Archrock, Inc.: Form 10-Q for the period ended Jun 30, 2024

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and the notes thereto included in this Form 10-Q and in conjunction with our 2023 Form 10-K.

OVERVIEW

We are an energy infrastructure company with a pure-play focus on midstream natural gas compression. We are a premier provider of natural gas compression services, in terms of total compression fleet horsepower, to customers in the energy industry throughout the U.S., and a leading supplier of aftermarket services to customers that own compression equipment in the U.S. We operate in two business segments: contract operations and aftermarket services. Our contract operations services primarily include designing, sourcing, owning, installing, operating, servicing, repairing and maintaining our owned fleet of natural gas compression equipment to provide natural gas compression services to our customers. In our aftermarket services business, we sell parts and components and provide operations, maintenance, overhaul and reconfiguration services to customers who own compression equipment.

Operating Highlights

(horsepower in thousands)

(1) Defined as idle and operating horsepower. Includes new compressors completed by third-party manufacturers that have been delivered to us.

(2) Defined as horsepower that is operating under contract and horsepower that is idle but under contract and generating revenue such as standby revenue.

Non-GAAP Financial Measures

Management uses a variety of financial and operating metrics to analyze our performance. These metrics are significant factors in assessing our operating results and profitability and include the non-GAAP financial measure of adjusted gross margin.

We define adjusted gross margin as total revenue less cost of sales, exclusive of depreciation and amortization. Adjusted gross margin is included as a supplemental disclosure because it is a primary measure used by our management to evaluate the results of revenue and cost of sales, exclusive of depreciation and amortization, which are key components of our operations. We believe adjusted gross margin is important because it focuses on the current operating performance of our operations and excludes the impact of the prior historical costs of the assets acquired or constructed that are utilized in those operations, the indirect costs associated with our SG&A activities, our financing methods and income taxes. In addition, depreciation and amortization may not accurately reflect the costs required to maintain and replenish the operational usage of our assets and therefore may not portray the costs of current operating activity. As an indicator of our operating performance, adjusted gross margin should not be considered an alternative to, or more meaningful than, gross margin, net income (loss) or any other measure presented in accordance with GAAP. Our adjusted gross margin may not be comparable to a similarly-titled measure of other entities because other entities may not calculate adjusted gross margin in the same manner.

Adjusted gross margin has certain material limitations associated with its use as compared to net income. These limitations are primarily due to the exclusion of SG&A, depreciation and amortization, impairments, restructuring charges, interest expense, gain on sale of assets, net, other expense (income), net and provision for income taxes. Because we intend to finance a portion of our operations through borrowings, interest expense is a necessary element of our costs and our ability to generate revenue. Additionally, because we use capital assets, depreciation expense is a necessary element of our costs and our ability to generate revenue and SG&A is necessary to support our operations and required corporate activities. To compensate for these limitations, management uses this non-GAAP measure as a supplemental measure to other GAAP results to provide a more complete understanding of our performance.

The following table reconciles net income to adjusted gross margin:

(in thousands)

The following table reconciles adjusted gross margin to gross margin, its most directly comparable GAAP measure:

(in thousands)

RESULTS OF OPERATIONS

Summary of Results

Revenue was $270.5 million and $247.5 million during the three months ended June 30, 2024, and 2023, respectively, and $539.0 million and $477.4 million during the six months ended June 30, 2024 and 2023, respectively. The increase in revenue was primarily due to increased revenue from our contract operations business during the three months ended June 30, 2024 and both our contract operations business and aftermarket services business during the six months ended June 30, 2024. See “Contract Operations” and “Aftermarket Services” below for further details.

Net income was $34.4 million and $24.7 million during the three months ended June 30, 2024, and 2023, respectively. The increase was primarily driven by higher adjusted gross margin from both our contract operations business and aftermarket services business. These changes were partially offset by increases in SG&A, depreciation and amortization expense, transaction-related costs and long-lived and other asset impairment, and a decrease in the unrealized change in the fair value of our investment in an unconsolidated affiliate.

Net income was $75.0 million and $41.1 million during the six months ended June 30, 2024, and 2023, respectively. The increase was primarily driven by higher adjusted gross margin from both our contract operations business and aftermarket services business. These changes were partially offset by increases in SG&A, depreciation and amortization expense, transaction-related costs, long-lived and other asset impairment, and decreases in the gain on sale of assets and in the unrealized change in the fair value of our investment in an unconsolidated affiliate.

Three Months Ended June 30, 2024 Compared to Three Months Ended June 30, 2023

Contract Operations

(dollars in thousands)

(1) Defined as adjusted gross margin divided by revenue.

Revenue in our contract operations business increased primarily due to higher rates and an increase in average operating horsepower for contract compression in response to higher utilization at Archrock and across our industry.

The increase in cost of sales, exclusive of depreciation and amortization, was primarily due to a $3.7 million increase in total employee compensation expense and a $1.1 million increase in parts expense. This increase was partially offset by a decrease of $1.9 million in startup expenses resulting from average horsepower utilization for the fleet at record levels as well as fewer unit stops.

Aftermarket Services

(dollars in thousands)

(1) Defined as adjusted gross margin divided by revenue.

Revenue in our aftermarket services business decreased primarily due to a decrease in part sales, partially offset by higher levels of service activities driven by an increase in customer demand.

Adjusted gross margin decreased in our aftermarket services business as a result of decreased revenue which exceeded the decrease in cost of sales, exclusive of depreciation and amortization, due to a mix of product sales.

Costs and Expenses

(in thousands)

Selling, general and administrative. The increase in SG&A included a $1.9 million increase in long-term incentive compensation expense, a $0.2 million increase in employee compensation expense and a $0.2 million increase in amortization of capitalized implementation costs, partially offset by a decrease of $0.3 million in legal and other professional fees.

Depreciation and amortization. The increase in depreciation and amortization expense was primarily due to fixed assets additions and accelerated depreciation associated with certain assets. The increase was partially offset by a decrease in depreciation expense associated with assets reaching the end of their depreciable lives, the impact of compression and other asset sales, and long-lived asset impairments.

Long-lived and other asset impairment. We periodically review the future deployment of our idle compressors for units that are not of the type, configuration, condition, make or model that are cost efficient to maintain and operate. We also evaluate for impairment our idle units that have been culled from our compression fleet in prior years and are available for sale. During the three months ended June 30, 2024 and 2023, we recognized $4.4 million and $2.9 million, respectively, of impairment charges to write down these compressors to their fair value. See Note 10 (“Long-Lived Asset and Other Impairments”) for further details on these impairment charges. The following table presents the results of our compression fleet impairment review, as recorded in our contract operations segment:

(dollars in thousands)

Interest expense. The decrease in interest expense was primarily due to the write-off of $1.0 million of unamortized deferred financing costs as a result of the Amended and Restated Credit Agreement during the three months ended June 30, 2023, and a lower average outstanding balance of long-term debt, partially offset by a decrease in capitalized interest and an increase in interest rates.

Transaction-related costs. We incurred $1.8 million of legal and other professional fees during the three months ended June 30, 2024 related to the TOPS Acquisition.

Gain on sale of assets, net. The decrease in gain on sale of assets was primarily due to gains of $0.3 million on compression asset sales and $0.3 million on transportation asset sales during the three months ended June 30, 2024, compared to gains of $0.6 million on compression asset sales and $0.4 million on other asset sales during the three months ended June 30, 2023.

Other expense, net. The increase in other expense, net was primarily due to a $1.7 million unrealized change in the fair value of our investment in an unconsolidated affiliate recognized during the three months ended June 30, 2023.

Provision for Income Taxes

The increase in provision for income taxes was primarily due to the tax effect of the increase in book income, offset by the reduction in valuation allowance during the three months ended June 30, 2024 compared with the three months ended June 30, 2023.

(dollars in thousands)

Six Months Ended June 30, 2024 Compared to Six Months Ended June 30, 2023

Contract Operations

(dollars in thousands)

(1) Defined as adjusted gross margin divided by revenue.

Revenue in our contract operations business increased primarily due to higher rates and an increase in average operating horsepower for contract compression in response to higher utilization at Archrock and across our industry.

The increase in cost of sales, exclusive of depreciation and amortization, was primarily due to a $5.2 million increase in total employee compensation expense, a $1.8 million increase in parts expense and a $1.4 million increase in local and miscellaneous taxes. This increase was partially offset by a decrease of $6.9 million in startup expenses resulting from average horsepower utilization for the fleet at record levels as well as fewer unit stops.

Aftermarket Services

(dollars in thousands)

(1) Defined as adjusted gross margin divided by revenue.

Revenue in our aftermarket services business increased primarily due to higher levels of service activities driven by an increase in customer demand, partially offset by a decrease in part sales.

Adjusted gross margin increased in our aftermarket services business as a result of increased revenue which exceeded the increase in cost of sales, exclusive of depreciation and amortization, due to differences in the scope, timing and type of services performed.

Costs and Expenses

(in thousands)

Selling, general and administrative. The increase in SG&A included primarily a $5.7 million increase in long-term incentive compensation expense, a $0.6 million increase in short-term incentive compensation expense, a $0.5 million increase in network and computer related costs, a $0.4 million increase in amortization of capitalized implementation costs, a $0.3 million increase in insurance expense and a $0.2 million increase in sales commissions expense, partially offset by a decrease of $0.7 million in professional fees.

Depreciation and amortization. The increase in depreciation and amortization expense was primarily due to fixed assets additions and accelerated depreciation associated with certain assets. The increase was partially offset by a decrease in depreciation expense associated with assets reaching the end of their depreciable lives, the impact of compression and other asset sales, and long-lived asset impairments.

Long-lived and other asset impairment. We periodically review the future deployment of our idle compressors for units that are not of the type, configuration, condition, make or model that are cost efficient to maintain and operate. We also evaluate for impairment our idle units that have been culled from our compression fleet in prior years and are available for sale. During the six months ended June 30, 2024 and 2023, we recognized $7.0 million and $5.5 million, respectively, of impairment charges to write down these compressors to their fair value. See Note 10 (“Long-Lived Asset and Other Impairments”) for further details on these impairment charges. The following table presents the results of our compression fleet impairment review, as recorded in our contract operations segment:

(dollars in thousands)

Restructuring charges. Restructuring charges of $1.0 million during the six months ended June 30, 2023 consisted of severance and consulting costs related to our restructuring activities. See Note 11 (“Restructuring Charges”) for further details on these restructuring charges.

Interest expense. The decrease in interest expense was primarily due to the write-off of $1.0 million of unamortized deferred financing costs as a result of the Amended and Restated Credit Agreement during the six months ended June 30, 2023, partially offset by a decrease in capitalized interest and an increase in interest rates.

Transaction-related costs. We incurred $1.8 million of legal and other professional fees during the six months ended June 30, 2024 related to the TOPS Acquisition.

Gain on sale of assets, net. The decrease in gain on sale of assets was primarily due to gains of $2.5 million on compression asset sales and $0.4 million on transportation asset sales during the six months ended June 30, 2024 compared to gains of $3.9 million on compression asset sales and $0.8 million on transportation and other asset sales during the six months ended June 30, 2023.

Other expense, net. The increase in other expense, net was primarily due to a $2.0 million unrealized change in the fair value of our investment in an unconsolidated affiliate recognized during the six months ended June 30, 2023.

Provision for Income Taxes

The increase in provision for income taxes was primarily due to the tax effect of the increase in book income and the limitation on executive compensation offset by the benefit from equity-settled long term incentive compensation and reduction in valuation allowance during the six months ended June 30, 2024 compared with the six months ended June 30, 2023.

(dollars in thousands)

LIQUIDITY AND CAPITAL RESOURCES

Overview

Our ability to fund operations, finance capital expenditures and pay dividends depends on the levels of our operating cash flows and access to the capital and credit markets. Our primary sources of liquidity are cash flows generated from our operations and our borrowing availability under our Credit Facility. Our cash flow is affected by numerous factors including prices and demand for our services, oil and natural gas exploration and production spending, conditions in the financial markets and other factors. We have no near-term maturities and believe that our operating cash flows and borrowings under the Credit Facility will be sufficient to meet our future liquidity needs.

We may from time to time seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity or debt securities in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, may be material, will be upon terms and prices as we may determine and will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors.

Cash Requirements

Our contract operations business is capital intensive, requiring significant investment to maintain and upgrade existing operations. Our capital spending is primarily dependent on the demand for our contract operations services and the availability of the type of compression equipment required for us to provide those contract operations services to our customers. Our capital requirements have consisted primarily of, and we anticipate will continue to consist of, the following:

• operating expenses, namely employee compensation and benefits, inventory and lube oil purchases;
• growth capital expenditures;
• maintenance capital expenditures;
• interest on our outstanding debt obligations;
• dividend payments to our stockholders; and
• shares repurchased under the Share Repurchase Program and to cover taxes required to be withheld on the vesting date of long-term incentive grants to employees.

Capital Expenditures

Growth Capital Expenditures. The majority of our growth capital expenditures are related to the acquisition cost of new compressors when our idle equipment cannot be reconfigured to economically fulfill a project’s requirements and the new compressor is expected to generate economic returns that exceed our cost of capital over the compressor’s expected useful life. In addition to newly-acquired compressors, growth capital expenditures include the upgrading of major components on an existing compression package where the current configuration of the compression package is no longer in demand and the compressor is not likely to return to an operating status without the capital expenditures. These expenditures substantially modify the operating parameters of the compression package such that it can be used in applications for which it previously was not suited.

Maintenance Capital Expenditures. Maintenance capital expenditures are related to major overhauls of significant components of a compression package, such as the engine, compressor and cooler, which return the components to a like-new condition, but do not modify the application for which the compression package was designed.

Projected Capital Expenditures. While market activity continues to be strong, we currently anticipate reduced capital expenditures in 2024 compared to 2023, which supports free cash flow generation after dividends, and plan to spend approximately $290 million to $300 million in capital expenditures during 2024, primarily consisting of approximately $190 million for growth capital expenditures and approximately $80 million to $85 million for maintenance capital expenditures.

Dividends

On July 25, 2024, our Board of Directors declared a quarterly dividend of $0.165 per share of common stock to be paid on August 13, 2024 to stockholders of record at the close of business on August 6, 2024. Any future determinations to pay cash dividends to our stockholders will be at the discretion of our Board of Directors and will be dependent upon our financial condition, results of operations and credit and loan agreements in effect at that time and other factors deemed relevant by our Board of Directors.

Sources of Cash

Credit Facility

During the six months ended June 30, 2024 and 2023, our Credit Facility had an average debt balance of $287.0 million and $282.5 million, respectively. The weighted average annual interest rate on the outstanding balance under the Credit Facility was 7.6% and 7.7% at June 30, 2024 and December 31, 2023, respectively. As of June 30, 2024, there were $4.1 million letters of credit outstanding under the Credit Facility and the applicable margin on borrowings outstanding was 2.1%.

As of June 30, 2024, we were in compliance with all covenants under our Credit Facility. Additionally, all undrawn capacity on our Credit Facility was available for borrowings as of June 30, 2024.

Cash Flows

Our cash flows, as reflected in our unaudited condensed consolidated statements of cash flows, are summarized below:

(in thousands)

Operating Activities

The increase in net cash provided by operating activities was primarily due to increased cash inflows of $65.9 million from adjusted gross margin, excluding deferred revenue recognized in earnings and amortization of freight and mobilization charges, changes of $14.3 million in accounts receivable due to increased cash receipts from customers, $11.4 million in accounts payable and accrued liabilities due to a reduction in overall spend and timing of vendor invoice payments and $8.7 million of inventory as a result of improvement in the lead time for parts.

Investing Activities

The increase in net cash used in investing activities was primarily due to a $20.5 million decrease in proceeds from the sale of property, plant and equipment and a $3.6 million increase in capital expenditures, partially offset by a $1.9 million decrease in investments in non-consolidated affiliates.

Financing Activities

The change from net cash provided by financing activities to net cash used in financing activities was primarily due to a $66.9 million decrease in net borrowings of long-term debt, a $4.5 million increase in dividends paid to stockholders and a $2.7 million increase in taxes paid related to net share settlement of equity awards, partially offset by a $5.5 million decrease in payments of debt issuance costs and a $1.2 million increase in common stock purchased under the Share Repurchase Program.

We are exposed to market risks associated with changes in the variable interest rate of our Credit Facility. A 1% increase in the effective interest rate on our Credit Facility’s outstanding balance at June 30, 2024 would have resulted in an annual increase in our interest expense of $3.1 million.

This Item 4 includes information concerning the controls and controls evaluation referred to in the certifications of our Chief Executive Officer and Chief Financial Officer required by Rule 13a-14 of the Exchange Act included in this Form 10-Q as Exhibits 31.1 and 31.2.

Management’s Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to management to allow timely decisions regarding required disclosures.

As of the end of the period covered by this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act), which are designed to provide reasonable assurance that we are able to record, process, summarize and report the information required to be disclosed in our reports under the Exchange Act within the time periods specified in the rules and forms of the SEC. Based on the evaluation, as of June 30, 2024, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that the information required to be disclosed in reports that we file or submit under the Exchange Act is accumulated and communicated to management, and made known to our principal executive officer and principal financial officer, on a timely basis to ensure that it is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) during the last fiscal quarter that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Other than the following items, there have been no material changes or updates to the risk factors previously disclosed in our 2023 Form 10-K.

Risks Related to the TOPS Acquisition

We may not consummate the TOPS Acquisition.

The TOPS Acquisition is subject to the satisfaction or waiver of customary closing conditions, and we cannot assure you that the TOPS Acquisition will be consummated in the anticipated time frame or at all. If one or more of the closing conditions are not satisfied, the TOPS Acquisition may not be completed. Some of these conditions are beyond our control, and we may elect not to take actions necessary to satisfy these conditions or to ensure that the TOPS Acquisition is not otherwise terminated. In addition, the purchase and sale agreement contains certain termination rights for both parties which, if exercised, will also result in the TOPS Acquisition not being consummated.

If the TOPS Acquisition is delayed, terminated or consummated on terms different than those described in the purchase and sale agreement, the market price of our common stock may decline to the extent that the price of our common stock reflects a market assumption that the TOPS Acquisition will be consummated on the terms described in the purchase and sale agreement or at all. Further, a failed transaction may result in negative publicity or a negative impression of us in the investment community and may affect our relationships with our business partners and the value of our common stock.

Under certain specified circumstances in which the purchase and sale agreement is terminated pursuant to its terms, Archrock ELT may be required to pay sellers a termination fee equal to $30.0 million or, in certain circumstances, sellers may be required to pay Archrock ELT a termination fee equal to $20.0 million. If the purchase and sale agreement is terminated under such circumstances, the termination fee Archrock ELT may be required to pay under the purchase and sale agreement may require us to use available cash that would have otherwise been available for general corporate purposes and other uses.

We may not be able to achieve the expected benefits of the TOPS Acquisition. We may also encounter significant

difficulties in integrating TOPS.

Even if we consummate the TOPS Acquisition, we may not be able to achieve the expected benefits of the TOPS Acquisition. There can be no assurance that the TOPS Acquisition will be beneficial to us. We may not be able to integrate the assets acquired in the TOPS Acquisition without increases in costs or other difficulties. The integration of a business is a complex, costly and time-consuming process. As a result, we will be required to devote significant management attention and resources to integrating our business practices and operations with the business practices and operations of TOPS. The integration process may disrupt our business and, if implemented ineffectively, would restrict the full realization of the anticipated benefits from the TOPS Acquisition. The failure to meet the challenges involved in integrating TOPS and to realize the anticipated benefits of the TOPS Acquisition could have an adverse effect on our business, results of operations, financial condition and prospects, as well as the market price of our common stock. The challenges of integrating the operations of acquired businesses include, among others:

• difficulties with the integration of the business of TOPS and workforce following the TOPS Acquisition;
• conditions in the oil and natural gas industry, including the level of production of, demand for or price of oil or natural gas;
• our reduced profit margins or the loss of market share resulting from competition or the introduction of competing technologies by other companies;
• changes in economic or political conditions, including terrorism and legislative changes;
• the inherent risks associated with our operations, such as equipment defects, impairments, malfunctions and natural disasters;
• the risk that counterparties will not perform their obligations under our financial instruments;
• the financial condition of our customers;
• our ability to timely and cost-effectively obtain components necessary to conduct our business;
• employment and workforce factors, including our ability to hire, train and retain key employees;
• our ability to implement certain business and financial objectives, such as:
• winning profitable new business;
• growing our asset base and enhancing asset utilization;
• integrating acquired businesses;
• generating sufficient cash; and
• accessing the capital markets at an acceptable cost;
• liability related to the use of our services;
• changes in governmental safety, health, environmental or other regulations, which could require us to make significant expenditures;
• the effectiveness of our control environment, including the identification of control deficiencies; and
• our level of indebtedness and ability to fund our business.

Many of these factors are outside of our control, and any one of them could result in increased costs and liabilities, decreases in the amount of expected revenue and earnings, and diversion of management’s time and energy, which could have a material adverse effect on our business, financial condition and results of operations. Further, additional unanticipated costs may be incurred in the integration of the acquired business.

The market price of our common stock may decline as a result of the TOPS Acquisition if, among other things, the integration of the properties to be acquired in the TOPS Acquisition is unsuccessful or transaction costs related to the TOPS Acquisition are greater than expected. The market price of our common stock may decline if we do not achieve the perceived benefits of the TOPS Acquisition as rapidly or to the extent anticipated by us or by securities market participants or if the effect of TOPS Acquisition on our business, results of operations or financial condition or prospects is not consistent with our expectations or those of securities market participants.

Any acquisitions we complete, including the TOPS Acquisition, are subject to substantial risks that could reduce our ability to make distributions to our common stockholders.

Even if we do make acquisitions that we believe will increase the amount of cash available for distribution to our common stockholders, these acquisitions, including the TOPS Acquisition, may nevertheless result in a decrease in the amount of cash available for distribution to our common stockholders. Any acquisition, including the TOPS Acquisition, involves potential risks, including, among other things:

• the assumption of unknown liabilities, losses or costs for which we are not indemnified or for which any indemnity we receive is inadequate;
• our inability to obtain satisfactory title to the assets we acquire; and
• the occurrence of other significant changes, such as impairment of long-lived assets, asset devaluation or restructuring charges.