NATURAL GAS SERVICES GROUP INC 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The discussion and analysis of our financial condition and results of operations are based on, and should be read in conjunction with, our condensed consolidated financial statements and the related notes included elsewhere in this report and in our Annual Report on Form 10-K for the year ended December 31, 2022 filed with the SEC (the "Annual Report"). This report and our Annual Report, as amended, contain certain forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended, and information pertaining to us, our industry and the oil and natural gas industry that is based on the beliefs of our management, as well as assumptions made by and information currently available to our management. All statements, other than statements of historical facts contained in this report as well as our Annual Report, including statements regarding our future financial position, growth strategy, budgets, projected costs, plans and objectives of management for future operations, are forward-looking statements. We use the words “may,” “will,” “expect,” “anticipate,” “estimate,” “believe,” “continue,” “intend,” “plan,” “budget” and other similar words to identify forward-looking statements. You should read statements that contain these words carefully and should not place undue reliance on these statements because they discuss future expectations, contain projections of results of operations or of our financial condition and/or state other “forward-looking” information. We do not undertake any obligation to update or revise publicly any forward-looking statements. Although we believe our expectations reflected in these forward-looking statements are based on reasonable assumptions, no assurance can be given that these expectations or assumptions will prove to have been correct. Please read Item 1A, Risk Factors, in our Annual Report, as it contains important factors that could cause actual results to differ materially from the expectations reflected in the forward-looking statements. 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 typically provide for initial terms of six to 24 months, with our larger horsepower units having contract terms of up to 60 months. After the initial term of our rental contracts, many 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 our rented compressors. As of June 30, 2023, we had 1,249 natural gas compressors totaling 372,596 horsepower rented t o 75 customers compared to 1,281 natural gas compressors totaling 311,379 horsepower rented to 79 customers at June 30, 2022. 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. The major components of our compressor packages are acquired through periodic purchase orders placed with third-party suppliers on an “as needed” basis, which presently require lead times between three to six months 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. Recent inflationary pressures have created price increases in both major and minor components for our compressors as well as longer than normal lead times for such components. To date, we have been able to increase our rental rates and sales prices proportionally; however, if cost increases continue and we are no longer able to increase our rental rates and sales prices such an event could have a material adverse effect on the results of our operations and financial condition. We also manufacture a proprietary 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. To provide customer support for our compressor 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 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. 15 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 rentals 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 unconventional 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 has increased the market need for larger horsepower compressor packages. We recognized this need in recent years and have been shifting our cash and fabrication resources towards designing, fabricating and renting gas compressor packages that range from 400 horsepower up to 2,500 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. In addition, recent heightened focus on the emissions profile of our customers has created a shift in demand from natural gas powered compression to electric motor compression in areas where the electric infrastructure can accommodate the energy demands of these units. Industry Update We typically experience a decline in demand during periods of low crude oil and natural gas prices. During the first quarter of 2020, we saw a substantial decline in the prices for oil and natural gas. Commodity prices stabilized somewhat during 2021 and increased in the first half of 2022 and declined in the second half of 2022 and began increasing so far in 2023. Historically, activity levels of exploration and production companies have been dependent on commodity prices. However, recent capital market focus on cash returns from exploration and production companies has restricted capital spending below levels that have historically been observed during higher commodity price environments. Generally, though, we believe that production activities (in which we are involved) will fare better than drilling activity. This is reflected in both the stability of our rental revenues, which is driven by production activities, and the volatility of our compressor sales, which tends to fluctuate with capital allocations. As such, we still expect compressor sales to be low for the remainder of 2023, as exploration and production companies have elected to rent compression units rather than allocating capital dollars to purchase new compression. Results of Operations Three months ended June 30, 2023, compared to the three months ended June 30, 2022. The table below shows our revenues and percentage of total revenues of each of our product lines for the three months ended June 30, 2023 and 2022. Three months ended June 30, 2023 2022 (in thousands) Rental $ 24,105 89.4 % $ 18,144 91.0 % Sales 1,595 5.9 % 1,292 6.5 % Service and Maintenance 1,257 4.7 % 490 2.5 % Total $ 26,957 $ 19,926 16 Total revenue increased 35.3% to $27.0 million for the three months ended June 30, 2023 compared to $19.9 million for the three months ended June 30, 2022. This increase was primarily a result of higher rental revenue (32.9% increase) during 2023. Rental revenue increased to $24.1 million for the three months ended June 30, 2023 compared to $18.1 million for the same period in 2022. This increase during the second quarter of 2023 was attributable to (i) an increase in high horsepower compression rentals as these units carry a higher rental revenue rate than our lower horsepower units and (ii) modest rental rate increases across a portion of our fleet intended to offset inflationary pressures related to the costs of our rental fleet. As of June 30, 2023, we had 1,911 compressor packages in our fleet, down from 2,043 units at June 30, 2022 due to the retirement of units during the fourth quarter of 2022 and th e disposition of a small number of compressors from the fleet during this year. The Company's total unit horsepower increased to 473,884 horsepower at June 30, 2023 compared to 426,811 horsepower at June 30, 2022, due to additions to the Company's fleet of 59 high horsepower compressors over the past 12 months. As of June 30, 2023, we had 1,249 natural gas compressors with a total of 372,596 horsepower rented to 75 customers, compared to 1,281 natural gas compressors with a total of 311,379 horsepower rented to 79 customers as of June 30, 2022. As a result, our total rented horsepower as of June 30, 2023 increased by 19.7% over the last twelve months. Our rental fleet had unit utilization as of June 30, 2023, and 2022, respectively, of 65.4% and 62.7%, and our horsepower utilization for the same dates increased to 78.6% from 73.0%. Our total rented horsepower increased by 19.7% contrasted against a 2.5% decrease in total rented units. This illustrates the growing demand for our high horsepower units while the demand for our smaller and medium horsepower units has not recovered in line with recent commodity price increases. Sales revenue increased 23.5% to $1.6 million for the three months ended June 30, 2023 compared to $1.3 million for the three months ended June 30, 2022. This increase is primarily attributable to increased parts sales during the second quarter of 2023 compared to the same period in 2022. Sales are subject to fluctuations in timing of industry activity related to our customers' capital projects and, as such, can vary substantially between periods. Cost of rentals increased t o $11.3 million during the three months ended June 30, 2023 compared to $9.2 million during the three months ended June 30, 2022. This 22.7% increase in costs of rentals is primarily due to more rented horsepower during 2023. Cost of sales increased 30.3% to $1.9 million during the three months ended June 30, 2023 compared to $1.4 million during the three months ended June 30, 2022. This increase was primarily due to an increase in the volume of parts sales at margins below our historical realizations. Selling, general, and administrative ("SG&A") expenses increased 110.4% to $4.9 million for the three months ended June 30, 2023 compared $2.3 million during the same period in 2022. This increase in SG&A expenses was primarily attributable to (i) $612,000 of severance expenses related to the retirement agreement between NGS and Stephen C. Taylor, our prior and current interim Chief Executive Officer, (ii) $800,000 increase in stock compensation expenses, (iii) and a one-time increase of $350,000 for reimbursement expenses related to our Cooperation Agreement with Mill Road Capital. Depreciation and amortization expense increased to $6.4 million for the three months ended June 30, 2023 compared to $6.0 million for the three months ended June 30, 2022, due to increased capital expenditures. We recorded an income tax expense of approximately $0.2 million for the three months ended June 30, 2023 compared to an income tax expense of $0.4 million for the three months ended June 30, 2022. For interim periods, our income tax expense is computed based upon our estimated annual effective tax rate and any discrete items that impact the interim periods. Our estimated annual effective tax rate differs from the U.S. federal statutory rate of 21% primarily as a result of expenses not deductible for income tax purposes. We recorded an impairment expense of $0.8 million related to capitalized software costs for the three months ended June 30, 2023. 17 Six months ended June 30, 2023, compared to the six months ended June 30, 2022. The table below shows our revenues and percentage of total revenues of each of our product lines for the six months ended June 30, 2023 and 2022. Six months ended June 30, 2023 2022 (in thousands) Rental $ 46,828 87.4 % $ 35,274 87.6 % Sales 4,587 8.6 % 4,184 10.4 % Service and Maintenance 2,162 4.0 % 804 2.0 % Total $ 53,577 $ 40,262 Total revenue increased 33.1% to $53.6 million for the six months ended June 30, 2023 compared to $40.3 million during the nine months ended June 30, 2022. This increase was primarily a result of higher rental revenue (32.8% increase) and higher service and maintenance revenue during the first six months of 2023 (168.9% increase). Rental revenue increased to $46.8 million for the six months ended June 30, 2023 compared to $35.3 million during the six months ended June 30, 2022. This increase during the first six months of 2023 was attributable to an increase in high horsepower compression rentals as these units carry a higher rental revenue rate than our lower horsepower units and, to a lesser extent, rental rate increases across a portion of our fleet intended to offset inflationary pressures related to the costs of our rental fleet. Sales revenue increased to $4.6 million for the six months ended June 30, 2023 compared to $4.2 million for the same period in 2022. This increase is mostly attributable to an increase in compressor sales partially offset by a slight decrease in parts sales. Sales are subject to fluctuations in timing of industry activity related to capital projects and, as such, can vary substantially between periods. Cost of rentals increased 24.4% to $23.0 million during the six months ended June 30, 2023 compared to $18.5 million during the six months ended June 30, 2022. This increase was primarily due to inflationary pressures on labor and parts as well as increased high horsepower units being placed into service. While repair and maintenance expenses are customary in our business, the timing of such expenses can fluctuate between periods resulting in periods with larger than normal expenses. Cost of sales increased 49.2% to $5.1 million during the six months ended June 30, 2023 compared to $3.4 million during the six months ended June 30, 2022. This increase during the first six months of 2023 was primarily due to a increased fabrication cost in costs of sales attributable to costs from our fabrication shops. Selling, general, and administrative expenses increased 95.8% to $9.4 million for the six months ended June 30, 2023 compared to $4.8 million for the same period in 2022. SG&A expenses during the first six months of 2023 were impacted by (i) $ 1.2 million of severance expenses related to the retirement agreement between NGS and Mr. Stephen Taylor, our prior Chief Executive Officer, (ii) a $800,000 increase in stock option compensation expense and (iii) $400,000 increase in legals costs associated with our cooperation agreement. Depreciation and amortization expense increased 4.0% to $12.6 million for the six months ended June 30, 2023 compared to $12.1 million for the six months ended June 30, 2022. This increase was the result of unit retirements in the fourth quarter of 2021. We recorded an income tax expense of $0.4 million for the six months ended June 30, 2023 and the six months ended June 30, 2022. For interim periods, our income tax (expense) is computed based upon our estimated annual effective tax rate and any discrete items that impact the interim periods. We recorded an impairment expense of $0.8 million related to capitalized software costs for the 6 months ended June 30, 2023. 18 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 non-cash stock compensation, severance expenses, impairment expenses, 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 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, and as a basis for strategic planning and forecasting. 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 (loss) income, for the three months ended June 30, 2023 and 2022, the most directly comparable GAAP financial measure. 19 Reconciliation The following table reconciles our net income, the most directly comparable GAAP financial measure, to Adjusted EBITDA: Three months ended June 30, Six months ended June 30, 2023 2022 2023 2022 (in thousands) Net income (loss) $ 504 $ (70) $ 874 $ 267 Interest expense 185 24 185 49 Income tax expense 249 372 396 361 Depreciation and amortization 6,418 6,042 12,583 12,103 Non-cash stock compensation expense 1,130 331 1,617 754 Severance expenses 612 — 1,224 — Impairment expense 779 — 779 — Adjusted EBITDA $ 9,877 $ 6,699 $ 17,658 $ 13,534 For the three months ended June 30, 2023, Adjusted EBITDA increased $3.2 million (47.4%) due primarily to a $7.0 million increase in total revenues partially offset by a $2.1 million increase in costs of rentals. For the six months ended June 30, 2023, Adjusted EBITDA increased 4.1 million (30.5%) due primarily to an $11.6 million increase in rental revenue partially offset by an increase of $4.5 million for cost of rentals. Liquidity and Capital Resources Our working capital positions as of June 30, 2023 and December 31, 2022 are set forth below: June 30, December 31, 2023 2022 (in thousands) Current Assets: Cash and cash equivalents $ 4,286 $ 3,372 Trade accounts receivable, net 20,872 14,668 Inventory 27,960 23,414 Federal income tax receivable 11,538 11,538 Prepaid income taxes 10 10 Prepaid expenses and other 1,446 1,145 Total current assets 66,112 54,147 Current Liabilities: Accounts payable 28,603 6,481 Accrued liabilities 18,492 23,726 Current operating leases 133 155 Deferred income — 37 Total current liabilities 47,228 30,399 Total working capital $ 18,884 $ 23,748 For the six months ended June 30, 2023, we invested $93.5 million in rental and property and other equipment by adding $92.3 million in new equipment to our rental fleet and $1.2 million primarily in vehicles as well as various other machinery and equipment. Our investment in rental equipment, property and other equipment also includes any changes to work-in-process related to our rental fleet jobs at the beginning of the period compared to the end of the period. Our rental work-in-process increased by $19.9 million during the six months ended June 30, 2023. We financed our investment in rental 20 equipment, property and other equipment with cash flow from operations, and borrowings under our Amended and Restated Credit Facility. We anticipate that our cash flows from operations as well as our borrowing capacity under our Amended and Restated Credit Agreement will provide adequate liquidity for our planned capital expenditures during the remainder of 2023. For any new capital expenditures in 2023 and beyond that exceeds our cash flow from operations and our borrowing base under our Amended and Restated Credit Agreement, we anticipate that we would need to negotiate an expansion of our borrowing capacity under our Amended and Restated Credit Agreement or raise money in the capital markets through sales of equity or debt securities. While we control the timing and extent of our capital expenditures, there is no assurance that any such borrowing expansion would be granted. At June 30, 2023 we had approximately $75 million available for borrowing under the Amended and Restated Credit Agreement, subject to borrowing base determination. Cash flows At June 30, 2023, we had cash and cash equivalents of $4.3 million compared to $3.4 million at December 31, 2022. Our cash flows from operating activities of $22.6 million were offset by capital expenditures of $93.5 million during the six months ended June 30, 2023. We had working capital of $18.9 million at June 30, 2023 compared to $23.7 million at December 31, 2022. We generated cash flows from operating activities of $22.6 million during the first six months of 2023 compared to cash flows provided by operating activities of $13.2 million for the first six months of 2022. Strategy For the remainder of 2023, our overall plan is to continue monitoring and holding expenses in line with the anticipated level of activity, fabricate rental fleet equipment only in direct response to market requirements, emphasize marketing of our idle gas compressor units and utilizing bank borrowing in line with market conditions. For the remainder of 2023, our forecasted capital expenditures are not anticipated to exceed our internally generated cash flows, cash on hand and borrowing availability under our Amended and Restated Credit Agreement. The majority of required capital will be for contracted, premium-priced additions to our compressor rental fleet and/or required service vehicles. We believe market conditions indicate significant demand growth for large horsepower compression in 2023 and beyond. While we believe that cash flows from operations, our current cash position and borrowing capacity under our Amended and Restated Credit Agreement will be sufficient to satisfy a portion of our capital activity, we may need to negotiate an expansion of our borrowing capacity under our Amended and Restated Credit Agreement to meet the capital expenditure requirements of any additional demand. Critical Accounting Policies and Practices Our condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States. In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting 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. Management has determined that our critical accounting policies are those that relate to revenue recognition, estimating the allowance for doubtful accounts, accounting for income taxes, accounting for long-lived assets and accounting for inventory. There have been no changes in the critical accounting policies disclosed in the Company's Form 10-K for the year ended December 31, 2022. Recently Issued Accounting Pronouncements Please read Note 2, Summary of Significant Accounting Policies, Recently Issued Accounting Pronouncements in our condensed consolidated financial statements in 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 June 30, 2023, the off-balance sheet arrangements and transactions that we have entered into include purchase agreements. We do not believe that these arrangements are reasonably likely to materially affect our liquidity or availability of capital resources. 21 Special Note Regarding Forward-Looking Statements Except for historical information contained herein, the statements in this report are forward-looking and made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve known and unknown risks and uncertainties, which may cause our actual results in future periods to differ materially from forecasted results. Those risks include, among other things, the loss of market share through competition or otherwise; the introduction of competing technologies by other companies; a prolonged, substantial reduction in oil and natural gas prices, which could cause a decline in the demand for our products and services; and new governmental safety, health and environmental regulations, which could require us to make significant capital expenditures. The forward-looking statements included in this Form 10-Q are only made as of the date of this report, and we undertake no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances. A discussion of these and other risk factors is included in our Annual Report on Form 10-K for the year ended December 31, 2022 filed with the SEC. Item 3. Quantitative and Qualitative Disclosures about Market Risk There have been no changes in the market risks disclosed in the Company's Form 10-K for the year ended December 31, 2022.