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Key Energy Services (NYSE:KEG)

Q1 2014 Earnings Call

May 01, 2014 11:00 am ET

Executives

West Gotcher

Richard J. Alario - Chairman of the Board, Chief Executive Officer, President, Chairman of Equity Award Committee and Member of Executive Committee

J. Marshall Dodson - Chief Financial Officer and Senior Vice President

Analysts

Neal Dingmann - SunTrust Robinson Humphrey, Inc., Research Division

Earl A. Stolz - Iberia Capital Partners, Research Division

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

Kurt Hallead - RBC Capital Markets, LLC, Research Division

John M. Daniel - Simmons & Company International, Research Division

J. Marshall Adkins - Raymond James & Associates, Inc., Research Division

Scott Justin Levine - Imperial Capital, LLC, Research Division

Daniel J. Burke - Johnson Rice & Company, L.L.C., Research Division

Michael W. Urban - Deutsche Bank AG, Research Division

Operator

Good morning. My name is Jeremy, and I will be your conference operator today. At this time, I would like to welcome everyone to the Key Energy Services Q1 2014 Earnings Conference Call. [Operator Instructions]

I would now like to turn the call over to the Director of Investor Relations and Corporate Development, Mr. West Gotcher. You may begin your conference.

West Gotcher

Thank you, Jeremy, and thank you, all, for joining Key Energy Services for our first quarter 2014 financial results conference call. This call includes forward-looking statements. A number of factors could cause actual results to differ materially from the expectations expressed in this call, including risk factors discussed in our 2013 Form 10-K and other reports most recently filed with the SEC, which are available on our website.

This call may also include references to non-GAAP financial measures. Please refer to our website for a reconciliation of any non-GAAP financial measures provided in this call to the comparable GAAP financial measures. For reference, our general investor presentation is available on Key's website at keyenergy.com under the Investor Relations tab.

I'm going to turn the call over to Dick Alario, Key's Chairman, President and CEO, who will provide some introductory comments regarding the first quarter and discuss current trends in our businesses. Then Marshall Dodson, our CFO, will review our results and provide some guidance commentary. Dick will return to conclude our prepared remarks and open the call for your questions. Dick?

Richard J. Alario

Thank you, West. Good morning, everyone. Let me first point out that Trey Wilson, our COO, is unable to join us on the call this morning. He's currently traveling out of the country on a previously scheduled trip. As a result, as West said, our normal call format will change a bit as you heard. So with that, we'll get started.

Key generated a consolidated GAAP net loss of $0.08 a share for the first quarter. These results include a $0.01 loss due to severance in Mexico that we had discussed on last quarter's call, yielding a normalized $0.07 loss for the quarter.

In the U.S., revenue in the first quarter was essentially flat to the prior quarter. These results fell below our previously guided range of 3% to 5% improvement, as what turned out to be the harshest winter in years took a toll on many of Key's principal operating regions. And on top of that, if you layer in the severe rain events that hit the West Coast, which didn't have anything to do with winter, but which had significant impact on our California operations, it's clear that our larger operating regions and in particular, those where our revenues are mostly production service-driven were not spared weather disruptions. In total, weather impacts accounted for approximately $0.01 of EPS loss in the first quarter.

On the other hand, our large-diameter coiled tubing units, our large well service rigs and premium drill pipe, driven by increased horizontal completion activity, performed well in the quarter, but didn't see a full seasonal recovery due to the weather disruptions that I mentioned earlier. Once those issues abated, however, these services experienced improved demand as increased well count and associated completion activity progressed above the pace of typical seasonality in many active unconventional resource plays.

Our 2 3/8-inch coiled tubing units, for instance, were completely sold out as we exited the first quarter, achieving effectively 100% utilization. Further, during Q1, we saw utilization of our 2-inch coiled tubing units improve over 1,000 basis points as we captured some additional work where the 2-inch units brought the same utility to our customers as the 2 3/8 units did. While this is certainly not a trend, it is an encouraging development given that as the number and service intensity of horizontal wells increases, incremental coil demand will likely be felt in the resource plays.

As such, Key is already in a position to leverage its underutilized asset base to take advantage of that impending market demand, which would yield meaningful top line and margin growth for that business. To that point, we believe that since these completion-driven businesses have moved beyond the weather disruptions of the first quarter, they should continue to show improved financial results as we move through the year and as the ramp-up in unconventional horizontal completion activity continues.

Our production-driven businesses, including Rig Services and Fluid Management Services performed slightly below expectations as the seasonally muted first quarter was further burdened by severe weather and changes in regional revenue mix. Demand for production-driven services remains good and should improve as the inventory of aging oil wells continues to grow at a healthy pace and as legacy oil wells continue to provide excellent returns at $100 a barrel oil. We have seen the volume of large-scale production-oriented tenders begin to ramp in a meaningful way recently, however, we're also seeing that the larger operators approach these projects at a methodical pace in order to identify the right long-term partners.

As an example, we were recently awarded a 100-well project in the Bakken for a large independent that is recompleting older horizontal oil wells, the first project of its kind to this operator. Not only are we encouraged by the fact that operators are beginning to perform significant workover and recompletion activities on older horizontal oil shale wells, the Bakken's being the oldest, but we're also pleased that once the start-up efficiencies were addressed on this project, we were able to deliver results approximately 25% faster than what the operator had budgeted. It's these types of results that contribute to be mutually beneficial to long-term partnerships and it's these types of long-term partnerships that we envision driving production services contracting for larger operators going forward.

Now I'd like to discuss some regional trends both in terms of the first quarter, as well as our outlook for the second quarter and the remainder of the year. Clearly, the Permian Basin is the region experiencing the most significant increases in activity as shown by the horizontal drilling rig count in this region reaching approximately 60% of total operating rigs, as compared to approximately 35% a year ago. Growth in the Permian horizontal completion market has already allowed Key to increase its relative revenue generation in the Permian by 200 basis points, as compared to the fourth quarter, to where we are now deriving 30% of our U.S. revenues from the Permian Basin. We expect Permian to contribute more relative revenue generation in our U.S. business as the shift to horizontal well development continues there, and as we continue to penetrate new customers and expand our business with existing customers.

Looking to the Mid-Continent, including the Mississippian Lime, the SCOOP, Granite Wash and to some extent the Haynesville, we've been encouraged by demand there in our activity levels over the last quarter or 2. We've successfully been able to capture opportunities for multiple service lines in this region. In fact, to this point in April, our Rig Services business in this market has seen the highest hours per workday in more than a year, up 9% compared to our Q1 average. In addition to unconventional oil shale activity, we've seen a tick-up in gas-related activity in this region, both production and completion activities.

On the completion side, as an example, we've had an East Texas-based coiled tubing unit that until recently was a nomad, picking up jobs in whatever market it was able. Now this unit has enough sustainable work to remain home and stay sufficiently utilized at least for the near term. And we haven't seen that in years. In addition, on the production side, we've begun to see some operator -- operators turn on old gas wells to take advantage of the current commodity price. While we're seeing signs of gas activity and certainly would be encouraged to see further activity increases, this is not yet a significant driver for our business, but it's worthwhile to note.

During the first quarter, as others recently noted, the California market experienced a number of challenges, including heavy rains, a slow ramp-up in early year activity and to some degree, well permitting issues in certain areas. Both our top line results and margins were pressured and we're currently assessing opportunities to increase activity to prior levels.

So to summarize my U.S. comments, I believe that as we move further into this quarter and then into the back half of the year, our completions-driven businesses should continue to see meaningful improvement and benefit from the unconventional horizontal completion activity in many of our principal operating regions. Further, I believe that underlying demand for our production-driven services remains strong and should likely improve in a measured pace as we move through the year and as operators execute on the larger-scale projects.

In terms of pricing, generally, pricing was stable to slightly pressured across our U.S. businesses in the first quarter as a large number of tenders hit the market. Competitive pricing dynamics remained the most severe in our frac stack, well testing and water hauling services. We expect that as activity continues to ramp, both in completion and production-driven services, pricing should stabilize further, setting up the potential for improvement as the year unfolds.

Turning now to International. As we expected on the last call, we exited first quarter with a positive EBITDA run rate. While we're pleased that we met the goal that we had set, we're far from satisfied with this segment as it currently sits. We continue to take the requisite actions necessary to move this segment back to profitability. We've reached the point where we're willing to say that our International business has essentially reached bottom. Mexico has clearly been the drag on this segment and at this point, we're only working 3 rigs in Mexico. So to put it in perspective, if Mexico rig activity was to go to 0, the run rate impact would be approximately $0.005 per quarter in earnings. Said differently, our Mexico business now represents an option on the recovery in growth for the Mexican oil and gas market.

During the quarter, we relocated 12 rigs from Mexico to the U.S. Our current plan is to proceed with moving another dozen rigs to the U.S. leaving us with 17 rig packages in Mexico to take advantage of the impending demand that's being created as production there continues to fall. I'd remind you that all of these rigs returning to the U.S. are large, highly capable units that are well-suited to work in the high-demand U.S. shale markets. The balance of our International segment performed roughly in line with our expectations though we remain focused on improving all of these businesses. We expect all of our foreign businesses to achieve positive operating income in the second quarter with the exception of Mexico.

Now I'll stop here and turn the call over to Marshall.

J. Marshall Dodson

Thanks, Dick. To repeat the headlines, our consolidated revenues for the quarter were $356.1 million, down 2% from the fourth quarter. U.S. revenues were $324 million, essentially flat compared to the fourth quarter, while International revenues declined 16% to $32.1 million. Our consolidated bottom line GAAP EPS was a loss of $0.08 for the quarter. These results include a $0.01 loss due to severance. Excluding the severance charges, the company recorded a $0.07 per share loss for the first quarter. First quarter top line results came in under our previously guided guidance range as severe weather disruptions impacted multiple service lines in multiple markets. These disruptions had a $0.01 impact to our first quarter earnings.

Looking at the U.S., our completions-driven businesses saw meaningful improvement as compared to the fourth quarter, though the recovery was somewhat muted due to the weather disruptions and the pressure is in the most competitive services. Coiled Tubing Services revenue improved 8% sequentially, and our large completion style well service rigs helped offset the decline in California and weather elsewhere in our Rig Services business. U.S. operating income margins came in at 11%, approximately 100 basis points below the high end of our previous expectation of a 200 to 250 basis point decline. Compared to the fourth quarter, Q1 margins fell 220 basis points, due to both the unemployment tax impact and costs associated with rig mobilizations, including rigs from Mexico, as well as domestic rigs. This offset some of the benefit from lower-than-expected depreciation.

While we were successful in getting 12 rigs out of Mexico in the first quarter, about 1/2 the estimated cost per rig remains as we put the rigs through their maintenance and final inspection programs. Weather in the first quarter cost an additional 50 basis points of the margin decline over the weather impacts we experienced in the fourth quarter. Outside of the U.S., we averaged 29 rigs working in the first quarter and experienced a 16% decline in revenues, just outside our previous guidance. Our consolidated International segment operating income margin came in at a negative 32.7% due to significant cost inefficiencies and lower activity, primarily in Mexico, as well as severance of $1.3 million. Although Mexico was about 3/4 of our International operating loss for the quarter, our other international businesses also combined for a loss, albeit at a level much closer to cash flow breakeven.

In addition to the operating loss, the International segment incurred a $1.5 million ForEx charge during the quarter, primarily due to the decline in the Russian ruble and the Colombian peso. We believe that with our current activity and stacking levels in Mexico, the cost reduction steps we have taken across our international operations and with most mobilization start-up inefficiencies behind us, we have effectively bottomed in this segment. We expect all of our markets, except Mexico, to post positive operating income in the second quarter and expect our Mexican operation to be only a slight drag on a cash flow basis until such time as activity in Mexico picks up.

We ended the first quarter with $39 million of accounts receivable outstanding with PEMEX and the contract finalization process with them is nearly complete. Under the terms of our contracts, we would then expect the remaining balances to be paid to us late this quarter or early next quarter.

G&A expense for the fourth quarter was $53 million or 14.8% of revenues. Substantially, the entire sequential increase in G&A was due to changes in the fair value of existing stock-based compensation and unemployment taxes. The unemployment tax burden will not recur in the second quarter. Depreciation and amortization expense was $51 million for the quarter due to the timing and levels of capital spend as well as lower amortization of intangible assets. Interest expense was $14 million. Cash flow from operations was $46 million and capital expenditures for the quarter were $29 million.

We redeemed the remaining $3.6 million of our outstanding 8 3/8% senior notes this quarter and did not reduce our outstanding revolver balance. We ended the first quarter with cash on hand of $40.9 million and a net debt to capitalization ratio of 36.2%, as compared to cash of $28.3 million last quarter and a net debt to capitalization ratio of 36.6%. We currently expect to continue to reduce leverage during 2014.

During the first quarter, we realized a greater-than-expected tax benefit of $7.7 million based on our pretax loss of $19.6 million, and this implies an effective quarterly tax rate of 39.3%. For the remainder and the full year of 2014, we expect our effective tax rate to average approximately 35% to 37%.

Looking forward, we expect completion activity in the U.S. to achieve meaningful improvement. However, due to more methodical work scale planning of our customers, we believe production-driven services may continue to trail the rate of activity increase as compared to our completion services. As such, we expect U.S. revenue to increase 4% to 6% in the second quarter with a further increase in the third quarter. We expect U.S. operating income margins to improve 250 to 350 basis points as we move past the weather and seasonal impacts of the past 2 quarters but our margins will remain burdened by the cost of rig redeployment from Mexico to the U.S. as we complete work on the first dozen rigs and begin our redeployment of the second dozen.

In our International segment, we expect our second quarter revenue to decline 5% to 10% sequentially as we average 27 rigs. We expect operating income margins to improve approximately 2,000 basis points as we realize a full quarter of a normalized cost structure in Mexico and a return to profitability in our other markets.

For the second quarter of 2014, we expect G&A expense to be between $55 million and $57 million, and expect depreciation and amortization expense to be between $52 million and $55 million. We reiterate our 2014 capital plan of $198 million. The current plan contemplates building 50 new well service rigs. However, to the extent the rigs coming back from Mexico are replacement rather than incremental, we will bring our capital spending on new build rigs down to quarterly.

While the 2014 plan contemplated limited growth capital given our focus on leveraging the investments made over the past few years, with our KVA implementation, we're challenging our team to identify and reallocate capital for incremental growth opportunities. To that end, we've already moved on some of those opportunities, primarily in our rentals business, and we're also adding saltwater disposal capacity.

Now I'll turn the call back over to Dick.

Richard J. Alario

Thank you, Marshall. In closing, I'd like to briefly recap several themes that we've focused on our comments this morning. First, completion-driven activity in unconventional resource plays will be a significant driver of North American land activity in the near term and we have sufficient excess equipment from our recent heavy capital spend cycle to take advantage of the first tranche of that with minimal new capital outlay. Second, large-scale production enhancement projects will begin to materialize at a measured pace as operators identify long-term partners and we believe Key to be well positioned to be a recipient of those. Third, the aging of the horizontal oil shale well inventory has begun to require recompletion solutions and we believe this trend provides an added dimension to U.S. service demand that we've not seen before. And finally, we believe that we've reached bottom in Mexico and we believe that when activity resumes, Key will be a primary beneficiary. As result of these themes, it's our view that as our customers continue to execute on their plans for the year, additional capacity from our service lines will be consumed, setting up a more constructive environment for pricing.

Operator, these conclude our prepared remarks this morning. We'll now open the call up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Neal Dingmann from SunTrust.

Neal Dingmann - SunTrust Robinson Humphrey, Inc., Research Division

Say, Dick, I'm trying to get a handle here now after the change in the -- kind of the movement of the rigs around, number one, I'm just wondering, of the higher horsepower rigs in the 450 or higher running, how many of those you have available in the U.S.? And -- or I guess another way to tackle that, sort of what the utilization rate of these rigs, I'm just wondering if you still have a lot of availability of these.

Richard J. Alario

Neal, we said that about 15% of our fleet -- 15% to 20% of our fleet that's actually out there working falls into that category, puts us somewhat over 100. That's what we're building primarily this year. These are the ones that we've talked about in our capital discussion. Mostly what we're building are the large rigs that you've described. So depending, as we said, on the rate of how much of those become incremental versus how much of those wind up being replacement, we'll be adding -- I feel sure we'll be adding a pretty significant number of the large rigs to our U.S. fleet in terms of our building program. But also, don't forget the 24 rigs that we are bringing back from Mexico, 1/2 of them which are already here, all fit into that category. So we'll be beefing up our large rig capability in the U.S. market pretty handedly this year. And as I said, now that we've begun to see the advent of the significant workover demand in the horizontal oil wells -- what I mean is significant type of work on a per well basis, these are the kind of rigs that require to do that, so it adds a dimension of demand that is new and that we haven't seen before, therefore, we feel like all those rigs coming back from Mexico have good homes and the demand out there is real strong to put them to work.

Neal Dingmann - SunTrust Robinson Humphrey, Inc., Research Division

Great. And then I know last quarter you talked about and you -- I guess even in the prior quarters, you've talked a lot about the operational efficiencies continued to be seen. Maybe, could you talk a little bit about that? I mean, again, is that sort of incorporated in some of this new guidance, your thoughts about whether we're talking in the coiled tubing or in the workovers some of the operating efficiency that you all think to be seen here going forward?

Richard J. Alario

Yes, listen, as we've said, as the market moves more and more towards pad drilling, I mean that's one of the things that causes the greatest amount of efficiency in our field operations. And the good news is that it is a positive for the service sector and Key as much as it is for the customers. When our customers go to pads, the planning cycle is much more efficient. And we can manage our labor forces and our delivery of goods, our inventory of various things to the locations a lot more effectively. And so we benefit from that, and that's included in our thoughts as we think about the year going forward. Obviously, the other side of that is it helps our customers to free up more cash to do more legacy-type work, so that's a sort of backside benefit for Key as well. But no doubt, we continue to see opportunities to deliver efficiency and it is part of what we're thinking about going forward. I'm not sure we have it all baked in as we think about the rest of the year and we haven't been that descriptive on it yet, but I mean we've got to keep a little bit in our pocket, right?

Neal Dingmann - SunTrust Robinson Humphrey, Inc., Research Division

Sure, sure. And then lastly, just on the pricing, you talked about sort of seeing some of these pricing should start to stabilize, I guess, or maybe even improve beyond that. Is that based on the tenders, Dick, that you're already seeing? Or do you assume that the tenders will continue and you will even potentially see more pricing beyond this?

Richard J. Alario

It is based on our expectation that these large tenders that we've seen come in recently will consume capacity in the market, whether it's Key capacity or someone else's capacity at first. The fact that it's going to tighten things up will, as we said, provide a more constructive environment in the back half of the year. It's also based on the levels of activity that we're hearing others talk about and experiencing ourselves in certain service lines. I mean, when you -- I go back to some of our commentary on the large-diameter coiled tubing, when you hear us say that we were 100% utilized coming out of Q1, obviously, there's not a whole lot of that being delivered to the market in terms of new capacity. So we believe it will be one of the first ones where there will be some pricing inflection in the back half of the year. It's just an example. I'm not saying that, that's the complete list, but that's the example as you get to 100% utilization. Then you have the expectation that it's firm enough to be able to possibly get some pricing as the year unfolds.

Operator

Your next question comes from the line of Trey Stolz from Iberia Capital Partners.

Earl A. Stolz - Iberia Capital Partners, Research Division

Just kind of go back to the margin guidance. Mostly talked about the 250 to 350 basis point improvement quarter-over-quarter, but if we look back, I think you said it was 220 basis points for payroll taxes, another 50 or so for weather, is there any operating leverage we should expect because I guess the guidance range doesn't account or allow for much?

J. Marshall Dodson

As Dick said, we hope to gain some efficiencies eventually move through and recall, that we had weather in the fourth quarter. We're kind of moving out of the down 2 quarters where we have weather and seasonal impacts. So that ought to be a benefit to us as we move into the second quarter and beyond. And we also will have the pressure, again, on our margins in the second quarter of the rig moves from Mexico. So we've got 12 rigs here in the States right now that we're working on as fast and as hard as we can to get out into the field and get working and that's kind of the second part of the process. And we've got another 12 that are about to get on trucks and are starting to move into the U.S. so we can go through that same process again.

Earl A. Stolz - Iberia Capital Partners, Research Division

And the rig moves and maintenance work there, any way you can quantify the impact maybe on the cost line for the quarter?

J. Marshall Dodson

Yes, so we had before talked about it at $250,000 per rig and spread kind of over the first half of the year and that's, what, $1.5 million a quarter. And so I think that's a pretty good average to use on the next dozen. We also mentioned that we had costs not only in the first quarter associated with the U.S. in getting the rigs into the U.S. but also with our domestic fleet in terms of getting some other rigs ready to go to work and moving them into position, so that shouldn't weigh on us as much next quarter.

Earl A. Stolz - Iberia Capital Partners, Research Division

All right. And moving on to the International segment. You mentioned Mexico being a slight drag on a cash flow basis and I assume the $7.5 million [indiscernible] figure probably still in effect. So are we looking at operating income or operating loss of something just over $7.5 million from that guidance?

J. Marshall Dodson

For...

Earl A. Stolz - Iberia Capital Partners, Research Division

For the International segment.

J. Marshall Dodson

So, well, a lot of -- there's a lot of different moving pieces in there, but it's going to be -- we're calling for about a 2,000 basis point improvement in our operating income margins Internationally. We're going to have a little bit less DD&A as we move rigs out. So depending on how many get out, that will impact the numbers some. But we would expect around a 2,000 basis point improvement in the margins and a slight decrease in the revenues.

Operator

Your next question comes from the line of Blake Hutchinson from Howard Weil.

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

Dick, you've talked a lot about the tendering process here from a qualitative basis. Can you help us understand a bit better because I think historically, we might have looked at your combination of businesses and thought of it as close to all spot all the time as any group of businesses out there. In terms of quantitative -- quantitatively, what portion of -- either your overall or maybe rig services asset base, could be subject or attached to in the tender-based activity versus spot. And just to clarify, Marshall has talked a lot about getting rigs ready, getting rigs ready to work. Are we consciously kind of holding assets out of the spot market to have availability for some of these tenders?

Richard J. Alario

Well, Blake, on the first question, I'm not sure that we will see a material increase in the amount of our rig capacity that's going to be bound by contracted arrangements. That's not the difference that we're citing here. What we're citing is that these are projects that we've anticipated coming to the market for a long time and the 2 aspects that we're commenting on is that they are pretty sizable in that they are horizontal oil well workovers. So they have service intensity, far beyond, what we see in our legacy shallow oil fields. And then the fact that they are large in terms of well number, when you get awarded 100-well project to do these rig completions, I mean this takes a long time to get this done and you're able to put a lot of focus on the efficiency of your operation and managing our own costs and things like that, delivered, as we said in the prepared remarks, a really good outcome for the customer in terms of being able to afford to save him some money. So we couldn't be happier about the advent of that sort of thing because it's a big question that has been asked of us many, many times. The answer to your second question is no, we're not holding back anything. But you should read into the fact that, as you heard Marshall say, we're spending more than the normal amount of money on getting rigs that are in stockyards ready to go to work than we normally do, because we see the sort of impending demand increasing, and we will take advantage of that. Again, not necessarily on a spot or contracted basis as far as we can predict right now, just on a general demand, and we expect that these larger customers who have these more pronounced projects, that they want to be pretty methodical about, that's the kind of work that Key is well set up for. So I'm not sure that we're calling a difference in the level of contracting commitment but we are seeing a difference in the level of demand and we're seeing these projects, which are much more complex and use 24 hour operations, large rigs and a lot more ancillary equipment, that's sort of the positive side of this.

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

Okay. And then just within the Rig Services business, the flat kind of revenue trajectory here sequentially, it kind of highlights the fact that California must have been a huge headwind. Can you help us understand how that might proceed going forward? Are we still on a kind of a quarter of recovery and flat into June before improving in the back half or what does that hold as in such a large contributor to that Rig Services business.

Richard J. Alario

Yes, we -- it did affect us materially, so you read that right. As I said, we have some other opportunities out there to reverse that and we're looking at those as we speak. But part of the issue out there, a big part of the issue is whether that's abated, a big part of the issues was some permitting delays in various counties in California, that hasn't gotten a lot better but it's improved as our customers learn to deal with some of the new permitting regulations that have been put in place out there. And so can I tell you that it will all be behind us at the end of this quarter? Hard to say at this point. It will certainly be improved as we go into Q3.

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

And then just a quick follow-on. You talked a lot about some improvement in some of the business lines exiting the quarter. Your broad guidance for 2Q in the U.S, is that more premised on kind of what you see is what you get from March-type -- March and April-type results? Or do we need some the back half of second quarter spending to kick in to kind of fill out those numbers?

Richard J. Alario

Blake, we're playing that kind of right down the fairway. We fully expect that we'll see some back-half improvement in the quarter but essentially, we are basing that off the run rates that we're currently seeing in the business.

Operator

Your next question comes from the line of Kurt Hallead from RBC Capital Markets.

Kurt Hallead - RBC Capital Markets, LLC, Research Division

Appreciate the color you guys provided this morning. Understand the comments pretty clearly coming across that the international market generally had bottomed and most of that alluding to Mexico. With the reduced loss on the International front going into the second quarter, what's your anticipation of when you can then get back into the black? You think that's something that could transpire in '14 or is it something that we'll -- we might have to wait until '15 for?

Richard J. Alario

Kurt, it's Dick. I think what we're saying is that, it's not going to take up, once we -- especially, once we get to next tranche of rigs out of Mexico and the DD&A drops as it will, then it doesn't take a whole lot for us to turn that corner. And based on commentary that we've seen from Mexico, from government budget planning, commentary that's just recently come out based on the view of some other large multi-faceted service companies who own some of these incentive contracts and integrated contracts, we are more encouraged about the back half of the year than we had been over the past couple of quarters. So the good news is -- that's why we say that we now have this option in our business model on the Mexican comeback because it doesn't take a whole lot for us to turn that corner, particularly after we get our DD&A down here over the next few months.

Kurt Hallead - RBC Capital Markets, LLC, Research Division

But in the...

Richard J. Alario

It very well could happen in the back half of the year, I guess, is what I'm saying. But we're being cautious because there's still a lot of things that have to snap together. I will make one more comment that we didn't have in our scripted notes, much as we talked about in the U.S. where some large production-driven tenders have come to the market recently. In Mexico, we've also recently seen a number of opportunities from integrated service companies under these incentive contracts, and some of those are under negotiation now, and hopefully, those will, as you sort of indicate, will get started sooner rather than later. I'm not ready to make any announcement at this point.

Kurt Hallead - RBC Capital Markets, LLC, Research Division

Okay. And when we look at the U.S. market, gave some earlier indications as to what product lines are doing well for you and what may still kind of be challenged. But what do you think from a growth standpoint -- maybe phrase it differently? What are some of the product lines that you think, in the second half of the year, could show the greatest improvement, second half versus first half?

Richard J. Alario

Well, we think that our rig business could see some very, very nice upside as some of these things we've talked about come to fruition. The second thing I would call out is in our rental business, I don't want you to miss the comment that Marshall had at the end of his script, we have already found some opportunities to shift some capital under our KVA assessment program that we have just now installed in the company, haven't really completely embraced it yet. We've already found some opportunities to some of the 2014 capital, which was almost totally maintenance-based, we've now found a way to free up some of that and have some demand on the premium drill pipe side and on some saltwater disposal wells in some premium locations in the shale plays that we can now get after here over the next quarter or 2. Some of that's already been ordered and we're in the final negotiations on a couple of SWDs. So we have, in fact, found some growth opportunity. And so I would say, those would be the first ones that will react. The other one I think that there is some mention, is what we put a little bit of color on in the script, which was our mid-sized coiled tubing fleet. Every day that goes by, we get better at finding ways to use 2-inch coil almost as effectively in certain types of well architecture as 2 3/8, and 2-inch is where we have the most oversupply, and that's not just true for us but for everybody. So if we can continue to get some traction there, that's a real nice growth opportunity, because it really throws some nice margin off because the asset is already sitting there and if we can find some more work for it, it becomes pretty effective.

Kurt Hallead - RBC Capital Markets, LLC, Research Division

Okay. And your comments on natural gas activity did get my attention because to this point, quite frankly, I haven't heard much in the way of moving on the natural gas front. So just could you maybe expand on that a little bit more for us?

Richard J. Alario

Well, let's start with exactly what we said. We don't -- we're not calling this an inflection point, but we're calling out some things that we haven't seen in several years that are now being seen and we felt it was -- or feel it's important that the market understand that Key is well positioned. We haven't abandoned the gas market. We still have facilities and people and relationships there, mostly over the last few -- several couple of years, actually, doing work in particularly areas where you have a good oil and gas production mix. Now, what we've seen are the early signs of a handful of customers who have taken advantage of the short-term commodity price inflection to go turn on some old gas wells that have good return metrics associated with these prices and the cost to do this. And at the same time, and as you well know, there has been some pickup in some of the poor acreage areas of particularly places like the Haynesville, where we find better opportunities. But again, don't read this into Key making -- putting a stake in the sand at this point, but read this as Key saying that we've begun to see some encouraging signs and we would be much more encouraged if we continue to see those signs. We cited a couple of examples of things with the coiled tubing unit that's now returned to East Texas and has good level of work lined up for it. And we haven't seen in that 8, 10 quarters. So it doesn't take a whole lot to encourage us and that's what I'm telling you. Our mindset is it's much more positive than it has been.

Operator

Your next question comes from the line of John Daniel from Simmons & Company.

John M. Daniel - Simmons & Company International, Research Division

Some are just some housekeeping. Marshall, I think you mentioned Q1 international rig count was 29 rigs. Can you remind us what Q4 was and then expectation for Q2?

J. Marshall Dodson

Q2, I think we talked about 27 rigs. I'll have to get back to you on the fourth quarter, I can't remember off the top of my head right now.

John M. Daniel - Simmons & Company International, Research Division

Okay. And then, Dick...

J. Marshall Dodson

It was around 30, I think. 30, 31 but...

John M. Daniel - Simmons & Company International, Research Division

And if I could put you guys to expand on the success in the Bakken. I think, Dick, I was trying to write quickly, but a customer in the Bakken where you expect to do or you're working about 25% faster than their expectations. Was that -- were those rigs employing the KeyView system and can you just expand on what drove that efficiency?

Richard J. Alario

Those rigs do -- the equipment we have up there does employ the KeyView system and it is part of the reason that we've been able to drive that efficiency. These are -- I'll give you a little more color. These are some of the first wells that this operator installed in the market -- in that oil shale. These are open hole -- these were originally open hole completions, where we're now going in and doing a complete redo with a refrac and all the associated -- we're not doing the frac-ing obviously but all the associated services that go along with that. By the way, we've also seen some production results and not only is it going well in the field but the customer seems to have every reason to continue on because the production results are pretty good. These wells are not getting to their original IPs but they're getting pretty darn close. So without commenting on their economics, it looks like they should be happy with the funds they're spending to get these wells redone. And again, the point I want to make is, a, we know how to do this stuff; b, we can do it even better than the customer -- this particular customer had cited it, at least in terms of how much time it takes; and we think it's the beginning of a level of activity that really hasn't been present in the business before. Again, this is what we've been saying about why we build big rigs and big coiled tubing units and invested in some of the other services that are required to do this kind of work. As you know, oil wells require maintenance. Horizontal oil wells require maintenance as well, and it's encouraging to begin to see some early signs of some reaction to that by our customers.

John M. Daniel - Simmons & Company International, Research Division

Okay. Just 2 more for me. And on that last question, I mean, given the success with that case study as you've seen earlier, have you been able to take that case study to other customers in the area to try to encourage them to do similar things?

Richard J. Alario

We are doing work around that right now. Haven't gotten to the point yet where we can, but we -- that's one of the things that we have some people looking at.

John M. Daniel - Simmons & Company International, Research Division

And then the last one for me. If you build the 15 new rigs that are coming out this year, do those automatically get the KeyView system or is that based off of a customer request?

Richard J. Alario

All of our new rigs get the KeyView system. Everything we build now receives KeyView.

Operator

Your next question comes from the line of Marshall Adkins from Raymond James.

J. Marshall Adkins - Raymond James & Associates, Inc., Research Division

You're pretty clear on the whole U.S. margin front and it sounds like a lot of that -- the margin improvement not being better is associated with the moving rigs back from Mexico. But 4% to 6% sequential growth just seems like, given the weather impact, that you have more Mexico rigs, you have more daylight hours, are you just being a little conservative there in the guidance for revenues?

Richard J. Alario

We're not getting out over our skis, Marshall. But listen, we -- as I said, a lot of tendering activity took place, some of it has yet to be decided and while a good bit of it could put some rigs and trucks and various things to work this quarter, we sort of want to see that begin to happen before we stretch any more. So read that like you will, but that's still above typical seasonality.

J. Marshall Adkins - Raymond James & Associates, Inc., Research Division

Right, right. Okay. The whole KVA thing, well, I actually think that's a big deal and I think it's great to push for better returns. Give us more detail on what you're doing there in terms of timing, and can you quantify any of the improvements you expect to see or is it just too early?

Richard J. Alario

We'll make some comments about that. First of all, in terms of where we are, we began to install the training or began to do the training around value-added approach January. And we've probably covered 2 levels of the organization thoroughly and are at the point now where we're getting to reach down to the regional/district level explaining to our people what this financial metric means and how they should think about it. The next step will be to -- and we've already started this, go back and look at what our plans are for this year. And so my first point is we have begun to do that and it has begun to have some effect. We were able to free up -- I don't want to get in the numbers yet, but were already able to free up some capital out of our 2014 budget, which was formally put aside for maintenance type work and it's now been driven more towards the growth side. So that's what you should expect. You should expect a more efficient capital organization, one that pays much more attention to the cost of capital. And the behavior is not fully healed at this point, but certainly by the end of the year, this is going to be embedded into our company, it's going to be a very staunch part of our culture.

J. Marshall Dodson

And Marshall, this is Marshall. Just to add one thing to -- a point to what Dick said. Under this methodology, the replacement asset costs as much as the new asset. And so the replacement asset with no growth carries a penalty but if you can get the new asset, it also covers your KVA yields growth, that's kind of the capital allocation distinction that's going on.

J. Marshall Adkins - Raymond James & Associates, Inc., Research Division

Well, it sounds like you're pushing us all the way down to the district level and when we look at the impact, really, you're starting to see some but it's more a '15 event than it is '14?

Richard J. Alario

I think that's very fair. You'll see some results in '14 but the more dramatic effect will happen next year.

Operator

Your next question comes from the line of Scott Levine from Imperial Capital.

Scott Justin Levine - Imperial Capital, LLC, Research Division

So I wanted to ask about the fluids business. It's seemingly you guys obviously have been pretty cautious about that business or downbeat with regard to fundamentals. I'm wondering whether you've seen any improvement there. And I think I heard some mention of interest in saltwater disposal wells, maybe a little bit more color on your thoughts on that business in general?

Richard J. Alario

Well, one of the things that we certainly recognize is that one of the keys to be successful in the water -- fluids management business is to have disposal wells in the right places. And to be frank, we've been less than aggressive in that area over the last couple of years as we focused most of our -- almost all of our new capital that went in the business went to the Bakken, where we did buy some disposal wells and have a good network of disposal capabilities. However, we didn't do that as much in places like the Eagle Ford and other resource plays. We're now turning our attention to those and so following on to some of the discussion you've just heard about KVA and what makes sense and what doesn't in sort of the new way we're thinking about things, certainly putting saltwater disposal capabilities in markets, which have a long fairway of solid water management growth ahead of them like the Eagle -- obviously, the Eagle Ford as an example, is a place where we're now going to allocate some of our capital. And it's going to enhance -- that business -- it's going to allow us to save some costs in places where we're using public disposals. It's going to allow us to better service our customers and be more competitive on a pricing basis. So kind of all around, sort of good things and a little bit of a rejuvenated view of the Fluid business on our part.

Scott Justin Levine - Imperial Capital, LLC, Research Division

Got it. And one follow-up, if I may. And I think you mentioned, start of the year, you guys were looking to pay down a little bit more debt. Maybe some additional thoughts with regard to that? And maybe at what level would you guys start looking at maybe some more growth investment or maybe a little bit more color on your thoughts on the balance sheet?

J. Marshall Dodson

Well, so we're sitting at a net debt to capital of around 36%. That's what we've targeted, a net debt to capital of mid 30s for quite a while. We have $85 million, I think, prepayable under our credit facility and as we look out through the year, we'll be going through and applying the KVA lens to our cash flow and our capital and we'll allocate it in there.

Operator

Your next question comes from the line of Daniel Burke from Johnson Rice.

Daniel J. Burke - Johnson Rice & Company, L.L.C., Research Division

Actually, one other question on the fluids business. I apologize if I've missed this earlier. But you all talked about regional revenue mix in the press release also affecting fluids. And if it's -- did you mean to say that fluids had a negative impact due to regional revenue shifts and can you help me better understand that?

Richard J. Alario

Well, I don't think we cited fluids particularly, but as I think that we've -- one of the things we're sort of highlighting there was the California situation. We don't have a big fluids business in California, so it wasn't as prevalent in that business as it was in rigs.

Daniel J. Burke - Johnson Rice & Company, L.L.C., Research Division

Okay, great. That's helpful. And then in terms of the commentary saying that production services growth will trail the rate of growth that you see coming in the completion services business. Again, this has been gone over a couple times, Dick, and you just alluded to it. But if you look at Rig Services business x California, would you assume that business could match the rate of revenue growth you anticipate on the completion side?

Richard J. Alario

More so than with California for sure. Although, again, given our customer profile, even in some other areas, there's -- we think theres's going to be a little bit of difference between the uplift, and don't misread what we're saying. We see traction there, just not as fast as on the completion side. One of the things has been, to some degree, surprising and more encouraging this year has been the speed with which operators have been attacking new well construction in these shale plays and in the Permian. And sort of the same syndrome we saw back in the early days of horizontal well installation, where more capital was being shifted into those areas than what had traditionally been done and it's been a little bit surprising at how much new well construction focus the customer base has had. Now again, as the cash flows of those companies continues to improve based on an increased production, that's going to free up more cash to go take care of the existing wells both in horizontal shale markets and in legacy markets that they -- those companies own. So we think the production services business is just lagging a quarter or 2. There ought to be some catch-up there at the back half of the year.

Daniel J. Burke - Johnson Rice & Company, L.L.C., Research Division

That's helpful. And then to cram one last one in. The international rig count sequentially moving flat to down, just to check, given the rig count is flat, what drives the improvement sequentially in your other international markets?

Richard J. Alario

The better mix of rigs working on contracts that are a little bit more profitable.

J. Marshall Dodson

We're also getting past some of the startup phase we had. We started up in Ecuador last year, that's kind of now all up and going. So it's moving with -- remember we moved out -- our first move with rig in Mexico was out of Mexico into other international markets. So as all that gets up and moving, that now allows us to kind of move up the curve and into more stable operating margins.

Operator

And your last question comes from the line of Mike Urban from Deutsche Bank.

Michael W. Urban - Deutsche Bank AG, Research Division

Just a clarification on Mexico. I think you said you had 17 rigs still in the country? Does that include that next [indiscernible] that still needs to come back to the U.S.?

Richard J. Alario

What we're saying, Mike, is we will be left with 17 after we move the next dozen out that we've -- we haven't really started that yet. We'll start that next. That will be additional.

Michael W. Urban - Deutsche Bank AG, Research Division

Okay. So that's all that will be left.

Richard J. Alario

Yes. After everything, that will be left.

Michael W. Urban - Deutsche Bank AG, Research Division

Okay. So that does leave you a good bit of potential leverage there if things get better. Okay. And then on the rigs that you have moved back and continue to move back, you highlighted the impact of the unit cost to mobilize those and do the maintenance there. Clearly, that's going to impact the second quarter. As you bring that next group back, does that also move into an impact to Q3 a little bit as well?

J. Marshall Dodson

Yes, so if we kind of take the same -- take 2 quarters to move them all here, move them through the process to get them out and ready, there's going to be a little bit of bleed over into Q3 from the second group of rigs.

Michael W. Urban - Deutsche Bank AG, Research Division

Okay, okay. And then last thing for me is you gave us some color on a couple of different categories of utilization for coiled tubing. What's your overall fleet utilization right now?

J. Marshall Dodson

I think in the mid-50s.

Operator

And we have no further questions at this time. I would like to turn the call back over to our presenters.

West Gotcher

Thank you, Jeremy. This concludes our call. The replay of this call can be accessed on our website, keyenergy.com, under the Investor Relations tab. Also under the Investor Relations tab, we will post a schedule of our quarterly rig interim hours after this call. Thank you for joining us today.

Operator

And this concludes today's conference call. You may now disconnect.

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