Enerflex Ltd. Q1 FY2024 earnings call

• Strong operational results across geographies and business lines in Q1. Energy Infrastructure and After-market Service are the foundation of financial performance. - U.S. contract compression fundamentals strong with fleet utilization >90% for two years. - International energy infrastructure has ~$1.5B go-forward revenue and payments under contract. - Expanded scope and extended term of a Build-Own-Operate-Maintain contract in Oman, now accounted as finance lease. - After-market Services benefiting from increased activity, price adjustments, and strong spare parts demand. - Engineered Systems had strong bookings, order backlog at $1.3B. - EH Cryo project in Middle East ~85% complete, but construction slower than expected, cost to complete increased by $105M, gross margin and adjusted EBITDA reduced by $41M. - Enerflex repaid $72M debt in Q1, leverage ratio 2.2 at end of March. - Focus on generating free cash flow, repaying debt, improving leverage, and lowering net finance costs.

The Energy Infrastructure and After-market Service business lines are the foundation of Enerflex’s financial performance, generating approximately 73% of gross margin before depreciation and amortization over the past 12 months. The Energy Infrastructure business line includes U.S. contract compression (fleet size ~424,000 horsepower, utilization >90% for two consecutive years, generating ~16% of gross margin before D&A over past 12 months) and international energy infrastructure (operates in 7 countries, ~1.5 million horsepower of compression over 25 natural gas processing plants and two treated water facilities, with ~$1.5 billion of go-forward revenue and payments under contract). The After-market Services segment is benefiting from increased activity levels, inflationary price adjustments, and strong demand for spare parts. The Engineered Systems product line had strong bookings, book-to-bill ratio above 1x during the quarter, with order backlog increasing to $1.3 billion at the end of Q1.

• Energy Infrastructure and After-market Services expected to account for 55%-65% of gross margin before D&A in 2024. - Majority of $1.3B Engineered Systems backlog expected to convert to revenue in next 12 months. - Disciplined capital program in 2024 with total expenditures $90M-$110M, including ~$70M maintenance and PP&E. - Committed to sustainable quarterly dividend, Board declared CAD$0.025 per share payable July 11, 2024. - Mexico court ruled in favor of Enerflex on employee severance pay dispute, matter returned to labor board.

• Delays and increased costs in EH Cryo project. - Security issues in Middle East affecting EH Cryo project, work suspended due to drone attack, no assurance security will improve. - Potential impact of weak natural gas prices on customer demand in North America affecting Engineered Systems.

Q: Good morning. Thanks for taking my questions. Marc, if I remember correctly, the Kurdistan project was sanctioned by Exterran prior to the acquisition. So I guess if appropriate, can you sort of walk us through how this project is different from other cryogenic projects that you'd perform internationally? And I guess, what can we expect from Enerflex on a go-forward basis for the product line?

A: Thanks, Aaron, for that question. In the prepared remarks, we mentioned that we booked six cryo projects in 2023 and two additional ones in Q1. Not a single one of those bookings include any construction risk or operations outside of Enerflex manufacturing facilities.

Q: Hey. Good morning. Just following up on Aaron's question there. What type of contract clauses you have in that Kurdistan project that might give you some protections around Force Majeure or give you some security around getting paid on the $147 million of unbilled contract asset?

A: Yes. Thanks, Tim. Good question. At this point in time, we're not in a position to go over the details of our contract with our customer. We are in Force Majeure, which is a defined thing within the contract. And while we're in Force Majeure we're going to be considering all the different steps we can take to protect the interest of Enerflex's people, Enerflex's shareholders going forward. But to give you much detail beyond that, I think it's premature to do so. But it's got 100% of management's attention, and despite it having our attention it's not going to distract us from focusing on our long-term strategic priorities of reducing debt, increasing free cash flow, prioritizing our infrastructure investments. That's what we're working on. Now we're going to be very proactive on this particular situation to make sure we do our very best to protect Enerflex' people and our financial interest long-term.

Q: Hi. Good morning. Marc, I just wanted to continue on that line of questioning relative to risks. Notwithstanding this project, more broadly can you just give us a bit more context on how you think that the overall free cash flow profile of the business is matched with the underlying risk profile of the business? Certainly, investors and the Street are looking for a lot more free cash flow to be generated by the business. And I think maybe some additional context of how risky is it going to be to get that cash flow, would be very helpful to frame out a little bit more. It sounds like this Peru project is more of a onetime thing. But can you just kind of run through some of the inputs to both the free cash flow and the risk side that might help get people a little bit more comfortable with where things are at.

A: Yes. Sure, Keith. Thanks for that question. There’s two main business lines that are going to generate free cash flow for our investors. The first one is our global EI business. And like I mentioned in the prepared remarks, 16% of the company’s gross margin comes from our U.S. contract compression fleet, which we think is a very low-risk asset base, and it’s been performing very well over the last two years. So that’s the first part. The second part of our EI business is the 1.5 million horsepower compression, the 25 gas plants and treated water facilities that today under contract of $1.5 billion in revenue under contract. And those are in, I would say, five core countries, where we have decades of experience and that we feel very comfortable about the security situation and the overall operational risk. We feel that they’re very much in the risk appetite of Enerflex and our shareholders. The Engineered Systems product line is the next big generator of cash. We’ve added to the backlog this quarter, and that backlog is the vast majority of that backlog is products that we will build within the four-wall confines of our shops in Tulsa and Houston and Calgary. So from a risk point of view, I think shareholders consider the vast majority of our free cash generation will come from these long-term 10-year take-or-pays in our core international jurisdictions, the U.S. contract compression fleet and our engineered systems business that’s executed in North America in our shops. In our investor – our new investor presentation on Slide 11, it gives a lot more detail around the tenure of our contracts, the margin of the contracts and our key counterparties. I think that slide should give investors a lot of confidence. And I think what can really give investors confidence is when you look at what we’ve done, the decisions we’ve made in the last couple of years, we prioritized shop-based engineered systems contracts with no construction risk. We prioritized capital investments in the United States and in Oman, two countries where we’ve got decades of experience, generating very good risk adjusted return. So I would say judges for what we’ve done in the last couple of years and what we’ve done is 100% oriented towards building a steady suite of assets and orders that provides very good risk-adjusted returns to our shareholders.

Q: Hi, Jamie. Thanks for the question. So on the delay side in Q1, we reassessed some of the activities, largely subcontractor related. We’re 85% done. We’re in the last 15% of construction and certain delays are – we’re trying to manage effectively, but we did realize those delays resulted in increased cost estimate. So in Q1 after a fair bit of discussion with our folks on the ground, we decided to increase our costs. And so the total increased cost to complete is now $105 million at the end of Q1 to completion and mainly due to subcontractor delays and issues on the – at the site level. So that’s the delays in cost. And overall, what we did, we took the imminent loss of $41 million at the end of the contract, when we increase the cost estimate, it produced a negative margin on the project. So we recognize that imminent loss to the end of the contract term. You’ll see in the financials. We have an asset on our books of $166 million, and that’s a receivable for the 85% of good quality work done. And there’s a provision of [indiscernible] million. The net asset is $147 million, underpinned by the work we’ve already created. So I don’t expect any other construction-related expenditures, so the $105 million estimate cost to complete is parked for now as we are in Force Majeure assessing all options. But the time in Q1 was a result of upgraded estimate of costs and the imminent loss. And that was our rationale for it.

Q: I just wanted to follow up and talk a little bit about the strong bookings in the quarter. Outside of the booking that would have been related to the IFRS 16 accounted finance lease. You had some pretty strong bookings in North America. Are you seeing continued momentum into Q2? Or was there anything that was sort of lumpy in nature in Q1 that won’t repeat?

A: On Q1, the conversion of that water project to an IFRS lease accounting had an impact on the bookings Also, we had two nice cryo plant orders out of our business in Broken Arrow. And I think that the – it’s difficult to say right now what we’re going to expect from Q2. But to a certain degree, we are seeing the very beginnings of some impacts of the lower gas price in some areas in the United States. Like I said earlier, Montney, Permian, liquids-rich plays activity is largely driven by oil. But I do think after almost two years of really busy activity on the Engineered System front in North America, we could see that slow down a little bit. It’s tough to say with exact certainty on that front.