Hello, and welcome to the Kodiak Gas Services Second Quarter 2023 Conference Call and Webcast. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to turn the call over to Graham Sones, Vice President, Investor Relations. Please go ahead, Graham.

Good morning. We appreciate you joining us for the Kodiak Gas Services conference call and webcast to review second quarter 2023 results. Participating from the company today are Mickey McKee, President and Chief Executive Officer; and John Griggs, Chief Financial Officer. Following my remarks, Mickey and John will provide a high-level commentary on the company, our market, second quarter financial results and our 2023 outlook. Before opening the call for Q&A. Before I turn the call over to Mickey, I have a few housekeeping items to cover. There will be a replay of today's call available via webcast on the Investors tab of our website at kodiakgas.com. There will also be a replay you can access by phone until August 17, 2023. Information on how to access the replays can be found in yesterday's earnings release. Please note that information reported on this call speaks only as of today, August 10, 2023. And therefore, you're advised that such information may no longer be accurate as of the time of any replay or transcript reading. In addition, the comments made by management during this conference call may contain forward-looking statements within the meaning of the United States federal securities laws. These forward-looking statements reflect the current views, beliefs and assumptions of Kodiak's management based on information currently available. Although we believe the expectations referenced in these forward-looking statements are reasonable, various risks, uncertainties and contingencies could cause the company's actual results, performance or achievements to differ materially from those expressed in the statements made by management. And management can give no assurance that such statements or expectations will prove to be correct. Listeners are encouraged to read Kodiak's prospectus available on our website or sec.gov to understand those risks, uncertainties and contingencies. The comments today will also include certain non-GAAP financial measures. Additional details and reconciliations to the most comparable GAAP measures are included in the quarterly press release, which can be found on our website. And now I'd like to turn the call over to Kodiak's CEO, Mr. Mickey McKee. Mickey?

Thanks, Graham, and thank you all for joining us today. I'm extremely proud of what Kodiak has accomplished for a company that was founded just 13 years ago, including the pricing of our IPO on June 28. I want to start out our first earnings call by thanking the extraordinary women and men of Kodiak Gas Services on the accomplishment of getting Kodiak where it is today. It has been no easy task. In becoming a publicly traded company, Kodiak is 1 of 6 energy IPOs since the beginning of the COVID-19 pandemic in the first contract compression IPO in 10 years. It's quite a milestone and I'm thrilled that through this IPO process, we were able to make each and every Kodiak employee a shareholder of the company. I'll begin our first public conference call by discussing a few highlights from the second quarter. And then I'll provide some commentary on the industry and our company. When I'm finished, John will provide additional financial details from the second quarter and discuss our 2023 outlook. To start and to address the 8-K that was released yesterday, Kodiak identified an error in the accounting for unrealized gains on our interest rate hedges that showed up in the Q1 '22 comparable financial statements in our S-1 filing. The error understated our net income of Q1 of '22 was noncash in nature and did not affect the annual audited financials for 2022 or any non-GAAP measures such as adjusted EBITDA, adjusted gross margin or discretionary cash flow. Kodiak is taking appropriate steps to make sure this doesn't happen again, and John will go into more detail in his section. We're happy to take any questions about it in Q&A. Now turning to yesterday's earnings release. To touch on a few highlights from the…

Thanks, Mickey. To start out, I want to provide more color on the 8-K, Mickey highlighted earlier. During Q1 of last year, we incorrectly recorded the journal entry related to the unrealized gain on our interest rate hedges, understating Q1 2022 net income by about $22 million. There was no impact on cash or our non-GAAP measures, including adjusted gross margin, adjusted EBITDA or discretionary cash flow. We identified the error in Q2 of last year and corrected it by adjusting the Q2 '22 financials rather than restating the Q1 '22 results. Obviously, we were private at the time and not publicly reporting quarterly results. Unfortunately, those numbers were presented in the quarterly comparable financials in our S-1 filing. As a result, we will restate the impacted line items in our soon-to-be-released 10-Q. Notably, there is no change to the full year '22 audited figures. We've taken action to mitigate the possibility of something like this happening again. Things like strengthening our accounting team, retaining a big 4 accounting firm to lead our ongoing SOX implementation in upgrading certain business systems. We set high standards at Kodiak, and we take great pride in all aspects of our work. We view challenges as opportunities for improvement and that's how we're approaching this one. All right. Back to the quarter. So as Mickey emphasized, it is a great time to be in the contract compression industry in an even better time to be at Kodiak. Here are some of the results from the quarter. Total revenues for the second quarter of '23 were a bit over $203 million, up about 7% sequentially and about 15% compared to the second quarter of '22. Adjusted EBITDA for the quarter was almost $108 million, up modestly from Q1 and up 11% versus the same quarter…

Thanks, John. So to quickly recap, we are very pleased with our second quarter results and look forward to continued profitable growth in 2023 and beyond. So what have we built here at Kodiak? Built a market leader in contract compression infrastructure with a focus on large horsepower compression and its critical role in the energy value chain. We concentrated our purpose-built fleet in the most economic cost advantaged basins with the best customers under long-term fixed revenue contracts that are resilient to short-term commodity price cycles. We've assembled an experienced leadership team that is honored to support the best employees in the business, every one of which is now a fellow shareholder. And we've built Kodiak with a commitment to sustainability. And with that, I'd like to close by again thanking everyone who has worked hard to get us where we are today, including all of our stakeholders that share in our vision as we continue our role as mission-critical infrastructure for the future of domestic energy production. At this point, we'll open up the line for questions. Operator?

[Operator Instructions] Our first question today is coming from John Mackay from Goldman Sachs.

Mickey, team, congrats for the first release here. I wanted to just start on pricing trends. I would just be curious to hear what you're seeing in the market now, where you kind of think of that trends from here and then acknowledging your high utilization level and high contracting level, but just any thoughts on how long it could take to turn the overall fleet up to some of these higher numbers we're seeing?

John, this is Mickey. Thanks for joining us today. On the pricing trends, I mean, I think that's pretty obvious between our calls and several of the others that we're in one of the tightest markets we've ever seen in the compression industry here, and it's really good times to be in the market. So we're signing contracts into the second half of 2024 right now, and they're at a considerable premium to where the current fleet is priced today. And we're excited about those rates. So it's all looking good and going up from here. I think that, like you said, we have a pretty highly contracted fleet, only about 5.5% of our fleet today is under month-to-month contracts. So basically all effectively fully contracted fleet. And so we -- with an average kind of primary term of contract for 3 to 5 years, I would expect that we kind of would expect 25% to 30% of our fleet to be available for recontracting and repricing every year to kind of give you some color there.

That's great. Maybe just as a follow-up. And John, you had some comments here. But just on gross margins on the core compression business, talked about some positive trends, I guess, cost efforts kind of tracking ahead of schedule, acknowledging the guidance for the rest of the year is kind of in line-ish or maybe slightly above, but largely in line-ish for what you saw in the second quarter, where could gross margins go from here? What would higher pricing that Mickey you're just talking about, what could that mean for gross margins, let's say, going into '24 or beyond?

Yes. Thanks, John. So I'll touch on the overall topic, not going to speculate too much about what's going to happen in '24 at this point. But I'd say cost optimization is something that gets a ton of attention here at Kodiak. As you mentioned, our compression operations margin was consistent with where it was last year, just [ a tick ] down from where we were a quarter ago. That's not something that gets a lot of our -- gets a lot of concern on our end because we kind of understand exactly what drove that [ tick ] down. So what we're really doing here internally is focusing on our needs and wants, making sure that we're optimizing every dollar that's spent. We've got a great leadership team on our operations side that's focused on that. So the guidance that we put forth is kind of where we think we'll be, but rest assured, we're focused on trying to see the operating leverage and see that margin expansion as we move beyond 2023.

Yes. And I'll just add that we've seen some beginning signs of relief in inflationary pressure from kind of lube oil and those kind of things. And so I would think we'd see some upward momentum on some margins going forward.

Next question is coming from Jeremy Tonet from JPMorgan.

I just want to start off. Thanks for the color with the release here and talking about where the initial dividend could fall out. But wondering if you could provide maybe a bit more color on capital allocation, the company's thought process going forward here in kind of -- with energy, we've seen the sector shift to living within cash flows and just wondering, I guess, how you wrap everything together today as far as capital allocation, given this tremendous growth outlook as you talked about.

Yes. We certainly have more growth opportunities than the capital that we're willing to spend on those growth opportunities. And really, I just -- I've met with some of the leadership from our commercial team this morning and really, it's probably 2 to 3x more opportunities than capital that we're willing to spend at this point in time looking at 2024. So obviously, again, a really tight market. But from a capital allocation framework, we've made a commitment to our investors that we're going to live within our free cash flow, and everybody defines free cash flow very differently. But the way we define it is living within free cash flow after we spend our growth CapEx and after we pay our dividend. So that's our commitment, and we want to make sure that the public world knows that in our first kind of call here. So when we look at our discretionary cash flow, we've got our EBITDA minus our cash taxes, minus our interest and minus our maintenance capital equaling our discretionary cash flow. We take that, and we are roughly allocating 35% to 40% of that to our dividend now coming out of the gate. And then right now, with the compelling opportunities that we have in front of us with strong returns on that capital deployed, we think the best thing to do right now, obviously, is to maximize our growth in that realm. And so making sure that we're spending 60% to 65% of that discretionary cash flow on growth capital going forward, and -- but those being the governors of what we're going to spend going forward and making sure that we're not borrowing money to pay a dividend ultimately.

Jeremy, I was just going to follow that up. The only other thing I would add is that we're going to do all that while we protect the balance sheet, preserve financial flexibility and ultimately move towards our long-term leverage target, which is that 3 to 3.5x, which we think will be there in 2025.

Got it. That's very helpful. And so given the focus on capital discipline there, just wondering if you could talk maybe a little bit more on where those dollars are going to be deployed. It seems like it's largely Permian-based. It seems like there are some key customers that you're growing alongside with is the focus to kind of look at their or look to expand the portfolio or just wondering how you think about where to deploy the capital as far as basin and customer-wise.

Yes. I mean, Jeremy, at this point in time, we can't keep up with what our core customers really need us to keep up with from a capital allocation perspective anyway. So we're doing our best to service the bulk of their needs and making sure that we stay aligned with the customers that kind of got us here. So I wouldn't suspect that we're going to make a concerted effort to go expand the portfolio unless there's a really, really compelling opportunity to do so. And like I said, I think taking that a step further, I think what you're probably getting at a little bit is I think that the majority of those dollars are going to be deployed and head into the Permian Basin.

Next question is coming from Neal Dingmann from Truist Securities.

Great first quarter. My first question is just maybe, John, for you, is on the EBITDA guidance. Obviously, very positive on the $730 million to $740 million on Compression and $70 million to $90 million on Other. I'm just wondering, you all have spoken today even on the prepared remarks about kind of what's going on with the compression market and all. I'm just wondering, is there anything you could speak to on just major assumptions behind this? Any changes we should be -- that you have kind of in that guide? Or is it just sort of steady as we go as they're going to [ get you ] those stellar numbers?

Yes. So speaking -- thanks, Neal. But speaking to the compression operations guidance, it's pretty consistent with everything we've talked about in the past, I gave in my prepared remarks earlier, kind of what we think the horsepower is going to increase on a year-over-year basis. So that's, what, about 140,000 or so horsepower. I will say it's about 2/3 back end loaded in 2023 in terms of when the horsepower will be delivered. So we do see a step up in terms of kind of the CapEx as well as the revenue potential for when those additions come on board. And then the rest of our guidance is reasonably self-explanatory around the margins.

That's good to hear. No, it's obviously fantastic margins in contracts. Making my last for you is just on the prepared remarks, definitely very always exciting to hear about the LNG opportunities. I'm just wondering, is there anything you could speak to yet just on -- is it still too early just on any developments or anything you could realize because obviously, to your point, just amount of potential compression that's needed is just really crazy to see how much could be out there. I'm just wondering any early talks or just any other color you could give around how you all could be involved in the maybe near term on this.

Well, I think that, look, the LNG build-out that we're looking at on the Gulf Coast of the United States and really further downstream of us, and it's not a market that we typically play in and kind of the long-haul pipeline and the regasification kind of -- or the liquefaction [ piece ] and that kind of thing. So really what we stand to benefit from in that dynamic is the fact that we're just going to have -- there just has to be an enormous amount of upstream infrastructure build-out that has to be built to support just the feed gas for all of that. And I think that gas prices where they're at today, that feed gas is going to have to come from Permian and Eagle Ford type of places and not necessarily the Haynesville yet until we see gas prices creep up a little bit more. And when you think about with those rich gas environments like the Permian and having to add multiple BCF a day of additional capacity, then you're talking about you need gas lift for oil compression or gas lift compression for oil lift and you need processing capacity that's going to need residue compression and centralized gathering facilities. And all of those applications need multiple stages of compression with low pressure gathering and low-pressure gas coming out of a tight rock, which is the reservoir, the Permian Basin and the Eagle Ford. So it's -- the interesting part is for every molecule of gas that comes out of the ground has to be compressed multiple times over multiple stages of compression. So it just lends to an environment that us and everybody in our space, I think, is going to greatly benefit from being in this world and having to be -- have an enormous amount of demand for compression coming at us. And I think it is in a market that's vastly undersupplied and under invested in compression right now.

Your next question is coming from Jim Rollyson from Raymond James.

Mickey, kind of circling back to Neal's comment -- question in your commentary, how well aware are your customers of this? Just kind of how tight things are and how much tighter that might go because when you look at everything being essentially sold out today and the lead times for equipment, the capital discipline by you and your big peers, kind of seems like we have a long-term problem in terms of actually adding enough capacity quick enough to actually fulfill some of the LNG export capacity growth. So just kind of curious your perspective on the cap there and the sustainability of that, but really how freak out your customers are about this kind of challenge.

Well, I think that the realization is happening more and more, eyes are open and more and more every day about how tight the market is with not only us but with our peers in the industry right now. And that's why we have some of our core customers already coming to us right now for commitments for 2025-horsepower and commitments, so they can get their names kind of in the hat for the portion of the capital allocation that they'll have for even almost looking at potentially 18 months to 2 years out right now. So I think that the intellectual ones and the smart ones right now are looking and saying, look, we've got to plan our business potentially 2 years ahead of time right now. And to us, that's a great thing because it allows us to plan, it allows us to forecast, it allows us to do some things that we -- really have been a challenge in the past. So it's a -- it's an interesting dynamic right now. And really in an environment, I don't see getting less tight anytime soon because you don't see supply chain kind of tightness lifting anytime soon and shop space to get equipment built or engine deliveries or anything like that. So these customers are snap into the realization right now that they better plan well in advance to get in the queue.

Makes perfect sense. And then just circling back to the pricing question. Maybe another way to ask kind of what they're trying to get to if you look at the contracts you're pricing out now for later '24 or even '25. How much higher is that roughly than what you just averaged in the second quarter? Just as thinking about a bogey that you guys would be rolling over to assuming it didn't keep going up?

I'm not sure -- I don't know right off the top of my head exactly how much higher it is. as far as a percent of revenues or that kind of thing. What I can say is that we've got a capital return hurdle that we have put in place. And so for every dollar that we put in place that we deploy from a growth capital perspective, we have a return hurdle that we make sure that we can cover that threshold. And so at that point in time, if the dollars are higher and they buy less horsepower, we're still going to get the same return on those dollars when they come back to Kodiak.

Your next question is coming from [ Salman Aqeel ] from [indiscernible]

So just kind of going back to '25 briefly in your outlook there. I presume your conversations are still at higher prices relative to what you're seeing today as you discuss things with customers and setting those expectations.

Salman, yes, I mean -- right now, I mean if -- especially with the tightness in this market if we want to -- if somebody wants to get in the queue for that capital allocation well out into the future that we're going to have to set pricing to make sure that we can get the returns that -- returns on those dollars that we deploy.

Got it. And then in terms of just revenues for this quarter, you talked about sort of 3 drivers. You talked about the additional fleet, renewing contracts at higher prices. And then you also talked about inflation adjustments running through. So in terms of looking at the overall revenue, can you say which one was the largest contributor to the higher revenues?

Probably the new horsepower deployments, I would guess, would be the largest portion of that. I think that we've had some opportunities for some recontracting throughout the second quarter there. I'm not sure exactly what the distribution was there, but I'd probably say that was second and then the PPI adjustments was probably the smallest effector of the revenues.

Got it. And then just the last one for me. I know labor is tight for everybody. So I'm just kind of curious how that's going for you.

It's definitely it. I think that you see it in the market, especially in the Permian. It was one of the double-edged sword of being so heavily weighted towards the Permian is that we have to deal with the labor issue kind of for a larger part of our fleet than in the Permian Basin. But we're fighting that battle every day, and we're really making sure that we pay attention to our training and our mentoring within our operations group. And I think that somebody had brought up earlier kind of some lower margins there in the second quarter, which I think 50 basis points is pretty normal type of fluctuation. But we did make a concerted effort in the second quarter to really beef up our operations group and make sure because we recognize that there's a lower -- the ability to hire experienced personnel in the Permian Basin is less today than it ever has been. So we want to make sure that we're hiring enough people. We make sure we have enough people that are on board so we can spend more time training them and getting them up to speed and having them be successful contributors within the workforce as soon as possible and make sure they're doing that safely. So as kind of the ability to hire experienced personnel goes down, we need to kind of beef up that operating group and make sure that they have adequate time and resources to train that - those personnel to operate safely.

Your next question is coming from Theresa Chen from Barclays.

Mickey, I'd like to go back to some of your earlier comments about the lack of investment in compression and overall tightness in this part of the value chain. But do you think this will constrain feed gas growth and potentially delay the pace of liquefaction growth for projects that have already passed FID? And how do you think the market resolves this?

Theresa, it's good to talk to you. Thanks for joining us. It's going to be interesting. I think there's going to have to -- we talk about the LNG capacity. I think there's going to have to be a lot of movement of and optimization of compression horsepower within the United States. I mean you talked about other more conventional resource natural gas plays have to bring some of that horsepower to the Permian to be able to support that. But I think that you're going to end up having kind of winners and losers in the deal and the winners are going to be the ones that are willing to plan well in advance. And the losers are going to be the ones that get caught holding the bag at the last minute and not have the planned infrastructure in place to support their operating needs and that kind of thing. And I think you've heard rumblings about rigs being laid down and lower rig counts in the Permian Basin, and we haven't seen any of that manifests itself into demand for our compression services at all because you're seeing higher gas to oil ratios and that kind of thing. So I think that obviously, pipeline and takeaway capacity and processing capacity in the Permian, and it's going to be -- have to be able to feed that LNG capacity. So I think that it's going to continue to be a tight market. And the market will do what it has to do to make sure that there's adequate and compression. It may be that equipment is more highly utilized than it ever has been before, which we're seeing that trend today. So it's just a tight market. And I think that hopefully, there's not a massive shortfall in compression, but I think that the investment is going to be an under-invested market for the next several years for sure.

Understood. And maybe more near term, have your conversations with your producer customers then if they put together the 2024 CapEx budget? And what's your overall expectation for top line growth across the basins you operate in?

I think that what we're projecting for the next year, I mean, we haven't released official guidance yet. But if you kind of back into what we've done in our capital allocation strategy, right, of 60% to 65% of our discretionary cash flows going to growth capital. I think that high single digits kind of top line revenue and EBITDA growth is pretty reasonable to expect for 2024.

Understood. And lastly, if I can squeeze one more in. To your earlier comments about having 2 to 3x to more opportunities and capital that you're willing to spend. Is that within contract compression alone, your bread and butter? Or is that including more downstream opportunities as well?

That's the bread and butter with our existing customer base. That's not even going out and chasing new customers that we would even want to bring into the portfolio. That's just the existing customers that we deal with on a day-to-day basis for core contract compression opportunities.

Thank you. We reach the end of our question-and-answer session. I'd like to turn the floor back over to management for any further or closing comments.

Well, thanks, everybody, for joining us for our inaugural Kodiak quarterly earnings call. It's been a fun morning for us, and we look forward to updating you again in our November earnings call. Thanks for joining us. Bye.

Thank you. That does conclude today's teleconference and webcast. You may disconnect your line at this time, and have a wonderful day. We thank you for your participation today.