Enerflex Ltd. (EFXT) Q2 2016 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Enerflex Second Quarter 2016 Results Webcast. [Operator Instructions] As a reminder, this call is being recorded Friday, August 5, 2016. I would now like to turn the conference over to Blair Goertzen, Enerflex’s President and Chief Executive Officer. Please go ahead.

Thank you, operator, and good morning everyone. Thank you for joining us and here today with us is James Harbilas, Enerflex’s Executive Vice President and Chief Financial Officer. During this call, we will be providing our financial results for the three months ended June 30, 2016, a brief commentary on the performance of our three business segments and a summary of our financial position at the end of the first half of 2016. Approximately 1 hour following the completion of this call, a recording will be available on our website under the Investors section. During the call, unless otherwise stated, we will be referring to the three months ended June 30, 2016 compared to the same period of 2015. I’ll proceed on the basis that you’ve all taken the opportunity to read yesterday’s press release. While notwithstanding the signs of a modest improvement during the quarter, the global energy markets still remain depressed from the prolonged downturn in oil and gas prices and significantly reduced capital spending activity levels. Although commodity prices continued to remain low, they've improved over the second quarter of 2016 and the company has realized increased opportunities in the United States and the rest of the world segments. For Enerflex, this has resulted in a $68 million or 78% year over year increase in bookings during the second quarter, with the most notable increases in the USA and the rest of world segments. The company also saw an increase in backlog of $11 million from March 31, 2016 due to stronger second quarter bookings. The improved bookings trend experienced during the second quarter of 2016 continued into the third quarter, with over $100 million in bookings for large projects in the USA and the Middle East regions for compression and process equipment. We continue to see additional meaningful opportunities in those markets through the remainder of the year. Overall, during the second quarter, global headcount was reduced by 153 to just over 1,900 people and $0.5 million of severance costs have been recorded. This step along with other ongoing cost savings measures have contributed to the reductions in costs during the second quarter and are anticipated to result in annualized savings of $35 million to $40 million. Enerflex’s financial performance also continues to benefit from the recurring revenue streams derived from existing and new long term rental and service contracts and through our view graphically diversified business. The company will look to continue to preserve awarded gross margins and aggressively manage SG&A expenses. Steps taken last year and into the second quarter of 2016 have allowed a greater focus on key market opportunities. The company has continued to deploy capital and pursue growth opportunities in the Middle East and Latin American regions. Building on the mid-2014 acquisition, Enerflex has successfully positioned itself to diversify its revenue streams and to increase recurring revenues globally. Enerflex will continue to pursue growth opportunities through the remainder of the year relative to internal return goals. During the quarter, the company completed the commissioning of the process equipment for a large rental project in the Middle East region. The company now has added approximately 105,000 horsepower in rental projects in the Middle East and Latin American regions over the last 15 months, growing the fleet to almost 500,000 horsepower, which will continue to contribute to increased recurring revenues going forward. Now, turning to the outlook for each of the segments, in Canada, bookings and aftermarket service activity has been negatively affected by the significant decline in activity levels from low natural gas prices and by the changes to the company's distribution agreement for GE Products respectively. As a result, bookings were $12 million in the second quarter compared to $37 million in 2015. Backlog has decreased to $107 million, which is a $44 million reduction from December 31, 2015. While some companies have proceeded with projects, activity has been drastically lower and the competition for the reduced pipeline of work has intensified putting pressure on awarded margins. Even with natural gas prices improving recently, it is expected that customers will continue to defer projects until there's greater clarity in the commodity price environment into 2017. The recent performance of the USA segment has been largely dependent on activities in the liquids-rich of US gas basins, which gave rise to new orders for compression and process equipment for this region. Despite the significant decrease in oil prices and the associated impact on NGL prices, the recent partial recovery in oil and gas prices may improve the outlook in the United States. For Enerflex, this resulted in bookings of $88 million for the second quarter compared to $50 million in 2015 and the first quarter 2016 bookings of $34 million. In addition, we have seen signs of continued strength in the third quarter bookings. At the end of the quarter, backlog was $132 million compared to $110 million in the first quarter of 2016 and $153 million at year end. Again, there is still uncertainty as to the duration of the new market reality in this region. Although if current prices hold, a slight uptick in bookings is expected; however, further increases in commodity prices would be required to significantly improve bookings. Enerflex is cautiously optimistic that there will be an improvement in enquiries during the remainder of 2016 and into 2017. Service revenues are expected to continue to provide some recurring revenue certainty in 2016. Enerflex has guarded optimism about the outlook in Latin America despite the political uncertainty that exists, most notably in Brazil. The development of the Vaca Muerta shale play in Argentina in the short to medium term and the ongoing energy reform in Mexico in the medium to long term could generate unprecedented opportunities for Enerflex’s products and services. Additionally, infrastructure developments in Colombia, Peru and Bolivia are expected to result in an increased Enerflex presence in these countries. In the rest of world, bookings increased by $55 million in the second quarter of 2016 compared to the same period of 2015. We also saw a $36 million increase in bookings for the first half of the year. Enerflex continues to pursue a number of large engineered systems and recurring revenue opportunities across the region. Backlog of $107 million at June 30, 2016 increased by $17 million since March 31, 2016 and decreased by $16 million since December 31, 2015. On another positive note, the company continues to improve its HSE culture and reduced its total recordable injury rate by 7% over the 2016 goal. Enerflex is also tracking above the 20% growth target for gas processing bookings and is currently within the range of its 35% to 40% recurring revenue target. I will now turn it over to James Harbilas, Enerflex’s Executive Vice President and Chief Financial Officer, to review our financial results.

Thank you, Blair. Financial results for the quarter weakened over the same period last year on lower gross margins in Canada and the USA, largely on reduced revenues, partially offset by an increase in the rest of world segment and by lower SG&A expenses and income tax expense. Consolidated revenue for the second quarter was $253 million. This decrease of $137 million was due to lower revenue in all three segments. Consolidated gross margin for the three months ended June 30, 2016 was $64 million or 25% of revenue compared to $82 million or 21%. Gross margin decreased in the Canada and USA segments, partially offset by an increase in the rest of world segment. The increase in gross margin percentage was attributable to project margin improvements and an increased proportion of higher margin rental revenue, partially offset by ongoing warranty disputes and severance costs. Selling, general and administrative expenses for the second quarter were $42 million compared to $45 million in 2015. The decrease was a result of a continued focus on controlling costs, including lower compensation expense, partially offset by costs associated with the OOCEP arbitration process and bad debt expenses. Compensation expense was lower due to lower headcount, reduced incentive accruals based on lower profitability, partially offset by larger mark to market impacts on share based compensation during the second quarter compared to the same period in 2015. EBIT for the second quarter of 2016 was $22 million compared to $38 million in the same period of 2015. The decrease was due to lower gross margin largely on reduced revenues, partially offset by reduced SG&A expenses. The provisions for ongoing warranty disputes, OOCEP arbitration process costs and severance and restructuring costs reduced EBIT by $6 million during the second quarter of 2016. For the second quarter 2016, Enerflex generated net earnings from continuing operations of $17 million or $0.21 per share compared to net earnings of $27 million or $0.34 per share in 2015. Over the course of the second quarter, Enerflex generated $18 million of cash flow from operations and for the first six months $68 million. Coupled with reduced capital expenditures, the company reported reductions on its borrowings of $39 million during the first half of the year. Continuing with the review of our product breakdown, engineered systems revenue decreased to $144 million for the second quarter, which was 44% lower as a result of reduced opening backlog in all three segments. Service revenue for the second quarter was $70 million, a decrease of 28% due to lower part sales and service revenues in all three segments. This decrease in service revenue was most significant in Canada which was impacted by the changes to its distribution arrangement for GE Products and by deferred maintenance by customers. Rental revenue for the second quarter was $39 million which was an increase over 2015. This was driven by increased activity in the Latin America and EMEA regions and an increase on customer contracts in the USA, partially offset by a decrease in Canada rental revenue. Moving on to our regional results, in Canada revenue decreased by $72 million to $58 million during the second quarter as a result of lower revenue across all three product lines, largely driven by the current economic environment. Engineered systems revenue decreased to lower 2016 opening backlog of $151 million compared to $332 million at the start of 2015. Service revenue was lower due to reduced part sales, while rental revenue was lower due to reduced utilization rates and lower unit sales. Operating income for the second quarter of 2016 decreased by $11 million as a result of lower gross margin, partially offset by decreased SG&A expenses. Lower gross margin was attributable to reduced revenues, lower project margins and severance costs of $0.5 million, partially offset by improved warranty experience. The decrease in SG&A was attributable to lower compensation expense on reduced headcount and lower office and occupancy costs, partially offset by higher bad debt expenses compared to the second quarter of 2015. In the USA segment, revenue for the second quarter of 2016 was $94 million. The decrease of $40 million was attributable to lower engineered systems revenue as a result of a decrease in 2016 opening backlog of $153 million compared to $412 million at the start of 2015 as well as lower service revenue on reduced part sales, which was partially offset by higher rental revenue on increased customer contracts. Operating income for the second quarter decreased by $7 million to $5 million due to lower gross margin, partially offset by reduced SG&A expenses. The decrease in gross margin was attributable to lower revenues, increased warranty expenses, partially offset by project margin improvements. Reduced SG&A expenses were primarily a result of the increased compensation expense on lower headcount. Revenue in the rest of world segment for the second quarter was $101 million. The decrease of $25 million was attributable to reduction in engineered systems revenue on lower 2016 opening backlog of $123 million compared to $172 million at the start of 2015 as well as a decrease in service revenue, partially offset by an increase in rental revenue with new rental projects in Latin America and EMEA. Service revenue decreased during the quarter on lower activity in Latin America and Australia and reduced part sales into Australia and Asia, partially offset by increased activity with long term service contracts in the EMEA region. Operating income of $16 million increased by $2 million than the same period of 2015 as a result of improved gross margin, partially offset by higher SG&A expenses. The increase in gross margin was a result of project margin improvements and an increased proportion of higher margin rental revenue, partially offset by the impact of lower revenues. The higher SG&A expenses resulted from the increase in costs associated with the OOCEP arbitration process, partially offset by lower compensation expense on reduced headcount. In managing liquidity, the company has access to a significant portion of its bank facility for future drawings to meet the company's future growth targets. As of June 30, 2016, the company held cash and cash equivalents of $163 million and has drawn $504 million against the bank facility, leaving it with access to $209 million for future drawings. The company continues to meet its bank facility covenant requirements with a net debt to EBITDA ratio of 1.86 compared to the required ratio of under 3-to-1. In summary, our second quarter financial results reflected the continuing uncertainty surrounding global commodity prices and we expect the commodity price challenges to continue through 2016, notwithstanding the significant uncertainty, reflected increased recurring rental revenues, improved project margins and increased bookings. The company continues to focus on controlling costs, preserving the strength of our balance sheet and generating free cash flow, positioning us to weather this prolonged downturn. We have deployed capital and will continue to pursue opportunities in those regions where there is economic growth such as the USA, Middle East Africa and Latin America regions. This completes the formal component of the webcast. Additional details can be found in our August 4 press release. We will now be happy to take any questions. Operator?

[Operator Instructions] Our first question comes from the line of Scott Treadwell with TD Securities.

I wanted to maybe just talk quickly first about the bid book and the bookings, obviously a good result in Q2 and it seems to have carried over. You said that there were some large projects that made up the Q3 to date bookings, does that imply that there's a little bit of chunkiness in that result in bookings and in the bids that you're currently working on or have you seen something, you hesitate to call anything sustainable, but it's a bit of a step function rather than just [go through a rattlesnake]?

James, do you want to address that?

We have seen a meaningful uptick in order enquiry levels in the US in Q2 relative to Q1, which have continued in Q3. So if we put that into relative or comparative terms, we've probably seen a four to five times increase in the number of order enquiries that we're seeing in the US. In the international markets, it is a case of very, very – somewhat larger projects than what we're seeing in the US, but we still see opportunities beyond what we've announced already in Q3 that could materialize between now and the end of the year, Scott.

That was the color I was hoping for. Moving on to the international stuff, I just wanted to get any color you can give me on your expected costs in the OOCEP process. Is that now a bit of a run rate or again you just don't have that visibility to give any sort of sense where costs might go as this unfolds?

The costs that you’ve seen, that shareholders have seen come through the P&L in the first six months of the year and we’ve always isolated those costs, I think that's a big chunk of cost that came in because we had a very intensive period of work that involved a lot of our expert witnesses and obviously our legal firm getting the case prepared and that was filed in April. So we expect a bit of a low here because now the ball is in OOCEP’s court and they've got to basically file their response. So we don't anticipate this to be the run rate. We’ll probably see additional expenses again in Q4 that could potentially be in this range that you see in Q2.

The last thing I just want to kind of touch on Canada, it sounds certainly from the commentary in the numbers that the improved gas pricing hasn't helped Canada yet, is that fair both from obviously order enquiries but service and any sort of sharp end of the stick revenue?

I think that here in Canada Scott, just to add to the bookings enquiries, there has been a significant improvement in the enquiries, although there hasn't been anybody that has decided to pull the trigger on the capital yet. But the enquiries have significantly improved with respect to engineered systems. On the service side, it is still the same environment that we've had for really the past two quarters where there is major deferrals, major maintenance and we’re really now in just sort of the minor maintenance oil change type mode and we don't see that changing unless there is run-to-failure or shut-ins that are occurring which again could even exacerbate the problem here in Canada further.

That’s great, because that actually leads to my next question, obviously one of the risks for producers or facility owners is like you said catastrophic failures, have you seen cannibalization or anecdotally heard about cannibalization where I know we'd talked in the past about a facility having four compression units but only having to run two and so you've kind of got some redundancy there. Do you get the sense we're chewing through that redundancy at your point, we haven't been spending money on it, so the wall is coming at some point?

Yeah, hard to really tell what producers are thinking or doing. Obviously, it's not anecdotal and we've seen that when some equipment does comes off service or off line when it fails and it's not put back online again, and so we really to provide any further opinion on that it would be probably a little bit problematic in the fact that we just don't have a great look at sometimes inside, because we're not getting called out other than for some very minor maintenance on kind of what their strategies are. But you can't run forever, it's equipment and we do know that.

And have you found the change in relationship with GE, has that hindered your sort of intelligence gathering capabilities or is it just – it's the markets, the market you kind of get it?

The GE relationship has not hindered our ability, we're still largest provider of service and we have great exposure, but the market is fairly closed at the moment.

Our next question comes from the line of Jon Morrison with CIBC World Markets.

James, is it fair to assume the Canadian margins will be challenged to expand from current levels absent the decent increase in bookings and facility throughput on the engineered systems side or a recovery in the field service work, just given the fixed operating costs you have in that business?

I think that Canadian margins here are going to remain challenged for the balance of this year, especially given what we're seeing in terms of the bid pipeline, Blair touched on that a little earlier where there's a lot of enquiries out there, but customers are very, very slow to pull the trigger. So we expect the balance of the year to be a challenge and as a result of that we expect manufacturing, absorption of overhead costs to deteriorate into the last six months absent any material bookings. So I wouldn't see a meaningful uptick from here absent some meaningful bookings that can obviously be booked and executed within the last six months to record revenue.

Is it fair to assume that you're fairly cautious about trying to make further cost reductions on the service side, given that things will ultimately turn at some point and you want to be there to take advantage of that opportunity set?

There are still a couple levers to pull, Jon. They're not big ones at the end of the day. So to I think support your observation is that we like the way that we're sized at the moment here in Canada with respect to service, in fact we’re quite happy the way we're sized everywhere in the world at this point after the past year and a half of adjustments. But we'll just have to continue to monitor how this goes over the next quarter in terms of margin. We've got great utilization. It just isn't generating a lot of revenue.

On the service side in Canada, have you seen any material decrease in hourly door rates for servicing customers in the past three months, just given the low base of work that's being bid out there in the field?

Yes.

Can you can you give any color on the expected delivery schedule of the bookings that you had in Q2 and post-quarter end? I'm just wondering if it's in line with your traditional schedule of kind of 12 to 18 months or under a tighter timeline than we normally see.

These bookings that we recorded in Q2 and obviously some of the subsequent bookings that we recorded in Q3 will be on a much more accelerated schedule, in fact some of those will obviously benefit Q3 and Q4 from a revenue recognition standpoint.

On the international wins that you guys had, is there any chance you can disclose country wins or you’d like to keep that close to the chest at this point?

We're going to keep close to our chest at this point. We’ll get into some more detail as the year progresses.

Can you give any update on the incremental opportunities that are out there in the market on the rental side? Are you seeing a major slowdown in the last six months in LATAM and EMEA or there still is things being bid out in the market?

James, do you want to address that?

I mean there's still opportunities out there, so I want to address that right up front and there are opportunities that we're pursuing. I don't think that the opportunities that we are pursuing though in the Middle East and in Latin America on the rental side will result in an award here in Q3. I think it's going to be a late Q4 award or potentially even early 2017 the way we're seeing the timeline shakeout, but there are still opportunities out there and we continue to pursue them. The timing of awards has just become a little more lumpy.

James, on the international margins, was there any one-time revenue that was captured this quarter where the cost would have already been incurred in the previous quarter? I'm just wondering if there's anything bumping up the Q2 margins or we're just seeing the impact of no one-time cost coming through in the quarter and ultimately you’re growing exposure to the recurring revenue stream.

I'll answer that question by talking about the margins on a consolidated basis, Jon, because you’ve touched on it. I mean, 25% gross margin is in the level that we've seen recently, so typically gross margins will always depend on a couple of factors, obviously product mix plays a role and that’s compression versus process equipment project execution relative to awarded margins obviously plays a role and then relative contribution of rentals and service to the overall revenue and finally absorption of overhead in our manufacturing facilities. So Q2, we see that as a high watermark with respect to the gross margin percentages. We basically ticked all of those boxes that I mentioned or those factors that I mentioned. So going forward, I think that it would be fair to say that we'd see margins come off of this level maybe 200 to 250 basis points. But this is obviously a high watermark for us and we did a great job of executing projects and we continue to benefit from a higher relative contribution of rentals and service which are a higher gross margin business.

Of the incremental awards or bidding opportunities that you're seeing in the US, is that your traditional customers and traditional geographies or are you appearing to win over certain new customers that you haven't been successful in the past?

They’d be very traditional in terms of customer and geography.

Last one just for me, just in terms of the awards that you are seeing come through and customers pulling the trigger, are you continuing to see a deterioration in the embedded margins or ultimately it feels like pricing has officially had hit a trough in the engineered systems side?

I think that certainly internationally is more favorable and just due to the type of work that's being awarded, but in the US, I would say that the margin seems to have hit a trough overall at the bottom and so there's nowhere to go now but up.

[Operator Instructions] Our next question comes from the line of Greg Colman with National Bank Financial.

I just had a couple of quick ones here; a lot of my questions have already been answered. Talking about capital deployment and your ability to take your operating cash flow [throw it back in the field] James, I know a lot of it depends on probably someone lumpy wins on the rental side, but can you give us any sort of goalposts as to what we could be expecting for the back half of the year in terms of putting capital to use?

The opportunities that we've got on our radar screen right now in total probably equal about $60 million to $80 million. Even if it is awarded though in let's say Q3 hypothetically, I think it will be later than that, but even if it's awarded in Q3, we wouldn't be spending to those levels, right. We would be allocating that capital to these opportunities and then obviously the spend would happen as we build the units and do any of the installation and construction work in the field. So I would see that spend happening in 2017 in a material way, not necessarily 2016.

So for the balance of the year, the out flow in capital in order to secure additional rental contracts will probably be relatively de minimus and then it would be in 2017 picks up again, again assuming successful award?

That would be a fair statement, Greg, yes.

Just quick modeling side, when we're looking forward, I think you touched on this early in your prepared remarks, but I’m sorry, I might have missed it. We did see continuation of sort of a few restructuring and severance cost in the quarter. Should we expect that level to carry on into Q3 or [indiscernible] to the end of what's necessary?

I think that Blair touched on it, I mean there's still a few levers to pull. And if we continue to see softness in the Canadian market, we will pull those levers and there could be additional severance costs that we record in the quarter Q3 and Q4. I wouldn't expect them though to be at the levels that we've seen in 2015 where we booked some very significant restructuring and severance costs.

And then just lastly for me, on the discussions OOCEP, you’ve given us great color as to legal costs and where we're going to see ebbs and flowing, but could you give us an idea as to the timeline for any additional information as to how that process is going or is this the sort of thing where we probably won't get any insights until things actually wrap up? And if that's the case, when that would be?

So it will most likely be the latter. I mean, we’re not going to talk about the OOCEP arbitration until we obviously have a decision and we’ll update the market at that point.

And what would be the expected timeline for a decision?

These arbitration processes take some time. We wouldn't expect a decision before the end of 2017.

Our next question comes from the line of Q - Jeff Fetterly with Peters & Co.

James, your comment earlier on the international side in terms of margins and the compression in the second half of the year from where you were Q2, how much of that is a function of, as you said, the execution element that was in Q2 and how much of that was just revenue mix shifting back towards the manufacturing side in subsequent quarters?

It would basically be more revenue – sorry, not revenue mix, but on the execution side I think that will drive the shift downwards and that's not to say that – and some project mix compression versus process, but that's not to say that we would do – we wouldn't hit our awarded margins. It's just that the project execution this quarter was extremely strong.

And secondly, the US side, so the increase in bookings and the increase in enquiries that you're seeing, is that predominantly coming out of the Permian or can you just give a little bit of color in terms of the dynamic you're seeing around the market opportunities?

It is in the Permian, Jeff, and that's been a very interesting shift for us over the past 12 months and it continues to really produce the most amount of enquiries and the most amount of success both in the service and in engineered systems.

And the enquiries coming either out of the Permian or broadly in the US, is that biased to the compression so much or the processing side?

At the moment its compression biased, but there is also some process equipment in there including cryo.

What's your view today on the opportunities in cryo and your desire to pursue them?

I think they're quite slim with the overhanging equipment that exists today in the US out of the 2014 time period. But again, we've pursued that; we've done the homework; we have the engineering and design; we have still the long lead items in inventory, so we're going to continue to pursue it with the same vigor that we had when we started off two and a half years ago with that as a product add.

And I guess lastly, you've touched on the Canadian service side, but you've seen obviously a weakening in service in the US on local currency basis. What’s the outlook there?

It's not dissimilar to Canada, Jeff, where low gas prices have really driven some deferrals in maintenance. We obviously have a negative impact in Canada from the GE relationship, but we had a positive impact in the United States with the availability of parts. So while there's – we probably have a bit more of a positive situation there just due to the fact that we have walk-a-shop parts available to us now in the US, but it is really along the same lines as the deferrals we're seeing here in Canada on major maintenance just generally speaking.

Our next question comes from the line of [Hussein] with Industrial Alliance.

So further elaborating from one of the previous questions, you talked about unprecedented opportunities in Latin America. Could you elaborate more on that? Is this based on some general trend or something specific? Or is it part of the opportunities you were talking about in Q4?

If you look at a market like Argentina, I mean, from our standpoint these opportunities are unprecedented for a couple of reasons. One, we've seen obviously a change in government there that is trying to create a much more business-friendly environment and as a result we're starting to see much more in the way of opportunities coming out of that market in the in the Vaca Muerta. And obviously Mexico's energy reform which we have said repeatedly will take some time to materialize, but we do continue to see opportunities in that market and we expect those to continue into the medium term and long term. So that is ultimately what we're referring to. And then the last thing I'll say is just with respect to the Middle East, we still see a lot of activity in the GCC countries in the Middle East and continue to pursue rental and engineered systems and service opportunities there.

And there appears to be no further questions on the phone lines at this time.

All right, operator. Since there are no further questions, I'd like to thank everyone again for joining the call and I appreciate the technology, James and I are at opposite ends of the country at the moment, so I do appreciate the technology in 2016. So we look forward to giving you our third quarter results in November 2016 and until then have a good summer, what's left of it. Bye for now.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.