Calfrac Well Services Ltd.
Q2 2017 Earnings Call Transcript

Published: 27 Jul 2017

[Executives:]

Fernando Aguilar - President, Chief Executive Officer, Director Mike Olinek - Chief Financial Officer, Vice President of Finance Scott Treadwell - Vice President of Capital Markets and Strategy

[Analysts:]

Sean Meakim - JPMorgan Ben Owens - RBC Capital Markets Stan Manoukian - Independent Credit Research Ian Gillies - GMP John Watson - Simmons & Co. Jon Morrison - CIBC Jeff Fetterly - Peters & Co.

[Operator:]

Good morning. My name is Denise and I will be your conference operator today. At this time, I would like to welcome everyone to the Calfrac Well Services Ltd. second quarter 2017 results conference call. All lines had been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. [Operator Instructions]. Thank you. Fernando Aguilar, President and Chief Executive Officer, you may begin your conference.

[Fernando Aguilar:]

Thank you Denise. Good morning and welcome to our discussion of Calfrac Well Services second quarter results. Joining me today on the call are Mike Olinek, Calfrac's Chief Financial Officer and Scott Treadwell, our Vice President of Capital Markets and Strategy. This morning's conference call will unfold as follow. I will provide an executive summary of the quarter, after which Mike would provide an overview of the financial performance of the company. I will enclose the presentation with an outlook for Calfrac's business. After the presentation, we will open the call to questions from the phone. In a news release today, Calfrac reported second quarter 2017 results. Please note that these financial figures are in Canadian Dollars unless otherwise indicated. Some of our comments today will refer to non-IFRS financial measures, such as adjusted EBITDA and operating income. Please see our news release for additional disclosures on these financial measures. Our comments today will also include forward-looking statements regarding Calfrac's future results and prospects. We caution you that these forward-looking statements are subject to a number of known and unknown risks and uncertainties that could cause our results to differ materially from our expectations. Please see our news release and all our regulatory filings for more information on forward-looking statements and these risk factors. As shown in our results this morning, the second quarter of 2017 represented continued growth from the unsustainable activity and pricing levels seen over the last few years. I would first and foremost like to thank all the employees at Calfrac that have delivered these results. Our people have maintained a high level of execution and cost management in a field of rapid growth that speaks to the talent and commitment of our team and deserves to be congratulated. Although market volatility was rampant during the quarter, our customers continue to execute on their stated programs, including more intensive completion designs across North America. Additionally, we saw increased focus on safety and execution from producers which are hallmarks of our business. in fact, Calfrac was given an award for outstanding completions vendor of the year from a major client in Pennsylvania where our record of safety and productivity are the best-in-class and more importantly, that performance continues today despite the demands of rapid growth in our business. Calfrac continues to engage with clients for further reactivations in North America over and above the two fleets that recently commenced was in North Dakota. We have begun the process of reactivating our San Antonio operations which could provide a beachhead for further activity gains late this year. Above all else, Calfrac seeks to work with professional operators who pride safety, productivity, technology and value rather than solely cost in their operations. As I look at our client list across North America, I know the number of top tier operators among our roster. As we begin the second half of the year, focus has absolutely shifted to 2018 for many industry watchers. While a number of discussions have occurred and we have some indications around the activity levels next year, until our clients disclose a proof capital plan for 2018, we have little to no certainty of those indications. Now, I will pass the call over to Mike who will begin with an overview of our quarterly financial performance. Mike?

[Mike Olinek:]

Thank you Fernando and thank you everyone for joining us for today's call. Consolidated revenues in the second quarter increased 116% year-over-year due to 140% increase in fracturing activity in North America. Adjusted EBITDA for the quarter was $39.9 million compared to negative $14.1 million a year ago. These improved results were driven primarily by significantly higher and more consistent utilization in North America, although results in Latin America and Russia also improved as compared to 2016. In addition, the company adjusted its stock based compensation accruals during the quarter, resulting in a $5.2 million improvement to adjusted EBITDA from the same quarter in 2016. This was partially offset by a $0.6 million increase in stock option expense due to additional options granted during the period. Turning to Canada, second quarter revenue was up 145% from the same quarter in 2016 primarily as a result of improved fracturing activity and higher pricing although it was partially offset by a smaller average job sizes due mix. The number fracturing jobs was higher due to an overall increase in completion activity in Western Canada and a greater focus on pads DUC completions that are less impacted by ground conditions. A number of coiled tubing jobs more than doubled from the second quarter in 2016, primarily due to the nature of Calfrac's coiled tubing business which supports the company's fracturing operation. Revenue for fracturing jobs decreased by 19% from the same period in the prior year as the company's job mix included a higher proportion of activity in lower intensity fracturing regions. Operating income margins increased by approximately 2,210 basis points year-over-year, which was primarily related to improved utilization and pricing. In the United States, revenue in the second quarter of 2017 was 220% higher than the same quarter in 2016 due to a 131% increase in active fracturing capacity as well as better pricing and productivity in all regions. Revenue per job increased by 61% due mainly to higher activity in North Dakota and Pennsylvania, although some work in Colorado did not include profit, which resulted in a lower revenue per job than what otherwise would be expected. This increase in revenue was also partially magnified by a 4% appreciation in the U.S. dollar. The company's United States operations generated operating income of $25.2 million during the second quarter of 2017 compared to an operating loss of $0.8 million in the same period in 2016. The turnaround to positive operating income was primarily due to the higher revenue base combined with prudent cost management. This increase was offset partially by $4.7 million in reactivation costs that were incurred during the quarter. SG&A expenses decreased by 6% in the second quarter of 2017 as the comparable quarter contained $0.3 million in bad debt expense. Revenue from Calfrac's Russian operations increased by 40% during the second quarter of 2017 from the same period in 2016. This increase in revenue was attributable to the 35% increase in fracturing activity as well as the 20% appreciation of the Russian ruble as compared to the prior year. Revenue per fracturing job increased by 8%, primarily due to the appreciation of the Russian ruble, offset partially by the completion of smaller jobs due to customer and job mix. Operating income in the company's Russian segment was $4.8 million compared to income of $3 million in 2016 due to currency exchange levels as well as a more productive and cost effective operation. Calfrac's Latin American operations generated total revenue of $28.6 million during the second quarter of 2017, an 18% decrease year-over-year. Revenue in Argentina declined primarily due to a 50% reduction in cementing activity as well as a 6% appreciation in the Argentinian peso. An operating loss of $2.2 million was incurred during the second quarter of 2017 compared to a loss of $4.4 million in the same quarter of 2016. The loss was due to lower utilization combined with higher labor costs. In addition, the company incurred $1 million of expenses to retrofit a fracturing fleet that will be dedicated to high-pressure operations in the Vaca Muerta unconventional gas play during the third quarter of 2017. Restructuring costs of $0.4 million were also recognized in the second quarter of 2017. SG&A expenses decreased by 65% in the second quarter of 2017 as the comparable quarter contained a bad debt provision of $4.6 million related to work previously performed in Mexico. Calfrac recorded a largely unrealized foreign exchange loss of $16.3 million during the quarter compared to a $1.5 million loss in 2016. Foreign exchange gains and losses arise primarily from the translation of net monetary assets or liabilities that are held in U.S. dollars in Canada and Latin America and liabilities held in Canadian dollars in Russia. The company's foreign exchange loss in the second quarter of 2017 was largely due to the translation of U.S. dollar denominated liabilities held in Argentina as the value of the Argentinian peso depreciated against the U.S. dollar during the second quarter. The translation of U.S. dollar denominated assets held in Canada also contributed to the foreign exchange loss as the U.S. dollar depreciated against the Canadian dollar. Turning to the balance sheet. The company had approximately $49.4 million of cash, including one fully-funded equity cure as well as working capital of approximately $293.4 million at the end of the second quarter of 2017. In addition, Calfrac had used only $2.8 million of its credit facilities for letters of credit and had borrowings of $45 million on its credit facilities, leaving $252.2 million in available liquidity subject to borrowing based limitations at the end of the second quarter. As at June 30, 2017, the company was in full compliance with its financial covenants. Calfrac's 2017 capital budget has been increased from $45 million to $65 million, which is mainly focused on sustaining capital projects to support the company's existing pressure pumping operations in Canada and the United States. I would now like to turn the call back to Fernando to provide our outlook.

[Fernando Aguilar:]

Thank you Mike. Before I give a detailed summary, I would like to offer our thoughts on the macro trends at work in our industry. In all of our North American operations, a material increase in rig count along with a strong improvement in drilling productivity has coupled with significant gains in completion intensity to fundamentally tighten the supply-demand balance in our business. In Calfrac's case, our North American operation, running just over 60% of our equipment, is now approaching 2014 levels, both in terms of stage count as well as sand pump. In the rig count environment, that was meaningfully higher than 2016, remains over 50% below the 2014 peak. This change in the demand drivers for our business means that regardless of short term noise in rig count or oil inventory reports, hydraulic fracturing is becoming or has become more and more critical to our clients' production and cash flow growth in North America. As a consequence of this ramp-up, we have seen multiple instances of poor performance on the part of many competitors in the field driven, in large part, by the sale of equipment but also due to labor shortages. Calfrac made no secret of our plan to ensure our stacked equipment was not cannibalized, our focus on remaining an employer of choice in spite of the challenges presented by the downturn and today, we are reaping the rewards of that strategy. Our operations are working well with basin leading execution that's establishing and cementing key relations with top customers and top tier producers across North America. It is our commitment to a safe and productive operation that guided Calfrac through the downturn and continues to set us apart in our industry. The outlook for the company's operations in Canada remains positive and the early ramp-up of activity post breakup bodes well for the third quarter. We are in the final stages of reactivating a seven fleet in Canada based in Red Deer that will primarily service larger completion opportunities in the Deep Basin and which will focus initially on one major new client in the area. Calfrac's plan is to reactivate an eight fleet in the latter part of 2018. However, labor availability and client programs in 2018 remain sources of uncertainty. We will keep markets updated on our plan as it evolves into the fourth quarter. As expected, proppant demand in Canada continues to grow rapidly and Calfrac's internal supply chain network has delivered with almost all those clients waiting on sand today in 2017 and is being recognized as a risk mitigation tool by our clients. Pricing improvements in the second quarter were welcome and other view. However, our results are still below levels I would classify as sustainable. In the current environment of uncertainty, oilfield service providers and clients must share in both the risk and reward in our operations. Calfrac U.S. operations reactivated two incremental fleets in late June and early July, both operating in North Dakota. Because of the strong execution of our team, one of our clients added a fleet in the Bakken while releasing some competitor equipment. As well, we are in the process of reactivating our operation in San Antonio, Texas and expect our first fleet there to generate revenue before the end of August. While client interest has been high, Calfrac feels that having an operating fleet in the basin was essential to securing longer term work with the right clients and potentially expanding the footprint in the near future. As with the case in Canada, pricing improvements have improved our results in recent months. However, the business is not yet at the level of profitability that could be characterized as sustainable. By executing at a higher level of productivity with professional operators, we believe improved profitability and continued growth are achievable through the remainder of 2017. Now I would like to discuss Calfrac international operations. In Russia, the second quarter exceeded expectations, largely due to strong execution by our team in country in terms of consistent activity and cost management. Our outlook remains for 2017 to be relatively similar to 2016 in Russia, aside from currency exchange impact. Our operations in Argentina were below our expectation in the second quarter as lower activity levels as well as some weather impacts and higher labor costs played out. Moving forward, Calfrac believes that increased activity, especially in the Vaca Muerta play, will unfold toward the second half of 2017 and into 2018 as large sums of incremental capital are deployed in country. As a result of increased activity and demand for equipment of our April forecast, the company is announcing an increase in its 2017 capital budget from $45 million to $65 million. The incremental spend will be focused on our North American asset base. Thank you very much for joining us today and now I will turn the call back to Denise for questions.

[Operator:]

[Operator Instructions]. Your first question comes from the line of Sean Meakim with JPMorgan. Your line is open.

[Sean Meakim:]

Hi guys.

[Fernando Aguilar:]

Good morning Sean.

[Mike Olinek:]

Good morning Sean.

[Sean Meakim:]

So obviously, a really strong result in the quarter, particularly in Canada. It's kind of a bit of a surprise from our side. So just thinking about what the implications are for the back half. How sensitive do you think Canadians E&Ps are going to be to commodity prices in the second half with respect to your plans? And I guess, thinking about that strong revenue you saw through the quarter, does that put any risk to the back half in the sense that customers may run through their budget earlier than expected? I am just curious how some of those dynamics could influence activity in the year end.

[Scott Treadwell:]

Sure. Hi Sean, it's Scott. Yes. I would say in Canada and similarly in the U.S., there's an area of prudence and potentially caution on the part of a lot of our customers. I think what you have seen is the plans as they were laid out in the earlier part of the year are largely unchanged. But there was, I would say, probably three or four months ago some expectation of increased activity in the back half of the year. We are not so sure that that plays out as it stands today. That being said, I think with uncompleted wells and drilling activity where it stands today in Canada and the U.S., we have got a pretty strong and solid outlook for the back half of the year. The other part of that though, is the supply-demand balance with equipment coming on and what that means for incremental revenue and potentially pricing. Again, I think we advanced those conversations on a one-on-one basis. We certainly won't comment on pricing dynamics publicly. But with the level of uncertainty in our customers' minds, we are certainly conscious of their need to get returns as well as ours. And I think that's probably going to be the dynamic that plays out through the summer. If oil prices break down towards $40 again, I think it probably resets lower. And if they break probably meaningfully above $50, you would look for some tailwinds.

[Sean Meakim:]

Got it. Okay. Well, that's all fair. One other point I wanted to talk more about was just kind of latest thoughts on plans to address the balance sheet. You are consuming cash right now. But of course, you need to go after the opportunities to put horsepower back to work. New builds still seem like they are a ways away. So as you look towards the back half into 2018, just thinking about can you convert to a free cash flow profile in the second half? Are there just other items we should be thinking about that could impact cash generation for the second half of the year?

[Fernando Aguilar:]

Yes, Sean. So before Mike addresses the full question, I just want to tell you that as we mentioned in our notes, we have 60% of the equipment basically in operation in North America. So we have a lot of room, not only with new equipment, but also with our equipment that was parked and well kept. So the idea of thinking of just going to the market and try to build all those new equipment is not required for Calfrac. And in fact, our ability to deploy equipment rapidly in the markets where we have been activating our fleets is demonstrated in this quarter. So Mike, now you can go through the different options.

[Mike Olinek:]

Sure. Well, as we look at the biggest consumer of cash, I think you would have to look at our working capital demand as the revenue grows. And so with the changes with the service intensity and pads DUC completions, we certainly understand working capital requirement certainly ramp up in this kind of increase from certainly last year. As I said on the call, I think we are well positioned in the fact that we have got over $250 million of available credit facility room. As well, we have the fully funded equity cure. So I think from that side, we are certainly able to navigate here the working capital requirements. We are internally focused on managing our working capital as best we can as we move forward. And I think as the rate of revenue growth slows, so will the draw in cash related to that.

[Sean Meakim:]

Okay. Thanks. I would like to get your thoughts on free cash profile for 2017.

[Mike Olinek:]

I think free cash flow, I think, in 2017 will be a difficult thing for the company to achieve. But as we look into 2018, I think that's a fairly achievable target.

[Sean Meakim:]

Okay. Thank you for all the feedback. I appreciate it.

[Fernando Aguilar:]

Thank you Sean.

[Operator:]

Your next question comes from Ben Owens with RBC Capital Markets. Your line is open.

[Ben Owens:]

Hi. Good morning.

[Fernando Aguilar:]

Good morning.

[Mike Olinek:]

Good morning.

[Ben Owens:]

Fernando, you mentioned in your prepared comments that Calfrac stage counts and proppant pump are approaching in 2014 levels which obviously highlights the trend of growing completions intensity. Just wondering if you could talk about what that means in terms of wear and tear on the active fleet? And what it means for the supply-demand balance of equipment in North America over the next couple of years.

[Fernando Aguilar:]

Yes. That's a very good question because when we try to analyze the situation between, let's say, difference between drilling and completions, you see that the drillers have become amazingly efficient. And those wells that were drilled in 45 days in the past are now drilled in 15 to 20. So that's generating a lot of inventory that is positive for our business and that will create bottlenecks in the completions side because the equipment is basically used, as you mentioned Ben, let's say, continuously, number one. Number two, the amount of maintenance that is required is increasing. So you remember that in different calls, we have been talking about how the U.S. was leading or it has been leading continuously with increasing intensity. Some of the competitors' calls that we heard this week were talking about slowdown in that respect, but that hasn't been the case for the Calfrac operations. So we have seen that activity, just not only increasing in the U.S. but also coming to Canada. So the wear and tear of the equipment, of course, is something that we have to be very careful with because the state and condition of the equipment, in general, in the industry, is not in very good shape and some of the success stories that we are referring in our call notes are due to the fact that the performance from some of our competitors is not basically what customers expect. Now they want to go back to work and execute continuously. So this is a very good opportunity for us because we have always been very serious about what we call our license to operate, which is related to the quality of our operation and the execution of our overall strategy, which includes as well the safety and technology part of the business. We are following and monitoring very close our equipment. And of course, as intensity increases, the amount of repairs and maintenance that goes into the business has to increase as well.

[Ben Owens:]

Okay. Thanks. I appreciate the color. As a follow-up to that, I wanted to ask about the data point that Halliburton provided on Monday that they saw decline in proppant pump per well sequentially for the first time in a while during the second quarter. I wanted to know what you guys are seeing there? And maybe if you could contrast what you are seeing in the Canadian market as compared to the U.S.

[Fernando Aguilar:]

Yes. Like I mentioned before, we were talking about increasing number of stages. We are talking about increase in the lateral length and then also amount of sand. And we believe that the Canadian operation are basically following the U.S. trend, but we are still far away from where the U.S. is. So the amount of sand that we pump in the U.S. is basically, I would say, maybe 60%, 70% higher than the one that we, it depends on the basin as well, Ben. I cannot give you the right number in general, but it depends where you are. But the amount of sand that we pump in the U.S. is higher than the Canadian one, for sure, but the Canadian market is basically asking us. Some of the lead operators in Canada are increasing their volumes. So we see that trend coming to Canada. When we listened to their call, we were going back to our books and our numbers, we didn't see that trend coming down anywhere. And it was very interesting to see that a comment from one of our competitors basically took the sand companies down by 15%, 16% after the news came out, so I don't think so. What I would like to say here is that while we have seen different to and I think as you were reiterating is that some customers are basically very interested in using regional sand because of logistics, because of cost and at the same time, because the availability of these mines are basically giving them very good results.

[Ben Owens:]

All right. Very great. That's really helpful color. I will turn it back.

[Fernando Aguilar:]

Thank you Ben.

[Operator:]

Your next question comes from Stan Manoukian with Independent Credit Research. Your line is open.

[Stan Manoukian:]

Good morning gentlemen. Thanks for taking my questions and congratulations on the operating progress. I just have two quick questions. It looks like you have purchased some horsepower during the quarter and I was wondering number one, what's the total cash spend for these purchases was? And what's the breakdown between maintenance capital expenditures, reinstatement of existing horsepower versus purchased horsepower?

[Scott Treadwell:]

Okay. Hi Stan, it's Scott. Two points. We didn't purchase any horsepower during the quarter. We allocated capital 2015, 2016 for a build program, totaling 100,000 horsepower that hasn't been commissioned or wasn't commissioned at the beginning of Q2. We have since started to commission some of that equipment into the operation, but that cash was spent in, at latest, 2016. So that's already been spent. And in terms of reactivation, the number is still running about $2 million to $3 million per spread that's going through the P&L.

[Fernando Aguilar:]

Which is not all on the equipment.

[Scott Treadwell:]

Which is, yes, more than just equipment. But on top of that, the maintenance capital impact is really linear with equipment. Within our number of $65 million, about $15 million of that is not maintenance capital, it's infrastructure. But $50 million of it is related to the equipment.

[Stan Manoukian:]

Okay. So this increase in total horsepower from 1,220 to 1,317 is the newly commissioned horsepower, right?

[Scott Treadwell:]

Yes. There's two things at play. 25,000 of that increase was new-build horsepower that's been commissioned. The remaining 72,000 was accounting impaired horsepower that was previously active. So had it been stricken from the books from an accounting perspective but it's still operational and we have now just brought that back into the operational horsepower.

[Stan Manoukian:]

And then I was wondering, just a more technology-related question. With the increased intensity of drilling, do you think that the new generation of fracking equipment will be required to provide more pressure power? Or you can accumulate the existing horsepower to increase pressure? How does it work?

[Fernando Aguilar:]

So okay. We can, offline, give you an explanation of the market trends in terms of pumping equipment and all of it, but the equipment that the industry is using today, Stan, is suitable for the type of business we are doing in terms of pressures and rates and volumes that we handle. Some people talk about increasing, let's say, the size of the pumps and bringing more horsepower into the play. But there are different elements that are basically have to be put into perspective. One is those pumps normally are heavier and we are transporting heavier equipment. You have some road bans and you have a little logistical implications for that. If you can have a super pump that you put on location and you run it from there and you don't move it, most probably you will have the opportunity of addressing the issue in that way. I think between 2,000 and 3,000 horsepower, their pump and using pumps in the jobs are basically giving very good results from a financial point of view and also from a cost point of view for customers, financial point of view for service companies and cost point of view for customers. So it's a good balance. However, all companies, including Calfrac, we are working at developing with our manufacturers and suppliers the best type of structure that we need in the field. So that's something that is continuously happening in the industry. But feel free to call us and we can give you a description of the different pumps and the different sizes and the different applications that are available in the industry and in our company.

[Stan Manoukian:]

That's wonderful and very helpful. And lastly, about Canada, about the shift in job mix that sort of caused decline of revenue per fracturing job. Is it a seasonal phenomena? Is it supposed to expected to change in the third quarter and for the rest of the year? Or shall I look at this differently?

[Fernando Aguilar:]

No. So before we give you more color into the split, I have to tell you something. If you see the way that Calfrac positioned its operation with the customers we have today for the quarter, that has been one of the most, let's say, successful quarters in the history of a breakup period in the Canadian operation. So you can basically combine the different basins where we play and have a little bit of, let's say, job mix that changes. But as we were mentioning before, the number of stages is increasing and sometimes customer's goal with lower-size stages and then different volumes. But in general, what we have is a quarter that, even though you have a job mix from Viking, Cardium into Montney Deep Basin, I believe and also Duvernay, you see that the operations that we are conducting are providing us with a very good performance for the quarter.

[Scott Treadwell:]

Yes. Just to add some color to that. Because it was such a strong quarter in Canada, what we saw was an earlier return to activity in Central and Southern Alberta and Saskatchewan and that does have an impact on the average job size. At the same time, we saw pretty continuous activity through the Montney Deep basin area, which are the bigger job sizes. But that's probably more in keeping with where we would have been a year ago. So the part of the big delta would have been just the seasonality and you would expect something a bit more normal in Q3. We don't provide any guidance on that, but it will be a pretty normal mix of jobs as we go forward.

[Stan Manoukian:]

Wonderful. Thank you very much and it has been very helpful. Good luck.

[Fernando Aguilar:]

Thank you.

[Scott Treadwell:]

Thanks.

[Operator:]

Your next question comes from Ian Gillies with GMP. Your line is open.

[Ian Gillies:]

Good morning guys.

[Fernando Aguilar:]

Good morning Ian.

[Mike Olinek:]

Good morning Ian.

[Scott Treadwell:]

Good morning Ian.

[Ian Gillies:]

The margins in both Canada and U.S. are looking to be quite strong. And as we go through the back half of the year, I am just wondering if you think you are going to be able to approach what we have seen in 2014? And maybe keeping in mind some of the changes on how you are treating fluid ends, is there potential for margins to even push higher than what we have seen in 2014 in both areas?

[Fernando Aguilar:]

Well, I think you remember very well what had happened in 2014, Ian. And at the time, we were saying that the market didn't really get to the lower pricing that we were expecting. You remember those days. And those prices were basically rising and increasing but didn't get to the level until the downturn hit the industry. So when you think about what is happening today, at the time in 2014 the industry had, let's say, enough. We had muscle that we can deploy fleets in different areas because we were geared for that growth and things were happening that way. The downturn came and eliminated a lot of jobs and also equipment that has been parked and in some cases, for some companies, this equipment is not coming back. The margin that we are generating today are still, as Scott has mentioned continuously, if the service industry is not up to an earnings per share level that is positive, it is going to be very difficult for companies to go back and build equipment. So that was one piece. So I think the margins will continue increasing because of the sustainability of the industry. The margins, like we said before, we started with 2016 when we mentioned that 2016 was a year to forget. We always talked about 2017 as a year of transition and I think we have been executing very well in that transition, keeping the operations in the U.S. that our competitors basically escaped or exited. We believe that the North American market is very, very strong between the two markets with a different type of margin that you can generate and intensities that you can have. But we are very positive that margins will continue bringing positive news in the near future. So how is that going to translate into 2018? That will depend on how the service industry is going to be able to gear up for the customer demands, number one. And number two, that volatility that we have with the current pricing. But as we see things today, the second part of this year should give us very positive results.

[Scott Treadwell:]

Yes. To maybe add to that, Ian, I would say that there's still some self-help that we can do to improve our profitability. Reactivating additional fleets in existing basins is pretty accretive because we don't really have a lot of district overhead. I think continuing to execute in the field at a high level, which has been pretty much the story of the first half of this year will continue to give us some profitability gains. Obviously, there is conversations on pricing but again, we are not going to really comment on that in a public forum. And certainly, we don't solely rely on pricing to drive our profitability. We recognize there's lots we can do internally. We will do our part and if the supply-demand balance allows pricing to move higher, then we will obviously be there as well.

[Fernando Aguilar:]

So pricing, as you all know, is a complex point. But what is important in our industry and I think some of the commentaries that we have been reading today about our performance, just thinking how the how the U.S. business basically turned. And today, we could be maybe three times or four times busier than we were a year ago. That is showing you the ability of this industry to become productive and efficient if you have activity in front of you. And some of the issues that we have been talking about, balance sheet and going back and forth with Calfrac, has always kept our options in front of us because we want to play them when we need them. So what is critical for us is to have the activity and the business that will give us the possibility of executing then generating the margins and cash that we need to take care of the issues that we have been discussing lately.

[Ian Gillies:]

Okay. Thanks. That's helpful. With respect to the reopening of the San Antonio base, I mean, once two crews are up and running maybe, let's say, that's early 2018, if we think about margins from that business, do you think they are accretive? Or do you think they dilute, call it, the Q2 margins of 16%? Or perhaps do you end up with a higher revenue base and a bit lower margin there? I am just trying to figure out, I guess, how pricing and customer commitments are looking in that region right now.

[Scott Treadwell:]

Well, I would say we wouldn't be reactivating if we weren't pretty confident on the customer side and what the economic returns look like. Certainly, in the first couple of quarters, I think there will be some noise. You are hiring people and reactivating equipment as well as the base. So there's going to be cost involved with that. I think once you get one crew running, you might be kind of covering your fixed costs and generating a little bit of cash. But it probably doesn't help your overall margin. But I think once you get to two, you should be pretty confident that it's probably not going to be a big headwind or a tailwind in terms of where your margin is. I would suggest the economics of running it to spread base in San Antonio were no different than the area in the Bakken or Pennsylvania or anywhere else. So we would expect that, all things being equal, it should be, like I said, not much of a mover for profitability once we are at two spreads.

[Fernando Aguilar:]

But we don't stop at two. I don't think the goal for Calfrac is basically stay at two. I think the ideal setup is basically try to run all the district with at least four fleets and that will give us a critical mass required to be more efficient from an SG&A perspective.

[Ian Gillies:]

Okay. That's helpful with providing the runway. And with respect to Canada, as we think about the increasing service intensity if R&M was, call it, X percent two years ago as a percent of revenue. I mean, where would it be this year? And how much impact is that having on your profitability?

[Mike Olinek:]

Hi Ian, it's Mike. As we look at R&M cost, it is down a few points. It's hard to compare back to 2014 though on a percentage basis just given where pricing was at and that goes. But it certainly is benefiting us probably a couple of points on the bottomline.

[Ian Gillies:]

Okay. That's helpful. Thanks guys. I will turn it back over.

[Fernando Aguilar:]

Thank you Ian.

[Mike Olinek:]

Thank you Ian.

[Operator:]

Your next question comes from John Watson with Simmons & Co. Your line is open.

[John Watson:]

Thank you. To follow up on one of Ian's questions, can you please speak to your accounting treatment of fluid ends? And does that differ between geographies?

[Mike Olinek:]

Hi John, it's Mike here. No, the accounting is the same. We are under IFRS as far as our accounting principles and that's what dictates how we componentize our equipment and one of the critical components is fluid ends. So as a result, that accounting practice is consistent amongst all our geographic markets and as a result, as it's been pointed out, yes, it a part of our capital budget. And as more pumps are activated in the field, maintenance capital goes up and locks step with that.

[John Watson:]

Right. Okay. That's helpful. And for the CapEx budget for this year of $65 million, could you speak to how much of that you expect to go towards replacing fluid ends?

[Mike Olinek:]

Well, I would say we have IFRS components that include transmissions, power ends and fluid ends and I would say it's probably approximately $50 million of the $65 million.

[John Watson:]

Okay. Great. And then an unrelated follow-up on the labor comments. Could you compare and contrast labor constraints in the U.S. versus in Canada and maybe even compare and contrast some of the basins you operate in, in the U.S?

[Fernando Aguilar:]

Yes. So that's something that we normally take as a very important aspect of our job. We are responsible for finding the people who are going to work for the company and make sure that when we have a contract that we need to execute, we are going to have the human resources available for that. The difference between the U.S. and Canada from the labor perspective is basically Canada is one-tenth the population of the U.S. So we are talking about a country that is 35 million people versus a country that is around 350 million. So when activity was basically at its peak in 2014 in Canada, there were many analysis and studies made in which it was shown that the province was 100,000 people short for the needs of the industry. And that basically generated some sort of activities for companies to go and cross provincial borders to try to attract people. As the downturn came, some of the people who came to the province basically and then also to British Columbia decided to leave the industry and not coming back. So we normally refer as from 200,000 to 300,000 people who left the industry in this downturn, one-third of the people are already back with us, one-third of the people are not coming back and the other third that are sitting, watching if the industry is going to be stable enough to do it. So what we are doing now is we have been successful, as we mentioned, trying to attract the people. And we have been attracting maybe 60%, 65% of the people who used to work for Calfrac out of the 2,500 people that we released in this downturn. So the Canadian business is basically incorporating those activities and we have exhausted the local pools in the areas where we operate in Canada. So we are trying to attract people that are basically younger, coming from different industries and also coming from different provinces. When you move into the U.S., it's a very, very different market and you can see that Texas is basically booming between the activity pickup again in the Eagle Ford and also coming to the Permian where, I think, there are not anymore Permian employees available as they are working for all the companies that are in this busy area. So people who are going to be working in the Permian in new companies and also for companies that are adding more equipment and activity in that place are going to be coming from other states and other areas. For the Eagle Ford operation that we were referring earlier, this is basically people that used to work for us and some new employees as well. So we are confident that that's not the case. Colorado has been very active. I believe the place where you can have some constraints and is again the numbers because so far, the limited results available could be the Bakken. But between Pennsylvania and Colorado, we have been successful attracting the people that we have. Is it an easy exercise? No, it is not, John, because people are basically watching how the industry is going to behave and how the commodity price effecting plans from customers. But it is a challenge. But basically we have a very, very good human resources group headed by Ed Oke, who's our VP of that area. And his team and himself with the recruiters that we have, have done an amazing job attracting the people that we need for our business. And as we continue adding fleets and we continue increasing the numbers in our training, let's say, centers, this operation is going very smooth for us.

[John Watson:]

That's very helpful. Thank you. Congrats on the great quarter. And I will turn it back.

[Fernando Aguilar:]

Thank you John.

[Mike Olinek:]

Thanks John.

[Operator:]

[Operator Instructions]. Your next question comes from Jon Morrison with CIBC. Your line is open.

[Jon Morrison:]

You referenced the legacy contracts being a headwind to realize margins in Canada in the quarter. How much do you believe those costs were, either in terms of basis points or absolute EBITDA, in the quarter?

[Scott Treadwell:]

I don't think we necessarily want to comment on that. But I would say our pricing entering Q2 had probably an average age of about two to three months. As we exited Q2, that number was probably down to four to six weeks. And so there was some positive momentum on the existing customer base as well as anything we picked up incrementally as we went through Q2 and as we look into Q3. But it was a headwind. It probably wasn't as big in Q2. It was probably more of an impact in Q1, to be honest.

[Jon Morrison:]

Okay. It was worth mentioning, but you don't want to quantify?

[Scott Treadwell:]

Yes.

[Jon Morrison:]

And given that a lot of the pricing conversations in Canada have already taken place for what will unfold in the next few months, it's fair to assume though, that Q3 pricing will be up over Q2?

[Scott Treadwell:]

Yes. And that's really just arithmetic. The exit rate of Q2 would have been higher than the average. We are not baking in any pricing increases. And even if we were, we really don't discuss them in this forum. But based on where we exited and the work programs we have in front of us, we do expect the average to move up modestly through Q3.

[Jon Morrison:]

Okay. Are you seeing any customer losses or perhaps delays in their programs when they realize that pricing concessions that they have been asking for in the last, call it, six weeks aren't going to unfold in Q3?

[Scott Treadwell:]

I won't comment to specific instances. I will tell you, the biggest operational challenge we have in one instance is that we have been so productive, we have gotten through a pad meaningfully faster than we thought we would and it's caused us to create a hole in our schedule that we have been able to fill. But I haven't really gotten a sense of, I need X percent price reduction or I am not going to do this program. I don't think we are there. If we were the other side of 40, I think that's probably the topic of the day, though.

[Jon Morrison:]

Okay. On the HR side, are you staffed to work all of the spreads that you have put out in the field so far, including the incremental Red Deer crew that you are putting into the Deep Basin?

[Scott Treadwell:]

Yes. It's close. I think if you ask anybody on the off-site, they would love to have another 50 people to backfill to provide training. But certainly, we can have all the equipment at work every day as it stands today.

[Jon Morrison:]

Okay. Is your attrition rate accelerating at this point? And are you starting to see a lot of employee movement from firm-to-firm, either for pay differentials or promotion at this point? I would have to assume that the labor markets are tight and plays are trying to take advantage.

[Scott Treadwell:]

You know what, I think with the uncertainty you saw at the macro level through kind of May, June, that probably put a little bit of a lid on that. I mean, it's never zero nor do you really want it to be zero. But we were probably far more focused on that as a risk as we entered Q2 in a more constructive macro environment. And again, it's a big incremental hurdle for growth and a bottleneck, but we haven't really seen that kind of mercenary behavior and we haven't really seen irrational activity yet by any meaningful competitor in the basin.

[Fernando Aguilar:]

The attrition normally is very high in the first six months of the contract of the employee. And after that, it is very low for Calfrac and people who really understand what this industry and business is about can stick with us for the longer term. So attrition, as you are progressing in time, you are developing your career and you are growing the company, that attrition number reduces. But a lot of people who joined the industry because they need a job, they don't realize how tough it is working in the harsh environments where the service industry operates.

[Jon Morrison:]

Perfect. In the U.S., just a point of clarification. As you are reactivating more crews, am I right to assume that all of your economics are underpinned by static pricing and you don't need pricing increases to unfold to do any of what you are talking about right now?

[Fernando Aguilar:]

No. We need everything. We need prices. We need activity. The prices that we have are basically, like Scott has always been mentioning, are at a level that have been improving. But I think the customers need a better commodity price. We also need a better price for our services. But the industry has basically got to a level, remember, Jon, in the last two years, a lot of the customers were basically keeping very little activity and not very interested in productivity and was more interested in cost but keeping some of their operations running. But today, when they go for production and they go for productivity, it is important for them to have company who can execute. So volumes for pricing is basically the formula that the service industry requires but also held by commodity prices where customers can pay those price as well.

[Jon Morrison:]

On the San Antonio crews that you are planning to put back to work, are those all part expected to be working in South Texas at this point? Or is there any contemplation that some of those working remotely in, call it, West Texas or New Mexico?

[Fernando Aguilar:]

Yes. We will let you know that when we start our operation. So what we are doing now is gearing up for the San Antonio reopening of our base. But more details will come as we disclosed them with our reports.

[Jon Morrison:]

Okay. Fernando, is there anything you can say on the hiring side in Texas? How it's been, just considering that you haven't been active in that market for a while?

[Fernando Aguilar:]

It's perfect. We have the people that we need for one crew already and again, Jon, this is related to the way that you treat your employees and your equipment. So Calfrac is very serious about the assets that as the executive team is custodian of those assets, the people who left the company in Texas are basically very happy to be back and work for us again.

[Jon Morrison:]

Last one just from me. Fernando, what's the contractual line of sight look like in Argentina right now? Do you have six months of visibility for some portion of your work? Like do you have visibility for 50% of what you believe you are going to do? And is there any contracts out in the market right now that would get you optimistic that sequentially, you could see a rise in activity levels in the back half?

[Fernando Aguilar:]

Yes. So as we know well and that is reflected by some of our larger competitors in the international, let's say, reports. When the industry downturn hits North America, then there is a momentum that continues for some time in the international part of the business. And then when activity picks up in North America is when the international part gets hit by the downturn. So we have seen that effect happening in some of our international operations in, let's say, Mexico and Argentina. But the good news about this is that we have continued penetrating the Vaca Muerta field as was mentioned in our notes. And the exposure through that unconventional fracturing activity for, let's say, today for the three most important and active customers is happening. However, one of the limitations that is basically affecting the performance is that the level of logistics that happens in Argentina is not there yet at the level where North America is. So that is the expectations that we can have as an efficient operator. When you have logistical issues, mechanical well issues and weather issues and union issues basically affects the performance. We are positive that the second part, without giving you any guidance, the second part of 2017 is going to be better than the first one. And as the government continues demonstrating how important it is for the country to support the industry, we are positive about Argentina. So we do have more than six months visibility because of the arrangement that we have with two or three of these customers and there are some tenders coming up that are going to help positioning Calfrac as a more active player in that respect.

[Jon Morrison:]

Appreciate the color. Great quarter. I will turn it back.

[Fernando Aguilar:]

Thank you. Bye.

[Mike Olinek:]

Thanks Jon.

[Operator:]

Your last question comes from Jeff Fetterly with Peters & Co. Your line is open.

[Jeff Fetterly:]

Good morning guys.

[Fernando Aguilar:]

Good morning Jeff.

[Mike Olinek:]

Good morning Jeff.

[Scott Treadwell:]

Good morning Mr. Fetterly.

[Jeff Fetterly:]

A couple of questions on the pricing side. For Canada, would leading edge pricing today be higher than where it was in Q1?

[Scott Treadwell:]

Yes. I don't think there is much risk in saying that the leading edge pricings continued to improve across the board. Obviously more at the lower end, but even at the higher end, I think you have seen pricing gains.

[Jeff Fetterly:]

And where would pricing on a leading edge basis today for the Canadian side sit relative to the Q3 reference point of 2016?

[Fernando Aguilar:]

10%?

[Scott Treadwell:]

No. From Q3 to the leading edge today, if you went kind of the average to the leading edge today, it's better than 20%. It's probably closer to 30%.

[Jeff Fetterly:]

Okay. And you said earlier, your expectation is that pricing on a leading edge basis is not going to move higher in Q3? It's the blended element that's going to, on a net basis, move up?

[Scott Treadwell:]

Yes. We had pricing movement on average through Q2. And even if we got no movement from the end of Q2 through the end of Q3, the average should be higher, unless something rolls off.

[Jeff Fetterly:]

Okay. And then a similar question from the U.S. side. So how much have you seen pricing move, I guess, over the course of Q2 versus Q1? And where do you think we sit relative to trough today, leading edge?

[Scott Treadwell:]

I would say pretty similar. I won't talk about quarter-to-quarter necessarily, but similar. We are up probably from the trough in that 30% range in the U.S. In terms of where that's come, I would say the bulk of that pricing, Canada and the U.S., came probably from March through June of this year.

[Jeff Fetterly:]

Okay. And are you seeing continued pricing traction in the U.S. on a leading edge basis going into Q3 and with these incremental crews coming out?

[Scott Treadwell:]

Again, we won't comment on the conversations that are happening today. I would say that the economics, as they stand in the market, are sufficient for us to look at the reactivation of the spreads we have talked about, the San Antonio and the incremental ones in the Bakken and Pennsylvania. It's a case-by-case basis. And again, we are not going to prejudice those conversations, put words in the mouth of our sales guys or make it harder for them. Where we have opportunities to move pricing when we think it's justified, we will advance that. But that's kind of all we will say.

[Fernando Aguilar:]

I think, Jeff, one of the comments that we gave you earlier in the introductory commentary is about teaming up with customers who really appreciate the importance of a company who can deliver. And I think this is more the challenge in the U.S. is to make sure that you are basically able to execute at the level. And just to give you an example. One of the contracts that we recently took in one of our basins in the U.S., we replaced a long term contractor that was operating for a customer, specific customer in that basin. And in the first week of the operation for Calfrac, we broke all-time records in terms of number of stages per day. So that tells you what the game is in between, like I was saying before, I think it was Ian who was asking about the pricing. It is not only about the pricing. It's the pricing. It's the volume. It's the continuous activity. It's let's say, the less interruptions that you get in your business to keep that machine running what makes basically integrates and compounds into the pricing effect, if you can call.

[Jeff Fetterly:]

Okay. Just last question from a margin standpoint in the U.S., it was asked earlier. But looking at the progression from Q1 to Q2 and the fact that you still had reactivation costs in Q2, absent additional pricing power, do you expect that margins would continue to move up as you layer in incremental crews and reactivate the Eagle Ford?

[Scott Treadwell:]

Well, I think if you take out the onetime cost of reactivation, you would expect margins to move higher. But as I said, the noise of reactivating the shop and the activation costs associated with equipment probably introduced noise into the short term. But yes, in the long term, I would expect that number to be able to move higher, absent any pricing.

[Fernando Aguilar:]

And this is a bit delicate because we will be giving you some guidance in terms of what we expect from pricing. But I believe the industry as a whole and Calfrac as a whole, combining those different effects, we like to have a better pricing in the quarters to come, for sure.

[Jeff Fetterly:]

Okay. Sorry, Mike, one clarification earlier for the working capital side. So you have put $85 million of working capital on the balance sheet year-to-date. Do you expect that you will continue to have working capital investments in the second half of the year? Or do you think there's some element of reversal or flattening that might happen?

[Mike Olinek:]

I mean, some of that is timing just on quarter end stuff, Jeff, as to how things sort of shake out. I do think that it will start to normalize and flatten a bit. But yes, we are going to have a bit of a working capital build, if our revenue projections come to what we think will happen. It should be equal as far as overall levels of growth.

[Jeff Fetterly:]

Okay. Perfect. Thank you. I appreciate the color.

[Mike Olinek:]

Thank you Jeff

[Fernando Aguilar:]

Thanks Jeff

[Operator:]

Okay. There are no further questions queued up at this time. I will turn the call back over to Fernando Aguilar.

[Fernando Aguilar:]

Thank you Denise and thank you everybody for joining our call today. Have a good week.

[Operator:]

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