Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Financial Statements, the notes thereto, and the other financial information appearing elsewhere in this 2020 Form 10-K. The following discussion includes forward-looking statements that involve certain risks and uncertainties. See “Forward-Looking Statements” and Part I Item 1A “Risk Factors” in this 2020 Form 10-K.
Overview
We are an energy infrastructure company with a pure-play focus on midstream natural gas compression. We are the leading provider of natural gas compression services to customers in the oil and natural gas industry throughout the U.S. and a leading supplier of aftermarket services to customers that own compression equipment in the U.S. Our business supports a must-run service that is essential to the production, processing, transportation and storage of natural gas. Our geographic diversity, technically experienced personnel and large fleet of natural gas compression equipment enable us to provide reliable contract operations services to our customers.
We operate in two business segments:
● Contract Operations . Our contract operations business is comprised of our owned fleet of natural gas compression equipment that we use to provide operations services to our customers.
● Aftermarket Services . Our aftermarket services business provides a full range of services to support the compression needs of our customers that own compression equipment including operations, maintenance, overhaul and reconfiguration services and sales of parts and components.
Significant 2020 Transactions
December 2020 Notes Offering
On December 17, 2020, we completed a private offering of $300.0 million aggregate principal amount of 6.25% senior notes due April 2028. The notes were issued at 104.875% of their face value and we received net proceeds of $309.9 million after deducting issuance costs, which were used to repay borrowings outstanding under our Credit Facility. See Note 14 (“Long-Term Debt”) to our Financial Statements for further details of this transaction.
July 2020 Disposition
On July 9, 2020, we completed the sale of the turbocharger business included within our aftermarket services segment. We recognized a gain on the sale of $9.3 million during the year ended December 31, 2020. See Note 4 (“Business Transactions”) to our Financial Statements for further details of this transaction.
2022 Notes Redemption
On April 1, 2020, we repaid the 2022 Notes with borrowings under our Credit Facility. See Note 14 (“Long-Term Debt”) to our Financial Statements for further details of this transaction.
March 2020 Disposition
On March 1, 2020, we completed the sale of certain contract operations customer service agreements and approximately 200 compressors, comprising approximately 35,000 horsepower, used to provide compression services under those agreements as well as other assets used to support the operations. We recognized a gain on the sale of $3.2 million during the year ended December 31, 2020. See Note 4 (“Business Transactions”) to our Financial Statements for further details of this transaction.
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Trends and Outlook
The key driver of our business is the production of U.S. natural gas and crude oil. Approximately 75% of our operating fleet is deployed for midstream natural gas gathering and wellhead applications, with the remaining fleet being used in gas lift applications to enhance crude oil production. Changes in natural gas and crude oil production spending therefore typically result in changes in demand for our services.
Spending on natural gas and crude oil exploration and production typically declines when there is a significant and prolonged reduction in natural gas and crude oil prices or significant instability in energy markets and increases during periods of rising prices and market stability. As our business is so closely aligned with production and is typically less directly impacted by commodity prices, we are not exposed to the volatility often faced in shorter-cycle oil field service businesses.
COVID-19 Pandemic
In the first quarter of 2020, the COVID-19 pandemic caused a deterioration in global macroeconomic conditions, including a collapse in the demand for natural gas and crude oil coupled with an oversupply of crude oil, which led to substantial spending cuts by our customers and a decline in natural gas and crude oil production. This global response to the pandemic has adversely impacted our market capitalization, revenue and cash flows. Though demand has shown modest improvement since the lows reached in the second quarter as economies started to reopen, additional surges of the disease are currently underway globally and much uncertainty still exists surrounding the magnitude and duration of the pandemic and resulting economic downturn. Similarly, the duration of the decreased spending and activity levels of our customers and the timing of their full impact on production remain difficult to predict.
The impact of the COVID-19 pandemic on our 2020 results is primarily visible in the $99.8 million non-cash impairment of our goodwill and the impairment’s resulting $22.6 million tax benefit. Horsepower, utilization and revenue experienced declines beginning in the second quarter as compared to 2019 and are expected to remain at lower levels into 2021 in both our contract operations and aftermarket services businesses. Long-lived and other asset impairment and restructuring charges have also been significantly impacted. See “Financial Results of Operations” below and Note 9 (“Goodwill”), Note 18 (“Long-Lived and Other Asset Impairment”), Note 19 (“Restructuring Charges”) and Note 20 (“Income Taxes”) to our Financial Statements for further discussion.
In recent years, prior to the COVID-19 pandemic, increased global demand for U.S. natural gas and crude oil production had contributed to increased production for both resources and record U.S. natural gas production in 2018 and 2019. Production fell sharply in the second quarter of 2020, however, as a result of the global response to the COVID-19 pandemic. According to the EIA, average U.S. dry natural gas and crude oil production in 2020, 2019 and 2018 were as follows:
Year Ended December 31,
2020
2019
2018
Average dry natural gas production (Bcf/d)
91.3
92.0
83.8
Average crude oil production (MMb/d)
11.3
12.2
11.0
The increases in production in 2018 and 2019 resulted in strong demand for our compression services in those years and into the first quarter of 2020. Additionally, we increased our investment in new fleet units in 2019 and 2018 to take advantage of improved market conditions. As a result of this increased demand and investment, our contract operations revenue and average operating horsepower increased 15% and 10%, respectively, in 2019 compared to 2018. In 2020, however, the decrease in demand and production brought on by the COVID-19 pandemic drove revenue and average operating horsepower back down to below 2019 levels.
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Outlook
The EIA forecasts the following year-over-year changes in its February 2021 Short-Term Energy Outlook report:
Increase (Decrease)
2021
2022
U.S. dry natural gas production
(1)
%
1
%
U.S. crude oil production
(3)
%
5
%
U.S. natural gas domestic consumption
(2)
%
(1)
%
Liquefied natural gas exports
30
%
9
%
Overall, U.S. natural gas and crude oil production is expected to show a modest decline in 2021 as producers limit drilling and completion activity to achieve maintenance levels of production and cash flows in the course of the COVID-19 pandemic. Accordingly, we anticipate demand for our compression services to also decrease, though with a potential for improved conditions later in 2021 and into 2022.
Long term, the EIA expects dry natural gas production to increase 7% and 12% through 2025 and 2030, respectively. Natural gas provides an affordable and reliable solution that we believe will play a prominent role in a cleaner energy mix, even as energy generation from renewables increases. We believe that the U.S. natural gas compression services industry continues to have growth potential over time due to, among other things, increased natural gas production in the U.S. from unconventional sources, aging producing natural gas fields that will require more compression to continue producing the same volume of natural gas and expected increased demand for natural gas in the U.S. for power generation, industrial uses and exports, including liquefied natural gas exports and exports of natural gas via pipeline to Mexico. We expect that such an increase in demand for U.S. natural gas will in turn lead to continued strong demand for compression services.
In our aftermarket services business, though activity levels decreased in 2020 and 2019 as customers deferred maintenance activities, the base of owned compression in the U.S. has increased over the past several years, which we believe will help sustain our aftermarket services business over the long term.
Key Challenges and Uncertainties
In addition to general market conditions in the oil and gas industry and competition in the natural gas compression industry, we believe the following represent the key challenges and uncertainties we will face in the future.
Capital Requirements and the Availability of External Sources of Capital. We have funded a significant portion of our capital expenditures and acquisitions through borrowings under the Credit Facility and have issued additional debt such that we now have a substantial amount of debt, which could limit our ability to fund future planned capital expenditures. Current conditions could limit our ability to access the debt and equity markets to raise capital on affordable terms in 2021 and beyond. If we are not successful in raising capital within the time period required or at all, we may not be able to fund these capital expenditures, which could impair our ability to grow or maintain our business.
Cost Management . In anticipation of lower customer activity levels in response to the COVID-19 pandemic, we implemented a plan in the second quarter of 2020 to reduce our annual operating, corporate and capital costs by between $75 million and $85 million.
In addition, in order to improve our operations, in late 2018 we began a process and technology transformation project that will, among other things, upgrade or replace our existing ERP, supply chain and inventory management systems and expand the remote monitoring capabilities of our compression fleet. We believe these improvements will reduce our operating costs and increase our uptime, and we anticipate that the project will continue to require significant resources and result in increased SG&A expense and capital expenditures for the implementation of new technologies in 2021.
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Cost management continues to be challenging and there is no guarantee that our efforts will result in a reduction in our operating expenses. Natural gas production growth and resulting demand for our services, once resumed, could also cause us to experience increased operating expenses as we hire employees and incur additional expenses needed to support the rebound in market demand.
Labor. We believe that our ability to hire, train and retain qualified personnel will continue to be important. Although we have been able to historically satisfy our personnel needs, retaining employees in our industry continues to be a challenge. Our ability to grow and to continue our current level of service to our customers will depend in part on our success in hiring, training and retaining our employees, including those employees impacted by our headcount reduction and furloughs through the course of the COVID-19 pandemic.
Later-Cycle Market Participant. Compression service providers have traditionally been a later-cycle participant as energy markets fluctuate. As such, we anticipate that any significant change in the demand for our contract operations services will generally lag a change in drilling activity. Increased natural gas and crude oil production in 2018 and 2019 contributed to increased new orders for our compression services during those years and into the first quarter of 2020, the revenue gains from which were realized in 2019 and the first quarter of 2020. In the second quarter of 2020, however, customer demand dropped sharply in response to the COVID-19 pandemic, and the associated decrease in our revenue occurred almost immediately.
Dry natural gas production, one of the key drivers of our business, increased 12% in 2018 and 10% in 2019 before falling 1% in 2020, and is expected to increase 7% in 2021 through 2025. We believe that, similar to the rapid drops in customer demand and associated revenue experienced this year, our revenue will increase concurrently with a pickup in customer demand as the COVID-19 pandemic runs its course. Long term, we expect to return to the more traditional cycle in which production growth increases demand for compression services, which results in increases in revenue and gross margin, though on a lag of several quarters or more.
Customer deferrals. Our aftermarket services revenue decreased in 2020 and 2019 as customers deferred near-term maintenance activities. We believe the large installed base of owned compression supports the long-term fundamentals of the aftermarket services business: however, the timing of a recovery is difficult to predict, particularly in light of the economic downturn caused by the COVID-19 pandemic. In the meantime, we remain focused on cost management and the higher margin business within our aftermarket services operations.
Increasing customer focus on free cash flow . Prior to the COVID-19 pandemic, many of our customers had begun transitioning their business model to focus on sustainable free cash flow generation rather than growth, and the COVID-19 pandemic has further fueled this change in focus. We expect this transition to have a positive impact on the industry in the long term, as we anticipate the change will reduce volatility through cycles and improve the financial strength of our customers. In the near term, however, we can expect this transition, combined with the impact of the COVID-19 pandemic, to result in a deceleration in the natural gas production growth rate, to which demand for our products and services is closely aligned.
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Operating Highlights
The following table summarizes our available and operating horsepower and horsepower utilization (in thousands, except percentages):
Year Ended December 31,
2020
2019
2018
Total available horsepower (at period end) (1)
4,120
4,395
3,963
Total operating horsepower (at period end) (2)
3,388
3,926
3,530
Average operating horsepower
3,657
3,708
3,386
Horsepower utilization:
Spot (at period end)
82
%
89
%
89
%
Average
86
%
88
%
87
%
(1) Defined as idle and operating horsepower. New compressors completed by a third party manufacturer that have been delivered to us are included in the fleet.
(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 gross margin.
We define gross margin as total revenue less cost of sales (excluding depreciation and amortization). 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 (excluding depreciation and amortization), which are key components of our operations. We believe 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, gross margin should not be considered an alternative to, or more meaningful than, net income (loss) as determined in accordance with GAAP. Our gross margin may not be comparable to a similarly-titled measure of other entities because other entities may not calculate gross margin in the same manner.
Gross margin has certain material limitations associated with its use as compared to net income (loss). These limitations are primarily due to the exclusion of SG&A, depreciation and amortization, impairments, restatement and other charges, restructuring charges, interest expense, debt extinguishment loss, transaction-related costs, (gain) loss on sale of assets, net, other (income) loss, net, provision for (benefit from) income taxes and loss from discontinued operations, net of tax. 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.
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The following table reconciles net income (loss) to gross margin (in thousands):
Year Ended December 31,
2020
2019
2018
Net income (loss)
$
(68,445)
$
97,330
$
29,160
Selling, general and administrative
105,100
117,727
101,563
Depreciation and amortization
193,138
188,084
174,946
Long-lived and other asset impairment
79,556
44,663
28,127
Goodwill impairment
99,830
—
—
Restatement and other charges
—
445
19
Restructuring charges
8,450
—
—
Interest expense
105,716
104,681
93,328
Debt extinguishment loss
3,971
3,653
2,450
Transaction-related costs
—
8,213
10,162
Gain on sale of assets, net
(10,643)
(16,016)
(5,674)
Other income, net
(1,359)
(661)
(157)
Provision for (benefit from) income taxes
(17,537)
(39,145)
6,150
Loss from discontinued operations, net of tax
—
273
—
Gross margin
$
497,777
$
509,247
$
440,074
Financial Results of Operations: Summary of Results
Revenue. Revenue was $875.0 million, $965.5 million and $904.4 million during the years ended December 31, 2020, 2019 and 2018, respectively.
The decrease in revenue during the year ended December 31, 2020 compared to the year ended December 31, 2019 was due to decreases in revenue from our contract operations and aftermarket services businesses. The increase in revenue during the year ended December 31, 2019 compared to the year ended December 31, 2018 was due to an increase in revenue from our contract operations business, partially offset by a decrease in revenue from our aftermarket services business.
See “Contract Operations” and “Aftermarket Services” below for further details.
Net income (loss) attributable to Archrock stockholders. We had a net loss attributable to Archrock stockholders of $68.4 million and net income attributable to Archrock stockholders of $97.3 million and $21.1 million during the years ended December 31, 2020, 2019 and 2018, respectively.
The change from net income to net loss attributable to Archrock stockholders during the year ended December 31, 2020 compared to the year ended December 31, 2019 was primarily driven by goodwill impairment of $99.8 million, increases in long-lived and other asset impairment, restructuring charges and depreciation and amortization and decreases in benefit from income taxes, gain on sale of assets, net and gross margin from our aftermarket services business, partially offset by decreases in SG&A and transaction-related costs and an increase in gross margin from our contract operations business.
The increase in net income attributable to Archrock stockholders during the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily driven by an increase in gross margin from our contract operations business, the change in provision for (benefit from) income taxes, an increase in gain on sale of assets, net and the decrease in net income attributable to noncontrolling interest, partially offset by increases in long-lived and other asset impairment, SG&A, depreciation and amortization and interest expense.
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Financial Results of Operations: Year Ended December 31, 2020 Compared to Year Ended December 31, 2019
Contract Operations
Year Ended December 31,
Increase
(in thousands)
2020
2019
(Decrease)
Revenue
$
738,918
$
771,539
(4)
%
Cost of sales (excluding depreciation and amortization)
261,087
297,260
(12)
%
Gross margin
$
477,831
$
474,279
1
%
Gross margin percentage (1)
65
%
61
%
4
%
(1) Defined as gross margin divided by revenue.
Revenue decreased primarily due to returns of horsepower amidst the market downturn, the strategic disposition of horsepower in 2019 and 2020 and a decrease in revenues associated with reduced mobilization activity. These decreases in revenue were partially offset by a $43.5 million increase in revenue attributable to the horsepower acquired in the Elite Acquisition in August 2019.
Gross margin increased due to the decrease in cost of sales, which was partially offset by the decrease in revenue discussed above. The decrease in cost of sales was primarily driven by decreases in costs to mobilize compression packages, maintenance expense and lube oil expense, all of which were chiefly driven by the decreases in operating horsepower mentioned above. In addition, there was a decrease in sales and use tax as the result of audit settlements in 2020. These decreases were partially offset by increases in maintenance expense and lube oil expense associated with the horsepower acquired in the Elite Acquisition.
Aftermarket Services
Year Ended December 31,
Increase
(in thousands)
2020
2019
(Decrease)
Revenue
$
136,052
$
193,946
(30)
%
Cost of sales (excluding depreciation and amortization)
116,106
158,978
(27)
%
Gross margin
$
19,946
$
34,968
(43)
%
Gross margin percentage
15
%
18
%
(3)
%
The decrease in revenue was due to decreases in service activities and parts sales, which were primarily driven by reduced customer demand and customer deferral of maintenance activities. Gross margin decreased due to this decrease in revenue, but benefited from a decrease in cost of sales, which was driven by the same decrease in service activities and parts sales.
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Costs and Expenses
Year Ended December 31,
(in thousands)
2020
2019
Selling, general and administrative
$
105,100
$
117,727
Depreciation and amortization
193,138
188,084
Long-lived and other asset impairment
79,556
44,663
Goodwill impairment
99,830
—
Restatement and other charges
—
445
Restructuring charges
8,450
—
Interest expense
105,716
104,681
Debt extinguishment loss
3,971
3,653
Transaction-related costs
—
8,213
Gain on sale of assets, net
(10,643)
(16,016)
Other income, net
(1,359)
(661)
Selling, general and administrative. The decrease in SG&A was primarily due to a $6.2 million decrease in sales and use tax that was mainly driven by audit settlements, a $2.1 million decrease in professional expenses, a $2.1 million decrease in compensation and benefits and a $1.9 million decrease in employee travel and meeting expenses. These decreases were partially offset by a $1.0 million increase in bad debt expense.
Depreciation and amortization. The increase in depreciation and amortization was primarily due to an increase in depreciation expense associated with fixed asset additions during 2019, including the fixed assets acquired in the Elite Acquisition, and the first half of 2020, partially offset by a decrease in depreciation expense resulting from assets reaching the end of their depreciable lives as well as the impact of asset impairments in 2019 and the first half of 2020 and compression asset sales during 2019.
Long-lived and other asset impairment. Each quarter, we 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. In addition, we evaluate for impairment idle units that have been culled from our compression fleet in prior years and are available for sale. See Note 18 (“Long-Lived and Other Asset Impairment”) to our Financial Statements for further details. The following table presents the results of our compression fleet impairment review, as recorded in our contract operations segment (dollars in thousands):
Year Ended December 31,
2020
2019
Idle compressors retired from the active fleet
730
975
Horsepower of idle compressors retired from the active fleet
261,000
170,000
Impairment recorded on idle compressors retired from the active fleet
$
77,590
$
44,663
Also during the year ended December 31, 2020, $1.7 million of capitalized implementation and unamortized prepaid costs related to the mobile workforce component of our multi-year process and technology transformation project was impaired. See Note 12 (“Hosting Arrangements”) to our Financial Statements for further details.
Goodwill impairment. During the year ended December 31, 2020, we recorded $99.8 million of goodwill impairment due to the decline in the fair value of our contract operations reporting unit. See Note 9 (“Goodwill”) to our Financial Statements for further details.
Restructuring charges . We recorded $8.5 million of severance and property disposal costs related to restructuring activities during the year ended December 31, 2020. See Note 19 (“Restructuring Charges”) to our Financial Statements for further details .
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Interest expense. The increase in interest expense was primarily due to an increase in the average outstanding balance of long-term debt, partially offset by a decrease in the weighted average effective interest rate.
Debt extinguishment loss. We recorded a debt extinguishment loss of $4.0 million during the year ended December 31, 2020 as a result of the redemption of the 2022 Notes. We recorded a debt extinguishment loss of $3.7 million during the year ended December 31, 2019 as a result of the redemption of the 2021 Notes. See Note 14 (“Long-Term Debt”) to our Financial Statements for further details.
Transaction-related costs. We incurred $8.2 million of financial advisory, legal and other professional fees during the year ended December 31, 2019 related primarily to the Elite Acquisition.
Gain on sale of assets, net. Our net gain on the sale of assets during the year ended December 31, 2020 was primarily due to a $9.3 million gain on the July 2020 Disposition, a $3.2 million gain on the March 2020 Disposition, which included a $4.8 million gain on the compression assets sold, and gains of $3.7 million on sales of transportation and shop equipment. These gains were offset by a $5.1 million loss on other compression assets sold during 2020.
Our net gain on the sale of assets during the year ended December 31, 2019 was primarily due to a $6.6 million gain on the Harvest Sale, gains of $7.9 million on other 2019 compression asset sales and gains of $1.6 million on sales of transportation and shop equipment.
Other income, net. The increase in other income, net was primarily due to a $0.7 million decrease in indemnification expense incurred pursuant to our tax matters agreement with Exterran Corporation.
Benefit from Income Taxes
Year Ended December 31,
Increase
(in thousands)
2020
2019
(Decrease)
Benefit from income taxes
$
(17,537)
$
(39,145)
(55)
%
Effective tax rate
20
%
(67)
%
87
%
The decrease in benefit from income taxes was primarily due to the release of a valuation allowance and the release of an unrecognized tax benefit due to the settlement of a tax audit during the year ended December 31, 2019, partially offset by the tax effect of the decrease in book income during the year ended December 31, 2020 compared to the year ended December 31, 2019. See Note 20 (“Income Taxes”) to our Financial Statements for further details.
Financial Results of Operations: Year Ended December 31, 2019 Compared to Year Ended December 31, 2018
Contract Operations
Year Ended December 31,
Increase
(in thousands)
2019
2018
(Decrease)
Revenue
$
771,539
$
672,536
15
%
Cost of sales (excluding depreciation and amortization)
297,260
273,013
9
%
Gross margin
$
474,279
$
399,523
19
%
Gross margin percentage
61
%
59
%
2
%
The increase in revenue during the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to an increase in contract operations rates driven by an increase in customer demand, an increase in average operating horsepower (excluding the horsepower acquired in the Elite Acquisition) and $33.2 million of revenue associated with the compression assets acquired in the Elite Acquisition.
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Gross margin increased during the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to the increase in revenue mentioned above partially offset by the increase in cost of sales. The increase in cost of sales was primarily driven by increases in maintenance, freight and lube oil expense associated with the increase in average operating horsepower and the horsepower acquired in the Elite Acquisition. These increases in cost of sales were partially offset by a decrease in cost associated with the start-up of compression packages, as the majority of the increase in average operating horsepower was comprised of newly-built compressors.
Gross margin percentage increased during the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to the increase in contract operations rates mentioned above.
Aftermarket Services
Year Ended December 31,
Increase
(in thousands)
2019
2018
(Decrease)
Revenue
$
193,946
$
231,905
(16)
%
Cost of sales (excluding depreciation and amortization)
158,978
191,354
(17)
%
Gross margin
$
34,968
$
40,551
(14)
%
Gross margin percentage
18
%
17
%
1
%
The decrease in revenue during the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to decreases in parts sales and service activities as customers deferred maintenance activities.
Gross margin decreased during the year ended December 31, 2019 compared to the year ended December 31, 2018 due to the decrease in revenue mentioned above, partially offset by a smaller decrease in cost of sales. The decrease in cost of sales was primarily driven by the decrease in parts sales and service activities.
Costs and Expenses
Year Ended December 31,
(in thousands)
2019
2018
Selling, general and administrative
$
117,727
$
101,563
Depreciation and amortization
188,084
174,946
Long-lived and other asset impairment
44,663
28,127
Restatement and other charges
445
19
Interest expense
104,681
93,328
Debt extinguishment loss
3,653
2,450
Transaction-related costs
8,213
10,162
Gain on sale of assets, net
(16,016)
(5,674)
Other income, net
(661)
(157)
Selling, general and administrative. The increase in SG&A expense during the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to a $9.2 million increase in sales and use tax expense primarily resulting from the settlement of audits in 2018, a $4.1 million increase in costs related to our process and technology transformation project and a $2.7 million increase in compensation and benefits.
Depreciation and amortization. The increase in depreciation and amortization expense during the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to an increase in depreciation expense associated with fixed asset additions, which was partially offset by a decrease in expense from assets reaching the end of their useful lives, asset retirements and the impact of asset impairments during 2018 and 2019. The increase in depreciation expense was partially offset by a decrease in amortization expense that primarily resulted from certain intangible assets reaching the end of their useful lives, partially offset by amortization expense related to the intangible assets acquired in the Elite Acquisition.
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Long-lived and other asset impairment. Each quarter, we 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. In addition, we evaluate for impairment idle units that have been culled from our compression fleet in prior years and are available for sale. See Note 18 (“Long-Lived and Other Asset Impairment”) to our Financial Statements for further details. The following table presents the results of our compression fleet impairment review, as recorded in our contract operations segment (dollars in thousands):
Year Ended December 31,
2019
2018
Idle compressors retired from the active fleet
975
310
Horsepower of idle compressors retired from the active fleet
170,000
115,000
Impairment recorded on idle compressors retired from the active fleet
$
44,663
$
28,127
Restatement and other charges. During the years ended December 31, 2019 and 2018, we recorded expense of $0.4 million and $1.3 million, respectively, for our share of professional and legal fees related to the restatement of prior period financial statements and disclosures and related matters. We recorded $1.3 million for the expected recovery of shared fees incurred during the year ended December 31, 2018.
Interest expense. The increase in interest expense during the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to an increase in the average outstanding balance of long-term debt, partially offset by a decrease in the weighted average effective interest rate.
Debt extinguishment loss. We recorded a debt extinguishment loss of $3.7 million during the year ended December 31, 2019 as a result of the redemption of the 2021 Notes. We recorded a debt extinguishment loss of $2.5 million during the year ended December 31, 2018 as a result of the termination of the Former Credit Facility. See Note 14 (“Long-Term Debt”) to our Financial Statements for further details.
Transaction-related costs. We incurred $8.2 million and $10.2 million of financial advisory, legal and other professional fees during the years ended December 31, 2019 and 2018, respectively. The $8.2 million of fees incurred during the year ended December 31, 2019 related primarily to the Elite Acquisition. The $10.2 million of fees incurred during the year ended December 31, 2018 related to the Merger. See Note 4 (“Business Transactions”) and Note 16 (“Equity”) to our Financial Statements for further details of these transactions.
Gain on sale of assets, net. The increase in gain on sale of assets, net was primarily due to a $6.6 million gain related to the Harvest Sale during the year ended December 31, 2019 and a $3.2 million increase in gains recognized on other compression equipment sales during the year ended December 31, 2019 compared to the year ended December 31, 2018. See Note 4 (“Business Transactions”) for further details of the Harvest Sale.
Other income, net. The increase in other income, net during the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to a $0.9 million decrease in indemnification expense incurred pursuant to our tax matters agreement with Exterran Corporation and income of $0.3 million related to equipment damaged at a customer site during 2019, partially offset by $0.5 million in indemnification income earned pursuant to that same tax matters agreement during 2018 and a $0.3 million decrease in interest income earned related to tax refunds and settlements.
Provision for (Benefit from) Income Taxes
Year Ended December 31,
Increase
(in thousands)
2019
2018
(Decrease)
Provision for (benefit from) income taxes
$
(39,145)
$
6,150
(737)
%
Effective tax rate
(67)
%
17
%
(84)
%
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The change in provision for (benefit from) income taxes was primarily due to the release of a valuation allowance in the year ended December 31, 2019, as well as a higher release of an unrecognized tax benefit due to the settlement of a tax audit in the year ended December 31, 2019 compared to the year ended December 31, 2018. See Note 20 (“Income Taxes”) to our Financial Statements for further details.
Net Income Attributable to Noncontrolling Interest
Year Ended December 31,
Increase
(in thousands)
2019
2018
(Decrease)
Net income attributable to noncontrolling interest
$
—
$
(8,097)
(100)
%
Net income attributable to noncontrolling interest was the portion of the Partnership’s earnings that were applicable to the Partnership’s publicly-held common unitholder interest through the completion of the Merger. Immediately prior to the Merger, public unitholders held a 57% ownership interest in the Partnership. Subsequent to the Merger, the Partnership is a wholly-owned subsidiary. See Note 16 (“Equity”) to our Financial Statements for further details of the Merger.
Liquidity and Capital Resources
Capital 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:
● growth capital expenditures, which are made to expand or to replace partially or fully depreciated assets or to expand the operating capacity or revenue generating capabilities of existing or new assets; and
● maintenance capital expenditures, which are made to maintain the existing operating capacity of our assets and related cash flows further extending the useful lives of the assets.
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 over its expected useful life that exceed our cost of capital. 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.
Growth capital expenditures were $79.1 million, $300.5 million and $251.6 million during the years ended December 31, 2020, 2019 and 2018, respectively. The decrease in growth capital expenditures in 2020 compared to 2019 was the result of a previously-planned decrease in spending in 2020, which was based on an expected deceleration in the growth rate of natural gas production, and a further reduction in spend in response to the decreased customer demand that resulted from the COVID-19 pandemic. The increase in growth capital expenditures in 2019 compared to 2018 was primarily due to increased investment in new compression equipment as a result of increased customer demand to support higher U.S. natural gas production levels.
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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.
Maintenance capital expenditures were $32.0 million, $58.6 million and $49.7 million during the years ended December 31, 2020, 2019 and 2018, respectively. The decrease in maintenance capital expenditures in 2020 compared to 2019 was the result of decreased customer demand amidst the COVID-19 pandemic and optimized engine overhaul practices. The increase in maintenance capital expenditures in 2019 compared to 2018 was due to an increase in scheduled maintenance activities in 2019 due to maintenance cycle requirements as well as the increase in horsepower as the result of the Elite Acquisition.
Projected Capital Spend
We currently plan to spend approximately $80 million to $106 million in capital expenditures during 2021, primarily consisting of approximately $30 million to $50 million for growth capital expenditures and approximately $40 million to $45 million for maintenance capital expenditures. We anticipate decreased 2021 capital expenditures, particularly growth capital expenditures, as compared to 2020 due to the impact that we expect the COVID-19 pandemic will continue to have on customer demand.
Financial 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 the 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. Beginning in the first quarter of 2020, the COVID-19 pandemic has caused a deterioration in global macroeconomic conditions, which has significantly impacted our estimates of future revenues and cash flows. However, 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 securities in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors.
Revolving Credit Facilities
Credit Facility. During the years ended December 31, 2020 and 2019, the Credit Facility had an average daily balance of $704.5 million and $855.3 million, respectively. The weighted average annual interest rate on the outstanding balance under the Credit Facility, excluding the effect of interest rate swaps, was 2.7% and 4.3% at December 31, 2020 and 2019, respectively. As of December 31, 2020, there were $12.4 million letters of credit outstanding under the Credit Facility and the applicable margin on borrowings outstanding was 2.4%.
In November 2019, we amended the Credit Facility to, among other things, extend the maturity date of the Credit Facility from March 30, 2022 to November 8, 2024 and change the applicable margin for borrowings under the Credit Facility such that (i) the applicable margin for LIBOR loans ranges from 2.00% to 2.75% and (ii) the applicable margin for base rate loans ranges from 1.00% to 1.75%.
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In February 2018, we amended the Credit Facility to, among other things:
● increase the maximum Total Debt to EBITDA ratios, as defined in the Credit Facility agreement (see below for the revised ratios);
● increase the aggregate revolving commitment from $1.1 billion to $1.25 billion;
● increase the amount available for the issuance of letters of credit from $25.0 million to $50.0 million; and
● increase the basket sizes under certain covenants including covenants limiting our ability to make investments, incur debt, make restricted payments, incur liens and make asset dispositions.
See Note 14 (“Long-Term Debt”) to the Financial Statements for further details of these amendments.
Portions of the Credit Facility up to $50.0 million are available for the issuance of swing line loans. Subject to certain conditions, including the approval by the lenders, we are able to increase the aggregate commitments under the Credit Facility by up to an additional $250.0 million. The Credit Facility borrowing base consists of eligible accounts receivable, inventory and compressors.
As of December 31, 2020, prior to Amendment No. 3, the following consolidated financial ratios, as defined in our Credit Facility agreement, were required:
EBITDA to Interest Expense
2.5 to 1.0
Senior Secured Debt to EBITDA
3.5 to 1.0
Total Debt to EBITDA
January 1 through June 30, 2020
5.50 to 1.0
Thereafter (1)
5.25 to 1.0
(1) Subject to a temporary increase to 5.50 to 1.0 for any quarter during which an acquisition satisfying certain thresholds is completed and for the two quarters immediately following such quarter.
As a result of the ratio requirements above, $444.1 million of the $844.6 million of undrawn capacity was available for additional borrowings as of December 31, 2020.
The Credit Facility agreement contains various additional covenants including, but not limited to, mandatory prepayments from the net cash proceeds of certain asset transfers, restrictions on the use of proceeds from borrowings and limitations on our ability to incur additional indebtedness, engage in transactions with affiliates, merge or consolidate, sell assets, make certain investments and acquisitions, make loans, grant liens, repurchase equity and pay distributions. As of December 31, 2020, we were in compliance with all covenants under the Credit Facility.
In February 2021, we further amended the Credit Facility to, among other things:
● reduce the aggregate revolving commitment from $1.25 billion to $750.0 million, and
● adjust the maximum Senior Secured Debt to EBITDA ratio and Total Debt to EBITDA ratios above to the following:
Senior Secured Debt to EBITDA
3.00 to 1.0
Total Debt to EBITDA
Through fiscal year 2022
5.75 to 1.0
January 1, 2023 through September 30, 2023
5.50 to 1.0
Thereafter (1)
5.25 to 1.0
(1) Subject to a temporary increase to 5.5 to 1.0 for any quarter during which an acquisition satisfying certain thresholds is completed and for the two quarters immediately following such quarter.
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Former Credit Facility. In April 2018, in connection with the Merger, we terminated the Former Credit Facility and borrowed on the Credit Facility to repay $63.2 million in borrowings and accrued and unpaid interest and fees outstanding. All commitments under the Former Credit Facility were terminated and the $15.4 million of letters of credit outstanding under the Former Credit Facility were converted to letters of credit under the Credit Facility. Prior to its termination, the Former Credit Facility required us to maintain various financial ratios and other covenants, all of which we were in compliance with through its closing. The average daily debt balance under the Former Credit Facility in 2018, through its closing in April 2018, was $51.7 million.
Senior Notes Transactions
In December 2020, we completed a private offering of $300.0 million aggregate principal amount of 6.25% senior notes due April 2028 and received net proceeds of $309.9 million after deducting issuance costs. The net proceeds were used to repay borrowings outstanding under our Credit Facility.
In April 2020, we repaid the 2022 Notes with borrowings under our Credit Facility.
In December 2019, we completed a private offering of $500.0 million aggregate principal amount of 6.25% senior notes due April 2028 and received net proceeds of $491.8 million after deducting issuance costs. The net proceeds were used to repay borrowings outstanding under our Credit Facility.
In April 2019, we repaid the 2021 Notes with borrowings under our Credit Facility.
In March 2019, we completed a private offering of $500.0 million aggregate principal amount of 6.875% senior notes due April 2027 and received net proceeds of $491.2 million after deducting issuance costs. The net proceeds were used to repay borrowings outstanding under our Credit Facility.
See Note 14 (“Long-Term Debt”) to our Financial Statements for further details of these transactions.
Cash Flows
Our cash flows as reflected in our consolidated statements of cash flows, are summarized below (in thousands):
Year Ended December 31,
2020
2019
2018
Net cash provided by (used in):
Operating activities
$
335,278
$
290,147
$
225,947
Investing activities
(85,031)
(514,560)
(284,923)
Financing activities
(252,835)
222,488
54,050
Net decrease in cash and cash equivalents
$
(2,588)
$
(1,925)
$
(4,926)
Year Ended December 31, 2020 Compared to Year Ended December 31, 2019
Operating Activities. The increase in net cash provided by operating activities was primarily due to decreased cash outflows for cost of sales, SG&A expenses, contract costs and transaction-related costs and increased cash inflows from accounts receivable, partially offset by reduced cash inflows from revenue and deferred revenue and cash outflows for restructuring charges in 2020.
Investing Activities. The decrease in net cash used in investing activities was primarily due to a $244.9 million decrease in capital expenditures, $214.0 million cash paid in the Elite Acquisition in 2019 and proceeds of $33.7 million from the March 2020 and July 2020 dispositions, partially offset by a $62.1 million decrease in proceeds from other sales of property, plant and equipment, $30.0 million of which related to proceeds from the Harvest Sale in 2019.
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Financing Activities. The change in net cash provided by (used in) financing activities was primarily due to $155.4 million of net repayments of long-term debt in 2020 compared to $323.5 million of net borrowings in 2019 and a $10.3 million increase in dividends paid to Archrock stockholders, partially offset by a $17.2 million decrease in payments for debt issuance costs.
Year Ended December 31, 2019 Compared to Year Ended December 31, 2018
Operating Activities. The increase in net cash provided by operating activities during the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to an increase in revenue from our contract operations business, the receipt of cash proceeds in 2019 pursuant to a settlement of certain sales and use tax audits and decreases in accounts receivable and cost of sales (excluding depreciation and amortization). These cash inflows were partially offset by increases in cash SG&A expenses and interest paid on our long-term debt and a decrease in accounts payable and other liabilities.
Investing Activities. The increase in net cash used in investing activities during the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to $214.0 million of cash paid in the Elite Acquisition during the year ended December 31, 2019 and a $66.1 million increase in capital expenditures, partially offset by a $47.0 million increase in proceeds from the sale of property, plant and equipment and other assets, including $30.0 million in proceeds from the Harvest Sale.
Financing Activities. The increase in net cash provided by financing activities during the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to a $214.3 million net increase in borrowings of long-term debt and an $11.8 million decrease in distributions paid to noncontrolling partners in the Partnership. These cash flows were partially offset by a $20.2 million increase in dividends paid to Archrock shareholders, a $19.1 million increase in payments for debt issuance costs and an $18.7 million decrease in contributions from Exterran Corporation.
Dividends
On January 27, 2021, our Board of Directors declared a quarterly dividend of $0.145 per share of common stock, or approximately $22.2 million, that was paid on February 16, 2021 to stockholders of record at the close of business on February 8, 2021. 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.
Contractual Obligations
The following table summarizes our cash contractual obligations as of December 31, 2020 (in thousands):
2021
2022-2023
2024-2025
Thereafter
Total
Long-term debt: (1)
Credit Facility
$
—
$
—
$
393,000
$
—
$
393,000
Senior notes (2)
—
—
—
1,300,000
1,300,000
Total long-term debt
—
—
393,000
1,300,000
1,693,000
Interest on long-term debt (3)
102,948
197,218
180,387
155,469
636,022
Purchase commitments (4)
17,699
4,353
1,702
—
23,754
Operating leases
4,126
6,221
4,726
9,766
24,839
Total contractual obligations
$
124,773
$
207,792
$
579,815
$
1,465,235
$
2,377,615
(1) See Note 14 (“Long-Term Debt”) to our Financial Statements for further details on our long-term debt.
(2) Represents the full face value of our senior notes, not reduced by unamortized discount, premium and deferred financing costs.
(3) For 2021, calculated using interest rates in effect as of December 31, 2020, including the effect of interest rate swaps. Beginning in Q2 2022 through 2024, calculated using the interest rates in effect as of December 31, 2020, excluding the effect of interest rate swaps due to the maturity of our interest rate swaps in March 2022. See Note 22 (“Derivatives”) for further details.
(4) Primarily includes commitments to purchase fleet and non-fleet assets and costs associated with the cloud migration of our ERP system and other information technology-related costs.
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At December 31, 2020, $18.9 million of unrecognized tax benefits (including discontinued operations) have been recorded as liabilities in accordance with the accounting standard for income taxes related to uncertain tax positions and we are uncertain as to if or when such amounts may be settled. Related to these unrecognized tax benefits, we have also recorded a liability for potential penalties and interest (including discontinued operations) of $2.1 million.
Off-Balance Sheet Arrangements
For information on our obligations with respect to letters of credit and performance bonds, see Note 14 (“Long-Term Debt”) and Note 26 (“Commitments and Contingencies”), respectively, to our Financial Statements.
Critical Accounting Estimates
This discussion and analysis of our financial condition and results of operations is based upon our Financial Statements, which have been prepared in accordance with GAAP. The preparation of our Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, expenses and related disclosures of contingent assets and liabilities. We evaluate our estimates and accounting policies on an ongoing basis and base our estimates on historical experience and other assumptions that we believe are reasonable under the circumstances. The results of this process form the basis of our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions and these differences can be material to our financial condition, results of operations and cash flows. We describe our significant accounting policies more fully in Note 2 (“Basis of Presentation and Significant Accounting Policies”) to our Financial Statements.
Allowance for Credit Losses
Outstanding accounts receivable are reviewed regularly for non-payment indicators and allowances for credit losses are recorded based on management’s estimate of collectibility at each balance sheet date. We measure expected credit losses on a collective (pool) basis when similar risk characteristics exist. If a customer does not share similar risk characteristics with other customers, we evaluate the customer’s outstanding trade receivables for expected credit losses on an individual basis. Each reporting period, we reassess our customers’ risk profiles and determine the appropriate asset pool classification, or perform individual assessments of expected credit losses, based on the customers’ risk characteristics at the reporting date. Judgment is used to determine the expected credit loss for customers that do not share similar risk characteristics with other customers, based on customer specific items such as legal proceedings, past experience with the customer and/or ongoing customer negotiations.
During the years ended December 31, 2020, 2019 and 2018, we recorded bad debt expense of $3.5 million, $2.6 million and $1.7 million, respectively. A five percent change in bad debt expense would have impacted loss before income taxes by $0.2 million during the year ended December 31, 2020.
Inventory
Inventory is a significant component of current assets and is stated at the lower of cost and net realizable value using the average cost method. This requires us to regularly review inventory quantities on hand and compare them to estimates of future product demand and market conditions. These estimates and forecasts inherently include uncertainties and require us to make judgments regarding potential outcomes. During the years ended December 31, 2020, 2019 and 2018, we recorded write-downs to inventory of $1.3 million, $0.9 million and $1.6 million, respectively, for inventory considered to be excess, obsolete or carried at an amount in excess of net realizable value. Significant or unanticipated changes to our estimates and forecasts could require additional write-downs in a future period. Given the nature of these evaluations and their application to specific inventories, it is not possible to reasonably quantify the impact of changes in these estimates and forecasts.
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Depreciation
Property, plant and equipment are carried at cost. Depreciation is computed on a straight-line basis using useful lives and salvage values that are estimated based on assumptions and judgments that reflect both historical experience and expectations regarding future use of our assets. The use of different assumptions and judgments in the calculation of depreciation, especially those involving useful lives, would likely result in significantly different net book values of our assets and results of operations.
Fair Value Estimates
Impairment Assessments of Property, Plant and Equipment and Identifiable Intangible Assets
We review long-lived assets, including property, plant and equipment and identifiable intangibles that are being amortized, for impairment whenever events or changes in circumstances, including the removal of compressors from our active fleet, indicate that the carrying amount of an asset may not be recoverable. An impairment loss may exist when the estimated undiscounted cash flows expected from the use of the asset and its eventual disposition are less than its carrying amount. Determining whether the carrying amount of an asset is recoverable requires us to make judgments regarding long-term forecasts of future revenue and costs related to the asset subject to review. These forecasts are uncertain as they require significant assumptions about future market conditions. Significant and unanticipated changes to these assumptions could require a provision for impairment in a future period. Given the nature of these evaluations and their application to specific assets and specific times, it is not possible to reasonably quantify the impact of changes in these assumptions.
Impairment Assessment of Goodwill
We review the carrying amount of our goodwill in the fourth quarter of every year, or whenever indicators of potential impairment exist, to determine if the carrying amount of a reporting unit exceeds its fair value, including the applicable goodwill. We perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is impaired. If the fair value is more likely than not impaired, we perform a quantitative impairment test to identify impairment and measure the amount of impairment loss to be recognized, if any.
Our qualitative assessment includes consideration of various events and circumstances and their potential impact to a reporting unit’s fair value, including macroeconomic and industry conditions such as a deterioration in our operating environment and limitations on access to capital and other developments in the equity and credit markets, cost factors that could have a negative effect on earnings and cash flows, relevant entity-specific and reporting unit-specific events and overall financial performance such as declining earnings or cash flows or a sustained decrease in share price. If indicated, a quantitative impairment test would compare the carrying amount of our reporting units to their fair value, and any excess of carrying amount over fair value would be recorded as an impairment loss. The fair value calculation would require us to make significant estimates to determine future cash flows, including future revenues, costs and capital requirements and the appropriate risk-adjusted discount rate by which to discount the estimated future cash flows.
Our goodwill was allocated to our contract operations reporting unit. In the first quarter of 2020, the global response to the COVID-19 pandemic significantly impacted our market capitalization and estimates of future revenues and cash flows, which triggered the need to perform a quantitative test of the fair value of our contract operations reporting unit as of March 31, 2020. The quantitative test determined that the carrying amount of our contract operations reporting unit exceeded its fair value and we recorded a full impairment loss on goodwill in the first quarter as a result.
Acquisitions
We account for business combinations using the acquisition method which requires assets acquired and liabilities assumed to be recorded at their fair value on the acquisition date. The excess of the consideration transferred over those fair values is recorded as goodwill. Significant judgment is used in determining the individual fair values of acquired assets and liabilities. We use all available information to make these fair value determinations and, for certain acquisitions, engage third-party consultants for valuation assistance.
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For the Elite Acquisition, we used the cost approach to value the acquired property, plant and equipment, whereby we estimated the replacement cost of the assets by evaluating recent purchases of similar assets or published data, and then adjusted replacement cost for physical deterioration and functional and economic obsolescence, as applicable. We estimated the fair value of the acquired identifiable intangible assets using the multi-period excess earnings method, which is a specific application of the discounted cash flow method, an income approach, whereby we estimated and then discounted the future cash flows of the intangible asset by adjusting overall business revenue for attrition, obsolescence, cost of sales, operating expenses, taxes and the required returns attributable to other contributory assets acquired. Significant estimates made in arriving at expected future cash flows included our expected customer attrition rate and the amount of earnings attributable to the assets. To discount the estimated future cash flows, we utilized a discount rate that was at a premium to our weighted average cost of capital to reflect the less liquid nature of the customer relationships relative to the tangible assets acquired.
The estimates used in determining the fair value of the asset and liabilities acquired in the Elite Acquisition are based on assumptions believed to be reasonable but which are inherently uncertain. Accordingly, actual results may differ materially from the projected results used to determine fair value. See Note 4 (“Business Transactions”) to our Financial Statements for further details of the Elite Acquisition.
Income Taxes
Our income tax expense, deferred tax assets and liabilities and reserves for unrecognized tax benefits reflect management’s best assessment of estimated current and future taxes to be paid. We operate in the U.S. only and, as a result, are subject to income taxes in the U.S. only. Significant judgments and estimates are required in determining consolidated income tax expense.
Deferred income taxes arise from temporary differences between the financial statements and the tax basis of assets and liabilities. In evaluating our ability to recover our deferred tax assets, we consider all available positive and negative evidence including scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies and results of recent operations. In projecting future taxable income, we begin with historical results adjusted for the results of discontinued operations and changes in accounting policies and incorporate assumptions, including the amount of future U.S. federal and state pretax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax-planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we use to manage the underlying businesses. In evaluating the objective evidence that historical results provide, we consider three years of cumulative income (loss) before income taxes.
Changes in tax laws and rates could also affect recorded deferred tax assets and liabilities in the future. Management is not aware of any such changes that would have a material effect on our financial position, results of operations or cash flows. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in various state and local jurisdictions.
The accounting standard for income taxes provides that a tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, on the basis of the technical merits. We adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Because of the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the liabilities. Such differences are reflected as increases or decreases to income tax expense in the period in which the new information becomes available.
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Contingencies and Litigation
Insurance
Our insurance coverage includes property damage, general liability and commercial automobile liability and other coverage we believe is appropriate. Additionally, we are self-insured for property damage to our offshore assets and substantially self-insured for workers’ compensation and employee group health claims in view of the relatively high per-incident deductibles we absorb under our insurance arrangements for these risks. Losses up to deductible amounts are estimated and accrued based upon known facts, historical trends and industry averages. We review these estimates quarterly and believe such accruals to be adequate. However, insurance liabilities are difficult to estimate due to unknown factors, including the severity of an injury, the determination of our liability in proportion to other parties, the timeliness of reporting of occurrences, ongoing treatment or loss mitigation, general trends in litigation recovery outcomes and the effectiveness of safety and risk management programs. If our actual experience differs from the assumptions and estimates used for recording the liabilities, adjustments may be required and would be recorded in the period in which the difference becomes known. At December 31, 2020 and 2019, we had $3.4 million and $3.0 million, respectively, in insurance claim reserves on our consolidated balance sheets.
Litigation and Claims
In the ordinary course of business, we are involved in various pending or threatened legal actions. While we are unable to predict the ultimate outcome of these actions, the accounting standard for contingencies requires management to make judgments about future events that are inherently uncertain. We are required to record a loss during any period in which we believe a contingency is probable and can be reasonably estimated. In making determinations of likely outcomes of pending or threatened legal matters, we consider the evaluation of counsel knowledgeable about each matter.
The impact of an uncertain tax position taken or expected to be taken on an income tax return must be recognized in the financial statements at the largest amount that is more likely than not to be sustained upon examination by the relevant taxing authority. We regularly assess and, if required, establish accruals for income and non-income based tax contingencies pursuant to the applicable accounting standards that could result from assessments of additional tax by taxing jurisdictions where we operate. Tax contingencies are subject to a significant amount of judgment and are reviewed and adjusted on a quarterly basis in light of changing facts and circumstances considering the outcome expected by management. As of December 31, 2020 and 2019, we recorded $26.6 million and $23.1 million (including penalties and interest and discontinued operations), respectively, of accruals for tax contingencies. Of these amounts, $21.0 million and $20.6 million, respectively, were accrued for income taxes and $5.6 million and $2.5 million, respectively, were accrued for non-income based taxes. If our actual experience differs from the assumptions and estimates used for recording the liabilities, adjustments may be required and would be recorded in the period in which the difference becomes known.
Subject to the provisions of our tax matters agreement with Exterran Corporation, both parties agreed to indemnify the primary obligor of any return for tax periods beginning before and ending before or after the Spin-off (including any ongoing or future amendments and audits for these returns) for the portion of the tax liability (including interest and penalties) that relates to their respective operations reported in the filing. The tax contingencies mentioned above relate to tax matters for which we are responsible in managing the tax audit. As of December 31, 2020 and 2019, we had an offsetting indemnification asset (including penalties and interest) related to our income tax contingencies of $7.9 million and $8.5 million, respectively. Additionally, we had an indemnification liability of $1.6 million and $2.8 million as of December 31, 2020 and 2019, respectively, for our share of non-income based tax contingencies related to audits being managed by Exterran Corporation.
Recent Accounting Developments
See Note 3 (“Recent Accounting Developments”) to our Financial Statements.
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