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Tesco (NASDAQ:TESO)

Q2 2012 Earnings Call

August 06, 2012 11:00 am ET

Executives

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

Robert L. Kayl - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Analysts

Joseph D. Gibney - Capital One Southcoast, Inc., Research Division

Jeffrey Spittel - Global Hunter Securities, LLC, Research Division

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

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

Josh C. Lingsch - Simmons & Company International, Research Division

John R. Keller - Stephens Inc., Research Division

Gregory M. Macosko - Lord, Abbett & Co. LLC

Douglas Garber - Dahlman Rose & Company, LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Tesco Corporation Second Quarter 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would like to introduce your host for today's conference, Mr. Julio Quintana, President and CEO. Mr. Quintana, you may begin your conference.

Julio Manuel Quintana

Thank you, Michelle. Good morning, ladies and gentlemen, and welcome to TESCO's Second Quarter 2012 Earnings Conference Call. I'm Julio Quintana, TESCO's President and CEO, and I'll be hosting the call. Bob Kayl, our Chief Financial Officer, is with me on the call. I'll begin with some general comments on the quarter, then Bob will give you an overview of our financial results. Following Bob's remarks, I'll return and provide an update on our business and plans for the future.

Before I begin, it is important to note that during the course of this call, Bob 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 that 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 a reconciliation of these measures to GAAP measures, and we refer you to that release for additional information.

Now on to our second quarter results. We reported net income and EPS in Q2 of $13.1 million or $0.34 per share on $136.7 million of revenue compared to $14.4 million of net income or $0.37 per share in Q1 on $152.4 million of revenue. Operating income increased during the quarter to $24.6 million, up from operating income of $19 million for Q1. Operating margins increased to 18% for Q2 as compared to 12% in Q1. This quarter's results include a $13.3 million pretax gain on the sale of CASING DRILLING business, which is included in the aforementioned operating income. When the results are adjusted for the gain from the sale of CASING DRILLING, as well as other one-off items, which we will discuss shortly, operating income would have been $14.7 million or 10.7% OI margin and then EPS would have been $0.22.

We ended the quarter with a backlog of 41 units with a potential revenue value of $57.3 million. Today, our backlog stands at 42 units. The sale of CASING DRILLING is the second quarter -- excuse me, the sale of CASING DRILLING in the second quarter opens a new chapter in the history of TESCO. We have created excellent organic top line growth over the recent years and have struggled at times with one-off costs as we have grown internationally. With the focus traded as a result of the CASING DRILLING sale, our go-forward strategy will have in its core an obsession with execution excellence. This focus, coupled with our innovative culture, should provide a solid foundation to deliver new products, improving operating results and ultimately long-term value for our shareholders.

I will get into this in more detail after Bob summarizes the financial results. Bob?

Robert L. Kayl

Thank you, Julio. I will discuss our second quarter 2012 operating results by business segment and then give some comments on our corporate and research and engineering expense.

Starting with Top Drive. Revenue totaled $90.1 million for the quarter, 15% higher than the same period last year but down 12% sequentially from prior quarter. The decrease from prior quarter is primarily a result of the lower number of Top Drive units sold, mostly associated with the lack of production of our ESI model, which was recalled in the first quarter due to gearbox supply chain issues. We sold 34 units for the quarter compared to 39 units in Q1 and 24 units in Q2 2011. Of the 34 units sold for the quarter, there were 33 new units and 1 used unit from our rental fleet. Of the 39 units sold in Q1, 35 were new units and 4 were used units. With the 33 new units delivered to customers in Q2, we ended the quarter with a backlog of 41 Top Drive units with a potential value of $57.3 million.

During Q2, we continued to see moderate Top Drive sales activity, and today, our Top Drive backlog stands at 42 units with several sales pending. We do not include a sale in our backlog until the contract is signed and we have received a nonrefundable deposit, if required by the contract. With that, 8 ESI units dropped from the backlog as a result of cancellations. Top Drive rental revenue was $33.9 million in Q2, down slightly from $34.6 million in Q1 and $34.7 million in Q2 2011. The decrease from Q1 was due to a decrease in the number of operating days. Currently, our fleet of rental Top Drive stands at 130 units, the same as at the end of Q1 2012. At quarter end, we were in the process of adding 7 new units to our Top Drive rental fleet.

Aftermarket sales and service revenue was $16.9 million in Q2, up from $16.8 million in Q1 to $13 million in Q2 2011. The increase from prior periods is due to higher market demand and a larger installed base of TESCO Top Drives. We continue to see increasing momentum in this revenue stream.

During the second quarter, we continue to work through the gearbox housing issue discovered in March 2012. We have completed the inspection for 12 units out of the first 18 ESI units produced. Based on the results of the completed inspections and repairs today, we have increased the specific warranty provision by $500,000 during the second quarter, in addition to the $3.9 million specific warranty provision recorded during the first quarter.

Our Top Drive operating margins were 25% in Q2, an increase from 24% in Q1 but down from 28% in Q2 2011. The increase from Q1 is primarily due to the $3.9 million ESI warranty expense recorded in the first quarter, partially offset by fewer used sales in Q2. The decrease from Q2 of last year is primarily due to the different mix of new Top Drive models delivered this quarter and the decrease of sales of used and consignment Top Drives, which typically provide higher margins.

Now on to Tubular Services. Revenue was $41.6 million in Q1 (sic) [Q2], down from $43.5 million in Q1 but up from $34.8 million in Q2 2011. Proprietary revenue was $33.1 million in Q2, up from $32.6 million in Q1, primarily as a result of increased MCLRS work, primarily offset by decreased proprietary casing running jobs and decreased sales of CDS equipment. Our Q2 2011 proprietary revenue was $29.2 million, which included no sales of CDS units. We performed 817 proprietary casing running jobs in Q2 compared to 859 in Q1 and 914 in Q2 2011. The Q2 2012 job count was negatively impacted by the continued rig migration from the dry gas fields to the liquid rich fields in North America and to regions where conventional work is more accepted by our customers and decreased activity in Latin America. Our CDS fleet was 306 units at the end of Q2, a slight decrease from the end of the first quarter as 2 of the CDS unit sales recognized during the quarter were new units out of our service fleet that have yet to be put to work.

Conventional revenue decreased to $8.6 million in Q2 versus $10.9 million in Q1, primarily due to decreased number of jobs in North America, which was partially offset by increased activity in the Middle East. Our Q2 2011 conventional revenue was $5.6 million. Overall, Tubular Services operating income in Q2 was $4.6 million with an operating margin of 11% compared to operating income of $4.9 million and 11% margin in Q1 and $2.5 million of operating income in Q2 2011.

Moving to CASING DRILLING. On June 4, the company completed the sale of substantially all the assets of the CASING DRILLING business to Schlumberger and recognized a pretax gain of approximately $13.3 million from the sale. This gain excludes any adjustment for net working capital. The final determination of the net working capital adjustment, in accordance with the sale agreement, should be finally recognized in the third quarter financials. CASING DRILLING revenue in Q2 was $4.9 million as compared to $7.1 million in Q1 and $3.9 million in Q2 2011. The revenue in Q2 only includes activity up to the date of the sale or approximately 2 months of activity. CASING DRILLING operating income of $8.9 million for Q2 includes the $13.3 million gain from the sale. In addition, we incurred approximately $1.9 million of severance costs related to the disposal of CASING DRILLING and $1.5 million expense for a historical CASING DRILLING injury claim. Excluding these items, CASING DRILLING operating loss would have been approximately $1 million.

Now on to corporate expenses, which were $8.4 million in Q2 compared to $7.4 million for Q1 and $9.2 million in Q2 2011. The sequential increase was due to higher stock compensation recorded in the second quarter.

Research and engineering costs for Q2 were $3.4 million compared to $2.5 million in Q1 and $2.4 million in Q2 2011. The increase from prior periods was primarily due to increased spending for our new Top Drive model. Research and engineering continues to be a strategic investment for the company, and we plan to continue to invest in our proprietary technologies and new Top Drive models. Q2 included $2.9 million of foreign exchange losses as a result of the increased volatility in the global economy and the changes in the several foreign currencies. In particular, fluctuations in the valuation of the U.S. dollar compared to the Russian ruble and several Latin American currencies significantly impacted this quarter. Our effective tax rate for Q2 was 35% compared to 30% in Q1 and 29% in Q2 2011. Our effective tax rate, which is income tax expense as a percentage of pretax earnings, increased from prior periods due to fluctuating mix of pretax earnings in the various tax jurisdictions in which we operate around the world.

Turning to the balance sheet. At June 30, 2012, cash and cash equivalents were $32.6 million compared to $23.1 million at December 31, 2011. During the second quarter, we received $39 million of cash from the sale of CASING DRILLING and used the cash to pay off approximately $25 million of debt, repurchase and build capital equipment for our remaining business lines. Total capital expenditures were $17.3 million in Q2 compared to $16.6 million in Q1 and $12.1 million in Q2 2011. We project our total capital expenditures for 2012 to be between $50 million and $60 million based on current market conditions. Most of these expenditures are discretionary and are for equipment, for Top Drive and Tubular Services expansion.

In April 2012, we renewed our credit agreement to provide a revolving line of credit of $125 million. The new credit facility has a term of 5 years and all outstanding borrowings on the new agreement are due and payable in April 2017.

I'll now turn the discussion back to Julio.

Julio Manuel Quintana

Thanks, Bob. Let me recap where we're at. Revenue for the quarter was $136.7 million and our quarterly operating income was $24.6 million. The operating income included $13.3 million gain from the sale of CASING DRILLING. Partially offsetting that gain was $1.9 million of CASING DRILLING severance costs and $1.5 million of expense from a historical CASING DRILLING injury claim. In addition, we had significant foreign exchange losses of $2.9 million due to valuations in the U.S. dollar compared to the Russian ruble and several Latin American currencies. When the performance is corrected for the gain on the sale of CASING DRILLING, as well as one-off items of CASING DRILLING costs and the foreign exchange losses, operating income would have been for $14.7 million or 10.7% OI margin and the EPS would have been $0.22.

Digging a little deeper into each of our business lines let me first address the Top Drive business. Today, our Top Drive sales business is healthy. We delivered 34 Top Drives during the quarter compared to 24 in Q2 2011. This was down from 39 units delivered in Q1. The drop from Q1 was primarily due to having to shift our production plans for new units given the ESI gearbox issue. We have successfully reallocated those ESI productions slots with other Top Drive models. We believe that the swap of our ESI gearboxes will take until Q4 to complete.

We ended the quarter with a backlog of 41 units, and today, our backlog stands at 42 units. Effectively, today, we are booking new Top Drive orders at about the same rate as our production level for third-party units. This provides a level of confidence that the product sales business should continue to hold up in the near term and provides us an opportunity to deliver new orders on a shorter delivery schedule. The sequential decrease in backlog was a combination of higher production rates, a slight decrease in order flow compared to the first quarter and a cancellation of 8 ESI units as a result of the gearbox problems. In addition, we estimate that we have lost over 20 ESI Top Drive sales as a result of this quality issue in addition to the cancellations. This has led to an overall decrease in backlog. From the positive side, the units we have repaired are working well and demand for the model remains high. We expect to begin to aggressively sell this unit again over the coming months. And today, we are taking orders for Q1 2013 delivery.

Manufacturing capacity now stands at 12 to 14 units per month depending on the models produced. This is the same as it was in the first quarter and consistent with the end of 2011. Keep in mind that our capacity serves both our third-party sales, as well as our internal demand for rental additions. Aftermarket revenue improved from last year. We are focused on this business and believe that it should continue to improve as rigs with Top Drives remain working and our installed base continues to grow. Today, our installed base stands at over 1,000 Top Drive units around the world. This installed base increased by over 12% in 2011 and more than 20% over the past 2 years. We believe that we can continue to differentiate TESCO from the competition with our service excellence and this business will provide organic growth for TESCO in future years.

On the rental front, we had steady revenue from our Top Drive rental business. Our operating days decreased 5% to 6,658 days for Q2 2012 as compared to 7,039 days in Q2 2011. The decrease in operating days was due to fewer operating units in Russia and the Asia-Pac region, partially offset by more units operating in Latin America. Our average day rate improved over last year.

Looking forward, we are beginning to see some customers opt to purchase Top Drive units instead of rent them, particularly in Russia and the Asia-Pacific region. As we have done historically, we continue to work the right balance between selling used Top Drives from our fleet and maintaining a healthy utilization rate. Today, 71% of our Top Drive rental fleet is deployed for international operations. We anticipate maintaining our rental fleet size around the current level of 130 units.

Switching to Tubular Services. In Q2, we generated $4.6 million operating income with 11% operating margin. We performed 817 proprietary jobs in Q2, down from 859 in Q1 and 914 jobs in Q2 2011. Lower job count was financially offset by significantly higher MCLRS revenue from the comparable periods. Our MCLRS business contributed $4 million of revenue during the quarter. Consistent margin performance continued despite an observed decrease in activity associated with the shutdown of rigs in East Texas and North Louisiana, slow operations in Latin America and the Canadian spring break-up. We believe that our proprietary activity will continue to increase in the coming quarters. We are currently expanding in several key international markets, which will help drive profitable growth in this segment in the medium to long term. With some new product offerings and a continued focus on cost and efficiency, we are taking steps to improve profitability of Tubular Services. We are committed to making this business a major contributor to TESCO, both in revenue and bottom line.

Finally, I want to take a few minutes to speak to our vision and strategy. Every September, our board meets to review the forward 5-year plan. With the sale of CASING DRILLING, the question of our future strategy is more important than ever. We are deep in the throes of defining that future and are confident that TESCO's best years are yet to come. We're not yet ready to provide you with the full picture, but there are some items that are worthy of note. One, we have the business momentum today to achieve a record annual revenue year in 2012 at near-record earnings. Two, we have a balance sheet which shows no debt, cash on hand and constantly improving. Three, we are the second-largest Top Drive provider and recognized for our Top Drive service excellence. Four, we continue to redefine pipe automation with our CDS technology and likely heading for a record revenue year in Tubular Services. What is also clear is that our strategy must shift to best-in-class execution excellence. We believe that the combination of TESCO's innovative culture and execution excellence will provide significant long-term value to our shareholders. We will now take some questions. Michelle?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Joe Gibney with Capital One.

Joseph D. Gibney - Capital One Southcoast, Inc., Research Division

Julio, I was wondering if you could discuss broader outlook on the sales activity, what you're seeing this quarter. I know you talked to sort of a moderate sales activity now, several sales pending. You gave some color on some of the ESI units getting dropped off out of backlog. But just general pulse in terms of order indicators, how things feel on the Top Drive side?

Julio Manuel Quintana

I think in North America, Joe, there's clearly been a drop in order flow as expected, not as obvious internationally. I think the activity there has actually held up reasonably well. In fact, you could argue that if we had actually put those 20 Top Drives we missed on the ESI and not have the cancellations, our backlog would, in fact, have been up and that almost all would've come from international sales. So as I look kind of forward, I would say expect a soft order flow for the next few quarters in North America, possibly some of that, if not most, being offset by international order flow.

Joseph D. Gibney - Capital One Southcoast, Inc., Research Division

Okay, helpful. And then just on the gearbox issue, indicated you sort of get this cleaned up by the end of the year. Just sort of what are some of the remaining hurdle points that you have to kind of get through this?

Julio Manuel Quintana

It's really just a question of getting the gearboxes ordered and back. Those things are fairly complicated. Castings take 22 to 26 weeks delivery. So what we've done is we've got 4 or 5 locations around the world -- 5 around the world, both in China and here in the U.S. and Canada where we're actually buying effectively extra boxes to ensure that we have enough boxes to provide it for everybody. And it's just a matter of those getting those boxes built, swapped out in the field and get the Top Drive up and running. Just the logistics of putting that together.

Joseph D. Gibney - Capital One Southcoast, Inc., Research Division

Okay, fair enough. And just one more and I'll turn it back. Bob, the R&D run rate now should be holding north of this $3 million per quarter as you guys work on additional Top Drive models? Just kind of curious how we should think about that.

Robert L. Kayl

No, I think the R&D expense in the second quarter was somewhat higher than the run rate will be, mostly because we're in process of designing a new Top Drive model and the bulk of that cost hit the second quarter. I think the run rate will kind of look like the last couple of quarters. The $2.5 million to $3 million last couple of quarters, I think the go-forward rate should be lower than that.

Operator

Your next question comes from the line of Jeffrey Spittel with Global Hunter Securities.

Jeffrey Spittel - Global Hunter Securities, LLC, Research Division

Julio, maybe if we can expand a little bit on some of the big picture comments that you made. And I know this is early on and I'm sure you're probably not necessarily going to commit to anything. But in terms of the strategic options on the table, could you kind of a frame, in general terms, what they might be? And could something further down the line -- along the lines of a sale or partnership with a larger service company be among the options that are on the table?

Julio Manuel Quintana

Yes, obviously, Jeff, that's one topic that I won't cover. Obviously, we're a public company, and as public companies we're available like any other company. But certainly, our strategy, Jeff, very clearly calls to get operational excellence with what we do. Look, we have a $600 million plus or minus revenue stream. We know we need to be able to generate better earnings off of that. We clearly recognize where our difficulties lie operationally. So you're really going to see a 2-faceted strategy. One is get the house in order, get these one-off items more under control that will drive profitability for a $600-million business. And that's kind of first and most critical short-term phase, short-term meaning the next 18 months or so. And then beyond that, we have some great ideas from an R&D perspective as we think that will be very complementary to both pipe handling philosophy -- around Top Drives and so forth, as well as Tubular Services. That will be a part of it. And then, of course, with a healthy balance sheet and acquisitions will be a logical addition, although for me acquisitions are not the strategy. Our acquisitions are a tag on to the strategy once we define it. So that's really what we're focused on, Jeff. I really don't have any comment on whether or not partnering with another company may or may not make sense now a year from now or 5 years from now.

Jeffrey Spittel - Global Hunter Securities, LLC, Research Division

Sure, understood. And then maybe shifting to the rig migrations that have been going on in North America. As it stands today, some of that downtime in the tubular and rental piece of the fleet, does that look like it's a little bit further along the lines of running its course?

Julio Manuel Quintana

Yes, absolutely. Certainly, over the last couple of quarters, as we all know, the dry gas activity has decreased. Work has shifted to places like Midland and Western Oklahoma and so forth that have a nice potential, but there's a cost to doing that. I would say we had 90% of that shift -- or 80% of that shift is completed. And so I would -- assuming that the rig count stays as it is now in North America, then I would expect that to stay pretty stable.

Operator

Your next question comes from Rob MacKenzie with FBR.

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

Questions for you. I apologize if you may have mentioned this earlier, but I must have missed it if you did. Did you say how much your Top Drive sales, Julio, was from -- those revenue was from used sales during the quarter?

Robert L. Kayl

Of the sales, Rob, there was only 1 used unit. It was about roughly $1 million of used sales revenue.

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

Okay. And switching to Tubular Services. As you mentioned, your proprietary running jobs were down sequentially but your revenue was actually up about 1%. Can you give us some more details on what you're seeing about either is it pricing that drove that or is it mix or both? Can you give us some color there?

Julio Manuel Quintana

Some of it is mix, Rob. But the biggest impact was the MCLRS revenue in the second quarter, did about $4 million of revenue of MCLRS in the second quarter, about $0.5 million of the CDS sales. The proprietary service revenue was fairly -- it was down slightly consistent with the job count but those 2 other areas made up for it.

Robert L. Kayl

And just to help a little bit more there. We do classify our MCLRS business as proprietary. I think basically what happens, Rob, is as we move from places like East Texas with the horizontal development and so forth into places like Permian, we find ourselves doing less CDS job count, more conventional job count. That was one shift. And then also, in Latin America, particularly in Colombia, a lot of the contracts were tied to CASING DRILLING. And so getting that -- and they would have probably worked there. And getting the CDS work there pulled out of CASING DRILLING and reassigned to us has just taken a couple of months. So I think that will kind of sort itself out over the couple of months.

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

Okay. And I wondered if you could give us some feel for how much you think the gearbox issue has hampered your ability to sell Top Drives here over the past quarter or so and add to your backlog versus how much of the weakness here is just industry-related.

Julio Manuel Quintana

Yes. So as I mentioned, certainly, we've seen some industry-related decrease in North America, not so much internationally. We really haven't seen anything that would suggest that our ESI problem has spilled over into any other of our models, in terms of any perception of quality or anything like that. So as I've mentioned, we estimate 8 -- excuse me, we had 8 cancellations of ESI. So if you take the 42 that we quoted you today, in theory, that would have been 50. And then on top of that, we have another 20 or so ESIs, at least 20 that we think we could have had but were not able to deliver because we couldn't get the gearbox and so forth, so we had to walk away from the opportunity. If you actually put that together, in fact, our backlog would have been up. And so I would say the bulk of the backlog problem we have today, although the softening in North America is a contributor, really have been more associated with our own doing of our ESI problem.

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

Okay. And my last question is, last quarter, I think you mentioned you're interested in smaller Top Drive that you thought would be successful in certain Latin American markets. I think Argentina was the one you mentioned. That's obviously changed dynamic. But could you give us an update on how that product's playing out?

Julio Manuel Quintana

Yes, sure. No, actually -- obviously, we haven't changed dynamics. I think we still have a great potential there, notwithstanding the instability in the country. But generally, for Top Drive sales, instability of the country is kind of secondary. We sell Top Drives and they do with it what they want. Yes, we have actually built 150-ton units. We have 3 built already. We want to put them into the rental fleet and make sure that we work all the kinks out of it, but we're very happy with that design. And in essence, we're going to be starting taking orders on that pretty quickly.

Operator

Our next question comes from Daniel Burke with Johnson Rice.

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

Julio, you've been pretty optimistic about the ability to improve Tubular Services margins over time. Can you maybe address the margin trajectory or the margin experience you had internationally in Q2 and sort of the trajectory you see on the international side of Tubular Services over the next 1.5 years or so?

Julio Manuel Quintana

Sure. Daniel, look, our -- my position is still clear, which is we can run this business at 20% type of margins instead of 11%. Obviously, we've done a nice job of moving from loss to 11%, so we've kind of stagnated here for the last couple of quarters. As you recall from my comments, there are several things that had to happen in order to get that profitability to 20%. One was to get North American business healthy, which effectively we've done. Two, is get the MCLRS business consistently yielding kind of what we did here in Q2. So that's kind of in place, that's going well. The third one is more sales of CDS product. So remember, we're starting to sell CDS as a product. We only have $0.5 million of sales this quarter, but we do see that ramping up for the rest of the year. Still, it will be choppy as we get ourselves up and running but I think that will continue to be a big contributor to profitability. And the fourth one is the stabilization and growth in critical markets of the Tubular Services business internationally. So some things are moving quite well there, other things are not that. For example, Asia-Pacific has done great. They continue to expand the business there. I think we'll see a great second half for Asia-Pac compared to the first half and they continue to grow. As I mentioned, Colombia is one of the setback for us in the last couple of months, in part because of the CASING DRILLING sale but that will take us here 1 month or 2 and in fact Russia, seeing some of that get fixed already as we speak, so that needs to take place. We have been investing very heavily in the Middle East. As you know, we bought a company there in Egypt. We had a little bit of a decrease in Egypt associated with some of the political turmoil there, but that's quickly being offset by revenue uptake in Saudi. That project has gone very well as we're ramping up that very important contract for us. Iraq should continue to expand there. We have a couple of other major bids in a couple of countries in the Middle East that I think, when combined, will help tremendously to get that profitability up and running there. So I'm still optimistic, Daniel, about being able to put that all together but I do recognize that we're a quarter or 2 behind on that strategy.

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

Okay, great. And then maybe one for Bob. On the working capital side, as the ESI issue continues, it looks like you pulled a little bit of -- a few dollars out of working capital. But Bob, what's the outlook on the working capital side in the second half of the year?

Robert L. Kayl

Yes. I think we should continue to see improvements there, Daniel, both on collection of receivables and on inventory. You're correct in stating that there's quite a bit of inventory that we're basically holding that's not moving because of the ESI gearbox issue. And that number is north of $10 million. On the receivable side, we had -- we did make pretty good progress through the second quarter but I think there's room to continue to improve that for the second half of the year.

Operator

Our next question comes from Josh Lingsch with Simmons & Company.

Josh C. Lingsch - Simmons & Company International, Research Division

It looks like the average selling price for Top Drive units is down about 10% sequentially. Was this primarily attributable to the mix of Top Drives coming out of backlog not having the contribution from the ESI models?

Robert L. Kayl

Yes, that's right, Josh. It dropped slightly from Q1 to Q2, that's really just dependent on the mix. Then, the 4 used sales that we had in Q1, those were pretty high valued sales as well.

Josh C. Lingsch - Simmons & Company International, Research Division

Okay, okay. And so backlog was essentially flat since end of the quarter. Is it fair to assume that you're in the range of 12 to 14 units production capacity in July?

Robert L. Kayl

Yes, that's correct. We said -- yes, our current capacity is between 12 and 14 units a month and that includes both third-party production plus our internal rental fleet demand.

Josh C. Lingsch - Simmons & Company International, Research Division

Okay, great. And then one final one. With respect to the preferred supplier agreement with Schlumberger. Can we see what kind of benefit are you expecting for CDS sales in the back half of the year? Is that something that will materialize? Or is that a '13 event?

Julio Manuel Quintana

No, no, no. We should see some recognition of revenue in 2012 and beyond. And of course, that will be a function of how fast they can ramp up the CASING DRILLING business. But we are optimistic that will be a pretty good contributor over the next couple of quarters.

Operator

Our next question comes from John Keller with Stephens.

John R. Keller - Stephens Inc., Research Division

Just a couple of quick ones on the rental side of the business. I think you mentioned that you had 7 in process that you're adding to that fleet. Do those have contracts? Or where are those going to be going?

Julio Manuel Quintana

Generally, we're in the mode, John, as you know, of adding to the fleet and then selling through the fleet. So I think you'll see us become a little bit more aggressive here in the second half of the year in delivering -- we have some commitments to deliver used units to several customers. And so those 7 will be to replenish some of the ones that we're selling. I think, correct me if I'm wrong, I think most of those units will go into Russia or Latin America and 2 for North America.

John R. Keller - Stephens Inc., Research Division

Okay. And I guess -- I mean, are you seeing that business change? You alluded to the fact that maybe in Russia, you were seeing some customers move toward the buy versus rent model. I mean, is that pretty specific to Russia? Or is that something that's more prevalent in other markets as well?

Julio Manuel Quintana

That comment was very specific to Russia, a little bit in Asia-Pacific. But let's be clear when we say that, we're not necessarily equating that to a decrease in rental activity, meaning we're still proposing to keep the rental fleet at about 130, John. It's just that a customer that chooses to -- that will rent, then chooses of buy, then we'll focus on 2 of the customers still would like to rent. So overall, I think there's some shifting going on but the Top Drive rental fleet is staying in this range. I think it's perfectly legitimate.

John R. Keller - Stephens Inc., Research Division

Okay, fair enough. And then maybe just one more on the CDS sales. Excluding the agreement with Schlumberger, sort of how is that going? How relative to your expectations maybe in terms of sort of penetrating the market with that? And that's my last one, I'll turn it over.

Julio Manuel Quintana

We're bidding on quite a few. But I would say, the booking is a little slower than we had anticipated, mostly since with our own research limitations we are focused on a lot of other stuff. But the interest is still quite high. So we're still comfortable that, that will become a substantial contributor.

Operator

Our next question comes from Gregory Macosko from Lord, Abbett.

Gregory M. Macosko - Lord, Abbett & Co. LLC

Just one question with regard to CapEx. Just give me some sense of where you expect to focus that in? Am I right in saying that's higher than last year?

Robert L. Kayl

No. It's pretty consistent with last year, Greg. Most of that CapEx today is going towards Top Drive units that are replenishing the used units sold out of rental fleet and then probably about an equal amount going into Tubular Services equipment, both for CDS but also for conventional equipment to support those CDS operations.

Julio Manuel Quintana

Yes, Greg, if you look at how the history of TESCO is certainly for the last decade I don't think it's any different now. 95% or 98% of our capital expenditure really is tied to equipment for expansion of the business, almost all of which is discretionary. And so we'll sell off the rental fleet and then replenish it as a way to keep the unit -- health of the units healthy. That seems to work very well for us. And really, we don't invest in CapEx for the most part on the Tubular Services front unless it's tied into a pretty good contract. So if we look, for example, in the Middle East where we have a couple of outstanding bids, you can be looking at $10 million to $20 million of CapEx for something like that. But we would only spend that if we actually won a multiyear, large-scale contract. That tends to be the nature of our capital expenditure.

Gregory M. Macosko - Lord, Abbett & Co. LLC

And just to remind me, if I had missed it. The rental unit operation, those -- that will be 130 units, that's basically -- no, you're adding 7. So does that relate to any particular contract?

Julio Manuel Quintana

No. As I mentioned earlier, what we typically do is sell off. So if I'm saying that we will put 7 into the fleet and keep the rental fleet at around 130, that effectively what I'm saying is that we will sell off older units because of that. That tends to be what we're doing. So if we just replenish it based on wherever the needs are, as I mentioned, a couple here in North America and a few to Russia, a couple to Latin America.

Gregory M. Macosko - Lord, Abbett & Co. LLC

And I would assume then that will be part of the strategic plan that you're in the process of putting together now.

Julio Manuel Quintana

You bet. Yes, the go-forward plan for the Top Drive rental business is a key part of that strategy. But again, there's nothing here that suggests to us that the rental business is not going to stay strong. Remember, as I've put in the prepared comments, 70-plus percent of our Top Drive rental fleet operates in international operations already and that business is still pretty steady.

Operator

Next question comes from Doug Garber with Dahlman Rose.

Douglas Garber - Dahlman Rose & Company, LLC, Research Division

I wanted to ask you about the Top Drive margins going forward. It seems like you're going to be selling more rental units in the back half of the year, one are those already in the backlog to sell the rental unit. And would that kind of mean that the margin should tick up here in the back half of the year due to the mix? Or are there other moving parts as well?

Robert L. Kayl

I think, Doug, the way you need to think about the used sales is those are pretty spotty levels, so anywhere from 1 to 5 units on any given quarter. We do not include those in our backlog. But generally, you're right. To the extent we have more used sales that should improve margins going forward. If you look at the new sales that we've booked during the quarter, those margins have been pretty consistent with what we booked over the last couple of quarters. We don't see a lot of opportunity to really improve those margins short of just trying to take cost out of our system, whether it's expediting the gearbox issue or just getting better sales price with some of those sales. So generally, the new sales margins should stay pretty flat but the used margins could drive the overall margins higher.

Julio Manuel Quintana

All in the context, of course, of the comment we made in the past that you should expect us to continue to improve our supply chain efficiency. Remember, last year, we had that hiccup there in Q3 that caused a little bit of extra cost in the system, and we're still finding ways to eliminate cost in that and just see that continue. Also, the mix of Top Drives as we start selling more ESIs, for example, could also drive that performance upward.

Douglas Garber - Dahlman Rose & Company, LLC, Research Division

Once the ESI gearbox issue is fixed, is the margin for that unit higher than your other units?

Julio Manuel Quintana

I would say slightly higher, yes. Certainly, as the revenue per unit would be higher and so the operating income on a per unit basis be higher, but the margin would be presumably slightly higher.

Douglas Garber - Dahlman Rose & Company, LLC, Research Division

Okay. And then just last one, the Top Drive margins, that $500,000 warranty cost that was -- that went against your margins in the second quarter, so that would have been about 26% without that charge. Is that the way to think about it?

Julio Manuel Quintana

Yes.

Operator

Mr. Quintana, at this time I am showing no further questions, please proceed with your further remarks.

Julio Manuel Quintana

Thank you, Michelle. In closing, I would like to thank you for participating in the call today and your interest in TESCO. We are entering a new chapter for our company, our third decade of existence. We believe that excellence of delivery will drive shareholder value like never before. We look forward to speaking to you next quarter. Thanks.

Operator

Ladies and gentlemen, this does conclude your conference for today. Thank you for participating, and have a great day.

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