Superior Drilling Products' (SDPI) CEO Troy Meier on Q1 2016 Results - Earnings Call Transcript

| About: Superior Drilling (SDPI)

Superior Drilling Products, Inc. (NYSEMKT:SDPI)

Q1 2016 Earnings Conference Call

May 13, 2016 12:00 pm ET

Executives

Deborah K. Pawlowski - IR, Kei Advisors LLC

Troy Meier - Chairman and CEO

Christopher Cashion - CFO

Analysts

Jason Wangler - Wunderlich Securities

Joseph Reagor - ROTH Capital Partners

Operator

Greetings and welcome to Superior Drilling Products First Quarter 2016 Financial Results. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to Deborah Pawlowski, Investor Relations. Thank you. Please go ahead.

Deborah K. Pawlowski

Thanks, Brenda, and good day everyone. We certainly appreciate your interest in Superior Drilling Products and for taking the time to join us on the call. I have with me Troy Meier, our Chairman and CEO; Annette Meier, our President and COO; and Chris Cashion, our Chief Financial Officer. Troy and Chris are going to review the results for the quarter as well as provide an update on the Company's strategic process.

You should have a copy of the financial results that was released before the market opened this morning, and if not, you can access it on our Web-site at www.sdpi.com. There are also slides that will accompany this teleconference that are available on the Web-site as well.

This morning, you should also have received the news release announcing our new distribution agreement with Drilling Tools International that was just finalized yesterday, or maybe it was this morning. If you haven't already seen that press release, it is available on our Web-site and I encourage you to take a look as we will be discussing that agreement during today's call also.

On Page 2, you will see the Safe Harbor statement, and as you are aware, we may make some forward-looking statements during the formal discussion as well as during the Q&A. These statements apply to future events that are subject to risks and uncertainties as well as other factors that could cause actual results to differ from what is stated here today. These risks and uncertainties and other factors are provided in the earnings release as well as with other documents filed by the Company with the Securities and Exchange Commission. These documents can be found on the Web-site or at sec.gov.

I also want to point out that during today's call, we will discuss some non-GAAP measures which we believe will be useful in evaluating our performance. You should not consider the presentation of this additional information in isolation or as a substitute for results prepared in accordance with GAAP. We have provided reconciliations of non-GAAP to comparable GAAP measures in the tables accompanying today's earnings release.

With that, let me turn it over to Troy to begin.

Troy Meier

Thanks, Deb. Thanks everyone for joining us. Let's go ahead and turn to Slide 4 in the slide deck and talk about the challenging market. As you look at this slide, you will see that our contracted services are down 74% year-over-year, and this is our bit refurbishment business that we talk about that we do exclusively for Baker Hughes, and this 74% decline has a strong correlation to the rig count. And so that rig count goes down, so does this part of our business.

And you look at the area that we contract in, the Rocky Mountain, Rockies has been hit even harder than what the overall average is for the U.S. And we also have to take into consideration that before we did a lot of overflow work from Baker facilities as their turn times become extremely long, and we don't see that work anymore. So that's why we're seeing the 74% decrease there.

The tool revenue decline of 57%, again this has correlation again with the rig count here in the Rockies. If you look at what's happened here in the Rockies, it's been major deduction in rig count. This is we've also seen some pricing pressure here, but more so it's been the decline in rigs.

But if you look at that, we're also finding out that there is lot of opportunities, as strange as it may sound, in this market. We are finding that as we look at the tool revenue going into the rest of the year. And we've talked to everybody about how the transformation of this Company going from a fabrication and sales organization is turning more into a fabrication and support organization to these teams that have these legacy relationships. So we are encouraged about that and we'll talk about that a little later with what we've been able to accomplish so far this year with bringing on another exceptionally high-quality company.

So let's move to the next slide. If you go to Slide 5, again as we talk about penetrating the market in these tough times, the Rockies, again I don't want to dwell on it, but it's been hit hard, and then we've got some customers within the Rockies that we were really, really servicing and tapped into very well and they've been hit extremely hard. So, as we are a small company trying to grow our customer base, we've been very vulnerable to certain customers dropping rigs that would really, really affect our revenue.

Again, we talked about the average run, price per run coming down slightly from $10,400 to $9,900. This has a lot to do with the diversification as we've introduced our tools into other basins. Their laterals are shorter and you've all heard me talk about this before. We don't get that 10,000 to 15,000 foot lateral that we've been used to in the Bakken. It's shorter. And so price per foot may be the same but we don't get as much footage. So that's part of that.

We're still bringing on new customers. In this first quarter, we've added another three, four quality customers to our profile. They've had some very good runs with our tools, mainly with the Drill-n-Ream, and we are very excited about these new customers and what the future holds with them. We've been doing some exciting stuff with another large service company out there that we've been helping them with their rotary steerable systems. And so we'll talk about these things as we talk about penetrating the markets and what we'll be looking at going forward, and I'll talk more about that at the end of the presentation.

One of the things that we're finding out is, customers are also putting the Drill-n-Ream in the vertical section of the hole. We are finding that those customers, such in the Bakken, that have had problems in the south sections, in the vertical, and we've brought on some quality customers that are now using Drill-n-Ream to help them in these swelling south and keep that from creating a lot of problems for them as they lay this intermediate string and go to do their lateral.

I'm sure you're all very familiar by now, with a few hours of the announcement, of the DTI. As we turn to the next slide, let's look at that. We've been working with DTI for a few months. We've been watching what they do and how they perform and the organization this company is, and we are incredibly impressed. They've got a world-class management team. It's lot of energy, lot of excitement. We are very proud that they have accepted to agree to take our tool, this quality tool, this Drill-n-Ream tool, and get it out to their customers, and we are very excited about the opportunity that this is going to do for both of our companies.

We've been able to agree upon a deal that has got commitments on both parts. They've got to hit objectives and maintain those objectives to keep this exclusivity in North America. And at the same time, we've got to perform and give them quality tools and do them in a timely manner to be able to get them and support their sales efforts and also their field efforts. As they grow businesses, we've got to be able to repair their tools and turn them around quickly, no matter where they are in North America. So it's going to be a very exciting period for us as we nurture this new relationship with DTI. And I'm sure there will be some questions about this as we get to the tail-end of this conference today.

With that, I'm going to go ahead and turn this over to Chris who can talk about the financials. So, Chris, how about it?

Christopher Cashion

Okay. Thank you, Troy, and good morning to everyone. Let's continue with our review of the quarter by looking at Slide 8, titled 'Managing Costs and Investments'. You just saw that this market has had a pretty big impact on our revenue line, and as we've seen over the last 18 months, a difficult marketplace but we continue to look at our cost base, we look at our operating expenses, we continue to right-size the organization.

So we've been able to do that, as you can see, drop 30% out of operating expenses over the last year, and in Q1 we've reduced headcount again, 24% reduction, and 50% over the year. We are very careful, however, to make sure that we keep the human resources in place that we need to support these two market channel partners that we have, Baker Hughes and DTI. So we are keeping that cost in place so that we're able to work with these partners, getting them up to speed on our tools, how to market the tools, targeting customers.

So we are maintaining the field infrastructure needed to do that. At the same time, we have continued to look at cost reductions and we are doing that in Q2. We're continuing to go through reduction in force as needed and keep an eye on our own cash and on our operating expenses.

Now if we go to Page 9 and look at cash, look at EBITDA, EBITDA and both net loss impacted significantly by the drop in revenue. Once again I just want to reiterate that while we are cutting cost, we are not cutting to the point where we cannot work with our new channel partners and get out in this marketplace and get Drill-n-Ream and Strider on rigs. We have brought our breakeven point down again to $1 million revenue per month.

And just as a reminder, as we talked the last time, we completed a program in Q1 whereby management and our Board exchanged cash compensation for equity. So it's a step that we feel indicates our optimism, our commitment and where we think this Company is going to go.

Now let's look at Page 10, and as we take a look at the balance sheet, CapEx, we continue to bring that number down. You can see that in Q4 2015, we spent almost $400,000 in CapEx. We spent a third of that roughly in Q1 2016, and we anticipate spending somewhere around $600,000 for all of 2016.

As we move from a rental tool business to a tool sale business, that requires less of a rental tool fleet for us. And so we are able to save cash by not having to build out our rental tool fleet, like we would have done if not for the fact that we now have DTI, a well-established company, that will be our sales and marketing arm. So CapEx, we continue to pull down.

Financing strategy, we are renegotiating the Hard Rock note, as I think most everyone knows, July 15 of this year. We have $1.5 million principal payment due. We have been in discussions with the holder of that note to restructure that payment. We're very optimistic that we will get that done. We were able to do that twice last year. So we will continue to negotiate that, renegotiate that.

And then liquidity options, as we've said before, all options are on the table, capital raise options, continue to work with our bank and just to maintain the liquidity that we need. So we are considering everything and continue to consider everything.

Let's look at Page 11 now as we take a look at 2016 and outlook, and once again we're just not able to provide quantitative guidance. That's a result of, as we said before, this market is just, as you all know, just unpredictable. It's a 40% decline in rig count since the end of calendar year 2015. The market ended at 698 rigs, and as of last Friday 415 rigs, the lowest since the 40s, 40% reduction just since the end of 2015. So we are very optimistic with what we can do with DTI.

Even though it's a 400 rig market, our share of that market is less than 10%. And so there is a lot of market, even at 400 rigs there is a lot of potential to get our Drill-n-Ream and our Strider onto wellbores. And we think we've got two established ways to do that, Baker Hughes with the Strider and now DTI with the Drill-n-Ream.

DTI agreement, it's a $1.5 million commitment from DTI to begin putting the fleet in place, it's an initial step, and we see that rolling out, $0.5 million of that $1.5 million we expect to book in Q2 and then $1 million in Q3. And that's just the initial stage. That's just to begin to get some tools in their hands and they get out into the field and they start generating revenue from the tools.

We amended our credit facility agreement. We needed some additional flexibility with regard to financial covenants and our lender agreed to do that. So we got that accomplished. So now we've got the financial flexibility with our lender for our growth capital.

As you may remember, we put a working capital line in place, and so we've got that available to us. As we ramp up the revenue through the DTI agreement, through the Baker Hughes agreement, we've got the ability to finance that working capital growth. And then just to reiterate, what's driving our growth in this market is our new channels to market, DTI and Baker Hughes. That's what's going to generate the demand for our tools as we go throughout 2016.

So with that, I'm going to turn the presentation back over to Troy to take a look at the 2016 outlook, the market outlook.

Troy Meier

Thanks Chris. So we have talked about – throughout the start of this year, we have talked about the transformation of our Company. As we look at the Company, an organization that supports world-class sales and marketing teams, with our engineering, our designing and our fabrication, we are very excited about the opportunity this has for us going forward. This is something we know we do very well and we know we have some tools already in our organization that we can turn over to these companies and they will see a great result with revenue from these tools right out of the gate.

The Strider, as we look at our Strider and what we are doing there, our initial performance on our Strider or what we call our smaller tool, it's the 4.75 tool, it's been a little bit of a fresh trading development process. We've had some phenomenal runs but at the same time we've had those same tools not perform as well as they should. And so we're working those bugs out. We don't want to tarnish our name. We've developed a very good name in the industry, and the fact that that tool is not performing as well as it should every time, has been very frustrating on us. And so we're doing those things to make sure that that tool is quality every time a customer puts it in the hole and it performs to the best of their expectations.

The alignment that we have with Baker Hughes on the Strider, their requirements required for their monobores that are now being drilled, they required a bigger tool than what we had developed. And we've now developed and tested a larger Strider for these monobore systems and we ran the tests in our facility here this week, and they are performing very well. We expect this tool to – everything that we have learned from the initial launch of the Strider, of this smaller tool, we've been able to take what we've learned and incorporate that into this 6.5 diameter Strider, and we believe it's going to perform extremely well.

The first six tools are now manufactured and they are leaving our facility on Monday, and those will be in the hole shortly. So keep up with us on the progress of that. We are very excited about that. That's the tools that Baker needs to satisfy their demands for their customers on these monobore systems.

Look at the Drill-n-Ream, we talked about it's getting more applications, we're starting to see runs, a lot more runs in the vertical and not just the horizontal anymore. One of the things that we've been doing with that is we've been working with a large service company because of the issues that their rotary steerable system has not been able to go through the curve, and we teamed up with this company and we've been running our Drill-n-Ream systems with them.

And one of the remarkable things about this alliance that we structured with them is they would supply us with the data that they obtain from running our tools. And for the first time, we actually had pictures of a wellbore run with a Drill-n-Ream tool, and it's phenomenal. What you see in wellbore that's not a Drill-n-Ream versus a wellbore that is, it is incredible, and we're ready to take this, and not just the data that we've been giving people but actually a visual that says, look, this is what your wellbore can look like when you run this system.

Had some very good meetings last week in Houston with some very large E&P companies, that people are understanding now the quality of wellbore. We see the performances, we see companies that use the Drill-n-Ream tool, and they have a lot less tool failures, lot less BHA failures, but to get that across to the marketplace has been tough for us I think mainly because of the size and the lack of legacy relationships we have.

Now these large E&P companies are talking to us and saying, we believe you're onto something. In the past, we've just been looking at our well at every 90 feet, and now they are starting to look at these wells at every 30 feet, and the difference between looking at a well in 90 foot sections versus 30 foot sections is just incredible. When you look at from 90 to 90, you don't see what goes on in between that 90 foot section, and the quality of the wellbore is horrendous when they start looking at every 30 feet. And the market is coming around and realizing how much time and money and BHA failures this is causing them. And so we're excited about this. Wellbore quality has become the new buzzword out there in the oil and gas industry and we think that we are at the forefront of delivering tools that help them with that.

We told you about the DTI alignment that we have. We are very excited about that. Like I was telling you earlier, this is a world-class organization. We are incredibly impressed with their management team and the energy that this company has. The relationships they have, they have really mastered their marketing and sales and we're excited to start delivering them tools that enhance the offerings that they can make to these legacy customers.

So with that, I'm going to turn it over to some questions and answers.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Jason Wangler with Wunderlich Securities. Please go ahead with your question.

Jason Wangler

Just curious on what you talked about, whether specific to the DTI deal or just as you talk about shifting from a rental business to the tool sales, just could you talk about how you see that flowing through from your sales, your revenues as far as will it simply be manufacturing, selling those products to them, they go and run them and take those revenues, or just how it breaks down to your side of the business, cash inflows and outflows and the differences kind of from the rental business that it was?

Troy Meier

Jason, I'm going to let Chris talk about this, but I do want to say something here that the work that has been put into a model for DTI, between DTI and us, Chris and the DTI team has done a phenomenal job about how we are going to market these tools, sell these tools and share in the revenue of these tools. And so I just wanted to say that. I'm very proud of what Chris has put together for them, and I'm going to let Chris tell you more about it.

Christopher Cashion

Okay. Thank you, Troy. Jason, we're going to get three revenue streams from this model. We'll get revenue when we sell the tool to DTI. In the agreement, we maintain the quality of the tool through the life of the tool. So what that means is that when it's time to refurbish that tool, DTI will ship it to us and we will refurbish it, and then we will charge a fee, a refurbishment/repair fee. So that will be the second revenue line. And then we also have a third revenue line and that's the royalty, and that royalty is on the revenue that they see in the field. So, three lines of revenue; royalty revenue, repair and service revenue, and then new tool sales revenue.

And negotiating prices and rates and all those kinds of things, what Troy was alluding to is, we took an internal rate of return look at it. So as we sell tools, that's cost to them, that's revenue to us, that's margins for us, margins for them as they rent the tool, and so we've got price points in the agreement whereby what they see in the field as it goes up and down, it impacts kind of what our economics look like.

So it's a way that we both share in the value of what the tools offer the customer. And that was very important for us, is that over the life of this agreement, and by the way it's a five-year agreement, that we are joined at the hip, if you will, in what value is created by these tools for the end-user.

Jason Wangler

That's really helpful. Okay, and I'm just going to maybe ask, obviously you talked about the $1.5 million of getting them tools. What's the plan with the current inventory that you have, is that going to be moved to them? And maybe this wraps to that same question, you mentioned that it's everything but the Rockies, would you still be, I don't know if that's kind of where you grew up the product obviously, is that where that inventory would go and you'll continue to do that portion of it on your own, or just trying to get some clarity on the inventory and just the Rockies part of it?

Christopher Cashion

It's a transition, and a part of the transition for us is, let's see how DTI does. We've got performance metrics in the agreement, market penetration metrics that they need to achieve to maintain exclusivity. And so initially, we've held onto our backyard, if you will, that's the Rockies and we've agreed with them that they would focus on the other areas.

And we intend, both companies intend that as they get out there, as they perform in their territory, which is defined as North America less the Rockies, that we will turn over the Rockies to them. I mean, so our idea, together with their idea, is to eventually they'll have distribution rights for the entire North America. And so there will be a process of kind of evaluating how they're doing and then we'll mutually agree to turn over the Rockies to them.

And so, yes, we need to maintain the ability to service our Drill-n-Ream customers in the Rockies for some period of time. And so, yes, we'll still be in the rental tool business, but just as quickly as they get up to speed and demonstrate their ability to do what we feel very confident that they can do, and that's to get us much further into this marketplace than we've been able to do, then we'll turn that equipment over to them.

So, yes, I mean we need to hold onto it for a while until both sides kind of demonstrate what we're able to do, if they are able to get the tools into the market, we're able to manufacture and repair and maintain, just like we know we can.

Jason Wangler

Thanks for the color, guys. I'll turn it back.

Operator

Our next question comes from the line of Joseph Reagor with ROTH Capital. Please go ahead with your question.

Joseph Reagor

Just kind of continuing on some of the stuff Jason brought up, looking at what you guys did in the first quarter, 29 total runs, that was Drill-n-Ream and Strider together, what's the breakdown there?

Christopher Cashion

Joe, just like we said the last time, we want to keep talking in terms of total. So we really want to just keep it as a total. We really hesitate to start breaking it down by individual tools. Eventually it's going to be looking at a well, a metric on the well, and the more tools we get into a well, the better our revenue per well is going to look. So, yes, that 29 is an average, monthly average for the quarter, but we want to start thinking in terms of or continue thinking in terms of tools on well and not so much as DNR and Strider and those kinds of things.

Joseph Reagor

Okay. Looking at the new agreement then, will you still be reporting the runs that are done of the Drill-n-Ream tool by DTI as part of your total runs, or it'd be revenue from them and then total runs of your guy's rental business, or like how will that work as far as your breakdown moving forward?

Christopher Cashion

We expect as we move forward and get further into our agreement that it will just be runs that we have, that we see, at least that's our thinking at this point, is that trying to get data from them on exactly what they see as far as runs, we're not sure that's necessary to have at all.

Deborah K. Pawlowski

Yes, so the number of runs metric is no longer going to actually be as relevant as we use more and more market channel partners for sales.

Joseph Reagor

Right, so those will just be separate revenue line items essentially, even though you guys don't break it out, and in theory from a modeling perspective that will be separate?

Christopher Cashion

Exactly.

Joseph Reagor

Okay, that helps. Then, at some point are you guys going to disclose the royalty percentage or maybe you guys could ballpark it for us, is it single-digit, low single digit percent on revenue, is there some kind of threshold on it, any additional color you can add there?

Deborah K. Pawlowski

Go ahead, Chris, you can tell him. And then also just so you know, Joe, we actually have filed the agreement. So there's only some things in there that had to be redacted for competitive purposes, but go ahead Chris.

Christopher Cashion

It's an 8% royalty, Joe.

Joseph Reagor

Okay. All right, that helps. And then what can we think of in terms of dollar savings to you guys on sales team reductions? Now that you're not going to be marketing the Strider basically at all, Baker Hughes is taking care of that, DTI is taking care of everywhere in North America except for the Rocky Mountain, what do we think can come out further from the sales team?

Christopher Cashion

We will still need what we call technical sales, and so we'll need that staff in place. And the technical sales is going to be allowing us to keep a pulse on the market. So we don't anticipate being removed from customer interfacing. So it will just be a different looking sales, more of a technical engineering sales function. So we probably think in terms of half as many people that we currently have now, something like that.

Deborah K. Pawlowski

And some of those have already been done, right Chris?

Christopher Cashion

Yes, there's been a few taken out currently. So, roughly, and I think I'll go ahead and answer this, Deb, roughly [75] [ph], something like that, kind of where we are to where we'll wind up being.

Joseph Reagor

Okay. All right, that's very helpful for modeling purposes. And then just kind of one maybe big picture question for Troy, do you think as you develop other products that this is going to be the game plan going forward that you guys aren't going to go back into the rental business and that you guys are going to be an R&D shop essentially and basically licensing or selling your products to better distribution channels?

Troy Meier

Correct. I mean this is where our focus is going. We're very intent on developing tools to put in the hands on these companies that can get them out in front of customers much better than what we can, and our goal is, manufacturing is all based off of volume, as you well know, and we've got some incredible talent here that knows how to produce volume in high quantity and extremely high quality, and we want to tap into that. We want these machines running seven days a week, but not as a third-party machine shop per se, but a partnership that when we look at what we've been able to achieve with DTI, a win-win.

So, yes, we'd love this opportunity to go forward and say, here is the next product, get it out to your customers and let us manufacture that as efficiently as we can and drive our margins up with how efficient we can be here in our manufacturing and our repair. We believe that we'll have a lot of opportunities in the repair side of things, and that as you know we are very, very good at, and we're able to – we're doing work right now – one of the frustrating things for me, Joe, is the fact that we've got such a quality facility here and such talented people, we were doing work for NASA right now, we're doing third-party work for some extremely high level customers, we want to do that for ourselves and for the people that we are attached to the hip at. So we want to just really get after our manufacturing capabilities.

Christopher Cashion

So just to kind of summarize the business model then, Joe, you're right; engineering; design; new tools, down-hole drilling tools; manufacture, high-end manufacturing of those tools; and then over the life of the tool, maintenance of the tool. And that maintenance part is critical, that's our reputation, that's where we'll be branding as our ability to design, engineer, manufacture and maintain quality tools.

It's with regard to the sales and marketing that we are turning that part of the business over into more capable hands. And to answer your question, this is the model that we're really excited to run with. So we really like how things have evolved as far as moving us into this model.

Joseph Reagor

Okay. Thanks a lot.

Operator

It seems we have no further questions at this time. I would like to turn the floor back to Troy Meier for closing comments.

Troy Meier

Thanks everyone for joining us again today. And you can tell, we are in a very tough time but there is plenty of opportunity out there and we're going after it. We're going to get very aggressive and we're going to do what we do very well. I want to thank you all for again taking the time today to join us and we'll be talking to you again in August in our second quarter teleconference. Thank you.

Operator

Thank you. This concludes today's teleconference. You may disconnect your lines at this time and thank you for your participation.

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