Cypress Environmental Partners, L.P.
Q1 2017 Earnings Call Transcript

Published: 13 May 2017

[Operator:]

Welcome to the Cypress Energy Partners First Quarter Earnings Release Conference Call. [Operator Instructions] I would like to now turn the call over to Richard Carson. You may begin.

[Richard Carson:]

Thank you. Hello and welcome to the Cypress Energy Partners’ first quarter investor conference call. I am Richard Carson, the General Counsel. With us today are Pete Boylan, our Chairman and CEO and Les Austin, our CFO. We released our first quarter 2017 financial results and posted the associated press release on our website, cypressenergy.com. In the press release, you will find an important disclaimer regarding forward-looking statements. This disclaimer is integral to our remarks and you should review it. Also included in the press release are various non-GAAP measures that we have reconciled to generally accepted accounting principles. Those reconciliations appear at the back of the press release. So with that, I will turn the call over to Pete.

[Pete Boylan:]

Good morning. Thank you for joining us today and your interest in our company. As outlined in our press release, we announced our first quarter results. We continue to operate with a solid balance sheet, attractive credit facility and finished the quarter with approximately $25 million in cash compared to our revised annual distribution of approximately $10 million. As discussed in March, the first quarter is seasonally our slowest quarter and this year, that seasonal effect was compounded by a lightning strike causing a fire at our Orla, Texas, Permian Basin SWD facility, resulting in an insured loss on the surface facilities there. Although the first quarter financial performance was sequentially down in all segments, we have seen slow, but steady progress through April and into May across all business segments. We have continued to focus on growing and diversifying our customer base and during the quarter we added 21 new customers across our three different business segments. Average domestic inspector headcounts continued to improve and our higher margin nondestructive examination business is doing very well with growing backlog of opportunities. At Brown Integrity, our 51% controlled hydrostatic testing business unit, our backlog has risen over 30% since the end of the first quarter and our utilization has improved substantially so that we should operate profitably for the next few quarters. Our water volumes in April were 4% higher than March, which was also higher than February. Our lines of business are not directly tied to rig count growth or upstream completions and therefore our revenues tend to lag behind the recovery in commodity prices, drilling activity and completions that we expect will eventually benefit our operations. As most of you know, 80% of our SWDs are located in the Bakken region whose recovery has materially lagged behind the Permian Basin. Q1 was also negatively impacted in this region by weather as has been reported by another – number of other public companies operating up there. A significant number of DUCs exist in both basins that when completed should benefit us. On a positive note, our inspection clients are once again starting new projects and increasing their spending on maintenance and integrity work that they deferred when possible during the 2-year industry downturn. Our sponsors, Cypress Energy Holdings and its affiliates, who control our general partner, remained aligned with our common unitholders with approximately 64% ownership interest in CELP. Because of this alignment, CEH has again provided financial support to CELP with temporary relief of the administration fee owed to CEH pursuant to the Omnibus agreement, which would have charged $1 million to CELP this quarter, absent the relief. As with the Omnibus agreement relief provided in prior quarters, CEH did not require any consideration from CELP for this additional support. With CELP’s operating performance sequentially improving in April and into May, CEH may not provide any incremental support for CELP for the balance of 2017. In the first quarter, we continued to evaluate several interesting acquisition opportunities and are currently actively working on four different prospects, while maintaining our disciplined approach to both due diligence and valuation. The lower yield in our common units provides additional flexibility in the consideration we can offer when bidding on accretive opportunities and providing sellers a tax-efficient alternative to cash. CEH remains willing to deploy capital to assist CELP in acquiring attractive assets that may be larger or substantially larger than what CELP can currently acquire independently, with plans to offer those assets to CELP as drop-down opportunities. As we discussed in April, our next distribution will be $0.21 per limited partner unit. Our Board believes it was prudent and responsible to make the difficult decision to reduce our quarterly distribution for the first time since our IPO on January 2014 by cutting the distribution approximately 48%. If the distribution and level is maintained through 2017, it will provide approximately $9.3 million of internally generated capital on an annualized basis compared to the previous distribution level of approximately $0.40 per quarter, or $1.63 annualized. This additional capital will provide the company with increased liquidity and reduced leverage will enable the company to invest in selected growth projects and will strengthen the company’s balance sheet. We believe this action has provided a sound catalyst to reduce our previously elevated cost of capital by de-leveraging the company, increasing the distribution coverage for our unitholders. We are confident these actions will support the long-term interest of our unitholders, employees and other stakeholders. We continue to see encouraging signs with some of the new customer additions, and we remain focused on organic growth and improved SWD asset utilization to improve cash flow that will in turn contribute to the improvement of all of our financial ratios. We continue to believe the fundamental increased demand for both inspection and water disposal remains strong over the long term, but the recovery has clearly been slower than previously anticipated. I would like to introduce Les Austin, our CFO, so that he can walk you through the highlights on the financials.

[Les Austin:]

Thanks, Pete. I would like to take a moment to highlight some of our financial information. Adjusted EBITDA, which we define as net income or loss plus interest expense, depreciation and amortization expenses, income tax expenses, impairments, operating cost, non-cash allocated expenses and equity-based compensation was $2.8 million. $3.1 million of which is attributable to our common unitholders and an EBITDA loss of $0.3 million is attributable to our non-controlling interest holders that own 49% of our hydrostatic testing subsidiary. Distributable cash flow for the first quarter was $1.3 million and on May 15, we will pay our quarterly distribution of $2.5 million or $0.21 per unit. Our coverage ratio was 0.52x, and we expect to see improved performance for the balance of the year, which should positively impact this ratio. I am providing this additional information to further help our investors understand our performance. On a GAAP basis, our net loss in the first quarter was $4.9 million, including impairment charges of $3.6 million related to goodwill impairments at our 51%-owned Brown Integrity division and asset impairments in our pipeline inspection and water divisions. Net loss includes 100% of Brown’s results before deducting the net loss attributable to our non-controlling interest owners. The net loss was comprised of $2.8 million attributable to our common unitholders, $1.2 million attributable to our non-controlling interest holders and $0.9 million attributable to our general partner. In addition to the financial highlights on net loss, adjusted EBITDA and distributable cash flow mentioned previously, I would also note we continue to have over 85% of our revenue generated from investment-grade customers and have continued to win new business with additional investment-grade customers that should be seen in future periods. We are currently bidding on some new major contracts and have picked up some nice new work despite the loss of a portion of our lowest margin inspection work for a good Canadian client to a competitor that was willing to accept those margins. More than 90% of our inspection clients continue to be investment grade. Our leverage ratio, as calculated under our credit facility, was 3.47x versus our covenant of 4x and our interest coverage ratio was 3.68x versus our covenant of 3x with our cash position standing at $24.8 million at the end of the quarter, in part as a result of the financial support from our sponsor. Although the first quarter experienced its consistently seasonal low headcounts as our clients start ramping up work following the holidays, through April and into May we have continued to see our average domestic inspector headcounts increased from the averages experienced in the first quarter of 2017. We closed our Calgary office to reduce our SG&A on April 30. However, we continue to perform services in Canada for several customers through our U.S. based inspection operations. During the first quarter, approximately 99% of total water volumes came from produced water and piped water represented a new high of approximately 52% of total water volumes. As commodity prices continue to improve and drilling activities increase, we expect to have significant operating leverage with our cost structure and minimal maintenance capital expenditures required as volumes increase. We have an estimated 514 drilled and uncompleted wells, or DUCs, within a 15-mile radius of our facilities, comprised of 302 in North Dakota and 212 in the Permian. As prices improve, we expect to benefit from the completion of these DUCs and other newly completed oil wells. Our SWD facilities are only utilized at approximately 23% of their capacity. When activity picks up in the Bakken, we should see some meaningful benefits given 80% of our facilities are located in this region. Several customers recently announced that they were going to increase spending in both the Bakken and the Permian, hence, for example, reported operating an average of 2 rigs in the first quarter, drilling 11 wells since adding 2 rigs and planning to add 2 additional rigs in the fourth quarter to the end of the year with 6 rigs. Our integrity service business, Brown Integrity, Q1 2017 results sequentially declined with an average utilization of 45% during the seasonally low winter period. Given the fixed cost nature of this business, we lose money unless we operate at greater than 60% utilization. We are now growing backlog and operating with much higher utilization that allows us to operate profitably. We continue to see the benefit of our significant investment in this business development talent and we have seen our backlog increase over $2.7 million. We averaged 1,083 inspectors and 15 field personnel per week for the first quarter of 2017. We have over 1,100 inspectors currently working. We disposed of 2.8 million barrels of saltwater during the first quarter of 2017. Average revenue per barrel was $0.68 for the first quarter of 2017. Despite the impact of lower drilling activity, oil prices and disposal rates, the water and environmental business still generated first quarter gross margin of 52.7% and strong adjusted EBITDA with nominal maintenance capital expenditures, which is an attractive relative to many service business serving the energy industry. Maintenance capital expenditures for the three months ended March 31, 2017 were $74,000 reflecting the attractive business model of limited maintenance capital expenditures required to operate our business. This remains a key differentiator for CELP versus virtually all other MLPs. And with that, I will turn the call back over to Pete.

[Pete Boylan:]

Thanks, Les. Our customers continue to be substantially more optimistic about 2017 and that optimism should benefit our business. The Bakken recovery remains slower than we had hoped. And as Les mentioned, the challenges we continue to have with Brown Integrity, our hydrotesting subsidiary, have been meaningful but the improved utilization and backlog should strengthen our performance in this segment. We continue to aggressively look for acquisition opportunities that will allow us to supplement our organic growth and are currently conducting due diligence on several promising potential targets that include expanding our existing lines of business and two completely new lines of business. We are also awaiting bid results on a few major inspection opportunities that Les mentioned. We successfully reduced our Canadian cost structure by moving various activities to our headquarters in the U.S., with the closing of the Calgary office in April. The inventory of DUCs around our facilities, are slowly being completed benefiting the long-term produced water anticipated to be received from some of these wells. The Bakken is and always will be a challenging environment to operate in compared to other more mild climates, especially in Q4 and Q1. Our customers are adding rigs and activity is finally picking up in the Bakken. We have a strong sponsor that has a material economic interest in the LP, owning 64%, that is truly interested in growing the value of the LP interest and assisting in financing acquisition opportunities that are larger than what the MLP could handle independently at this time. We also remain focused on thoughtfully managing our distribution policy to ensure that we continue to have suitable metrics and a viable currency to grow our partnership over the long term. We remain optimistic that we are now positioned to start growing again after this 2-year industry downturn. We truly appreciate your valuable time, investment and continued support, and we remain focused on execution, organic growth and sequential improvement in our current operations. Our board, management team, employees also remain committed to building a great company, with a focus on long-term unitholder value through a disciplined approach to growth. Operator, we may begin taking some questions.

[Operator:]

Our first question comes from Brian Butler. [Operator Instructions] Brian, please state your question.

[Brian Butler:]

Good morning. Thanks for taking my questions.

[Pete Boylan:]

Good morning.

[Brian Butler:]

Can you guys hear me?

[Pete Boylan:]

Yes, sir.

[Brian Butler:]

Just to make sure I wasn’t on mute there. On the water and environmental services piece that was down significantly part of that due to obviously the business interruption. How do we think about that trend coming back through the remainder of the year? Are you back at, call it, the almost 3,000 barrels – or 3 million barrels a quarter kind of pace or is that significantly improving from that level?

[Pete Boylan:]

Well, the 3 million barrels a quarter is, I guess, 33,000 barrels a day and we have seen some improvement, meaningful improvement. In fact, I was just looking at some numbers yesterday and we had a 42,000 barrel a day. A lot of things impact the average daily volumes. Unfortunately, Orla is one of our best facilities. As you know, it’s probably in the most coveted piece of real estate in the United States right now, Reeves County off Highway 285. And so with that facility getting hit by lightning, we have three pipelines under that facility, we were able to get those back online quickly and then we set up temporary facilities and we are now able to handle as many as – we push as many as 70 trucks a day through there, but we are clearly losing a lot of water. And we have been working on a new design that would potentially expand our capabilities at that particular location. So, volumes are hard to predict in this business, but as you can see, we are now about 90 – what was it, 99% produced and we have got a large percentage of it that’s piped. And where we really get the tailwinds is as these wells get completed and we start getting flow back again that’s typically rich in skim oil, you will see the nice tailwinds associated with the skim oil that has been very de minimis over the downturn the last couple of years.

[Brian Butler:]

Okay. Well, maybe another way to ask is how much of – how much volume did you lose because of the fire and the downturn in the first quarter?

[Pete Boylan:]

Well, it’s hard to say, because obviously there is a competitive market and other things going on. And then North Dakota, as I mentioned in my comments, also had some pretty tough weather that many other public E&Ps had commented on or service companies up there. So it’s not just Orla, it’s the cumulative nature of 80% of our facilities being up in the Bakken and 20% of the facilities being in the Permian and our best facility, obviously, having the lightning strike. So I’d be guessing if I could tell you how many barrels we really lost.

[Brian Butler:]

Okay. How about on a daily basis, where was it before the lightning strike and where is it now?

[Pete Boylan:]

A lot depends again on the competitive landscape. But we have had days that are in excess of 20,000 barrels and we had a period of time where there were no barrels and it can float to anywhere from, Les, what 5,000 to 30,000 barrels a day at its peak.

[Les Austin:]

Yes, that’s probably fair.

[Pete Boylan:]

That one facility.

[Brian Butler:]

It seems kind of in line over the last couple of quarters. Is that the right level? Are you seeing any improvement in that pricing or I guess any pressure?

[Pete Boylan:]

Brian, you cut off at the first part of your question. Could you repeat it?

[Brian Butler:]

I apologize. On the pricing on the water disposal, you are running at about $0.68, I think, in this quarter and that’s kind of what you have seen over the last couple of quarters. Are you seeing any improvement as volume – as more activities out there or is that still kind of the right rate to think about disposal?

[Pete Boylan:]

Yes, it’s – again, it’s unfortunate, there is no sound bite simple answer to the question, but I will try to give you a high-level simple answer. In North Dakota, there is still differential pricing between flowback and produced water. And both flowback and produced water have and continue to command higher prices than Texas. So you’ve got that dynamic with 80% of our facilities up there. Texas has seen substantial price competition, and we have seen some people take water at prices that we would pass on the business because all you’re doing is wearing out your well and not making any money. And in other cases, we’ve seen compaction. Offsetting both of those comments is skim oil, and skim oil is a function of, number one, the flowback that’s coming in; number two, the quality of that skim oil; and number three, the pricing of WTI, because generally when we recover that oil and sell it, we are selling it at a discount to WTI plus the taxes, which are materially different between Texas and North Dakota. So, the net of it is, there is a bunch of things going on in the math that ultimately lead to this price per barrel. But as I mentioned, the flowbacks that have skim oil can provide some positive tailwinds to that average revenue per barrel, if that helps answer your question.

[Brian Butler:]

Okay. And then on the Brown Integrity services you guys talked about operating profit being positive in the remainder of the year. Is that positive on a gross margin level or is that on the operating profit level?

[Pete Boylan:]

Both.

[Brian Butler:]

Both?

[Pete Boylan:]

Yes. Brown had a very, very disappointing first quarter. There were a couple of big jobs we thought we would win that we didn’t, so they got deferred. And as you know, we took a lot of cost out of that business last year. We clearly were top heavy in our supervisors in Q1 in anticipation of being able to staff and handle multiple simultaneous 24/7 jobs and those jobs didn’t materialize. The backlog, as Les mentioned, is strong for Q2 and Q3, and we’re bidding on some work for the balance of the year. So it’s our intention to not only operate profitably at gross margin, EBITDA and cash flow, but if we find ourselves in a position later this year where we don’t have the backlog to cover the fixed cost, we will take additional fixed cost out of the business to address that issue.

[Brian Butler:]

And from a profitability point, is this going to be better or worse than where we were in ‘16?

[Pete Boylan:]

Les, you want to comment on that?

[Les Austin:]

Well, I think obviously in 2016, we had $2.5 million of annualized cost that we took out of the business when we shutdown the Houston operations in May and June of 2016. So that run-rate cost should be out for the entirety of 2017 as Pete previously referenced. And to the extent that the backlog continues to build like we have seen, we should see improved performance over the ‘16 run-rate.

[Brian Butler:]

Again, across both the gross margin and the EBITDA line?

[Les Austin:]

That would be our expectation.

[Pete Boylan:]

Okay. And just to put it in perspective, right now with market-based margins on jobs, we have got our breakeven cost structure at EBITDA at what about $600,000, $700,000 a month?

[Les Austin:]

I think so, yes.

[Pete Boylan:]

Right in that ZIP code, if that’s helpful. And so, once you cover your fixed cost, you have a substantial contribution margin and we have a plan in place to reduce that fixed cost if necessary to the extent we don’t have the revenue to support it.

[Brian Butler:]

Okay. And on the distribution and the reduction that has been announced, can we talk about, I guess, the coverage in the first quarter was about 0.52x and I am guessing this was – you expect for the full year that the coverage is going to be over 1. Is that the right assumption? And what was the board’s thinking of getting to this level? Is that a coverage of 1x or something better than 1? And how do we think about growth going forward in regards to what a reasonable coverage metric would be the board comfortable with?

[Pete Boylan:]

Sure. I think nothing has really changed in terms of philosophy on the coverage ratio from the time we did the IPO. We went at 1.15x. We told everybody that we weren’t going to have a fixed philosophy or policy on coverage ratio. We were going to be thoughtful and consider what’s really going on in the business, what might happen in M&A, and that is our goal to run with the coverage ratio in excess of that over time. But given some of the seasonal aspects of our business that we’ve talked about and other things, obviously the coverage ratio is too low in Q1. And it was for a lot of those reasons that we concluded that it was appropriate to adjust our cost of equity capital by rightsizing the distribution until we can have some sequential repeatable growth in the underlying business and/or an acquisition opportunity that yet changes all of those dynamics.

[Brian Butler:]

Okay, great. Thank you for taking my questions.

[Pete Boylan:]

Thank you.

[Les Austin:]

Thanks.

[Operator:]

Okay. Our next question comes from Patrick Wang with Baird. Please state your question.

[Patrick Wang:]

Hey, good morning guys. Just a couple of quick ones for me. So, can you – moving back to the Orla facility, can you give us an update on the progress around rebuilding that? Is it fair to say that for the entire 1Q, you guys were operating with your temporary surface facility? And then what are your latest thoughts on the in-service timing and capacity of the new facility compared to your previous one?

[Pete Boylan:]

Sure. Good morning. You are correct, first quarter was all on temporary storage and gun barrel and so forth as well as the piped water. We now have two different designs that we are in the process of pricing. There is a few long lead time items in terms of ordering, fabricating, delivering and installing some of the equipment. We happen to own 18 acres there, fee simple with no royalty, which is very, very unusual in the Permian Basin. And there are a number of other business opportunities that we are evaluating above and beyond produced water and flowback handling that have become attractive, lucrative opportunities in the marketplace. And so owning the land and having that much to work with, we are trying to have a thoughtful master plan that would allow us to introduce these other lines of business that could be things, for example, like the TRD facility, a truck washout facility, freshwater and brine pits, potentially even some solids landfill disposal. So we are in the process of studying all of that. So I do not anticipate us having the permanent facilities open in the second quarter. It’s probably going to be a third quarter event, but we haven’t yet decided exactly what we’re going to be rebuilding. We – owning all the land, we also believe we’ve got the opportunity to put a second wellbore in there and that could double our downhole capacity. The existing wellbore we have, we believe, is not only a very good one, but it operates at a low pressure and we believe can over time take quite a bit of water.

[Patrick Wang:]

Okay, got it. So, it sounds like there could be some nice organic growth opportunities there. Okay. So, then moving just over to the Canadian SG&A savings, can you help us size up the degree of cost savings you expect to see from there going forward, relative to, let’s say, your 2016 run-rate?

[Pete Boylan:]

Les, you want to take that?

[Les Austin:]

Yes, we are not going to talk about any specific cuts that we have done, but the savings that we have pulled out is consistent with what we have been running in there. It’s probably safe to say that in the second quarter, we are continuing to work down the customer that changed providers. And so we are not anticipating seeing any cost structure of significance on the gross margin line, but the operating margin line with removal of the office and the operations up there should have a material impact there.

[Pete Boylan:]

We have about 10 or 15 people and office lease copiers, phones, all the stuff that goes with that.

[Patrick Wang:]

Alright, got it. And then my last one, so moving to Brown, so is it fair to assume that the current backlog levels there that you have already booked for 2Q and 3Q, is that sufficient to cover 60% plus utilization level?

[Pete Boylan:]

Definitely in Q2 and Q3, well in excess of it.

[Patrick Wang:]

Okay, that’s helpful. That’s it for me. Thanks, guys.

[Pete Boylan:]

Thank you.

[Operator:]

And it doesn’t look like we have any further questions. I will now turn the call back over to Peter Boylan.

[Pete Boylan:]

Okay. Thanks, everybody. We appreciate your time. We look forward to reporting a better Q2 when we talk to you next time. Have a great weekend. Thank you.

[Operator:]

This concludes today’s conference call. Thank you for attending.