NCS Multistage Holdings, Inc. (NCSM) Q2 2019 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to the Q2 2019 NCS Multistage Earnings Conference Call. All participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded.I would now like to turn the conference over to your host, Mr. Ryan Hummer. Please go ahead.

Thank you, Angela, and thank you for joining NCS Multistage's second quarter 2019 conference call. Our call today will be led by Robert Nipper, our Chief Executive Officer, and I will also provide comments.Before we begin our call today, we would like to caution listeners that some of the statements that will be made on this call could be forward-looking statements, and to the extent that our remarks today contain information other than historical information, please note that we are relying on the Safe Harbor protections afforded by federal law.Such forward-looking statements may include comments regarding future financial results and are subject to several known and unknown risks. I'd like to refer you to our press release issued last night along with other public filings made from time to time with the Securities and Exchange Commission that outline those risks.I also need to point out that in our earnings release and in today's conference call, we have discussed and will refer to adjusted EBITDA, adjusted EBITDA margin, adjusted EBITDA less share-based compensation, adjusted net income, adjusted net earnings per diluted share and free cash flow, all of which are non-GAAP measures of operating performance. We use these measures of operating performance because they allow us to compare performance consistently over periods without regard to costs associated with our current capital structure and in a manner that we believe better reflects our operating performance.Our press release from yesterday, which is posted on our website, ncsmultistage.com, provides reconciliations of these non-GAAP financial measures to the nearest GAAP financial measures. With that said, I'll turn the call over to our CEO, Robert Nipper.

Thank you, Ryan, and welcome to our investors, analysts and employees joining our second quarter 2019 earnings conference call. Today, I'll review high level second quarter results, and we'll discuss what we're seeing in our Canadian, U.S. and international operations. I'll also walk through the items that resulted in our gross margin being lower for the quarter and the work being done to improve it. I'll also provide details on the cost reduction initiatives that were mentioned in yesterday's earnings release. After that, I'll turn it over to Ryan to discuss the quarterly results in more detail.I'll then provide some closing remarks, highlighting some of our recent accomplishments. Total revenue in the second quarter was $39.8 million, 8% below the year ago period and a 25% decrease sequentially and in line with the high end of the guidance we provided in last quarter's call. Adjusted EBITDA in the second quarter of minus $1 million reflected an adjusted EBITDA margin of minus 3%.Starting with our Canadian operations, our revenue of $11.5 million for the second quarter was 17% lower than the second quarter of 2018 and 54% lower sequentially, coming in slightly better than the high end of the guidance range provided in the last quarter's call.I'm very proud of what our team in Canada has been able to accomplish this year in the face of a very challenging market environment. The group is truly firing on all cylinders right now and executing on the business strategies we have in place in that market. We have a team that is working extremely well together and delivering excellent execution in the field, resulting in winning new business and gaining market share.Our 17% year-over-year decline in revenue in the second quarter was achieved in the face of a 24% reduction in rig count and also in spite of pricing adjustments we made in Canada last year, demonstrating significant improvements in market share. We sold only 1% fewer sliding sleeves in the second quarter than we did in last year's second quarter and completed more wells with our customers.Our business development and operations teams have effectively highlighted the value that we bring to our customers by leveraging publicly available data to demonstrate NCS' operational efficiency relative to other completion techniques and our direct competitors. The work is directly translating into additional business.We are growing our presence with certain key customers, increasing our scope of work across our operating areas. We are also leveraging our market position in fracturing systems to grow our sales of well construction products and tracer diagnostic services, allowing our customers to streamline their vendor relationships and providing us with incremental revenue opportunities.While we continue to perform well in Canada, the overall market environment remains challenging. Based on conversations with our customers, we continue to believe that the capital budgets for 2019 will be more heavily weighted to the second half of the year than in prior years. However, the rig count thus far in the third quarter is 41% lower than last year, indicating that activity remains muted.While current oil and condensate prices, differentials and exchange rates as well as historically low service costs have positioned our customers to benefit from higher cash flows than expected in their initial budgets without additional pipeline capacity, there remains little incentive for our customers to grow production. As a result, we believe that the primary application of our customers' excess cash flows will continue to be to reduce debt or return capital to shareholders until additional pipelines are completed, potentially in 2021 or beyond.Now turning to the U.S. Our revenue for the second quarter of $26.7 million was 3% lower than the year ago period, but was 6% higher sequentially. We delivered sequential growth in product revenues for the seventh consecutive quarter, with 8% growth in the second quarter. The product sales growth was primarily driven by Repeat Precision. Revenue from our well construction products fell slightly during the quarter, reflecting a modest decline in volume as well as more competitive pricing environment.Our fracturing services product sales were slightly higher in the second quarter as compared to the first quarter. We expect further growth in our fracturing systems business in the U.S. in the second half of the year based on specific customer drilling and completions programs as our customers continue to value the combination of controlled fracture networks and the elimination of post completion intervention offered by our pinpoint completion technology.U.S. services revenues declined by 2% sequentially, with a slight increase in activity in tracer diagnostics, offset by a slight decline in services revenue related to fracturing systems. Tracer diagnostics activity continues to improve modestly, and we expect further growth in the third quarter.The pricing pressure for our tracer diagnostic service business in the U.S. has largely stabilized, and we continue to expect that we will be able to retain a premium to discounted competitive offerings based upon our ability to offer particulate tracers and the quality of our field service and laboratory operations.I'd like to highlight the success of our Repeat Precision business. Our PurpleSeal frac plug has been fully commercial for just over 18 months now, and we are approaching 60,000 cumulative plugs sold. We believe we are currently a top 5 supplier of frac plugs in the U.S., an amazing achievement for an organic development.Since commercializing the PurpleSeal frac plug, we have continued to expand our product offering, having introduced the PurpleSeal Express system, which combines our frac plug with a single-use disposable setting tool. This integrated, easy to use and factory assembled system now accounts for well over 25% of our plugs sold, and we believe the percentage will continue to move higher.As we discussed on the last call, just as customers see the efficiency and field safety benefits of integrated perf gun and charge systems for perf - and perf operations, our PurpleSeal Express system brings similar efficiency and HSE benefits to the plug side of the equation. We have also recently begun selling our RP 10 and RP 20 single-use disposable setting tools on a stand-alone basis and have also introduced our PurpleSeal Bridge plug, responding to customer demand.With these product introductions, we continue to expand the addressable market we serve and provide flexibility to our growing customer base. Our international revenue for the second quarter of $1.5 million was below the low end of our guidance. However, as we discussed during last quarter's call, we continue to expect our international revenue to be more heavily weighted to the second half of the year. Our international activity has picked up significantly during the third quarter, and we are either currently working in or expect to work in Argentina, China, the U.K., the North Sea, Russia, Oman and Saudi Arabia during the third quarter.I'll now review our gross margin performance for the quarter and the steps we're taking to improve it. Our gross margin for the second quarter was 42%, down from 49% in the first quarter and below the midpoint of our guidance range. We had several factors that contributed to the result, some of which we believe are temporary.The first item is pricing. We're in a very competitive industry and one in which activity levels for our customers is declining in North America. This is apparently U.S. rig count as well as completion count, and activity in Canada has been at depressed levels for over a year now. There's overcapacity across oilfield product and service lines right now and significant price competition across any moderately differentiated or commoditized product or service, and we expect this to continue.For NCS, we saw increased pricing pressure during the second quarter in our well construction product line and, to a lesser extent, in fracturing systems, tracer diagnostics and Repeat Precision. We are focused on demonstrating the value that we bring to our customers to combat pricing pressure and are also exploring opportunities to produce savings through our supply chain to support our margins.We have also experienced the impact of underutilization of our field service personnel in the U.S. during the second quarter, as we had lower volumes of fracturing systems and tracer diagnostics jobs than we anticipated. Activity in both fracturing systems and tracer diagnostics has improved in the third quarter to date, which is helping to more fully absorb the fixed costs we carry to support the business. I mentioned earlier the growth that we had at Repeat Precision, a result of increasing penetration of the PurpleSeal Express within our product mix and the fact that we recently began selling our RP 10 and RP 20 single-use disposable setting tools.To accommodate this growth, we opened a second manufacturing facility in Mexico in late 2018. We made the decision to move machining capacity that supports NCS sliding sleeve components to the new facility so that we can integrate the full scope of our PurpleSeal and setting tool operations in the original facility.We plan to move the sleeve manufacturing equipment during spring break up when volumes are typically lower for our Canadian business. As we have commissioned work at the new facility in Mexico, we have been slower to ramp up our prior volumes than we had anticipated. We also had very successful sales efforts in Canada during spring break up, which resulted in a rapid increase in sleeve demand in June and into the third quarter as activity increased.These volumes also included additional work for large -- a large existing customer in new operating areas. The combination of a high volume of demand for sliding sleeves in Canada with relatively short lead times and delays in ramping up volumes at our new facility in Mexico required us to increase our utilization of third-party machine shops to build sleeve components and assemble sleeves, primarily in support of our Canadian operations. The impact on NCS is twofold as pricing from outside machine shops is higher than our internal cost and because we don't benefit from our share of the profit generated at Repeat Precision when an outside machine shop produces sleeve components.We believe that these issues will be fully resolved by the end of the year, although an impact will continue to be felt in the coming quarters. We are methodically increasing our capabilities at the new facility in Mexico, and have also renegotiated pricing with certain third-party machine shops that we are using for overflow capacity, which will partially mitigate future cost variances. We're also working to staff a second shift in our Houston assembly facility, which allows us to increase our assembly capacity without requiring any additional capital. We are focused on both short-term and long-term initiatives to support our gross margin.In the near term, we will work to increase the output from our new Mexican facility and continue the path to commercialization of our shorter, lower-cost sliding sleeve for high-pressure applications. We will also continue to gain efficiencies and cost reductions from other areas within our supply chain. With these initiatives as well as the seasonal and market share-driven growth that we expect in the third quarter, we estimate our gross margin to be between 42% and 46% in the third quarter.Longer term, margins can only be supported through continued innovation, bringing solutions to market that allow our customers to operate more efficiently, reduce cost and improve profitability. We have R&D projects underway in each of our product and service lines to support innovation. We also believe that our margins will also be supported through our growth in international markets, which are growing both onshore and offshore, where our technology brings clear benefits to our customers and where the competitive environment is more disciplined than onshore North America.Turning now to the cost reduction initiatives that were mentioned in yesterday's release. As I've mentioned throughout this call, it's clear that we're operating in a challenging market environment with declining customer activity in North America and excess capacity amongst our peers and competitors. NCS is built and structured for growth, both in North America and internationally, and we continue to believe that we can grow our business in this environment.Our management made a difficult decision to implement a reduction in force that impacted approximately 6% of our friends and coworkers. We've also reduced salaries for certain executives as part of our cost reduction efforts. This was a very difficult decision since we believe that we were already lean and streamlined with annual revenue per employee of approximately $500,000, which is above many of our competitors.We believe that the reduction in force and executive salary reductions will result in an immediate pretax annualized expense reduction of approximately $5 million, which will be primarily reflected in SG&A. Beyond these measures, we continue to evaluate other opportunities to further reduce expenses, which we expect to implement over the coming quarters.We anticipate that we will incur one-time severance expenses related to the reduction in force of less than $1 million in the third quarter. With the headcount reductions, we also implemented changes to flatten our reporting structure and changes which we believe will allow us to be more responsive to changes in the market environment, accelerate new product development and support our international growth objectives.We believe these cost objectives -- or cost reduction initiatives will support our ability to generate free cash flow and will facilitate improved return on invested capital over time. We continue to believe that the investments that we've made in the past several years, organically, through Repeat Precision and the Spectrum acquisition provide us with multiple long-term opportunities for capital-efficient growth in each of the markets we operate. We continue to balance the investments required to innovate and drive revenue growth with a capital-light business model that can produce free cash flow.We have taken steps to right-size our operations for the current market environment and are making progress on near-term challenges that have impacted our gross margin. Through disciplined growth and free cash flow generation, we plan to continue to improve our return on invested capital and create value for our shareholders.I'll now turn the call over to Ryan to discuss our financial results in more detail.

Thank you, Robert. As reported in yesterday's earnings release, our second quarter revenues were $39.8 million, 8% lower than the prior year second quarter and in line with the high end of the guidance we provided on last quarter's earnings call. On a sequential basis, overall revenue in the second quarter was 25% lower than revenue in the first quarter with a 6% sequential increase in U.S. revenue more than offset by normal seasonal decline in Canadian revenue and lower international revenue.Gross profit defined as total revenue less total cost of sales, excluding depreciation and amortization expense was $16.7 million in the second quarter or 42% of revenue. This compares to $23.5 million or 54% of revenue in the prior year second quarter, with lower margins on both product sales and services revenue.This gross margin percentage was below the midpoint of the guidance we provided for the quarter based on the factors Robert mentioned earlier. For a sequential comparison, gross profit was $26.1 million or 49% of revenue in the first quarter. Selling, general and administrative costs, or SG&A, increased to $22.9 million in the second quarter from $22.1 million in the prior year second quarter, but decreased slightly from the first quarter's level of $23 million.As a reminder, our reported SG&A includes share-based compensation as well as certain nonrecurring expenses, including ongoing litigation. The year-over-year increase was primarily driven by higher headcount, increased litigation expenses, support services related to our new ERP system, higher share-based compensation expense as well as higher bad debt expense, partially offset by reductions in accrued bonuses and other professional services. Adjusted EBITDA for the second quarter was negative $1 million as compared to a positive $5.3 million in the prior year second quarter.Adjusted EBITDA as a percentage of total revenue was negative 3% in the second quarter of 2019. Our second quarter 2019 depreciation and amortization expense totaled $2.6 million. During the second quarter, we recorded an impairment charge of $7.9 million to goodwill related to our tracer diagnostics reporting unit. This impairment, together with the deferred tax asset valuation allowance we recorded in the first quarter, resulted in an income tax expense of $2 million in the second quarter despite a pretax loss of $17.5 million.We had net income attributable to noncontrolling interest of $2.7 million in the quarter, reflecting positive net income at Repeat Precision. Our average basic share count for the quarter was 46.8 million, and our current basic share count remains 46.8 million. Our adjusted loss per diluted share for the second quarter was $0.11, which compared to an adjusted loss per diluted share of $0.09 in the prior year second quarter.Turning now to cash flow items in the balance sheet. Cash flow from operations in the second quarter was $9.1 million and was $6.1 million for the first 6 months of the year. Our net capital expenditures for the second quarter were $1.3 million and were $4.1 million for the first 6 months of the year. As a result, our free cash flow for the quarter was $7.8 million and was $1.9 million for the first 6 months of the year.At June 30, 2019, we had $12.2 million in cash and total debt of $19.5 million, which included $16 million drawn under our U.S. revolving credit facility. We reduced our debt balance by $6.5 million during the quarter. We also have up to $59 million in total potential availability under our revolving credit facilities, bringing our total potential liquidity at June 30 to approximately $71 million.I'll close with a few points of guidance for the third quarter. For the third quarter, we currently expect total revenue to be $59 million to $65 million. With U.S. revenue higher by 8% to 18% on a sequential basis, driven by Repeat Precision, fracturing systems and tracer diagnostics activity. In Canada, we expect a seasonal sequential increase in revenue of 115% to 135% from the second quarter, reflecting improvements in our market share with new and existing customers.We expect international revenue of approximately $5.5 million to $6.5 million as we benefit from the work we have across the multiple geographies that Robert mentioned earlier. Approaching the higher end of the revenue range will depend primarily on continued seasonal increases in the rig count in Canada, which have been slower to materialize than in prior years. We expect our gross margin to be between 42% and 46%, reflecting a modest increase relative to the second quarter, reflecting better fixed cost absorption and supply chain initiatives we have underway.We expect our reported SG&A, inclusive of share-based compensation and nonrecurring items to be between $21.5 million and $22.5 million. This includes approximately $3 million in share-based compensation expense, the $0.6 million to $0.7 million in severance expense related to our reduction in force and ongoing litigation expenses. The decrease compared to the second quarter will primarily be driven by the cost reduction initiatives Robert outlined earlier.We expect our third quarter depreciation and amortization expense to be between $2.6 million and $2.8 million. We expect our net interest expense to be between $0.40 million and $0.6 million in the third quarter, and we expect our booked effective tax rate for the remaining quarters of 2019 to be a benefit of 15% to 20%.We have again reduced our expected capital expenditures for 2019 with a new full year range of $7 million to $10 million. At the midpoint of this range, our capital expenditures for 2019 would be approximately 45% below 2018 and are $2.5 million below our initial guidance range for the year.I'll hand it over to Robert for closing remarks.

Thank you, Ryan. Before we open up the call for questions, I'd like to highlight a couple of our accomplishments through early August. In Canada, we continue to execute on our strategy to increase our market share and cross-sell our products and services in order to fully capitalize on our strong market presence. As I mentioned earlier, we sold just 1% fewer sliding sleeves and completed more wells in Canada in the second quarter as compared to the second quarter last year.This coming in the face of a 24% year-over-year reduction in rig count. In the U.S., we have posted our seventh consecutive quarter of increased product sales, driven in large part by market share growth for our PurpleSeal frac plugs and a continued expansion of Repeat Precision product offering in response to customer demand.We expect continued growth in the U.S. in the third quarter despite a declining rig count and flat completions market with improving activity across fracturing systems, tracer diagnostics and Repeat Precision. Internationally, we successfully shifted sleeves that have been installed on a customer's well in China for over 4 years, which speaks to the quality and durability of our products. We have also booked follow-up orders for products that were trialed in Saudi Arabia and have secured a trial well for work in Oman.We continue to grow our presence in international markets, which we believe will have a more stable near and medium-term outlook in North America. I'll close with just a couple of brief comments. We continue to execute on the strategies that we've had in place for the past several years.We have leadership positions in the product lines and services in which we compete. We have tactically expanded our product and service offering over time and have invested in our sales force and international infrastructure to allow us to capitalize on our revenue opportunities across the globe. We are not immune, however, to the challenges that we're facing as a company and our industry in North America. We are focused on addressing the company-specific challenges that we faced in the second quarter as we rapidly increased our activity in response to customer demand, which we believe will lead to a recovery in our gross margin in the second half of the year.In addition, we recognize that our customers are reducing activity levels in North America, limiting growth opportunities and increasing competition amongst service companies. We have made the difficult choice to implement cost reduction initiatives that included a 6% workforce reduction in order to better align our operations with the opportunities in the market.We have already achieved run rate savings of approximately $5 million from these actions and are actively evaluating and implementing strategies to further reduce our expenses. As a technology-driven company, we continue to innovate to bring new products and services to market that are highly valued for our customers, improving efficiency, reducing costs, enhancing recoveries and improving their financial returns.As a result, we believe we are well positioned to deliver capital-efficient, long-term organic growth through increased adoption of our innovative completion equipment and services. Our capital-light business model provides us with the ability to generate free cash flow while maintaining a very strong balance sheet. This, in turn, provides us with optionality to allocate capital to high-return investments and evaluate options for the return of capital to shareholders over time.And with that, we'd be happy to take your questions.

[Operator Instructions] And our first question comes from the line of Marshall Adkins with Raymond James.

Good morning guys. It seems like your Canadian share in sliding sleeves continues to be a standout on the positive side. So I've got to start with, given the increasing concerns of parent-child in the U.S., where do you stand on penetration of that market in the U.S.? And give us some color on why the Canadian market share continues to grow in U.S.? Seemed to be, I guess, a little slower to buy into the sliding sleeve theme.

Yes, good morning Marshall. Yes, so as I said earlier, I'm really proud of the effort that our teams put in place in Canada to grow market share there. That market share is not coming from the existing basins that -- in which we're working, it's coming from the new areas, so the Montney, the Duvernay, with existing customers, but also with new customers for NCS.As we look to the U.S. and our efforts with sliding sleeves here, as I've mentioned on the last three or four calls, we recognize the fact that we haven't grown the market share in the U.S. the way that we had hoped that we would. And there's a number of factors, we believe, that are related to that. One, it's just been very, very difficult with the technology that's been entrenched for 30 years in the industry. The infrastructure around plug and perf is built out and it's very difficult to get customers to change.But one of the big issues is that plug and perf has become much more efficient in terms of cost over the last three to five years, where when we first came into the U.S., we were slightly cheaper than plug and perf in terms of the cost for the customer. And now plug and perf is, in some cases, less expensive than pinpoint is. So the value proposition to a customer would be, you have the potential to get better production. But there's no way to prove that upfront, so the customer who are faced with a more expensive completion technique chooses not to change over.However, what we have seen in the U.S. is that if we break the -- or dissect the market down into all the different opportunities out there, there are certain areas and certain applications where we and our customers believe pinpoint is superior, even from a cost standpoint or from an efficiency standpoint.Some of those opportunities are, where you did mention the child-parent relationship, the impact of frac hits on offset wells, that's one application where our customers are using us for value. And the cost is about the same or a little bit more for the customers, but what they're seeing is that they're able to control the issue of impacting their offset wells during the frac jobs.Another opportunity that we've seen where we continue to get repeat business is in basins where there's lower pressure in the formation, which causes drill out issues when you're drilling out composite plugs. The drill outs can be quite long. The risk is higher because there's a risk of actually getting the bottom hole simply stuck. And so to remediate those types of issues is very expensive. So when you look at the cost for pinpoint compared to plug and perf in those applications and you amortize it over a project, it is less expensive, and customers recognize that.So as I said earlier, we expect fracturing systems to grow sequentially in the U.S. in the third quarter over the second quarter. We continue to focus on that product line. We have a product line manager over that product line. We continue to improve the products. We continue to take cost out of the system so that it is more competitive with plug and perf. But again, we realized that it's just not going to grow as fast as we hoped it would originally.

Okay. Yes, you mentioned that, I guess, in your earlier comments that you were having a lot of competitive pricing issues. I just assumed maybe it was competitor's sliding sleeves, but it sounds like it's more competition in plug and perf. Is that on the cost side or pricing side? Am I leading that right?

You are. You are. In the U.S., the real competitor is plug and perf. And the cost pressure is on the cost of plug and perf versus sliding sleeve. One of the other things I didn't mention that does seem to be changing in the market a bit, which is a tailwind for us is that when we do a cost analysis for a customer on what it costs to do pinpoint versus plug and perf, there's puts and takes there. There's a cold tubing unit on location, longer, doing pinpoint, that's a cost add, but you don't have to pay for the wireline or for the composite plug. But one of the big offsets to cost is that doing pinpoint, there's not as much horsepower required on location. So instead of a 50,000 horsepower spread, we only need 35,000 horsepower.And so there's a cost benefit for the customer there that offsets a significant amount of the savings that plug and perf has. We've had difficulty in being able to have our customers be able to take advantage of that in the past because most customers are contracted and they're contracted for frac spreads. And those frac spreads are 50,000, 60,000, whatever the size is, and it's been very difficult for the customers to get their service providers to change the contract so that they can get 35,000 horsepower or whatever the requirements are for that operation and get the cost reduction associated with that.But in the environment that we find ourselves in today, what we're seeing is that the customers are having more success in being able to get those pricing contracts changed so that they're only paying for the horsepower that they need. So we believe that, that's a tailwind that we haven't really factored into the activity growth that we see in fracturing systems, but it certainly could give us an additional boost.

Yes, that makes a little more sense since there's a few extra horsepower on the fence right now. Shifting gears to the tracer and international guidance, which for the -- for this upcoming quarter looks a lot better. And I guess that's positive surprise for me. You have the rig count going down in the U.S., but tracer revenue is going up. So give me some color on that. And likewise, the international business, it looks like a substantial quarter-to-quarter improvement expected there. Is that just normal lumpiness we should expect to continue going forward or is there something else that you can help us with the thought process there?

Yes. First, on tracer diagnostics. In the last call, we talked about the pricing pressure that we were seeing in the marketplace. It was twofold. One, the reduction in activity in the U.S. market as well as new competitors coming into the marketplace with tracer diagnostics. And there was a lot of pricing pressure and we were holding prices a little more firm than what our competitors were. And so it did cause a revenue reduction in the first quarter and as well as the fourth quarter from the previous year. So that has somewhat mitigated itself.We've made some adjustments in pricing, but we've also been able to go back to our customers and where they've had an opportunity to try new entrants into the market. Seeing what the quality was that they were actually getting, we've been able to win back some of that work.So in fact, recently, we've been -- a number of times, we've been completely sold out in terms of personnel being able to go on location. So we've seen that changing in the market. And some of the lower pricing that we believe was not sustainable, we're starting to see it wasn't sustainable, and those prices have slightly come up. So all those things together have combined in helping us to have a more clear view that tracer diagnostics is increasing in the U.S.Looking at the international business, on the last call, I mentioned that we were going to be down in revenue in the second quarter, but that we expected that we would have a pretty big jump in the second half of the year, and that's exactly what we're seeing now. And it is lumpiness in the international markets, but it's not unpredictable lumpiness, if you will.So what this was, it was a result, I mean, a big part of that increase is from the Aker BP contract that we've got in the North Sea. That project had stalled for a bit, with the intention of kicking back off in the third quarter, which we're actually seeing now. We already have shipped orders into Norway now to support that project, and we continue to see that business growing, as we thought that it would. But we've also been successful in getting some trial wells in the Mid East, which, as I'm sure you know, is pretty -- it can be a long protracted process to be able to even get those field trials.We've been successful in being able to make it a less long process, and we've had success in the field trial. So now we're starting to see the benefits of that. And so, there's been a lot of things that we've been doing over the last few quarters internationally, and it just takes time to build up over time. But I think we will see that the international business will continue to be lumpy, but we will see it -- the line will be moving up to the right.

Yes, and you'll have visibility ahead of time. Thank you all very much.

Thanks Marshall.

Thanks Marshall.

And your next question comes from the line of Sean Meakim with JPMorgan. Please go ahead.

Thanks, hey good morning.

Good morning, Sean.

Just maybe to follow up on the comments on pricing pressure. Core talked about the discretionary nature of spend on tracers on their call, which is what -- how they described the impact based on the second quarter, reducing their revenue. It doesn't sound like you had the same experience in the second quarter, but you did, to some degree, in the first quarter. And you've seen some pricing pressure on the other product lines, including well construction that you called out. So could you maybe just give us some more detail on pricing pressure in terms of the fundamental drivers for each of the major product lines.I kind - to think of tools that is generally always experiencing declining pricing for any product, just due to the natural obsolescence cycle. So you always need to deliver new iterations of products to support your pricing and your gross margins. So how much of what you're seeing is natural pressure on pricing versus more aggressive behavior by competitors and even your customers as they're feeling a squeeze to reduce their costs as well?

Yes. So it's a mix of all that. I mean, I appreciate the comments that you mentioned, that Core had around discretionary spending. And certainly, we see some of that because there are projects where that's one of the things that gets cut earliest in a budget, but it hasn't been that significant for us. In the tracer product line, the most significant pricing pressure that we saw was from a new entrant into the market, and really, how you are going to get market share when you come in with a new service offering, and it's to cut pricing typically, if it's not a better widget. So that's what we saw in Q4 and then the first quarter of this year and now into the second quarter of this year. But as I mentioned earlier, that's starting to alleviate a bit.Looking at fracturing systems, the pricing pressure there is really against plug and perf and not necessarily direct competitors in the U.S., however, in Canada, there is direct competitive pressure, which we just deal with. And as you say, you have to come out with new products and services to continue to obsolete so that you can continue to stop pricing pressure. And that's what we've done.We continue to bring out what we call the HP 3s [ph] that we've been talking about. It's the lower cost sliding sleeve that we expect to see some benefit in margin from coming into the third quarter and into the fourth quarter of this year. But yes, I mean, with fracturing systems, we're probably seeing less pricing pressure from a pure competitive standpoint in the U.S. than any other product line.Looking at Repeat Precision, our composite plug product line. So we've chosen not to be the low-cost provider. We believe that we have a differentiated technology there, not just with the PurpleSeal Express, but also inherent into the plug itself, a few of the features and benefits there that are bringing value to customers.And so we've been able to hold pricing fairly steady there. But we still -- I mean, there's 30 competitors with composite plugs out there. And there's, at some point, will be a fight to the bottom. But right now, we're not seeing -- we're seeing prices somewhat stable in that, but that could change over time, as you said before. If it's a highly commoditized product offering, pricing does tend to disintegrate pretty quickly. But right now, we've been able to hold our pricing in the Repeat Precision product line.So that's -- finally, the other products that we have -- product line is wellbore construction. So primarily the AirLock, which the AirLock, if you recall, is a product that we developed a few years ago, introduced into the market, it wasn't unique. There was another company that had a version of a casing buoyancy system, but it was very expensive in terms of rig time as well as the cost of the customer to buy it, but what we did is we were able to design something that was a fraction of the cost to the customer and was intervention-less. And so we're a market where there was probably 1% of the wells total that we're using casing buoyancy. Now we believe that, that's climbed above 15% and still climbing higher.And with any type of successful new product coming into the market, there's going to be competition. And so we've seen a number of other companies that have come into the marketplace with similar type offerings and so that -- it drives pricing pressure. But again, as you mentioned earlier, we have to continue to innovate, and we have new, improved offerings on what we call the AirLock system that are coming out. But we have to continue to innovate that. And that's one of the reasons that we continue to have a strong SG&A spend because we do invest in technology development.

Right, thank you for that. That's really helpful feedback and it's a good segue. I was hoping to get more feedback on your cost structure going forward. So you noted your revenue per employee is fairly high versus peers at $500,000 each. And no doubt, making these kind of cost reductions, decisions are difficult. So after cost reductions, your G&A is still running at 40% to 45% of sales on trailing 12-month basis.So if activity does not recover above Q2 '19 levels, let's say, through the end of next year, and it seems like there's an increasing portion of the probability distribution that says that could be the case, what levers are available to you to improve profitability? So international growth is one piece, you highlighted there's more opportunities growing there. What else is available to you in that scenario or do you just hold tight for optionality for market share growth in the U.S.?

Well, we're going to control the things that we can control. And the market share growth for sliding sleeves or fracturing services in the U.S. is something that we expect to continue to grow over time, but it's not going to be the big driver that we had hoped it was at one time.So we're not going to just sit and wait for something to happen or not happen. So as we have done in the past, over the last 3 years, we'll continue to add ways that we can take advantage of the infrastructure that we've built as a company at NCS, both in our ability to introduce new products into the market as well as the channels that we've already developed into markets.As you've seen, our international business is growing. It's a result of effort that we put in, in an infrastructure that we put in place over the last couple of years. And so we're starting to see that pay off and so we'll continue to drive other products and services out internationally. That's a big opportunity for us because right now, in a lot of the places that we work internationally, it's a single product service, and we're just starting to drive additional products into some of the markets.As an example, in Argentina, we started there with fracturing services, and now tracers is becoming a pretty big part of that business, and we'll continue to drive wellbore construction products and our Repeat Precision products into those markets. So we have a lot of opportunities internationally. We still have a lot of room to run in the U.S. with our Repeat Precision products.So as I mentioned earlier, only about 25% of the plugs that we sell today are PurpleSeal Express. So that's something that's growing very fast for us. We're still in 1 of the top 5 providers of composite plugs in the U.S. So there's still opportunity for us to continue to gain market share, as we've done over the past.So we'll continue to pull all the levers that we can to continue to add products. We look at our engineering effort, I talked on the last call about our enhanced oil recovery systems that were being developed and that we're field trialing today. That's not a 2020 big revenue producer. But in 2021, it could be a really big revenue producer, but we'll continue to invest in those, and we make decisions today Sean, on how to allocate the capital and how to allocate our SG&A spend, which is where our research and development spend is.And if we see a market that we can't grow in, or we can't grow to the extent that we think is appropriate, and we'll have to make some decisions on how we allocate that spend. Do we continue to invest in longer-term projects or do we just invest in shorter-term projects? As you pointed out, SG&A is still a big percentage of our revenue. And we believe it's appropriate today. But if market conditions change, we have the ability to adjust that, just as we've made some tough decisions previously. But we're also not finished with our cost-cutting measures.We have made the headcount adjustments that we think are appropriate for now. But there's still other line items in SG&A other than headcount that we're focused on making reductions in and doing things that we believe are more appropriate in an environment that we're in today. So there will be more cost-cutting measures that you'll see the benefit of over the next quarters, as I mentioned earlier, but this is the start.

Yes, it is definitely not your decision, but I appreciate all the feedback there. Thank you, Robert.A - Robert NipperThanks, Sean.

And your next question comes from the line of Ian MacPherson with Simmons. Please go ahead.

Hey thanks, good morning. Hey and Robert, given how you've described the technological innovations on plug and perf have really improved the cost competitiveness in the U.S. I imagine your -- even though your total U.S. revenue mix continues to do better than the market, your revenue growth that is, your mix must be less weighted towards sleeves than you had envisioned a couple of years ago, and I just wonder how you think about deployment of R&D capital for the U.S. market going forward?If you think that you need to continue to emphasize your brand as a pinpoint brand in the U.S. or if pinpoint is really just under a much broader umbrella in terms of new product development going forward and really becoming more of a hybrid that embraces plug and perf for the U.S. market over the next two or three to four years?

Yes, Ian, I think that's probably the right way to think about it. It's another service offering, a product and service offering that we have in the U.S. It's not going to be what we had hoped it would be three years ago. But it's still something that we can continue to grow in the U.S., and we can make money off of it. Traditionally, the R&D spend has been highly weighted to pinpoint because that was the primary business. It was the only business line three years ago. So as we've changed over time, we've also changed our philosophy on how we allocate those R&D dollars. It was still a very high spend in research and development in 2018, but that's coming down now.As of last quarter, we -- sorry, as of the beginning of the third quarter, we had R&D product -- projects for each of our product lines in engineering for the first time ever. So we are allocating additional spend for Repeat Precision, for wellbore construction. There's still different places or different ways that we can add products and some of the current product groups, if you will, that we offer today that we're focused on.And I mentioned EOR again. I mean that's something that it's a longer term project, but it has the potential to be a really big project. One of the things that we've been fortunate to be able to do is instead of having to fund 100% of that development internally at NCS, we were just chosen to participate in a Department of Energy program, where we do have a grant for funds, and we're working specifically with another operator or with an E&P operator in an EOR project where our Qumulus product line is going to be developed. So we'll be able to continue to fund the development of that project, but we won't have to do it organically.

That's interesting, thanks Robert. Unless I missed it, it sounded like you confined your second half guidance to the third quarter. I believe that was the case. But I was impressed by your outlook for U.S. total revenues in the third quarter, given how challenged the market is, double digit top line growth would be certainly differentiated.Do you have any visibility beyond the third quarter that the U.S. could remain similar or even stronger in the fourth quarter or is that just opaque at this point? I think we would expect the seasonality lower in the fourth quarter for Canada, but just curious about the U.S. side? And then following that, maybe anything you could tell us about the margin progression from Q3 to Q4 as well, if possible.

Yes. As far as Q4, I could guess if you want, but that's all it would be. And we don't really have clear visibility. I mean, I think there's a possibility in the fourth quarter that we could see budget exhaustion. The customers that we're talking -- that we're working for today and talking to, they're not giving us real clear guidance on what the fourth quarter looks like. So we don't have anything better than any of the other 14 calls that you've heard over the last couple of weeks.I'm sorry, what was the other part of that question? Margin progression. Right. Yes, I mean, what I'll say on the margin is what we said earlier is that the 42% that we posted for Q2, that's the bottom we believe, and there's a number of ways that I discussed earlier that we're going to move that margin back up. I mean, the way I look at the margin is that, that was an investment that we made in future revenue.The biggest piece of the margin decline that we had was around our cost structure. So pricing certainly was part of it. But the biggest part was, we got a contract for a customer, one of our large customers in Canada that we weren't expecting to get that had incremental business in it and our supply chain wasn't set up to be able to fill those orders.We also -- sorry, there's something on the line. We also got -- there were two major customers in the Deep Basin plays in Canada that we got ordered work for that is continuing work. And so we weren't expecting that. So the cost to be able to support those projects, because we didn't -- we weren't ramped up for it, that was the biggest driver in hurting our gross margins. But as I mentioned earlier, we're putting things in place to get that back aligned, and we'll see that move out over the next two quarters.

So you would say that the sequential decline in Q1 to Q2, when your margins went from 49% to 42%, that third-party machining cost was the biggest individual component of that pressure in the second quarter?

That was the biggest individual. If you put that with pricing pressure, primarily in wellbore construction, that was probably 75% of it, both of those combined.

Got it, thanks a lot Robert. I'll pass it over.

Yes, thank you.

And your next question comes from the line of George O'Leary with Tudor, Pickering. Please go ahead.

Good morning, guys.

Hi, George.

Hi, George.

I think you guys mentioned that disposable setting tools seeing some tailwinds and also kind of sales of them independently. I wondered if you could provide more color on what exactly that means and how that's a change from how you've been selling it historically? Does that mean you're kind of de-bundling it from frac plug in certain instances? Any more color there would be appreciated.

Sure. When we started this project with the disposable setting tools, we chose to focus on what we call PurpleSeal Express, which is where we deliver a complete unit to location that includes the bridge plug and the setting tool. As we've been able to ramp our capacity and our ability to build these tools, we've started to expand that. And what that allowed us to -- and what that means is that we're not just selling the setting tools on a bridge plug, we're going to wireline companies now and selling the setting tools directly to the wireline companies, and they can put it on whoever's setting tool -- or whoever's plug that they want to put it on.So it's a really big market that we didn't take advantage of early on because we didn't have the capacity to do it. But now that we've been able to build out the capacity, we're starting to expand into that other market. And it very well most likely will be a higher number of setting tools gets sold through that channel versus on the bridge plug itself. But the bridge plug, the PurpleSeal Express, the bridge plug and the setting tool together, it is highly differentiated right now, and we're the only ones in the market that are doing it.

Great. That's helpful color. And then just also curious on the intervention-less system that you guys have been working on for some time now. Just any update there on progress. Seems like as we go out in the field and talk to some folks, we'd still love to see more sleeve products where you don't have to use coil tubing alongside them. And so that seems like a nice market opportunity for you guys. Just curious what you're seeing there? How dialogue with customers is on that front as well?

Yes, we're hearing the same thing, but cost is what's driving everything. And so the system that we're working on, that we have the intervention-less system. And I talked about the improvements in the cost structure for plug and perf over the last couple of years, while those efficiencies have been significant enough that an intervention-less system has to be cost competitive with it.And the intervention-less system that we were working on -- that we began working on was, what we found in this new environment, it's not going to be cost competitive with plug and perf. So we've actually changed the engineering specs on that, and we're still working on an intervention-less system, but it's probably going to be more for tow type applications than it is going to be for full wellbore just because plug and perf has become so much more efficient from a cost standpoint. But yes, the market is looking for something intervention-less, it just has to be cost competitive as well.

Thanks guys.

Thank you.

And your next question comes from the line of Kurt Hallead with RBC Capital. Please go ahead.

Hey, good morning guys. How are you doing?

Hi, Kurt.

Good morning, Kurt.

The -- I appreciate all the color you've provided so far. I guess the focal point for me at this juncture would just be just getting a read on the pathway to free cash flow as you kind of get through the second half of '19, maybe we can start there and maybe focus on the working capital dynamics because you've already provided guidance on CapEx.

Sure, Kurt. As we've said in the call, we still believe we can deliver free cash flow in 2019. We're modestly free cash flow positive through the first six months of the year, and I would point out that we haven't many adjustments there. In the cash flow from operations, we're also accounting $3 million that we paid to Repeat Precision as part of that earnout.We would expect the second quarter from a working capital perspective to create a little bit of a draw -- to -- so maybe about free cash flow neutral through the first nine months and then generate additional free cash flow in the fourth quarter to keep us positive on the year.

Okay. And then that positive swing back will come from working capital. Okay, I appreciate that.

Earnings and working capital.

Okay. All right, I appreciate that. Now again, you guys have gone through great pains to explain what you see happening with respect to your business, in particular, and I would echo one of the earlier questions about one thing that definitely caught my attention was your expectation for U.S. revenue growth in the third quarter, given everything that we've heard from the industry about activity being down, both in terms of rig count and completion activity in the third. So pretty clear.You've talked about PurpleSeal Express and gaining share in those types of dynamics, but I was hoping maybe you could flesh it out, just maybe a little bit more in what is driving that conviction or that expectation, I would say, for your revenue growth to more than buck the trend on total activity in the U.S.?

It's all market share. The market is definitely down. But we're fortunate enough that our market shares are low in fracturing services, I mean, it's less than 1% of the market. So we're not dependent a 100% on the market. A market with tailwinds will be fantastic because there are certain areas that we've traditionally worked in with fracturing systems where customers aren't working right now just because of the economics. So we'd love to have those tailwinds.But having said that, with PurpleSeal Express, with fracturing systems, with our tracer diagnostics business, we can still grow through market share and we -- it's not that we hope we get the market share, it's market share that we've already gained and that we see orders for. So we feel fairly confident in putting out there what we can do in the third quarter.

That's very impressive. In the context of the Canadian dynamic, right, you referenced, again, overall activity there being down 40% on a year-on-year basis and however that activity level progresses. So to what extent do you think you could outperform that? Should we use kind of the proxy so far through the first half of the year and kind of look at your Canadian revenue relative to activity and kind of extrapolate that through the full second half of the year. Would that be a fair way to kind of assess your Canadian market position?

Yes. I think what I'd say is we've certainly increased our market share within fracturing systems in the Canadian market over the course of the last six, nine months. We've also been successful in bundling together well construction and tracer diagnostic products, taking advantage of the platform we have there. If you're looking for some calibration as far as how to think about Canada going forward, I'd look more at the combination of the first nine months, including our guidance for this quarter as opposed to just the first 6 months.

Okay. All right, that's helpful. Now over the last couple of years, there has been a seasonal dynamic in the fourth quarter, where your revenues have come down. And Robert, I know you answered the question earlier, it would be a pure guess on your part. And I think we're all guessing at this stage as to what may transpire in the fourth quarter.But let's just assume that '19 kind of replicates '17 and '18, you get a seasonal downtick in revenue. Given the cost reduction measures that you have in place and so on, is there an outside chance that your margins could -- gross margins could potentially hold firm, even if revenues decline in the fourth quarter, or that would be too much to ask? What's your sense?

Well, it just depends on the magnitude of it, Kurt. But we do believe that we're going to hit the bottom for these gross margins anyway.

Okay, all right, I appreciate that. Thanks guys

All right, thanks.

And your final question comes from the line of Chris Voie with Wells Fargo. Please go ahead.

Good morning.

Most of my questions have been answered, but I guess just one to get a little color around the U.S. and Canada. Can you give a sense of the portion of revenue that came from sleeves, frac plugs and other products like AirLock, respectively, or maybe a rank at least in those markets?

We don't break down revenues like that. We just break it down by service and sales.

Okay, all right. That's all I had, thanks.

All right, thanks.

And I'm showing no further questions at this time. I would now like to turn the call back for closing remarks.

On behalf of the entire management team and our board, we'd like to thank everyone that joined us on the call today, including our shareholders, employees and research analysts who cover NCS. I'd like to personally thank our nearly 400 employees around the globe, which I continue to believe is the best team in the industry. It's through the talents, effort and dedication of this team that NCS is able to grow our customer base, provide exemplary customer service, and drive the innovations that we bring to the industry. We appreciate everyone's interest in NCS Multistage, and we look forward to talking again on our next quarterly earnings call in November. Thank you, operator.

Ladies and gentlemen, this concludes today's conference. I thank you for your participation, and have a wonderful day. You may all disconnect.