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Executives

Lindsay Naylor

Stephen C. Taylor - Executive Chairman, Chief Executive Officer and President

Analysts

Gary Farber - CL King & Associates, Inc., Research Division

Jason A. Wangler - Wunderlich Securities Inc., Research Division

Jeffrey Kerr

Peter Van Roden

Natural Gas Services Group (NGS) Q3 2013 Earnings Call November 7, 2013 11:00 AM ET

Operator

Good morning, ladies and gentlemen, and welcome to the Natural Gas Services Group third quarter earnings conference call. [Operator Instructions] Your call leaders for today's call are Lindsay Naylor, IR coordinator; Steve Taylor, Chairman, President and CEO.

I will now turn the call over to Ms. Naylor. You may begin.

Lindsay Naylor

Thank you, Erika, and good morning, listeners. Please allow me to take a moment to read the following forward-looking statements prior to commencing our earnings call.

Except for the historical information contained herein, the statements in this morning's conference call are forward-looking and they are made pursuant of the Safe Harbor provisions as outlined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements, as you may know, involve known and unknown risks and uncertainties, which may cause Natural Gas Services Group's actual results in future periods to differ materially from forecasted results.

Those risks include, among other things, the loss of market share through competition or otherwise; the introduction of competing technologies by other companies; and new governmental safety, health or environmental regulations, which could require Natural Gas Services Group to make significant capital expenditures.

The forward-looking statements included in this conference call are made as of the date of this call, and Natural Gas Services Group undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances. Important factors that could cause actual results to differ materially from the expectations reflected in the forward-looking statements include, but they are not limited to, factors described in our recent press release and also under the caption Risk Factors, in the company's annual report on Form 10-K filed with the Securities and Exchange Commission.

Having all that said, I will turn the call over to Steve Taylor, who is our President, Chairman, and CEO of Natural Gas Services Group. Steve?

Stephen C. Taylor

Okay. Thanks, Lindsay, and thanks, Erica, and good morning and thank you, everyone, for joining me for our Natural Gas Services Group's third quarter 2013 earnings review.

To summarize a bit before we get into the details, NGS performed well this quarter, led by significant growth and progress in our core oil and gas compression business.

Rental revenues grew at a high rate, with year-over-year revenue gains of 26%, along with 7% revenue growth on a quarterly basis. We continue to anticipate further gains in this part of our business, and as a result, have ramped up our fabrication throughput by approximately 20% this year when compared to 2012.

Our compression sales business, rebounded from last quarter's revenue levels, is on pace with the rate of growth we had forecast. After last quarter's exceptionally high levels, rental and sales margins returned to their typical range and we anticipate them continuing at that pace, which are among the highest, if not the highest, margins in the industry.

Now, let's move on to the details and I'll expound more. Total revenue. Looking at total revenue in the year-over-year quarters, the third quarter of 2013 revenues increased 13% to $21.9 million from $19.3 million in the third quarter of 2012, with rental revenues showing a year-over-year increase of $3.7 million or 26%. The sequential quarters of the second quarter 2013 compared to the third quarter of this year, total revenues increased $1.6 million or 8% and rental revenue increased 7%. Comparing gross margins of the third quarter of this year to the third quarter of 2012, total gross margin increased 17% from $10.2 million to $11.9 million. Sequentially, gross margin decreased approximately $400,000 to $11.9 million or 54% of revenue. This decline was due to a combination of a mix shift towards lower margin compression sales and more normalized sales in rental margins.

SG&A increased a little over $180,000 in the year-over-year quarters and approximately $100,000 sequentially. SG&A is running at 10% of revenue for all comparative periods. Comparative year-over-year quarters for operating income reflected 20% increase from $4.2 million in the third quarter of 2012 to $5.1 million this current quarter. Sequentially, operating income decreased approximately $750,000 from $5.8 million to $5.1 million due to the mix and margin differences I just mentioned. Approximately 1/3 of the decrease was attributable to higher rental depreciation from rental fleet expansion.

In the comparative year-over-year third quarters, net income increased 30% from $2.6 million last year to $3.4 million this year. Sequentially, net income decreased by $450,000 to $3.4 million, around 16% of revenue.

Interestingly, looking at the comparative year-to-date 9-month periods of 2012 and 2013, and we were calling that we had approximately $11 million of extraordinary sales last year, our revenues are off only 6%, our operating income is up 16% and net income has grown 23%. Despite the revenue differences, we are delivering appreciable bottom line growth.

EBITDA increased 21% from $8.2 million or 42% of revenue in the third quarter of 2012 to $9.9 million or 45% in the current quarter. Sequentially, EBITDA in the third quarter of this year was up $347,000 compared to the second quarter of 2013. But at 45% of revenue, we continue to experience a very strong cash generation.

On a fully diluted basis, EPS this quarter was $0.27 per common share compared to $0.21 in the second quarter of 2013 and $0.31 last quarter. This quarter marks our strongest 12-month trailing earnings per share since 2009.

Now reviewing the business segments. In year-over-year quarters, total sales revenues, which include compressors, flares and parts, decreased from $4.9 million in the third quarter of 2012 to $3.9 million in the third quarter of this year, primarily due to lower compression and flare sales. However, gross margins in both quarters were steady at 37%.

Sequentially, total sales revenues increased 17% to $3.9 million this quarter, from $3.3 million in the prior quarter, primarily due to higher compressor sales. Gross margin decrease of 52% last quarter, which was a record high, to a more typical 37% in the sequential quarters, primarily due to a more normalized mix and margins.

Looking at compressor sales alone. In the current quarter, they were $2.2 million with a gross margin of 23%, compared to $2.8 million at 24% in the third quarter of 2012. Our compressor sales were running at lower levels than last year because, as I mentioned in prior calls, we have dedicated more shop floor space to building rental units. But we are at the $1.5 million to $2 million per quarter levels we've projected in our first quarter call.

Our compressor sales backlog at the end of the third quarter was a little more than $4 million. Compressor rental revenue had a year-over-year increase of $3.7 million or 26% from $14.1 million in the third quarter of 2012 to $17.8 million for this current quarter, with the gross margins consistent at 58% of revenue for both periods. Sequentially, rental revenues gained 7%, with an increase of $1.1 million to $17.8 million this quarter, while margins decreased from 63% to 58%. Comparatively, last quarter's margin was the highest we'd experienced in almost 4 years, and as I mentioned, we have one of the highest margin profiles in the industry, so the retreat wasn't unusual. That quarter was also helped by 1 less pay period.

For the year-to-date 9-month periods, rental revenues were up 22%, with gross margins up from 58% last year to 59% this year.

Rental fleet utilization has also shown excellent progress over the year. We ended the third quarter at 80% on a unit basis, which is up from 79% last quarter and 75% at the end of the third quarter of 2013. An interesting number we watch periodically is the fleet churn, defined as the number of units installed divided by the number of units terminated. Churn is a normal function of the rental business and can give us an idea of the strength of the market. For example, a churn of 1 indicates no growth, while a higher number is good and lower is bad. For the 9 months year-to-date this year, our churn is at 2.1. So we are selling more than 2 compressors for every 1 returned. This compares to full year churns of 1.6 last year in 2012, a strong year; 2.1 in 2011; and 1.4 in 2010. Looking even closer at the individual number of new installations and terminations and annualizing 2013, the number of units installed in 2012 and 2013 will be within a close range of each other. But the unit terminations are down over 20% this year. This is contrary to what others in the industry are experiencing, so we are not only growing absolutely but picking up share.

Fleet size at the end of September was 2,466 compressors. This is a net addition of 74 compressors this quarter compared to 65 in the second quarter and 49 in the first. These 188 new fleet compressors added this year are already 90% of the level we added in the full year of 2012. This is an approximate 20% increase in throughput. So as we laid out to you previously, we have made appreciable progress ramping up our rental throughput without added roofline.

Approximately 40% of our active rental fleet is in oil or liquids plays. However, we have also added about 5% more dry gas units to active status this quarter, so we have seen some oil and gas growth. That's not necessarily a trend, and I think it's predominantly attributable to our share gains. But it is interesting when it seems few others are seeing any activity in dry gas markets.

We spent $10.8 million for capital expenditures in this third quarter compared to $10.7 million in the second quarter. This is a total of $29.2 million for the year-to-date with 97% of this going for rental fleet additions. During last quarter's call, I raised our capital budget estimate for 2013 from $30 million to $35 million to $35 million to $40 million. And we are tracking on the upper end of that higher range.

Going to the balance sheet. Our total long-term and short-term debt was approximately $750,000 as of September 30, 2013, and cash in the bank was almost $28 million. Our cash flow from operations through the first 9 months of the year was $28.4 million.

I had mentioned in the past that I don't try to predict commodity prices anymore and I'll just -- and that I'll just reflect consensus opinion, but even that can be tough. So repeating what EIA thinks, the Energy Information Administration, natural gas price is predicted to average $4 per MCF in 2014, up from $3.71 average this year and $2.75 in 2012. While this price level is not enough to drive much added drilling, we think it will give added support for at least keeping existing dry gas compression in the field.

Brent crude oil is projected to be $102 per barrel in 2014, with a discount for WTI decreasing down to $6. We think a $96 average oil price will continue to drive good levels of activity for our equipment and services in all the oil shale areas we operate.

We continue to anticipate a good and growing year in 2014. Preliminary indications are that our customers are planning for additional growth in 2014 and we are confident we will remain a significant supplier of their wellhead compression needs. We are well-positioned in many growing areas, our fabrication capacity is increasing and our service response is second-to-none.

Erica, that's the end of my prepared remarks and I'll turn it back to you for any questions anyone might have.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Gary Farber from CL King.

Gary Farber - CL King & Associates, Inc., Research Division

Just a couple of questions. One, just on the CapEx, it sounded like you were seeing possibly $40 million this year. Can you sort of give some -- give some thoughts as regarding next year, preliminarily? And then also talk about the pricing environment, what you're seeing? And you mentioned also taking share. Can you talk about, what -- do you think it's service that's driving your share gains? Is it something else?

Stephen C. Taylor

Let's see, from a CapEx -- yes, right now, well, we haven't got full skull on 2014 yet from all the activity in all the areas. We're just kind of starting into the process for the last couple 3 weeks. I mean everything is looking positive. Yes, I'll say, I think, we'll at least be in that $40 million range and I'll put a plus or minus on that just to kind of have a number until they come in, but the year's looking to be a growing year, next year. As I mentioned, we're just not exactly sure how much. But we think it's -- that's going to equate into the 220 to maybe up to 240, maybe a little more compressors. So we think we'll be on track to put more out than we put out this year and then the capital budget will commensurately reflect that. Pricing-wise, it seems to be generally okay. We still see spots that don't make some sense in some respect. It seems like maybe -- yes, I think we pick up share just from the service standpoint, a lot of others try to pick up share through pricing. And of course, that tends to be what we see, I think, sometimes. So it's not fully rational yet, but maybe I can say semi-rational at this point. Much better than we have seen in the last year or 2. And again, from a share perspective, just like I mentioned, primarily, our service capability, we've got an excellent reputation in the field. [indiscernible] were sent to everybody, and we see that certainly in just some of our numbers but also, anecdotally, and we know of -- yes, we've seen in a couple of specific areas where we have overtly gone in and picked up some competitive share there. So, yes, we think that'll -- I would -- it's hard to predict that, when that will happen. So, let's not -- just have to [indiscernible] also up to the customer and the existing provider. So hard to say, but we've had pretty good luck with it this year.

Gary Farber - CL King & Associates, Inc., Research Division

And one last, would you say it's accelerating the share gains?

Stephen C. Taylor

It's higher this year than I think what was seen in the last couple of years. But again, I can't say it's a trend or if it will continue or anything else. It's just we've had pretty good luck this year.

Operator

[Operator Instructions] Our next question comes from Jason Wangler from Wunderlich Securities.

Jason A. Wangler - Wunderlich Securities Inc., Research Division

Just on the churn thing, and thank you for that, it's very interesting. Is there any way to maybe just add a little color, as far as, as you're adding 2 -- are you seeing those, basically, 2 going to oil markets and the 1 coming back from an oil market? Is it 2 in oil and 1 from gas? I mean, is there anything -- is there a generalization you could make on that or is it really case by case?

Stephen C. Taylor

Yes. We didn't break it down much. We could -- we just haven't gone to that much detail.

Jason A. Wangler - Wunderlich Securities Inc., Research Division

You'll be in danger by giving us some detail, I understand.

Stephen C. Taylor

Well, I mean my feel is certainly the last 2 to 3 years, it's primarily been oil going out and gas coming back. But I think, this year, certainly, the oil growth has continued. But this quarter, again adding 5% more attributes [ph] on the gas side, we've seen oil going out and gas going out. And I think, primarily still, the returns we get are primarily out of dry gas, but we've been able to offset those pretty well this quarter. In the past and you've seen the numbers, we stayed pretty constant. X gas going out and x gas come in, so it stayed pretty flat. But now we've gotten 105x [ph] going out and x coming back. So both of them -- oil is still the grower, but just a little...

Jason A. Wangler - Wunderlich Securities Inc., Research Division

Gas is kind of being a little bit -- being a little better, I guess, I could say is maybe...

Stephen C. Taylor

Yes. And again, I think it's primary from our share gains.

Jason A. Wangler - Wunderlich Securities Inc., Research Division

Sure. Okay, and then just on the utilization -- it's not the utilization, but the compressors getting the throughput up to the 20%. I know you've talked about it in the past, I think you're pretty darn close to putting as much out of there as you can. I mean, do you see much more or are you kind of at that level where, look, we're about as good as we can get and anything else we're going to need to look to outsource or go somewhere else?

Stephen C. Taylor

Yes, we're still looking at expanding capacity and how we might want to do that. And again, there's couple ways we can, either build onto our existing facilities or outsource and we're still looking at both those to see which might be a little better. Of course, the advantage when you do it yourself is you control it a little more and have a little more, check on your supply chain. Whereas if when you outsource, you've got to -- sometimes you're in line behind some other people at times. But we're looking at both just to see where the dollars look best and balancing that against our ability to control that supply chain a little better.

Operator

Our next question comes from Jeffrey Kerr from Kerr Financial.

Jeffrey Kerr

Oil, I missed the percentage of the fleet in oil plays.

Stephen C. Taylor

Yes, it's right around 40%.

Jeffrey Kerr

40%. I guess the other question to kind of follow-up what you just said about building or outsourcing and like that. Do you think about using the capital -- you've talked in the past about maybe doing acquisitions or whatever. And is it -- would it be correct to think about the -- maybe doing an add-on to the current footprint as replacing the acquisition strategy? And would that be kind of the use of capital now?

Stephen C. Taylor

Yes, I mean it's -- I think they fit together, from a perspective of how we go about growing. As I mentioned in the past, we looked at a lot of cash in the past, but there's always been one issue or the other, either the price or the quality of the fleet that has kept us from doing anything there. And again, it's not just us. You look over the past 4 or 5 years, there's not been a whole lot of acquisitions in this business, presumably due to the same thing. So yes, when you look at our rental fleet growth, particularly, it's been a 20% growth over the last 3 years. So from a -- if you're looking at -- it's not that we're saying, okay, organic is the only way to go in oil, you cannot do anything else. We still look at stuff but if you look at the organic growth being in that kind of range, yes, we're growing fairly quickly that way, not having to have any M&A, although we don't discount it. So when you look at that and just looking at ways to increase that capacity, yes, as I mentioned, adding onto existing facility is one way to do it. And the advantage of that, of course, is, as I mentioned, control over some of that. Now, control, if it doesn't come at too high a price. But the good thing about out here in the West Texas, where although it's busy and things are a little higher priced than what they had been, it's not an extraordinary expense to add roof on to some of our facilities, depends on what we do and how much we do. So right now, frankly, that probably looks attractive. But we are going out to get some market indications of what other fabricators may be able to do for us, too. It'll make the financial decision, number one; the control decision from supply chain, number two. And also, outsourcing certainly gives you more of a swing capacity if things do tail off at some point. Much easier to get rid of that than the bricks and mortar we've now got.

Jeffrey Kerr

How fast do you kind of think about being able to add on that bricks and mortar, if you choose to go that strategy?

Stephen C. Taylor

Yes, we've got a couple of bids on that. I think it could be a 90-day sort of situation. So it's not extremely long. And again, we made, as we're looking at this to potentially be a combination of a process for maybe we outsource a little, while this place is getting built too, if we decided to go that way. So there's a little flexibility on what we -- how we can go forward.

Jeffrey Kerr

How about workforce? Would there be any issue in growing the workforce or finding the capable people to put in a new building?

Stephen C. Taylor

Well, it's gotten better here in Midland. A year ago, that's when we really started looking at outsourcing, because we weren't going to outsource here in Midland necessarily, because there weren't any people anywhere. Yes, we're looking within 100-mile radius, at least keep it close to the house. So -- but now, about 12 months later, the market has loosened up a bit, so now we're able to staff up to where we want based on -- that's how we've got some of the throughput now. And then we think we can -- we think we could -- if we do decide to build ourselves, we think we could staff it.

Operator

Our next question comes from Peter Van Roden from Spitfire Capital.

Peter Van Roden

I just wanted to talk a little bit about gross margins. I know that you said that this is going to be kind of the new normal going forward. But was there any sort of increase in maintenance activity in the quarter? And if you do kind of pick between the 62 and the 58, are we going to end up in the middle for the year and going forward? Just a little bit color there will be great.

Stephen C. Taylor

Yes. Well, as I mentioned, right now, year-to-date, 9 months, we're 59% gross margin on rentals, and last year we're at 58%. So we've actually made some progress there. The contrast -- the big contrast we have between Q2 and currently, of course, between 63% and 58% was -- part of it was that extra pay period, it was actually about 3 points. That's more than half of the difference. We've had about -- relatively added another $400,000 in payroll across this quarter. So you saw little of that. But there wasn't any more maintenance activity Q3 than what we had Q2. So really if you get down, thrown out that pay period fluctuation, you've got a 1 or 2 percentage point swing in the margin, which is really going to be kind of your normal quarterly variation. It's just -- it's exacerbated by the, number one, 63 being very high and, number two, that payroll is so -- on a relative basis, it makes a little more tougher comparison. But yes, I think -- I mean, again, we're 59% running now. Yes, we want to get up into that 60% range pretty consistently. And we have kind of averaged that, 58, 62, depending on what the quarter is. But next year we want to aim for -- have it at a pretty good solid consistent 60.

Peter Van Roden

Okay, that's helpful. And then just a quick update on, what's my favorite topic, the VRU rollout.

Stephen C. Taylor

Okay. All right. That's for -- if everybody hasn't followed it, there's an EPA regulation that just come out, called regulation OOOO, which is quad O, and it's actually starting to take effect now. I know there's a lot of pushback on the regulation from the industry, mainly because it's not a very economic sort of exercise. But it's intended to control methane emissions or really just natural gas emissions off of locations. There are couple ways you can control these emissions, one is roof flares, and one was with VRUs, that's cover units which has small gas compressors. So both those fit right into our present business lines and bailiwick. And we had seen some VRU activity last year. I'd announced that a couple of contracts we've gotten, one has been in full swing and then one of them, probably really won't start up much until next year. Beyond that, we haven't seen a whole lot of additional movement out of that market yet. Now we think, either, we're talking to a lot of customers out there on what they're seeing, what they're planning, what they're doing. There seems to be a general feel that maybe this thing gets pushed off again. It's been pushed off a couple times. I don't know if that's -- if that general feel is based on fact or just hope. I think maybe more the latter. So we're still -- April -- April 2014 is when this regulation is supposed to take full effect so -- as we get closer to it, I expect to see a little more activity than we're seeing now, but really, we haven't seen as much as I would have thought. And of course, we haven't anticipated anything from a -- or any comments we've made from the point of business or anything else. But just seeing that as icing that may come on top of the growth cake we've got anyway. But we're not seeing any more than what's been happening in the last few quarters. So we're still waiting to either see, push -- EPA actually push it back a little or there should be some movement coming in the next couple quarters, I would think.

Peter Van Roden

And then one last question on the, I guess, a little bit more macro, is that I saw that a couple more shales are going to push to outlaw flaring. I think the Utica is about to do that. Are you starting to look at ramping up activity in those areas?

Stephen C. Taylor

Yes, we're already in the Utica. This flaring issue, that's kind of the funny thing about it. The EPA is all for it and nobody else is now. So, figure that one out. And of course, we're in the flare business and the compressor business, but -- and we've always said the flare business, really our ramp up in that and it's about tripled the last 3 years. It's just an opening window and that window will be closed at some point. And it's not closing yet. But I think -- certainly, the pushback is coming. I mean -- it doesn't go to 0, but it does throttle down. But whether it's the Utica or the Bakken, I think the pushback is interestingly not coming from Washington or ilk of that sort. But really more from a local and state pushback. State politicians and then local populace. So we've already started seeing that in the Bakken pretty heavy and you've seen large operators up there announced that within x number of years, they won't be flaring anymore. Now part of that is -- part of it is, okay, we'll get out front. But part of it, as I've always talked about, there just hasn't been the infrastructure out there anyway. So it didn't matter whether you want to flare or not, you didn't have any choice for you to produce oil but to flare. But that's getting alleviated on its own, too, because there's pipelines, gas lines going in. So part of this, I think, is, yes, we're not going to flare. But ultimately, we're not going to flare anyway because that gas can go into a pipeline.

Peter Van Roden

Yes. I actually meant it more as a positive in terms of not flaring the gas. They might actually want to use a compressor...

Stephen C. Taylor

Yes, and I should've followed up with that. Yes, the logical extension for us is, when you don't have flares out there and you have a pipeline, you put a compressor in there. So yes, we think that's certainly a future growth area and I'm actually going to look at it in the Bakken for a bit. We're up there with a little compression but really not a whole lot. And we think the big push will come when those pipelines get in. And that flaring does go away. So I appreciate you finishing my sentence here, Peter.

Operator

[Operator Instructions] Steve, at this time, I have no further questions.

Stephen C. Taylor

Okay, Erika, thanks and thank you, everyone, for joining on the call. I appreciate your time this morning and look forward to visiting you again next quarter. Thank you.

Operator

This concludes today's conference call. Thank you for attending.

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