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 in-house and through third-party contractors, natural gas compressors and related equipment which we rent and sell to customers. Our primary focus is on the rental of natural gas compressors. Our rental contracts typically provide for initial terms of 6 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 September 30, 2023, we had 1,233 natural gas compressors totaling 400,727 horsepower rented t o 78 customers compared to 1,196 natural gas compressors totaling 305,953 horsepower rented to 77 customers at September 30, 2022. We also fabricate in-house and through third-party contractors, 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 assembly by us or third-party contractors 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, generally 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 customers' 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 September 30, 2023, compared to the three months ended September 30, 2022. The table below shows our revenues and percentage of total revenues of each of our product lines for the three months ended September 30, 2023 and 2022. Three months ended September 30, 2023 2022 (in thousands) Rental $ 27,705 88.3 % $ 18,631 84.5 % Sales 1,413 4.5 % 3,086 14.0 % Aftermarket service 2,251 7.2 % 326 1.5 % Total $ 31,369 $ 22,043 16 Total revenue increased 42.3% to $31.4 million for the three months ended September 30, 2023 compared to $22.0 million for the three months ended September 30, 2022. This increase was primarily a result of higher rental revenue (48.7% increase) during 2023. Rental revenue increased to $27.7 million for the three months ended September 30, 2023 compared to $18.6 million for the same period in 2022. This increase during the third 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) $0.3 million in rental rate increases across a portion of our fleet intended to offset inflationary pressures related to the costs of our rental fleet. As of September 30, 2023, we had 1,947 compressor packages in our fleet, down from 1,976 units at September 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 509,198 horsepower at September 30, 2023 compared to 423,658 horsepower at September 30, 2022, due to additions to the Company's fleet of 59 high horsepower compressors over the past 12 months. As of September 30, 2023, we had 1,233 natural gas compressors with a total of 400,727 horsepower rented to 78 customers, compared to 1,196 natural gas compressors with a total of 305,953 horsepower rented to 77 customers as of September 30, 2022. As a result, our total rented horsepower as of September 30, 2023 increased by 31.0% over the last twelve months. Our rental fleet had unit utilization as of September 30, 2023, and 2022, respectively, of 63.3% and 60.5%, and our horsepower utilization for the same dates increased to 78.7% from 72.2%. Our total rented horsepower increased by 31.0% contrasted against a 3.1% increase 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 decreased (54.2)% to $1.4 million for the three months ended September 30, 2023 compared to $3.1 million for the three months ended September 30, 2022. This decrease is primarily attributable to lower compressor sales during the third 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. Aftermarket service revenue increased 590% to $2.3 million for the three months ended September 30, 2023 compared to $0.3 million for the three months ended September 30, 2022. This increase is primarily attributable to freight and commissioning of high horsepower units during the three months ended September 30, 2023. Cost of rentals increased t o $13.5 million during the three months ended September 30, 2023 compared to $10.0 million during the three months ended September 30, 2022. This 34.8% increase in costs of rentals is primarily due to more rented horsepower during 2023. Cost of sales decreased 27.7% to $1.5 million during the three months ended September 30, 2023 compared to $2.1 million during the three months ended September 30, 2022. This decrease was primarily due to lower sales activity. Selling, general, and administrative ("SG&A") expenses decreased 30.0% to $2.8 million for the three months ended September 30, 2023 compared $4.1 million during the same period in 2022. This decrease in SG&A expenses was primarily attributable to (i) a decrease of $0.6 million in severance expenses related to the retirement agreement between NGS and Stephen C. Taylor, our prior permanent Chief Executive Officer and current interim Chief Executive Officer, and (ii) $0.4 million decrease in stock compensation expenses. Mr. Taylor continues to be employed as our interim CEO while we search for his permanent replacement. Depreciation and amortization expense increased to $6.8 million for the three months ended September 30, 2023 compared to $6.0 million for the three months ended September 30, 2022, due to increased capital expenditures. We recorded an income tax expense of approximately $1.0 million for the three months ended September 30, 2023 compared to an income tax benefit of $0.1 million for the three months ended September 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. 17 Nine months ended September 30, 2023, compared to the nine months ended September 30, 2022. The table below shows our revenues and percentage of total revenues of each of our product lines for the nine months ended September 30, 2023 and 2022. Nine months ended September 30, 2023 2022 (in thousands) Rental $ 74,533 87.7 % $ 53,905 86.5 % Sales 6,000 7.1 % 7,270 11.7 % Aftermarket services 4,413 5.2 % 1,129 1.8 % Total $ 84,946 $ 62,304 Total revenue increased 36.3% to $84.9 million for the nine months ended September 30, 2023 compared to $62.3 million during the nine months ended September 30, 2022. This increase was primarily a result of higher rental revenue (38.3% increase) and higher aftermarket service revenue during the first nine months of 2023 (290.9% increase). Rental revenue increased to $74.5 million for the nine months ended September 30, 2023 compared to $53.9 million during the nine months ended September 30, 2022. This increase during the first nine 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 decreased to $6.0 million for the nine months ended September 30, 2023 compared to $7.3 million for the same period in 2022. This decrease is mostly attributable to a decrease in compressor sales. Sales are subject to fluctuations in timing of industry activity related to capital projects and, as such, can vary substantially between periods. Aftermarket service revenue increased 290.9% to $4.4 million for the nine months ended September 30, 2023 compared to $1.1 million for the nine months ended September 30, 2022. This increase is primarily attributable to freight and commissioning of high horsepower units during the nine months ended September 30, 2023. Cost of rentals increased 28.1% to $36.5 million during the nine months ended September 30, 2023 compared to $28.5 million during the nine months ended September 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 20.1% to $6.6 million during the nine months ended September 30, 2023 compared to $5.5 million during the nine months ended September 30, 2022. This increase during the first nine months of 2023 was primarily due to a increased fabrication costs attributable to our fabrication shops. Selling, general, and administrative expenses increased 38.2% to $12.3 million for the nine months ended September 30, 2023 compared to $8.9 million for the same period in 2022. SG&A expenses during the first nine 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 $0.5 million increase in stock compensation expense when compared to the first 9 months of 2022 and (iii) $0.4 million one time increase in legals costs associated with our cooperation agreement. Depreciation and amortization expense increased 7.0% to $19.4 million for the nine months ended September 30, 2023 compared to $18.1 million for the nine months ended September 30, 2022. This increase was the result of units in service during 2023. 18 We recorded an income tax expense of $1.4 million for the nine months ended September 30, 2023 and $0.3 million for the nine months ended September 30, 2022. For interim periods, our income tax (expense) benefit 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 nine months ended September 30, 2023. 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 and the nine months ended September 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 September 30, Nine months ended September 30, 2023 2022 2023 2022 (in thousands) Net income (loss) $ 2,171 $ (80) $ 3,045 $ 187 Interest expense 1,600 25 1,785 74 Income tax expense 1,046 (73) 1,442 288 Depreciation and amortization 6,807 6,016 19,390 18,118 Non-cash stock compensation expense 209 583 1,826 1,337 Severance expenses — 1,258 1,224 1,407 Impairment expense — — 779 — Adjusted EBITDA $ 11,833 $ 7,729 $ 29,491 $ 21,411 For the three months ended September 30, 2023, Adjusted EBITDA increased $4.1 million 53.1% due primarily to a $9.3 million increase in total revenues partially offset by a $3.5 million increase in costs of rentals. For the nine months ended September 30, 2023, Adjusted EBITDA increased $8.1 million (37.7%) due primarily to an $20.6 million increase in rental revenue partially offset by an increase of $8.0 million for cost of rentals. Liquidity and Capital Resources Our working capital positions as of September 30, 2023 and December 31, 2022 are set forth below: September 30, December 31, 2023 2022 (in thousands) Current Assets: Cash and cash equivalents $ 197 $ 3,372 Trade accounts receivable, net 28,041 14,668 Inventory 26,115 23,414 Federal income tax receivable 11,538 11,538 Prepaid income taxes — 10 Prepaid expenses and other 1,436 1,145 Total current assets 67,327 54,147 Current Liabilities: Accounts payable 30,550 6,481 Accrued liabilities 14,608 23,726 Current operating leases 98 155 Deferred income — 37 Total current liabilities 45,256 30,399 Total working capital $ 22,071 $ 23,748 For the nine months ended September 30, 2023, we invested $128.6 million in rental and property and other equipment by adding $126.4 million in new equipment to our rental fleet and $2.2 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 $17.9 million during the nine months ended September 30, 2023. We financed our investment in 20 rental 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 September 30, 2023 we had approximately $47 million available for borrowing under the Amended and Restated Credit Agreement, subject to borrowing base determination. Cash flows At September 30, 2023, we had cash and cash equivalents of $0.2 million compared to $3.4 million at December 31, 2022. Our cash flows from operating activities of $25.7 million were offset by capital expenditures of $128.6 million during the nine months ended September 30, 2023. We had working capital of $22.1 million at September 30, 2023 compared to $23.7 million at December 31, 2022. We generated cash flows from operating activities of $25.7 million during the first nine months of 2023 compared to cash flows provided by operating activities of $20.2 million for the first nine 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 either in-house or through third-party contractors only in direct response to market requirements, emphasize marketing of our idle gas compressor units and utilize 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 September 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.