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Tesco (NASDAQ:TESO)

Q1 2014 Earnings Call

May 05, 2014 9:00 am ET

Executives

Julio Manuel Quintana - Chief Executive Officer, President and Executive Director

Christopher L. Boone - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Fernando Rafael Assing - Chief Operating Officer and Executive Vice President

Analysts

Robert J. MacKenzie - Iberia Capital Partners, Research Division

Jeffrey Spittel - Clarkson Capital Markets, Research Division

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

Thomas Curran - FBR Capital Markets & Co., Research Division

Matthew Marietta - Stephens Inc., Research Division

Operator

Good morning, ladies and gentlemen and thank you for standing by. Welcome to the Tesco Corporation First Quarter Earnings Conference Call. [Operator Instructions] This conference is being recorded today, Monday, May 5, 2014. And I would now like to turn the conference over to Mr. Julio Quintana, Chief Executive Officer. Please go ahead, sir.

Julio Manuel Quintana

Thank you, Luke. Good morning, ladies and gentlemen, and welcome to TESCO's First Quarter 2014 Earnings Conference Call. I'm Julio Quintana, TESCO's President and CEO, and I will be hosting our call today. Chris Boone, our Chief Financial Officer; and Fernando Assing, Executive Vice President and Chief Operating Officer, are with me on the call. I'll begin with some general comments on the quarter, and Chris will give you an overview of our financial results. Following Chris' remarks, I'll return and provide an update on our business and plans for the future. Then we will switch to our presentation on the 5-year strategic plan. And finally, open the door -- floor for questions on both our financial results and on our 5-year plan. When we switch to the 5-year plan, you can follow our presentation by going www.tescocorp.com in the Investor Presentation section.

Before I begin, it is important to note that during the course of this call, Chris and I will make forward-looking statements within the meaning of the Private Securities Litigation Act of 1995 and Canadian Securities Legislation. These statements are based on current expectations and involve risks and uncertainties, which could cause actual results to vary from those anticipated. These risks and uncertainties have been and are more fully described in our annual reports and quarterly reports filed with the SEC and with securities regulatory authorities in Canada. You should not place any undue reliance on these forward-looking statements made in the conference call, nor do we intend to update these forward-looking statements. Also, we will use certain non-GAAP measures. The earnings release issued this morning contains an explanation and/or reconciliation of these measures to GAAP measures, and we refer you to that release for additional information.

Now on to our first quarter results. We reported adjusted net income for the quarter, ended March 31, 2014, of $8.4 million or $0.21 per diluted share. Adjusted net income for the first quarter excludes the after-tax impact of foreign currency translation losses in Argentina, Venezuela and Russia, totaling $2.9 million, or $0.08 per diluted share; bad debt from 2 international customers totaling $1.6 million after-tax, or $0.04 per diluted share; and certain tax-related charges in Latin America totaling $900,000 or $0.02 per diluted share.

Reported net income and EPS for Q1 was $3 million, or $0.07 per diluted share, or $121.4 million of revenue, compared to $5.5 million of net income or $0.14 per share in Q4 2013 on $136.9 million of revenue.

As we advised in our March call, Top Drive shipments were lower in Q1 2014 due to the timing of shipments from backlog, and lower Top Drive rental utilization was a result of contract startup delays in Mexico. Adjusted operating income decreased during the quarter to $11.4 million, down from operating income of $12.2 million for Q4. This drop was essentially a result of $15.5 million lower revenue. Nevertheless, our operating margins were slightly up from Q4 2013.

During the first quarter, there were several positive trends that give us greater optimism for the full year 2014 results. Tubular Services generated record quarterly revenues of $56.7 million, record adjusted operating income of $12.3 million and record adjusted operating margin of 21.7%. With continued growth of offshore work and improving activity levels in North America, we believe Tubular Services is on track to post another record year.

In addition, we ended the quarter with a backlog of 45 units, with a total potential value of $54.7 million, an increase of potential value of almost 25% over the prior quarter. With a backlog of 43 units for the total potential value of $51.9 million at present and a number of active quotations, we believe the expected new Top Drive shipments in 2014 could begin to approach 2012 levels.

Our balance sheet and cash flow generation continued to be strong. Cash levels remained flat during the quarter that typically has higher cash outflows. This strength, combined with improving profitability, will allow us to make investments that drive growth along with turning -- along with returning cash flows to shareholders.

I will give more detail into this after Chris summarizes the financial results. Chris?

Christopher L. Boone

Thank you, Julio. I will discuss our first quarter operating results by business segment and then give some comments on our corporate and research and engineering expenses. Please note that many of the details previously reported on these calls are now included in the press release.

Starting with Top Drives. Revenues totaled $64.7 million for the quarter, a decrease from $81.9 million in Q4. The decrease from Q4 is primarily a result of decreased Top Drive sales and fewer rental service days in Mexico. With 19 new units delivered to customers in Q1, we ended the quarter with a backlog 45 Top Drive units with a potential value of $54.7 million, up from 32 units, with a potential value of $44.2 million at the end of Q4. Today, our backlog stands at 43 units.

Operating income before adjustments in the Top Drive segment for Q1 2014 was $10.7 million, compared to $15.8 million in Q4 2013 and $15 million in Q1 2013. Our Top Drive operating margins, before adjustments, were 17% in Q1 2014, a decrease from 19% in Q4 2013 and 20% in Q1 2013. Excluding adjustments of $900,000, operating income was $11.6 million, and operating margins were 18%. The decrease from Q1 2013 is primarily due to the decreased Top Drive rental operating days in Latin America and the lower Top Drive deliveries.

Now on to Tubular Services. Revenue was a record $56.7 million in Q1, up from $55 million in Q4 and up 11% from $51.1 million in Q1 2013. Automated casing running revenue was $45 million in Q1, effectively flat to $45.3 million in Q4. Our Q1 2013 automated casing running revenue was $40.2 million. Conventional casing running revenue increased to $11.7 million in Q1 2014, compared to $9.7 million in Q4 2014, primarily due to increased conventional job activity in the Middle East. Our Q1 2013 conventional revenue was $10.9 million.

Overall, Tubular Services operating income, before adjustments in Q1 2014, was $10.9 million, compared to our operating income of $8.6 million in Q4 2014 (sic) [Q4 2013] and $7.4 million in Q1 2013. Our Tubular Services operating margins were 19% for Q1 2014, up from 16% in Q4 2013 and 15% in Q1 2013. Excluding adjustments of $1.4 million, operating income was $12.3 million, and operating margins were 22%. The increase from Q4 2013 was primarily due to increased flow-through to operating income in the Latin America and Middle East regions.

Now on to corporate expenses, which were $9.7 million for Q1 2014, compared to $10.4 million for Q4 2014 (sic) [Q4 2013] and $10.5 million in Q1 2013. Research and engineering costs for Q1 2014 were $2.5 million, compared to $1.9 million in Q4 2014 (sic) [Q4 2013] and $2 million in Q1 2013. Foreign exchange losses for Q1 2014 were $3.3 million, compared to $2.3 million in Q4 2013 and $400,000 in Q1 2013. The foreign exchange loss increase was primarily driven by Latin American currency devaluations during the first quarter of 2014.

Our effective tax rate for Q1 2014 was 41%, compared to 32% in Q4 2013 and 30% in Q1 2013. Our effective tax rate, which is expense -- which is income tax expenses as a percentage of pre-tax earnings, increased from Q4 2013 due to the fluctuating mix of pre-tax earnings in the various tax jurisdictions in which we operate around the world, the nondeductible nature of foreign exchange losses and a $400,000 increase to tax expense for audit adjustments in a foreign jurisdiction in Q1 2014.

Turning to the balance sheet. At March 31, 2014, cash and cash equivalents were $97.2 million, compared to $97.3 million at December 31, 2013. Total capital expenditures were $8 million in Q1 2014, compared to $9 million in Q1 2013. We project our total capital expenditures for 2014 to be approaching $45 million based on current market conditions.

I'll now turn the discussion back to Julio.

Julio Manuel Quintana

Thanks, Chris. We clearly experienced several unexpected costs below the operating level, which are disappointing. However, the base business continues to be solid, and in fact, is strengthening. Some highlight includes: General industry activity in North America continues to show signs of improvement. Depending on how activity progresses, it could lead to positive price strengthening for the first time in a couple of years. Tubular Services set, again, another record in revenue. As importantly, our operating margin of 21.7% is well ahead of our stated 20% objective. This increase is particularly impressive since North American land pricing continues to be depressed. Our Gulf of Mexico deepwater contract is barely initiating and our CDS product sales was lower this quarter. This increase in profitability is a direct result of the phenomenon we have been describing to you around building critical mass in the countries where we work.

Next, backlog and order flow is at the highest it has been in a couple of years. There were several clear indications that the products business is continuing to strengthen. If orders continue like they have for the first 4 months of the year, we could approach 2012 record deliveries. We also delivered successfully and profitably our first automated catwalk, a watershed moment for Tesco moving from a Top Drive company to a products company. As mentioned, our cash generation continues strongly. The first quarter is often a high-cash-demand quarter, and yet our cash balances held nicely.

Finally, Mexico rental was down, but trends point toward a stronger second half for the whole of this business. Further, we are working with a customer in Mexico to help them move forward with their Top Drive needs, and fully expect to see improving global utilization for the rest of the year. So overall, business trends are making us bullish on the next several quarters.

This, again, is an excellent segment into the presentation of our 5-year strategy. We will be presenting a series of slides. Anyone interested can follow our presentation through the webcast. Instructions can be accessed on our website under the Investor Relations tab. We will take 1 minute to set up the presentation, and after that presentation, Fernando, Chris and myself will gladly answer any questions on either the quarter or on the strategy. So please stand by for 1 minute or so.

Okay. We will now move over to the strategy discussion. So again, you may follow at www.tescocorp.com. So as we discussed back in January, we spent several months, as we do every 12 to 18 months, reviewing the 5-year strategy of the company. In this particular case, we did a very detailed model, both deterministic and probabilistic models, to really understand our market, understand the next 5 years. And the presentation that you're seeing is a condensed version of that analysis. So follow along with me, and we'll go from there.

So I'm on the slide, The 5-year Plan Objectives, I guess. Okay, they see it, so I apologize. Okay, so when we look at the 5-year strategy, there's 2 overarching aspects to the strategy. The first one is a recognition that with the strong cash flow that we are generating, we need to invest more aggressively than we have in the base business. So the first part of that strategy calls us to invest both in organic growth, as well as in bolt-on acquisitions to drive the business faster.

But just as importantly, the second half is that we actually have the ability to not only invest aggressively in our business, but to also return cash to shareholders. And so as you saw this morning, we're initiating a program to do just that. We believe this will drive our business from today's roughly a $500 million business to over $1 billion revenue annually by 2018, and drive our profitability such that, by 2018, we're yielding a 20% return on capital employed.

To further break down that reinvestment strategy, as we mentioned, a key part of the strategy is the cash flow generation and the proper redeployment of that cash. Over the next 5 years, we will be deploying a total of $650 million in cash that will be invested 4 different ways. We plan on investing $250 million in capital spending, primarily to expand the Tubular Services business. In addition, $250 million in bolt-on acquisitions, and Chris will get more into detail on exactly what that consists of. Then we're going to do an initial repurchase -- share repurchase of $100 million. As you saw, we have a schedule over the next 2 years, and we underline the term initial in that, as the cash flow generation becomes clear over the next several years, we could easily do more than that. And then finally, a cumulative -- estimated cumulative dividend over the next 5 years of $50 million, and we will do that on a quarterly basis. The sum of those 4 adding up to an estimated $650 million over the next 5 years.

When we think about how we're going to get there, you've heard us say time and time again that the need for critical mass, the foundation that we have is really a fundamental part of our strength as a company. You've heard me say that the company is, in many ways, stronger than it's ever been and really positioned for growth. We spent the early 2000s growing nicely. And as the downturn came, we adjusted accordingly in the last 2, 3 years, and really getting ourselves ready for the next growth spurt, and that growth spurt is here. So there's kind of 4 overarching focus areas that we want to emphasize on how we're going to get there.

The first one is, again, what I already mentioned, which is the effective cash deployment, and really optimizing the balance sheet to get maximum leverage on the business. The second one is execution excellence. We really do believe that we are highly differentiated in our space, both because of our service provision with our customers, but also our focus on quality, on health and safety. And we believe that the company, to maintain that level of service differentiation, will ultimately win the game. So a key part of the go-forward strategy is a continual obsession with this concept we have of quality.

The next one is -- and you saw is the, certainly this quarter with Tubular Services, is the leveraging of the global infrastructure. A very small-moving revenue, when you have such an investment in the global scale, makes a big difference to the profitability of the company. And so a key part of the strategy is to look at each of our geo market and ask ourselves, how can we drive profitability and grow faster through those markets? So really a fundamental part of the strategy is not about expanding into 15 different markets, it's about doing more with what you have, with the customers that you have in the geo markets where we operate.

And then finally, TESCO likes doing things differently. We believe that we are highly differentiated in our space for what we do. And through both new products that we're going to introduce, as well as this concept of best-in-class differentiation and service, you will see a highly differentiated company, both to our customers and, we believe, ultimately, to our shareholders.

So with that as the backdrop, then I'm going to ask Fernando to give you a little bit more detail on a segment-by-segment basis as to what we mean by this 5-year strategy. So Fernando?

Fernando Rafael Assing

Thank you, Julio. We're on Slide 7. Our strategy implementation is divided in 2 key areas: Growing our core and maintaining focus in our execution excellence. Let's address growing our core first. A key aspect of TESCO going forward is a significant opportunity for growth. We have built a strong platform and we have made investments that position us well in key markets. We now need to add critical mass in those markets, as Julio just referred. This strategy centers on accelerating that. The bulk of the growth identified will come from Tubular Services, next is our aftermarket business, followed by product sales.

Tubular Services is really poised for aggressive growth. Most notably, we want to double the offshore contributions from 15% to 30% of revenues. That market growth is viable and this is achievable. We will aggressively expand into adjacent businesses to leverage our platform, and we will pursue bolt-on acquisitions in the places in which we operate. We will evolve our Top Drive business from selling Top Drives to one that more broadly supports our customers pipe-handling process fleet. We will be the corner that will keep their rigs running. We will add significant new technologies, too.

These are aimed at automating all of the pipe handling, and this is from the arrival of the tubular to the location, to the cementing of the casing and the running of the completion in the well. We will also add technologies that allow for remote monitoring and management of all those processes. Some of these technologies are under development, by the way. We are talking about a vast market. With this, we can claim that we are global, and we're really ready to grow.

Next slide. Slide 8 -- 9. I'll now talk about execution excellence. We have been very focused over the last couple of years on this, and can now see some of the benefits of those earlier efforts. It's time now to take that execution excellence to the next level. The cornerstone of this effort, as Julio just referred, will remain our commitment to our agency [ph] and our quality.

So now let's go quickly over our priorities to get that execution excellence to the next level. We need to continue to optimize our cost. The focus is on a combination of 2 things: The actual cost reduction of at least 10% of -- in average, for parts and products; and in controlling our indirect cost structure. This includes corporate and SG&A. The idea is to grow those costs at a slower pace than revenue, and we're really well-positioned to achieve both.

We need to capitalize on what we do best, and our reputation and track record provides a solid platform for that. For example, we can improve our Top Drive operating margins by selling more aggressively to fill out -- to fill our installed manufacturing capacity. We can also do this for our aftermarket services, for which we have a vast, large network.

In addition of the catwalk -- in addition, the catwalk product line is really a great example as it will provide incremental revenue with little additional indirect costs. We will be looking to replicate that success in a number of areas. There is also a lot more we can do by continuing to optimize and automate our processes. Our global ERP is now up and running, and investments made in our global process improvement team are now starting to pay off. The full benefit of those initiatives are still to come.

Lastly, we are and will continue to be the drilling innovation company. New technologies play a significant role in this strategy. And we need to get those technologies in the market even faster. In fact, we're committed to just doing that: Doubling the revenue contribution from new technologies within the next 5 years. For that, we will systematically measure, moving forward, the revenue generated by those new technologies that are less than 5 years old.

Next slide. Speaking about our platform. Two businesses -- 2 business segments on the one global platform does provide for significant synergies. Our platform is solid. The strategy going forward is about leveraging what you need to extract incremental profitability. We can't think of no other company of our size that can match our global coverage. We're ready to grow effectively and profitability.

I'll spend a few minutes in this slide to detail this. It's important, since we have 2 businesses, what our strategy calls for 4 targeted implementation.

First, we'll expand our Tubular Services business to become broader and more integrated. We'll be looking at a full Tubular Services offering that particularly targets to the complex wells and offshore markets. This includes both casing running and completion running. One example of this is we have right here, is the large offshore integrated Tubular Services contract in the Gulf of Mexico you have heard us disclose in prior quarterly calls.

Second, we will take advantage of our significant installed capacity to expand our product sales portfolio. Traditionally, they have been focused on Top Drives only, and broaden this to design, manufacture and sell other pipe-handling equipment. We have the capacity and capability to do that. An example of this, again, is the recent catwalk product line I spoke earlier. We have delivered the first of those in Q1.

We'll also add remote Equipment Health Monitoring capabilities, or EHM, to our products to allow us and our clients to increase their reliability and cost-effectiveness. Third, we will leverage our large infrastructure to achieve 2 things for the aftermarket services. One, ensure that we protect and increase our market share on our installed base; and second, we leverage our current capabilities and infrastructure to service our clients to SMART equipment fleet. SMART stands by Specialized, Mechanized, Automated Rig Technologies. With this, we will increase our addressable market 4x.

Last, we'll leverage our rental infrastructure to rent more products. We will be a broader rental company. We'll become more integrated through the use of tools such as our EHM, just mentioned earlier. And we really have the capacity and the capability to do this. In fact, we run our Top Drive rental fleet at 99% of the time. Our Top Drives are rarely down, but we can apply the same capabilities to run other rental equipment.

Next slide. Let's dive now a little deeper into the 2 businesses and their execution plans. Let's start with Tubular Services. Our strategy is clear. We will take market share from the 2 major competitors. Those guys control half of the global markets, particularly offshore. The market is looking for an alternative high-end supplier, and we are that alternative.

Although 40% of the market is in the hands of mostly small, local regional competitors, and we believe that technology, with complexity and higher standards, will drive the market to consolidate. We are in a great position to be that consolidator.

There are 3 things that we must achieve to realize this strategy. One, we need to fill in and leverage our infrastructure to grow faster, safely and effectively, through a more complete tools services offering. Two, as we have said a few times, we need to increase our offshore participation. And three, we need to ensure that our technology differentiation continue to allow us to compete in the complex well markets.

Next slide. We must drive our revenue per job higher to accelerate our profitability. This is key for Tubular Services. This can be achieved in different ways. We will be doing more work out of our current operational hubs, and we will be selling more to our current plants, for example. We'll also be adding scope to our current jobs and migrating more workload to high-end wells, including, again, offshore.

More offshore work is important, as the average revenue per job is 2 to 4x higher than the average job in land, sometimes even 10x higher. There's also significantly less competition in that space. Another way in which we will grow our core is by converting more conventional work to proprietary work. We can, for example, utilize our proprietary side entry cement swivel in more serious jobs. This attracts more revenue per job with little additional costs. In addition, we could sell more casing rotation-related accessories, like Torque Ring or centralizers, rimmers, that complement the CDS rotational capability. Using this strategy, we could, for example, increase the typical casing running job ticket from some $25,000 per job to $35,000 per job, all with limited additional costs.

Lastly, we are well positioned to accelerate our strategy by integrating a number of acquisitions, primarily in the places in which we operate. This will allow us to obtain maximum leverage of our platform and maximize synergies. Acquisitions are an acceleration mechanism. We have done 9 small Tubular Services acquisitions over time, and we have -- that has helped us fuel the current business.

The most recent in Egypt helped us to accelerate our entry into Saudi Arabia, one of the most important Tubular Services market of the world. We now have a solid foot into expanding that market.

Next slide. Now moving to Top Drives. One of TESCO's main differentiator remains its global service capabilities and product excellence. This allow us to keep our clients' rigs running. We have jobs and technical staff around the world. Consistent with our strategy, we'll now be increasing that infrastructure. Our strategy is to expand our offerings to incorporate other products and services, more of the critical third-party equipment of our client rigs fleet, as mentioned earlier, the SMART equipment. Just like in the case of Tubular Services, this strategy is also about feeding more work into the current infrastructure, so that we leverage it more effectively and drive more profitability in the process. We have both the capability and the capacity to do this. And in fact, already started performing some of that third-party work.

Let me reiterate that we will be doing 3 things. One, we will significantly expand the product portfolio to leverage our installed manufacturing capacity. We'll do this by adding more rig mechanization and automation products. Most importantly, we know how to do this. We have done it before. Two, we will significantly expand our market, our aftermarket offerings. That will allow us also to capture meaningful market share of the third-party equipment service market. We're well-positioned to do this and the market is there. And three, we will be evolving our top line rental platform to rent other products, better and more effectively utilizing our current global infrastructure. We will optimize the rental fleet and mix to match market conditions and to generate maximum cash.

Next slide. Continuing with the Top Drives execution plan. For Top Drives, our driver is to increase the revenue per rig. As we implement this strategy, we plan to evolve our Top Drive business into a broader product sales, services and rental business for the drilling and completion industries. We will sell and look after more of equipment needed to run high-performance rigs. It's an ambitious strategy, but we already have the platform and key elements necessary for our success. The market is there. We will focus in critical equipment, with high nonproductive time or entity. Entity remains a big problem in our industry, and this problem will only increase with both well complexity and rig complexity going up.

Entity reduction will be an even bigger differentiator for TESCO. Our commitment is to be the best at keeping our clients' rigs running, and we're positioned to do that. This is another area where bolt-on acquisitions make sense, again, as an acceleration mechanism. We'll realize our strategy faster and take advantage of minimum -- meaningful synergies by plugging in additional process and services where needed.

Next slide. Now moving on to the markets. Next slide. We're very proud of the global platform we have built and the footprint it provides. We are already in the key locations we need to be in. We are where the markets and where our clients are. Again, very few companies of our size have achieved this and have been able to be profitable in the process. By making the investments we have made, this strategy will allow us to capture the critical mass needed to drive the profitability up.

Our team is charged with selling more of what we do to the same clients, and doing it in the same places in which we already operate. By utilizing our current infrastructure, we will drive both revenue per job and revenue per rig up.

TESCO has truly become an international company. In 2013, more than 60% of the revenue was from locations outside North America. Our strategy is consistent with this, and continues to look for substantial growth from the East. These are also the markets where our products, our services, our infrastructure provides maximum differentiation.

While most of the growth will come internationally, in North America, our focus will be twofold: To accelerate the migration of our Tubular Services operation towards offshore, as disclosed earlier, and towards high-end complex drilling, where our value proposition makes more sense; and to accelerate our Top Drive technology deployment as the market continues to demand high-end, highly automated rigs to drill competitively more complex wells.

Next slide. As you can see, the international rig count is twice the one of North America, and it will also grow faster. Most importantly, the Top Drive technology adoption is only 50%, with other rig automation technologies like Catwalk nearly in existence. With respect to the well complexity the international markets have taken behind North America, the opportunity is there for TESCO to capitalize on both trends.

It is important to understand that this graph showing future market growth, our conservative estimate. That applies to both rig counts and well counts, which display similar conservative patterns.

Now you see that our strategy sets us to grow about 5x faster than this market. It is important therefore, to understand that we will do that by expanding our offerings, expanding our product mix and by deploying additional technologies, not only by betting on an expanding market. We will sell more of what we do well, and we'll expand our offerings in the process. We will also capture -- by doing this, we believe -- we strongly believe we can capture more of our clients' by this. In short, we're betting on earning a higher market share of available markets, which are already vast.

Most importantly, if the markets improve we will be positioned to benefit even further.

Next slide. As you see here, we have small shares of vast markets. The time is right for us to play a far bigger role. We're well-positioned to become the global alternative in this space.

Interestingly, we look at our size as one of our advantages. We are the smallest of the big global players, but consistently compete with them successfully and operate at those same standards. Nowhere this is more evident or a bigger opportunity than for our Tubular Services. This is a business in which we have the smallest market share with the biggest momentum. We operate in a nearly $4 billion market. Half of that market is in the hands of just a few companies, mostly offshore. We can double our market share by winning just a fraction of that market.

We have identified also the need in the market for a strong third global player to compete with them. We hear this from our own clients. TESCO is that alternative. We have running room and willing clients. We are ready.

Another good example of this is in our aftermarket business. Since our strategy now calls for looking after service and managing the life cycle of both TESCO products and third-party equipment, with this strategy we'll become the largest independent SMART equipment service network globally.

In addition, it's important to understand that a strong aftermarket services is also key to selling more products, as many clients will buy their premiums from the company that we believe will keep their rigs running.

With that, I will pass it over to Chris who will address the financials. Thank you.

Christopher L. Boone

Thank you. For acquisitions, our strategy is to stay true to our core and maximize synergies. Acquisitions means to accelerate our operational strategy and will be balanced again organic opportunities. In general, we'll be looking for opportunities that: One, expand our market share in existing product lines and geographic markets; two, add technology to our products and services to maintain differentiation; three, add ancillary products and services to our existing lines that can leverage our infrastructure and existing customers. This chart shows examples of these types of ancillary lines, but are not an exhaustive list. These types of ancillary lines may be targeted at specific geographic regions based on competition and customer requirements.

Next slide. Again, we believe our strategy will yield performance that will allow us to invest heavily in growth and return cash to our shareholders. As was announced in the press release this morning, the board has approved 2 shareholder return programs. First, the board has authorized an initial $100 million, 2-year stock repurchase program. We will follow a disciplined approach in the timing of the repurchases by considering growth opportunities versus share price.

In addition, the board has authorized the initiation of a quarterly dividend program. The initial quarterly rate is $0.05 per share to be paid on June 2. We are targeting future dividends, produce yields of 1% to 2% and approach an earnings payout ratio of 20%.

Turning to the balance sheet. The balance sheet is -- a critical element of funding this strategy is to optimize the use of our balance sheet. We believe we can fund the strategy without needing leverage over 1x EBITDA. However, we will be able to increase leverage levels as additional growth opportunities become available.

Also, in order to reach our free cash flow targets, we will be pushing to exceed ROCE levels above 20%. To achieve this, we must increase the utilization of our assets and infrastructure, produce days working capital and increase the sophistication of our global tax and cash planning.

You've heard our strategy, and this is the profitability we have to deliver. Tubular Services: annual revenue growth of 20%, operating margins over 20%, EBITDA margins over 30%. Top Drive: annual revenue growth of 10%, operating margins approaching 25%, EBITDA margins approaching 30%. R&D: growing to 1.5% to 2% of revenue and doubling the revenue contribution of new technologies. Corporate: reduce to 4% of revenue. We have the infrastructure, technology, skills and R&D pipeline in place now to support our goals. Execution will be the key. We will be keeping you updated on our progress. Julio?

Julio Manuel Quintana

Thanks, Chris. So in summary, as I mentioned, I believe that TESCO really is the healthiest it has been in our history. This is measured in many different ways from profitability to position for growth, to cash generation, to best-in-class through A to Z [ph] performance. Really, I do believe the next 5 years will be the best 5 years performance in our history. We're going to do that, as I mentioned, by doubling the revenue over that 5-year period, over 250% increase in EPS, zeroing 20% return on capital employed, and do all this while still giving substantial amount of cash back to our shareholders. So we're really quite excited about next 5 years.

With that, then, we're going to open it up to questions both on the quarter and on the 5-year strategy presentation. So Luke, over to you.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question today will come from the line of Robert MacKenzie of Iberia Capital Partners.

Robert J. MacKenzie - Iberia Capital Partners, Research Division

I guess, first question that comes to mind, Julio, is related to the 5-year plan, your goals of double revenue within the next 5 years. Talk to us about the infrastructure you think you need to add to achieve that.

Julio Manuel Quintana

Sure. In summary, Rob, very little. Most of the places we have around the world where we have shops and operations, we could easily absorb somewhere in 15% to 100% with minimal amount of investment. If I had to kind of guess at the level of capital in terms of shops and fixed type capital over that 5-year period, I could not imagine it approaching even $10 million. So I think we're really well positioned to leverage. It's all about utilization of the assets that we have and hiring people.

Robert J. MacKenzie - Iberia Capital Partners, Research Division

Okay. And will any of that double of revenue contingent on acquisitions that you talked about in terms of your capital allocation?

Julio Manuel Quintana

Sure, sure. Absolutely. Roughly speaking, we tend to spend about $1 of M&A investment for every dollar of revenue. So -- in initial investment, right? So if you spend a couple of hundred million dollars in acquisitions, you would expect a couple of hundred million dollars of revenue. So probably, something around 40% to 50% of that growth would come from acquisitions.

Operator

Your next question will come from the line of Jeff Spittel of Clarkson Capital Markets.

Jeffrey Spittel - Clarkson Capital Markets, Research Division

Maybe, first on the big picture related to the 5-year plan. When you think about the growth in the Tubular Services business and expanding your portfolio to include cementing and some other capabilities, I'd imagine some of that goes around the CDS. Is the goal here really just to up the amount of proprietary work that's done by expanding that portfolio?

Julio Manuel Quintana

Well, Jeff, I think, our CDS really is best-in-class. I do think it does give us great differentiation in the market. But in the customers' eyes, they really want to see a provider that can do everything, not just CDS work. Yes, proprietary work will grow, and yes, we're going to add more products like accessories and cementing heads and so forth onto the fold. But at the end of the day, it's about providing a complete system to the customers so they can actually go from surface pipe to intermediate pipe to completion casing to the entire completion string and production string. And it's about providing the whole package. I think that's the ultimate objective. Then the technologies that we add are really just a way to maintain differentiation, particularly differentiation against the smaller players that don't have access to the technology.

Jeffrey Spittel - Clarkson Capital Markets, Research Division

Okay. And then it sounds like geographically, you're more than happy to just go after incremental wallet share in the markets in which you're already stationed, is that fair?

Julio Manuel Quintana

That's correct. Yes. It's the best way for us to drive the profitability. There are a couple of markets around the world where you'd say, "Okay, that could be a pretty interesting one to get into," but that's kind of a secondary part of the strategy. The strategy really is pretty much most places where we're already at. It is how can we double the revenue in that market. And as you saw from the slide that Fernando presented on market share, we're really a relatively small player in the market, and it's kind of amazing that we're the #3 player. We're relatively small in that market, so it's pretty easy to double in those markets and still not have to take a majority market share.

Jeffrey Spittel - Clarkson Capital Markets, Research Division

That makes sense. And then maybe on the Top Drive business, if I could squeeze in one more. As we think about the margin progression for the rest of the year, I know you got the mixed shift with more ESIs, but hopefully the margin profile on an ESI being delivered getting a little better. And it sounds like you're assuming a little bit of improvement on the rental business, particularly in places like Mexico. So that, I guess, enough to get us back to Q4 run rate, or hopefully, a little bit better as the year progresses.

Julio Manuel Quintana

Yes, for sure. As you know, Top Drive rentals plays a huge part in our profitability. So when you have hiccups like in Mexico where we have to kind of start -- excuse me, stop and start again, that always sets us back. We're seeing improvements there already this quarter. We'll see improvements kind of throughout the year on that front. And then the second big chunk, really is, it's not so much ESI versus not -- you're right, our ESI issue is behind us and we're getting stronger on the ESI profitability, but it really is more about -- we have kind of fixed cost associated with our manufacturing. So if we can deliver, instead of 80, 100, instead of 100, 120, that's a huge driver to the bottom line. So it's a combination of those 2. Fernando, I don't know if you want to add anything to that?

Fernando Rafael Assing

Yes, correct. Just to complement on that, Julio. The margins and the ESI are getting better as we've worked from the issues we had a couple of years ago. We would like to see that profit line to its potential sometime next year, with the worth climbing quarter by quarter, in those margins. And as Julio said, the -- we have manufacturing capacity that far exceeds our market demands at this stage. So a lot of that is in fixed cost, and whatever dollar we can add to that infrastructure really generates bottom line very quickly.

Julio Manuel Quintana

I would say, Jeff, the kind of -- if you asked me what's the single biggest risk that's right there, we're variable to the rest of the year in terms of being able to deliver great on the profitability front for Top Drives, it really is just how many Top Drives we can book. Rentals is pretty well lined out. If I take Q1, of course, the year looks great, but we still have all those Top Drives booked. So I think the next 3 months’ worth of bookings will define pretty closely what the rest of the year brings. Everything points to a pretty positive rest of the year.

Operator

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

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

Maybe just stay on the Top Drives side, but switch back towards the 5-year plan. I think you guys talked about a margin target of 25%. That's been a level you all have achieved in the past. And I guess, looking forward with the top line growth, it looks like you all anticipate generating on that side coming out of aftermarket. Can you talk about mix impacts moving forward in terms of the sensitivity of being able to get margin to the mid-20s versus potentially higher?

Julio Manuel Quintana

Sure. So as you know, Daniel, the single biggest contributor to margins for Top Drive is Top Drive rentals. Historically, second was aftermarket, though it was certainly weak last year. And then third, product sales. Product sales just kind of overtaking aftermarket in the short term. So as you look forward, we've said that the rentals business will be flattish over the 5-year period. We'll add additional products like catwalks, which, by the way, we had very nice profits on the catwalk sales this quarter, and I think will continue going forward. But products like the catwalks will drive profitability positive towards the 25%. And then finally, it's the volume of Top Drive sales that will drive profitability from that side. So it has to be -- if you asked me how do I get to 25%? It has to be flat rentals, it has to be good volume of total product. It doesn't have to be Top Drives. If we ship 50 catwalks and 100 Top Drives, that would be great. If we shipped 120 Top Drives and 15 catwalks, that would be great. A combination of enough product to spread out the fixed cost. And then finally, we've got to drive aftermarket top line from the current $60 million, plus or minus, revenue over $100 million. If we can do those 3 things, then the line of sight to 25% is very clear. So it really is very much at the Tubular Services business. It's getting all the rights that we're leveraging on that investment that we have made to get to that 25%. And then the last chunk is -- Fernando's team continues to drive hard on the cost front. We are very focused on supply chain optimization. We really are not seeing a lot of benefit from that yet, but we are working on that very hard to the extent that, that becomes a very successful tactic for us, then that will kind of be a triple target to the whole thing. But that's not built in yet into the current performance. Chris, you want to add to that?

Christopher L. Boone

And, Dan, just one note -- and for everyone. In our operating margin modeling, we also factored in sometimes the slightly diluted impact of M&A from the different areas, purchase accounting impact of increased D&A, which why we also put the EBITDA target. You'll see more of the impact to that in Tubular Services, than necessarily in the Top Drive. But I didn't want to highlight that, that those margins are adjusted for potential purchase accounting impact.

Julio Manuel Quintana

So just to be clear, much like we did with Top -- with Tubular Services with our team going on 3 years ago now, have put the stake on the ground that we will run this north of 20%, we have that stake in the ground with Top Drives. And again, we're going to evolve from talking about Top Drives to a products business. But the products business will run north of 20%, and our stake in the ground is to get it to 25%.

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

That's helpful, Julio. And maybe just as a follow-up there. On the aftermarket side, you talked earlier about product sales overtaking aftermarket in terms of margin here in the near-term. Is that more about just -- I mean, again, the recovery on the product side both in terms of volume and ESI? Or how much near-term repair are you doing on aftermarket as you do start also looking to grow the top line more aggressively?

Julio Manuel Quintana

Well, the aftermarket has kind of 2 components to it. One is the service part, it's about 50-50 split between service and parts. So the service component is one part where we need to leverage infrastructure more, so that's where the dynamics are similar to the rest of the business, how can we run twice the product through our shops so we can spread the cost out and do better. So that's more of a top line issue. The second was in the parts side, which is, we've got to become more effective at managing on inventory and driving costs out of the system through supply chain. And if we do both of those, then my feeling is it'll actually ultimately go back and surpass the product sales side again. But we have to get both of those right. And one of the things that we want to do is, as we've mentioned before, is buy a few companies. Relatively small acquisitions, right? Single-digit millions into tens of millions kind of numbers that just give us that critical mass of capability in 2 or 3 markets around the world, places like North America, Middle East and a couple other places where, if we could just add 40% of the business, profitability just takes off.

Operator

Your next question will come from the line of Tom Curran of FBR Capital Markets.

Thomas Curran - FBR Capital Markets & Co., Research Division

Shifting gears to more of a present to near-term focus. Julio, could you give us an update on where the M&A pipeline stands as of today? Does it still look as if you're on track to hit about $50 million in bolt-ons this year? And then, how would you expect -- whatever it does look like you're going to do, how would you expect that to split between Tubular Services and Top Drive?

Julio Manuel Quintana

Well that's a tough question to answer. Let me say that, yes, we do have lease today, and we're in active discussions with companies, varying in size from a $5 million investment to close to $100 million investment. That's the full spectrum of what we have today. We will do acquisitions in 2014 -- we will close acquisitions in 2014. I'm confident of that. I would put it at a -- all of the -- maybe 50-50 chance they will spend the $50 million in 2014 at this point. But again, those are kind of hard to say just because -- and these are private companies, you're working with them, you think you got it and then you end up having to pull back for various different reasons. So obviously, today, we're optimistic, Tom. But it's hard to put a number on it. I would say, I'm much more comfortable saying we will spend $100 million over the next 2 years. Maybe -- all $100 million in February next year, I don't know. But we have enough leads to certainly spend the money wisely. It's just a matter of getting it done. In terms of which ones come first, I think, my instinct says we'll spend more on Tubular Services than on the product side, again, just on the level of communications we have today. But we have very good leasing thrown our way on both of those. Fernando?

Fernando Rafael Assing

Yes, I agree, Julio. That's difficult to put up -- to make a bet on the exact number, but the leads are there. It's just timing. And as you said, sometimes it's very difficult to predict the timing of some of these transactions. I would add to that, that the -- for -- in the short term, there might be a split between maybe some Top Drives and some Tubular Services acquisitions. In the long term, within the 5 years, clearly, the bulk of acquisitions will be towards Tubular Services.

Thomas Curran - FBR Capital Markets & Co., Research Division

Okay. And then when it comes to Top Drives, could you give us an update either for 1Q orders or the exit backlog in the current mix between North America and international, and how that compared to both last quarter and the year ago quarter?

Julio Manuel Quintana

Sure. You want to take it?

Christopher L. Boone

Yes, we booked -- this is Chris. We booked a little over 30 -- I think 32 units during the quarter. Our backlog mix is definitely -- has increased to a higher North American content than what we saw last year when Top Drives came down. I don't have the exact percentage from last year, what was North America's booking...

Fernando Rafael Assing

I think, last year, we sold about 3/4 international. And the backlog now is heading close to 50-50 of North America versus international. So definitely, we've seen a swing over the last 4 or 5 months towards North America.

Thomas Curran - FBR Capital Markets & Co., Research Division

Great. And then last one for me. On the Tubular Services side, Julio or Fernando, could you provide some color on -- with how the deepwater Gulf of Mexico contract is progressing, number of rigs you're on, earliest we might see reach the maximum potential for that contract? And then, any other promising opportunities you're currently pursuing offshore, specifically in deepwater?

Fernando Rafael Assing

Yes. Well, on the Gulf of Mexico, the contracts are going very well. And we're actually limited by our ability to ramp up, just limited by ourselves. This is equipment arrival and resources. We really want to be sure we do it right and we do it well. So we don't want to rush it too much. We are the ones limiting our deployment. I believe we're in 3 rigs now or scheduled to be on board into -- scheduled to be -- we have 4 rigs assigned. And it'll take a while for us to get on board. We see that contract ramping up throughout the entire year, and probably reaching its maximum potential early next year, by the time at which we expect a very healthy run rate. In -- there are a couple of more propositions internationally. One that comes to mind is in offshore Mexico, where we are already in discussions with large international clients to get onboard with some of those rigs. We should be seeing some of that activity start to materialize in Q4 this year. Again, by next year, we're really committed to that strategic target of doubling offshore revenue contributions, that the ability of that to attract -- to accelerate revenue and to disproportionately increase profitability is huge. We're really, really focused on that.

Thomas Curran - FBR Capital Markets & Co., Research Division

And Fernando, just one quick follow-up on that. With the opportunity in Mexico, should we assume that would actually be with PEMEX and on the shallow water side or in deepwater?

Fernando Rafael Assing

It's a combination of the 2, actually. And it's a combination of clients, one opportunity with PEMEX, a couple of opportunities with a -- through the integrated contracts. And I believe it's mostly of deepwater at this stage.

Operator

Your next question will come from the line of Matthew Marietta of Stephens.

Matthew Marietta - Stephens Inc., Research Division

So my first question, kind of on a bigger picture. After you've walked through this business review and established a pretty detailed 5-year plan, does the company see a need for debt or as a mentality in how TESCO views longer term or permanent debt? Has that changed at all coming out of that plan? And maybe some commentary around that could be helpful.

Christopher L. Boone

Sure, this is Chris. As I said, the -- we are willing to take on debt. I think that was clear in our statements. Certainly, again, we're -- being an international company, there'll be, especially, times where in the short term, it might not be tax efficient to pool cash from one international jurisdiction -- from where we have cash in another place. So there are very well many times where while we show cash on the balance sheet, we may be pooling debt for that. But again, other times, we're willing to, if we need to pool in some investment and double up during certain periods, again, we're willing to take on debt to do that. As we said, we don't think we have to do the greater than 1x leverage over the life as planned, but it doesn't mean we wouldn't be willing to, especially if we had incremental opportunities above and beyond, that the markets all of a sudden accelerate faster than what we have assumptions in here, we're willing to take on those debt levels.

Julio Manuel Quintana

I think, if I may expound a little bit on that, Matt. We have companies that we think are a great fit for TESCO that would be investment of several hundred million dollars. And if the right opportunity presented itself, we would execute on those acquisitions. That's a right combination of a reasonable price for us and a willing seller. When we did the 5-year strategy, we asked ourselves, "Well, what are the probabilities that we can get one of those to happen?" And I would not put them at 0, but I put them relatively low. So we said, "Okay, we cannot create a 5-year strategy that bets we’re going to do those kinds of acquisitions." If they come, we will absolutely execute it, we can handle a lot more than 1x debt position, and we will look at that. But we've decided instead to build a strategy that allowed us to invest incrementally in these smaller acquisitions and still deliver excellent results. And when I talk about those companies, by the way, we're not talking about a third or fourth business line, we're talking about the kind of stuff that we're in business of, rental business here, and Tubular Services there. But some of those are pretty good sized companies that would require further investments. So part of keeping our balance sheet relatively healthy is to keep ourselves in a position that we can pull a trigger on something like that if they come our way over the next 5 years.

Matthew Marietta - Stephens Inc., Research Division

That's very helpful, I appreciate it. And then my last question, to get a little bit more into the weeds on Top Drive sales for 2014. The commentary you said is it's going to approach 2012 levels on a unit count basis. So this kind of implies new sales of about 30 to 35 units per quarter for the remainder of the year. Can you maybe give us a point, what April kind of looked like in terms of units sold and if you're able to provide that? And also how you plan to increase the output from 1Q, which was 19. Has there been any change in manufacturing capacity, or is this just customer demand?

Julio Manuel Quintana

Sure, I can answer that, Matt. So yes -- well, obviously, we're going to talk about specific Q2 numbers, but let me kind of give you a sense. You're right, if I take Q1 multiply it times 4, we have 120-something units to deliver. Part of what happens is, we, as a team, are having to constantly speculate on what's going to come in Q3, what's going to come in Q4, which model, et cetera. And so that's an imperfect process, so I think we're getting pretty darn good at it. And so I think it's a bit risky right now to take Q1 and multiply it times 4. I just don't have the level of visibility for you. The second -- Q1 bookings...

Christopher L. Boone

The Q1 bookings.

Julio Manuel Quintana

Yes, Q1 bookings. Multiply times 4. I just don't have that level of visibility. The second thing is timing. If you tell me that we're going to -- that Q2, for example, is going to put out another 30 to 40 bookings, and they're consistent with what we're speculating the model to be, then, yes, we can deliver 120-plus units in 2014. I just, again, don't have that level of visibility. So I think, directionally, what I would say, Matt, is I would put a spread of 100 to 120 as being very reasonable. It might end up as good as 2012, maybe a little bit shy, maybe a little bit better. It's just not quite clear right now. It's going to take another couple of months for that whole thing to sort out.

Christopher L. Boone

But, Matt, this is Chris. If you noticed the -- in our press release, inventory levels did go up this quarter. And that's a great result of, again, the planning, looking ahead for what we think we needed to go ahead and get on order to satisfy the future demand, the long-lead-time items to get coming, so we could turn around quick orders.

Julio Manuel Quintana

Sure. As it relates to the second part of your question, which is our ability to deliver 19 versus 30 versus 40, literally, that's just an inventory game. Our manufacturing capacity can spit out 40 Top Drives, if we have all of the product, all of the inventory on hand. And so, it really is just a question of how bullish we want to get with the inventory. And to the extent that we see a bullish 2015, for example, then I'm willing to go buy 5 more motors and put them on the shelf because that means we're going to ship them in Q4, we going to ship them in Q1. So we're looking at that. We are very nimble. We can deliver 30, 40 units pretty easily, if we need to, going forward. So I don't see any TESCO manufacturing as being a bottleneck to us delivering the 120-plus units.

Operator

[Operator Instructions] Your next question is a follow-up from Rob MacKenzie of Iberia Capital Partners.

Robert J. MacKenzie - Iberia Capital Partners, Research Division

A quick follow-up, I guess, more of housekeeping question. I may have missed it, if you said it, but did you lay out the MCLRS and CDS sale revenue this quarter?

Julio Manuel Quintana

The -- I think the MCLRS, we did. It's like $1.6 million -- yes, $1.9 million.

Christopher L. Boone

You'll see -- again, that's probably an area that will be -- as far as the number we give out, will be reduced. It's becoming more of an integrated offering within our offshore Tubular Services package, and that's just harder to break that revenue out. And so that may be a number that we don't like emphasizing as much in the future. And the CDS sales, I don't remember the exact number, but...

Julio Manuel Quintana

I think like $3 million, or something like, of CDS. About half of it was in Q4 was CDS sales, and about $1.9 million of MCLRS. So down on CDS, up on MCLRS. But as Chris mentioned, part of what's happening is we're evolving into this deepwater offering. So what happens is, if you look, for example, the deepwater contract that we were talking about, we'll go and run big casing strings one day, and then the next day, we'll actually do a completions work, which may or may not include MCLRS, so kind of a total bid package for the customer. And so, as Chris pointed out, it almost makes no difference to us. The profitabilities are very similar. We'll be happy to do MCLRS, if that's what you need this month, Mr. Customer, or we'll be happy to run a 26-inch casing, if that's what you need. Either one. But in summary, back to your question, MCLRS was up quarter-on-quarter, CDS sales was down quarter-on-quarter. And that's just a timing thing, there's no fundamental shift in either one of those businesses, up or down. As you know, those 2 tend to be kind of choppy.

Operator

And, gentlemen, there are no further questions at this time. Please continue.

Julio Manuel Quintana

Thank you, Luke. In closing, I would like to thank you for participating in the call today and your interest in TESCO. This is the first time in our history that we share a 5-year view with our shareholders. We're bullish about the next 5 years. Our focus on improved quality, coupled with optimization of our global footprint, is proving to be successful and will be a key driver for value over the coming years. I look forward to our discussions next quarter. Thank you.

Operator

And thank you. Ladies and gentlemen, this does conclude the TESCO conference call for today. If you'd like listen to the replay of today's conference, please dial 1 (800) 406-7325, or (303) 590-3030. We would like to thank you for your participation and you may now disconnect your lines.

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Source: Tesco's (TESO) CEO Julio Quintana on Q1 2014 Results - Earnings Call Transcript
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