Cypress Environmental Partners, L.P.
Q2 2017 Earnings Call Transcript

Published: 14 Aug 2017

[Operator:]

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

[Richard Carson:]

Thank you. Hello and welcome to the Cypress Energy Partners' second quarter 2017 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 second 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 an essential component of our remarks and is important that you 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 towards the end of the press release. So with that, I will turn the call over to Pete.

[Pete Boylan:]

Thanks Richard. Good morning everybody. Thank you for joining us today and thank you for your interest in our company. We continue to operate with a solid balance sheet, liquidity and finished the quarter with approximately $22.5 million in cash. We are encouraged by the improved second quarter results compared to the prior year and sequentially compared of the seasonally low Q1 '17 results. We've continued to focus on growing and diversifying our customer base and during the quarter we added 20 new customers across our three business segments. Average domestic inspector headcount continues to improve sequentially and compared to prior year. Our hydrostatic testing utilization rate has materially improved and our backlog grows over 33.5% in the second quarter. However, it continues to underperform relative to its true potential. Our water volumes improved sequentially, although they continued to lag below our prior year volumes primarily as a result of the natural decline curves on the water in North Dakota. 80% of our SWDs are in the Bakken region with 53 rigs currently drilling, up 25 rigs from one-year ago. The recovery of which has materially lagged that of the Permian Basin, which currently has 379 rigs drilling, up 202 from one-year ago. Fortunately, a significant number of DUCs exist in basins that one completed should benefit us. Additionally, in July, Mother Nature struck again hitting one of our North Dakota SWB facilities that was struck by lightning leading to a fire and an additional ensure damage at that location. We won four years without a lightning strike unlike many competitors and then within six months we have suffered two hit. On a positive note, our inspection clients are once again starting new projects and increasing their spending on maintenance and integrity work that was deferred whenever possible during the two-year industry downturn in 2015 and 2016. Remarkably, we now finally have a quorum at FERC with new commissioners appointed by the President and confirmed by the Senate just last week that should free up some projects previously caught in gridlock. We remain fortunate that we have a business model that requires a very modest amount of maintenance capital expenditures. During the quarter, we reached an agreement with an existing customer to develop a new pipeline connecting 15 new oil wells in North Dakota to one of our existing SWDs. Assuming we can timely secure the necessary entitlements, this should benefit us later this year and is consistent with our long-term strategy. Our sponsors, Cypress Energy Holdings and its affiliates who control our general partner remained aligned with our common unit holders with approximate 64% ownership interest in CELP. Because of this alignment Cypress Energy Holdings has again provided financial support to see 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. In the second quarter, we continued to evaluate several interesting acquisition opportunities, including some that are under letter of intent and exclusivity, and in the later stages of due diligence. We continue to look at new acquisition opportunities across all of our business segments as well as traditional midstream opportunities, while maintaining our disciplined approach to both due diligence and valuation. Although our yield is still elevated, our common units provide additional flexibility in the consideration we can offer in bidding on accretive opportunities and providing sellers a tax efficient alternative to cash. CEH remains willing to deploy capital to assess the CELP in acquiring attractive assets that may be larger than what CELP can currently acquire independently with plans of course to offer those assets to CELP as drop down opportunities. As we announced in July, the quarter's cash distribution will be $0.21 per limited partner unit. If this distribution level is maintained through 2017, it will provide approximately 9.9 in total distributions. We continue to see encouraging signs with some new customer additions in our inspection division as we are focused on organic growth to improve cash flow that will in turn contribute to the improvement of our financial ratios. We continue to believe the fundamental increased demand for inspection and water disposal remain strong over the long term but recovery has been slower than previously anticipated, especially in the Bakken with $50 oil prices. The hydrostatic testing integrity division continues to underperform our expectations but has encouraging potential given the number of projects we are currently bidding. I would now like introduce Les Austin our CFO so that we can walk you through our financial highlights.

[Les Austin:]

Thanks Pete. I would like to take a moment to highlight some of the financial information. We defined adjusted EBITDA as net income or loss plus interest expense, depreciation, amortization and accretion expenses, income tax expenses, impairments, non-cash allocated expenses, equity-based compensation expense, less other extraordinary or non-recurring items. Adjusted EBITDA for the second quarter was $4.8 million, which is almost entirely attributable to our common unit holders. Distributable cash flow for the second quarter was $2.1 million which includes a payment of $1 million for our final 2016 cash tax obligation. And today, we will pay our quarterly distribution of $2.5 million or $0.21 per unit. Our coverage ratio was 0.84 times, up from 0.52 times in the first quarter and we would expect to see improved financial performance for the balance of the year, which should continue to positively impact this ratio. I am providing this additional information to further help our investors understand our performance. Our net income in the second quarter was 0.5 million. We did not record impairment at any of our segments in the second quarter of 2017. The net income was comprised of $1.5 million attributable to our common unit holders, a net loss of 0.1 million attributable to our non-controlling interest holders and a net loss of 0.8 million attributable to our general partner. In addition to the financial highlights, our net income, 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 reflected in future periods. We are currently bidding on some new major contracts and have picked up some new work. More than 90% of our inspection clients continued to be investment grade. Our leverage ratio as calculated under the credit facility was 3.58 times versus our covenant of 4 times and our interest coverage ratio was 3.46 times versus our covenant of 3 times with our cash position standing at $22.5 million at the end of the quarter in part as a result of the financial support from our sponsor. Our average domestic inspector headcount increased approximately 9.5% from the first quarter of 2017. We closed our Calgary office to reduce our SG&A expenses on April 30, but continued to perform services in Canada for several customers through our US based inspection operations. During the second quarter, approximately 94% of total water volumes came from produced water and piped water represented approximately 50% of our total water volumes. As commodity prices continue to improve and drilling and completion activities increase, we expect to have significant operating leverage with our current cost structure and anticipate minimal maintenance capital expenditures as volumes increase. Our latest research shows an estimated 500 drilled and uncompleted wells or DUCs within a 15 mile radius of our facilities, with 300 in the Bakken North Dakota region and approximately 200 in the Permian Texas Basin. As prices improve, we expect to benefit from the completion of these DUCs and other newly completed oil wells. Our salt water disposal facilities are currently utilized at less than 25% of their capacity. When activity picks up in the Bakken, we should see some meaningful benefits considering 80% of our salt water disposal facilities are located in this region. During the quarter, we reached a tentative agreement with an existing customer to explore and develop a new water pipeline connecting over half a dozen new oil wells in North Dakota to one of our existing salt water disposal facilities. Assuming we can complete this conditional agreement, expansion capital expenditures related to this agreement should benefit us assuming the water pipeline completes later in the year. Our integrity service business' second quarter operating results improved significantly over the first quarter operating results with a 74% average utilization of field personnel compared to an average utilization of 45% during our seasonal low first quarter. Given the fixed cost nature of this business, we must operate at a rate of at least 60% utilization to breakeven. Backlog continues to grow and we are operating with a much higher utilization that should allow us to operate more profitably. We continue to see the benefit of our significant investment and business development talent in this segment resulting in increased backlogs. We averaged 1,186 inspectors and 18 field personnel per week for the second quarter of 2017. We have approximately 1,300 inspectors currently working. We dispose of almost 3 million barrels of salt water during the second quarter of 2017. Average revenue per barrel was $0.68 for the second quarter of 2017. Despite the impact of lower drilling activity, oil prices and disposal rates, the water and environmental business generated a second quarter gross margin of 70% and strong adjusted EBITDA with nominal maintenance capital expenditures which is attractive relative to many service businesses serving the energy industry. Maintenance capital expenditures for the three months ended June 30, 2017 were $14,000 reflecting the attractive business model of limited maintenance capital expenditures required to operate our business. This remains a key differentiator for us versus virtually all other MLPs. And with that I will turn the call back over to Pete.

[Pete Boylan:]

Thanks Les. The rising activity levels as a result of the growing rig count have clearly benefited virtually all of our customers and in turn us despite a generally negative macro investor sentiment toward energy over the last three or four months. The Bakken's activity and financial results continue to be lower than anticipated. And as Les mentioned, the challenges we continue to face with Brown Integrity, our hydro testing subsidiary have been significant. But the improved utilization of field personnel and the increased backlog are anticipated to 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 and as mentioned have assigned LOI with exclusivity on one transaction we are excited about. We recently started a new line of business in our inspection division and have hired some talent and already won our first project for this new division from an investment grade company. We have a strong sponsor that has material economic interests in us owning approximately 64% of the LP. Our sponsor is truly interested in growing our value and assessing and financing acquisition opportunities that are larger than what we could handle independently at this time. Our inspection business has turned the corner and we believe the best is yet to come. We truly appreciate your interest in CELP, your valuable time and your continued support. And we remain focused on execution, organic growth, and sequential improvement in our current operations. Our Board of Directors, our Management Team and our employees also remain committed to building the best company we can be with a focus on long-term unit holder value through a disciplined approach to growth. Operator, we may now begin taking some questions.

[Operator:]

[Operator Instructions] Our first question comes from Marshall Adkins of Raymond James, please state your question.

[Marshall Adkins:]

Good morning guys, can you hear me?

[Pete Boylan:]

Yeah, good morning Marshall, how are you.

[Marshall Adkins:]

So it sounds like the inspection area has had a very nice uptick. And that at least at this stage continues going. Couple questions on that. Give me an overview what's driving, you mentioned early in the call that you know we're getting the regulatory thing worked out, in washing at least we're headed in that direction. But what's driving that, what driving your confidence this continues in the future.

[Pete Boylan:]

It's a good question. I think it's a combination of things. Number one is, I think we're doing a much better job of evangelizing the story about our capabilities and broadening the number of customers, we offer our inspection and integrity services to and we've only scratched the surface there, Marshall. I think there's over 1,200 plus customers that regularly spend money on inspection and integrity and we're doing business with less than 100 of them. If we can continue to pick up four, five, six, ten new customers a quarter, it always starts out with a handful of guys. As you probably recall, our NDE, non-destructive examination in some of our other integrity work is substantially higher margin than for example our basic new construction inspection services for welds and coating and so forth. So that can be as much as a 10 to 1 ratio of profitability with those type of opportunities. And even as new construction slows down over time, maintenance and integrity will continue to grow. And so we beefed up our business development team, we're still looking at adding talent to it. And we've now assigned those 1,200 plus clients to individuals who have a focused effort on calling on those prospects and we think over time that will pay great dividends. In some cases, we knock on doors for years before we get a breakthrough. In other cases, you happen to introduce your resources capabilities at an opportune time where they're getting ready to do an RFP or not satisfied with the current vendor. And the door opens and you can actually put people to work pretty quickly. So that's a primary focus.

[Marshall Adkins:]

So it sounds like it's more of a market share situation rather than just the industry itself getting a lot better is that a fair characterization?

[Pete Boylan:]

I would say it's both, but that's a fair characterization and the reason I say it's both is during '15 and '16, you know better than I with a lot of the companies you cover, every energy company was under some level of duress and had to cut expenses and really manage their balance sheet with the sharp decline in commodity prices. And so there are some things that you can defer and you can't defer them forever because you need to be a prudent operator and comply with DOT and PHMSA and operate safely. But there's some discretion on when you do some maintenance and integrity work, and so I think, everybody that had to manage their balance sheet and deal with the realities of the downturn did so. And then as you know there were many new construction projects that either couldn't get financed or there wasn't a sufficient level of commitment or activity to justify the projects and/or in some cases with the administration, projects got held up at FERC and/or at the state level. And so a combination of the markets improving a little bit, people starting to spend more both on maintenance and integrity as well as a bunch of new projects that have been green-lighted in a variety of basins and then some of those that were held hostage to the whims in Washington with FERC are happening as well. We for example have been awarded a very large project in the north east and we're hopeful that that project will indeed proceed now that the gridlock is starting to be unwound, but there's no assurances and until we're putting the inspectors out there on the project, that's just an example of something that we thought that project was going to go forward some time ago, but it slid to the right with the gridlock.

[Marshall Adkins:]

And then just shifting over to the water side and I might have missed this, because I got on a little bit late, but the damaged facilities, what are the plans there and in terms of your future opportunities, are you seeing more piped opportunities and could you comment on geographies where you do see expansion opportunities?

[Pete Boylan:]

Sure. First, the damaged facilities, so the first facility that got hit is our Orla facility, down off 285 and Reeves County, probably the best real estate in the United States right now and we have finalized the redesign, we're going to use this as an opportunity to build a better facility. We, as you may recall, have a vision of ultimately having a variety of services at an SWD. This particular facility has three pipelines into it and there's a tremendous amount of activity around the area and our vision has always been to pipe whenever economically viable for the customer, water to the facility as opposed to truck it. It is a competitive market and there was price erosion during the downturn and there is plenty of competition, but the activity there is very robust. Incremental services, we might consider adding in the future there would be a solids facility, capable of taking tank bottoms and drilling mud and so forth, potentially a truck washout facility and ultimately potentially a recycling facility, but first things first, we were back up taking the pipe water in about eight days after the lightning strike, but we did spend some time redesigning the site because we bought that under construction. It wasn't our design and so we saw an opportunity to build a better facility. As it relates to the North Dakota facility, it was our Grassy Butte facility, it didn't do a whole lot of volume because of the economics of the Bakken and what's happening with only 53 rigs working, but we did lose several thousand barrels a day, so we are working through the insurance process right now and evaluating some opportunities with some producers in the area and it remains to be determined exactly what we will do there in terms of rebuilding it. As it relates to other geographies, we remain very interested in getting bigger in Texas. We continue to look at the scoop and the stack, but quite frankly, we just haven't found good opportunities that have an appropriate risk reward profile, given the need to stay away from the areas of known seismicity. We've looked at a number of opportunities up in the northeast and with the consolidation that's going on up there, with the Rices, the EQTs, the Anteros and the recycling, we again just haven't found the appropriate risk reward profile. There is one opportunity we're still looking at that's interesting, but it's too early to say. The formations up there will not take much water. For the most part, Pennsylvania does not allow salt water disposal wells and so most of the injection wells are in Ohio, so people do a fair amount of clean-up and reuse of produced for completions when there are fresh water. But, there are some opportunities available in the Eagle Ford right now. We always look at those things, but the Eagle Ford rock just doesn't produce a lot of water and therefore there is less pipeline opportunities there, but that's kind of a big picture on how we continue to look at the liquids side of the waste business and the solid side is pretty interesting, especially with elevated rig count and these longer laterals. There is a tremendous tonnage of waste that needs to be properly handled with the completions of these wells.

[Operator:]

Our next question comes from Brian Butler of Stifel.

[Brian Butler:]

Just on the disposal pricing, it looks like it's held up pretty good on salt water disposal. Can you give some thoughts on if that trends continue during the third quarter and how to think about it kind of in the back half of the year?

[Pete Boylan:]

Yeah. So good question, Brian. It's a multi-dimensional kind of average rate. So there's differential pricing in North Dakota for a flowback versus produced water that you don't really have in Texas and other places. We have some managed facilities that provide some management income and then of course you've got the skim oil recovery, which is a function of how rich is the oil and the water, what kind of recovery and what kind of oil prices are there available on the sale of that and of course there is material - materially different economics today in what we receive for oil in the Bakken as an example with its discount to WTI and the taxes up there versus taxes. So having said all of that, it's held up reasonably well and - that's kind of what goes into the math and unless, Les, you've got anything to add? I don't think we see anything really changing on that.

[Les Austin:]

The only thing that could change on that is if we execute the construction of the pipeline and then we'd have a new revenue stream from that transportation.

[Pete Boylan:]

Yeah. Thanks for pointing that out. That's something I missed. So I mentioned in my prepared remarks, we've entered into an agreement with a publicly traded energy company in North Dakota to build what will be about a 10 mile pipeline, connecting three different well pads, and 15 state of the art wells that we're working on all the entitlements right now and that would be one of the first opportunities we've had to actually build the pipeline as opposed to the client building the pipeline directly to our facility. Those are the two different models out there and if we complete this, which we anticipate doing, have a chance to deploy some growth CapEx, we think it's got attractive returns and to Les' point would actually enhance those numbers.

[Brian Butler:]

On that pipeline actually, just can you give a little color on what's the magnitude of the capital to be deployed and when you talk about attractive returns, is that 20%, is that something better, any color there would be helpful?

[Pete Boylan:]

Yeah. I'd rather not comment on the returns just for competitive reasons. But, the size of the opportunity is probably about $2.5 million of growth CapEx. But needless to say, we wouldn't be pursuing it if we didn't consider it to be attractive and accretive for the MLP.

[Brian Butler:]

And then you talked about the skim oil being a contributor. Now that you've seen flow back go from, I guess, 1% to closer to 6%, do you have any detail on what the skim oil contribution in the second quarter was?

[Les Austin:]

I think that's disclosed in our 10-Q that we just filed while we were on the call here and so that should be available for you fine.

[Brian Butler:]

On your taxes in this quarter, your tax rate looked somewhere close to 30%. Do you have any color on what pushed that up and how to think about it again also first '17 as the full year?

[Pete Boylan:]

I'll make a couple of comments and I'll let Les elaborate on that. 90% of an MLP's income needs to be qualifying. There's a kind of 10% safe haven. Because of our small size, we have opted to be conservative and block our non-qualifying income, which is primarily our PUC inspection and integrity business, where we have to pay, I think, in excess of about 40% tax on that work we do for public utility companies in various states. It's great work that still has good net economics, but it's substantially less lucrative on an after tax basis. As we get bigger as a company and no longer need to block that because we've got enough size to have it fold within the 10% safe haven, that will be incrementally accretive. But that's primarily what you're seeing as it relates to cash taxes and the timing of the payment related to what's due to the IRS for the calendar year 2016 is my recollection, but Les you may want to.

[Les Austin:]

Yeah. So the three primary components of tax are what Pete talked about, our PUC business in the inspection and integrity. We pay federal and state primarily California for that business. In Canada, as we're winding down Canada, we pay taxes on that income stream and then the total MLP pays a small amount of Texas margin tax. So those are the three components to tax. So the mix of work in the quarter on the inspection side with the winding down of the Canadian work and the ramping up of the PUC work are what led to that current quarter expense.

[Brian Butler:]

And then one or two more. Just on the sponsor's willingness to continue to provide fee relief at about $1 million dollars a quarter, how do we think about this in the back half? I know it's kind of an open question of will there, won't they, but just thinking about what level that can be, can it be less than that or is it variable in between it? Just your thoughts would be helpful.

[Pete Boylan:]

Sure. Well, everything you said, the qualifiers are correct and yes, it could be less. Ideally, we would like to see the business continue to recover and grow where we don't need to provide financial support. We actually didn't need to do it for covenants or anything, but we chose to do it this quarter and it's something that we look at on a quarter-to-quarter basis, discuss with both the board of directors of the LP and the ownership of the holding company and I think we've demonstrated over the last several years that our interests are aligned with the shareholders and we've been very supportive. We, someday, may require some consideration like most other sponsors received when they support an MLP, but to date, we have provided this support free of charge without a drip or without equity or some type of note or what not, because again our focus is on creating long term value and growing the dividend again. If that's helpful?

[Brian Butler:]

You said you're not dripping any comments without the relief, where would have leverage been in the second quarter? I think you said it was at about 3.58. If you did not have the relief, would it have been just under 4 or I guess it would have been definitely higher?

[Pete Boylan:]

Certainly, would have been higher, but it wouldn't have been a covenant issue.

[Les Austin:]

Yeah. It wouldn't have been. You can take the TTM EBITDA and just pull $1 million off of it and that will give you the calculation.

[Operator:]

Our next question comes from Patrick Wang of Baird.

[Patrick Wang:]

So on the contract renewal front, it looks like you guys continue to make some nice progress with building the customer base with those 20 odd this quarter, but I'm just looking at the existing business, how would you quantify the renewal risk that you're facing with any of your major existing contracts that are coming due. Can you just give us a sense of the percentage of contracts relative to your total before you expect to renew in the near term?

[Pete Boylan:]

Just to refresh everybody's memory is the way this business works is virtually every one of our customers are publicly traded entities that require MSAs and contracts and all of them operate a little differently with work orders or POs or different things. But, as we stated when we took the company public, there is no such thing as a long term contract. It's some type of take or pay arrangement or a guarantee, so we have to earn our business regularly and have been doing so with our inspection and integrity business very well for 13, 14 years since it was started. It is a cyclical business, substantially less than stuff tied to completions and as you may recall, when the financial crisis happened in '08 and '09, the inspection business softened a little bit and clearly the inspection business also softened some during this dramatic downturn where we went from $100 oil to $25 oil during '15 and '16. Having said all of that, we do have multi-year pricing arrangements with some customers. We have current pricing arrangements with others, some review pricing annually, some review it just randomly if the company decides to go out and test the market and so we regularly deal with that all the time. We have been quite successful here of late with some contracts that came up for the opportunity to revisit pricing and I'm pleased to state that we just won a nice piece of integrity work with a great publicly traded customer that we had never done integrity work for in the past, we had only done new construction work for them and so we're excited about that, but that's kind of how it works in the business and we feel like we're in good shape, taking good care of our customers, but again, you don't have long-terms, so I hope that answers your question a little bit.

[Patrick Wang:]

And then just a couple of quick follow-ups here. So on the Canada business, with the wind down of the physical footprint during the second quarter, how much of a benefit in SG&A reductions where you able to realize during the quarter and then should we expect some incremental benefit to hit in the third quarter?

[Pete Boylan:]

Les, you want to take?

[Les Austin:]

Like I said, we closed the office down in April. We will probably see the majority of that incremental benefit starting in the third quarter, but we were able to extract several hundred thousand dollars out of the G&A for that.

[Pete Boylan:]

And we're still operating in Canada, servicing a number of clients, primarily out of the US. We have one full time employee up there focused on business development and we were fortunate in that our real estate lease was coming up for expiration and so we didn't get stuck with any multi-year real estate obligation.

[Patrick Wang:]

And then lastly back over to the Permian facility, do you have an update on the timing for when you expect the new facility on to service. It seems like you finally have the blue prints all finalized and then looking forward to some incremental service lines that you could potentially add in the future, but at least for the base new service facility, do you have an expected in service timing?

[Pete Boylan:]

Yeah. I would hope that we can get that done by the end of the quarter, if not early October. The long lead time items or the storage tanks and we've spent a fair amount of time thinking about what's state of the art and lightning avoidance and we hired a consultant to further evaluate that in light of having the bad luck of getting hit with two facilities. Again, we have other competitors that I won't name that have had many more facilities hit. Mother Nature is Mother Nature, but that would be my guestimate on timing.

[Operator:]

[Operator Instructions] Yeah. I'll turn the call back over to Peter Boylan for concluding remarks.

[Pete Boylan:]

Well, thank you, everybody. We appreciate your time and we'll look forward to speaking with you next quarter. Thank you.

[Operator:]

Thank you. This does conclude today's conference call. We thank you for your participation. You may disconnect your lines at this time and have a great day.