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Key Energy Services (NYSE:KEG)

Q2 2012 Earnings Call

July 27, 2012 11:00 am ET

Executives

Gary L. Russell - Vice President of Investor Relations

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

T. M. Whichard - Chief Financial Officer and Senior Vice President

Newton W. Wilson - Chief Operating Officer, Executive Vice President and Assistant Secretary

Analysts

Michael Cerasoli - Goldman Sachs Group Inc., Research Division

Tom Curran - Wells Fargo Securities, LLC, Research Division

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

Robert MacKenzie - FBR Capital Markets & Co., Research Division

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

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

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

Operator

Good morning. My name is Keanne, and I will be your conference operator today. At this time, I would like to welcome everyone to the Key Energy Services' Second Quarter 2012 Earnings Conference Call. [Operator Instructions] I now turn the call over to Gary Russell, Vice President of Investor Relations. You may begin your conference.

Gary L. Russell

Thank you, Keanne, and good morning, everyone. Thank you for joining Key Energy Services for our Second Quarter Financial Results Conference Call. I'm Gary Russell, Vice President of Investor Relations.

This call includes forward-looking statements. A number of factors could cause actual results to differ materially from the expectations expressed in this call, including risk factors discussed in our report most recently filed with the SEC.

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

Now I'll turn the call over to Dick Alario, Key's Chairman, President and CEO.

Richard J. Alario

Thank you, Gary. Good morning. Keeping with our typical format today, I'll make a few introductory comments and then Trey Whichard, our CFO, will summarize our financial results and provide some financial guidance commentary. Then Trey Wilson, our COO, will provide an operational overview, and I'll come back and wrap up and take your questions.

In the second quarter, we generated earnings per share of $0.21, $0.01 a share above our revised guidance range. There were several factors that impacted our second quarter results. Activity and pricing continue to decline in natural gas markets in the U.S. This has had a negative impact on our Fluid services Coiled Tubing and Edge Frac Stack and Well Testing businesses, primarily due to drilling rig activity declines in the Haynesville Shale. Last year, Coiled Tubing and Edge businesses in the Haynesville produced significant revenues at high operating income margins than this year due to lower activity and pricing pressure we've seen there to downsize these businesses and move the assets to other markets.

We ended last year with roughly 75% of our U.S. business derived from oil markets. Now due to activity trends and our own operation relocations, our U.S. split is roughly 80% oil and 20% natural gas. While we've seen a steady drop in activity in the gas markets, they appear to be stabilizing.

And while customer activity is still growing in the oil markets, that rate of growth has slowed in response to the decline in oil prices this year. Also, significant additional service capacity has entered these markets. In fact, just over 50% of U.S. land drilling activity's now concentrated in 3 major oil plays, the Permian Basin, Eagle Ford Shale and Gulf [ph], compared to 34% approximately as we began 2011.

The revenue and profitability of our Coiled Tubing business in the second quarter was much better than the first and we're expecting continued revenue growth and margin improvement in the third quarter. We're definitely applying our own dose of self help. We believe the market of Coiled Tubing services remains favorable, and we feel good about the leadership and operational changes we've made in that business.

Key's Rig Services unit has been a strong performer in 2012 and the financial results for the business were roughly in line with our original forecast for the year despite market dynamics that I described earlier. Customer demand for our premium workover rigs in oil markets remain strong and we expect that will remain the case through the year-end.

Internationally, our franchise continues to grow and prosper. We believe that the success of our Mexico operations is attributable to the efforts of our international management group and our operations team in-country. Our talented leadership understands this complicated market very well and have been very effective in demonstrating Key's value and service quality to our customers, thereby enabling us to generate more opportunities there. In fact, in addition to the 40 rigs we're already operating in Mexico, we expect to deploy additional assets there in the second half of the year and Trey Wilson will make a commentary on that in his presentation.

Our efforts to sell our Argentine business have been complicated by the change in the political landscape there, yet sale process continues and we are currently in discussions with potential buyers. Commensurate with flattening activity levels in the U.S., we recently announced the $100 million reduction in our capital budget this year. Trey Wilson will elaborate further on our capital plans. Now I'll turn the call over to Trey Whichard for his financial review.

T. M. Whichard

Okay, Dick. Second quarter 2012 consolidated revenue, $516 million, was up 6%. Roughly 75% of the sequential improvement was generated by our International operations. Consolidated operating income margins of 11.9% were down 110 basis points from the first quarter as a result of U.S. margin declines, which were down 240 basis points sequentially. Second quarter U.S. revenue 431 -- just under $432 million generated operating income of $82.5 million or 19.1% margins.

Rig Services revenue, up 2.6%. Their margins were flat sequentially. Coiled Tubing revenue increased 7.5% from the first quarter, producing incremental operating income margins in excess of 65% as a result of improved utilization and favorable job mix. Much of their improvement was generated late in the quarter, and we expect margins in this business to continue improving as we progress through the year.

The gains from our Rig Services and Coiled Tubing businesses were offset by sequential declines in our fluids management business, and our Fishing & Rental Services business, including Edge. In addition to the loss of high-margin work in the gas markets, Fishing & Rental Services margins were negatively affected by equipment mobilization and inspection costs related to redeployed assets and new asset deliveries into our oil markets, which should begin generating revenue in the third quarter.

Second quarter International revenue of $84.4 million was up 36.5%, with more than 80% of the sequential revenue improvement attributed to activity increases in Mexico. International operating income margins of 19.1% were up 230 basis points sequentially despite costs associated with the assets mobilized into Oman and equipment costs associated with our activity ramp in Mexico that spilled over into the second quarter.

Our second quarter G&A was just 51 -- just at $58 million or 11.3% of revenue. We continue to expect full year 2012 G&A to approximate 11% to 12% of revenue. Depreciation expense was $52.5 million in the second quarter and is still projected to come in around $220 million for the full year.

Interest expense remains in line with our estimate of approximately $55 million for the year. Capital expenses in the quarter were just under $140 million, and we're right at $309 million for the first half of 2012. Now, although we've hit the brakes on our CapEx spend, our actual 2012 CapEx may modestly exceed our revised $350 million budget as we work with vendors to cancel or defer longer lead-time items that have been on order for several months.

Regarding guidance. As noted in our press release, we expect consolidated revenue to increase about 4% in the third quarter, driving a 20% to 25% increase in operating income from the second quarter. We expect to benefit from continued improvements in coiled tubing operating efficiencies, activity gains associated with rental equipment deployed into our oil markets during the second quarter, together with new revenue from Oman and continued operating efficiencies in Mexico. Our International business is tracking with earlier guidance, and third quarter International revenue is projected to increase in the range of 10% to 15%.

We are more cautious about the fourth quarter at this point and we estimate results to be flat with the third quarter. We are assuming that improved coiled tubing efficiencies that we will continue generating throughout the year. Rental services activity growth and further growth in the international market will be offset by typical seasonal declines in the U.S., which we believe will be more impactful than prior years as a result of additional capacity in oil markets and a more expensive fixed cost structure.

Before turning the call over to Mr. Wilson, I would like to review our U.S. revenue composition by market. For all of 2012, our U.S. revenue is projected to be up roughly 15% year-over-year. This compares to the general consensus view that overall drilling rig count will be up 5% from 2011.

Presently, 80% of our revenue is tied to the oil markets. This compares to 75% at the end of 2011. The Permian Basin is our largest market. It accounts for roughly 20% of our total U.S. revenue. California Bakken and Eagle Ford Shale markets account for roughly 40% of U.S. revenue. Together, these 4 markets, representing 60% of our U.S. revenue, will generate roughly 75% of our forecasted U.S. revenue increase for 2012.

Gas-related revenue in Q2 was down 14% sequentially and is down 20% compared to the fourth quarter of 2011. And the wholesale en masse asset relocations out of the gas markets is behind us. Revenue from the Haynesville market presently accounts for roughly 10% of our total U.S. revenue, and it accounts for about half of our total gas-related revenue.

Regarding Edge. Compared to their 2011 exit rate, annualized revenue is down about 10%. This time last year, Edge generated 100% of its revenue from the Haynesville market, which has experienced a 60% decline in drilling activity year-over-year. Comparatively, Edge's Haynesville-related revenue is down about 40% over the same time period. The annual revenue impact of their falloff in the Haynesville market is roughly $50 million, accompanied by a 50% margin decrement. Roughly 35% of their Q2 business was generated in oil markets.

With respect to our Coil Tubing business, we averaged 41 units available to work in 2011, and we ended the year with 42. Currently, we have 47 units available to work, excluding 2 units being shipped to Mexico this quarter. Before discussing utilization, I need to note we revised our methodology to reflect a more comprehensive measure of efficiency. Prior periods reflect this revised methodology. Average utilization was 61% in the second quarter, this is up from about 50% in the first quarter. Utilization for the month of June was 70%. This compares favorably to third quarter 2011 when we averaged 71% utilization and also before we began experiencing activity reductions in our gas markets beginning in Q4.

June's gross revenue was a record high for our Coiled Tubing business, producing margins in the high-teens compared to single-digit margins in Q1. Their oil and gas business mix is currently 65-35 compared to roughly 50-50 a year ago. And their overall revenue is projected to increase about 5% in 2012 as a result of gains in the Eagle Ford Shale and the Permian Basin markets.

Overall pricing in our coil markets is down 16% year-to-date. Pricing in the gas markets is down about 20%, and oil market pricing is off about 14%. Most of the slippage in oil market pricing occurred during the first quarter.

Approximately 30% of our fluids management business is tied to the gas market, down from roughly 40% at the end of the year 2011. Year-to-date, roughly 30% of our truck fleet operating in the gas markets has been relocated to oil markets, and roughly 40% of frac tanks we had operating in gas markets have likewise been relocated to oil markets.

Last but not least, our rig business generates roughly 90% of its revenue from the liquids market, and pricing in these markets has been firm. And with that, I'll hand off to Trey Wilson.

Newton W. Wilson

Thanks, Trey. I'll start with some additional commentary about the U.S. market trends and a review of our U.S. operations and then I'll provide a review of our International operations. With regard to the U.S., throughout last year, the industry witnessed declining activity in natural gas markets. However, natural gas market declines have become significantly more pronounced this year. Since the first of this year, in addition to lower activity in the gas markets, we've also seen meaningful downward pricing pressure on nearly all our services in these markets, with rig services being the noteworthy exception.

Market weakness in the Marcellus has negatively impacted our fluids management business, and to a lesser extent, our Coiled Tubing business. Fluids services has also been adversely affected in the Arctic [ph] region. And additionally, the sharp activity decline in the Haynesville Shale has hit our Coiled Tubing and Edge business pretty hard. And these Haynesville businesses were among our highest profit operations last year.

In our rig services business, throughout last year, we were successful in securing higher-value opportunities in oil markets, which naturally led to less natural gas market exposure in that business by the time the market began to fall more sharply in the fourth quarter. Accordingly, our rig services business has been the most consistent performer of our U.S. businesses so far in 2012. In the oily markets, demand for services continues to be strong although more equipment is moving into these markets, while at the same time, the growth in drilling activity in these areas has slowed. Our businesses in the oil markets are generally performing well, and we're focused on improving utilization efficiencies.

In Rig Services, where we're known for our premium service offering, a substantial portion of our rig fleet is consumed by demand from our larger customers. Our top 10 customers made up almost 65% of our second quarter Rig Services revenue. And because of the strong demand for our Rig Services in the oily markets, especially among our larger customers, we've been able to successfully relocate assets from gas markets to oil markets and accrued the relocated equipment in part with personnel rotations without significant detrimental impact to our financial results. As I mentioned earlier, the profitability of our Fluid Management Services business has been adversely affected by the weakened gas markets as Key had a substantial number of assets in these markets at the beginning of the year.

Year-to-date, our operating income margin for this business is just over 800 basis points lower than the average margin for the business in 2011. We've been actively redeploying assets from the gassy regions to oil markets, but market pressures and redeployment costs associated with these efforts have weighed on results. We're also taking steps to address our fixed costs in certain markets, which costs aren't currently justified by our near-term activity outlook for those markets.

As Dick and Trey has stated in their remarks, we expect to grow and improve the profitability of our Coiled Tubing Services business. We're gaining traction in the Permian Basin, a new Coiled Tubing market for Key, and we're having improved success improving our equipment in all our markets. Additionally, we believe that the majority of the inefficiencies associated with moving the equipment and personnel from the gas markets to the oil markets is behind us. We are achieving improved operating efficiencies, which we expect will drive better financial results through the remainder of the year.

We had a good second quarter in our traditional Fishing & Rental business although results were down slightly from the first quarter. We incurred some cost in the quarter for paying for new equipment delivery and experienced delays in rental equipment deliveries from vendors. We believe these factors were transitory and should reverse in the third quarter, resulting in higher revenues and profitability for that business.

Our Edge, Frac Stack and Well Testing business had a tough quarter as we worked to position assets in the oily markets and manage the cost of moving equipment and the inefficiencies of starting up in new markets. In the third quarter, we expect improved profitability as oil market activity grows and as we achieve better overall cost absorption and operating efficiencies.

As to our International business, as stated earlier, we had a very strong quarter. Revenue was 36.5% higher than the first quarter, driven by largely by our performance in Mexico. In Mexico, we significantly increased the number of well interventions in the quarter as we improved operating efficiency with our 40 deployed rigs. We intend to add additional rigs in the latter half of the year, as well as slickline and Coiled Tubing equipment.

We predict continuing strong remedial activity -- service activity in Mexico, and we believe that we're well-positioned to take advantage of any further expansion of activity. In Colombia, our 9 rigs are actively working. We've broadened our customer base in the country and we are exploring further growth opportunities as we continue to demonstrate the Key franchise of service reliability and operating efficiency much as we've demonstrated in Mexico. We're at full utilization in Bahrain and building on our success here and we expect to begin generating revenue in Oman this quarter. And we expect to continue increasing our overall critical mass in this opportunity-rich region as we add assets in these and other countries in the Middle East.

Lastly, utilization has improved in Russia and we've trimmed our operating cost structure, and this has helped improve results in the second quarter.

Now for a few comments on capital spending.

With the almost $310 million capital spending year-to-date, we spent about 40% of that on our business in Mexico in response to increased demand for PEMEX in the ATG field. We are reaping the benefits of that significant investment now. We spent about 20% of our first half CapEx on U.S. oilfield rental equipment like drill pipes in response to the specifically identified customer demand growth opportunities, as well as well testing and frac stack equipment to facilitate and accelerate our oil market growth strategy for the Edge business to help offset the activity declines experienced in the Haynesville Shale.

We expect to benefit from this investment in the second half of the year. And for the remainder of 2012, we will be primarily focused on leveraging the assets we purchased in the first half. The capital remaining in our budget for this year will be primarily spent on additional rental equipment and additional premium workover rigs for our U.S. and International markets, all of which are targeting high investment return opportunities.

So in conclusion, we experienced inefficiencies in several of our businesses in the first half of the year primarily related to big drops in activity in the gas markets and inefficiencies associated with moving equipment to oil markets. We believe most of the associated pain is behind us and expect better performance for both our U.S. and International businesses in the third quarter.

Now I'll turn the call back over to Dick for his concluding remarks.

Richard J. Alario

Thank you, Trey. As we sit here today, we believe Key's business in the U.S. gas markets will remain roughly flat throughout the remainder of the year. And that our oil market activity should grow moderately. So overall, U.S. revenue for the second half of the year should be up modestly compared to the first half, with better incremental margin production as transitory cost in the first half of the year abates somewhat. In other words, we do not view the activity and cost challenges so far this year to be a repeat of the '08, '09 cycle downturn. We believe oil prices and demand trends remain supportive of continued activity growth in the remainder of this year and next. We believe this view is supported by customer demand trends to date and feedback from customers regarding second half 2012 oil market activity plans. Regarding customers, we're well-positioned with a huge and growing share of our field activity consumed by large, well-capitalized oil and gas companies who rely on Key to service their wells at the high end of the value spectrum and in large volume. It's comforting to see their commitment to build a stronger presence in the U.S. and this is among the primary reasons we see our results improving in the second half of the year.

In conclusion, we believe the overriding investment themes for Key are: oil market fundamentals remaining favorable, especially longer-term; and oil activity bodes well for Key's service offerings. In the event of uncertain or declining oil price environments, our customers tend to focus more on field maintenance and workovers due to the compelling economics even with lower commodity prices. Growing horizontal well activity generates a higher level of intensity for the services we provide. Generally speaking, our top customers are growing their exposure to the U.S. shale markets. And finally, our International business is just beginning to hit its stride as we grow in Mexico and Colombia and expand our footprint in the Middle East where the fundamental opportunity set for our services is extremely attractive.

Operator, we will open up the call now for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Mike Cerasoli from Goldman Sachs.

Michael Cerasoli - Goldman Sachs Group Inc., Research Division

Just -- could you talk a little bit more on the equipment migration? You mentioned that Key's relocation efforts are largely, if not, totally complete. Do you think that's the case with the rest of the market and if it is, if it's -- if there's still assets left to migrate, do you think it's more of the private players that are going to be doing the migrating or do think there's still some portion of larger players that have to move assets?

Richard J. Alario

Mike, I think that totally depends on where the assets are located. Some companies will be better off given the concentration of their assets if they're already in the oilier areas in terms of they won't at least have the inefficiency and cost to move those assets around. I guess my other comment would be it's probably more difficult for private players to make these moves because you assume that private players are limited in terms of the number of regions that they operate in. And therefore, as they move to a new region, they've got to go start up a business. We don't have to do that. We operate everywhere and so, we are simply adding assets to a business that's already flying its flag, if you will, in these new markets. Other than that, I hesitate to comment on who and when and how much. Those are our general thoughts, however.

Michael Cerasoli - Goldman Sachs Group Inc., Research Division

Okay. And just your strategy for getting kind of getting Edge into the oil market seems to be kind of -- it seems to be working. I'm curious to know the returns I believe, are a little lower in oil than they were in the gas markets. But is this just the cost of entering a new market or over time, do you think those returns can creep up or -- just a little bit more color on how that process is going.

Richard J. Alario

Yes. They should creep up obviously, as we get settled in these new markets and focus on costs and efficiency. And you make a point, a good point, high pressure gas markets generate more rentals in the Edge line of business than -- and even high-pressure oil markets because the relative size and volume of the equipment, it's a little less than in the oily markets. But as these guys in the Edge group get their businesses, their foundations well built and the customer bases widened and the reputation stronger in the new markets, we should see things improve.

Operator

Your next question comes from the line of Tom Curran from Wells Fargo.

Tom Curran - Wells Fargo Securities, LLC, Research Division

I'm curious, when you decided to make the negative pre-announcement, at that time, did you have customers indicating that they were close to or expected to cut planned programs that given the abrupt significant rebound we've had in oil prices since then, that they've since indicated or you suspect that they'll now actually move forward with?

Richard J. Alario

Not as much as you might suspect. If you think about the preponderance of assets and crews that we have working for the larger operators, they tend not to react real quickly up or down to short-term commodity price changes. And so I don't think that was -- I don't think it's accurate to say that, that was part of what we were seeing. However, having said that, as we've said in our script, there's been some flattening of the growth. It's still growing in the oil markets, particularly, but then -- and they've been -- and there's been some flattening. Obviously, where we have seen the change in customer trend is on the gassy side but that's one of the benefits of having a large concentration of our business placed with large independents and majors. They don't seem to react as fast to commodity price changes and it's one of things that's helping us have the view that we have for the second half of the year.

Tom Curran - Wells Fargo Securities, LLC, Research Division

And on the with a Rig Services side, when it comes to maintenance and workover programs, so I'm excluding artificial lift installation, which I think of as a must do unless you're going to shut-in the well or I -- but just sticking with maintenance and workover programs, what is your sense is the average required oil price for this program to be economic in the Bakken, Eagle Ford and Permian, respectively?

Richard J. Alario

Well, we all know the differentials that exist in a market like the Bakken, say, compared to the Permian. So those are to be considered here. Frankly, we don't focus as much on the pricing levels that our customers look at primarily because the answer I give you a minute ago, it's not a short-term function. What we see though is a distinction and I'll point it out relative to say, the downturn in '08, '09. There's no doubt that plans that we've seen, discussions we've had and activity that we've been able to benefit from so far this year tells us that the typical trend of spending OpEx to keep existing wells flowing is much more prevalent today than it was in '08, '09 when the markets -- the credit market shut down, essentially all spending, that's the first thing. And then the second thing is the percentage of horizontal wells that exist in these liquids markets require greater service intensity, and even in some cases, more frequency. Therefore, we feel very good that these customers that we enjoy today are going to stay busy at the foreseeable commodity strip prices. To try to guess where they would begin to change their activity is largely dependent on their own internal cash flow and I'd rather have them answer that question for you than us.

Tom Curran - Wells Fargo Securities, LLC, Research Division

Okay. Just one more for me then. Trey Wilson, turning to the Coiled Tubing market. Based on all of the sources you guys use, what's your current best estimate of the size of the large diameter fleet? And then how many more units will be coming into the market between now and year-end?

Newton W. Wilson

I guess you had several questions there. Basically, let me just begin with our Coiled Tubing. Our large diameter coiled tubing work that we're doing in the Eagle Ford rig is going well. So there's good demand there. In terms of additional equipment coming into the market, I guess recently, we haven't seen much additional large diameter coiled tubing equipment coming into the market.

So I can't give you an accurate count from the manufacturers in terms of how many new units were coming into the market. All that I can say is that our ability to work, the utilization of our larger diameter equipment is improving. And we're not seeing a significant influx of additional equipment that hasn't been in the market before. And because we have the newer equipment, I think the highest-quality of the large diameter equipment available, we're getting good customer response from our work, our service quality is good and utilization is improving. So I think our overall theme is that, that business is still good, good customer demand and we're seeing improvement. But I am sorry, I can give you an exact count of additional new equipment that's scheduled to come into the market.

Operator

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

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

Trey Wilson, for you. You mentioned the opportunities in other International arenas. Can you share with us how many countries you see now as target markets? And do you see any potential of awards this calendar year?

Newton W. Wilson

I think this year, John, we're going to be very, very focused on Mexico and Colombia. We think that we have some real near-term opportunities in Mexico, not necessarily in ATG, possibly in other areas. And we also are evaluating some additional opportunities in Colombia. So we're really focused for the remainder of this year on Latin America, Mexico and Colombia. We're just getting started with our new business in Oman. And as we think about next year, what we might do next year will be -- focus on adding additional equipment in Oman and Bahrain. And hopefully, beginning service delivery in another Middle Eastern country. That will be a major focus.

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

Okay. Coiled Tubing, you guys noted the coiled tubing pricing pressures, appreciate the candor there. But also, coiled tubing utilization is rebounding. Are the utilization improvements a function of the lower pricing, that is you're taking share? Or is the utilization improving more because of better personnel and just the relocation of assets to better markets?

T. M. Whichard

Well, Josh, this is Trey Whichard. It's really multi-pronged. Our new coil manager has been very focused on not just utilization efficiency but also job mix and it's made a significant difference. And the gas markets that have slowed so much as he moved personnel and equipment around to other markets that could put that equipment to work. We, for example, in the Haynesville market, have experienced a tremendous rebound and profitability there and they were a big contributor to results in Q2 compared to Q1. Even though they are operating at the smaller base, they're much more profitable as a result of better utilization and favorable job mix. So despite the fact that pricing has softened somewhat, margins are going to overcome that as a result of just being more effective with the way we're working the equipment and the type of work we're pursuing.

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

Okay. Last one for me, just housekeeping. I think you put this in the Q, but if you have it handy, can you tell us what the rig and the truck hours were in the quarter?

T. M. Whichard

Can Gary follow-up without on you on that, John? I don't have it in my fingertips.

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

Yes. That's fine.

Operator

Your next question comes from the line of Rob MacKenzie from FBR.

Robert MacKenzie - FBR Capital Markets & Co., Research Division

A follow-up I guess from the current line of questions. Can you give us a feel of, Trey or Dick, on -- if you're seeing any pricing pressure and where in the well service rig business?

Richard J. Alario

I think it's fair to say that it's flat. We've moved a handful of equipment sets from one market to another to keep it flat but because as you might imagine that there is light pressure in the gas markets. But that's been the astounding thing about the rig business this year. I don't want the comment to get lost. That business is performing at the level we anticipated it would when we did our forecast in late 2011. It's the only business unit we have that is and it's pretty remarkable. I think it tells us we built the right kind of equipment. And we have the service profile that fits the new market, the horizontal market very, very well. So no pressures seen there on our business and we anticipate that kind of being flat for the rest of the year based on demand and the positioning that we have.

Newton W. Wilson

This is Trey Wilson. We had a few instances where customers let's just say, in Oklahoma, for example, Mike, say we want lower prices and we basically said, no thanks, and we took that rig to Williston Basin and we're operating it up there. So because of our footprint, our huge footprint and across North America and then particularly in these oilier markets, we don't have to accept lower prices, haven't had to accept lower prices. We've been able to move equipment effectively.

Robert MacKenzie - FBR Capital Markets & Co., Research Division

Okay. And then a related follow-up here. Dick, how would you characterize the supply-demand balance for the larger premium workover rigs which you guys have a fair number of that fleet. Is that still undersupplied as you have talked about before?

Richard J. Alario

It is. It's our tightest sort of product, if you will. We're sold-out.

Robert MacKenzie - FBR Capital Markets & Co., Research Division

Okay. And care to expand on that? Are you getting pricing increases? Are you seeing more of those being built by the competition? How do you see that developing in the next couple of quarters?

Richard J. Alario

Well, our understanding is, if we stay on plan, we're going to build more of those than anyone and maybe even the entire market combined for this year, at least based on the data that we have. And while there are some -- there are other companies certainly that have recognized that it takes a new style of rig to work on a new style of well. But we've had the edge there and we anticipate because as you heard Trey say, when we talked about the budgets for the remainder of the year, that's 1 of the only 2 places in the company that's going to continue to get capital because we see that as high return with a great demand profile. So we've been stay out on KEG [ph] on that one.

Operator

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

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

You went through almost line by line, businesses that are improving, pointed to the fact that at least on the margin line, whether it's Coiled or Edge or Rig Services, all quarter-to-quarter should be improved. You mentioned that the gas markets should at least flatten out in the back half of the year. How does that kind of -- it seems that any 1 or 2 of those would kind of get you to the margin guidance that you laid out here. Are we -- talk to me about the elements of the model that are working in the opposite direction. What's weighing you down? I guess that was just terribly conservative or were you just starting in such a hole where June margins well below what U.S. margins were for the quarter. And so you're starting in a hole to get to these margin comparisons, there's just going to be a back half of 3Q before you get there. Just kind of open playing field for you guys?

T. M. Whichard

Well, Blake, it's Trey Whichard. The Q3 margins in the U.S. are going to recover from Q2 and we started seeing that in June, in fact. As noted, a couple of items pressured Q2 margins. In the rentals side of the business, for example, where they had some costs ahead of the activity that they're currently getting that'll be booked in Q3. So those costs would be out of the way. The coil guys really hit their stride in June. So the first couple of months of the quarter, we're still pressured. And we're going to -- we hit the ground running in Q3 on that side of the business and certainly, that will improve. We've got cost issues that Trey talked about on the fluid side of the business that we need to address. The near-term activity levels don't support our infrastructure costs and that will continue to weigh into Q3, we expect. On the Rig Services guys, they're performing at a top level and they have been pretty consistently. And certainly, we don't anticipate any slippage from them. But it's going to be hard for those guys to ratchet it up much higher than where they are now. And as far as it relates to Edge, the same commentary that I had on the rental side of the business would apply to them. Internationally, should experience a pretty nice quarter sequentially as they still had some cost lingering in Mexico that spilled over into Q2 that won't hit them in Q3 and we won't have to deal with the mobilization cost in the Middle East. And in those, our assets start working there this quarter. So on the whole, Q3 will be better than 2. And then typically, when we go into the Q4, Blake, our consolidated margins on average, over the years, have been pressured 100 to 200 basis points, kind of on average, 150 basis points as a result of seasonality in the U.S. and it primarily impacts the rig business and the fluids business and we think that, that slippage could be exacerbated this year as a result of the high fixed cost base. Meanwhile, the rental guys and the coil guys will continue recognizing improved results as will International.

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

So it sounds like the one area that sticks out in terms of negative sequential comparison is going to be the fluids management business. But by June, on average, the business as a whole is running higher margins than what was recorded for 2Q? Would that be safe to say as you're already off to a good comparative start as -- for the business as a whole.

T. M. Whichard

As a whole?

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

Yes.

T. M. Whichard

The business as a whole or with respect to fluids, Blake, I'm sorry?

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

Or either the U.S. business or the consolidating business.

T. M. Whichard

Well, as a whole, yes.

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

Okay. And then I guess, I can make my own assumptions in the model, but as we think about the guidance towards 20%, 25% op income growth, is that -- in your model, is that pretty evenly weighted between the U.S. and International driving that?

T. M. Whichard

International is, on a percentage basis, will be up a little higher then U.S. will be on a percentage basis but I'm not going to get into just exactly how much of each.

Blake Allen Hutchinson - Howard Weil Incorporated, Research Division

Sure, I appreciate that. That's as much as I need. And then as we think about CapEx spend in the back half of the year, I'm guessing that most anything that goes internationally is kind of sacred. But kind of just to demonstrate your confidence in the different businesses, what's kind of the next level of areas that you're -- you're just still in this environment, wouldn't be looking to cut?

Newton W. Wilson

Well, this is Trey. As I said, in my remarks, Blake, we've got a very good demand for rental equipment, whether that's blowout preventers, drill pipe tubing rentals. So our rental business is very strong. So we're going to continue to spend some money on rental equipment in the second half. You're going to see -- we're going to see some benefit in the third quarter from the money we spent in the first half. And so we're going to spend some more money on rental equipment. And the rental equipment would include frac stack and well testing equipment as well. As we said in our remarks, we're trying to grow our businesses and having success in growing our businesses in the oily markets. And so, we have to continue to feed that demand pool with additional equipment. We're also going to spend money on big rigs, the 550-horsepower rigs that are kind of our staple, our franchise rigs. We're going to be buying and building more of those rigs in the second half and deploying them both internationally and in the U.S. So those areas will be the major focus of our spending in the second half.

Operator

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

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

Could you give us a little bit more color on Mexico? You mentioned you had 40 rigs there. But are you bringing in other products, complementary products? Fill us in on where you see that going.

Richard J. Alario

Marshall, it's Dick. Yes, we're adding rigs there in the second half of the year, so we'll have more than 40. We're adding some slickline, mechanical wireline units. We already have a few down there. We're adding to that fleet and then we're shipping a couple of coil tubing units. These are units that are designed for remedial work. And there's -- we should have them there this quarter. Those are the things, items that we've identified that will be headed down there shortly.

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

I assume margins there have been pretty good. You're probably not going to improve much on what you have, or is that an incorrect assumption?

Richard J. Alario

You mean using the new assets?

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

Yes, overall margins in Mexico going forward. I wouldn't presume we're going to get a lot of improvement there, are we?

T. M. Whichard

Well, yes, Marshal, we will because just from fixed cost absorption.

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

Okay. Well, that's good.

Richard J. Alario

The other thing I would comment on that the question sort of alludes to, I just don't want the market to miss it. Trey made a comment earlier that we anticipate that some of the assets that we'll be sending down there in the second half the year will be working outside of ATG or what was for formerly known as Chicontepec. So that's a signal that we began to expand our footprint in the country, as well as expand the product lines.

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

Okay, good, good. We haven't heard a lot about Russia lately. Can you give us a quick overview of what's going on there?

Richard J. Alario

Go ahead, Trey.

Newton W. Wilson

This is Trey Wilson. As I said earlier, we're getting much better utilization there. I think we have 2 -- we have a couple of very good, large well-capitalized customers there. We have our 2 larger rigs. They're working continuously under longer-term arrangements. They're working very high day rates and our smaller equipment utilization on that is improving. And we've made some cost structure changes. We've lowered the overall structure, cost structure for our company there and consequently, our financial performance is improving there. So we're pleased with the improvement in Russia.

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

So profits improving, but don't look for that as a good, big area of revenue growth?

Newton W. Wilson

I would say not in the near term, that's correct. [indiscernible] better opportunities in Mexico and other places.

Richard J. Alario

That's what [indiscernible] primarily boils down to. This is Dick, let me just comment. We've said in the past and we still subscribe to this. You shouldn't think of Russia being the biggest part of Key's International business. There are opportunities that run on capital that have better returns and other features of those markets that we just like better. However, it's the second largest well candidate market in the world [indiscernible] to maintenance and workover. So as the biggest player in that business globally, we feel like it's a market we need to be in, need to be able to track and focus on as it changes. And as time goes by, hopefully things in the environment down there continue to improve and stabilize. We'll have opportunities but frankly, today as we sit here, there are better ones in other places that we just like better, so that's where the capital flow is.

Operator

[Operator Instructions] Your next question comes from the line of Neal Dingmann from SunTrust Robinson Humphrey.

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

Just 2 quick ones. Dick, what's your thoughts when you were -- Trey Wilson maybe see about the fourth quarter seasonal decline that we typically see, just your thoughts this year, expectations, kind of how you baked that into your overall guidance you were saying for the second half?

T. M. Whichard

Neal, it's Trey Whichard. The seasonality impact traditionally on average will ding our Q4 results by 150 basis points sequentially, negatively. And that's driven by Fluids and by Rig Services. And that's against consolidated results. We think we're projecting at least as we head into the back half of this year that the impact this year could be greater than what we've seen historically because fundamentally we have a higher fixed cost structure in these markets that are subject to seasonal declines.

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

Okay, great answer, Trey and then just one for you or Dick. You hit this a little bit just as you go across our segments but maybe particularly in the workover side. I'm just wondering on the labor cost, what you're seeing in that particular segment. I haven't heard too much about it.

Richard J. Alario

Sure. Neal, this is Dick. Let me go back to your prior question to add one thing to what Trey said, from a 50,000-foot view, as we grow our International business, the impact of shorter daylight hours and holidays and all these other rigs and equipment that don't work 24 hours around the clock or daylight will become less. All of our international markets that we work in today and most of the rest of the world operates 24/7 in these services. So just another piece of color that as we continue to get larger in the international, the seasonality will become more and more muted. With regard to labor, obviously in these oily and liquids-rich markets, the fight is still on and we have gotten better at recruiting and retaining. You can see that in the -- the best example of that is evidenced by the performance that we had in Coiled Tubing in the quarter. That's an area where we had struggled in the past but not only have we gotten better there at crew retention and training and recruiting, I think the company as a whole is -- I can see signs of improvement but the workforce is short and it's competitive. The opposite is true in the gassy markets and what I would tell you is we -- and I think this is probably true for the whole industry or most players in the industry. We've all gotten better at incentivizing and managing employees who're willing to rotate. We have a lot of rotators in the company now who live in the gaseous markets which aren't as busy and we're -- providing services for us in the oily markets or in rotational in remote bases and that's where the infrastructure challenges and all that comes into play but the good news is this workforce has become much more mobile in this market cycle than it has in the past, and I think we're doing a better job as a company of identifying the needs of the workforce with regard to that. So improving, still very competitive, still short but with our good training programs, a very high focus on recruiting and getting better and better at retention, we feel that the whole picture is getting better for us. And by the way, we certainly recognize that the way we make money is by having highly-qualified people delivering service so it's the absolute #1 focus for Key.

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

Dick, is that more on the key areas then is it fair to say that, that's one of the key areas that gives you the confidence in margins around the Coiled Tubing improvement continuing?

Richard J. Alario

There's no doubt that the self-help that we've dosed ourselves with over the last 120 days or so is a big, big part of that rationale.

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

Okay. And then last one, if I could, just on workovers. Just again, I understand I think your point is well taken as far as the large amount of business from the larger customers. But just wondering when you see, Dick, as far as new capacity still out there, are you seeing either yourselves or just a few peers that I guess are out there, quite a bit new capacity still coming on for the remainder of this year or is that sort of backed away and that should actually maybe be a benefit because of the lack of capacity coming on?

Richard J. Alario

And you're talking specifically about well services, right?

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

Yes, sir.

Richard J. Alario

Yes, I think it's 2 stories. On the rig side, there's certainly muted capacity additions. Part of the reason for that is the replacement ratio, right? The general fleet in the rig side is still pretty old, and so net additions aren't climbing as fast as the capital flow might otherwise generate, nothing like what's happened in the Drilling Rig business. To some degree, the opposite is true on the fluid management side. There's probably a bit more capacity created softness on price and utilization in that business with regard to trucks and frac tanks. The one element of that business which hasn't been going along is the saltwater disposal capabilities. And as you know, we're very big and strong in that business. But in terms of the rolling stock assets and frac tanks, that's not the case. That's one reason we've had to move so much of that equipment from one market to the other. But clearly on the rig side, the attrition rate of the older equipment is having an effect on -- a positive effect for us as a service company on the overall market capacity. And then maybe even bigger component of that is this need to build a new style of equipment for new style of wells. So we're not seeing any threats at this point with overcapacity on the rig side, at least for the kind of work that we focus on and the kind of customers that we tend to target.

Thanks a lot. Operator, we'll conclude the call and could you wrap it up, please?

Gary L. Russell

Thank you, Keanne. This is Gary Russell here. As a final note, shortly after this call, we will post our quarterly rig and truck hours on our website at keyenergy.com under the Investor Relations tab. Also, as noted in our press release, we have focused certain prior period financial information pertaining to our continuing operations, which excludes our Argentina operations. And lastly, a replay of this call can also be accessed on our website under the Investor Relations tab. Thank you for joining us today. That concludes our call.

Operator

This concludes today's conference call. You may now disconnect.

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