Superior Drilling Products, Inc.
Q3 2018 Earnings Call Transcript

Published: 9 Nov 2018

[Operator:]

Greetings and welcome to the Superior Drilling Products Inc. Third Quarter 2018 Earnings Call. [Operator Instructions]. I would now like to turn the conference over to your host, Ms. Deborah Pawlowski, Investor Relations for Superior Drilling Products. Thank you. You may begin.

[Deborah Pawlowski:]

Thanks, Melissa, and hello, everyone. We certainly appreciate your time today and your interest in Superior Drilling Products. Joining me on the call are Troy Meier, our Chairman and CEO, and Chris Cashion, our Chief Financial Officer. You should have a copy of the financial results that were released before the markets opened this morning and also, you should have the slides that will accompany our conversation today. You can find both of those documents on our website at www.sdpi.com. As you are aware, we may make some forward-looking statements during the formal discussion as well as during the Q&A session. These statements apply to future events that are subject to risks and uncertainties, as well as other factors that could cause the actual results to differ materially from what is stated here today. These risks and uncertainties and other factors are provided in the earnings release, as well as in other documents filed by the Company with Securities and Exchange Commission. You can find these documents on our website or at sec.gov. I'd like to also point out that during today's call, we will discuss some non-GAAP measures which we believe will be useful in evaluating our performance. You should not consider the presentation of this additional information in isolation or as a substitute for results prepared in accordance with GAAP. We have provided reconciliations of non-GAAP with comparable GAAP measures in the tables accompanying the earnings release, as well as in the slide deck. With that, let me turn it over to Troy to begin. Troy.

[Troy Meier:]

Thanks, Deb. Thanks, everyone, for joining us for our Q3 highlights. As we go through this, I want you to remember back when, in our second quarter, we talked about expansion. I think we talked a lot about that in the first quarter as well. But as we go through the slide deck today, keep in mind of the expansion, expansion, expansion that we've touched on in the second quarter. As we go through this slide deck, we'll start with the revenue up 7% year-over-year. That's nice. When we look at our royalty, we talk about this fleet that we have out there right now and how this program builds legs. When you look at the royalty and fleet maintenance revenue growth of 46%, that's what we've been talking about. The contracted services, you're going to see that that's up 11%. This is mainly due to the new Baker Hughes contract that we have in place. This contract's working out very well for both parties and we're pleased so far with the improvement that we've seen in our relationship with them regarding the services that we provide for them in that contract services area. You look at the tool sales in the U.S., it's been softer than what we anticipated through this contract negotiation that we're currently in with them. We believe that the way that we've modeled this out and how we're building that relationship, we think that we can get that back in line and get tool sales back where they need to be. But honestly, when we look at that, what we're seeing is our tools are lasting about 25% longer than what we had modeled out. When we were looking at a fleet that would be - the useful life of the fleet would now be getting replaced, we modeled that out at 12. Twelve runs per tool. I think when we end this year, we're going to find out that those tool runs are going to be closer to 15, maybe even 16 per tool. The drilling ream's a great tool and it brings in some good value to our channel partner. You look at year-to-date revenue growth up 24%, two and half times. We're pleased with the direction of what we're doing, the Company and everything that's going on there. We would like to see increased market share throughout '19, and that's what we're working on right now. Our agreement with this channel partner is what are tool sales look like to match the market share growth potential of the drilling ream and that's what we're trying to nail down as we go through these negotiations with them. You'll notice the nice cash-generated, $4 million now, year-to-date. That's a major plus. One of the things, let me go back to the expansion as we talk about the near completion of what we're doing. Let's go to - let's talk about the Middle East. We've got the agreement that you've all seen with Smith International Gulf Coast. We have an agreement with them that allows us to rapidly set up and operate repair facilities where needed in the Mid-East. We've started off in Dubai, and we'll be servicing tools over there before the end of the year. This is to facilitate what we believe is going to be a wonderful opportunity in the Mid-East. As we've touched on the Mid-East, let's just stay there for just a minute. The opportunity that we originally thought was there, we feel has really, really increased. The activity of the sales over the Mid-East aren't what we expected year-to-date, and that has a lot to do with the logistics complications of sending tools from the Mid-East back to Vernal, Utah to be repaired. We have a test fleet over there of 20 tools. I believe we are up to 22 now. That fleet, when it gets run, it's got to come back and be repaired. From the get go, we didn't think that was an efficient way of doing that but that's what our partner recommended we do. Putting this facility over there with [indiscernible] in Dubai is really going to help as we finish up our due diligence in this marketplace throughout the remainder of this year. Acceptance of the tool, we're very pleased with. We have one of the NOCs over there now is requesting that service companies use the drilling ream. We have service companies coming to us in regards to the drilling ream and the opportunity that they may have with us on the drilling ream. We're very pleased with where we're at in the alliances that we're putting into place. I believe that we'll see, we'll be able to announce a very significant partner over there. We're working with a world-class service company. We're in the final stages of getting our agreement done, so hopefully here over the next four or five weeks, we're able to announce something, if not sooner, in regards to who our partner is going to be, our additional channel partner for the Mid-East region. But we're very pleased on what's happened over there. The expansion into Abilene, we talked about that in second quarter. That is now complete and done. I'm very proud of our team, they were able to get that up and going in the first week of October. By the first week of October, they really knocked it out of the park. I don't know how many of you are familiar with expanding a service like that into a - it's very complicated, it's very time consuming, and our team just did an outstanding job on that. I'm very, very proud of them. Going down here, is where we talked about the service companies calling us in regards to inquiries about the DNR. We now have not just engineers from the E&P side wanting to know more information about the DNRs, we actually have very high-end service companies now that are requesting DNRs in the standard sizes that we have but also in much larger sizes than we've ever designed and made. That's very exciting. Let me just go through my notes here. As we look at the Strider tool, the tool that continues to whoop up on me. This tool has got a steady increase in run throughout the quarter. We're very pleased with the smaller tools and what we're seeing there. We've got a partner now that's been distributing the tools in Texas and Louisiana and we're happy with what they're doing. We have a very high end, one of the top service companies in the oil and gas industry is now running this tool in Alaska, our open-hole Strider tool that we're very excited about that. There has been some issues with that tool, when we look at our open-hole tool, that we've got to work out with. One of the suppliers that we have in a key component in this tool, we think that we can help them bring their quality program to the next level and make sure that the parts that they deliver to us are good and we've had an issue or two with their component going out a little sooner than it should. We're working with them on that. We feel we'll have that behind us. You all remember in the past, I talked a lot about the high-tech material that we had identified that we're now using in the Strider tool. We were able to get an agreement with the supplier of this material that we're very, very pleased with. They've committed to the demands that we'll have for this material. This material is a key component in the Strider tool, and we're very pleased with the agreement that we have with them and we look forward to taking that material, and as we move forward in years to come, we believe this material's got a great application, will have great ability in the downhole tool market. We're very pleased with what we see with that. Overall, it was a quarter of expansion and I'm pleased with where we're at and I'm excited to what this expansion means for us as we go into 2019. This was a lot of the groundwork that we had to get done so that when we start telling you what we're going to do in 2019, we can hit those numbers. Anyway, with all that being said, I'm going to turn it over to Chris.

[Chris Cashion:]

Okay. Thank you, Troy. Welcome, everyone, to the call this morning. Let's go to Page or slide Number 6 and look at some of the details around what Troy has mentioned as far as the revenue for this quarter. Troy mentioned that over the year-to-year, up about 7%, and you can see from the bar chart that that's in both lines of business. That's the tool revenue as well as the contract services revenue are up year-to-year. Down a bit from Q2 and that's primarily on the tool revenue side and Troy mentioned a couple of those reasons. The contract, it's just taken us a little bit longer with our distributor in the U.S. to get that contract nailed down. We're very close to having that done. The other thing that Troy mentioned that we're seeing is our tools are lasting longer, and that's, near-term that has a softening effect on our replacement tool sales. Longer term, the tools will eventually wear out and they'll need to be replaced. It's good news that the tool is more durable and the lack of the tool economics are going to be higher because it's just a well built, solid tool. But as I've said, it does have a near-term dampening effect on tool replacement sales. When you look at our Middle East revenue in Q2, we have some Middle East revenue, Q3 not as much. This year, as you may recall, is the year of understanding and developing the market in the Middle East. We came out of the chute really strong with one of the countries over there. It's taken a while with a couple of the other countries. But the bottom line is, as Troy mentioned, the drilling ream is being recognized in the Middle East and we're getting calls about how other service companies can get that tool. We've only got a very small limited fleet of tools, as Troy mentioned. We don't have a commercial fleet of tools in the Middle East. The logistics inefficiencies really has - it has slowed down our ability to get more tools in the hole and get more tests and advance that program. We saw some of those inefficiencies in Q3, and so that also contributed to the softness in our Q3 revenue. But when you look at it over a trailing 12-month basis, we're up over 18% over 12 months for 2017. We're continuing to grow and we're very pleased with that and Troy mentioned that Baker Hughes contract and you can really see the benefits of that contract, when you look at the bar chart, you see Q4 revenues, the $1.1 million level for Contract Services, $1.1 million again in Q1, and then you see that jump to $1.3 and $1.4, and it was April 1 of this year when we put that new contract in place. That is bearing fruit and you can see that clearly there in the bar chart. Let's go to Slide 7 and look at the tool revenue a little closer. As I mentioned, the tool sales a little soft, but still in that roughly million five, $2 million, $2.5 million. Q2 was just a very good quarter for us. But you can see at $1.7 million in Q3 that that's right in that $1.5 million to $2.5 million range that we've been operating under for the last five quarters. That just means that our distributors are continuing to build their fleet of tools, getting tools deployed, and then that gets manifested and then we see that other tool revenue growth of 46% year-over-year, $1.2 million in Q3 of '17 to $1.7 in Q3 '18. Unlike sales that can be lumpy, you see that's a nice steady rate of growth. We're real pleased with how the royalty and the repair revenues continue to grow at a nice steady pace. Then when you look at things on a trailing 12-month basis, you can see that the tool revenue is up 28% over 2017, and 54% if you look at that other related revenue. We're very pleased with how the tool is being deployed and the revenue that is generating for us. Now, we go to Slide 8. We're looking at investments on this slide. Troy mentioned that, yes, we are in expansion mode. Upfront, that means, making some investments, and that's what we're doing. We're making some investments and domestic and international expansion, not only Abilene facility here in the U.S., but as Troy mentioned, we're going to be opening up a facility in the Middle East to repair the drilling reaming and eliminate those logistics inefficiencies that we're seeing right now. R&D, continuing to invest in prototype tools for the Strider so that we can get more prototypes into the marketplace to continue that exhaustive field testing and we've talked about that in the past, five different sizes of tools and that takes some investment in R&D to do that. You see that. You see SG&A on Slide 8 going from $1.1 million in the prior-year quarter to $1.9 million in this quarter and it's a jump from $1.4 in the trailing quarter and that's just a continued investment in those expansion opportunities that we see and we're really excited about. Let's go to Page 9 and look at the operating income and with everything we've spoken about, it translates into lower operating income for Q3, and it's driven once again by our expansion efforts in the Middle East and Abilene and R&D. At the same time, the investments that we're making in those areas, we're still generating positive operating income and we're real pleased with that. If you look at Page 10 and look at our EBITDA, we're really excited about how EBITDA in Q3, 28.6%. With revenue softening a bit and with increased investments in SG&A, we are still able to achieve 28.6% EBITDA for Q3 and 29.9%, right at 30% EBITDA, on a trailing 12-month basis, and we're really pleased with the EBITDA generation, once again, in light of the investments we're making in SG&A. If you go to Slide 11. Looking at the balance sheet, this is where the EBITDA manifests itself and we doubled cash from the end of 2017, nine months, 2018 cash has doubled roughly from $2.4 million to $4.3 million operating cash flow, up strong in Q3, just under $2 million. We've been able to increase net cash by $2 million and pay down $1.8 million of principal on debt. When you look at our net debt to EBITDA, trailing 12-month EBITDA, we are at 1.3. Our balance sheet has become much stronger over the course of this year, generating the cash, paying down debt. The maturities of our debt is what we're working really hard on right now and we're going to have this maturity issue restructured and resolved by the end of this year. Overall debt, as I said, net debt to EBITDA at 1.3, that's not a problem at all. It's the maturities of the debt. We are in the process of refinancing that debt, and once again, we'll have those maturities extended to more easily match our operating cash flows as we go forward into 2019. Now to Slide 12, our guidance. Revenue between $18 million and $21 million, reflecting some of that softening we're talking about. Also, the overall general softening in all those services that we're seeing along with a lot of other folks. Our range is $18 million to $21 million, that represents a 15% to 35% growth. Still strong growth. Operating margin, we've lowered that a bit between 5% to 8%. That's taken into account a little softening on revenue, and of course, the investments in the expansion that we've spoken about. Interest expense, unchanged, roughly $750,000 a year. D&A, just under $4 million, unchanged. CapEx, about a $1 million. You probably saw in our year-to-date CapEx is under $200,000. Q4 is going to be a CapEx quarter for us, and once again, that's when we pick up the investments in service centers in Texas and in the Middle East. We'll have a little bit of CapEx in Q4 and will be approximately a million, probably come in a little bit lower than that $1 million for the year. With that, I'm going to turn it back over to Troy for Q&A.

[Operator:]

[Operator Instructions]. Our first question comes from the line of Jason Wangler with Imperial Capital. Please proceed with your question.

[Jason Wangler:]

Good morning, all.

[Troy Meier:]

Good morning, Jason.

[Chris Cashion:]

Good morning.

[Jason Wangler:]

I wanted to maybe just, firstly, Chris, for you, the tail-end of your conversation there with the CapEx. I assume it's to do with some of the expansion plans that you have. Obviously, wasn't much spent on CapEx in the third quarter. But that ramped up CapEx spend, is that basically around the expansion, whether it's here in the U.S. or the Middle East? Maybe just a little color on what that would be on, have you looked at that?

[Chris Cashion:]

You bet, sure. You're right. It's for both the expansion of service centers in Texas and the Middle East. We've got, as Troy mentioned, another channel partner that we're in deep negotiations with, that we expect to have an agreement quickly. With regard to that channel partner, we'll be putting some more tools, the drilling ream and another test fleet into the Middle East. We've got the test fleet with the Weatherford initiative that, as Troy mentioned, 22 tools. We'll be investing in a fleet of tools for the second Middle East channel partner. Between investment into tools and then the couple of service centers, that's where the CapEx is going to be required in Q4.

[Jason Wangler:]

Okay, and maybe that is partially the answer to this question. But, Troy, as you talk about the expansion in the Middle East, and I think, Chris, you said it, that there's now a big fleet over there of tools. Yet, I assume that that is something that you guys are going to be working on, is just ramping up that fleet of tools. Should we then think of that as this CapEx that you guys, that you'll be spending initially, then obviously [indiscernible] those tools out to them? Then, as it relates to that, as you think about going forward spend, I guess, whether it's 2019 or beyond that, but how you think we should think about the capital spend or the spending on tools as they ramp that up?

[Troy Meier:]

You're correct. To start off, it will be a CapEx on us as we prove these tools out. The current negotiations that we're in, they've made it very clear, they want to buy and own tools. Of course, we'll be the only ones that can service those tools. But yes, it'll be a CapEx for us and then rolling it over to them as their rental fleet.

[Jason Wangler:]

That's helpful. Thank you. I'll turn it back.

[Troy Meier:]

Yes. Thank you, Jason.

[Operator:]

Thank you. Our next question comes from the line of John Sturges with Oppenheimer and Company. Please proceed with your question.

[John Sturges:]

Thank you. A lot of moving parts, but it looks like it's all in the right direction. [indiscernible], there's anecdotal information about taking roughly nine days for drilling and completion, and I'm just wondering if you're getting a more rapid turnover in use of DNR?

[Troy Meier:]

No, we're not seeing a more rapid turnover in the use of DNR. Mainly, the customers that are currently running DNR, they're on the forefront of taking days off a well. Typically, if you see a basin that somebody is really keyed into the benefits of drilling ream, they're normally out in front of the other operators and setting that pace on how important wellbore conditioning is to their well. But, one of the top reasons we see a softening right now is, again, this year, the efficiencies to drill a well were not forecasted spot on. You see customers that have drilled up their budget because the 22 wells that they were going to drill this year, they finished them in October instead of December like they had forecasted. There's still efficiency that we don't quite capture as service companies that always seems to leave us short, come November or December, from what we thought it should be. But I think '19 is going to be a year where we finally start to get a lot closer to. We think it's going to take an average of nine days to drill a well. It'll probably be around nine days to drill a well and not seven.

[John Sturges:]

Right. Also, you made comments about the material in Strider. It sounded like you might have had, you have in mind, other applications for other products. Is that something you can add some color to?

[Troy Meier:]

Yes. The color around that is, as we went down the road to develop Strider, the way that this tool works, and the thrust that it creates, the pulse that we create is really unique and to do that, it's a very harsh environment inside the tool. If you look at our frequency, of six, so six times a second, we essentially create a water jet, and this water jet tore apart every material we could find. Every material that we were, that we knew very well, your laser cladding, hand-laid carbides, your salt bath. Everything that we knew to do to for this to fight off this abrasive environment. This material came to us as really kind of an odd deal from a trade show, just talking to a company that had this unique material. We really thought they were up in the [indiscernible]. Since then, this has really opened our eyes to what this material can do for us in the oil and gas industry. We were able to go over and deal with this supplier. They've got there - it was difficult for them to get the manufacturing of this [indiscernible] down, but they've got it down now and we've got something that works for us very well, and I went over there and set down with them and we negotiated some really good - a really good agreement on, essentially, first to market opportunities that we have with this material in oil and gas. What it does, John, is it just opens, it gives us more opportunity as we look at things going down the road, from our R&D department knowing that we know this material is pretty much unheard of in the oil and gas downhole tool market. It just gives us a lot of opportunity of what we can develop and put out there, years to come.

[John Sturges:]

Okay. It doesn't price the tools out, out of basically their economic value?

[Troy Meier:]

No. What we found was, when we looked at the hardening and cladding of the parts that we were using, this came in right there. The prices that we were used to and the manual labor that we were used to, by [indiscernible] these parts up, we find that this material comes in right there at that price point. It's not costing us anymore to use something that last much, much longer.

[John Sturges:]

Got it. Thank you.

[Operator:]

[Operator Instructions]. Our next question comes from the line of John White with ROTH Capital Markets. Please proceed with your question.

[John White:]

Good morning, everyone, and thanks for taking my question.

[Troy Meier:]

Hey John, how are you doing?

[John White:]

Good. How are you, Troy?

[Troy Meier:]

Good.

[John White:]

The lower revenue guide, is that primarily due to the tools lasting longer?

[Chris Cashion:]

That's a couple of things and that's one of them. It's also the logistics inefficiencies that we talked about in the Middle East. We did generate decent revenue in Q2. We saw that slow down a lot in Q3. We're kind of thinking that, until we get our service center up and running in Dubai, that we just better plan on the logistics inefficiencies to continue throughout the rest of the year. Once we're up and functioning in that region, then we would have mitigated those issues and we'll be back on track from a revenue perspective. But yes, it's just both of those things really contributed to the dip in the guidance down a bit.

[John White:]

I appreciate that, Chris, and then the effect on margins is your Texas and Middle East expansion, is not only CapEx but also some additional operating expenses, is that fair?

[Chris Cashion:]

Absolutely. We're going from basically one tool service center, that being Vernal, Utah, to three. Vernal, Texas, and the Middle East now. Yes, you've got some capacity utilization. It's going to be lower for our overall infrastructure until we get the revenues ramped up and that will be next year with the revenue start coming. You're right. It's just some OpEx as well as CapEx.

[John White:]

All right. Thank you very much.

[Chris Cashion:]

Thanks, John.

[Operator:]

Thank you. Our next question comes from the line of Mike Briard with Hodges Capital. Please proceed with your question.

[Mike Briard:]

Thank you. Just out of curiosity, your second channel partner in the Middle East, will they have a specific territory set aside for them or will they be competing with Smith?

[Chris Cashion:]

No. We don't have a territory set aside for them. In our agreement with them right now, we've targeted a country that we know the tool is performing very well, and when we talk about Smith International Gulf Coast, that is not the Smith International Drilling Tools that you're familiar with.

[Mike Briard:]

Yes.

[Chris Cashion:]

What we call SIGC, Smith International Gulf Coast, they purchased the Smith International and this is a group over there that does very high-end manufacturing and repair of downhole tools. We don't compete with them at all and nor will this channel partner. This is just going to be a place that services tools. If you talk about Smith that is now owned by Schlumberger, I don't believe they have a reamer tool line but maybe they do. But we haven't seen that as competition at all. We haven't seen anything from them.

[Troy Meier:]

Well, we'll have two channel partners. We've got Weatherford. We've had Weatherford for the entire year and then we'll have the second partner and it's not exclusive to both of them.

[Mike Briard:]

Okay. By the way, I talked to one of your new customers. They are extremely pleased with the DNRQ tool and want to use in all the wells.

[Troy Meier:]

Oh, wonderful. Wonderful. We like hearing that.

[Chris Cashion:]

Yes, thank you.

[Mike Briard:]

Okay.

[Operator:]

Thank you. Mr. Meier, there are no further questions at this time. I will turn the floor back to you for any final comments.

[Troy Meier:]

Okay. Thanks, everyone, for joining us today. We appreciate your time. We look forward to the time and the resources that we've put into expansion. We believe that 2019 is going to be a fantastic year for the Company, that we start to see a good return on our investment on these expansions. Pay attention to the news releases that you'll see coming out over the next, I would say, throughout November and December. I think these releases will be very important to the growth of our Company and the direction that we're going. Again, thank you, all, for joining us today.

[Operator:]

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.