NATURAL GAS SERVICES GROUP INC 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion is intended to assist you in understanding our financial position and results of operations for each of the years ended December 31, 2020 and 2019. You should read the following discussion and analysis in conjunction with our audited financial statements and the related notes. The following discussion contains forward-looking statements. For a description of limitations inherent in forward-looking statements, see “Special Note Regarding Forward-Looking Statements” on page ii. Overview We fabricate, manufacture, rent and sell natural gas compressors and related equipment. Our primary focus is on the rental of natural gas compressors. Our rental contracts generally provide for initial terms of six to 60 months, with our larger horsepower units having longer initial terms. After the initial term of our rental contracts, most of our customers have continued to rent our compressors on a month-to-month basis. Rental amounts are billed monthly in advance and include maintenance of the rented compressors. As of December 31, 2020, we had 1,274 natural gas compressors totaling 287,646 horsepower rented to 80 customers, compared to 1,419 natural gas compressors totaling 299,836 horsepower rented to 95 customers at December 31, 2019. Of the 1,274 compressors rented at December 31, 2020, 948 were rented on a month-to-month basis. We also fabricate natural gas compressors for sale to our customers, designing compressors to meet unique specifications dictated by well pressures, production characteristics and particular applications for which compression is sought. Fabrication of compressors involves our purchase of engines, compressors, coolers and other components, and our assembling of these components on skids for delivery to customer locations. These major components of our compressors are acquired through periodic purchase orders placed with third-party suppliers on an “as needed” basis, which presently requires a two to three month lead time with delivery dates scheduled to coincide with our estimated production schedules. Although we do not have formal continuing supply contracts with any major supplier, we believe we have adequate alternative sources available. In the past, we have not experienced any sudden and dramatic increases in the prices of the major components for our compressors; however, the occurrence of such an event could have a material adverse effect on the results of our operations and financial condition, particularly if we were unable to increase our rental rates and sales prices proportionate to any such component price increases. We also manufacture a line of compressor frames, cylinders and parts, known as our CiP (Cylinder-in-Plane) product line. We use finished CiP component products in the fabrication of compressor units for sale or rental by us or sell the finished component products to other compressor fabricators. We also design, fabricate, sell, install and service flare stacks and related ignition and control devices for onshore and offshore incineration of gas compounds such as hydrogen sulfide, carbon dioxide, natural gas and liquefied petroleum gases. To provide customer support for our compressor and flare sales businesses, we stock varying levels of replacement parts at our Midland, Texas facility and at field service locations. We also provide an exchange and rebuild program for screw compressors and maintain an inventory of new and used compressors to facilitate this business. We provide service and maintenance to our non-rental customers under written maintenance contracts or on an as-required basis in the absence of a service contract. Maintenance agreements typically have terms of six months to one year and require payment of a monthly fee. 21 The following table sets forth our revenues from each of our three operating categories for the periods presented: Year Ended December 31, 2020 2019 (in thousands) Rental $ 60,826 $ 56,701 Sales 5,657 19,763 Service and maintenance 1,572 1,980 Total $ 68,055 $ 78,444 Our strategy for growth is focused on our compressor rental business. Margins, exclusive of depreciation and amortization, for our rental business historically run in the mid-50% to low-60% range, while margins for the compressor sales business tend to be in the mid-20% range. If our rental business grows and contributes a larger percentage of our total revenues, we expect our overall company-wide margins, exclusive of depreciation and amortization, to improve over time. The oil and natural gas equipment rental and services industry is cyclical in nature. The most critical factor in assessing the outlook for the industry is the worldwide supply and demand for oil and natural gas and the corresponding changes in commodity prices. As demand and prices increase, oil and natural gas producers typically increase their capital expenditures for drilling, development and production activities, although recent equity capital constraints and demands from institutional investors to keep spending within operating cash flow have meaningfully restrained capital expenditure budgets of domestic exploration and production companies. Generally, increased capital expenditures ultimately result in greater revenues and profits for service and equipment companies. In general, we expect our overall business activity and revenues to track the level of activity in the oil and natural gas industry, with changes in crude oil and condensate production and consumption levels and prices affecting our business more than changes in domestic natural gas production and consumption levels and prices. In recent years we have increased our rental and sales in unconventional oil shale plays, which are more dependent on crude oil prices. With this shift towards oil production the demand for overall compression services and products is driven by two general factors; an increased focus by producers on artificial lift applications, e.g., production enhancement with compression assisted gas lift; and declining reservoir pressure in maturing natural gas producing fields, especially non-conventional production. These types of applications have historically been serviced by wellhead size compressors, and continue to be, but there has also been an economic move by our customers towards centralized drilling and production facilities, which have increased the market need for larger horsepower compressor packages. We recognized this need over the past two to three years and have shifted our cash and fabrication resources towards designing, fabricating and renting gas compressor packages that range from 400 horsepower up to 1,380 horsepower. While this is a response to market conditions and trends, it also provides us with the opportunity to compete as a full-line compression provider. We typically experience a decline in demand during periods of low crude oil and natural gas prices. During 2019, we witnessed a moderation of crude oil prices as well as drilling and completion activity levels. During the first quarter of 2020, we saw a substantial decline in the prices for oil and natural gas. Activity levels of exploration and production companies have been and will be dependent not only on commodity prices, but also on their ability to generate sufficient operational cash flow to fund their activities. Generally, though, we feel that production activities (in which we are involved) will fare better than drilling activity. . For fiscal year 2021, our forecasted capital expenditures will be directly dependent upon our customers’ compression requirements and are not anticipated to exceed our internally generated cash flows. Any required capital will be for additions to our compressor rental fleet and/or addition or replacement of service vehicles. We believe that cash on hand and cash flows from operations will be sufficient to satisfy our capital and liquidity requirements through 2021. If we require additional capital to fund any significant unanticipated expenditures, including any material acquisitions of other businesses, joint ventures or other opportunities, this additional capital could exceed our current resources, might not be available to us when we need it, or might not be on acceptable terms. Critical Accounting Policies and Practices We have identified the policies below as critical to our business operations and the understanding of our results of operations. In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting 22 of results of operations and financial condition in the preparation of our financial statements in conformity with accounting principles generally accepted in the United States. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We describe our significant accounting policies more fully in Note 2 ("Summary of Significant Accounting Policies") to our consolidated financial statements. Our critical accounting policies are as follows: • revenue recognition; • estimating the allowance for doubtful accounts receivable; • accounting for income taxes; • accounting for long-lived assets, intangible assets and goodwill; and • accounting for inventory. Revenue Recognition Policy The Company adopted ASC 606, Revenue from Contracts with Customers ("ASC 606") on January, 1, 2018. Revenue is measured based on a consideration specified in a customer’s contract, excluding any sale incentives and taxes collected on behalf of third parties (i.e. sales and property taxes). We recognize revenue once a performance obligation has been satisfied and control over a product or service has transferred to the customer. Shipping and handling costs incurred are accounted for as fulfillment costs and are included in cost of revenues in our Consolidated Statements of Operations. Nature of Goods and Services Rental Revenue. The Company generates revenue from renting compressors and flare systems to our customers. These contracts may also include a fee for servicing the compressor or flare during the rental contract. Our rental contracts typically range from six to 60 months, with our larger horsepower compressors having longer minimum contract terms. Our rental revenue is recognized over time, with equal monthly payments over the term of the contract. After the terms of the contract have expired, a customer may renew their contract or continue renting on a monthly basis thereafter. Sales Revenue. The Company generates revenue by the sale of custom/fabricated compressors, flare systems and parts, as well as, exchange/rebuilding customer owned compressors and sale of used rental equipment. The Company designs and fabricates compressors and flares based on the customer’s specifications outlined in their contract. Though the equipment being built is customized by the customer, control under these contracts does not pass to the customer until the compressor or flare package is completed and shipped, or, in accordance with a bill and hold arrangements, the customer accepts title and assumes the risk and rewards of ownership. We request some of our customers to make progressive payments as the product is being built; these payments are recorded as a contract liability on the Deferred Income line on the consolidated balance sheet until control has been transferred. These contracts also may include an assurance warranty clause to guarantee the product is free from defects in material and workmanship for a set duration of time; this is a standard industry practice and is not considered a performance obligation. Allowance for Doubtful Accounts Receivable We perform ongoing credit evaluations of our customers and adjust credit limits based on management's assessment of the customer's financial condition and payment history, as well as industry conditions and general economic conditions. We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Management believes that its allowance for doubtful accounts is adequate; however, actual write-offs may exceed the recorded allowance. Accounting for Income Taxes As part of the process of preparing our financial statements, we are required to estimate our federal income taxes as well as income taxes in each of the states in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting 23 purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not probable, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense in the tax provision in the statement of income. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We currently have no valuation allowance and fully expect to utilize all of our deferred tax assets. ASC 740 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In order to record any financial statement benefit, we are required to determine, based on technical merits of the position, whether it is more likely than not (a likelihood of more than 50 percent) that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes. If that step is satisfied, then we must measure the tax position to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest amount of the benefit that is greater than 50 percent likely of being realized upon ultimate settlement. Our policy regarding income tax interest and penalties is to expense those items as other expense. Long-Lived Assets, Intangible Assets and Goodwill Rental Equipment, Property and Equipment (Including Retirement of Rental Equipment) Rental equipment and property and equipment are recorded at cost less accumulated depreciation, except for work-in-progress on new rental equipment which is recorded at cost until it’s complete and added to the fleet. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Our rental equipment has an estimated useful life between 15 and 25 years, while our property and equipment has an estimate useful lives which range from 3 to 39 years. The majority of our property and equipment, including rental equipment, is a direct cost to generating revenue. We assess the impairment of rental equipment and property and equipment whenever events or changes in circumstances indicate that the net recorded amount may not be recoverable. The following factors could trigger an impairment review: significant underperformance relative to historical or projected future cash flows; significant adverse changes in the extent or manner in which asset (or asset group) is being used or its condition, including a meaningful drop in fleet utilization over the prior four quarters; significant negative industry or company-specific trends or actions, including meaningful capital expenditure budget reductions by our major customers or other sizable exploration and production or midstream companies, as well as significant declines in oil and natural gas prices; legislative changes prohibiting us from leasing our units or flares; or poor general economic conditions. An impairment loss is recognized if the future undiscounted cash flows associated with the asset (or asset group) and the estimated fair value of the asset are less than the asset's carrying value. Goodwill (Including Impairment During 2019) Goodwill represents the cost in excess of fair value of the identifiable net assets acquired. Goodwill is tested annually for impairment or as needed upon the occurrence of certain events or substantive changes in circumstances that indicate goodwill is more likely than not impaired. During the third quarter of 2019, the Company examined various qualitative factors to determine if a quantitative goodwill impairment test was needed. As a result of our qualitative assessment, we proceeded to perform our quantitative goodwill impairment analysis, where we used an independent valuation specialist to assist us in determining the fair value of our net assets. In this impairment analysis, the estimated fair value of our net assets was determined utilizing market and income-based approaches. Determining fair value in this analysis required significant judgment, including judgments about appropriate comparable companies, appropriate discount rates and our estimated future cash flows, which are subject to change. As a result of our quantitative evaluation, we recorded a goodwill impairment charge of $10.0 million in 2019. Intangibles At December 31, 2020 and 2019, NGS had intangible assets, which relate to developed technology and a trade name which was acquired in our acquisition of Screw Compression Systems in January 2005. This asset is not being amortized as it has been deemed to have an indefinite life. Our policy is to review intangibles that are being amortized for impairment when indicators of impairment are present. In addition, it is our policy to review indefinite-lived intangible assets for impairment annually or when indicators of 24 impairment are present. We review intangibles through an assessment of the estimated future cash flows related to such assets. In the event that assets are found to be carried at amounts in excess of estimated undiscounted future cash flows, then the assets will be adjusted for impairment to a level commensurate with a discounted cash flow analysis of the underlying assets. Based upon our analysis, we experienced no impairment of intangible assets (excluding goodwill) during the years ended December 31, 2020 or 2019. In addition, in conjunction with our quantitative assessment of goodwill, we used the services of an independent valuation specialist to assist us in determining the fair value of our trade name during the third quarter of 2019. In this impairment analysis, the estimated fair value of our trade name was determined utilizing an income-based approach that required significant judgment, including those about an appropriate royalty rate and discount rate. This analysis indicated no impairment of our trade name. Inventories We value our total inventory (current and long-term) at the lower of the actual cost and net realizable value of the inventory. We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on current and anticipated customer demand and production requirements. The Company accesses anticipated customer demand based on current and upcoming capital expenditure budgets of its major customers as well as other significant companies in the industry, along with oil and natural gas price forecasts and other factors affecting the industry. Given its concerns about the industry backdrop, Company management determined during 2019 that an increase of its inventory allowance was necessary. Due to the slow moving nature or obsolescence of a portion of the Company's long-term inventory and inventory related to the retirement of rental equipment, management recorded a charge of $3.8 million to write-off obsolete inventory from the balance sheet. For the year ended December 31, 2020, inventory allowance and write-off totaled $0.3 million. We ended 2020 with an inventory allowance balance of $221,000. Our Performance Trends and Outlook On January 30, 2020, the World Health Organization (“WHO”) announced a global health emergency because of a new strain of coronavirus known as COVID-19 due to the risks it imposes on the international community as the virus spreads globally. In March 2020, the WHO classified the COVID-19 outbreak as a pandemic, based on the rapid increase in exposure globally. During this time, the market began to experience a decline in oil prices in response to oil demand concerns due to the global economic impacts of COVID-19. These developments have led to significant weakness in oil prices and ensuing reductions of exploration and production company capital and operating budgets. With the significant decline in oil prices as well as the general economic decline caused by the impacts of COVID-19, we expect utilization to continue to decline among our smaller horsepower and medium horsepower units during the remainder of 2021 after a minimal decline during 2020. In terms of sales, we expect minimal compressor sales for the year due to much lower capital expenditure budgets throughout the industry, including those of our major customers. Finally, we have recently experienced and expect to continue to experience pricing pressure from our customers and competitors until industry and economic conditions improve. We are currently experiencing no issues with potential workforce and supply chain disruptions. In addition, our relationship with our major customer continues to be strong, and they have continued to pay our invoices in a timely, consistent manner. Nevertheless, if any of these circumstances change, our business could be adversely affected. While management anticipates that the industry and economic impact of the pandemic will have a negative effect on its results of operations in 2021 and perhaps beyond, the degree to which these factors will impact our business remains uncertain. Please read Item 1A, Risk Factors, in this report. 25 Results of Operations Year Ended December 31, 2020 Compared to the Year Ended December 31, 2019 The table below shows our revenues and percentage of total revenues for each of our product lines for the years ended December 31, 2020 and 2019. Revenue Year Ended December 31, 2020 2019 (dollars in thousands) Rental $ 60,826 89.4 % $ 56,701 72.3 % Sales 5,657 8.3 % 19,763 25.2 % Service & Maintenance 1,572 2.3 % 1,980 2.5 % Total $ 68,055 $ 78,444 Total revenue decreased to $68.1 million from $78.4 million, or 13.2%, for the year ended December 31, 2020 compared to 2019. This decrease was mainly a result of lower sales revenue (71.4% decrease) primarily due to decreased compressor sales partially offset by increased rental revenue (7.3% increase) primarily due to a greater number of large horsepower units being rented. Rental revenue increased to $60.8 million from $56.7 million for the year ended December 31, 2020 compared to 2019. As of December 31, 2020, we had 2,224 natural gas compressors in our rental fleet, down from 2,304 units at year end 2019. Despite this decrease, the Company's total unit horsepower increased by 2.1% to 438,524 at December 31, 2020 compared to 429,650 horsepower year end 2019, which reflects the addition of 24 high horsepower compressors with 20,600 horsepower to the Company's fleet during 2020. As of December 31, 2020, we had 1,274 natural gas compressors totaling 287,646 horsepower rented to 80 customers, compared to 1,419 natural gas compressors totaling 299,836 horsepower rented to 95 customers as of December 31, 2019. The rental fleet had a unit utilization as of December 31, 2020 and 2019, respectively, of 57.3% and 61.6% while our horsepower utilization for the same periods, respectively, was 65.6% and 69.8%. The decline in both utilization metrics was mainly the result of the decline in demand for our lower horsepower units. Sales revenue decreased to $5.7 million from $19.8 million for the year ended December 31, 2020, compared to 2019. This decrease in largely attributable to a decrease in compressor sales primarily driven by reductions in capital spending from our customers due to a weakened oil and natural gas price environment during 2020. Sales are subject to fluctuations in timing of industry activity related to capital projects and, as such, can vary substantially between periods. Company management routinely reviews its inventory balances for obsolescence. Due to the slow moving nature or obsolescence of a portion of the Company's long-term inventory and inventory related to the retirement of rental equipment, management recorded an increase of $251,000 in the inventory allowance reserve for costs that may not be recoverable in the future. We ended 2020 with an inventory allowance balance of $221,000. Company management routinely reviews its rental fleet to determine which units are no longer of the type, configuration, make or model that our customers are demanding or that are not cost efficient to refurbish, maintain and/or operate. As a result of this review, we determined 216 units should be retired from our rental fleet. Accordingly, we recorded a $291,000 loss on retirement of rental equipment during the year ended December 31, 2020. Operating loss decreased to $3.6 million for the year ended December 31, 2020 compared to an operating loss of $15.2 million for the year ended December 31, 2019. The decrease in operating loss was mainly due to a $10.0 million goodwill impairment charge in 2019 as well as lower losses on inventory allowance and write-off and reduced charges related to retirement of rental units. These decreases were partially offset by lower sales revenues. Selling, general, and administrative expenses decreased to $10.6 million for the year ended December 31, 2020, as compared to $10.7 million for 2019. This 1.5% decrease was primarily the result of decreases in deferred compensation expense (approximately $187,000) and expenses related to stock options (approximately $100,000) partially offset by increased insurance costs ($86,0000). 26 Depreciation and amortization expense increased to $25.2 million from $23.3 million, or 8.3%, for the year ended December 31, 2020, compared to 2019. The increase is the result of higher capital expenditures for larger horsepower units being added to the fleet. We added 42 units (approximately 23,265 horsepower) to our fleet during the twelve month period ended December 31, 2020. Twenty-four of those units were 400 horsepower or larger (including 10 at 1,380 horsepower), representing approximately 89% of the horsepower added. Income tax benefit increased to $4.8 million from $0.7 million for the year ended December 31, 2020 compared to 2019. Our effective tax rate for both years differs from the U.S. federal statutory rate of 21%. On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") was enacted in response to the economic impact caused the COVID-19 pandemic. The CARES Act allows federal net operating losses ("NOL") incurred in 2018, 2019, and 2020 to be carried back to each of the five preceding taxable years to generate a refund of previously paid federal income taxes. The Company generated significant NOLs during 2018 and 2019. The Company filed its NOL carryback claims for 2018 and 2019 during 2020. Accordingly, the Company recorded a federal income tax receivable of $15.0 million and an increase to its deferred income tax liability of $10.1 million on its condensed consolidated balance sheet. During the third quarter of 2020, the Company received refunds totaling $3.9 million related to its 2018 NOLs, which, along with year end provision adjustments, reduced its federal income tax receivable to $11.9 million on its consolidated balance sheet as of December 31, 2020. In addition, the Company recorded a current income tax benefit of $4.8 million on its consolidated statement of operations for the year ended December 31, 2020. Our income tax benefit in 2019 was largely due to our net loss of $13.7 million but was largely offset by a difference in goodwill impairment for tax purposes as well as an adjustment to our state tax rates that increased our deferred income tax expense by approximately $0.8 million. Adjusted Gross Margin Year Ended December 31, 2020 Compared to the Year Ended December 31, 2019 The table below shows our adjusted gross margin and related percentages for each of our product lines for the years ended December 31, 2020 and December 31, 2019. Adjusted gross margin is the difference between revenue and cost of revenues, exclusive of depreciation and amortization expense. Adjusted Gross Margin (1) Year Ended December 31, 2020 2019 (dollars in thousands) Rental $ 32,320 53.1 % $ 29,118 51.4 % Sales (554) (9.8) % 3,666 18.5 % Service & Maintenance 858 54.6 % 1,350 68.2 % Total $ 32,624 47.9 % $ 34,134 43.5 % (1) For a reconciliation of adjusted gross margin to its most directly comparable financial measure calculated and presented in accordance with GAAP, please read "Non-GAAP Financial Measures" below. Our overall adjusted gross margin percentage increased to 47.9% for the year ended December 31, 2020 compared to 43.5% for the year ended December 31, 2019, exclusive of depreciation and amortization. Our increase in gross margins is mainly due to an increase in total revenue related to our rental revenue. Rental revenues comprised 89% of our total revenues for the year ended December 31, 2020 compared to 72% of total revenues for the year ended December 31, 2019. As our rental activity inherently realizes higher adjusted gross margins, the increase in revenue concentrations will increase our overall adjusted gross margins. Sales margin decreased to (9.8)% in 2020 from 18.5% in 2019 due to significant declines in sales revenues (71.4%). While many sales costs are variable, certain costs such as labor are less variable as a certain staff level is retained to meet demand when market forces shift. Third party service and maintenance margins decreased to 54.6% from 68.2% for the year ended December 31, 2020 compared to 2019. Service and maintenance only represents 2.3% of our revenue in 2019, providing minimal impact on our overall adjusted gross margin. Non-GAAP Financial Measures Our definition and use of Adjusted EBITDA “Adjusted EBITDA” is a non-GAAP financial measure that we define as earnings (net (loss) income) before interest, taxes, depreciation and amortization, as well as impairment of goodwill, an increase in inventory allowance and inventory write-offs, and retirement of rental equipment. This term, as used and defined by us, may not be comparable to similarly titled 27 measures employed by other companies and is not a measure of performance calculated in accordance with GAAP. Adjusted EBITDA should not be considered in isolation or as a substitute for operating income, net income or loss, cash flows provided by operating, investing and financing activities, or other income or cash flow statement data prepared in accordance with GAAP. However, management believes Adjusted EBITDA is useful to an investor in evaluating our operating performance because: • it is widely used by investors in the energy industry to measure a company’s operating performance without regard to items excluded from the calculation of Adjusted EBITDA, which can vary substantially from company to company depending upon accounting methods and book value of assets, capital structure and the method by which assets were acquired, among other factors; • it helps investors to more meaningfully evaluate and compare the results of our operations from period to period by removing the impact of our capital structure and asset base from our operating structure; and • it is used by our management for various purposes, including as a measure of operating performance, in presentations to our Board of Directors, as a basis for strategic planning and forecasting, and as a component for setting incentive compensation. Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under generally accepted accounting principles. Some of these limitations are: • Adjusted EBITDA does not reflect our cash expenditures, future requirements for capital expenditures, or contractual commitments; • Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; • Adjusted EBITDA does not reflect the cash requirements necessary to service interest or principal payments on our debts; and • although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any capital expenditures for such replacements. There are other material limitations to using Adjusted EBITDA as a measure of performance, including the inability to analyze the impact of certain recurring items that materially affect our net income or loss, and the lack of comparability of results of operations of different companies. Please read the table below under “Reconciliation” to see how Adjusted EBITDA reconciles to our net income, the most directly comparable GAAP financial measure. Reconciliation The following table reconciles our net (loss) income, the most directly comparable GAAP financial measure, to Adjusted EBITDA: Year Ended December 31, 2020 2019 (in thousands) Net income (loss) $ 1,808 $ (13,864) Interest expense 14 15 Income tax (benefit) expense (4,792) (693) Depreciation and amortization 25,198 23,268 Impairment of goodwill — 10,039 Inventory allowance 184 3,758 Retirement of rental equipment 291 1,512 Adjusted EBITDA $ 22,703 $ 24,035 28 Our definition and use of Adjusted Gross Margin We define “Adjusted Gross Margin” as total revenue less costs of revenues (excluding depreciation and amortization expense). Adjusted gross margin is included as a supplemental disclosure because it is a primary measure used by our management as it represents the results of revenue and costs (excluding depreciation and amortization expense), which are key components of our operations. Adjusted gross margin differs from gross margin, in that gross margin includes depreciation expense. 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. Depreciation expense does not accurately reflect the costs required to maintain and replenish the operational usage of our assets and therefore may not portray the costs from current operating activity. Rather, depreciation expense reflects the systematic allocation of historical property and equipment values over the estimated useful lives. Adjusted gross margin has certain material limitations associated with its use as compared to gross margin. These limitations are primarily due to the exclusion of depreciation expense, which is material to our results of operations. Because we use capital assets, depreciation expense is a necessary element of our costs and our ability to generate revenue. In order 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. As an indicator of our operating performance, adjusted gross margin should not be considered an alternative to, or more meaningful than, gross margin as determined in accordance with GAAP. Our adjusted gross margin may not be comparable to a similarly titled measure of another company because other entities may not calculate adjusted gross margin in the same manner. Reconciliation The following table calculates gross margin, the most directly comparable GAAP financial measure, and reconciles it to adjusted gross margin: Year Ended December 31, 2020 2019 (in thousands) Total revenue $ 68,055 $ 78,444 Costs of revenue, exclusive of depreciation and amortization (35,431) (44,310) Depreciation allocable to costs of revenue (24,578) (22,908) Gross margin 8,046 11,226 Depreciation allocable to costs of revenue 24,578 22,908 Adjusted gross margin $ 32,624 $ 34,134 29 Liquidity and Capital Resources Our working capital positions as of December 31, 2020 and 2019 are set forth below. As of December 31, 2020 2019 (in thousands) Current Assets: Cash and cash equivalents $ 28,925 $ 11,592 Trade accounts receivable, net 11,884 9,106 Inventory, net 19,926 21,080 Federal income tax receivable 11,538 — Prepaid income taxes 66 40 Prepaid expenses and other 379 597 Total current assets 72,718 42,415 Current Liabilities: Accounts payable $ 2,373 $ 1,975 Accrued liabilities 6,770 2,287 Line of credit 417 417 Current operating leases 198 189 Deferred income 1,103 640 Total current liabilities 10,861 5,508 Net working capital $ 61,857 $ 36,907 For the year ended December 31, 2020, we invested approximately $15.3 million in rental equipment, property and other equipment. During the year, the Company added $13.0 million in new equipment to our rental fleet and $2.2 million in other property and equipment. Our investment in property and equipment includes any changes to work-in-progress related to our rental fleet jobs at the beginning of the year compared to the end of the year. Our rental work-in-progress decreased by $4.0 million during 2020. We financed our investment in rental equipment, property and other equipment with cash flows from operations during 2020. Cash flows At December 31, 2020, we had cash and cash equivalents of $28.9 million compared to $11.6 million at year end 2019. Our cash flow from operations of $32.6 million was partially offset by capital expenditures of $15.3 million during 2020. We also had working capital of $61.9 million at December 31, 2020 compared to $36.9 million at December 31, 2019. On December 31, 2020 and 2019, we had outstanding debt of $417,000, which is all related to our line of credit. We had net cash flow from operating activities of $32.6 million during 2020 compared $29.4 million during 2019. Our cash flow from operating activities of $32.6 million was primarily the result of our rental and sales revenues partially offset by associated costs of sales as well as a federal income tax refund of approximately $4.1 million. At December 31, 2019, we had cash and cash equivalents of $11.6 million, working capital of $36.9 million and total debt of $417,000, under our credit agreement which was due on March 31, 2020. Our cash and cash equivalents decreased from 2018, due to an increase on our capital program for contracted new large horsepower compressor builds and the construction of our new corporate office. We had positive net cash flow from operating activities of approximately $29.4 million during 2019. This was primarily from a net loss of $0.5 million and non-cash items of depreciation and amortization of $23.3 million, $2.6 million related to stock-based compensation, a decrease in deferred income taxes of $0.3 million and a decrease in cash flows related to working capital and other items of $0.2 million. Senior Bank Borrowings We had a senior secured revolving credit agreement the ("Amended Credit Agreement") with JP Morgan Chase Bank, N.A (the "Lender") that expired on March 31, 20201. We have decided not to renew the Amended Credit Agreement and on March 17, 2021, we repaid the outstanding principal balance. No further amounts or obligations are owed on the Amended Credit Agreement. We are in the process of negotiating a new credit facility which we expect to complete by the end of April 2021, although no guarantee can be made that we will be successful in finalizing and securing a new credit facility. 30 Components of Our Principal Capital Expenditures Capital expenditures for the two years ended December 31: Expenditure Category 2020 2019 (in thousands) Rental equipment and property and equipment $ 15,257 $ 69,938 The level of our expenditures will vary in future periods depending on energy market conditions and other related economic factors. Based upon existing economic and market conditions, we believe that our cash on hand, operating cash flow and available line of credit are adequate to fully fund our net capital expenditures requirements for 2021. We also believe we have flexibility with respect to our financing alternatives and adjustments to our capital expenditure plans if circumstances warrant. We do not have any material continuing commitments related to our current operations that cannot be met with our cash on hand and our line of credit. However, our financing capacity could be negatively impacted by the COVID-19 pandemic. Please see Item 1A, Risk Factors, of this report. Off-Balance Sheet Arrangements From time-to-time, we enter into off-balance sheet arrangements and transactions that can give rise to off-balance sheet obligations. As of December 31, 2020, we did not have any material off-balance sheet arrangements. Recently Issued Accounting Pronouncements In December 2019, the FASB issued ASU 2019-12, Income Taxes (ASC Topic 740), which simplifies accounting for income taxes by removing certain exceptions to various tax accounting principles and clarifies other existing guidance in order to improve consistency of application. These amendments are effective for public entities for interim and annual periods beginning after December 15, 2020. We are currently evaluating the impact of ASU 2019-12 on our consolidated financial statements and note disclosures. In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (ASC Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments to ASC Topic 326 require immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets, including trade receivables. For companies that qualify as smaller reporting companies, the amendments in this update are effective for interim and annual periods beginning after January 1, 2023. We are currently evaluating the impact of ASU 2016-13 on our consolidated financial statements and note disclosures. Environmental Regulations Various federal, state and local laws and regulations covering the discharge of materials into the environment, or otherwise relating to protection of human safety and health and the environment, affect our operations and costs. Compliance with these laws and regulations could cause us to incur remediation or other corrective action costs or result in the assessment of administrative, civil and criminal penalties and the issuance of injunctions delaying or prohibiting operations. In addition, we have acquired certain properties and plant facilities from third parties whose actions with respect to the management and disposal or release of hydrocarbons or other wastes were not under our control. Under environmental laws and regulations, we could be required to remove or remediate wastes disposed of or released by prior owners. In addition, we could be responsible under environmental laws and regulations for properties and plant facilities we lease, but do not own. Compliance with such laws and regulations increases our overall cost of business, but has not had a material adverse effect on our operations or financial condition. It is not anticipated, based on current laws and regulations, that we will be required in the near future to expend amounts that are material in relation to our total expenditure budget in order to comply with environmental laws and regulations but such laws and regulations are frequently changed and we are unable to predict the ultimate cost of compliance. We also could incur costs related to the cleanup of sites to which we send equipment and for damages to natural resources or other claims related to releases of regulated substances at such sites. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Our consolidated financial statements and supplementary financial data are included in this Annual Report on Form 10-K beginning on page F-1. 31 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None.