as one of the key outsourced service providers that can help them do that. So we don't see any flags or any reasons to not be supportive and optimistic that further discipline and consolidation overall in the sector is good for the strong participants. We plan to be one of them.

Understood. And if I could just ask 1 more, I'm sorry. Any more thoughts in terms of asset sales as 2021? Is that just always continuously under review? Should we expect more? Or is there anything you can say there?

Yes. It's been continuous. 2020 has certainly a higher level of asset sales than we've had in prior years. But in all prior years, we've had it. We're going to continue to be very disciplined in looking at our fleet hard and moving out assets that we think are not strategic for our operations and our business. And so a level of asset sales will be ongoing.

Yes, this is Doug. I'd like to maybe top-up Brad's answer too on 2021 demand and outlook. And I think it's one of -- our caution is well heated. And we're simply saying that the market is opaque, but I think longer term, and I don't want this to be lost in today's message, is really the longer-term impacts of natural gas on greenhouse gases, on what's transpired, as Brad mentioned in his prepared remarks, on a major reduction in that area. And we do very much see natural gas as a fuel of the future, and we see demand being great. Our question just at this point, is that back half of '21? Is it later in the year? Is it earlier in the year? And I think that's where we feel a little more rather than to get over our skis on trying to predict that.

Our next question comes from the line of Thomas Curran with B. Riley Securities.

Trying to understand how demand is tracking the trending completions relative to the typical lag we've seen in past recoveries. Did your operating horsepower sequentially decline each month through 3Q? Which month was the lowest? And then did operating horsepower decline from September to October?

So what we're seeing right now is a fairly steady, and that includes month-over-month, and it includes quarter-over-quarter decline in horsepower as stop activity is higher than start activity. And it's pretty ratable to the quarter and to the midpoint of the second quarter to give us the exit utilization rate -- exit horsepower rate that we had, that we announced today.

Okay. So not quite at a clear bottom yet then?

Well, I think what we've said so far would indicate that we think the bottom is ahead of us as we still see softness for a couple of quarters. And then we do expect to see candidly, some outpaced opportunity for growth in the back half of 2021.

Yes. Just, again, further clarification. The rate of decline has slowed significantly, but still, in our view, decline in horsepower ahead.

That all makes sense. Doug, two guidance follow-ups for you. For aftermarket's 2020 revenue guidance range when it comes to the 5% reduction at the midpoint, does that cut solely reflect the disposal of the turbocharger business? And then could you give me the split between parts and services for 3Q?

On the guidance, yes, it's almost all the turbocharger. Q4 also tends to be seasonally one of the weaker quarters. So that's a piece. And then what was the question, I guess, historical on parts versus service?

Just what it was for 3Q, and ….

Q3 percent of revenue, services was 59%, parts 41%, and that was like 17.9% on service and 12.4% on parts.

Great. And then on SG&A, a nice reduction there in the guidance range from $113 million to $116 million to $105 million to $108 million what are the factors behind this latest step down? And do you think of this current quarterly run rate is sustainable into 2021?

I think, look, yes, on part of that, I think we do see the gross margin improvements as being sustainable longer term, I'll be candid and tell you that salary reductions -- while some of the headcount reductions are permanent and we have cut SG&A at all levels in the organization, I would see less permanency at those overall lower levels into perpetuity. Because we do want to get our salary levels back at some point to be able to attract and retain high-quality talent.

The next question comes from the line of TJ Schultz with RBC Capital Markets.

So what are the major things you need to spend money on to bring some of that idle capacity back to market if it's younger and larger horsepower. Is it just cost in moving around the units or mobilization costs? And would you think maybe moving those units to more gas tracted or different basins, whereas maybe the mix wasn't as large there before? Or are there other meaningful modifications that need to be made to redeploy the idle units?

Sure. The primary expense in putting units back to work is just make-ready. That is if they sat idle or if they've been on location, then we do take the time to go through the units and make sure that the maintenance is up-to-date. And since it's been idle for a period of time, it gives us that opportunity to do so without interrupting our customers' gas production. So that make-ready expense is a part of it, just making the unit ready. Second is, yet, shipping and startup. And so those are the main costs associated with that. If we have units that need some additional changes to their configuration, whether it's to the size or to the controls, to move to that next application, then we would potentially engage in some repackage activity. Some of that shows up in growth CapEx. Some of that shows up in OpEx. But those are the primary expenses that are required to reactivate. And I'll point out that, that's in our guidance, and that's a level of investment or spend that is always in our business, either on gross margin or in our CapEx.

Okay. But make-ready costs are OpEx?

Yes.

There are no further questions in the queue. I'd like to hand the call back to Mr. Childers for closing remarks.

Great. Thank you. Thank you, everyone, for participating in our call today. As our results demonstrate, we continue to take the right steps to differentiate Archrock and deliver value for our shareholders. I look forward to updating you on our fourth quarter call early next year. Thanks, everyone.

Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.