Greetings, and welcome to the Select Energy Second Quarter Earnings Conference Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference call is being recorded. It is now my pleasure to introduce your host, Mr. Chris George. Thank you. You may begin.

Thank you, operator, and good morning, everyone. We appreciate you joining us for the Select Energy Services conference call and webcast to review our financial and operational results for the second quarter of 2020. With me today are Holli Ladhani, our President and Chief Executive Officer; and Nick Swyka, Senior Vice President and Chief Financial Officer. Before I turn the call over, I have a few housekeeping items to cover. A replay of today's call will be available by webcast and accessible from our website at selectenergyservices.com. There will also be a recorded telephonic replay available until August 19, 2020. The access information for this replay was included in yesterday's earnings release. Please note that the information reported on this call speaks only as of today, August 5, 2020, and therefore time-sensitive information may no longer be accurate as of the time of the replay listening or transcript reading. In addition, the comments made by management during this conference call may contain forward-looking statements within the meaning of the United States federal securities laws. These forward-looking statements reflect the current views of Select management. However, various risks, uncertainties and contingencies could cause our actual results, performance or achievements to differ materially from those expressed in the statements made by management. The listener is encouraged to read our annual report on Form 10-K for the year ended December 31st, 2019, our subsequent quarterly reports on Form 10-Q and our current reports on Form 8-K, to understand those risks, uncertainties and contingencies. Also, please refer to our second quarter earnings announcement released yesterday for reconciliations of non-GAAP financial measures. And now, I would like to turn the call over to our President and CEO, Holli Ladhani.

Thanks, Chris. Good morning everyone and thanks for joining us today. The second quarter of 2020 was one of the most challenging periods we've ever been through as a company and as an industry. Although our industry is used to the cycles, the past few months have presented their own unique challenges. First and foremost, as an essential service, we've been focused on keeping our people safe, while continuing to support our customers' critical operations. I'd like to thank our employees for their continued dedication and incredible hard work over the last few months and our thoughts are with all of those affected directly or indirectly by COVID-19. While our second quarter financial results were clearly challenged, we did have continued success in our cash generation efforts, and our cost management strategy is certainly delivering results. In a moment, Nick will review the quarter's financial results in more detail, but first I'd like to touch on a few macro points, provide you with some updates on the specific actions we've taken to meet the challenges of today's market and then review our positioning looking forward. Although crude prices have since recovered off the trough levels seen in April and May, the impact on our second quarter results was significant. Gas basins held in better than oil basins, but there was really nowhere to hide during the second quarter. We experienced activity reductions across the board over the course of the second quarter with total U.S. rig count down 55%, horizontal completions declining more than 60%, and the number of active frac fleets declining approximately 70%. It's always challenging to manage cost downward as fast as activity can drop particularly when the pace of the decline is as steep as it was in the second quarter. That said, the speed and…

Thank you, Holli, and good morning everyone. While the second quarter was certainly difficult from an industry activity perspective, we effectively matched our best free cash flow quarter ever as a public company and exited the quarter with unprecedented balance sheet strength. Our $56 million of free cash flow generated during the second quarter demonstrates the resilience of our business model and our disciplined capital structure as well as our nimble and resolute approach to cost rationalization. Roughly 80% decline in completions activity from peak levels earlier this year makes for an extremely difficult hill to climb in terms of taking cost out quickly enough to keep pace with declines in activity in what was effectively a free falling market. We eliminated significant costs from both the field and back office and after adjusting for non-recurring expenses, we achieved our SG&A target reduction, a quarter early with more savings to come. As Holli mentioned, our ability to hold decrementals to near 20% levels in the face of revenue declines we've never before seen as a company, represents a significant achievement. While these cost savings measures were unable to prevent adjusted EBITDA from going negative during the second quarter, given the speed of the revenue declines, we've seen continued improvements in July with modest revenue growth and adjusted EBITDA projections approaching breakeven. I feel optimistic that we're positioned to return to adjusted EBITDA levels of breakeven or better in the third quarter, supported by moderate revenue improvements. But I'd caution that forecasting certainly remains a difficult proposition in this environment. Our $97 million of year-to-date free cash flow has further bolstered our already pristine balance sheet, and provides us with increasing optionality in a distressed landscape. We now have over $166 million of cash on hand as of the end of…

Thank you. [Operator Instructions] Our first question comes from Kurt Hallead with RBC. Please proceed with your question.

Hey, good morning.

Good morning, Kurt.

I appreciate the color and commentary and the update. I think the – we're getting a lot of commentary about a pickup in frac activity going into the third quarter, but again some mixed read as to what that may look like going out into the fourth. So understanding that nobody really has a crystal ball here, and can see things clearly. I just want to get your perspective on your discussions with any customers and maybe with your ear to the ground on the E&P side of the business. What is your expectation for frac activity, do you think you can maintain momentum going into fourth quarter or do you think that there is still some risk of maybe a decline in frac activity for seasonal purposes?

Yeah, it's a great question, Kurt. And as you would imagine, the answers you get varies greatly between customers, and how they've managed their capital program. But clearly there was a heavy weighting toward building of docks in the first half of the year. So, we do expect to see the dollars first going toward completions and we've seen that in the frac crew count as it's been increasing over the course of July. And as you think about trajectory, it's absolutely heading in the right direction. We would expect it to get to triple digits. The question then to your point becomes what happens in Q4? And we had gotten into a pretty good routine of understanding while it wasn't any fun, we knew that Q4 would drop off fairly meaningfully because of the capital exhaustion and seasonality. Because we're starting from such a lower base this year, I don't expect the fall off to be as extreme as it has in the last few fourth quarters. But I think just, based on behavior and the holidays and everything else as people reset and recharge for 2021, we will see some decline in the fourth quarter. So we're expecting a fairly steady ramp over the course of the third quarter and then that November, December timeframe, we're certainly going to be prepared for a situation where activity levels scale back.

Got it. Okay. I appreciate that. Now, you're in a very enviable position with no debt on the balance sheet and continued positive free cash flow from based on your commentary here for the second half of the year. Can you just help us kind of remind us of what your priorities might be in terms of cash allocation and do you feel like any external pressures to have to do anything with that spare cash?

Yeah. Kurt, so as you noted, we are in an enviable position here. I'd say returns to shareholders are a priority through the cycle. But as I mentioned, probably something that we'll step back from a little bit on a quarterly basis while we survey the market. So, well we've talked about we're interested, we know there's dislocation, there may be some good franchises out there that need new homes or new capital. And so we're going to look around for that, but we don't feel any outside pressure to rush off and do anything that wouldn't be in shareholders' interest. We're going to carefully evaluate everything. If we see a great opportunity, we're going to look into it further, if we don't, then we'll wait for a better time and keep looking.

Okay, that's great. That's it from me. Thank you.

Great, thanks.

Our next question comes from Ian MacPherson with Simmons & Company. Please proceed with your question.

Thanks. Good morning, Holli and Nick.

Good morning, Ian.

Good morning.

I wanted to make sure I understand where we are in the cost resizing park, if you will. So, you're a bit cautious on Q4 seasonality, but just hypothetically, if fourth quarter revenues on a consolidated basis were pretty flat from Q3 and Q4, would you still in that case still expect a bit of margin improvement, because of the schedule, cost restructuring benefits playing out through a full quarter or do you think that the margins that we took – that you've described in Q3 are gets in play as your stabilized run rate going forward?

You know, there is probably, I'll say a little bit of room of improvement in there, if revenue were to remain flat, Ian. Just because to your point, we won't get a full quarter's benefit of some of this, and as your business ramps back up, similar to the way down, you're never as efficient. And so we'll have some fits and starts of how we add resources back, people, things like that, that will probably make the third quarter a little less than optimal. So, if we were into a steady state flat revenue in the fourth quarter, we would expect that you could find some incremental benefits. But what I think is obviously quite important is the team was able to manage the business so carefully and make structural changes, we've been able to take as we mentioned in the prepared remarks, 20% decrementals for this business. But we would expect, what I'll call historical incrementals and that is because of the permanent elimination of certain costs that will certainly benefit the business and provide some tailwinds.

Okay, that's helpful. Thanks Holli. And so if we got into what we saw could be a decent recovery trajectory next year and if just to throw out bogeys, 20% or 30% recovery if frac crew activity allows for that, are the 25%, 30% gross margin incrementals that we've talked about historically are those amplified going forward or are they pretty consistent?

Yeah. We have a good operating leverage especially with our pipelines and our Chemicals business. So, in Q2, we saw very little activity in the pipelines, especially the Bakken that's changing here in the third quarter, and we hope that trajectory continues. And as far as chemicals, it's more of a manufacturing business. So the ability to fully utilize that manufacturing facility is critical to efficiently absorb the costs as well. So, we see about 30% to 35% incrementals overall for the business when kind of blending the three segments together and thinking about some of those that low-hanging fruit we have especially in pipelines.

And when you think about the target gross margins for the individual segments, Ian, in some of the guidance we've given in the past, what will be critical there is what happens with pricing, and then what is the contribution. To Nick's point, if our pipelines are contributing more than I think getting back to our historical margins on the infrastructure segment should be possible. When we look at Services and water services and when we look at Chemicals, we'll have to follow pricing quite closely. And one of the – as I mentioned again in my prepared remarks, we haven't seen the same overbuild in our space. So if we get back to a – I'll call it a reasonable activity level in 2021, we think there could be a tightening of supply and demand for the services that we offer, and see some support for pricing. And if that does play out, then I think some of the historical margins that we generated and targeted would be possible.

All right, it makes sense. Thanks, Holli. Thanks Nick. I'll pass it over.

Sure.

Thanks Ian.

[Operator Instructions] Our next question comes from Sean Meakim with JP Morgan. Please proceed with your question.

Thank you. Good morning.

Good morning, Sean.

I'd love to hear more feedback on your expectations for completions activity in the third quarter versus the second quarter. We touched on it a bit, but it sounds like you're guiding flat to up trajectory quarter over quarter for water services. It doesn't seem unreasonable within the band of feedback across other completions companies this quarter. In terms of frac fleet count, it sounds like July was up modestly off of June, but still down 20% off the 2Q average. So, I guess I'd just love to hear more about based on your customer discussions, confidence in terms of the ramp in August and September, being sufficient given the relatively tough comp you have in April.

Yeah. That you just hit on it, Sean, that the shape in the quarters is so vastly different, it's actually hard to make any sort of apples to apples comparison. But we're not expecting the slope of the – I'll say, the improvement in Q3 to be as extreme as the fall in Q2. So, April was still well above 100 frac crews. And then you saw in May, in June, you get down to the low 60s and maybe the high 60s. And yes, we have seen an improvement in that, in July and then it's going to become, and maybe we're in the 80s, 90-ish frac crews here in the very near-term and could see that break the triple-digit mark. But I think it's just – we're not going to have the benefit in Q3, that we had in Q2 of that April month and to your point, that's why we would expect water services to be flat to maybe slightly down. But I would note that we expect Chemicals to be up and part of that just because they can be a little bit of a leading indicator if you think about you're – largely that's a product business versus a service. And so, during the downturn, our customers will consume their inventory. And then as things pick up, they need to rebuild a little bit of inventory. So it should be – it should improve a little more quickly than the services space. And then on the infrastructure side, we had essentially no contribution from the North Dakota – North Dakota pipeline system, and we are seeing contribution in the third quarter. And then on the New Mexico system, we expect volumes to be flat there as well. So I think our Infrastructure segment, we would also expect to see some improvement there, Q3 relative to Q2.

Got it. Yeah, that's helpful clarification. And I do want to touch on Chemicals a bit more as well. So negative gross margins in the quarter, you noted some inventory drag higher priced inventory and then of course some pricing concessions. And so, you expect revenue up sequentially in the third quarter, can we talk more about what drives the sequential improvement? Is the production coming back online? Is it just some restocking? And how should we think about the implications for gross margin in the third quarter?

Yeah. When you – if you think about our Chemicals business, 10%-ish or less is production chemicals. So that's not going to drive the segment. We are seeing wells coming back online. So, we do expect an improvement in our production chemical business in Q3 versus Q2, but it's really not that material. So, the majority of the benefit will come from our completions and treatment WCS businesses. And that's just – that's partly to your point of the restocking of inventory. But it's driven by activity levels. And when we think about the margins, again a manufacturing business is going to have more fixed cost. So, we would expect our margins to get back to the mid-single digit certainly in Chemicals, in Q3. And certainly as we can start to increase our volumes through our plants that will have a material difference on those margins.

Very good. Thanks, Holli.

Yeah.

Our next question comes from Ryan Pfingst with B. Riley. Please proceed with your question.

Hey, good morning guys.

Good morning.

Can you provide some detail on how for water services temporary transfer pricing progressed throughout the quarter and to the early part of 3Q this far and have you seen competitors actually price themselves out of business yet?

It's an interesting question, because you really have to – I'll say peel back the layers of the onion when you think about pricing, because as you can imagine, of the frac crews that are working today, the customers, the operators that are actually supporting that business, it's a pretty wide range, size-wise and leverage wise. And some of your smaller operators are incredibly price sensitive and many of those operators will make a decision based solely on price and frankly they're working with vendors and suppliers that are smaller organizations that many of which I have to assume are reaping the benefits of the payroll protection act. So, they're essentially getting their labor subsidized. So, there are jobs being bid and executed at, I'll say historically low pricing levels. We are not participating with those customers. It doesn't fit our model for a lot of different reasons, one is the price obviously, the other is just the consistency of the work. I'd also add that the credit quality of those customers, we would be particularly concerned about in this particular market. So, I think that the labor subsidy is probably keeping more of the competitive landscape on life support, than we would have seen in prior cycles. But that will eventually go away, and I think that's when you will start to see even though it's on a deferred or a lag basis, you'll start to see the competitors unable to support their businesses when they have to fully price in their labor.

Thanks Holli, I appreciate all that detail.

Sure.

And then turning to water infrastructure, you guys mentioned that the Bakken system will make a bit of a comeback in 3Q, but can you provide some additional color on how you view utilization for the Northern Delaware through the rest of the year, both for your anchor tenant, and otherwise?

Yeah. We certainly saw a drop in Q2 on that system from the first quarter, but again, we are expecting a slight improvement in Q3 and then Q4 will be again, that's where I wish I had a better crystal ball, but it – would expect some seasonality there. And with regards to the anchor tenant, keep in mind that is a take-or-pay contract. But the way it works is that if we don't deliver the volume this year, we won't be paid this year. It gets trued up in the early part of the following year. So, we wouldn't recognize earnings for the benefit of that take or pay. So depending on how those volumes move that will obviously have implications from a timing perspective on when we're able to recognize those revenues.

That's helpful. Thanks. I'll turn it back.

Ms. Ladhani, there are no further questions at this time. I'd like to turn the floor back over to you for closing comments.

Well, again, thanks for your time today. We all know that there is a tough market in front of us, but I hope one of the key messages that you all took away is that Select is quite well-positioned to deal with this recovery as Nick mentioned. I think our capital allocation discipline over the last couple of years to eliminate all of our debt to be sitting here in the cycle with cash on our balance sheet creates a lot of options. And certainly what we're hopeful for is that when the time is right, we'll be playing offense while some others are playing defense. And we will stay focused on our core business and making sure that we start to generate the right sort of cash flow again to support investments across the space. But again, thanks for your time and have a good week.

Ladies and gentlemen thank you for your participation. This does conclude today’s teleconference. You may disconnect your lines and have a wonderful day.