Enerflex Ltd. (EFXT) Q2 2019 Earnings Report, Transcript and Summary

Good day Ladies and gentlemen, and welcome to the Second Quarter 2019 Results Call. At this time all participants are in a listen only mode. Later we will conduct a question and answer session and instructions will be given at that time. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the call over to Marc Rossiter, Enerflex's President and Chief Executive Officer. Sir, you may begin.

Good morning everyone. Thank you for joining us. Here with me today is Ben Park Enerflex's Interim Chief Financial Officer. During this call, Ben and I will be providing our financial results for the three months ended June 30, 2019. A brief commentary on our performance and outlook of our three business segments and a summary of our financial position. Approximately one hour following the completion of this call, a recording will be available on our website under the Investors section. During this call unless otherwise stated we will be referring to the three months ended June 30, 2019 compared to the same period of 2018. I will proceed on the basis that you have all taken the opportunity to read yesterday's press release. Enerflex's second quarter financial results, including revenue and gross margin benefited from our strong execution on major engineered systems projects. Additionally, we saw continued growth in our service and rental product lines, resulting from the company's ongoing strategy to expand our recurring revenue offerings. During the quarter, new project activity levels and customer spending reflected the challenges facing the natural gas industry, particularly in North America. New capital funding regimes and temporary egress constraints in key basins resulted in engineered systems' bookings that were lower than the same period last year. Enerflex remains focused on opportunities to increase recurring revenue from our rental and aftermarket service business lines in all regions. In the United States, we invested heavily in the expansion of our contract compression business, which has grown by 51% on a horsepower basis in the last year and over 80% since July of 2017. Our contract compression fleet contributed to significant recurring revenue growth in the USA segment this quarter, and is a major part of our strategy going forward. Additionally, sustainable progress was made on our last term BOOM projects in Latin America in the Middle East. These projects remain on track to commence operations and begin generating recurring revenue in the first half of 2020. Looking to our regions. In the United States, recent performance has been largely driven by the industry's investment in shale oil and gas. In recent periods, our customers have made a general shift to using free cash flow to fund growth CapEx, which has resulted in a more disciplined approach to capital spending. Additionally, the Permian continues to experience temporary egress issues for gas and liquids. We anticipate that the resolution of these issues will offer relief to our customers. The company's acquisition of rental assets in 2017 added an established and growing platform that contributed to increasing recurring revenues for this segment. Enerflex has continued the expansion of the U.S. contract compression fleet, which now consists of approximately 260,000 horsepower. We remain focused on investing in these assets and as production increases, the company sees additional potential in this high growth market. As we look forward Enerflex remains focused on building on the success of its engineered systems products in the various liquid-rich plays, where we aim to be the supplier of choice for gas compression and gas processing solutions. Additionally, our products and services will support the continued development of upstream operations and the supply of gas required by expanding LNG industry. Further development in key resource plays it should translate into increase demand for Enerflex's engineered systems products, as well as contract compression solutions to improve performance in maturing fields. Looking at the rest of the world segment, opportunities for BOOM project's rental and service offerings remain strong in several countries. In the Middle East, we continue to see stable earnings from our rental fleet, which consists of approximately 100,000 horsepower on contract. The company is constantly developing new recurring revenue opportunities in this region. In Latin America, Enerflex remains optimistic as the key driver for growth is a development and build out of natural gas infrastructure in gas producing markets. Argentina, Brazil and Colombia represent significant asset ownership growth opportunities. Enerflex is focusing on the build out of infrastructure that will serve producers in a vacuum [ph] where to shale in Argentina, presale gas in Brazil, and associated gas that comes with oil production in Colombia. One of the company's core priorities is maintaining a high utilization in our global rental fleet. We have redeployed assets from Latin America into the U.S. region and internationally to this end. As mentioned, we are making progress on the multiple BOOM projects in Latin America and Middle East, which are expected to commence operations and begin generating recurring revenue in the first half of 2020. BOOM projects are a valuable part of our future strategy, which we aim to grow by combining our engineered systems and aftermarket service expertise with a strong track record of asset ownership. Turning to Canada, revenues from major projects award in the second half of 2018 drove strong financial results in the quarter. However, a fulsome consideration of the macroeconomic conditions Canada, leaves Enerflex to expect growth to be challenged in the near to mid-term. As a truly global organization with a favorable mix of geographies and product lines, Enerflex has a positive outlook. We've demonstrated excellent execution of our backlog, notable growth in service and rental product lines. And because we sell, rent, service, own and operate natural gas infrastructure we are well positioned to continue providing optimal solutions for our customers as they navigate their way through the cycles of their industries. I'll now turn it over to Ben Park, Enerflex's Interim Chief Financial Officer to review the financial results.

Thank you, Mark. Revenues of $542 million for the quarter reflect improved results across all product lines, particularly engineered systems on the strength of projects in the USA and Canada segments. Enerflex's service and rental product lines benefited from increased service activity levels and the continued organic expansion of the contract compression fleet in the USA. Consolidated gross margin for the quarter was $110 million compared to $72 million as a result of the increased revenue and improved gross margin percentage. The improvement in gross margin percentage was due to strong project execution, the realization of higher margin projects from the opening backlog and the continued contributions of the service and rental product lines. These improvements were partially offset by higher estimated cost to complete certain projects in the rest of world segment. Selling, general and administrative expenses for the quarter were $47 million. This was $3 million higher due to increased compensation resulting from higher headcount and increased profit share on improved operational results, partially offset by mark-to-market impacts on share based compensation. The increased revenues and improve gross margins resulted in EBIT for the quarter of $64 million. Net earnings for this period was $41 million, or $0.45 per share, compared to net earnings of $20 million, or $0.23 per share in 2018. Adjusted EBITDA was $84 million versus $51 million in the prior year. The increase in adjusted EBITDA was largely driven by the higher margins as previously mentioned. During the quarter, Enerflex invested $61 million in rental assets, largely in the USA, continuing the organic expansion of our contract compression fleet. On a regional basis, in the USA segment, Enerflex’s bookings of $97 million, were reflected of decreased customer spending in the quarter as Mark mentioned. Revenue in the USA was $327 million. This increase of $108 million was largely due to engineered systems revenue as a result of the continued progress on certain large projects. Service revenues also saw an increase as a result of higher activity levels, while rental revenues improved due to the organic growth of the contract compression fleet. Operating income for this segment increased to $50 million driven by the higher revenues across all product lines, and improve gross margin performance on strong project execution. This was partially offset by increased SG&A cost driven by the higher compensation on a larger workforce and increased profit share on improved operational results. In the rest of world segment, bookings of $15 million are related to projects in Latin America and the Middle East. The backlog of $40 million was lower than at December 31 2018, as engineered systems revenue has outpaced bookings during 2019. Revenue in the rest of world for the second quarter was $92 million, a decrease of $25 million from the comparative period due to lower engineered systems revenue, partially offset by higher service and rental revenues. Engineered systems was down in the quarter as a result of lower opening backlog. Service revenues increased due to higher activity levels in Australia and revenues generated from service agreements in Latin America. While rental revenues were higher on the continued performance of long-term rental assets, and the sale of idle rental units in Latin America. Operating income of $3 million represents a decrease of $8 million, compared to the same period of 2018. This decrease was the result of lower revenues and higher estimated cost to complete certain projects, which negatively impacted margins in the quarter. SG&A costs were consistent with the prior year. Turning to Canada. Bookings of $59 million included a power generation solution sold to a customer outside the oil and gas industry. In addition, Enerflex secured over $10 million of long-term service and maintenance agreements in the second quarter of the year. Revenue in Canada was $123 million, an increase of $54 million over the compared period on higher revenues for all product lines. Engineered systems revenue was up due to continued progress on projects from opening backlog, while service and rental revenues improved largely due to increased parts in equipment sales. Operating income increased by $12 million due to higher revenue and improved gross margin percentage, again resulting from strong project execution. SG&A costs were consistent with the comparable period in 2018. Turning to the balance sheet, Enerflex continues to expand our global rental fleet, consistent with our strategic objective of increasing recurring revenue. Rental revenues grew by 28% over the comparative period. The company also remains diligent in managing working capital to retain flexibility, to pursue opportunities as they arise. Enerflex also has access to a significant portion of its bank facility for future drawings to fund the company's growth. As at June 30 2019, the company held cash and cash equivalents of $224 million and had drawn $55 million against the bank facility, leaving it with access to $615 million for future drawings. The company's net debt-to-EBITDA ratio currently stands at 0.5 to one. This concludes our second quarter financial update. I will now turn the call back to Marc, for his closing remarks.

Thank you, Ben. Production of natural gas will grow globally, which should continue to drive demand for Enerflex products and services in the long-term. Strengthening the backlog provides a visibility for engineered systems revenue through 2019 and into 2020. Enerflex continues to benefit from the earning stability derived from our asset ownership platform and long-term service agreements. The strategic priorities for Enerflex are: Number one, to focus on increase in our recurring revenue streams derived from BOOM rental and service contracts. Number two, to develop a geographically diversified business. And number three, to continue expanding our product offerings in the engineered systems space globally. This strategy and priorities have allowed Enerflex to deliver superior returns over the long haul. Moving forward, the company remains committed to this long term proven strategy. This completes the formal component of the webcast. Additional details can be found in our August 8 press release. We would now be happy to take any questions.

[Operator Instructions] And our first question comes from Jon Morrison with CIBC Capital Markets. Your line is open.

Good morning, all. Marc, can you talk about the elevated international costs in the quarter? What drove those and ultimately some sense of your degree of confidence that those will be fairly ring fenced to Q2 specifically?

Yeah, sure. Thanks, Jon, by the way for the question. Erosion of the results from costs related to the completion of ITK field work in the MEA region. The relevant projects are nearing completion. We don't expect further erosion going forward. In addition, as part of our continuous improvement efforts, we've developed a new project matrix, which requires ITK projects to satisfy three specific criteria before we consider bidding them. They have to use mostly Enerflex equipment, they have to include an opportunity for current revenues. And the total ITK revenue from all those projects and our global portfolio can't exceed 20% of revenues. The projects had experienced some margin erosion in the quarter were all booked and executed prior to this new app risk appetite statement. So I do believe using your words that these projects are ring fenced. And it's our goal going forward to not have any projects like this provide material erosion to results?

Is it fair to assume that the cost creep is largely on things that you would have outsourced and not been necessarily within your controlled settings?

I think it's a little bit of both. I think when you do an ITK project, everything is within your control to a certain degree. And you have to have that mindset. What I can tell you is that these projects are nearing completion. And we hope to have them in the rearview mirror in short order.

In terms of the order inquiry, you highlight that it's still healthy, but obviously, conversion into bookings has been slower. And we've seen that across a number of your peers. Do you believe that the function of bids having already been put in the market that weren't necessarily delayed at this stage? But could get delayed because of spending constraint that you're seeing across producers? Or do you ultimately just believe that it is a function of some timing and it's just kind of a shifting around, sanctioning your projects from quarter to quarter?

So I think it's more the second thing you said. I believe, so our customers are midstreamers and producers. And our midstreamers customers, customers are producers. So we can sort of focus on producers, I believe that there's uncertainty around what commodity prices they're going to realize in the short to medium term. I also think there's some uncertainty about what living off of free cash flow really means when it comes to sanctioning larger projects. And so, as the companies start to get more certainty around what their cash flow is going to look like, what their price decks are going to look like, they'll have more confidence in the coming quarters to proceed with the infrastructure that they need to get the gas online.

So it's fair to assume, though, that you don't believe you've experienced any sort of a market change in your hit rate or win rate across North America at this point?

No, I do believe that our market share in North America has not changed. And that's not what's causing this decrease in bookings from Q4 to Q1 and Q2. I think it's more of a market thing than an Enerflex thing.

Okay. Maybe just next one is better ask for Ben, but you just talked about the expectations of bookings moving to more normalized levels. Would it be fair to assume that we should be expecting a book to bills ratio below one time for at least the next couple quarters in the context of that statement, and just given how strong the backlog is given where we are right now?

So Jon, I'll take that one. Try to balance the fact that we don't provide quarter by quarter guidance. So we would not really want to tell you what we believe the book to bill ratio is going to be for the next couple of quarters in that light. And when we use the term historical levels, I also know that that's somewhat difficult to understand what we mean by that. I think the macroeconomic conditions in the US and Canada that you know very well that will be reflected in our bookings. That's about as specific as that's like to get.

No. I appreciate that. Marc obviously Enerflex has had a strong track record for picking up market share in North America in the last 18 months and arguably internationally. And we can see that through some of the disclosures of your peers. Do you believe that's creating environment where we could see increased pricing pressure in the next couple of quarters, just from a perspective that a few of your competitors probably want to give up market share for too long before trying to win back some of what was lost.

So I do think that's a reasonable expectation and this is something that Enerflex people, especially people in engineered systems business have essentially been managing for the 40 years of our company's existence is something that I have been heavily involved with over the last 20 years that I've been at the company. So managing these cycles up and down as part of what we do. One of the things that happens in the down cycle is your cost structure changes along with maybe pricing power that's in the market. So I do expect there to be tough competition in the next few quarters. But I do believe we’re well-positioned to be as competitive as possible.

Perfect. Maybe just a last one for me on the international side, you talked about. BOOM still being strong in terms of bidding opportunities out there. Have there been any major awards that you didn't receive that you thought you are well positioned for? And then just secondarily would you expect any of those opportunities to be awarded in the next two, three, four quarters? Just I know it's tough given the long gestation period for some of those projects, but anything you can give us to how calibrate our expectations that would be helpful.

Sure. I would like to tell you that our market share for international BOOM projects is right where I want it to be. Every quarter there's projects that we are working on. We do have a good bid pipeline for BOOM projects in Latin American and international regions. And I wouldn’t say that there's any material losses that we would have to bring up to discuss in this call in that market.

Okay, perfect. I appreciate the color. I will turn it back.

Thank you.

Thank you. And our following question comes from the line of Greg Colman with National Key [ph] Bank Financials. Your line is now open.

Thanks for taking my questions. Congratulations on a very strong performance in the quarter. I wanted to start by looking at your margins, gentlemen. We had really good margin expansion in the quarter, both year-over-year and sequentially which you have been guiding to strength in the margin profile the backlog. Where are we standing now with the margins we saw in Q2? Is this what we should be thinking about as a good run rate margin level or would you still, as you have in the past, point to the margin profile of the backlog, exceeding that of what we're already seeing in the income statement results?

Greg first of all thanks for recognizing the good operational performance in the quarter because that something we're really proud of. When we entered this year with this record backlog, the biggest challenge to all of our 2500 employees was delivering on that backlog at booked or better than booked margins. And I'm happy to say that the team is done a really good job in the first half of the year doing that. I don't expect their performance change. We got a good group of people that are laser focused on executing on that backlog. With respect to point you to particular margins we expect over the coming quarters I would rather not do that. But I do like the backlog. I like the way our people are executing on it. And I fully expect that to continue.

No worries, we will take that interpretation there. And switching over the booking side. I will give another shot. In previous conference calls the company's guided towards historical booking levels of $250 million to $300 million. We saw this quarter with bookings of $170 million and obviously the microenvironment is what we all know it is. Should we be thinking about this quarter as a good indication of what our historic average is or would you still point to those prior conference call comments of 250 million to 300 million as being a good bookings level?

I would rather not point to a particular number by any stretch. If you look over the last four and half year since the beginning of 2015, when we are really entering that the downturn 2015, our quarterly bookings average is $272 million when you stretch back 4.5 years. And there is a number of quarters in that 4.5 years where we were below $272 million, including the last two quarters. So, without getting into exactly what the bookings numbers are going to be here, what I expect them to be the next two quarters. I'd like to leave you with, we are good at managing the quarters that were below the average and we're good at managing the quarters where we're above the average. So I've got a high degree of confidence that our sales teams are doing the best job they can to get all the bookings we can get in the marketplace. And a lot of the factors that will show you exactly what we booked in Q3 and Q4 have a lot to do with the market. But I like our market share. I like what our people are doing. And we'll see what the future brings. But I am optimistic about it because I know what our people are working at. And I do think that some of the egress issues in the United States, they're being solved a little bit slower than we thought. But we do you see some solutions coming in the latter half of the year.

That's right. I appreciate it. And that makes sense versus your historic average. Switching over the BOOM contracts for a minute that are coming out stream in early 2020. Would you be willing to quantify the associated EBITDA that's being switched on an aggregate with those contracts?

I don't think we are willing to tell you what the EBITDA is going to be coming from those contracts. And I am just looking at Ben to make sure that we're consistent with as disclosure.

That's right. I don't think that we've ever really given that information.

Okay, no worries. That's worth a shot. On the quarter just been focusing a little bit on the cash flow statement here. Pretty large investment working capital during the quarter not unexpected given the very strong performance on the EBITDA. Moving to the back part of the year, how should we be thinking about working capital? And also -- and then related to that regarding free cash flow, how are you thinking about priorities in deploying any of that free cash flow the back part of the year?

So, Greg on the working capital for the quarter, if you take a look, we had a significant impact from the decrease in our unearned revenue. So as Marc mentioned, we have some fairly significant projects that were in the backlog. And we asked customers, obviously to prepay for some of those because we don't want to be funding those projects. And so that is why you saw such a significant impact as we progress those projects on our unearned revenue. So that's a significant portion of what happened or occurred within the working capital. Other than not, I would say that we were continuing to manage it as we normally do and make sure that we're as disciplined as possible with respect to that working capital.

So just sort of taking that and stretching it out over the back part of the year projects kind of come through, should we expect that that working capital draw that we saw in Q2 to reverse into a harvest as the projects come through to completion?

Yes. I think it's fair to say that that trend should soften a little bit we shouldn't see as big a decline. And as we receive more milestones, buildings on these significant projects, you can see it going in the opposite direction as well. But again, with working capital it's a function of timing as well, right? So can't guarantee specifically what's going to happen with it.

Got it. Okay. And then just one more for me. This is actually on staffing and then don't take this the wrong way at all. I am just curious on the CFO search, is this something where we should be looking for something potentially announced in the near term, whether internal or external? Or is this a longer term process where they'll bug you on it, and it's something that will come up over the coming couple few quarters?

Thanks for asking Greg. The getting to leadership had Enerflex' solidified. And on board, the strategy is a top priority of mine. The search has been going very well with a lot of great candidates. So we're working as quickly as we can to get the right kind of financial leadership in the company that will serve us over the long term. And that's probably all I want to say about it.

But a high priority, so we can interpret that as we see.

Oh, yes.

Got it.

Yeah. Very high priority. Very high priority.

That's it for me, guys. Thanks a lot. I'll pass back.

Thank you. Our next question comes from the line of Aaron MacNeil with TD Securities. Your line is open.

Hey, good morning, guys?

Good morning.

Greg, obviously I already asked you the question on margins. But if I specifically drill down to the US segment, I assume from your comments that there was nothing one time in the segment that positively impacted margins and the quarterly performance we saw is just a function of stronger than -- stronger execution and perhaps maybe higher fixed costs absorption with higher throughput through the Houston facility. Is that correct?

Well, that's an extrapolation Aaron of my comments a little bit. In our engineered systems, business and margins that realize margins are a function of book margins' execution, and cost base. And I think when you -- we can point to each one of those three things to various degrees. When we look at the increase in margins. We did talk about the fact that the product mix in the backlog entering the year was more heavily weighted towards gas processing and international opportunities then in year, in quarters past those opportunities typically come with higher book margins. So that’s a part of it in addition of the fact that our team did really well. And in probably the recent past costs for input materials have leveled off from a lot of volatility we saw especially in the steel markets in 2018.

Okay. And so what’s like the higher throughput in the Houston facility the factor it all or…?

Yeah. So that’s a good point. You get the most profitability out of a shop when it’s very busy as long as you’re managing that business well. And in the first half of the year in Calgary in the U.S. our shops were at a good level of business and a management level business. But it doesn’t allow you to absorb a lot of those fixed overheads more efficiently than if you are not so busy.

Okay. And then maybe adding on Jon’s previous question on international margins. Were the ITK contributions negatively contributed to EBIT and I guess I'm looking at it from the rentals perspective and thinking like would EBIT drive from the $31 million of rental revenue be higher than the combined segment result?

I can tell you that a lot of people know that recurring revenue margins are better than engineered systems margins. And we don’t talk about ITK versus new units within the engineered systems segment, but it’s reasonable to assume that the margins from recurring revenue are higher than the margins in the ITK business. And the recurring revenue is what we’re really happy within the region and that going forward a lot of our project oriented work is going to be focused around recurring revenue and a little bit less so on ITKs and engineered systems sale.

Okay. And I guess moving to capital allocation, can you give us any guidance on what do you expect capital spending to be in 2019? And maybe even if it’s just -- if you expect to stand within cash flow or exceed cash flow, under-spend cash flow. And maybe you can also give your updated outlook on the growth potential of the U.S. contract to Russian business.

Sure. I’ll answer the first part of that. Then I will ask Ben to fill on any details if I missed. We made our CapEx plans known at the beginning of the year. And I don’t see us materially changing from those plans. Now as it comes to specifically on spending cash flow if you look at the whole year, I don’t expect to but Ben I’ll hand it over to you on that front.

No I would agree with you. I think that our plans were dates kind of at the beginning of the year and we see continued strength, I guess in our recurring revenue lines which should not alter our plans as we outline before.

Okay. And then the second piece of it just a general growth outlook for the U.S. contract compression business?

The outlook is good. That is the segment of the overall U.S. business. Where we have the most positive line of site to new orders. And I think it’s a big function of the fact that we’re starting from a relatively small base. But we’ve been successful in adding horsepower to the fleet. Adding it under bid contracts. And building the equipment in our own shop to satisfy those needs. So we’re really optimistic about our ability to grow market share in the United States on a contract compression business.

Would it be fair to assume that maybe the strength, the greater strength in the contract compression business versus engineered systems just given your customers focus on capital deployment spending cash flow like I guess so you seeing a shift in demand from sale of equipment to rental of equipment?

We’re definitely seeing some customers. And this is on an anecdotal basis, but we talked and that prior to this would have been very much people that buy equipment and put on their own balance sheet. And now we have good discussions with them about what Enerflex can offer in that regard. So I would hate to call it a macro shift, but there is situations where traditionally purchasing customers are looking rent. Part of buying the platform in 2017 was to introduce ourselves to brand new customers that only ever rented. And so there’s a lot of people that above has been rental and we’re starting to develop the relationships with them and growing our business there. So I would say growth in contract compression is a combination of those two thinks; people that want to know what contract compression can do for them as they try to understand what living within free cash flow means; and other people are about [ph] rental companies whose demands are just increasing.

Okay. And then last question from me. Can you give us any additional details on the rental assets in Mexico that are coming up against their contract expiries? I guess I'm just wondering, like as pricing changed in the country or are you just seeing better opportunities in other markets like the U.S.?

If the equipment is idle, then the entire management team has a number one priority to reemploy those assets, anywhere in our global platform to get them making money for us again. And so it's not -- I wouldn't say it's as much of a micro pricing issue that we could think we can get better pricing elsewhere, it's just one step does come off rent, we look globally where the best places to put them back on rent under the best possible contracts and that's where we move them. It's part of our global footprint that allows us to outperform people that are strictly isolated to one particular geographic market when it comes to rentals.

Okay. And I guess I'm paraphrasing here. But I recall that the commentary was something like that you wouldn't participate in the upcoming bids and Mexico. And so I might interpret that as the assets, there isn't an upcoming bid and the assets would be idle or I guess -- any comment?

Yeah. So, it's a good question. And thanks for bringing that up. We've got a good management team in Mexico, who's charged with maximizing utilization of our assets in the country. And dealing with Pmax is something that they're good at and understanding the short to midterm plans that Pmax has, and how we can navigate that system as effectively as possible. In past quarters, we said we would not participate. There's individual discrete bid processes that from time to time are attractive to us and from time to time are not attracted to us and we pursue those under their own merits. We are however committed to Mexico as a country within which we want to operate. It's provided good recurring revenue for us. And we look forward to a time where we can count on it being a growth region. The best I could tell you right now is -- we don't see Mexico as a large driver for growth for the company. That's why in my prepared remarks, I specifically called out Argentina, Brazil, Colombia, because we have line of sight to growth opportunities there, in those countries. Mexico, we're kind of taking it day-by-day, quarter-by-quarter, and doing our very best to maximize the profits that we have from those assets. And where we don't see an opportunity to continue utilizing assets profitably in the country, we'll move them elsewhere where we do see that.

Okay, that's all for me. I'll turn it over. Thanks, guys.

Thank you. And our next question comes from Andrew Bradford with Raymond James. Your line is open.

Thank you very much. Good morning guys.

Good morning Andrew.

So I'm just wondering -- I'm wondering about the near-term, we're going to focus back on the U.S. again. And I'm sorry for beating this one a bit more, but I just want to understand a couple of things. So one is, what is the -- what is your rate of build going to be looking like them as the backlog sort of contracts here? Are you going to keep up, this relatively high rate of engineered systems revenue going for the next couple of quarters or is that going to start to moderate as the backlog starts to diminished?

Andrew, thanks for the question. And I don't mind you coming back to it. It's obviously a topic of interest amongst our analysts and investors. It's -- the backlog that we had entering to the year was contracted with particular delivery dates that our clients wanted. So to a large degree, we can't unilaterally moderate the build rate, we have to fulfill the comments we made to customers. I can tell you that several of our customers, when they need the equipment has changed a little bit since they ordered it. And so we do have the ability to spread out the workload to a certain degree to meet the delivery dates that those customers want and make sure that we keep the load in the shop as smooth as possible. I would hate to tell you any particular change in the revenue that you'll see, but you might see some moderation in it, but largely we have to do what our customers want.

Okay. So I appreciate that. And then that being the case, then because we touched on sort of how the loading and all in the Houston facility has been a contributor to margins. If you do see that moderate, should we expect that that would have an impact on the efficiency of the shop? Or you sort of hinted to do this as smoothly as possible so that that wouldn't impact margins to a noticeable degree?

Well, there's two things that play when the level of activity in any particular shop decreases. The first one is we got a management team in Houston that's been managing that shop for over 20 years. And they managing the ups and they managing the downs. And there's fixed costs and there's variable costs. So when they forecast that what the level of activity will be in the shop, they work proactively to understand what we have to do in this variable costs. The second aspect to it is typically in a declining market cost decline. And so our team is also very keenly aware that they need to maximize any discrete opportunities to take advantage of those reducing costs in the supply chain. And I would say the exact same comments apply to our Canadian job.

Okay. When we see big changes in the margin, like we did both EBITDA and EBIT margin and, in the US, it obviously grabs our attention. And it was a nice, nice jump in the quarter. And I'm wondering, sort of -- you mentioned that there was a lot of production systems -- production systems revenue in the first half. And so can we infer from that that the margin in the remaining backlog might be a little bit lower than the margin that was in the backlog at the beginning of the year?

I'm not going to confirm or deny that assumption. I'll go back to the backlog entering the year, like you said, was more highly levered towards gas processing international work. That backlog is still being executed, and it will be executed throughout the balance of this year. So that's about as specific as I would like to get on that front.

Okay. Can we say that the -- not to press the point that we say that the mix within the backlog has become more domestically oriented with less international, with fewer international projects?

I wouldn't say that. If there has been a change in the mix, I don't believe it's material. It was -- we had such a big Q3 and Q4 that we're still chewing through a lot of that work.

Okay. And it really nice to see the rise in both service and rental revenues in US segment as well. I'm wondering as we sort of delve forward, like we will have our own ideas about how each revenue -- how each source of revenue will contribute to the forward quarters. But can you make any comment on how changing mix has had to this point and influenced on EBIT and/or EBITDA margins?

Well, it's going to have a good impact. That's exactly why we are putting our cash into those businesses because we like the margins. And it's -- the increase in margins is a relatively near term thing that we like to see. But we'd also like to reassure the investment community, the returns on those investments are also quite good. So we're not plowing a bunch of money into those assets, just to get short term EBITDA by any stretch. We think they're good long term investments. But I do believe that it will provide a lift to the blended EBITDA and EBIT margins in the regions where that have been traditionally engineered systems that we are trying to move over time in a responsible way to be good recurring revenue areas as well.

Okay. That's it for me on US margin questions. Thanks a lot.

Thank you.

Thank you. And our next question comes from the line of Jeff Fetterly with Peters Company. Your line is now open.

Good Morning, guys. A few random questions on stuff that's already been touched on. For the US business, Q2 throughput on engineered systems, how reflective of that is the expansion or the expanded capacity?

It's pretty reflective. We occupied that shop in early in the quarter. So there's multiple sort of mini projects within the overall expansion. A couple of the bigger projects got up and running early in the quarter and definitely allowed us to execute on the backlog at a higher clip than you would have seen in the first quarter or fourth quarter of '18.

So is it reasonable to assume then when we think about Q3, there's not necessarily going to be a step change in revenue or throughput for US engineered systems relative to what we saw from Q1 and Q2?

I think that's reasonable.

Okay. And then, apologies, but back to the margin side in the US. If we look at the change from Q1 to Q2, you had a substantial lift in the EBIT margins or EBITDA margins. Even just conceptually, can you help us understand between, as you said the execution component, the throughput or just operating earnings leverage component, the revenue mix elements, how much would those have contributed to margin improvement and how many -- how of those -- how each of those you think is sustainable?

So I would say that the number one contributing factor to the margin uplift is the book margins in the backlog. So the operating teams can only do so much after job has been booked with the cost estimate that are pretty accurate. So the uplift, I would say number one would be what they were originally booked at. And that sort of due to all the good work of the front end of the company, the sales and estimating teams to get that work in house. And I would say that the ability to execute from a labor and a cost point of view would be tied for second place in how you get those extra margins.

And the mix as Andrew touched on between the recurring revenue versus manufacturing revenue piece. How meaningful or impactful is that as we think about going forward?

So Jeff, if you could ask that question again. I don't know if I fully understand that I want to make sure I get it right.

So back to what Andrew asked, the mix, the changing revenue mix within your U.S. business in your view is that structurally improving your EBIT or EBITDA margins in the U.S.?

Yes, it is. And we love the compression business. We very much are prioritizing growing market share in gas processing, and being the premier manufacturer for international engineered systems. So we like the higher margins that those product lines can bring. It's not always a guaranteed thing. But in general, compared to the more standard compression that would be delivered to the U.S. market, the margins are better. And we're prioritizing growth in both of those areas to try to maintain the highest possible margins in engineered systems.

Okay. In terms of U.S. rental fleet growth, we've seen commentary from some of the public peers in Q2 reporting about scaling back rental fleet additions in the latter half of '19 or going into '22. Have you changed your view of the opportunity set for rental additions or slowed down, how you expect to add to the fleet in coming quarters?

So I'll go, I'll take just a quick step back. Our CapEx for the year we budgeted at about $160 million. I'm still good with that for the balance of the year. And we spend that money we'd look at the utilization in the fleet as the first factor. And then we would look at what the inquiry pipeline looks like as a second factor. And then we look at the macroeconomic conditions to steer us towards when we release more CapEx or when we may hold on to it. The first two categories are really quite good. The utilization in the U.S. fleet is really high and our pipeline of inquiries is also quite good. We are paying very close attention to the overall macro and our rental fleet that we bought was largely in the Permian in Western Oklahoma. So we pay very close attention to the changing macro conditions in those markets to make sure that we're making good decisions now in anticipation of what the demand is going to be, say six to 12 months down the road. I would like to point out that we have had contract compression fleet additions in the Eagle Ford and the Marcellus. So we're not just a Permian story when it comes to contract compression, we very specifically have tried to address opportunities in those other basins to balance any potential downturns in a single basin. So we are thinking about it, Jeff. Obviously, we're thinking about it. We have to think about it. And that's something we've been talking about for some time, making sure we're making good investments in that marketplace and not just blindly growing it. And what our competitors are doing in the space is not lost on the either. Especially because a lot of them have been doing it for a long time and their outlook is something we take into consideration as well.

Just two quick clarifications. Your comments earlier about asset ownership opportunities in Argentina, Brazil and Colombia. Is that specific to new build equipment or would there be opportunities to acquire Brownfield projects or Brownfield equipment?

It's -- our history has been primarily new stuff. We are very much open to putting other people's equipment on our balance sheet if it is under good contractual terms. And I think that our -- the size of our businesses in those regions and the maturity of our teams and the size of the back office in Calgary that supports them is such that we're probably in a better position to look meaningfully at those brownfields and let's say purchase leaseback opportunities now than ever before.

Last thing, Ben just a clarification. So the deferred revenue reduction, do you expect to see further draw down on your deferred revenue liability item in coming quarters?

Yeah. As we progress some of those larger projects that should come down. Now, it also depends on how many new projects get added and what the milestone buildings might be on those. But yeah, I think it's safe to say that we should expect that to draw down.

And can you give us a sense where it might land? In the past you've average $150 million or $175 million give or take in that category. Is that a reasonable level to think about where you might end up?

Well, if bookings trend the same way they have been historically then that would be a safe assumption. But again, it is so dependent on the bookings numbers that come in and the type of milestone buildings that we require from those customers. So, but historically, you're right, that could be around the level that it should normalize too.

Great, thank you. Appreciate the color. Thanks.

Thanks, Jeff. Okay, operator? Well, I don't think we have any more questions. So I think I will move on. Oh, operator, are you there?

Yes. There's one more question left in the queue.

Wonderful.

Elias Foscolos, Industrial Alliance. Your line is open.

Good morning and thanks for taking my question. I want to focus a little more macro, rather than margin related. You've clearly kind of shown your hand and how you want to focus capital spending, on compression additions, but I'm interested in getting your take, given your balance sheet on how you would be looking at acquisitions.

We'd be looking strongly at acquisitions. Elias, thanks for the question. In our investor presentations, in our conversations with investors over the past three, four months, we made it very clear that our priorities are as follows. Number one is organic growth. Number two is inorganic growth. And number three is maintaining and growing the dividend in a responsible way. We do see a lot of M&A opportunities and we are looking for the right assets and the right places at the right price. And so we're actively evaluating anything that comes in and actually thinking about where we want to go in all the regions of the globe.

And would you have a bias towards assets? And I'm just going to ask any engineered systems versus compression or is it really focused compression?

It's really focused on asset ownership opportunities, if I could. Anything that we can put on our balance sheet and get a good rate of return on that is stuff that we build. So compressors, gas plants, gas fire generators, any one of those things we'd be more than happy to invest in as a long-term asset. With respect to investing in M&A opportunities of engineered systems business. I rather not predict the future, but I don't see a lot of those opportunities coming forward. It's most of the ones we're seeing and that we would like to prioritize with the ones in the asset ownership space.

Okay. One last question on your priorities, and you kind of led into it. You have one, two and three being growing the dividend reasonably? How would you and I'm realizing ultimately, this is a board decision, but isn't something like an issuer bid off the table?

We wouldn't take any of our capital allocation avenues off the table right now. And for the foreseeable future, when I say foreseeable future, I mean, one to two years out, I really see a lot of opportunity in organic growth and in organic growth and ensuring that we sustainably fund the dividend. So, that's what our track record is said, I see lots of opportunities to put money in those avenues. And so the inside view is something that's in our tool kit that we draw on if the situation calls for it.

Got it. That's it for me. Thank you very much.

Thank you.

Thank you. [Operator Instructions] Our next question is from Tim Monachello. Your line is open.

That is pretty close not to [indiscernible]. Just one question for you guys around the pace of US outlook in terms of bookings. Some of your competitors commented, sort of said that the pace is slow and that's really been focused on capital discipline. And they've gone as far to say that their entry level is actually increasing since the first quarter. The commentary, or Enerflex commentary, is that a little bit more, I guess subdued than that. So I was wondering how you categorize the level of demand in US if you've seen increased levels falling since the first quarter, staying flat or growing.

Thanks for the question, Tim. We, I guess I could sum it up saying that Enerflex has got a conservative approach to communicate in the market and managing. So our subdued comments relative to others, I think is more about our corporate culture than a fundamentally different outlook on the market. In the United States, we're a relatively big player, especially in engineered systems. So our visibility to the bid pipeline offers us quite a good perspective on what future quarter is going to look like. I'll repeat what I said earlier, is that the bid pipeline is good. Whether or not our customers will be able to wrap their hands around the funding and pull the trigger in a meaningful way is really the $64,000 question. We deal with a lot of good companies that have good balance sheets and good management styles. But they're taking a bit of a pause to try to understand exactly what their funding looks like and indeed what the funding of their customers looks like in the situation where our clients are mainstreamers.

Okay. Thanks for that. And then one more question. You mentioned that your capital allocation, I guess growth capital within the rentals market in the US will be dictated by macro outlook. If you're happy with $160 million allocated in 2019. If you were to see no changes to macro look going into 2017. How do you think that would affect your growth in 2020? Do you think CapEx stays that $160 million, around $160 million range or it comes down from that?

I would very much like to see us increase our growth CapEx every single year. If the macro stabilizes in the United States, and in Canada for that matter, considering that and considering the pipeline of recurring revenue opportunities we have in the rest of the world segment, I would love to see our CapEx next year be higher than $160 million.

Okay. So outside of -- recurring revenue opportunities outside of the US, just specific to us rental [ph] compression fleet growth, you expect that to continue to accelerate through 2020?

Again, I would like it to and maybe going back to the question Jeff asked, it would be somewhat foolish of us not to consider that the slowdown in engineered systems, bookings might be signaling some issues with the US market that will have an impact on our contract compression growth. So that's on our mind and we're keeping a close eye on it. It is a different set of customers. And it does tap into a different funding model within those customers. So the engineered systems of contract compression, definitely do not work in lockstep with one another as far as the outlook goes. But I'm just reticent to tell you that I'm feeling 2020 is going to be great for contract compression, because we're going to wait and see and manage the business responsibly. However, it has been the bright light so far this year. And we've got a great team. And we've got good relationships with customers. And we've got a small market share today. So I do think that's our best opportunity for sustained steady growth over the coming four to eight to 12 quarters.

Okay. Makes sense. Thanks for taking my questions.

All right. Thank you.

Thank you. And I'm not showing any further questions at this time. I would now like to turn the call back to Marc Rossiter for closing remarks.

Thank you, operator. Since there are no further questions I would like to once again, thank everyone for joining us on the call. We look forward to giving you our third quarter results in November. Have a wonderful weekend.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.