Good day, ladies and gentlemen, and welcome to the Enerflex third quarter 2018 results conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touch-tone telephone. As a reminder, this conference call may be recorded. I would now like to introduce your host for today's conference, Blair Goertzen, President and Chief Executive Officer. Please go ahead.
All right. Thank you, operator, and good morning, everyone, and thank you for joining us this morning. Here with me today is James Harbilas, Enerflex's Executive Vice President and Chief Financial Officer, as well as Marc Rossiter, Executive Vice President and Chief Operating Officer. During this call, James and I will be providing our financial results for the three months ended September 30th, 2018, a brief commentary on the performance of our three business segments, and a summary of our financial position. Approximately one hour following the completion of this call, a recording will be available on our website under the investor section. During this call, unless otherwise stated, we will be referring to the three months ended September 30th, 2018, compared to the same period of 2017. I will proceed on the basis that all of you have taken the opportunity to read yesterday's press release.
Enerflex's solid third quarter financial results were highlighted by record bookings and backlog, with continued strong inquiry and activity levels across the company. Bookings of CAD 629 million were driven by the USA and Canada segments, with the USA continuing to see significant activity across numerous resource basins for a variety of product offerings and Canada benefiting from an increase in midstream activity. Engineered Systems backlog has grown significantly and has exceeded CAD 1 billion, a first in the company's history. This backlog provides good visibility for Engineered Systems revenue throughout the remainder of 2018 and 2019. Enerflex continues to see opportunities to increase recurring revenue from our rental and service product offerings.
In the USA, the company has been focused on organically expanding the contract compression business, while internationally, recent successes with long-term Build-Own-Operate-Maintain projects in Latin America, as well as the newly awarded 10-year Build-Own-Operate-Maintain contract in the Middle East, are expected to generate revenue of approximately CAD 32 million-CAD 35 million per year over their 10-year terms. Looking to the regions. In the United States, with strengthening commodity prices and lower corporate taxes, the industry has experienced a surge in activity. Continued increases in production have resulted in significantly higher inquiry levels and bookings, which translates into strengthened financial performance for the overall organization. As we look forward, Enerflex remains focused on building on its successes for Engineered Systems products in various prolific liquid rich plays.
The company has seen strong demand for compression and processing equipment in the U.S. for over the past two years, and it's optimistic that continued demand should translate into additional meaningful opportunities going forward. The company continues to monitor egress issues in the Permian but has yet to see a slowdown in product inquiries related to the basin. Our optimism is reinforced by the anticipated resolution of Permian egress issues in the latter half of 2019 and increased activity in other U.S. basins where we are positioned to capitalize on opportunities. The acquisition of rental assets in 2017 added an established and growing platform, which contributed to increasing recurring revenues for this segment. During the quarter, Enerflex invested CAD 23 million in rental assets in the U.S.A., continuing the organic expansion of the U.S. rental fleet, which has grown 39% since the acquisition, totaling approximately 180,000 horsepower.
Enerflex remains focused on investing in these assets. As production in West Texas and other regions continues to expand, the company sees additional potential in this high-growth market. Rest of World delivered improved results across all product offerings, resulting in increased profitability. Opportunities remain strong in many of the regions covered by this segment. Looking specifically at the Middle East, this region continues to provide stable rental earnings with a fleet that consists of approximately 105,000 horsepower. We are seeing opportunities across this diverse region, including in Kuwait, Bahrain and Oman, as evidenced by the recent award of a 10-year Build-Own-Operate-Maintain project. In addition, the company is exploring new markets and opportunities in order to enhance recurring revenues. In Latin America, Enerflex remains optimistic about the outlook as customers recover from soft commodity prices.
The company believes there are near-term prospects within Argentina, Brazil, Bolivia, and Colombia. Mid to longer-term prospects in Mexico. In Argentina, Enerflex has completed significant projects in the Vaca Muerta shale play and believes further development opportunities exist in this formation as producers expand production. Enerflex is well positioned to capitalize on these opportunities. In Brazil, Enerflex was awarded a 10-year contract to provide a natural gas treatment facility, which will support our goal of increasing recurring revenues. During the first quarter of the year, the company booked an Engineered Systems project in Colombia and commenced operations on a previously awarded 10-year Build-Own-Operate-Maintain project.
As capital investments increase to develop Colombia's natural gas infrastructure, there will be further opportunities for Enerflex products and services. The company's positive outlook, backlog, and continued high inquiry levels, particularly in the U.S. and Rest of World segments, provide strong support for additional manufacturing capacity to meet demand in these segments. Given the current and anticipated future project requirements, the company is currently expanding the square footage of its Houston fabrication facility by 55%, approximately 100,000 square feet. This expansion is scheduled to be completed during the first quarter of 2019. In the Canadian region, the oil and natural gas industry remains somewhat constrained by oil differentials and egress issues. However, there has been increased activity in the midstream sector. This has been reflected in bookings in the quarter, which totaled CAD 201 million, driven by multiple project wins.
Despite recent progress in transportation issues and optimism for the liquefied natural gas project, there is still some uncertainty in the Canadian market. Given our backlog position, positive outlook for activity in 2019, and strong free cash flows, the board of directors has approved an increase in the quarterly dividend to CAD 0.105 per share, which is CAD 0.42 per share on an annualized basis. The new dividend represents an 11% increase and reiterates the company's commitment to returning capital to its shareholders. Enerflex has increased its dividend by 75% since reemerging as a public company in 2011. I will now turn it over to James Harbilas, our Chief Financial Officer, to review our financial results.
Thank you, Blair. Revenues of CAD 446 million for the quarter increased compared to the previous period due to improved results across all product lines, particularly Engineered Systems, which increased by CAD 109 million, driven by strength in the U.S.A. and Rest of World segments. Enerflex's service and rental product lines benefited from the company's focus on increasing recurring revenue streams and from higher activity levels. Consolidated gross margin for the quarter was CAD 89 million, compared to CAD 52 million as a result of increased revenues and improved gross margin percentage. Selling, General, and Administrative expenses were CAD 40 million, which were comparable to the prior period. Higher compensation costs and foreign exchange impacts, primarily in Argentina, were partially offset by cost recoveries related to the OCEP arbitration and lower third-party costs associated with this matter.
Higher compensation costs were the result of a larger workforce in the U.S.A. segment, mark-to-market impacts on share-based compensation, and increased profit share on improved operational results. EBIT for the quarter was CAD 56 million, driven by an increase in gross margin and the OCEP recovery, offset by lower gains on disposal of property, plant, and equipment. During the quarter, Enerflex generated net earnings from operations of CAD 38 million, or CAD 0.43 per share, compared to net earnings of CAD 25 million or CAD 0.28 per share in 2017. Adjusted EBITDA was CAD 65 million versus CAD 35 million in the prior year. The increase in adjusted EBITDA was largely driven by higher revenue and margins, as previously mentioned. During the quarter, Enerflex received a partial ruling related to the OCEP arbitration.
The tribunal awarded Enerflex the full final milestone payment, as well as variation claims relating to additional costs, delays in construction, and interest on the outstanding amounts totaling CAD 40 million. The positive impact on EBIT in the quarter was CAD 9 million. The allocation of costs and expenses of the proceedings will be the subject of a final round of submissions, and a separate final award by the tribunal is expected no later than January 31st, 2019. Moving on to our regional results. In the U.S.A. segment, Enerflex's bookings of CAD 361 million represented a significant increase of CAD 203 million, or 128%, when compared to the third quarter of 2017. We continue to see strong demand in this region for a variety of product offerings spread across numerous resource basins.
Backlog at the end of the period was CAD 719 million, which represents the highest level of backlog for this region. During the quarter, revenue in the U.S.A. was CAD 273 million. This increase of CAD 120 million was largely due to higher Engineered Systems revenue as a result of the realization of strong bookings in recent quarters and continued progress on some large projects. Service revenue saw an increase due to higher activity levels, while rental revenues improved as a result of the acquisition of the contract compression business and the organic growth of the fleet over the last half of 2017 and through 2018. Operating income of CAD 27 million for the third quarter was higher compared to the prior year due to improved Engineered Systems revenue and margin, as well as strong contributions from the service and rental product lines, partially offset by higher SG&A.
Increases in SG&A were driven by compensation costs on a larger workforce, mark-to-market impacts on share-based compensation, and increased profit share on improved operational results. In the Rest of World, the CAD 67 million of bookings relates to projects in the MENA region. This segment's bookings are typically larger in nature and, as a result, are less frequent. Backlog of CAD 102 million at September 30, 2018, decreased slightly relative to December 31, 2017, due to Engineered Systems revenue outpacing bookings in 2018. Revenue in the Rest of World segment for the third quarter was CAD 109 million. This increase of CAD 30 million was attributable to higher Engineered Systems and service revenues. Engineered Systems improved due to projects in MENA, while the increase in service revenues was the result of higher activity levels in Australia.
Rental revenue was consistent year-over-year, with slightly decreased utilization rates in Mexico being offset by rental revenues on the 10-year Build-Own-Operate-Maintain project in Colombia. Operating income of CAD 18 million represents a CAD 12 million increase over the same period of 2017. This improvement was the result of higher revenues and a reduction in SG&A costs, partially offset by lower project margins in MENA. The decrease in SG&A costs was largely driven by cost recoveries related to the OCEP arbitration and lower third-party costs associated with the arbitration, which was offset by some negative foreign exchange impacts in Argentina and higher compensation costs. In Canada, multiple project awards drove bookings of CAD 201 million, an increase of CAD 158 million compared to the same period in 2017. The Canadian market is seeing increased midstream activity, and the company continues to have healthy inquiry levels in this segment.
Revenue in Canada was CAD 64 million as compared to CAD 82 million in the third quarter of 2017. This decrease is primarily attributed to lower Engineered Systems revenue as a result of weaker bookings over previous quarters. Service revenues increased due to parts sales, while rental revenues decreased from the prior year due to lower associated equipment sales. Operating income increased by CAD 2 million due to lower SG&A costs driven by lower compensation on reduced headcount. The company continues to closely monitor SG&A costs in response to a challenging but improving Canadian business environment. Turning to the balance sheet, Enerflex continues to spend capital on rental equipment to expand the fleet in the U.S., which is consistent with our strategic objective of increasing recurring revenue. The company also remains diligent in managing working capital to retain flexibility to pursue opportunities.
In managing liquidity, the company has access to a significant portion of its bank facility for future drawings to meet the company's future growth targets. As at September 30th, 2018, the company held cash and cash equivalents of CAD 267 million and had drawn CAD 119 million against the bank facility, leaving it with access to CAD 593 million for future drawings. The company also repaid CAD 59 million of debt in the quarter. The company continues to meet its bank facility covenant requirements with a bank-adjusted net debt-to-EBITDA ratio of 0.7 to 1 and an interest coverage ratio of greater than 12 to 1. Demand for natural gas is growing globally, with sustained pricing gains, Enerflex is optimistic that customers will increase capital spending and production, translating into increased demand for Enerflex's products and services.
Bookings this quarter were the highest in the company's history, driven by strong market conditions in the USA and Rest of World segments and improved activity in Canada. Bidding activity for Engineered Systems remains strong across all regions, the company continues to see interest for rentals and Build-Own-Operate-Maintain solutions in the USA and Rest of World segments. Building off the success of adding assets which contributed to recurring revenues, the company remains committed to this strategy in 2018 and going forward. This completes the formal component of the webcast. Additional details can be found in our November 8th press release. We will now be happy to take any questions. Operator?
Thank you. Ladies and gentlemen, if you have a question at this time, please press the star followed by the number one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Once again, to ask a question, please press star and then one now. Our first question comes from Greg Colman from National Bank. Your line is open.
Hi, gentlemen. Congratulations on the strong quarter.
Thank you.
Wanted to start by taking a look at the backlog. Very strong. Great to see that. Can you give us a view as to the breakdown in the backlog between compression processing and deep cut activity versus the trailing 12 months of Engineered Systems revenue? Not looking for specifics necessarily, but trying to get a handle on the margin progression for Engineered Systems as the backlog turns into revenue.
Greg, it's James here. Obviously we started the year with our backlog kind of heavily weighted towards compression. We've seen that balance out as the year has progressed closer to an even split between compression and process equipment, and as a result, we've seen a stronger margin profile within the backlog. We would expect that to continue into Q4 of 2018 and obviously as we enter 2019.
Outside of the one deep cut facility that you announced earlier, has there been any more success on that side?
There continues to be opportunities and inquiries on deep cut facilities. None of the other ones that we're pursuing right now have been awarded at this point, but we continue to be very competitive in that product offering.
Got it. Okay. Looking specifically at Canada within the backlog, that's a pretty big number there. Is the current bookings rate in Canada sustainable, or should we think of Q3 as a bit of an outlier in customers wanting equipment all at once and they were sort of pulling forward development timelines?
We continue, and we've said this in the release and obviously reiterated on the conference call here, that we continue to see some very strong inquiry levels in Canada and predominantly driven by midstream activity and a lot of those projects have been publicly sanctioned from an FID standpoint. We do continue to see opportunities in the Canadian market that could result in very strong bookings in subsequent quarters.
Great. Just a little bit more on that backlog. In prior quarters, earlier this year and last year, we've seen some noise related to what I think are LSTK contracts. I've got two questions on that subject. First of all, was there any noise in this quarter on the EBITDA line regarding any contract execution issues? Secondly, how much in the backlog, either number of projects or dollar value, however you think about it, would be of these full service turnkey contracts that you've had in the past?
Sorry, before I answer the question, can you repeat that acronym that you used? Was it LSTK?
LSTK, Lump-Sum Turnkey contracts is how I've been thinking about it, but you could use a different one.
Yeah, we refer to them as integrated turnkey projects. I just want to make sure we were talking about the same thing. We did see a little bit of noise in the quarter, in the rest of the world segment. We wouldn't consider it material relative to what we've experienced in the past. It was about 150 basis points, roughly of margin erosion in that segment. In terms of the overall breakdown in the backlog, though, we don't typically break down our Engineered Systems segment into ITK. I can tell you that most of our projects and most of what's in the backlog comes from product only at this point, supply.
Okay, good to know. Then, just really quickly on some of the BOOM contracts, nice wins there. Just wondering what the competitive environment was like when you were awarded them. Should we expect sort of normal pricing and margins from these bids? Or when you were bidding for them, was the market either skewed towards a buyer's market with obviously lower margins because competitive pricing or seller's market with potentially higher margins as there was less supply available?
We considered it a balanced market, there was obviously the same competition that we see on these opportunities, they were competitively bid, we feel that the margin profile on these projects will be consistent to what we've executed on in the past with respect to these projects.
Great to hear. My last one here. Long term, you've talked in the past about a stated EBIT margin aspiration in the 10% range. In Q3, we saw 8.9%, obviously we're seeing Engineered Systems take a pretty big ramp with that huge backlog. How do you think about that target going into 2019 with this record Engineered Systems backlog, which typically we think of as lower margin compared to the recurring part of the business?
Internally, when we look at it, we feel pretty good about 2019 for a couple of reasons. Obviously that 10% margin that we've been marching towards, for the first time heading into a calendar year into 2019, we've got all of our regions very well positioned to experience growth year-over-year. Whereas the last three years, we've seen some very turbulent times in Canada had some up and downs. I think that we can march closer to that 10% goal in 2019 because we'll have strong activity in all of our regions. We've obviously got strong margins embedded in the backlog, we continue to see progress and contributions from our recurring revenue product lines, which are the highest EBIT margin businesses that we have within our footprint.
Got it. Well, that's it for me. Thanks very much.
Thank you.
Thank you. Again, ladies and gentlemen, to ask a question, please press star and then one now. Our next question comes from Jon Morrison from CIBC Capital Markets. Your line is open.
Morning, all. Congrats on the two BOOM contracts. How should we be thinking about them from a timing and commissioning perspective? How should we be thinking about both absolute capital outlay for those projects and what the spending profile will look like as you bring them on?
I'll start with the first part of your question, Jon. In terms of them being commissioned and completed, we expect that to happen in Q4 of 2019. Excuse me. Capital requirements are gonna be roughly for the two projects combined will be roughly CAD 60 million-CAD 65 million for the two BOOM projects combined. They will incorporate some idle equipment that we've got in the fleet that have come off rent in Mexico as well to be able to get them operational. In terms of contribution from a revenue standpoint, we would obviously expect that late in Q4 with an annualized contribution in 2020.
Okay. From a 2019 CapEx perspective, it's fair to assume that you're probably going to be CAD 100 million or a touch above that with the incremental expansion at Houston?
That's in the ballpark, yes. I just want to clarify though that the Houston expansion, we pretty much sold idle facilities and generated gross proceeds on the sale of those idle facilities in Wyoming and Alberta that will equal the capital outlay on the Houston expansion. From us, from a cash flow standpoint, it's net neutral. We're selling idle facilities and adding a facility that's going to be very busy in 2019 when it becomes operational. The CAD 100 million that you cited would be purely for expansion CapEx and the rental fee.
Okay, perfect. That's very helpful. How many other BOOM opportunities are you guys currently bidding on right now? Would it be meaningfully different that what you were bidding on 12 months ago, or did you just happen to win two of these fairly close together? I'm just trying to get a sense of whether it's indicative of things going right at one particular point in time, or is it indicative of an increasing market for BOOM type of contracts?
Yeah, Jon, there are a number more than we had a year ago. I would say that the inquiry in Rest of World . It is much better, probably over double where we were. Again, remembering that the gestation period on these are long and sometimes a year or two years in length. We don't see any of these coming to fruition after we get a phone call or we get from our market research in 30 days. This is six months or so, but we do expect 2019 to be more generous with us in terms of our win percentage than we were in 2017 or 2018.
Okay. Was there anything specific that drove the dividend increase that you did put through versus, say, a 5% bump or a 15% bump? Just trying to get a sense of how you calibrated the increase being the right number in the context of market conditions and what you guys see on the horizon.
Well, we've always said for the past seven years that we would ensure that the dividend is affordable and sustainable. As we looked at the past two years and our ability to maintain it, and we look forward the next three to five years and where we think the natural gas market is going globally, the 11% increase was certainly affordable and sustainable. While we have no formal plan around what that should look like, there's a lot of conversation about the plan, how we're working the plan. Is it going to generate the types of returns that are sustainable and recurring revenue? All that comes into our decision as management and vis-a-vis the board when we made the call. We're very comfortable in terms of the percentage of free cash flow, even in the near term as we build out and execute on our strategic plan.
Is it fair to say that a continued increase in the dividend over time takes priority over any sort of a share buyback or NCIB at this point?
Yeah, go ahead, James.
Yeah. That would be a fair conclusion, Jon. We think that for us, dividends and increasing that dividend is a great way to return capital to our shareholders, in addition to obviously investing our cash flow in organic growth opportunities and opportunistic M&As should it present itself.
Is pricing for Canadian service work largely holding in the context of the environment that we're in right now?
It is, actually, we're seeing improvement in some of the areas that have heated up. I would say that we're very proud of the way that the service business has executed on its budget and plan in 2018. Certainly it has, I think, even more opportunity in 2019 going forward.
James, Canadian margins were obviously strong in the quarter relative to what we've seen over the trailing history here. If you think about the bookings that you guys have in the backlog, the base of the product support business that Blair just talked about, and the fixed cost absorption overlaid against the delivery schedule that you guys are thinking about, is Q3 margins indicative of what we should see in the coming quarters, or should we be thinking about it as a bit of a high watermark?
No, I think that Q3 was obviously a very strong quarter in Canada from a margin standpoint. The backlog that you see now, we've said all along, is going to start to contribute meaningfully in Q1 of 2019 and then through the balance of 2019. We might take a little bit of a step back in Q4, but I would say that 5% and better is very achievable heading into 2019 given the backlog we have, the steps that we've taken to basically shrink all of the idle facilities that we've had in Canada over the years, and obviously the level set that we did on SG&A. I think that 5% is achievable in 2019, even higher if we do a great job of execution.
Just to follow on Greg's question, there's obviously been a decent amount of variability in U.S. margins, but you had talked about them grinding higher over time just from a product mix perspective. Is it fair to assume that anything that you added to the backlog in Q3 is again in line to perhaps additive to your margin profile?
Relative to where it was in Q3?
Relative to where you were going in, and that you wouldn't expect the product mix to become a drag in a few quarters or anything like that.
No, we would not expect the product mix to become a drag in a few quarters. If anything, we've seen a balance in the split between compression and process. We continue to see additions to the rental fleet. As those additions become operational and start contributing a full quarter's worth of revenue and EBIT margin, we would expect to see continued traction in that EBIT margin profile.
Last one, just from me. From a high-level perspective, were you guys surprised by the bookings that you had in the quarter? Would you say that your hit rate on bids was much higher than we've seen in the past? Essentially, what I'm trying to understand is, was the strong bookings really driven by, one, a lot of things just happening to get captured within the quarter from a timing perspective? Two, was it a function of things just all happening to go right? Three, is it really indicative of a much stronger environment and macro backdrop across a lot of the regions where you guys operate?
I think it's number three, Jon, certainly we weren't overly surprised given the bid pipeline in both Canada, the U.S., and Rest of World . If you look at, again, there are shorter time frames for awards in North America, typically where the majority of this backlog came from. Again, we reiterate what we've said in the press release and the MD&A is that these inquiries are still very much alive, especially here in Canada, on the type of work that they're looking for Enerflex to provide. These midstreamers where there are larger plants, we're still very much involved in our traditional compression and smaller gas plants, some of these midstream projects are larger projects. The competition is less, they've got material impacts on both bookings and backlog and an improvement in margin over time.
At the end of the day, we see this continuing on, it just really is a function that our win percentage hasn't really improved, but the volume of work has certainly increased over the two areas.
Sincerely appreciate the color. I'll turn it back.
Thanks, Jon.
Thanks, Jon.
Thank you. I am showing no further questions from the phone lines. I'd now like to turn the conference back to Blair Goertzen for any closing remarks.
All right. Thank you, operator. Since there are no further questions, I would once again like to thank everyone for joining us on this call, and we very much look forward to giving you our 2018 year-end results in February. Have a great weekend, and bye for now.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone have a wonderful day.