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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Welcome to the Cactus Fourth Quarter and Full Year 2017 Earnings Call. Today’s call is being recorded.
At this time, I would like to turn the conference over to Steve Tadlock, Vice President and Chief Administrative Officer.
Thank you and good morning, everyone. We appreciate your participation in today's call. The speakers on today's call will be Scott Bender, our Chief Executive Officer, and Brian Small, our Chief Financial Officer. Also joining us today is Steven Bender, Vice President of Operations.
Yesterday afternoon, we issued our fourth quarter and 2017 earnings release, which is available on our website at www.cactuswhd.com. Please note that any comments we make on today's call regarding projections or our expectations for future events are forward-looking statements covered by the Private Securities Litigation Reform Act. Forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond our control. These risks and uncertainties can cause actual results to differ materially from our current expectations. We advise listeners to review our earnings release and the risk factors discussed in our filings with the SEC. Any forward-looking statements we make today are only as of today's date and we undertake no obligation to publicly updated or review any forward-looking statements.
In addition, during today's call, we will reference certain non-GAAP financial measures. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are included in our earnings release. And finally, after our prepared remarks, we will answer any questions you may have.
So with that, I’ll turn the call over to Scott.
Okay. Thanks, Steve and good morning to everyone. I'm pleased to welcome you to our first investor call as a publicly traded company. As many of you are aware, Cactus commenced operations only six and a half years ago shortly after a dinner meeting convened between our family and 18 of our valued associates with whom we had managed two previous ventures. During this meeting, we offered these individuals an opportunity to do for themselves what they had previously done for others, displaying the same confidence in each other that we felt they left the security of one of our largest competitors to join us.
That evening, we shared our vision for Cactus, which remains as valid today as it was then, to become the market leader in the US, while providing financial security and reward to our associates and our shareholders. I'm very proud to say this core group remains with us today in its entirety, barring one individual lost in illness. And as the company grew, these individuals attracted others who wish to be part of the success. And so on behalf of all the Benders, I first wish to offer my sincerest thanks to these individuals who helped develop our unique Cactus culture and strategy of recognizing that the loyalty of our customers defines our company's value. And so importantly, I want to thank those oil customers who welcomed us from the onset as partners, rather than dismissing us as a startup.
For those of you with whom we've not had the opportunity to meet, I’d like to provide a brief overview of the company. Cactus is a pure play provider of wellheads and frac rental equipment services to the US onshore market, which is arguably the best market in the world for oilfield services companies. We believe we offer a multifaceted value proposition. We design to manufacture a wellhead system, specifically for the US onshore market with both significant time saving features and safety enhancements, particularly in pad drilling applications.
Similarly, our pressure control products for frac operations are designed and manufactured in-house and we believe no one offers more reliable equipment and service. We offer two distinct, but highly complementary business lines, products and rooms, both of which are supported by our field service techs and we generate more than 50% of our revenues from product sales, which include consumables deployed during both drilling and production, while our rental business is comprised primarily of frac wells and related components as well as drilling tools used in conjunction with the equipment we sell.
We have a culture of innovation and execution that our customers have come to expect and we serve these customers through 14 strategically located service centers in the US. Our supply chain model is competitive, nimble and flexible, blending low cost production from our wholly-owned facility in China with our highly responsive manufacturing plant located in Bossier City, Louisiana and we have a management team that's demonstrated its prowess, navigating the industry challenges through numerous cycles.
The drivers of our business are primarily well count for our product sales and completion activities for our rail business. Cactus has become synonymous with industry leading technology, saving up to 28 hours per well of rig time with our wellhead systems, which translates to meaningful cost savings for our customers. And on the frac rental side, reduced nonproductive time saves hours of frac spread time for our E&P clients. We generate some of the best margins in the oilfield services industry because our customers recognize that we deliver real value to their business.
We're proud of the fact we remained EBITDA positive through the trough of the cycle and we generate high levels for cash flow as well as a strong return on capital employed. Cactus produced some of the strongest operating results and returns in our space in 2017 with revenues more than doubling as our average quarterly onshore wellhead market share grew from 21.2% to 26% from Q4 2016 to Q4 2017.
We believe these results are a validation by our customers of the technical superiority, reliability and efficacy of our products and services. We expect continued growth in 2018 for several reasons. We've recently increased our CapEx program by manufacturing additional valves and components to expand our frac rental fleet and we continue to innovate with features that reduce repair cost and enhance reliability.
Our 2018 CapEx is currently expected to be approximately $40 million to $50 million and Brian will provide more details on this. We added field service techs in the second half of 2017 to a level that was in excess of demand in order to better position ourselves to support our growth initiatives and the expected increase in demand. And finally, we expanded the Suzhou, China facility which we expect will continue to support our product and rental margins as well as our growth.
So with that, I'll turn the call over to Brian Small, our CFO who will review our 2017 results. Following his remarks, I'll make a few closing comments and then open the lines for Q&A. Brian?
Okay. Thanks, Scott. I will review some of the key financial metrics for 2017 and then discuss our fourth quarter results. As Scott mentioned, we achieved tremendous revenue growth in 2017, up 120% with steady growth each quarter. Product revenue accounted for the majority of last year's growth, increasing 143%. Net income rose to 66.5 million in 2017 from a loss of 8 million in 2016. Adjusted EBITDA rose almost 250% to 112 million, evidenced in the leverage we have to higher margins, which increased 32.9% from 20.8%, just a great year financially for us.
Looking at the fourth quarter, our results were right on target with the preliminary estimates and our final prospectus filed with the SEC. Fourth quarter revenue was up sequentially $8.8 million or 9.1% with solid gains across each of our revenue categories. Year-on-year quarterly revenue more than doubled to 104.8 million from 49.5 million. On a sequential basis, net income and adjusted EBITDA were both up marginally. As expected, we saw some seasonal impacts in the fourth quarter. We had increased costs that reflect the ramping up of our field service tech staff as Scott mentioned, particularly on the frac rental services side.
As we bring on board new field service tech trainees, we understandably did not generate revenue commensurate with these additional costs. However, we fully expect the positive impact to material in the coming quarters. SG&A, while down on a sequential basis in the fourth quarter is expected to increase in the subsequent quarters due to additional costs associated with being a public company.
Year-on-year, quarterly net income rose sharply to $22.8 million from 1.3 million, while adjusted EBITDA more than tripled to 35 million. As expected, our fourth quarter adjusted EBITDA margin percentage was down sequentially and consistent with the cost that we incurred as we positioned ourselves for growth in 2018. On a year-over-year basis, fourth quarter adjusted EBITDA margin percentage increased to 33.4% from 23.1%.
We have decided to bring forward our scheduled investments in large bore frac rental equipment [indiscernible] and to further expand the initial plan for 2018 and response to mounting loss opportunities caused by a shortage of these assets. Larger pod sizes, more requests for hydraulically operated valves and the rising popularity of zipper manifolds are placing additional demands on our rental fleet.
As we manufacture the majority of such products, we intend to leverage the flexibility our supply chain model offers us to more effectively address the market share available to us. We now estimate that our CapEx program for 2018 will be between $40 million and $50 million with the increases front loaded for the year. We expect these increases to positively impact ROCE over time.
During the course of the year, we will expand our Bossier City facility to accommodate increased lower cost components from our wholly-owned facility in China. And in addition, we plan to expand our service centers in the [indiscernible] New Mexico where we expect market share growth opportunities to continue. These expansions are necessary to efficiently handle the volumes of product sales and rentals available in these areas. We are very purposeful in deploying capital, which is why we delivered some of the highest returns in the sector. In 2017, our returning capital employed as measured by operating income over the average of our last two years capitalization was almost 50%.
Upon completion of our IPO and the associated exercise of the greenshoot, we received net proceeds of $467.4 million, with which we used to pay off our term loan and accrued interest of $251 million. The remainder was primarily used to redeem units held by prior owners of the business. We currently have $8 million drawn on our $50 million revolver and approximately $14 million of cash. We expect to pay the remainder of the revolver off in March. So we begin life as a public company with a very strong balance sheet, which will allow us to capitalize on opportunities such as we are seeing in our frac rental business along with our other business lines.
That covers the financial review. I’ll now turn the call back to Scott.
Thanks, Brian. While our results to date have been gratifying, we still have much to accomplish. We intend to continue our pursuit of market share in our products business, while we place increasing attention on solutions for the increasingly complex and demanding completion challenges our customers are facing. Most importantly, we’ll continue to focus on execution, particularly considering the well documented labor shortages we are all expecting. We would be remiss in not mentioning that we're carefully monitoring the potential tariffs being discussed on steel.
We don't believe that our products from our Suzhou, China plant are directly addressed in the Section 232 report, given they are finished components. While these -- and these imports had been our greatest concern. We do have raw material in the US for our Bossier City plant and we purchase various components and accessories from third parties to complete our finished assemblies. We’re unable at this time to predict the impact of section 232 on these goods, particularly as exemptions appear likely for certain countries. Based on our past experience however, we believe that our customers will be accommodating should the impact of these new tariffs prove to be significant.
Before I open up the lines for Q&A, I want to acknowledge and thank a number of groups of people who have been instrumental in our success. First, I want to thank our customers, again, whom we view as strategic partners in our business. Our success is a direct result of their confidence in our team, our products and the services we provide. We look forward to continuing to work closely with them and we’ll remain focused on ensuring we're responsive to their ongoing needs.
Secondly. thanks to all of our associates and special thanks to those who spent countless hours, preparing for our launch as well as to our external team of bankers, attorneys and advisors who assisted us with our very successful IPO. To our board of directors and our partners at Cadent energy, your guidance and support allowed us to operate our business despite the demands inherent in this process. To our new shareholders, thank you for your support and confidence. We could not be more aligned and we are committed to delivering superior results and returns. I look forward to working with you and the sell side analysts who will be following us and look forward as well to seeing many of you at the Howard Weil Conference in New Orleans later this month.
So with that, I’ll turn it back over to the operator so we may begin the Q&A portion.
[Operator Instructions] We’ll take our first question from Scott Gruber with Citi.
Congrats on your first call as a public company. We've heard from many service companies on a slow start to the year here in 2018. Can you just speak to what you're seeing in terms of the revenue trajectory in rental into 1Q and comment on how we should think about incrementals for that segment, as you start to absorb some of the cost you layered in late last year?
Well, Scott, I think that -- we're about two-thirds of the way through Q1 and I don't -- we're not detecting any surprises from what we have expected for the quarter. So in terms of our rental business, as we anticipated, our rental business is growing more rapidly than our wellhead and products business. As you recall, that’s the area that we felt we had the greatest headroom.
So in terms of incrementals, Brian, do you want to opine on -- Scott you’re referring to rental incrementals?
Yes. In particular, I’d also take some color on overall incrementals if that's easier.
Hi. It’s Brian here. I think really as Scott said, the early indications are that where we stand versus where we thought we would be on the key drivers, which for product revenues is record market share, for rentals revenues and for services utilization, where we are in line with expectations for Q1.
And on the CapEx Brian, would you be able to break down how much overall is being directed at facilities, at incremental rental equipment and how much you consider to be base maintenance, you just bucket growth a little bit?
Yeah. I’ll try my best. In terms of the 40 million to 50 million that we mentioned in the call, probably a few quarters of that is rental. Fewer maintenance CapEx, we reckon is probably under 5 and the balance, as I alluded in my portion, is we've got three small expansions of facilities and the New Mexico and we're also adding a little bit of roof lane in our plant to Bossier City to handle some storage.
And we’ll take our next question from James Wicklund from Credit Suisse.
I realized this isn't as easily denominated like wellheads, but generally what do you think your market share is in the frac rental business? I know it's fragmented and it's formally a mom and pop business, but can you talk about where you think you stand in that and what the evolution of that business if there's been any over the last couple years and what you expect going forward.
Thanks. You come up with a harder question for us. You know how hard that is to -- for us.
I know and I'm not asking for hard numbers, but if you could just talk to it, it would be appreciated.
Okay. So let me -- I will speak to it happily. We are very confident that we're well below 10% in terms of our frac rental market share. The issue that we have is that do you measure market share by the number of crews you service or do you measure it by the number of wells because we could be on a crew with a 10 well pad and we could be following a crew that’s working two well pads.
A common denominator is hard to find. I agree. But 10% would indicate that you have a decent amount of upside over the next couple of years as opposed to what -- if you had 37%. I mean I'm just thinking potential from here and again, have there been any trends? I mean, are mom and pops getting forced out of the business or are they still a major part of this industry?
I would say that and Steven you can opine as well, Steven is much closer to the day to day frac well business than I. I would say that we're seeing less impact from mom and pops over the last six months to nine months and we attribute that to the much more severe intensities of these fracs, and -- but the reason of course that we see fewer of them is that frac valves that are simply purchased out of the Far East, for example, without pedigree, without design verification and validation, tend not to hold up as well in these harsh environments. So it's severely I think reduced what I would refer for to as the approved vendors for many of our customers and it's reduced to those who perhaps design and manufacture their own frac wells.
A second if I could. You've got two legs, rental and products, wellheads and valves. What else sits in there if anything over time?
Jim, I've been in this business for 40 years and I've asked myself that question for 40 years. The problem that we have is this business is rather unique and that it generates so much cash flow and it has always had a very high ROCE characteristic to it. So if we look at the other products, we're focused on products that we can manufacture because we think we add value. We're focused on products that are differentiated because we try to avoid selling on the basis of cost.
And then lastly, we focus on products that can be sold directly to end users. So that completely eliminates, at least for the time being, consideration of products that move through distribution. We just don't want to -- we want something that will allow us to leverage this customer equity that we have right now. So that's the long answer. The short answer is, we have yet to identify a product that meets that profile.
It's tough starting at the top.
We will take our next question from Bill Herbert with Simmons and Company.
So year to date, drilling activity gains have been pretty strong actually and stronger probably the most people expected coming into the year due to the austerity refrain on the part of kind of the leading lights of E&P and the driver of those gains have been predominately private E&Ps, I would call, secular growth majors. So of your exposure to lower 48, what roughly is your percentage exposure on the wellhead side to the privates and secular growth majors?
Bill, maybe I could rephrase that. You’re really asking how much wellhead business do we do at the super majors, the big majors.
Well, no, so Exxon and Chevron specifically plus private E&Ps. So collectively, those two buckets roughly speaking or more than 50% of the rig count and certainly driving the majority of the drilling activity gains whereas the leading lights of E&Ps, the Conchos, et cetera are kind of more methodical and they're pivoting to a more restrained capital allocation. So the growth is being driven by another bucket, so that other bucket, private E&P, secular growth majors, what roughly would be your percentage exposure to that? Would it be 50%, 50 plus percent in line with the overall rig count, representation, I'm just trying to get a sense of that particular mix for you?
I'm going to probably have to answer it the way I look at it, rather than the way you look at it. We're very well represented with the entire population of end users in terms of wellhead with the exception of the majors. And Bill, I think there's a reason for that that probably won't surprise you and that is that when we find companies are ready to embrace innovation, the majors are just historically much more cautious and they're much more oil to their suppliers. That's the first point. Interestingly enough, the way in to the majors we are finding is through the frac rental business.
So while we've spent a lot of time last year taking our wellhead customers and migrating and trying to add their frac business to our revenue stream, in terms of majors, the way in has been this year through their frac rental business. The reason for that is really important -- probably more interesting to be than it is to anyone else is that they're suffering non-productive times. So they can't afford to be as cautious as they were and I'm thinking of two majors right now with whom we're doing business that we were not doing business with at this time last year and it's through their frac rental demands. So our hope is that we can move that into something better. Go ahead.
And then just two quick follow-ups from me. First, you've got -- even with the increasing capital spending, you've got super free cash flow and especially next year when CapEx is expected to then lower and so what you see as the most likely uses of surplus cash that's -- and then secondly labor cost inflation, historically low rates of unemployment and all energy base, just curious as to what that's running for you on the leading edge basis?
Okay. All right. Good questions. I think that in terms of what are we going to do with our cash, so we made a decision to accelerate and expand our CapEx in frac rental valves because we view that as meeting our criteria for ROCE. If we can no longer find investment opportunities that meet our criteria, then we will naturally begin to think about dividends. And if we can't find an acquisition that meets our ROCE threshold as well as the other criteria that I enumerated earlier. So I think that while I certainly wouldn’t want -- we wouldn’t want to commit to an answer, that broadly is the way we're thinking about this.
And then in terms of labor, the labor issues have been much more acute in terms of our field service people and our shop folks and last year, we were -- we were mid double digit.
I would say, last year for the early folks, double digit increases to recruit and retain.
So the first digit begins with a one though, not a five. I think it's been 15% to 16%, maybe for certain areas. For -- and by the way, we seem to have stabilized in terms of a loss of people because of wages. So I think we found the right spot. For 2018, we believe that we can contain that to mid to high single digits and that really addresses our hourly, in particular, our field service techs.
And we’ll take our next question from Sean Meakim with J.P. Morgan.
I was hoping we could maybe talk a little bit more about capital deployment for the rental business, for example, you mentioned some of these large bore rentals being a particular opportunity, given there's a shortage and the shift in activity underway, maybe, could you talk about how you think about the economics of adding incremental units? Is it return hurdle, cash payback, time periods? And I think also would be helpful to get a sense of the run rate for CapEx as a percentage of sales for rentals, how you see that normalizing over time?
Hi. It’s Brian here. Let me try and answer that one, Sean. I mean, historically, we find a good return on our rental equipment, because ROCE is important to us. You'll see that for 2017, our rental revenues I think were about $78 million. The gross cost of a rental fleet is $85 million. And in broad terms, we look at payback so less than a year.
And then just thinking about the composition of your manufacturing capacity over time, what would you say is the optimal mix between lower cost Chinese volumes versus quickly timed capacity here in the US, recognizing that you've got the opportunity to flex your Chinese capacity as well, how do we think about what is an optimal mix for the business over time?
The optimal mix is 100% from the Far East. The practical mix, I think, the practical optimal mix will be in the 60% range from the Far East, maybe 65%. We are -- in addition sort of -- the answer to that question is, I think maybe even more interesting than just from a cost perspective, it's incumbent upon us to move as much of the labor intensive portion of our product to the Far East as we can. And so that not simply the machining and the assembly, but even the final assembly. So I think that in a perfect world, if we could bring goods in, it required a very minimal amount of intervention here in the US. It would go a long way to solving at least from our perspective this issue of labor shortages here. So that's a long answer. I would say 60% to 65% though.
And then let me just tack on to that, just anything -- any considerations with respect to working capital needs, other outcomes we should think about with respect to moving towards that mix, getting longer lead times, et cetera.
Hi. It’s Brian here. On working capital, in very broad terms, it represents around about three months revenue. And it’s never really very too much on that, except in the down time, obviously, inventory didn’t decrease in the same rate as the AR.
Sean, with respect to China, obviously, we would expect inventory to have longer days. In China, it takes about 120 days to get product over. So you would see some movement in that number, but not material. I don't think.
And we will take our next question from J.B. Lowe with Bank of America.
I just want to say congrats on your successful IPO. I know, it was kind of a wild market when you guys were coming out, but I think at least time is right for your shareholders. My question, I know we've talked about kind of your -- what you think your max market share could be in the US. I guess another way to look at it would be, given the capacity you have now at Bossier and at Suzhou, what do you think the max number of rigs that you could follow is?
Wow, I never thought about the maximum number, that would be such a high level problem. Let me -- I have an inability to give you a short answer on this. First, you have to sort of remove the non-horizontal wells or rigs from our population because we're not -- our system -- wellhead system is not well suited for vertical simple wells. So we are very well suited for pad drilling complicated wells, multi casing strings that sort of thing. And I think probably horizontal accounts for, I don't really look at it this way, but probably 80%, maybe 75% of the number of rigs.
In terms of our market share, I actually was reflecting back on our wood group days and in 2004, at wood group, we were at about 30% market share in the US, Cameron was in the mid to high-30s at that time. So we have some headroom in terms of wellhead product market share. I think that we don't really discuss it here among our sales staff and we want to get every bit of work that we can actually take care of and I think perhaps our supply chain is not the constraint. Our constraint right now is the infrastructure we have in our branches and we're focused on that. So I guess, the short answer is we're going to take as much as we possibly can, but there's no question in my mind we’ve some headroom there.
So you could get to following 350 rigs, given some of the infrastructure issues you mentioned, you’ve worked those out and get to that number?
Yeah. I think that’s absolutely the case.
My other one was just on, I know, we've talked about frac rental pricing being somewhere like 40% below the peak. Is that still the case now and just given structurally the market, do you think that getting back to peak pricing is achievable or do you think that something below that is probably where the market will eventually top out of that?
Steven, what do you think?
Well, to answer your first question, I think we are still below peak if you want to call it that 2014. Do I think we can get there? I do, given the intensity of the fracs and to answer maybe Jim's earlier question about regional and mom and pop players maybe falling out through the atrophy of their fleet, there's definitely a demand and supply issue going on in the Permian right now that’s pushing pricing up. So I think 2014 levels are achievable.
So that's on the pricing. Do you think margin wise same story?
There is no reason why it wouldn't.
We’ll take our next question from George O'Leary with Tudor, Pickering.
On the product side of the equation, just curious with the mixes, I imagine it’s very heavily skewed towards the wellhead side, but how many of your customers on the wellhead side are also production tree customers and maybe any color on just ballpark the revenue mix and production trees versus wellheads and might there be some market share capture on the production tree side that maybe we aren’t really thinking about.
So, it's a general rule of thumb if we provide the wellhead, pardon me, we're going to end up with the production trees, not always the case. The reason it's not always the case is that there's a very low barrier, entry barrier for production tracers. That's a very commoditized portion of our business, but in general if we provide the wellhead, we provide the production trees. The area that probably is not totally consistent with that would be West Texas where there is a proliferation of mom and pop companies that provide that only.
In terms of our total product mix, I'm going to suggest, we're at about 20% production and 80% wellhead. And we actually see a growth in our production trees right now. A lot of it has to do with us putting production trees on wells that we drilled a year ago. So there's this natural delay as you know. We often pick back at our first year, year and a half of business, we didn’t sell any production trees because we didn't have any wellheads installed until the end of 2011 and we had that delay. So we are seeing an increasingly high percentage of production trees right now.
And then maybe a bigger picture question, there are some longer term plans for you guys to expand in the Middle East and just maybe a general update on where you sit within that process and kind of what maybe hurdles or landmarks we should be looking for, for you guys in the international markets?
We have exactly one person devoted right now to the international market and that would be primarily focused on the Mid East. So it's such an -- these are such early days. I would sort of caution you against doing any work on international. The areas of course with which we’re familiar from our previous experience, I’ll be probably fairly well known. We did quite a bit of work with the RampCo, ADMA, ADCO, KOC, PDO over our history and so we know the players in those areas and we're just sort of right now just dipping our toes into that potential market. I do have to caution you though the US market remains far and above a better market for us.
It appears there are no further questions at this time. And I would like to turn the conference back over to today’s speakers for any additional or closing remarks.
With that, we appreciate your time today. Thank you for your support. And we look forward to seeing you at Howard Weil.
Thanks everybody. Have a good day.
This concludes today's conference. Thank you for your participation. You may now disconnect.